Tuesday, July 17, 2012

Wall Street Firms Only for Employees?

So I keep hearing people say that Wall Street firms exist only for their employees.  One guy on Bloomberg TV said that GS only exists for it's employees; why not get that compensation down and return some of it to shareholders? 

As proof that GS exists only for the employees, he states that compensation is 40-50% of net revenues.

OK, so let's think about this for a second.  Is it really true that GS only exists for employees?  If someone started a business only for the benefit of the employees, can it really exist for a long time?  I tend to doubt that.  We have heard so much how awful GS is despite the "muppet" story and Fabulous Fab etc.  Are people really that stupid and irrational to keep doing business with these awful people?  Or does GS actually provide a service that people want to pay for?

Compensation Ratio
Anyway, first of all let's think about this 40-50% compensation expense ratio.  Banking is a service business and it makes sense that much of the expense in a service business is labor cost.  Unfortunately, there isn't much detail in financial disclosures to calculate labor costs in various industries.

One industry where labor cost is disclosed is the restaurant business, which is a service business.  McDonald's has a breakdown of costs for their owned restaurants.    From that we see that owned restaurant labor costs as a percentage of restaurant sales is 25%.  But wait a minute; banks and investment banks report revenues as "net" revenues, net of interest expense which is basically their cost of goods sold.

So let's look at labor costs at McDonalds as a percentage of "net" revenues (revenues less cost of food and paper).  That comes to 38%.

So 38% of McDonalds restaurant sales (net of cost of goods sold) go to payroll and benefits.  McDonalds, too, then exist only for their employees?  By this definition, yes.  McDonalds restaurants only exist for the employees.

How about another restaurant?  Darden Restaurants is a large chain restaurant.  I am not cherry-picking any names here; that's the first one that came to mind that seems like a 'typical' chain restaurant (that runs "owned" restaurants versus franchises them which have different economics).

Labor costs at Darden is 32% of sales.  If you exclude cost of goods sold, then labor costs is 45% of "net" sales.  So I suppose Darden restaurants too only exist for their employees according to this person that is complaining that GS only exists for their employees.

How about another one?  I remember Dimon mentioning newspapers when he commented on this issue. 

Again, I am not picking names that make my point.  The first pure play newspaper that comes to mind is the New York Times.  Wages and benefits at NYT in 2011 were 37% of total revenues.  That's 37%.  Yup.  New York Times too exist only for their employees.

How does this 37% compare to the evil banks?

Compensation and benefits expense as a percentage of net revenues for the three financial firms I mention often here are:

GS:        42%
JPM:      30%
WFC:    34%

These are all figures for the full year 2011.

OK, so maybe I am reaching here a little bit.  Fine.  

Let's look at this another way then.

People keep saying that GS (and other investment banks and banks) exist only for their employees but let's look at shareholders.

I already mentioned how great JPM has done for shareholders throughout the crisis.  You can see growth in tangible book and book value per share over time, plus JPM pays a nice dividend even now.

Here's the post on the JPM 2Q.

It looks to me like JPM is doing fine for shareholders. 

GS No Good For Shareholders?
OK, fine you say.  JPM has a lower compensation ratio than even the New York Times.  And they have done well for shareholders over time (management can't control stock price so you have to look at ROE, growth in BPS etc...).

Let's see how the poor GS shareholder has done (I'm just cutting and pasting here from an old post):

  • The average ROE from 2001-2011 is 17.2%, and for the last five years it's been 15.1%.

That looks good to me.  How many companies have achieved that?  I'm sure New York Times shareholders would love performance like that!

BPS for some key years were:
                   2006       2007      2011
BPS           $72.62     $90.43   $130.31
TBPS         $61.47     $78.88   $119.72
  • Since the peak in 2007, GS grew BPS by +9.6%/year and tangible BPS by +11%/year.
  • For five years, the respective growth rates were +12.4%/year and +14.3%/year.
  • For the past decade, 2001-2011, BPS grew +13.6%/year.

That looks pretty impressive to me.  How many companies have achieved something like this, especially after all that has happened in the past decade?

Anyway, it doesn't really matter what people say but when people keep saying something over and over without looking at the facts, it gets a little annoying and I can't NOT point it out.  It's a little disappointing that so many reporters and commentators have been in the business for many, many years and still don't seem to check the simple facts before commenting.   There are a lot of people saying a lot of things all the time and a lot of it has no basis in fact!    Beware of these people.


  1. Not that I disagree but as a counter how about Einhorn's VIC speech on Nov. 2006 at least for Goldman - http://manualofideas.com/files/blog/einhornspeech200611.pdf

    1. Good article, as usual. I like Einhorn, but I tend to disagree a little with that. I actually think the fee + b/s model is actually good. The reason why investment banks when managed well tend to have great ROE's over time compared to say, the returns of hedge funds, is precisely because they have fee income that helps stabilize the business.

      This was the secret to why John Merriwether at Salomon was able to make so much money while he couldn't do it (or blew up) as an independent hedge fund (where he had no access to the steady stream of fee income that can be used to offset bad times in his mark-to-market portfolio).

      This is true in many cases. Actually, my next blog post might be why GS ROE is so bad and JPM's so good right now. Is JPM's investment bank so much better than GS's? I think it's because of the diversity of the JPM business model that allows it. But that cuts both ways. I am still not sure I will make a post about it or not, but we'll see.

      In any case, he is right that maybe the b/s usage of investment banks dilute the high ROE nature of the advisory business, but the advisory fee income stream can be highly volatile too (just look at the listed independent advisory firms). This is why they are getting into asset management to smooth out that boom-bust cycle of fees.

      In any case, as proof of how good the IB business model is when done right is just look at the book value growth of GS or JPM in the last few years and compare that to the growth in the S&P 500 index. It says something when they can outdo the S&P in this kind of environment.

      Also, the fact that 50% of the revenues goes to employees doesn't really matter; if you look at ROE and growth in book, that already accounts for the high cost of employees.

      And besides, employee/labor is obviously the big cost factor in this business.

      You can say the same about your accountant or lawyer. Those companies aren't listed, but I bet that a high percentage of the costs of those law firms/accounting firms are labor costs. Sure, they use no balance sheet so ROE might also be high.

      Anyway, it's an interesting topic.

      I don't mind disagreeing with people I highly respect. Charlie Munger, who is a hero of mine too, put out a really disparaging article about Wall Street. He hates just about everything about it.

      And I understand his viewpoint, and I respectfully disagree and that's totally fine.

      There are so many amazing, brilliant minds with vastly divergent views so I don't worry about being on the other side of these geniuses. I can only say what I think and believe. (and nobody is going to agree with anyone on every single issue).

      Anyway, interesting topic, thanks for posting!

    2. Oops, also forgot to mention; Einhorn talks about the 50% compensation ratio as being more egregious than the hedge fund model (20% incentive), but again, if you look at book vaue growth (plus dividends), that is already *after* the compensation expense.

      So yes, a 2%/20% fee structure looks better than a 50% comp ratio, but if you look at hedge fund returns, many of them are 10-15% return *gross* (before fees). Yes, some have done 15-20% over time net of all fees.

      So to be fair, you have to look at it that way; what is the total return after fees (or compensation expense in the case of banks) over time?

      And my point is that GS, JPM, WFC have done really well in that regard.