Much ado about nothing with Goldman Sachs trading code theft?
The news that the FBI arrested Sergey Aleynikov, a Goldman Sachs (GS) computer programmer, over the July 4 weekend quickly circled the financial world. Aleynikov is suspected of stealing the proprietary coding that drives Goldman's automated trading, with the intent to sell it or pass it along to his new employer -- a start-up hedge fund founded by former Citadel Investment employees.
Plenty of speculation as to whether the computer code leak spells the downfall of Goldman has taken place, except for one important forum -- the stock market. As of Tuesday close, the stock was down just two percent since Friday's close, with the S&P 500 off 1.5 percent in the same time. This hardly implies that market participants with money on the line think the alleged code theft is going to result in serious harm to profits. There are two particular things that make this response, or lack thereof, interesting.
First, Goldman's segment for "Trading and Principal Investments" typically makes up about 70 percent of non-interest revenues. Even though the program trading based on the allegedly-stolen code might only make up a fraction of those results, it's important to remember that a financial institution's main assets are intangibles -- their people and processes. Although the earnings streams of financial companies have become more complicated over time, the underlying idea remain the same, namely earning more on capital than the cost of capital.
Were Goldman (or any financial company) staffed by average employees, it would be reasonable to expect that the company would earn very average returns on its assets. Since there's nothing special about average returns, it would be difficult to justify paying more than 1x book value for the company. Goldman, though, trades at 1.5x book value of common equity. This premium amounts to about $22 billion in market value, and represents the excess earnings the market expects from Goldman because they are Goldman.
If Goldman's trading code suddenly became someone else's trading code, the competitive advantage would disappear -- as would some of the excess earnings and premium market valuation. But that hasn't happened yet, and it raises the second point: the market has come a long way to solidifying its faith in certain financial companies.
As a matter of perspective, think back just a few months to earlier this year, when the conventional wisdom was that pretty much the financial sector would be nationalized because they were insolvent and had no earnings power. Goldman stock, for instance, was trading below $60, compared to the present price around $140. Fast forward, and a direct contributor to Goldman's profitability can be stolen from them and possibly transmitted to rivals, and the markets shrug it off. Is it a sign of complacency from a newly bullish investment community, or a sign that the code theft saga -- as interesting as it might be -- is really a non-event?
James Cullen also edits and writes at CollegeAnalysts.com. He is the Vice-President of the Boston College Investment Club, which owns GS, but has no personal position in the stocks mentioned above.