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Published: June 8, 2010
The major credit ratings agencies continue
to be caught in the crossfire of finger pointing that has
occurred since the housing bubble burst and fanned the flames of
a major credit crisis in late 2008. There has been much talk of
increasing regulation of these firms, and very recently the
Senate passed reforms on the ratings firms as part of financial
services reform legislation.
But this is no reason for investors to stay away from the
ratings agencies. In fact, somewhat stringent regulations and
continued attacks on the ratings agencies could actually turn
out to be extremely positive for new investors. The
business model of the agencies should remain impressively
profitable. Additionally, negative sentiment has sent share
prices to very depressed levels that now easily account for any
downside risk to
cash flow and earnings.
The first thing to point out is that the ratings agencies did
indeed miss signs of the bubble. Recent testimony from the
Financial Crisis Inquiry Commission (FCIC) in Washington
detailed that more than 80% of the residential mortgage backed
securities (RMBS) rated "AAA" by Moody's (NYSE: MCO) in
2006 and 2007 were subsequently downgraded to junk status.
Furthermore, both Moody's and Standard and Poor's parent
McGraw Hill (NYSE: MHP) lost objectivity and provided
favorable ratings in their structured products groups to boost
growth and capitalize on the frenzy to issue mortgages.
After all, housing prices had never fallen dramatically in the
history of the United States, so how could they fall, even after
an +89% run-up in only seven years?
The problem with singling out the ratings agencies is that the
vast majority of market participants missed signs that housing
had become a bubble. The problem with bubbles is that they
eventually burst and it's never clear why or how, which is
precisely what John Kenneth Galbraith mused in his aptly-named
stock market bubble recollection, The Great Crash of 1929.
In other words, everyone was at fault, including homebuilders,
Fannie Mae,
Freddie Mac, and those who purchased homes under the
expectation that they could sell them a short time later for a
big profit. As such, laying a disproportionate amount of blame
on the ratings agencies just doesn't make sense.
At about 11 times earnings, shares of both
Moody's and McGraw Hill have taken a big hit and are now
undervalued. The multiple the market is placing on their
depressed earnings should eventually return to their averages of
closer to 15 times earnings. Better yet, earnings should
continue to recover as they have during the past year and the
shares could see +50% upside from current levels. With profit
growth going forward, investors should expect consistent share
price gains for many years to come.
McGraw Hill is the safer bet because it operates many businesses
not related to credit ratings or structured finance products.
Last year, its Standard & Poor's financial services segment
accounted for only 44% of sales, though it did make up 73% of
total operating profits. However, the credit markets portion of
financial services only made up 30% of total sales last year and
sales have already stabilized after an extremely challenging
2008. McGraw Hill also operates sizeable education and
information & media segments that continue to do just fine and
provide stability as S&P regains its footing.
Moody's has been hit harder than McGraw Hill because it is a
pure play on credit ratings and the related research and
analytical tools it provides for clients. Despite the near-term
challenges to its sales and business prospects, net margins
remain impressive at more than 23%. Overall, despite its current
woes, Moody's generates way more capital than it needs and buys
back large amounts of stock to further bolster earnings.
In recent testimony to the FCIC, legendary value investor Warren
Buffett defended the management team of Moody's and pointed out
that the entire public was duped during the greatest bubble he's
ever seen. In his words, very few people could have predicted
the housing bubble and the fantastic manner in which it burst.
Berkshire Hathaway's (NYSE: BRK-B) stake in Moody's has
suffered, but it continues to be the largest shareholder in the
company.
Action to Take -->
Investors can do a lot worse than following Buffett's lead.
Looking forward, shareholders in both McGraw Hill and Moody's
should immensely profit as business returns to normal and they
easily integrate new regulations into their operations.
-- Ryan Fuhrmann
Contributor
StreetAuthority |
