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Moody’s and S&P as Investments

June 05, 2007 | About:
Joe Citarrella

Joe Citarrella

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Every investor is familiar with Moody’s and Standard & Poor’s credit ratings, which constantly distill information into simple and easy to understand analyses of thousands of companies and governments. But what’s interesting to me is that Moody’s and McGraw-Hill (the company which owns S&P) are themselves spectacular companies, perhaps fittingly. After all, it would be ironic for Moody’s to have to rate itself a Caa1 or something.

I’ve done a bit of research on the two companies over the past week. The big picture is not hard to see — both companies are dominant franchises in the credit rating business, each with around 40% market share. The competitive advantages are easy to spot. Investors seek a reputable source for information as important as the creditworthiness of an investment, and, as such, firms have an effective mandate to pay the rating fees for coverage. In a sense, to “signal” the creditworthiness and financial standing of the company and, thereby, lower their cost of capital.

Because both companies are so heavily entrenched in the capital markets, investors and firms alike are willing to pay up for ratings. Ratings firms do not, then, compete on price. Rather, they compete on quality, reputation, flexibility in product coverage, and geographic extent — indeed, the fact that both firms cover companies all over the world provides a common metric for any investment, and confers yet another competitive advantage over would-be entrants to the field who would have to play catch up. Both firms sport high margins and the benefit of pricing power (the best hedge against inflation, might I add).

And what’s more interesting are the tailwinds enjoyed in this essential duopoly. Worldwide capital markets are growing at a tremendous clip (with issues up over 23% compounded in the past five years) and become increasingly complex. Emerging markets continue to emerge and grow and more established markets increase their activity. The complexity, despite its connotation, is a good thing for the ratings firms. With the growth of complex issues like structured products, investors are even more sensitive to the need to have a trusted rating from a reputable source. Because S&P and Moody’s can provide this, they stand to reap the rewards of complexification.

Okay, so I just made up the word “complexification.” But I didn’t make up disintermediation (go ahead and Google it). That term refers to another tailwind involving the more and more popular trend of companies skipping the middle man investment bank and going it alone to raise capital. This is a good thing for Moody’s and S&P since those actually providing the capital will place a heavier emphasis on an independent rating given that an established bank has not underwritten the deal.

Moody’s, S&P (McGraw-Hill): Great companies. Emerging markets, disintermediation, complexification. Good things for great companies. But how about the price(s)?

Well, Moody’s, for instance, generates strong free cash flow with very little capital expenditures given that it is not capital intensive, and trades at PE around 25. Given that one may consider it a growth company, this is actually probably a reasonable price to pay. My own DCF puts the shares anywhere between $65 and $90, and that range is arguably conservative. For a great company with durable competitive advantages in a growing industry, that’s not too shabby.

About the author:

Joe Citarrella
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.3/5 (9 votes)

Comments

armeetofo
Armeetofo - 7 years ago
I like both of them, there are only 3 rating companies, the 3rd is Fitch, i got both, i like to own Fitch if i can find it to buy, let me know if any one has more informatioms, thanks
raccoonjohnny
Raccoonjohnny - 7 years ago
Moody's much superior vrs MHP on just about all metrics includind ROA,ROE,operating and net margins. Also very low capex and a whopping share buyback. Moddy's wins this race hands down! Looks to be a great price at $46.
harison
Harison - 7 years ago
I just don't get why everyone is so ready to jump right in to Moody's. This is a falling knife that is really sharp. The stock hasn't been downgraded since February, analysts are too positive. Structured finance has accounted for such a huge portion of their earnings over the past 3 years, virtually all of that is going away. And who knows what legal risk Moody's might face. Yes we can comfort ourselves by saying that they are protected by the first ammendment, but some some powerful people(including the government apparently) are coming after them, do you know if there defense is airtight? Are you getting a margin of safety by paying 15x inflated trailing earnings, I don't think so. I know everyone thinks long-term this could be a good play, and I don't necessarily disagree, but like Bill Miller said if you're too early it looks a lot like being wrong. It is probably still too early for MCO. Let everyone one throw in the towel first.
DaveinHackensack
DaveinHackensack - 7 years ago
I think Harison's caution makes sense. Moody's and S&P appear to have dropped the ball again with their ratings of sub prime-backed securities. The current model of credit rating agencies getting paid by the issuers of the securities they rate is ripe for revolution. What's to stop a new a consortium of institutional buyers (pension funds, etc.) from forming their own rating agency which, since it wouldn't take any money from securities issuers, would have more credibility than Moody's & S&P?
armeetofo
Armeetofo - 7 years ago
thanks, everyone, negative or postive, i'll swallow it,

again i own both of them, i don't mind to stick with them to bankruptcy or 10 folds gain in the future,

only time will tell,

btw, i'll buy more and more when i'm ready.
armeetofo
Armeetofo - 7 years ago
i've to say mr. market and mr. gov't are my good business partners which offer me very good prices once in a while. i can't miss them.

thanks a lot.

mr. maket belong to ben, mr. gov't is mine, concept, it is trademark! ha ha ha ha.....
billytickets
Billytickets - 7 years ago
No offense to all my friends in here but whats gonna be KEY for this stock is IF WEB added to his position DURING this time frame?( provided he is allowed to).Does anyone know if he can? Is this imagined risk or real Risk?

Personally I am not able to tell.just my 2cents
armeetofo
Armeetofo - 7 years ago
billytickets Wrote:

-------------------------------------------------------

> No offense to all my friends in here but whats

> gonna be KEY for this stock is IF WEB added to his

> position DURING this time frame?( provided he is

> allowed to).Does anyone know if he can?

i don't know whether he can or can't, i don't think it is important either.


Is this

> imagined risk or real Risk?

both?!

>

> Personally I am not able to tell.just my 2cents

i can't help you.

everyone's outlook is much different from each other.

happy investing,


armeetofo
Armeetofo - 7 years ago
look at warren's filters:

Filter #1 – Can we understand the business?

Filter #2 – Does the business have a durable competitive advantage?

Filter #3 – Does it have management I can trust?

Filter #4 – Does the price make sense?



then you'll get the right answer from them.

hope it'll be of help.

happy investing, guys.
armeetofo
Armeetofo - 7 years ago
filter #5: i like the stock the people are angry at.
armeetofo
Armeetofo - 7 years ago
i bought some MCO today, MHP will be my next buy, happy investing, guys!!!
armeetofo
Armeetofo - 7 years ago
it seems to be my MCO and MHP holdings had a nice day, not bad uh?

never mind, it is one of those days.

happy investing, guys.
billytickets
Billytickets - 7 years ago
Kudos my friend to the Victors goes the spoils
armeetofo
Armeetofo - 7 years ago
billy: thanks a lot and happy investing.

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