A Compelling Case for Investing in the Ratings Agencies

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.