The ratings agencies have taken their fair share of abuse from Congress, media outlets as well as SeekingAlpha’s contributors. Todd Sullivan, Money Morning, Tom Brown are just a few of the contributors who have taken their shots against the controversial trio of Standard & Poor’s (MHP), Moody’s (NYSE:MCO) and Fitch Ratings. Add another one to that list. These companies have destroyed the meaning of their very own ratings. They have played a crucial role in redefining how investors view the risk of assets. MHP and MCO shares, however, have held up reasonably well to the financial sector (NYSEARCA:XLF).
Since the start of 2009, ratings agency shares have even begun to outperform the sector. Meanwhile, monoline insurers and many toxic asset holders like investment banks have seen 90%+ declines in market value over the past two years. Shares of the agencies have not yet taken the beating that they deserve. Shorting the shares outright is going against major institutional grain. As of 2008 year end, Berkshire Hathaway (NYSE:BRK.A) owns 20% of MCO and T. Rowe Price holds just over 10% of MHP. Yet, after simply examining the operating segments of these two major public companies in the credit rating business, one can see that they’re not quite equals. Moody’s operating segments are all financial related while Standard & Poor’s is only one, though by far the most profitable, of three divisions within parent company McGraw-Hill.
McGraw-Hill is more than just a financial company. The company generated $3.6B of revenue in non-financial businesses in 2008. These education and media businesses, however, have far lower profit margins than its financial segment. Information and media, unlike education and financial services, saw revenue growth from 2007 to 2008. Certainly, the non-financial segments of McGraw-Hill have positive value in addition to providing a bit more business diversification than its counterpart Moody’s. When strictly comparing the operating income of S&P and Moody’s in relation to the market value of the latter (as of market close on March, 20th 2009), these two segments of McGraw-Hill appear to be worthless.
Rather than risk a pure short position on MHP/MCO, this back of the envelope, sum of the parts valuation supports a long MHP/short MCO pair trade. Plus, there’s a bit more cushion from the fact that MHP’s 4.8% dividend yield is substantially higher than MCO’s 2.1%. There are no perfect peers for valuation in this manner and peer companies certainly need to have positive operating income for this methodology to apply properly. If Moody’s is considered to be slightly stronger in credit and S&P is a bit more diversified in its financial service lines, then even these two may be valued differently. I don’t believe that difference, given the extremely high correlation between the two stocks, is strong enough to produce such a large gap in present market valuation.
Disclosure: The author does not hold any positions in any of the mentioned securities at the time of this writing.