Risks for Market Darlings, Moody’s and S&P Global

Moody's (NYSE: MCO) and S&P Global (NYSE: SPGI) rarely trade cheap. The market values their royalty-like business models, but there are a few things that could send their businesses, and thus their stock prices, off the rails.

From government tax policy to the emergence of competitors -- Morningstar has tried to enter the bond ratings business -- these businesses aren't without their risks. At current prices, shares of the bond ratings agencies assume that the business can only get better from here.

In this segment of Industry Focus: Financials, join host Gaby Lapera and Jordan Wathen as they discuss the ways in which these top-performing stocks could get knocked off their thrones.

A full transcript follows the video.

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This video was recorded on June 26, 2017.

Gaby Lapera: Another thing to think about is government tax policy, right?

Jordan Wathen: Yeah. There's been some talk in D.C. about eliminating the ability of companies to deduct interest as an expense on their taxes. I don't know if this will happen. Supposedly the GOP is going to come up with a proposal by September. They've talked about it, but companies last year, The Wall Street Journal said, they quoted I think it was $1.3 trillion in interest expense last year. If, for some reason, interest is no longer a tax-deductible expense, obviously that makes issuing debt much less attractive, too. So, that may be a long-term hurdle if it happens. I don't want to get into trying to predict what happens in D.C., but it's obviously a factor.

Lapera: Yeah, it's a bad business trying to predict what's going to happen here. [laughs] Sorry, that long-suffering chuckle is the sound of someone who's lived in this area for 28 years. Another potential threat, as is a threat in any industry, is that there's a potential for new entrants to enter the field. I don't think this one is a particularly big deal either, because if you think about how brand recognition plays such a huge role in soda, imagine how much brand recognition is important when you think about people who are in charge of saying whether a company is credit worthy or not.

Wathen: Right, that's a really good point. You have to look at it through the lens of someone who's using their ratings to make a decision. If you're an investment analyst, for example, and you work at a bond fund, and you say, "We should buy this bond because Jo Schmo's credit rating agency rates it AAA," there's some job risk there. If you come to it and say, "Moody's didn't see it and Fitch didn't see it and S&P didn't see it, so of course, they rated it AAA and I still bought it," you might actually keep your job. I think the brand value is important. But to the extent that maybe some smaller agencies pick off some of the more valuable business, it might happen, but it hasn't happened. So, I always like to ask the question: If it hasn't happened yet, will it happen? I don't know. I think, to some extent, the rise of index funds has made it a lot harder for the smaller shops to gain traction.

Lapera: Yeah. I think the smaller CRAs had their opportunity post-financial crisis when people were really questioning especially Moody's, because they played a role in rating some of these securities and bonds that companies had been selling with the housing bundles in them as better than they actually were. And both S&P and Moody's, ended up paying huge fines. If I recall, Moody's was around $850 million, and I think S&P paid...$1.5 billion?

Wathen: Yeah, it was a lot of money. And it's still coming through today. I think they've just finally in 2017 put most of this behind them. But we'll see. And that's a risk, too. That's worth mentioning. If these companies miss the mark again, there's going to be fines, and it opens the field for competition, if it's going to happen.

Lapera: If it's going to happen. Which, like I said, the smaller rating agencies had a chance earlier in 2008, but they didn't really take off, so who knows if it would really make a difference in the future. But, that would be a second strike, so who knows. That's one of those things with investing, it's looking into your crystal ball, and there's just clouds. We're just not very good clairvoyants here.

Wathen: It's hard to say. When you invest in a credit rating agency today, if you look at the multiples they're trading for, it's 25 times or more earnings. So, your return is not going to come from the current environment. It has to come from the, basically, assumption that they're going to do more business in the future. Your return is going to come primarily from growth. So, the question is, does that come through pricing? Does it come through volume of debt issued? Where does it come from? You basically priced in no downside, you haven't priced in many risks to the downsides. So, you need these things to work out really well.

Gaby Lapera has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Moody's. The Motley Fool has a disclosure policy.