McGraw-Hill Is Still a Good Buy Despite S&P Lawsuit

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Despite the recent lawsuit filed by the Justice Department against McGraw-Hill (NYSE: MHFI) and Standard & Poor’s, which alleges the company knowingly issued inflated positive ratings to mortgage securities and lenders from September 2004 to October 2007, it’s unlikely that the outcome of the suit will negatively impact the long-term stability of the company or the ratings industry as a whole.

Both McGraw-Hill and Moody’s (NYSE: MCO) stock prices have already dropped as investors learned of the suit last week, apparently amid fears of billions of dollars in fines and restitution coupled with the potential for an endless stream of subsequent lawsuits. While the short-term outlook for the world’s largest ratings companies may appear bleak, these stocks still have a place in portfolios with time horizons beyond the next few years.

It’s no secret that the public has a long-term memory deficiency when it comes to corporate scandals, or any scandal for that matter. The case against McGraw-Hill will, like the countless charges that have been filed over the years against other companies for various egregious or negligent actions, fade into the background. The public eye will soon be focused on the next CEO screw up, the politician’s extramarital affair or some other Wall Street mashup of The Young & The Restless.

However, the public’s insatiable thirst for new gossip is not the only reason that McGraw-Hill will survive the DOJ’s lawsuit. The company’s financials are strong, so even if the case isn’t settled for a lesser amount and the court orders McGraw-Hill to pay the proposed $5 billion fine, it’s unlikely that the penalty will be little more than collateral damage. Business will continue, and the mortgage ratings scandal will become a mere hiccup on the timeline of the company’s century-long history. Even in the face of the government's fraud lawsuit, and the subsequent 25% decline in share price, the company still reported earnings per share expectations for 2013 to range from $3.10 to $3.20. 

There’s also the possibility that this case could be settled for a lesser amount, or dragged through the legal process at such a snail’s pace that by the time any money is actually due from the defendant, necessary preparations will have already been completed to adequately protect the company’s balance sheet. Undoubtedly, Moody's is already engaging in similar economic shuffling to prepare for their own battle with the Justice Department. 

Aside from the general public’s short-term supermarket tabloid mentality, plus the billions of dollars in cash and market capitalization possessed by the ratings companies, the simple fact that Standard & Poor’s and Moody’s, and to a lesser extent, Fitch, have a monopoly on the ratings industry will assure their continued existence regardless of the outcome of the Justice Department’s fraud lawsuit. Over 96% of ratings are issued by these three companies, and the immense obstacles a smaller competitor would have to overcome to gain SEC approval before selling similar ratings make it highly unlikely that S&P or Moody’s will ever be replaced. 

Gambone has no position in any stocks mentioned. The Motley Fool recommends Moody's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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