Are the Ratings Agencies Pointless?

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The ratings agencies have had their reputations damaged in recent years and I confess I have a certain amount of sympathy for them. They get pilloried and lambasted by the finance industry who has found someone to conveniently blame for their idiotic investment decisions during the sub-prime debacle. On the other hand, they get little credit when their work turns out to be accurate.  Every profitable investment decision is, of course, the sole creation of the investment professional looking at it. Let me be clear, I am not saying they didn’t make mistakes, they did, but they are not responsible for pushing buttons at trading desks.

With that said I thought it would be interesting to look back at what stocks Standard & Poor’s had on positive and negative outlook and see how they performed in terms of stock performance. I know they are analyzing the debt situation so they really should be judged on that basis but, like I said, this is a bit of fun.

 

The Results are in!

I went back to the start of the year to see what S&P had on positive and negative outlook and then tabulated performance. I’ve tried to be fair and pick a random sample of 16 stocks each and matched them up in terms of sector.

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Unfortunately the ‘negative outlook’ stocks have outperformed the ‘positive outlook’ stocks although both underperformed the S&P 500 which is up 13.2% in the comparable period. This doesn’t speak volumes for using S&P ratings to pick stocks!. I happen to think that it is a useful analysis because bond outlooks usually reflect the same factors that equities do.

Now before readers start preparing hate letters to Standard & Poor’s, I want to discuss some of the stocks here and give some opinions as to what is going on.

 

Negative Outlooks

Frankly I can understand the call on R.R. Donnelley (NASDAQ: RRD). The stock's debt dwarfs the market cap and there is little growth in the business whilst plenty of downside risk. Printing always will be a highly cyclical activity. When the going is good the presses are rolling but when it’s bad the printers are lumbered with underutilized capacity. Moreover there is a huge secular challenge for traditional printers as more and more media moves online. It’s hard to see what it can do about it. The yield is huge but will it be paid?

I can understand the negative call on United Technologies (probably due to defense cutbacks) but Abbott Labs is quite puzzling, it’s one of the stronger health care names out there.  Elsewhere, I was surprised to see Walgreen (NYSE: WAG) on negative outlook. Okay nobody liked the Express Scripts deal but its debt is not huge in relation to its cash flow and the business is not going bust anytime soon. Despite believing that it will be tough to get back as many customers as it hopes, I think the stock is cheap and the sector has plenty of upside catalysts.

 

Positive Outlooks

I don’t get the positive call on Advanced Micro Devices (NYSE: AMD). This is a business with declining earnings and revenues which is a distant second to Intel in many markets. In addition the semiconductor market is cyclical and while most industry commentators were predicting an upturn this year (which didn’t happen) this is not an industry with a huge amount of earnings visibility and AMD is not even a strong player in it.

I like Roper Industries (NYSE: ROP) and think it deserves a positive outlook. The company is acquisitive and in consequence usually has some debt, but it is seeing gross margin expansion in its mix of niche markets. Cash flow generation is very strong and it is a leading player on all of its end markets.  Margins are high and return on equity is usually good so this is not a business that typically has high maintenance capex requirements.

Coca-Cola and United Health Group were good judgments but I think the call on Oracle (NYSE: ORCL) was a good one that might not have resonated with many at the time. The company has a significant amount of cash on the balance sheet, but going into the New Year it had given a nasty trading statement and was faced with the obvious need to make acquisitions to buy itself into the cloud space and fight back against SAP. It wasn’t obvious in January that Oracle would have such a good year and S&P deserves some credit.

 

The Bottom Line

Overall this analysis did not produce a good performance and it suggests that S&P are no better than most at predicting end markets. Don't rely on the ratings agencies to make your investment decisions!

The other point that keeps going through my head is that it is fine to value an asset, but in the end it is the underlying direction in the trend of that asset that truly matters. Investors may think it is all a matter of just buying low valuations and selling high, but actually they need to be aware of the basis on which that valuation lies. For example, Spain and Ireland used to think they had solid debt situations and strong banking sectors thanks to their booming housing markets. Enough said.

 

 


SaintGermain has a position in Roper Industries. The Motley Fool owns shares of Oracle. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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