A great company at a fair price
Rating agency Moody’s is a quality business and together with Standard & Poor’s it dominates the credit ratings market with a combined market share of more than 80%. What’s not to like?
ratingagencies are an essential component of capital markets and in our view offer a compelling way of gaining exposure to the financial services sector. Moody’s, which we believe to be one of the great quality businesses of the world – is one of the top 10 holdings in the Investec Global Franchise portfolio.
The market for credit ratings is a duopoly, dominated by Moody’s and Standard & Poor’s (S&P) (they have a combined market share in excess of 80%, with Fitch a distant third at around 18% market share). This economic moat means that barriers to entry are extremely high – the brand and network effect confer a competitive advantage to the incumbent agencies that is insurmountable barring a structural change to the financial system or government or regulatory intervention in the credit rating market.
Moody’s earns fees from issuers of debt, but also houses an analytics business, which has a number of revenue streams including the sale of credit research and enterprise risk consulting to the financial sector. Approximately half of the company’s credit rating-related revenue is generated on debt issuance and half from frequent issuer programmes. Moody’s has phenomenal pricing power when it comes to credit ratings since the cost saving from a Moody’s rating on financing costs to an issuer is well below the cost of a rating, on average 40 basis points versus 5 basis points. It is therefore in the issuers’ best interest to seek a rating.
By far the biggest potential detractor from the investment case would be the volatility of debt issuance, on which 50% of ratings revenue relies. Issuance tends to dry up during a credit contraction and it can be difficult to gauge where one is in the cycle, which makes “normalised” earnings tough to judge. However, we believe there are structural tailwinds for debt issuance. In Europe, bonds have been rising as a proportion of corporate debt and debt capital markets are expected to continue growing well above total credit growth.
The other risk to the investment case relates to regulation. Moody’s has a good track record in this regard, with the majority of cases relating to the 2008 financial crisis having been dismissed or settled. Looking ahead, a statute of limitations applies to new cases relating to the financial crisis period. The one exception applies to the US department of justice investigation