Moody's

Moody's is a cornerstone of the modern financial world and one of the “Big Three” credit rating agencies, alongside Standard & Poor's and Fitch Ratings. Founded in 1909 by financial publisher John Moody, the company pioneered the business of analyzing and grading the creditworthiness of corporate and government debt. In essence, Moody's acts as a financial referee. When a company or a government wants to borrow money by issuing a bond, Moody's assesses its ability to pay that money back, with interest and on time. It then assigns a grade, or a credit rating, to that debt. These ratings, from the gold-standard 'Aaa' to the riskiest 'C', are used by investors, fund managers, and banks worldwide to quickly gauge the risk associated with a particular investment. While the ratings business (Moody's Investors Service) is what it's famous for, the company also operates a large financial intelligence and analytics division called Moody's Analytics, which provides software and research to financial professionals.

Think of a Moody's credit rating as a financial report card for a borrower's debt. It’s a simple, standardized opinion on the likelihood that a loan will be repaid. This simple grade saves individual investors countless hours of complex financial analysis. Instead of digging through hundreds of pages of financial statements for every single bond, an investor can look at the Moody's rating for a quick summary of its risk level. The rating system is broken down into two main categories:

• Investment Grade: These are ratings for debt considered to be of high quality with a low risk of default. The borrower's ability to meet its financial commitments is strong. The scale for long-term debt runs from:
  1. Aaa: The highest possible rating, indicating minimal credit risk.
  2. Aa: Very high quality and very low credit risk.
  3. A: High quality, low credit risk, but with some susceptibility to economic changes.
  4. Baa: Medium-grade, with some speculative characteristics and moderate credit risk.
• Speculative Grade (or “Junk Bonds”): This debt is considered to have a higher risk of default but typically offers a higher yield to compensate investors for taking on that extra risk. The scale includes:
  1. Ba: Has speculative elements and a significant credit risk.
  2. B: Highly speculative and subject to high credit risk.
  3. Caa, Ca, C: Ratings for debt that is either in or near default.

While less famous, Moody's Analytics is a powerhouse in its own right. This segment of the business doesn't issue ratings. Instead, it sells a vast array of products and services, including economic forecasts, risk management software, and professional training. It provides the tools for banks, insurance companies, and corporations to manage their own financial risk. This division provides a steady, diversified stream of revenue for the company, complementing the more cyclical ratings business.

For a value investor, Moody's is a fascinating subject, both as a tool to be used with caution and as a company to potentially invest in.

The father of value investing, Benjamin Graham, taught his students to be skeptical and to do their own homework. This lesson applies perfectly to credit ratings. While a rating can be a helpful first screen to filter out obviously risky securities, it should never be a substitute for your own independent analysis. Why the skepticism? A key reason is the potential for a conflict of interest. The company or government issuing the bond (the “issuer”) pays Moody's for the rating. This “issuer-pays” model has been criticized for creating pressure on agencies to give favorable ratings to keep clients happy. A true value investor uses the rating as a single data point, then proceeds to analyze the company's financial health, its business model, and its management to form their own opinion on the safety of the investment.

From the perspective of investing in Moody's stock, the company is a classic example of a business with a wide economic moat. Moody's, along with S&P, operates in a duopoly. Their brand names are so powerful and their ratings are so deeply embedded in global financial regulations that it is nearly impossible for a new competitor to challenge them. This durable competitive advantage is exactly the kind of thing that legendary investors like Warren Buffett look for. In fact, his company, Berkshire Hathaway, has historically been a major shareholder of Moody's, recognizing the immense pricing power and resilience of its business model.

No discussion of Moody's is complete without mentioning its controversial role in the 2008 Financial Crisis. Moody's and other rating agencies gave their highest 'Aaa' ratings to thousands of complex financial products known as mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). These securities were essentially bundles of home loans, many of which were of very poor quality. When the U.S. housing market collapsed, these “safest” investments proved to be toxic, leading to catastrophic losses and triggering a global financial meltdown. This episode serves as the ultimate cautionary tale: ratings can be wrong, sometimes spectacularly so. It powerfully reinforces the value investor's creed: Veritatem Tuam Invenies — “Find your own truth.”