Inside Value: “Warren Buffet and the Subprime Slime”

by Travis Johnson, Stock Gumshoe | March 23, 2008 6:10 pm

This ad came in from Philip Durell[1]’s Inside Value newsletter from the Motley Fool[2], which they’re currently offering for $149. This is the “deep value” newsletter from the Fool, so it probably shouldn’t be any surprise that it’s one of the worst Fool performers recently — it’s beating the S&P by just a point or two, perhaps because value stock portfolios tend to be quite heavily weighted in low-PE stocks like financials. And we all know the kind of year the financials have had.

This is sort of another financial company, and the ad says that “Wall Street overreacted when it smeared this financial with the subprime slime!”

Perhaps more importantly, for our sleuthing purposes, is that they note that Warren Buffett[3]’s Berkshire Hathaway owns 18.6% of the shares of this company. That makes it a fairly easy one to pick out, but let’s look at another clue or two.

It’s for sale at a “fire sale” price 50% below it’s highs.

They say it’s a “venerable blue chip financial” and a “rock-solid” recommendation.

And, to get a little more specific, let’s look at a bit of an excerpt of their ad:

“The best time to buy a value stock is usually when the rest of the market wants nothing to do with it. Sure, sometimes investors turn up their noses at a company with good reason, but often, negative news drags shares of blue-chip firms down much further than is justified.

“And that’s precisely what’s happened to this wonderful company whose business has exposure to the credit crisis.

“This venerable, well-respected financial company was founded in 1900, has offices in foreign countries, and is expanding into developing markets through joint ventures and local affiliations.

“The company’s services are a necessary staple in the financial world, and until just recently, demand had been growing steadily.

“Customers include corporate and government issuers of securities, as well as investors, depositors, creditors, investment banks, commercial banks, and other financial intermediaries.

“The company has a sterling reputation and over the years has proven itself to be totally independent, accurate, reliable, and trustworthy.”

Now, I think you might have a few people questioning that last sentence lately, because this company is …

Moody’s Corp (MCO)

Moody’s is primarily a rating agency, which is why so many people hate them right now. They, along with Standard & Poors and Fitch, are the folks who decided that so many of these CDO-squared bond abominations should be AAA rated. So in some ways they’re being scapegoated for the collapse of the debt markets, though it’s a matter of opinion whether you believe it was really the fault of the ratings agencies that this debt turned out to be, in many cases, worth so much less than their rating would indicate.

So … yes, the first thing I thought upon noticing that this was referring to Moody’s was “you’ve got to be kidding me!” But the second thing I thought was, of course, this is a value newsletter and by many indications a fairly contrarian one, so it makes sense. It’s hard to get attention or be rewarded with a bargain for standing up and saying you like Moody’s in 2004 when Warren Buffett is riding their remarkable success to more and more gains … but if you come out and recommend them today, when the work they have done over the last few years seems likely to threaten them with oodles of lawsuits, client defections, and investor skepticism … well, sure, you might be the one who’s bucking the trend, and maybe you’ll end up with a gem of a business at a discount price.

And Warren Buffett has owned it for years and years and years, and very rarely sells, so I have no idea whether he’d consider it a viable investment opportunity today. He didn’t mention them in his latest annual letter, but perhaps it came up during one of his chat-fests on CNBC, in which case I missed it.

On the flip side, Buffett also got a little bit of flack from conspiracy theorists who believe he leveraged his Moody’s holdings to make them downgrade Ambac and MBIA — at the same time the Berkshire Hathaway was launching it’s own bond insurance business. I would be surprised if there was meat on those bones, since clearly Ambac and MBIA deserved a downgrade long, long ago … but I don’t know.

Moody’s has been an Inside Value recommendation for some time, though I don’t know what price it was when it was first recommended (before a little hiccup in 2006 and the more recent subprime meltdown, Moody’s history shows a nearly ideal stock chart, moving steadily and inexorably up). Before now, Moody’s was also never really cheap, at least not in my memory — it was a high margin business in what was essentially a duopoly, with tremendous opportunity to make money with very little work if they kept their noses clean. The idea that you could pick up Moody’s for a PE of 13, which is about where it is now, would have been laughable. It actually is (or maybe was) a great example of a Buffett stock — not necessarily cheap on current earnings, but an incredibly strong and growing business with a defensible moat and a simple business model.

Whether Moody’s did keep it clean is a matter of some debate — did they allow the financial engineers to talk them into AAA ratings because of the other consulting business they did with those firms? Or simply because the bond sellers are the ones who pay the ratings agency to do its rating work? Or did they really believe that the “diversification” sunk into the CDOs and similar now-toxic debt was on par with Berkshire Hathaway’s debt? (Berkshire is one of the few genuine AAAs in the insurance business). I certainly don’t know, and I’ve never considered investing in Moody’s so I haven’t dug very deeply.

But one thing seems likely — there will still be a market for ratings agencies, and if all else was equal I’d guess that it will remain a duopoly or near-duopoly. Is triopoly a word? Someday, people will trust ratings agencies again and they’ll resume making money … whether Moody’s will be one of those, or if it will even remain independent, I have no idea. If anyone else has anything to share about ratings or the agents who issue them, feel free to opine here … this is certainly an area where I could stand to learn a thing or two. I know that the Motley Fool is teasing us with Moody’s here, but I’m not sure what I think about it.

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