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Coveted credit ratings are not a 'buy' signal

A Toronto-Dominion Bank branch in New York. TD is one of only five companies worldwide that possess Moody's coveted AAA rating.

Shannon Stapleton/Reuters

What are we looking for?

Moody's Investor Service recently downgraded 15 global banks and securities firms, including Royal Bank of Canada, over their exposure to risk.

A downgrade typically means companies will pay more interest when raising money because they are considered riskier. This downgrade piqued the interest of my partner Neil Wickham to ask whether there was any relationship between credit ratings and stock performance.

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The screen

In 1980, there were 60 companies worldwide that possessed the coveted AAA rating. By 2000 that list had dwindled to 15, and today there are only five: Microsoft, Automatic Data Processing, Johnson & Johnson, Toronto-Dominion Bank and Exxon Mobil.

Many AAA rated companies lost their ratings when they were taken over, and their new owners loaded them with cheap debt to help pay for the deal. (As an aside, this is not a new phenomenon. It also happened to some of the original 1896 Dow Jones industrial average companies, like Tennessee Coal Iron and Railroad Co., the Distilling and Cattle Feeding Co., and U.S. Leather.)

Other companies have found that an AAA credit rating is not something worth aspiring to if a more conservative approach means lower profits.

The financial crisis and deep recession laid into several of the sturdiest pillars of American capitalism. Berkshire Hathaway, General Electric and Pfizer all lost their AAA rating. Some other companies that once were rated AAA are IBM, Kellogg, Procter & Gamble, DuPont, and Sears, and of course GM and Ford.

What did we find?

The screen ranks all the AAA, Aa1 and Aa2 companies around the world. There are 15 companies on the list, from the U.S., Britain, Switzerland, Japan, Hong Kong, and of course, Canada.

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The company at the top of the list has the one of the best rates of return, but that's coincidence. Look further and you can see there is no correlation between credit rating and stock performance.

Conclusion

Many critics have pointed out that the rating agencies were part of the cause of the global financial crisis of 2008-09. They granted AAA ratings to collateralized debt obligations that were full of garbage mortgages, thereby helping to precipitate the financial crisis. As noted economist Paul Krugman said, "They didn't miss the bubble, they helped cause it."

Based on this screen, ratings agencies also seem to be of little help when it comes to picking stocks. Investors should avoid taking a high rating as a sign of a good investment.

Michael Bowman is portfolio manager at Wickham Investment Counsel Inc. in Hamilton.

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About the Author
Portfolio Manager

Michael Bowman is a portfolio manager at Hamilton-based Wickham Investment Counsel Inc., an adviser to high net worth clients. Mr. Bowman has 30 years experience as an investment adviser and financial planner serving both individual and corporate accounts. More

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