Going just by rating can hurt

Last Updated: Sat, Oct 13, 2012 18:41 hrs

Investing in stocks or bonds is an act of faith. While investors can do the best due diligence, returns are always a function of market conditions and economic environment.

Hence, before investing, it is natural for us to seek some sign-posts which will guide us in arriving at the right decision. Until recently, one had to rely on one’s acquaintances or ‘market experts’ for this purpose. However, we have now moved a step forward. Today we have a triumvirate of agencies (CRISIL, CARE and ICRA) providing the bulk of credit ratings and grading of bonds and equities respectively.

Before assessing the pros and cons of this approach, here are a few features and distinctions between a rating and a grading :

Ratings are relied upon by prospective and current investors in debt or quasi-debt instruments such as non-convertible debentures, bonds, preference shares, commercial papers, certificates of deposit, company fixed deposits, loans, structured debt, etc.

Any rating reflects the rating agency’s current opinion on the relative likelihood of timely payment of interest and principal on the rated obligation. It is an unbiased, objective, and independent opinion as to the issuer's capacity to meet its financial obligations and conversely, the probability of default on the rated obligation

A rating is a forward-looking opinion, specific to the instrument being rated and may not reflect the agency’s view on the company/institution as a whole. While the rating symbols vary, depending on the agencies, a sliding scale from ‘AAA’ (Denoting the highest safety) to ‘D’ (Default) is the general convention.

Equity gradings, on the other hand, markedly vary from ‘ratings’. They involve an independent assessment of two critical factors considered by an investor prior to investing in a particular company’s share:

  • Fundamentals : Whether the company is fundamentally sound with respect to its business, its financial position, its management and its prospects.  
  • Valuation : What is the Intrinsic Value (CIV) of the stock and how does it compare to its current market price.

While the exact symbols vary, depending on the agencies, equity gradings are usually depicted on a composite scale of 1 to 5, with ‘1’ denoting either poor fundamentals, expensive valuations or both.

Ratings / gradings could assist you in the following manner :

  • They bring about an element of objectivity to the process since the agencies assign the grades only after employing several mathematical / statistical stress-tests to the instruments involved. Such rigourous testing and scenario analysis is beyond the scope of most individual investors.  
  • While issuers will always state only the positive aspects of their instruments, rating agencies are likely to provide a more balanced perspective, thereby helping you arrive at a more informed decision.  
  • You could develop your own screens which will help you avoid certain types of issues. For instance, you could construct a portfolio which consists of all equity shares graded ‘4’ and above and all debt instruments only with ratings above ‘AA’.

However, beware of the following :

  • While the ratings are based on a clearly articulated analytical framework, one must not forget, that, after all, they are only an opinion.  
  • Rating agencies are paid by the issuer and not the investor. Hence, the scope for ‘conflict of interest’ is not completely obviated.  
  • Issuers can choose as to which rating they can publicise. Hence if they have obtained ratings from more than one agency, they will obviously hide the one which is the most adverse.  
  • Increased competitive intensity among the rating agencies may induce them to reduce the standards of oversight for fear of losing business if they are too rigid or ‘issuer-unfriendly’.  
  • Today rating agencies offer various other services such as research, advisory etc. Overly stringent ratings may lay them open to the threat of losing clients / access to management which may adversely affect their other divisions.  
  • They are not a comment on the issuer's general performance nor an indication of the potential price of the issuers' bonds or equity shares.  
  • Investors must first ascertain their own optimum asset allocation in consultation with a Certified Financial Planner and not invest merely on the basis of ratings, as such ratings /gradings are not indicative of the suitability of the issue to any particular investor. Such suitability would be contingent on factors unique to the investor, such as age, income level, dependents, responsibilities, risk appetite, investment allocation etc.  
  • In additional to suitability, whether the investment timing is right, would depend on macro economic factors like growth, credit policies, systemic liquidity, flows from domestic and foreign institutional investors, overall investor risk appetite etc. In other words, the element of subjectivity and judgment cannot be done away with.  
  • Though ostensibly ‘forward-looking’, rating agencies have often been berated for being too slow in changing their ratings. That is why one must be alert and keep a close watch on the companies that one has invested in. By doing so, one may observe several red flags and take remedial action much before any ratings downgrade is actually effected.

Finally, remember that there is no such thing as a ‘free lunch’...Ratings/gradings should therefore be used as a complement and not a substitute for ‘Due Diligence’.

The writer is head – Marketing, PPFAS Asset Management.Views expressed are his own

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