From a fundamental standpoint, I see two major reasons to establish a short position:

Granted, both have difficulties associated with them – but just as with going long, basing something solely on valuation carries much more risk of a long period of adverse price changes. A deeply flawed business model (usually coupled with less-than favorable industry economics) is something to fall back on, whereas the action based only on valuation requires the ability to hold the bet to term.

I raise this because of the commentary surrounding the Obama Administration’s financial reform package, much of which was critical about the seeming indifference toward changing the rating agency system. Some, like hedge fund manager David Einhorn of Greenlight Capital, have publicly said they are shorting Moody’s (MCO). Berkshire Hathaway (BRK) is the largest shareholder in Moody’s, and Warren Buffett has not offered any insight into how he sees the situation.

Which of the above two categories does Moody’s fall into – is the company overpriced with a $6 billion market cap, or is the business model broken? Looking back, Moody’s has typically traded at a 30% premium to the market P/E; right now the two are essentially equal. On a price-to-cash flow basis, the multiple is usually about twice as high for Moody’s as the S&P 500; the current multiple is almost exactly in-line with recent history.

If there was not going to be government intervention or regulation of the ratings agencies, or a change in policy to accelerate entrants for purposes of competition (new NRSROs), Moody’s would be a good buy here. They, along with Standard & Poor’s (part of McGraw-Hill, MHP), effectively control the toll booth for companies to access the debt markets. The profitability of the business is enormous; Moody’s earned over $450 million in 2008 – a very down year, as prior earnings were over $700 million – all while having no real capital invested in the business. Book value is quite negative, tangible book even more so. As you can figure out, the value of the franchise is not on the balance sheet, but in a combination of the quasi-government sanctioned stranglehold on rating debt and the concentration of ratings information and data. Is that going to change, and if so, at what cost to Moody’s?

One possibility is that the game changes for ratings agencies, but the consequences to shareholders are minimal. For instance, phasing out Moody’s or S&P ratings as triggers in certain situations like collateral posting would be a change, but it wouldn’t necessarily hurt profitability. But for asset managers who can only own AAA-rated securities, making the transition away from that designation to something new could be very problematic.

The issue of confidence in the AAA-rating going forward is problematic. Yes, it was exposed in this cycle for having been given out far too easily. At the same time, that is now well-known, and would it be better to have a new ratings agency with their own top-tier criteria, or the old AAA/Aaa crowd making judgments under a newly suspicious gaze? Keep in mind, there aren’t really any substitutes that are readily available – meaning that ratings could be a profitable game for a long time before the situation is addressed. Again, Moody’s made $90 million last quarter, and these are extraordinarily bad business conditions for them. Surviving this cycle would imply the ratings agencies are all but invincible, even if they get things quite wrong and contribute to trillions in losses. What kind of multiple would you pay for a company like that?

This brings up risk and reward on the short thesis, which I’ll address next time.

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