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Relevance of Credit Rating Agencies and the Responsibility of Regulators in Current Environment

Modified on August 19, 2019

We have a section dedicated to answering queries from readers: “Ask Your Queries”. Over time, many readers have asked their queries related to many aspects of stock analysis and sought clarifications about investing. We have responded to these queries as replies to their comments.

“Q&A” series is an attempt to share the queries & their responses, which have featured on “Ask Your Queries” section, with all the readers. The primary aim of this new feature is to share the knowledge with other readers of the website, who might have similar queries.

The current article in this series provides responses related to the following queries:

 

Relevance of Credit Rating Agencies and the Responsibility of Regulators in the Current Environment

 

Dear Sir,

I am writing to you to understand the current state of affairs in the market- particularly to the corporate governance issues and role of various agencies, which operate in the investing ecosystem.

 

1) Relevance of Credit Rating Agencies:

First, the rating agencies; you give a lot of emphases to read credit rating reports of companies to gain more insights about the business model and not necessarily the rating.

Of late, a lot of companies, which were otherwise rated well or positive things were written about them have suddenly gone into distress or rather defaulted. This trend started with IL&FS and has now cascaded to other smaller companies. All corporate governance issues could be brewing in for quite a long time; however, this comes in the public domain as a nasty surprise where reported numbers suddenly take a hit in one quarter and of course the stock prices start getting hammered much earlier (it could be read as insider information coming out/large investors exit). There are various live examples- Talwalkars, Byke Hospitality, Dewan Housing Finance Ltd. etc. where ratings assigned were good and then suddenly the business goes for a toss in just one or two quarters.

The latest example of them is Talwalkars, which enjoyed an AA rating some months ago. Business and financials were looking good until recently and suddenly in Q1-FY20, they reported humongous losses. Where are we headed?

I have worked in a rating agency earlier and therefore, I know the limitations that these entities have. Their views are based on the audited financial statements with no real-time data available. RBI does not give them access to CRILC database, which captures weekly default data. Their ratings are based on some key financial indicators, which are often manipulated in case of companies with poor corporate governance. Therefore, to support their good ratings they tend to write positive comments and quote certain business insights, which could be construed as useful information by the investing community.

Actions of credit rating agencies are always reactive. Once a company’s default is known in the public domain, what they do is a mere downgrade to “D” with a newly discovered weaknesses in the business model and financial flexibility, which further accentuates the fall in stock prices.

Whom do we blame for this? The auditors, the rating agencies or the bankers who keep funding such companies? What is the usefulness of credit rating reports today?

I request your current categorical and candid views as I have already gone through the articles on your blog.

 

2) Responsibility of Regulators and Govt. Agencies in Corporate Governance:

Any good investments found through persistent homework can go horribly wrong, as you do not know when the promoters will lose their integrity and the auditors will collude with them. I understand that one needs to do regular monitoring; however, what is the metric to evaluate one’s honesty and ethics? What is the responsibility of the regulators and Govt. agencies to prevent investors from accidents? How does one revive confidence?

Thanks & Regards,

Ranjan

 

Author’s response

 

Hi Ranjan,

Thanks for writing to us!

We appreciate that you have shared your learning from your work experience in the credit rating industry and have highlighted the limitation of the analysts preparing the reports.

 

1) Credit Rating Agencies:

As rightly pointed out by you, we stress that instead of focusing on the “Rating”, an investor should focus on the information provided in the credit rating report.

Credit Rating Reports: A Complete Guide for Stock Investors

Moreover, credit rating reports are only one of the inputs/documents that are available to the investor for stock analysis. Other documents being the annual reports, red herring prospectus (RHP), corporate announcements & exchange filings, investor’s own analysis financial analysis of last 10 years financial data, in-depth management analysis etc. We believe that in most of the cases, a comprehensive analysis is able to indicate to the investor whether all the aspects of the company are good or there is something out of place.

In addition, when an investor analyses more and more companies, then she gets to identify patterns of management decisions, management commentary etc. where a company might have attempted to hide something or project an image that is better than reality.

At the end of the day, the aim is not to outsource the investment decision to the opinion/information provided by analysts of credit rating agencies or equity research agencies (stockbrokers).

Therefore, in case, an investor finds that the credit rating reports have the information and the data points, which help her to take an investment decision, then she may use them in her analysis. However, if she believes that the credit rating reports are not able to provide credible information, then she may stop using them and instead rely on the other documents mentioned above in her investment decisions.

 

2) Responsibility of Regulators and Govt. Agencies:

You are right that in any investment decision, shareholder-friendliness, the integrity of the management are major parameters. We believe that once an investor has analysed a sufficient number of companies like 50 and more, then she would realize that she could complete the financial and business analysis quickly and that the most time-consuming assessment is management quality.

Why Management Assessment is the Most Critical Factor in Stock Investing?

Regulators and govt. agencies are mostly a step behind the company managements. Dishonest managements always exploit the loopholes in regulations to take advantage of the situation/existing laws. This has been the case in the past and will always be there in the future. We do not blame regulators and govt. agencies for this. Post the event/fraud; the regulators update the regulations to block the loopholes, which in turn, helps the investors.

For example, until the Satyam fraud in 2009, it was not necessary to disclose share pledge in shareholding filings. However, after the Satyam fraud, the regulations were updated to make it a mandatory disclosure.

SEBI asks promoters to disclose pledged shares in 7 days (Economic Times, February 01, 2009)

Now, the case of Yes Bank has shown that the promoters bypassed this disclosure by entering into structured deals with mutual funds & NBFCs. Let us hope that the regulations are now tightened further to block this loophole.

How Rana Kapoor Avoided Declaring ‘Pledged’ Shares, through a Loophole (Moneylife, November 26, 2018)

Therefore, the investment field is a dynamic environment and regulators and govt. agencies keep responding to the newer scenario by responses that they feel appropriate. We believe that investors also need to keep on updating themselves according to the changing environment.

However, at the end of the day, the essence of most of the management frauds is to benefit from other people’s money. Therefore, the mainstay of judging any company’s management by identifying money-hungry managers who rely a lot on the debt and equity dilution to fund their businesses does not lose its significance in any era. It was true in the past and likely, will stay true in the future as well.

An investor may read more about our approach to identify management quality in the following article:

Steps to Assess Management Quality before Buying Stocks

Moreover, there is always an inherent risk of losing money in equity investments. An equity investor assumes this risk when she enters stock markets and puts her money at the stake. This risk is compensated by the probability of higher return on her investment. Therefore, it may happen that in spite of all the hard work done by the investor, her investments may not do well or the managements of her investee companies betray investors and she loses money. Then, in such cases, she can take these instances as learning and improve her investing approach to take better decisions in the future.

All the best for your investing journey!

Regards

Dr. Vijay Malik

 

P.S.

 

DISCLAIMER

Registration Status with SEBI:

I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013

Details of Financial Interest in the Subject Company:

Currently, I do not own stocks of any of the companies discussed above.

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