Investment Contrarians

Investment Opportunity Due to a Lawsuit?

By for Investment Contrarians |

Investment OpportunitySometimes the best investment opportunity arises when a situation looks the bleakest. When a firm’s earnings outlook is stable and there is little volatility in the stock, this makes it extremely difficult to identify an investment opportunity, since all the good news is usually priced into the stock.

An interesting situation is taking place now, and I’m surprised it hasn’t happened sooner. The United States Department of Justice (DOJ) is taking the Standard & Poor’s (S&P) unit of The McGraw-Hill Companies, Inc. (NYSE/MHP) to court, alleging that the ratings agency was involved in fraudulent activities.

From 2004 through 2007, according to the complaint, S&P allegedly issued credit ratings on approximately $1.2 trillion worth of collateralized debt obligations and $2.8 trillion of mortgage-backed securities. The government is seeking $5.0 billion from the firm for damages incurred, as they believe the ratings were fraudulently issued. (Source: Pettersson, E., “McGraw-Hill, S&P Sued by U.S. Over Mortgage-Bond Ratings,” Bloomberg, February 5, 2013.)

Initially, the government was seeking a fine of $1.0 billion in addition to an admission of guilt from the S&P unit. Failing to reach an agreement, the government is now escalating the case, along with the fine.

To begin with, I do not like the way rating agencies operate. For those who aren’t aware, a ratings agency is actually paid by the issuer to rate it before being sold to investors. This creates an obvious conflict of interest. For a rating agency that is interested in increasing its earnings outlook and creating a greater investment opportunity for the future, its best interest, in my opinion, is to issue favorable ratings that will entice more companies to use their services.

However, I am not here to make a moral judgment, but to understand if the stock offers a reasonable investment opportunity. The truth is that S&P is only one unit within the group of many McGraw-Hill companies. Other units include J.D. Power & Associates, as well as the McGraw-Hill Education unit. (Source: McGraw-Hill Companies, Inc. web site, last accessed February 7, 2013.)

Standard &Poor’s recently released a statement refuting the DOJ allegations, stating, “Claims that we deliberately kept ratings high when we knew they should be lower are simply not true. We will vigorously defend S&P against these unwarranted claims… Unfortunately, S&P, like everyone else, did not predict the speed and severity of the coming crisis and how credit quality would ultimately be affected.” (Source: “Standard & Poor’s Says DOJ Civil Lawsuit Is Unjustified And Without Legal Merit,” Standard & Poor’s web site, February 5, 2013.)

One well-known analyst, Meredith Whitney, who has been very critical of the banks in the past stated on Bloomberg, “The case of the government is that S&P actively defrauded investors. I find that very hard to believe and I think that’s going to be very hard to prove.” (Source: Dexheimer, E., “S&P Fraud Will Be Tough for Government to Prove, Whitney Says,” Bloomberg, February 7, 2013.)

Without this lawsuit, the earnings outlook for the company was quite stable. This is a stock that pays out a dividend yield of 2.5% and is expected to have a mild increase in its earnings outlook over the next several years. The company also has over $1.2 billion in cash. (Source: Yahoo! Finance, last accessed February 7, 2013.)

While the government’s initial claim of $1.0 billion in fines is quite large, it would not cripple the company; it would simply erase one year’s worth of income. For the long-term investor, this might create an interesting investment opportunity, as long as guilt was not admitted.

A $5.0-billion fine, however, is very severe. Even with a stable earnings outlook for the remaining businesses, this would not be a good investment opportunity, as it might force the company to completely restructure or even shut down completely.

McGraw Hill Cos Inc Chart

Chart courtesy of www.StockCharts.com

This is a 10-year weekly stock chart for McGraw-Hill Companies. Note the massive selling pressure currently taking place. Normally, I don’t advise trying to pick a bottom, as a fall in price can continue for a very long time.

An interesting investment opportunity might occur around the $40.00 level. On the chart above I’ve circled several instances over the past decade in which the $40.00 level played an important role as either a pivot or resistance point.

There are four scenarios to consider:

1) If the company were to be completely exonerated through the courts, this should be massively bullish; since there would be no fines, a stable earnings outlook makes this is an obvious investment opportunity.

2) If the company were to settle at or below $1.0 billion, as per previous negotiations, and not admit guilt, this too would offer a long-term investment opportunity, as the future earnings outlook would not be impacted by the massive repayment of fines and future litigation.

3) If the company were to settle and admit guilt, this would lower the investment opportunity; an admission of guilt would open the door to potentially increased levels of civil litigation, lowering the company’s future earnings outlook.

4) If the company were to lose in court, this would be an admission of guilt in addition to a $5.0 billion fine. In no way would this be an investment opportunity, as the entire business and the company’s survival could be in jeopardy.

I am not a lawyer in any way, and this is purely my opinion. I believe option one has a very low probability (less than five percent) of occurring. I also don’t believe that option four will occur, as proving fraud in court is extremely difficult.

I personally believe the company and the DOJ will settle, without admitting guilt, at the previously estimated levels of approximately $1.0 billion. If that were to occur, 10 years from now, we will look back and view this pullback as an investment opportunity, since the earnings outlook will continue to be strong for many of the firm’s divisions.

Having said that, I would not buy the stock at this point; I’d simply wait to see how developments occur and at what price the stock stabilizes. It could drop to $20.00 before stabilizing, so buying now is dangerous.

Once we get some more information over the next few months, I can better assess the risks and rewards when calculating if this is a good investment opportunity and how the earnings outlook will be affected.

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