Managing risk in your portfolio - the importance of credit ratings

Building a portfolio - the issue of risk

When selecting companies to build a portfolio, the best stock market players are those that have built up the clearest picture of how each company is likely to perform in the future and the risk/return trade-off each represents.

To be successful at this, one of the most important things that must be considered is whether a company’s financial health is likely to improve, remain steady or decline in the future.

Buying shares in companies that are likely to fail or perform poorly in the months ahead is clearly a recipe for disaster and significant capital loss, so determining the riskiness of the stocks you purchase and then the overall riskiness of your investment portfolio is something that cannot be taken lightly.

So do you know the underlying financial risk of the companies you invest in or are thinking of investing in?

In the past, many investors relied on building their portfolios around the big brand name companies - the so-called blue-chip companies - believing that such companies are sure bets. But the calamitous demise of US energy giant Enron, the country’s seventh biggest company at the time, followed soon by telecom WorldCom, Italian dairy company Parmalat and closer to home, HIH Insurance, highlight the riskiness of this approach

Brand name and company size cannot be relied upon when deciding what to put your money in. Furthermore, with equity markets peaking around the world, debt markets should also be considered for their steady returns and relatively low risks.

Determining risk – the importance of credit ratings

A credit rating is an important, if not the most important measure of the financial health of a company. It gives an indication of how the company is performing in absolute terms and is also makes it possible to compare a company’s credit worthiness against other company’s in similar markets or industries worldwide. It gives an indication of how a company is expected to perform in the future and whether it is well placed to repay its debts and meet its overall financial obligations. Changes to a credit rating, such as a credit downgrade can see a company’s share price tumble, as markets are particularly sensitive to news of this nature. A downgrade can also result in higher costs of capital (or borrowing costs) lowering profitability, which can also lower the share price.

Credit rating agencies use different alpha, numeric and alphanumeric scales to rate companies (such as ‘AAA’ or ‘Aaa’ for the highest rated companies, ‘BB+’ or ‘Ba1’ for medium risk and ‘D” for the lowest rated). However it is relatively easy to compare the ratings of different agencies to see if there is any difference in the assessment of the same company.

In addition, most ratings include an outlook forecast such as ‘stable’, ‘positive’ or ‘negative’ giving a signal as to which direction the credit ratings is likely to move in the future.

Qualitative versus Quantitative Ratings

Essentially there are two kinds of credit ratings. The more traditional rating agencies put out what are known as qualitative ratings – these ratings are essentially opinions about a company’s financial health by specialist analysts who use a combination of financial data, company interviews and other market information to determine a rating.

These ratings are more subject to bias as they involve an analyst’s opinion in their determination - in the Enron debacle traditional rating agencies and investment houses came under intense scrutiny and criticism for failing to spot the problems at the energy giant, with some even recommending the company as a good investment just months prior to its collapse.

The qualitative ratings market is dominated by only a few major global players who are well entrenched with very strong brand names. Since the Enron/ WorldCom crisis, the US Securities and Exchange Commission, the country’s chief financial watchdog, has moved to ensure greater transparency in determining nationally recognized statistical rating organizations (NRSROs) and is also pushing for more competition in the industry – similar moves are being implemented by other foreign regulators, including Australia.

Quantitative rating avoid all opinion and bias by focusing solely on available financial data and ratios (made available in financial statements) to obtain a rating. Quantitative rating agencies use sophisticated software to compute ratings and can input financial data from a variety of sources to create a more robust system. The benefit of these is that ratings are updated more frequently; they avoid the bias inherent in qualitative ratings and also ensure that analyst opinion does not come into the equation.

Investors should also be aware that credit ratings are also used by banks and other lending institutions when determining whether to provide financing to companies that wish to expand or take on new debt - a poor credit rating can severely limit a company’s ability to make acquisitions, manage its debts and compete in the market place.

The share price is not a good indicator

Basing your investment decision solely on share price data and history is not a sound investment strategy. Research carried out by Rapid Ratings has shown that a company’s share price is a lagging indicator of financial distress, not a leading one. This means it is a not a good tool for predicting how a company is performing. In the case of the major corporate disasters of the last five years, the share price did not deteriorate until the company was on the verge of bankruptcy proceedings – so investors had no warning.

On the other hand a credit rating, particularly a quantitative which incorporates the most recent financial statements along with other relevant historical and financial data, is generally a good leading indicator of financial distress.

Every investor needs to consider his or her individual needs and goals. But whether they be short term, medium term or long term, they should always choose quality companies that are well managed to minimise the risk of having an “Enron or HIH” lurking in their portfolio – in this respect, credit ratings can help all investors’ research and monitor their portfolios. In addition, differences in credit ratings between rating agencies may highlight an opportunity or a potential problem.

Combining this knowledge with companies that show good potential for capital growth and possibly also deliver good dividend returns will help ensure more successful investment decisions.

About Larry Schlesinger

Larry Schlesinger is senior editor at Rapid Ratings, a quantitative global credit rating agency, based in Brisbane. He was previously website editor and reporter at Accountancy Age magazine in London, a weekly newspaper read by over 70,000 accountants in the UK

In 2002, he was short listed by the Periodical Publishers Association, the UK trade magazine association, in the category ‘New Online Journalist of the Year’ as part of its annual New Journalist Awards.

(c) All rights reserved 2005. This article has been prepared by a third party and licensed to ASX. The views are those of the author and not necessarily of ASX. This material is educational and it is not intended to constitute financial advice. It has been prepared without taking account of any person's objectives, financial situation or needs and because of that, any person should, before making an investment decision, consider the appropriateness of the advice having regard to their objectives, financial situation and needs.

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