The Big AAA and AA Joke
Over the last several months, we have heard several things such as AAA, AA and so on. In fact AA might pass off as Alcoholic Anonymous to many people, but the media has made sure that people have learnt something new at least the labels.
I have seen that 99% of the stuff is never reported and what gets written is often what will sell… However the key is to always understand the context and thus it is important to look at some finer points. So let’s demystify these labels….
First Some statistics.
1. Even in the US , only two U.S. corporations have a AAA rating as of August 2019: Microsoft(MSFT) and Johnson & Johnson (JNJ). This means the chance of default these two companies have compared to the U.S. government is lower.
Questions to ask yourself :
Why is Coca Cola (Coke) which is a key jewel in Warren Buffets portfolio not AAA? Why are some of the best and biggest companies not AAA?
2. Forget these companies, even the United States Debt is not AAA. So why are people really lending to the US government thinking that it is safe?
3. What is India’s Credit Rating? (There are no A’s…….It’s BBB)
There are so many lay people doubling as experts who don’t understand a thing about credit and debt yet will give their expert opinion on everything.
The Top 5 Stocks in Warren Buffet’s portfolio are
2. Bank of America
3. The Coca Cola Company
4. Wells Fargo
5. American Express
One of the world’s most valuable companies Apple has a market capitalization (value) of $1.35 Trillion Dollars as of January 6, 2020. Only 14 countries in the world have a GDP more than this . Apple’s value is 45% of India’s GDP. Yet this is not a AAA rated company.
Walmart which has paid $17 billion dollars to our own Indian Startup Flipkart is not even AAA. The point that I am trying to drive that these labels in isolation have no meaning. The point that you should also understand that most companies borrow. They do that so as to earn a higher return on their Invested Capital.
Let’s take an example.
Let’s say you invest in a project by investing Rs. 50 Crore ( 50% of your own money – Equity) and borrow 50% at a rate of 10%. This means your Debt to Equity Ratio (D/E = 50%/50%) is 1. Anything less than 1 is always better because you have put in your own Equity as well. Now think that you get a 20% return on this project .
Now Value of the Project is Rs.120 Crore . Your interest cost is Rs. 5 Crore . You are left with Rs.115 Crore. If you sell this project and pay off the bank you are left with Rs.65 Crore. Even though you invested Rs.50 Crore of your own, and your project got a return of 20% your overall return is 30%. This is because you borrowed the other half and is known as leverage . Now just as gains are magnified when the calls go right, losses are magnified too if the calls go wrong.
Thus you have to borrow smartly and be very prudent about your borrowing. The Lower the Debt-Equity ratio the better. The key is to manage your D/E Ratio smartly to not just boost returns but MOST IMPORTANTLY MANAGE RISK. Many companies went overboard on their debt to make overseas acquisitions or to scale up aggressively and landed in big trouble.
The key question then is “How should an investor interpret these labels?”
It’s difficult for lay people to interpret all ratings but you should understand that AA does not mean bad or that the company will default. It just means that the rating agency has assigned a lower rating based on the size of company debt (A company’s Debt-Equity Ratio – The Lower the Better) and it’s ability to repay the debt. These ratings do go up and down occasionally and this too is normal.
It’s important to have a constructive discussion with your advisor to understand this. Your advisor should be able to explain these concepts and how he would construct a debt portfolio that can help you manage risk smartly , protect overall portfolio capital but at the same time earn meaningful returns.
Warren Buffet said “Be Fearful When Others are Greedy and Be Greedy when others are Fearful.” The debt market may be giving investors an opportunity to get greedy but are there any Takers.