3 Ratings Companies with Data in Demand

Investors chasing glamourous big tech, pushing stocks to their all-time highs, might want to consider opportunities that have proven to be relatively immune from the COVID-19 market crash. One such opportunity can be found in companies that provide financial data, analytics, research, and benchmarks for investment performance, and which are a far more favourable position than others in the broader financial services sector.

While the S&P 500 index’s year-to-date returns remain negative, the stocks of companies in the ‘financial data and stock exchanges’ industry have clocked oversized gains that range from 21% to 41%, as of July 15, 2020. These businesses operate in a heavily regulated industry and provide market intelligence and data solutions that investment banks and corporations rely on. They also provide data-driven benchmarks to financial markets through a business monetized with subscriptions and other fees and royalties.

The following companies boast sustainable competitive advantages, with sufficiently entrenched products that face little or no competition, which has helped them corner a lion’s share of their market, insulating them from the fallout of the coronavirus pandemic.

S&P Global (SPGI) offers information regarding ratings, benchmarks, and analytics in the global capital and commodity markets. S&P Ratings is the largest credit ratings agency in the world, which accounts for more than 40% of the firm's revenue and more than half of its operating income. The company’s other businesses include Market Intelligence (data solutions to investment banks, corporations), Indices (benchmarks for financial markets), and Platts (benchmarks to commodity markets).

S&P Global boasts sustainable competitive advantage, or wide moat, supported by credit ratings, financial indexes, or commodity price reporting. “Given the embedded nature of these benchmarks, S&P enjoys a strong competitive position and strong operating margins,” says a Morningstar equity report.

The company's S&P Dow Jones Indexes segment, its fastest growing and highest margin business, possesses two of the most widely recognized equity benchmarks - the S&P 500 Index and the Dow Jones Industrial Average. The S&P 500 index, the crown jewel of the S&P Indices segment, is monetized from index subscriptions to active asset managers, license fees for passive ETFs, and mutual funds, and royalties from exchange-traded options and futures. “For most retail and institutional investors in U.S.-listed equities, beating the S&P 500 is the standard benchmark for performance,” the report says, noting that changing benchmarks is an arduous process, which often puts “fund companies at the mercy of benchmark providers.”

The company’s ratings business (51% of adjusted operating income) derives its revenue primarily from bond issuance volume. Other segments including Market Intelligence (19% of adjusted operating income), S&P Dow Jones Indices (18%), and Platts (12%), “help diversify revenue,” says Morningstar, equity analyst, Colin Plunkett, who puts the stock’s fair value at US$261.

The world's second-largest provider of credit ratings, after S&P Global, Moody's (MCO) provides ratings on more than a third of the total bond ratings in existence. Within ratings, roughly half of its revenue is derived from corporate issuers, while the rest is split among financial institutions, structured products, and public institutions. Moody's Analytics (13.5% of operating income) provides ancillary software and data solutions to issuers and investors.

“Though COVID-19 will definitely weigh on near-term revenue, Moody’s remains well-positioned to take advantage of long-term trends such as banking disintermediation and continued development in global bond markets,” says a Morningstar equity report.

Moody’s operates in a duopoly with S&P where the two account for more than 80% of the total bond ratings issued. Such dominance affords it considerable pricing power, which helps offset weaker economic growth. “Most often, institutional investors require issuers to have at least one of the two largest nationally recognized statistical rating organizations, S&P or Moody’s, rate its bonds,” says Morningstar, equity analyst, Rajiv Bhatia, who appraises the stock’s fair value to be US$230.

Bonds that bypass Moody’s or S&P achieve less liquidity, resulting in a higher cost to borrow. Rating fees often cost only about 6 to 7 basis points of total issuance, a small price to pay for issuers to make their bonds more marketable, adds Bhatia.

The subscription revenue model and high retention rates of the analytics segment help offset some of the volatility in the ratings business. “Moody's Analytics will benefit from changes in regulation, [as] changes in accounting standards require banks to make more detailed loan-loss projections [thereby boosting] sales of Moody’s analytical offerings, says Bhatia.

MSCI (MSCI) has two main businesses, benchmark indexes and portfolio risk analytics tools. The firm's index segment currently accounts for nearly 80% of operating profits, with its analytics division generating another 18% of operating income. MSCI’s benchmark indexes and analytics tools are primarily used by institutional investors around the world.

MSCI’s wide economic moat stems from intangible assets such as “its MSCI-branded indexes, which many asset managers use to benchmark their investment performance when displaying results,” says a Morningstar equity report, adding that the firm’s “All Country World Index is recognized as the standard for global equity portfolios by institutional investors and consultants.”

There is a significant switching cost advantage attached to the benchmarks MSCI. Institutional clients of fund companies “are not interested in taking on the added cost of changing their mandates to accommodate a new benchmark,” notes Michael Wong, Morningstar sector director.

A staggering US$11 trillion in assets globally are benchmarked to MSCI indexes. “As many foreign markets often do not have a widely recognized index as a benchmark for investment performance, MSCI, through the strength of its brand, has been able to insert itself as the leader in benchmarking for these markets,” says Wong.

Even the global pandemic has only marginally affected MSCI's business as the company retained its leadership position. “MSCI's recognized brand and high switching costs represent a steep challenge for incumbents that is unlikely to be surmounted in the near to distant future,” says Wong, who puts the stock’s fair value at US$245, and forecasts 9.2% revenue growth during 2020-24, with its top-line surpassing US$2.4 billion in 2024, as a result of the company's rapidly growing ESG franchise.