Not Your Daddy's AAA-Rated Stocks

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"AAA-Rated Subprime Collateralized Debt Obligation" has become my favorite oxymoron.

Think about it: AAA is the highest rating one can achieve. It implies impeccable creditworthiness. "Subprime" implies creditworthiness of very inferior quality, yet Wall Street managed to manufacture a AAA security using only consumer loans of inferior quality.

We know how this brilliant experiment to disguise bad credit as good credit worked out for some of those CDO producers like Lehman, Bear Stearns, and Merrill Lynch (yes, even Merrill failed in my book as it was acquired for chump change).

And the drama is far from over.

Credit quality has also been deteriorating in corporate America for many years. Right now there are only six AAA-rated companies; in 2001 there were nine, in the early 1990s there were 22, and in the late 1970s, an environment characterized by high interest rates, high inflation, and surging commodity prices, there were 58 AAA-rated U.S. corporations. I don't like this trend.

The latest AAA victim
General Electric's (NYSE: GE  ) coveted AAA status was the latest to bite the dust. The AAA rating is important for a company because it lowers borrowing costs, which gives the company a competitive advantage. Worries about undisclosed losses in its finance subsidiary were the main driver of GE's credit downgrade, as well as the cyclical performance of its industrial businesses, which tend to suffer in an economic slowdown.

For GE shareholders, the loss of the AAA rating was the insult added to the injury of the company's first dividend cut since the Great Depression. Ironically, the shares have been rallying ever since the cuts in the dividend and the credit rating, as the market appears to have discounted the worst-case scenario. If we are anywhere near the low point of this recession, GE could make a pretty good stock since the company is leveraged to an economic recovery.

The AAA club
The only remaining AAA-rated U.S. companies are Berkshire Hathaway (NYSE: BRK-B  ) , ExxonMobil (NYSE: XOM  ) , Johnson & Johnson (NYSE: JNJ  ) , Microsoft (Nasdaq: MSFT  ) , Pfizer (NYSE: PFE  ) , and Automatic Data Processing (NYSE: ADP  ) .

Let me elaborate on which ones I think have issues.

1. Pfizer
One AAA-rated company in danger of losing the coveted status is Pfizer, which cut its dividend in half in January when it announced that it is buying Wyeth. There are serious issues with patent expirations and political headwinds as the Obama administration tries to reform health care. A lot of that may be reflected in the share price, but we are yet to see how the political issues unfold, so be careful.

2. Microsoft
Microsoft has me in a bad mood: I blame it for crashing my laptop with its cumbersome Vista operating system. (I got the blue screen of death.) I went as far as having an expert friend of mine install a Linux OpenSUSE 11.1 on an older, back-up laptop, and I must say that Microsoft has a reason to fear that competitive threat. My expert friend tells me that Microsoft's software is suboptimal -- every new version is bigger and more cumbersome.

Microsoft has threats from many angles. Linux is the real deal, and although it doesn't have the marketing muscle that Microsoft has, it has made real inroads into Europe and Asia. Apple also has superior software, but it still remains a consumer-oriented technology outfit. Microsoft's Zune music player was a flop, and the Live search technology is a joke.

Yes, there is strong cash flow and very little debt (hence the AAA rating!). But with Google outmaneuvering Microsoft at seemingly every turn, it seems behind the curve. I'm not saying that the credit rating is in any danger in the near term, but its cash flows might begin to deteriorate down the road.

3. Berkshire
Berkshire has been under fire for having big bets in derivatives and the largest drop in book value in its history. Fitch has already axed the AAA rating; S&P and Moody's have not yet done that. The drop in book value should have been expected as the stock market had a generational decline and Berkshire has a lot of stock holdings. The derivative bets -- short put positions on S&P 500 European-style over-the-counter options -- have gone against Warren Buffett so far, but the public misses the point that European-style options can only be exercised upon expiration, which in this case is several years from now. So far, those are only paper losses.

I recall reading Russell Napier's forecast that the S&P 500 could go to 400 by 2013. Napier used the Tobin's Q ratio, which compares the market value of companies relative to the replacement value of their assets. The Q ratio on U.S. stocks recently dropped to 0.7 from a peak of 2.9 in 1999, and a reading of 0.3 has always signaled the end of a bear market, according to Napier. Not a pretty forecast, but something to keep in the back of one's mind when you know that Berkshire wrote S&P 500 puts (Buffett's paper losses increase as the market declines).

When it comes to AAA-credit-rated stocks, do not assume that you should skimp on your investment homework. GE is the best example of that, but others may follow the same fate.

More on AAA-rated companies:

Fool contributor Ivan Martchev does not own shares in any of the companies in this story. Johnson & Johnson is a Motley Fool Income Investor pick. Berkshire Hathaway, Microsoft, and Pfizer are Motley Fool Inside Value recommendations. Google is a Motley Fool Rule Breakers recommendation. Apple and Berkshire Hathaway are Motley Fool Stock Advisor picks. The Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletters today, free for 30 days.

Read/Post Comments (10) | Recommend This Article (26)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 07, 2009, at 3:30 PM, madcowmonkey wrote:

    That's my line. Royalties?

  • Report this Comment On April 07, 2009, at 3:40 PM, FinancialFellow wrote:

    I would've thought that corporate America was a little better about managing their debt/credit worthiness than the average American. Apparently corporate America has/is going the same direction. In addition to individual Americans it appears that corporations may have leveraged themselves a bit too much. No knock on the above companies. Although some are in danger of losing their AAA rating their credit rating will still be pretty darn good. It's the companies with lower credit ratings that are flirting with junk bond status that concerns me.

    Speaking of individual American debt, here's an interesting read on whether or not you should assume a fixed rate mortgage or an ARM:

  • Report this Comment On April 07, 2009, at 3:46 PM, outoffocus wrote:

    Still wondering why the US hasnt lost its AAA rating...

  • Report this Comment On April 07, 2009, at 4:26 PM, FinancialFellow wrote:

    Right on outoffocus. If the US was a corporation our treasuries would be junk bonds...

  • Report this Comment On April 07, 2009, at 6:19 PM, UltraContrarian wrote:

    Other US companies that probably deserve AAA ratings:









    Con Ed

  • Report this Comment On April 07, 2009, at 11:21 PM, chopchop0 wrote:

    I think out of all of those companies, JNJ and XOM have the biggest fortress of a balance sheet to protect their AAA rating.

    Oh yeah,

    Should the US be AAA?

  • Report this Comment On April 08, 2009, at 12:46 PM, KWT8011 wrote:

    The US hasn't been reduced to junk status because (excluding the European Union, esp. since you can't buy EU bonds) it has the largest GDP BY FAR in the world. China's GDP is roughly half of the US.

    The corollary to me is if a baseball team that leads its division by 20 games and loses 3 in a row, it doesn't automatically lose its status as a contender for a championship.

    If its downgraded or junk, then that just means all other alternatives are that much worse as well.

  • Report this Comment On April 08, 2009, at 12:52 PM, theMovement wrote:

    Just had a talk about this in one of my MBA classes yesterday from a professor who used to be an investment banker and also did a lot of work with bonds.

    If you're reading this article and wondering if a lower rating means lower stock price......... it doesn't!

  • Report this Comment On April 08, 2009, at 1:36 PM, Gardnermiles wrote:

    When we can find an American made item that should be our choice over any type of foreign product until we pull ourselves out of this mess. For example there are to darn many foreign cars on the road here in America. Try finding American made toys, or clothes. My view is pay the little extra for American made products and get a good return on your money.

  • Report this Comment On April 08, 2009, at 7:38 PM, chopchop0 wrote:

    I might agree for American toys, but not for American cars. GM may have finally started improving, but it's case of a too little, too late IMO

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