"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
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
Let me elaborate on which ones I think have issues.
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.
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.
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.