Last week, bond-rating agency Fitch Ratings downgraded the rating of the United States. Instead of the highest AAA, the U.S. now has a rating of AA+. Fitch grabbed some headlines, but they did not have the impact that S&P Global had when it downgraded the U.S. in 2011. I personally would like to thank Fitch for better timing; I was supposed to be on vacation in 2011 when S&P made their downgrade…as it was, my wife and kids enjoyed the beach and pool while I stayed inside working remotely with a better view than the one from my office. At least Fitch had the decency to wait for the Osbornes to get back from their summer vacation before throwing their bomb at the market.
In 2011, the downgrade made a big splash: We were just recovering from our own financial crisis, Europe was still having their financial crisis, and the market was on shaky ground. This time, the market took the news with hardly a shrug. I wonder how much this shrug played into Moody’s decision to downgrade banks five months after Silicon Valley Bank went under in the non-crisis that the financial media tried to create. They did this with the dire warning that it isn’t over.
There is no banking crisis. There is a difficult environment for banks, but a difficult environment is not the same thing as a crisis. One has to wonder about the timing of the downgrade. Where was the downgrade of banks before Silicon Valley failed? Why is the U.S. being downgraded now? The problem with rating agencies is and always has been that they view the world through the rear-view mirror. They react to what has already happened and do not, in my opinion, actually provide investors with forewarning as most investors believe. After their remarkable failure leading up to the 2008 Financial Crisis, it is a wonder anyone pays attention at all to the rating agencies.
How should one measure risk if not by looking at ratings? We believe that prudent investing is risk averse, and that risk is best measured by what Benjamin Graham referred to as the “margin of safety.” The margin of safety is the difference between the value of an investment and the current market price of an investment. Calculating the value is a subject beyond the scope of this Insight (at Iron Capital we use our own research and models to do this), but the end result does not need to be exact – we need to know only that the value is much higher than the price.
How can we do that? U.S. Treasuries and banks happen to be two great examples. The yield on U.S. Treasuries were extremely low in recent memory; for most of the last 15 years, the 10-year Treasury had a yield in the neighborhood of 2 percent. The prices of bonds are inversely related to the yield. In other words, low yields mean high prices, and high yields mean low prices. Treasuries are usually considered “risk free” because, regardless of the rating Fitch or S&P wish to bestow, the Treasury is not going to default on its debt. However, record-low yield means record-high prices, and any time something sells for record-high prices, the margin of safety is low. Sure enough, when rates finally rose in 2022, bond investors had the worst returns in the history of the aggregate bond index – with no warning from any rating agencies.
Banks offered the reverse. When Silicon Valley Bank failed and the pundits kept yelling “crisis,” we purchased two banks. That seems like the riskiest time to invest in banks, doesn’t it? It is amazing how often safety seems risky and risky seems safe. We purchased Western Alliance Bancorp and Truist Financial for appropriate portfolios. I name these for educational purposes only, so don’t just go out and buy them.
Both banks are well run and in solid shape. Both were selling for a price not seen since the Financial Crisis. The margin of safety was high. Western Alliance, which is a more aggressive investment, is up 50 percent in the short time we have owned it. Truist has not been as exciting, and is actually slightly down, but it is paying a 6.5 percent dividend and we are confident it will weather this difficult environment and do well over time. Meanwhile, our clients will gladly collect the 6.5 percent coupon.
Does this mean our timing is better than the rating agencies? Well, timing is a fool’s errand. No one can time the market, including the rating agencies. One can pay attention to price and value and the margin of safety. Prudent investing is risk averse, which often leads to counter-intuitive moments. No one knows the future of Treasuries, but at a 4 percent yield they have a better margin of safety than at a 2 percent yield, regardless of what Fitch says. One cannot predict the future of the entire banking sector, but the margin of safety on individual banks can be calculated and is often the most attractive when investors are the most nervous.
The rating agencies can say what they want. We will continue to invest prudently, and that largely means ignoring ratings.
Warm regards,
Chuck Osborne, CFA
Managing Director
