Integrity in Credit Rating5 min read

At the end of the book titled ‘The Interpretation of Financial Statements’[1] by Benjamin Graham, in a chapter titled ‘Conclusion’ he writes the following;

“There are other factors outside of the company that are perhaps equally important in their influence of the value of its securities. The outlook for the industry, general business and security market conditions, periods of inflation or depression, artificial market influences, the popular favour of the type of security- these factors cannot be measured in terms of exact ratios and margins of safety. They can only be judged by a general knowledge gained by constant contact with financial and business news.”

This paragraph follows many chapters of text deconstructing financial statements in a methodical manner, which in the words of the paragraph preceding the one quoted above, suggesting that “By an examination of the statements it is possible to form an opinion as to the present position and potentialities of the company”

The book concludes on the note that;

“The investor who buys securities when the market price looks cheap on the basis of the company’s statements, and sells them when they look high on this same basis, probably will not make spectacular profits. But on the other hand, he will probably avoid equally spectacular and more frequent losses. He should have a better than average chance of obtaining satisfactory results. And this is the chief objective of intelligent investing.”

Efficient Market Hypothesis

To quote Wikipedia[2];

“The efficient-market hypothesis (EMH) is a theory in financial economics that states that asset prices fully reflect all available information. A direct implication is that it is impossible to “beat the market” consistently on a risk-adjusted basis since market prices should only react to new information.”

Benjamin Graham’s work and Eugene Fama’s theory represent a broad consensus amongst financial professionals. Benjamin Graham’s work is considered the Bible to value investors. Eugene Fama’s work is widely taught at universities.

Taking both to be true it is fair in my opinion to suggest that the share price and its movements suggest a trend in underlying credit worthiness of an institution. The logic is that the aim of an investor is to price a share according to its current asset holding and future earnings. Future earnings make possible the repayment of credit. This when combined with EMH suggests that the market price reflects all available information. This thinking is present in the academic literature[3].

To quote from the latter referenced paper’s abstract;

“an approach of estimating failure probabilities based solely on stock market prices…

We find a close correspondence between changes in the estimated probabilities of failure and the actual credit events occurring. Credit ratings from major credit rating agencies, on the other hand, are shown to react much less and much slower to credit quality changes”

A declining share price relative to the market (a decline greater than the market) would suggest a decline in credit worthiness. This is why most people in fair markets see a decline in share price highly correlated with a decline in credit rating. 

Put more simply the decline in the price of Melstacorp is due to its recent acquiring of shares in JKH. The acquisition is not perceived as beneficial to future earnings. The company obtained significant credit over the last year and should have been downgraded.

Laughable Ratings

To quote from the Fitch Ratings press report[4] on Melstacorp

“The group had a comfortable liquidity position at end-March 2018, with LKR19 billion of unutilised but committed credit lines and LKR15 billion of unrestricted cash available to meet LKR19 billion of debt maturing in the next 12 months. We expect Melstacorp to generate around LKR5 billion of negative FCF in FY19 amid higher capex at ASP. The group has strong access to local banks due to its position as one of Sri Lanka’s largest corporates and its solid credit profile.”

Melstacorp has the highest possible rating for an LKA institution of AAA. This rating is in spite of forecasted net cash outflows and a currently negative cash position. The company has been in a negative cash position for many years.

Taking the Interim Statements

The recent interim statements uploaded to the CSE were noticeably missing the cash flow statement. This is an issue that I raised with the company. Though a forgivable oversight I do not see why it was not picked up earlier by analysts. This is further made worse by the fact that the CSE uploaded a corrected version as if though no error had been committed.

From the year 2017 to 2018 total assets of the company increased from 121 billion to 232 billion. Though this may be due to the way in which they now consolidate their accounts it is unlikely to suggest that the underlying assets are at the disposal of the holding company.

Conclusion

Why is the share price movement at such odds with the credit rating? Who is giving finance to Melstacorp and why?

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[1] The Interpretation of Financial Statements, Book by Benjamin Graham and Charles McGolrick

[2] https://en.wikipedia.org/wiki/Efficient-market_hypothesis

[3] Measuring the risk of financial institutions’ portfolios: some suggestions for alternative techniques using stock prices, S. G. HALL AND D. K. MILES; Estimating Default Probabilities Using Stock Prices: The Swedish Banking Sector During the 1990s Banking Crisis by Hans NE Byström

[4] http://www.lankabusinessonline.com/fitch-assigns-melstacorp-first-time-aaalka-rating-outlook-stable/