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It's All About Bond Rating Analysis

If value investing is going to stay in vogue, this stuff many investors find arcane is going to become increasingly important.
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Editor's Note: Aaron Task is traveling and unable to comment on Monday's market activity or update GuruVision. He'll return Tuesday with the regularly scheduled fare.

SOMEWHERE OVER MIDDLE AMERICA -- If you haven't already, read the lead story in the business section of Sunday's

New York Times

. I've flagged Gretchen Morgenson in the past for (among other things) overuse of the casino analogy, but she really

rolled a seven

with her piece about the bond market.

If value investing is going to stay in vogue -- hard to argue it's not, with the

S&P Barra Value Index

up a few percentage points for 2000 as of Friday's close, while its value counterpart is down nearly 15% -- this bond stuff that so many investors find so arcane is going to become increasingly important.

From my experience as an editor at

Standard & Poor's

in the early 1990s, I can tell you bond rating analysts eat balance sheets for breakfast (

for a balanced breakfast, try balance sheets

... ) As a result, there's a whole lot more science than art in analyzing fixed income, especially when compared with stock analysis.

I don't mean that as a knock. But the job of the bond rating analyst is, essentially, to predict the likelihood an issuer will repay its debts as scheduled. That's determined, essentially, by pre-established formulas that say if a company has X amount of debt and Y amount of free cash flow, the odds are Z that it will make its debt payments on time, given the stability and dependability of that cash flow in a particular economic environment. There are less empiric factors, but the bottom line is the bond analysts don't have a lot of wiggle room.

Cash-flow analysis needn't supplant a focus on the income statement, but should be part of every equity investors' tool chest.

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TheStreet Recommends

Jim Cramer

has written about this as it pertains to telecom companies, but it cuts across many industry segments.

For example, Brian Gilmartin, portfolio manager at

Trinity Asset Management

in Chicago, said he would sell


(GPS) - Get Gap Inc. (The) Report

stock if the retailer's credit rating dipped below investment grade. Currently S&P rates Gap's long-term debt single-A with a negative outlook.

But Gilmartin, formerly a fixed-income analyst at a mutual fund company, noted Gap's stock soured long before the bond rating agencies first caught on to problems. From his point of view, bond analysts are not as forward thinking as equity analysts and are too conservative, preferring to be "wrong on the upside rather than the downside."

I contend the opposite is true of equity analysts. Given the way stocks have performed this year, maybe discretion is the better part of valor -- and analysis.

Ones to Watch

Ravi Suria, the convertible bond analyst at

Lehman Brothers

who dissected

(AMZN) - Get Inc. Report

, is the best-known bond analyst. Two others whom investors may soon find invaluable are Carol Levenson and Kathy Shanley, both of

Gimme Credit

in Wilmette, Ill.

On Aug. 18, Levenson released a "Bottom Ten List" of bond issuers that included

Crown Cork & Seal

(CCK) - Get Crown Holdings Inc. Report

, whose stock is down nearly 69% since the report was issued,

J.C. Penney

(JCP) - Get J. C. Penney Company, Inc. Report




, off 29% each, and


(UAL) - Get United Airlines Holdings Inc. Report

, which is off 24%. In the same time period, the

S&P 500

is down 8.3%.

On Sept. 18, Shanley issued a similar list focused exclusively on financials, including:


(FNV) - Get Franco-Nevada Corporation Report

, down 80% since as of Friday's close,



, down 36%,

Providian Financial


, which is off 17.2% and

First Union


, down 14.4%. Over the same timeframe, the S&P is down 5.3%.

In an email exchange, Levenson said she wouldn't remove any of the companies from her original bottom 10 list, and noted the bonds of


(XRX) - Get Xerox Holdings Corporation Report



(T) - Get AT&T Inc. Report

(which weren't on her list) also flashed warning signs.

Additionally, she said there's "no doubt equity analysts have begun to pay more attention to things such as balance sheet, discretionary cash flow, and especially liquidity that they weren't worried about in the 'trees growing to the sky' phase of things."

Of course it would have been nice for shareholders of the aforementioned to have known beforehand, but I only just got those reports late last week. Still, the performance of those stocks begs the point about how at least acknowledging the existence of bonds can help equity investors.

There were some misses on Gimme Credit's list, the most notable being


(UIS) - Get Unisys Corporation Report

, which is up 8.6% since Levenson put it on her list. But given the performance of the other names, perhaps Unisys shareholders should feel as if they've been given a reprieve -- even despite the stock's clobbering midsummer. (Finova, for one, already was down considerably from its 52-week high when cited by Shanley.)

Speaking of high-tech names, most haven't issued debt because soaring stock prices have given them a relatively cheap source of capital to finance their continued growth. But most of those stock prices aren't soaring anymore. So, don't be shocked if tech bellwethers start issuing more debt in the coming months and years (and Wall Street firms in need of underwriting fees start encouraging the practice if the market for secondary issuance of stocks continues to worsen). It's already starting to happen.

"In the past year we've had substantial growth in the tech sector from companies who fundamentally don't need cash today but want a rating relationship," said Bruce Hyman, a director at S&P who noted there is already about $200 billion in rated debt from high-tech companies worldwide.

Vitesse Semiconductor



Analog Devices

(ADI) - Get Analog Devices Inc. Report

, and

Comverse Technology


are examples of tech companies that have recently issued debt (usually convertible securities) in order to "get access to dry gun powder," Hyman said.

In the end, selling bonds won't necessarily be a bad thing for tech names because the practice necessitates cold, hard and (yes) calculated analysis of the balance sheet. Many high-tech concerns will likely discourage that kind of scrutiny.

But those that can (

you're running around, I won't ...

) stand it might actually do their shareholders a favor because the layer of concrete data that accompanies a bond sale can be worth much more than the paper it's printed on.

Aaron L. Task writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.