United States Vs. McGraw Hill: The Case For Efficient Markets

The stock market may not be perfectly efficient, but it is beautifully close. Monday, the S&P Ratings announced that they were anticipating being sued by the United States Department of Justice over their role in the financial crisis. S&P is part of the McGraw Hill conglomerate ( MHP). McGraw Hill's stock fell almost immediately about 13%. Yesterday, the Attorney General placed a number on the damages being sought, $5 Billion. Within hours, McGraw Hill had fallen another 5.7% on the news.  McGraw Hill's total loss of Market Cap reached $2.7429 Billion by 12:00 pm on February 5 th , 2013, or 54.85% of the amount of damages being pursued by the Us Attorney General.

One could say that the market participants have given the US a 54.8% chance of winning; Or to be more precise since the courts can award partial damages, the market believes that court costs and damages will add up to approximately $2.75B for McGraw Hill. By market close on Tuesday, MHP had lost over 22% of its value, losing $3.75 Billion in market cap, an astonishing 75% of the total damages sought by the DOJ.

The investment opportunity, for any who doubt the efficiency of the stock market, lies in speculating upon the outcome of the trial. A settlement for anything less than $3.75B should cause McGraw Hill's stock to appreciate, with a slight premium added in for the removal of uncertainty. A full victory for the Attorney General will cause McGraw Hill to fall by another $1.25 Billion.

A periphery investment opportunity arises from S&P's competitors, Moody's and Fitch. Moody's, a subsidiary of Moody Corp ( MCO), had shed $1.3 B in market cap within hours of Tuesday’s announcement. By the closing bell, MCO was down over 17% in the last two days, losing $2.16B in market cap.  Essentially, the market is giving Moody's a 43% percent chance of incurring the $5B liability mentioned by the Attorney General for S&P. This is essentially a 75% chance of S&P losing, and a 57% chance that if S&P loses, Moody's will also be brought to trial and lose. 

These percentages may understate the market odds being given to Moody’s. Moody’s had revenues of $2.28 Billion in the last year. This is slightly more than a third of the $6.2B in revenues brought in by the McGraw Hill Companies. $5B would be crippling for MHP, but it would be catastrophic for Moody’s. If the damages are proportionally adjusted by revenues, then the DOJ, if they sue MCO, should seek slightly more than $1.75B in revenues from Moody’s. Moody’s already lost more than that in market share. At times, investors are seized with fear and overreact. If this is the case, then the price of MCO will correct to reflect a more rational probability of incurring a liability, giving investors an opportunity to profit by buying MCO.

FIMALAC, a French firm, owns Fitch's, the third rating agency, as a 50% joint venture with privately held Hearst Corp. French markets are currently closed, but interestingly, FIMALAC only shed $1.7 M in market cap yesterday. It would appear that market participants are discounting the threat of legal action against Fitch.

According to the Wall Street Journal, there is not any publicly available information which indicates why the DOJ is focusing on S&P or to what extent the investigation will spread.  In fact, in a statement made by S&P, this fact appears to be central to their defense. They claim that they were using the same data available to the rest of the market, and reached the same conclusions as their competitors.

Nevertheless, there is a greater degree of uncertainty surrounding Fitch which is not reflected in the price of FIMALAC (EPA:FIM) shares. I understand that since they only own 50% of Fitch, they face only half of any liability incurred by their subsidiary, but if investors gave Fitch the same chance as Moody's of also facing litigation, they should be liable for approximate $38.64 Million*(calculation explanation at the bottom). Significantly more than the $1.7 Million they declined by yesterday. 

In addition to these short term movements, one must consider whether litigation is a binary event. Do these companies either win or lose? I would argue that it is not. It is possible to settle out of court for a fraction of the costs, it is possible to win in court yet still incur costs, it is possible to lose in court for the full $5B, or the firms could lose in court but incur a lesser liability. $5 Billion would be a crippling settlement against McGraw Hill, which had Net Income of around $867 Million in the last 12 months.  Speculating on the awards of the court or the legal outcome of this case is beyond my area of expertise; however, watching the market react in real time to the publication of further information is fascinating, and sometimes profitable. 

*5B represents 31.3% of MHP's market cap. FIMALAC is significantly smaller. 31.3% of 1.03 B (FIM market cap) is $322 Million. 12% (market odds of Moody's being found liable) of 322 M is $38.64 Million. 

By Kapitall Contributor David Emami

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