Perhaps you know someone like this in your life… A well-educated person with a high-paying job. Or someone who lives in a mansion and drives a Mercedes. But they built that lavish lifestyle on debt… All it takes is a recession and they can lose it all.
Anyone can fall victim to this habit. My good friend Brad Thomas is one of the most successful businessmen I know. He built a $25 million real estate empire… and then lost it all during the Great Recession for the same reason: he couldn’t service his debt.
Brad’s since rebuilt his fortune and is more successful than ever. Now he and our Wide Moat Research team can spot when a company’s forming a “bad habit” – it’s all in the balance sheet.
The most famous recent example we saw is the catastrophic plunge of FTX. Praised as the savior of crypto as it bought up struggling crypto companies, FTX was more focused on lining its pockets than it was on ensuring its salvific moves were actually sustainable for its balance sheet.
A company’s balance sheet should be the focus of your investing this year. As I mentioned last week, all data points indicate that we are heading into a recession. So now’s the time to thoroughly evaluate your investments’ balance sheets and make sure they are set to withstand the bad times.
Today, I will break down a well-known table that determines the strength of a company’s balance sheet, show you how we use it in our own research, and give you a free recommendation to a solid company that I’ve been following.
The Credit Ratings Table
Most people have heard of credit ratings, but few know what they mean.
Don’t get me wrong. Credit ratings aren’t perfect. During the Great Recession many toxic mortgage bonds that were given the highest rating, AAA, went bankrupt.
But overall, credit ratings are the single best measure of the strength of a company’s balance sheet, giving us an estimated fundamental investing risk. That’s because credit ratings are based on over 100 years of default data for tens of thousands of companies.
And believe me, the evaluation model has been updated since 2008 and 2009.
So in other words, if you want to know the risk of a company you own going bust over time, these ratings are the best first line of defense you can use.
|
Credit Rating |
30-Year Bankruptcy Probability |
|
AAA |
0.07% |
|
AA+ |
0.29% |
|
AA |
0.51% |
|
AA- |
0.55% |
|
A+ |
0.60% |
|
A |
0.66% |
|
A- |
2.5% |
|
BBB+ |
5% |
|
BBB |
7.5% |
|
BBB- |
11% |
|
BB+ |
14% |
|
BB |
17% |
|
BB- |
21% |
|
B+ |
25% |
|
B |
37% |
|
B- |
45% |
|
CCC+ |
52% |
|
CCC |
59% |
|
CCC- |
65% |
|
CC |
70% |
|
C |
80% |
|
D |
100% |
(Source: S&P 500)
There are 22 possible credit ratings, and they are based on the probability of a company defaulting on its debts within the next 30 years.
The outlook, stable, positive, negative, and negative watch, indicates the probability of an upgrade or downgrade of the credit rating within the next two years.
What makes these credit ratings so useful is that they incorporate risks based on debt metrics like debt/cash flow as well as interest coverage ratios and long-term risk management.
For example, the S&P 500 has included its long-term risk management ratings for every credit rating in the past two decades.
What is this long-term risk management rating composed of?
It is based on over 30 major risk categories, including over 130 subcategories and 1,000 individual metrics, 50% of which are industry-specific.
S&P’s risk management scores factor in things like:
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This risk management model includes anything and everything that can go wrong with a business. And that model is part of S&P’s credit rating system.
And it’s not just the S&P 500. Moody’s and Fitch each have their versions of long-term risk management rating systems, as does DBRS (Canada’s rating agency) and AMBest (insurance ratings).
So how do we tell if a company has a strong balance sheet and a healthy business that can survive this recession or any future downturn? At Wide Moat Research, we combine ratings from up to seven agencies, along with the bond market’s fundamental bankruptcy risk estimates.
We have access to something called Credit Default Swaps or CDS data. These are the publicly traded bankruptcy insurance policies bond investors take out on thousands of companies.
When news breaks, such as a major new lawsuit against a company like Johnson & Johnson (JNJ) or 3M (MMM), we can see in real-time what the bond market thinks this means for the fundamental risk of the company.
So let me show you how you can apply credit ratings and fundamental risk to help you retire rich and stay rich in retirement.
An A+ Investment
One of the companies that I have been following for a while is the Bank of Montreal (BMO). BMO is an A+ rated Canadian bank with long-term risk management in the top 6% of global companies.
In the chart above you’ll find that the “A+” rating gives you a 30-year bankruptcy risk of “0.60%” according to S&P 500 credit rating model.
But don’t take my word for it, look it up!
Online, type in “S&P 500 credit rating for BMO” into Google. It will come up with an “A+” credit rating for BMO.
This means if you buy it today, your risk of losing all your money is approximately 1 in 167.
BMO’s 4.1% yield is very safe, growing about 8% over time. That means 12% long-term returns, 20% more than the S&P 500.
How dependable is BMO’s dividend? It began paying one in 1829 and hasn’t missed a single payment in 194 years. That’s the most impressive dividend growth streak of any Canadian Bank.
And guess what? BMO isn’t even the safest bank in Canada.
There are much safer banks with faster growth rates and better risk management. And in our Fortress Portfolio, you can find out what they are. Click here to learn more.
The more you understand how to identify a strong balance sheet and mitigate your overall financial risk, the safer and stronger your portfolio will be.
Safe Investing,
Adam Galas
Analyst, Intelligent Income Daily