[00:04:31] Shawn O’Malley: As mentioned at the top of the show, today’s episode is about the company behind the famous S&P 500 index. Alongside me today is my friend, Daniel Mahncke, who is an excellent stock investor in his own right. And we’ll be co hosting the episode with me. Welcome to the show, Daniel.

[00:04:46] Daniel Mahncke: Thanks for having me, Shawn. I’m excited to be here and talk about S&P Global.

[00:04:50] Shawn O’Malley: Yeah, it’s a really interesting company. Before we dig in too much, I want to paint some color around the company’s history. First things first, S&P stands for Standard & Poor’s. The name connects back to the 1941 merger of Henry Varnum Poor’s Company, Poor’s Publishing, with Standard Statistics.

[00:05:08] Shawn O’Malley: To go back even further, its origins date to 1888 when James H. McGraw purchased the American Journal of Railway Appliances. Over the next decade, he continued to acquire publications until he established the McGraw Publishing Company in 1899. Around the same time, in 1902, John A. Hill had produced several technical and trade publications which he formed into the Hill Publishing Company.

[00:05:31] Shawn O’Malley: In 1909, McGraw and Hill joined forces to form the McGraw Hill Book Company and 8 years later combined other elements of their separate businesses into the McGraw Hill Publishing Company. 10 years on from there, McGraw Hill founded the popular Businessweek magazine, which it sold to Bloomberg in 2009.

[00:05:49] Shawn O’Malley: In 1966, McGraw Hill would make its first major step toward becoming the S&P Global we know today by purchasing the credit rating agency Standard Poor’s. You might recognize the McGraw Hill name from your days in school, since the company is one of the major publishers of academic resources like textbooks.

[00:06:05] Shawn O’Malley: By 1986, actually, buyouts of other publishers had made McGraw Hill the largest publisher of educational material in the U. S. In 2012, McGraw-Hill spun off its education business and sold it to the private equity firm, Apollo Global Management, for $2.5 billion. And in 2016, it sold off its ownership of JD Power, and the remaining company officially rebranded itself as s and p Global after a shareholder vote.

[00:06:30] Shawn O’Malley: So multiple mergers, spinoffs, and acquisitions over the last 130 years or so bring us to the s and p Global, which operates today with a market capitalization of roughly $153 billion. That behemoth of a business breaks down into the ratings business. We already briefly mentioned it’s market intelligence business, which includes the capital IQ and capital IQ pro platforms.

[00:06:53] Shawn O’Malley: It’s index business, which produces indexes like the S&P 500. It’s commodity insights business based in London, which helps set prices for benchmarks for global energy metals and agricultural markets. And it’s S&P mobility business, which is industry leading data on automobiles.

[00:07:09] Daniel Mahncke: It’s worth mentioning, too, that there has been another big change at the company even more recently. S&P purchased another one of the financial industry’s biggest data providers, IHS Market, for 39 billion in a deal that was announced in 2020 but closed in 2022. For every share that holders of IHS Market’s stock held, they received roughly 0. 3 shares of S&P stock in exchange. Bloomberg reports that, quote, the deal marries S&P, one of the most famous names in financial markets, with a research company that supplies forecasts to most of the world’s biggest companies, as well as pricing for bonds and credit default swaps.

[00:07:53] Daniel Mahncke: This was a pretty big consolidation of financial data providers, announced just a year after the London Stock Exchange’s parent company agreed to acquire Refinitiv. Another provider of data and analytics in financial markets. When you account for the approximately 5 billion of net debt that S&P assumed by acquiring IHS market, the total deal value is about 44 billion.

[00:08:20] Daniel Mahncke: IHS’s valuation in the deal came out to almost 30 times its 2019 earnings, which was the last full year of financial results before the deal was agreed upon.

[00:08:31] Shawn O’Malley: Yeah, investors in the company have done a lot of work to try and determine whether S&P overpaid for that deal. The premium they paid over IHS’s stock price at the time was less than 5 percent though, which is fairly modest compared to some of the buyout premiums in big companies.

[00:08:46] Shawn O’Malley: The premium they paid over IHS’s stock price at the time was less than 5 percent though, which is fairly modest compared to some of the buyout premiums big companies pay. Can you just walk us through a bit of what S&P received in this deal?

[00:08:58] Daniel Mahncke: Of course. With IHS market, S&P added another pillar to its corporate structure with its S&P Global Mobility Division.

[00:09:07] Daniel Mahncke: IHS has long been a leader in providing insights and forecasts related to all parts of the automotive value chain, from manufacturers to car buyers and service shops. The company has some of the best data on trends in vehicle demand, technology, marketing, and sales optimization. Their data is critical to any stakeholders who touched the automobile industry.

[00:09:33] Daniel Mahncke: But this mobility unit focused on automobile data may not remain a pillar of the company for too much longer. Earlier this year, Reuters reported that S&P was considering selling its mobility business since it was beyond the scope of its core focus on financial markets. Private equity firms have apparently been eyeing the business unit for purchase at a price of around 12 billion dollars.

[00:10:00] Daniel Mahncke: Besides its data on the automotive industry, IHS brings to the table a lot of software tools used by big banks to underwrite corporate stock and bond offerings, as well as transportation and energy data that complement S&P’s existing services. The bigger picture is that there’s a race between the biggest financial data companies like S&P, FactSet, Bloomberg, and Moody’s to become the one stop shop for financial institutions, which is a sort of broad term but can include everyone from investment bankers to day traders or corporate executives.

[00:10:38] Daniel Mahncke: S&P ranks third in annual revenue behind Bloomberg and Refinitiv, while IHS Market ranked eighth before it was acquired. I would imagine that the rationale for the acquisition boils down to S&P identifying valuable data and tools at IHS that would be costlier for S&P to incrementally build out themselves.

[00:11:02] Daniel Mahncke: So, they decided to buy IHS outright. For example, with IHS, S&P reportedly added in price data onto its platforms for over 19 million bonds. Early projections for the deal suggested it could generate almost 700 million dollars in so called cash flow synergies, which essentially reflects the savings that can be found by combining the two companies and cutting out redundancies.

[00:11:29] Daniel Mahncke: On top of that, IHS had a lot of products that were really heavily relied on by financial institutions, but weren’t used by other types of corporations. Whereas s and p has much deeper ongoing relationships with a broader spectrum of companies. So the first step after the acquisition was to capitalize on selling IHSS offerings to s and p’s, wider base of clients.

[00:11:56] Shawn O’Malley: I want to break down what S&P looks like after the merger. Its legacy S&P Global Ratings business makes up one third of the total company and over 40 percent of its operating profits. S&P is actually the largest credit rating firm in the world, just a bit larger than Moody’s, but combined the two account for around 80 percent of the global ratings industry with the third biggest being Fitch, which has a 10 percent market share.

[00:12:20] Shawn O’Malley: Fortunately for these companies, the entire world of fixed income has been built around them being key intermediaries. For example, investment funds may only be able to invest in certain types of bonds based on a minimum credit rating from one of the major agencies. And regulated entities like banks and insurance companies have hard limits on the types of bonds they can hold based on their credit rating quality.

[00:12:43] Shawn O’Malley: Ratings from S&P and Moody’s really set the standard globally for how investors interpret the risks connected to certain companies and governments and the types of debt they issue. There’s a feedback loop here where investors and regulators have come to primarily accept only ratings from the big three ratings agencies, which pushes more companies and governments hoping to borrow money to secure credit ratings from these agencies.

[00:13:05] Shawn O’Malley: That further entrenches them as the go to sources for ratings. And if you’re trying to borrow money without a credit rating, your options become more limited. You either have to hope for loans from banks or find private investors like private credit funds that are willing to lend to you. Private lending, or private credit as some call it, where investment funds pool money together and make loans to companies has actually boomed in recent years, but there are still limits to this.

[00:13:31] Shawn O’Malley: Especially when it comes to really big borrowings for large corporations and governments, they need to go out into the public markets and sell bonds to the largest possible audience of investors who can fund that debt. So bank lending and private credit can probably only scale up so far. Borrowers will typically get a rating on an entity level, such as how credit worthy the borrower is generally, and that might break out into ratings for whether they’re borrowing short term or long term, and it can also vary depending on the currency they borrow in.

[00:13:58] Shawn O’Malley: Transcribed Specific issuances of debt will also get separate credit ratings as well. So Apple, for example, might have a long term borrower rating, generally, and a handful of ratings for different bonds it has issued. If it has two sets of bonds paying different interest rates with different maturity dates, they could have different credit ratings.

[00:14:15] Shawn O’Malley: Because S&P’s rating teams have decades of experience modeling out financial risks for borrowers, their assessments are trusted by investors and regulators worldwide. A rating from S&P or Moody’s ultimately lowers a company’s borrowing costs, even if the rating itself isn’t great. Without a credit rating, there’s just too much uncertainty and thus companies have to borrow at higher interest rates to address that greater uncertainty.

[00:14:38] Shawn O’Malley: So it really is a win win. With a credit rating in hand, companies typically save more on interest costs than they pay S&P for a rating. And it’s hard to displace S&P or any of the big three because if a new agency offered credit ratings for free, since that new competitor hasn’t built up trust yet, they couldn’t actually help debt issuers get any interest savings.

[00:14:59] Shawn O’Malley: Paying for a rating from the big three is quite literally more valuable than a free rating from almost anyone else. This oligopoly in ratings has survived for decades, including numerous financial crises, and it’s hard to imagine that changing too much within our lifetimes. This can be somewhat of a cyclical business though.

[00:15:18] Shawn O’Malley: When interest rates are seen as low companies and governments can go on a borrowing spree to try and lock in those rates, which means a surge for the ratings business. Generally speaking, when interest rates are high or rising, borrowers are more reluctant to issue bonds, and thus, there are fewer credit rating requests.

[00:15:34] Shawn O’Malley: At the time of recording, interest rates haven’t come down yet, but it certainly seems like they’re on pace to, which could be a boon for the ratings business. The one constant in our world today is that debt at all levels seems to be growing and growing, governments, companies, and households. Our tolerance for debt is considerably higher than in past generations, and S&P is one of the middlemen who arguably benefit the most from the world’s growing reliance on borrowed money.

[00:15:58] Shawn O’Malley: As S&P’s CEO Doug Peterson explained to investors at a conference in June, nominal economic growth is the best indicator of debt expansion, and therefore higher credit ratings. So a strong economy supports the rating business most directly, as borrowing appetites increase when businesses are doing well.

[00:16:17] Shawn O’Malley: But even in periods of modest economic slowdowns, falling interest rates can spur borrowing too, which helps to nerf some of the cyclicality of the business. That is to say, the ratings business can do well in economic good times and modest recessions. And overall, corporate debt growth has been very steady in the past 80 years, rising at an average of 4 percent per year.

[00:16:37] Shawn O’Malley: Around the same size is S&P’s market intelligence unit, which includes that Capital IQ Pro platform we talked about. As opposed to the cyclical ratings business, market intelligence revenues tend to be more recurring since they’re earned as subscriptions sold to corporations. Companies, banks, governmental agencies, and so on have all trained employees on using Capital IQ for years, so that reliance and those relationships tend to be quite sticky.

[00:17:03] Shawn O’Malley: S&P also has a ton of data packages and analytics products that it sells besides its subscriptions for Capital IQ Pro, and it has a handful of related products tied to real time data targeted at firms that need the most up to date market prices, like high frequency traders. There are also packages where institutional investors can purchase research from S&P’s credit ratings teams and tools for firms to conduct their own estimates of what a credit rating should be.

[00:17:29] Shawn O’Malley: One really cool way that S&P has continued to build trust in its data and improve it is through a bounty program where the company actually pays customers if they find a mistake in their data. S&P’s next three business units are all about the same size, with low double digit percentage shares of revenue.

[00:17:46] Shawn O’Malley: That is, the Commodity Insights, Mobility, and Index businesses. For the Commodity Insights unit, the bread and butter of it is called S&P Platts, which is the leading independent provider of benchmark prices in commodity and energy markets. They compile the pricing data on everything from petroleum to iron ore, petrochemicals, crops, and metals.

[00:18:07] Shawn O’Malley: Revenue for this business comes usually from either subscriptions or royalties from licensing the data to other providers. You can imagine that this sort of data isn’t just valuable to investors, but also to the companies competing in these spaces, as well as farmers, engineers, governments, and geoscientists.

[00:18:24] Shawn O’Malley: The business tends to be quite sticky because it’s baked into a lot of long term agreements. For example, with futures contracts tied to the price of oil, both sides have to agree to go off the pricing data provided by a third party, and that third party’s data may directly or indirectly tie to S&P’s Commodity Insights business unit.

[00:18:42] Shawn O’Malley: And with IHS, S&P gained even more data on this industry. It reportedly has technical information on over 6. 5 million oil and gas wells, over 5, 000 basins, and 3, 400 land rigs. That brings us back to the mobility unit we talked about, which is a huge provider of data for the automobile industry. In this unit, S&P actually owns Carfax, which you might be familiar with if you’ve ever tried to purchase a used vehicle.

[00:19:08] Shawn O’Malley: The company is a leader in these vehicle history reports. In terms of data, to just give a taste of what the mobility unit does, it forecasts future production rates for more than 50, 000 different vehicle models, and in the US, it has a database of something like 12 billion ownership records for vehicles, dating back across the last few decades.

[00:19:28] Shawn O’Malley: This unit is particularly valuable at the moment due to the massive changes happening in the automobile industry surrounding the transition to electric vehicles. As everyone tries to understand how that is unfolding, S&P’s mobility unit has the data and insights they need. And last but not least, that brings us to the S&P Dow Jones Indices Division, home to, you guessed it, the S&P 500 and Dow Jones Industrial Average.

[00:19:54] Shawn O’Malley: S&P actually manages thousands of indexes, with 25 percent of all ETFs linked to an S&P Dow Jones Index. Although this is not as big of a business unit as you might think, at around 10% of revenues, it’s very high margin. In fact, it has the best operating profit margins of any business unit in the company at 69% s and p license its name and indexes to asset managers.

[00:20:18] Shawn O’Malley: The largest ETF in the world, for example, has the ticker SPY and tracks the s and p 500. So it pays royalties to s and p global to be able to do that. It licenses a wide range of other indexes though, from small cap stocks to ESG investing bonds, and ones even connected to derivatives like S&P 500 futures contracts, S&P 500 index options, and even indexes tied to volatility measures.

[00:20:42] Shawn O’Malley: What’s wonderful about this business is that investment funds seldom change the index benchmarks that they either track closely or measure their performance against. Doing so introduces liquidity and tax costs and can represent material changes and strategy that investors in these funds didn’t necessarily sign up for.

[00:20:59] Shawn O’Malley: So there are trillions of dollars in investment funds, tracking indexes managed by SMP and SMP will continue to reap the rewards from fees for licensing those indexes to asset managers. In the same way that S&P has been one of the biggest beneficiaries of the growth of debt markets with its ratings unit and the growing reliance on big data and finance, it also has been a big winner in the trend toward passive investing, as in the movement away from actively managed mutual funds with higher fees toward low cost index funds, which was initially spearheaded by Vanguard back in the day, but has now been adopted by most of the major asset managers.

[00:21:35] Shawn O’Malley: As more people allocate to their 401k and other investment accounts and to passive index funds, S&P’s index business grows. Given the structural advantages of passive investing, and the fact that every year people have more income to contribute to these strategies, I’d expect its index business to keep growing steadily.

[00:21:53] Shawn O’Malley: To be sure, most of this business unit’s growth has probably already been tapped into, but it remains a reliable and profitable unit. There is also a sixth division called global engineering solutions, but it’s only around 3 percent of revenues and it’s not really consequential to the big picture around SMP global. This came over from the IHS merger and profits from publishing standards and codes used by product designers and engineers.

[00:22:18] Daniel Mahncke: From a 30, 000 foot view, the company has a great mix of revenue sources, particularly recurring revenues. More than three quarters of S&P’s revenues come from recurring sources like credit rating services, data packages, subscriptions to Capital IQ Pro, and licensing royalties.

[00:22:38] Daniel Mahncke: According to FinChat, this is a company that has compounded revenues at over 10 percent per year for the last decade, with a gross margin of about 68%. Its operating profit margin is also quite high at 40%. And after stripping out things like debt costs and taxes, its net income margin is about 25%. This is a tremendously profitable company with high quality earnings in the same league as companies like Meta and Microsoft for profit margins.

[00:23:10] Daniel Mahncke: It is also financially stable. Analysts assessing a company’s financial health often use a measure called EBIT, which measures operating profits and stands for Earnings Before Interest and Taxes. S&P’s EBIT is about 16 times higher than its interest expenses, so the company has plenty of financial breathing room to absorb debt costs.

[00:23:32] Daniel Mahncke: Fitch Ratings actually gives S&P Global an A rating on its long term debt borrowings. which is considered a healthy upper medium grade for large corporations. So S&P’s balance sheet has almost 10 billion dollars of net debt. But that isn’t as much as it sounds relative to the company’s size and stability.

[00:23:55] Daniel Mahncke: Obviously, the IHS acquisition was a big transaction, and really, your assessment of S&P’s fair value today will be derived from whether you think its purchase of IHS created value or destroyed it. I would love to hear your take on S&P’s outload though, Shawn.

[00:24:13] Shawn O’Malley: It’s a great question. I don’t think you could really grasp the company’s prospects without diving in a bit more into its market intelligence and ratings units, which are its two biggest.

[00:24:23] Shawn O’Malley: Starting with the ratings business, let’s consider the different channels through which corporations borrow money and how this relates to ratings agencies. One option is the commercial paper market. This is a market for a short term corporate debt that is typically unsecured, meaning there’s no collateral posted against the borrowed money.

[00:24:42] Shawn O’Malley: Lenders in the more than 1 trillion commercial paper markets take on this risk because the borrowings are very short term, ranging from just a few weeks to a few months, and because companies in the commercial paper market usually have credit ratings that signal to lenders that they’re not at imminent risk of being unable to repay these debts.

[00:25:00] Shawn O’Malley: The commercial paper market is great for companies to access short term financing, for payroll obligations, or to finance monthly inventories, but it doesn’t provide them with longer term capital to invest in new projects or products with, and even for these limited borrowings, the status quo is very much that companies need to have credit ratings from the major agencies to participate in this market.

[00:25:21] Shawn O’Malley: Companies may also have revolving lines of credit with banks, which are like monthly or yearly credit card limits that they can tap into as needed. But companies in healthier financial positions tend to rely more on the commercial paper market since these revolving bank loans can have layers of embedded fees.

[00:25:38] Shawn O’Malley: Revolving lines of credit at banks largely go unused backstop to access short term funds, but companies can also borrow via term loans from banks. Term loans are more similar to bonds, where a company gets the full amount of loan money up front, and pays back the interest over time, and then must repay the principal amount at the end of the loan period.

[00:25:58] Shawn O’Malley: But there are trade offs and limits to working with banks. Banks tend to be very conservative about the risks they take, so they’re not going to make huge loans to companies. Companies then usually can’t meet all their borrowing needs by relying on just banks. So the problem ultimately with bank loans is the scale.

[00:26:15] Shawn O’Malley: In many cases, they’re more advantageous than bonds, but companies cannot borrow enough from banks to meet their needs and must turn to the public markets to raise further funds. This is where ratings agencies like S&P really shine. While banks are equipped to underwrite the lending risks and doling out money to a certain company, the broader investing public of retail and institutional investors do not have the same capacity to assess every potential corporate borrower’s creditworthiness.

[00:26:41] Shawn O’Malley: Because bonds are offered to the public to invest in, as opposed to being directly negotiated between a company and its bankers, bond issuances must be registered with the Securities and Exchange Commission. The benefit is that you can pull money from a much, much larger base of investors for corporate bond markets to function smoothly.

[00:26:59] Shawn O’Malley: Ratings agencies have really filled that void by providing assessments of each borrower’s financial health on top of the ratings they provide for specific bond issuances. That way, you can trust that by purchasing an ETF, for example, of investment grade corporate bonds, the bonds included in it are truly reputable and reliable companies.

[00:27:16] Shawn O’Malley: If you couldn’t trust the ratings on these bonds, or had to rate every single corporate bond out of the thousands that might be included in an ETF yourself, these products just couldn’t exist. Having agreed upon third party ratings helps ensure that you aren’t taking undue and unexpected risks from investing in what you thought were relatively safe corporate bonds.

[00:27:36] Shawn O’Malley: Ratings agencies trustworthiness is boosted by their careful regulation, given their importance to financial markets. Their internal processes, bookkeeping, communications, and business practices are all carefully monitored. From corporate borrowers perspective, bonds allow them to lock in the interest rate they pay for years or decades.

[00:27:54] Shawn O’Malley: That is a huge advantage because your options for using that borrowed money expand dramatically when your payback date is pushed from, say, 3 months to 10 years. Turning back to S&P, the company commands over 50 percent of the bond rating market share. It handles 54 percent of ratings for government securities and 45 percent of ratings for corporate issuers.

[00:28:16] Shawn O’Malley: When looking at S&P’s rating business, you’d want to consider how borrowing trends are evolving. There are obvious questions like whether S&P’s share of bond ratings is holding steadily overall and within narrower categories, but also whether the ways companies borrow money are changing and how that impacts the future stream of business coming to S&P.

[00:28:35] Shawn O’Malley: Companies turning more to banks, for example, would reduce the number of bonds for which S&P can charge ratings. S&P does also issue ratings for some bank loans, but loan ratings aren’t nearly as common as ratings for bonds. The biggest disruption in this space has been with the rise of private credit, which we mentioned briefly earlier.

[00:28:52] Shawn O’Malley: These are non bank investment firms making loans to companies and private deals, meaning they aren’t directly registered with regulators like the SEC, which also means they aren’t accessible to the general public to invest in. According to a report from S&P in April of this year, the private credit industry has ballooned in the past decade, reaching a size of nearly 1 trillion in the US and 500 billion in Europe.

[00:29:16] Shawn O’Malley: And this increase in private lending has certainly pulled some capital out of public bond markets, though the industry has largely been built up around smaller companies than those that borrow in the bond markets. In particular, private credit has stepped in to fund a lot of private equity buyouts of companies, which was formerly the domain of bank lenders.

[00:29:36] Shawn O’Malley: So arguably the rise in private credit has been more disruptive to banks than it has been for traditional bond markets. But S&P isn’t going to let the opportunity in private credit pass them by either. According to the company’s CEO, S&P has worked closely with private credit investors to provide analytics that is still relevant for them even if every loan they make doesn’t get a credit rating from ratings agencies.

[00:29:58] Shawn O’Malley: S&P’s ratings division revenues from private markets rose 70 percent year over year in the second quarter, which is very promising. And on top of that, there’s also an opportunity to provide credit ratings on securitized products tied to private credit, where essentially a number of private credit deals might get lumped together into a single asset, similar to the mortgage backed securities and collateralized debt obligations that became popular in the early 2000s.

[00:30:23] Shawn O’Malley: There are honestly probably limits to how much the private credit industry can expand before it makes regulators uncomfortable, since many of these transactions occur beyond their purview. It’s still a big part of the story for S&P, though my takeaways have been that S&P benefits most directly from more bond issuance and ratings on those bonds, but its ratings unit can still profit from borrowing that occurs in private transactions too.

[00:30:47] Shawn O’Malley: What also makes Ratings such a great business unit is that it doesn’t require much invested capital to keep it running. It needs to maintain a large staff to oversee and monitor the ratings it has issued in the past and to assist with new ratings, but this is not a unit that needs to invest in new data centers or warehouses to expand.

[00:31:03] Shawn O’Malley: It also already has created many of the formulas and processes to calculate ratings over its decades of experience, which reduces the amount of incremental work needed to update or issue new ratings. From 2015 to 2021, capital expenditures for the ratings unit fell 31 percent to about just 1 percent of revenues.

[00:31:21] Shawn O’Malley: On top of that, the ratings business is not a winner take all industry. It has become standard practice for borrowers to receive two or more opinions on their debt, which means that S&P and Moody’s, for example, aren’t really directly competing with each other. A borrower will likely go to both Moody’s and S&P for a rating rather than trying to pick one over the other.

[00:31:40] Daniel Mahncke: The elephant in the room here is what happened in the 2008 financial crisis and how some saw the major credit ratings agencies as being complicit in contributing to the bubbles in the financial system. Do you want to just quickly tell the audience about that?

[00:31:57] Shawn O’Malley: Sure, yeah, one of the fundamental risks for S&P and really any big brand is that something will happen to damage its reputation.

[00:32:05] Shawn O’Malley: And a broader loss of faith in the financial system in 2008, paired with a lot of finger pointing toward S&P and Moody’s, was really a nightmare scenario for the entire company, but especially its ratings division. Ratings agencies collectively failed, like so many different financial institutions at the time, to accurately model and understand the mounting risks.

[00:32:24] Shawn O’Malley: Thanks. One of the best examples of this was in structured finance, where different assets like mortgages would get bundled together into a single product. S&P stamped some of the highest possible credit ratings on these products, which were thought to be so diversified that investors were taking very little risk overall by investing in them.

[00:32:43] Shawn O’Malley: The problem, of course, is that the wave of defaults that hit the housing market in 2008 was unprecedented, which revealed that these financial products were nowhere near as safe as thought. These inaccurate credit ratings alone could have been enough to severely damage the big three credit ratings agency’s reputations, but even worse was that there were allegations of S&P and Moody’s engaging in pay to play schemes where they worked with investment bankers to help them sell subprime mortgage backed securities by slapping their seal of approval on them in exchange for fees.

[00:33:13] Shawn O’Malley: From 2000 to 2007, Moody’s rated more than 45, 000 mortgage backed securities, and S&P probably rated a similar amount. The Financial Crisis Inquiry Commission, which was tasked with investigating the 2008 crisis, estimated that by April 2010, of all mortgage backed securities Moody’s had rated AAA in 2006, 73 percent were downgraded to junk.

[00:33:36] Shawn O’Malley: So this was a big scandal for all of the ratings agencies. The commission said credit rating agencies at the time were quote, key enablers of the financial meltdown. Despite those misleading ratings, the ratings agencies enjoyed some of their most profitable years ever leading up to the crisis. After all was said and done, there were hundreds of millions of dollars worth of lawsuits, and the SEC significantly strengthened its ability to supervise the ratings agencies.

[00:34:04] Shawn O’Malley: The whole thing was a mess. Ratings agencies were understaffed, employees were underpaid, and the system was ripe for abuse as Wall Street bankers tried to play the ratings agencies off of each other to get more favorable ratings for the structured financial products tied to real estate they were hoping to sell.

[00:34:21] Shawn O’Malley: Books like Andrew Ross Sorkin’s Too Big to Fail cover this all in far better detail than we possibly could. But, some 15 years later, the ratings agencies are alive and well. Yes, they’re closely monitored, and at S&P, the ratings business is almost completely siphoned off from the rest of the company.

[00:34:39] Shawn O’Malley: Employees of the other divisions are essentially supposed to have no contact with those who work on ratings. But for better or worse, they did survive. Ratings agencies weren’t nationalized like Fannie Mae and Freddie Mac, and they maintained their critical role in global markets. Any blow to their reputations has not really had a lasting impact.

[00:34:59] Shawn O’Malley: Even in 2011, the Big 3 ratings agencies issued 97 percent of all ratings in the US that year, so there wasn’t even much of a fall off in the immediate aftermath. While regulators had hoped to encourage more ratings agencies to join the scene as competitors to the Big 3, none did. Their ability to survive a crisis of this magnitude, as well as regulator attempts to break up their market share, is really a testament to the strong moats and network effects that defend their businesses.

[00:35:27] Shawn O’Malley: You may have your own opinions on whether ratings agencies should be public or private institutions, and whether they were sufficiently punished after the great financial crisis. But if there was ever going to be a time to reform their oligopoly on credit ratings, it would have been probably 15 years ago.

[00:35:42] Shawn O’Malley: The political momentum to do so has pretty much been lost in the meantime. From the perspective of a shareholder in these businesses, I would feel pretty assured that short of a great financial crisis 2. 0, there’s no reason to think that they will lose market share anytime soon. That might sound bad to say, but I also don’t think that broadly speaking, ratings agencies have a parasitic effect on markets.

[00:36:03] Shawn O’Malley: They really are important and valuable, though the lead up to 2008 was a huge blemish on the record. With all that said about ratings, what are some of the risks you’re seeing in the market intelligence business, Daniel?

[00:36:14] Daniel Mahncke: There’s some reason for concern that financial institutions may purchase fewer subscriptions for access to things like Capital IQ Pro. if they end up shrinking their staffs, namely because fewer workers are needed thanks to AI tools. It’s not implausible to imagine that AI will come for jobs in white collar industries, especially finance, where a lot of jobs are based around organizing and entering data into Excel or other modeling tools.

[00:36:44] Daniel Mahncke: But at this point, concerns that financial institutions will reduce their subscriptions with S&P. have already been baked into the company’s projections and stock price, at least according to its CEO. Peterson also makes the point that while certain banks have been cautious about hiring and spending, that isn’t true of most of Market Intelligence’s clients.

[00:37:08] Daniel Mahncke: He told investors that the sales and renewal cycles with insurance companies, pension funds, and sovereign wealth funds, among others, have remained normal. It’s also worth mentioning that AI tools go both ways. Even if some financial institutions laid off more workers than they hire in the coming years, meaning reduce spending on market intelligence subscriptions, S&P could also plausibly make use of AI tools to reduce its own staff and unlock offsetting cost savings.

[00:37:39] Daniel Mahncke: Peterson outlines additionally that S&P has real advantages in AI, since it owns so much proprietary financial market data and data inputs are everything to developing AI systems. So far, it seems like S&P has no interest in licensing this data to the outside world and is instead choosing to train their own models to license while keeping all the data in house.

[00:38:05] Daniel Mahncke: Overall though, despite its size, the market intelligence business has the least attractive profit margins. Its operating profit margin for 2023 was 33%, compared with 56 percent for the ratings business. That gap in profitability, generally speaking, stems from the fact that the market intelligence business It’s just a lot more competitive.

[00:38:28] Daniel Mahncke: Companies like Bloomberg, Refinitiv, and FactSet are all competing with S&P for many of the same clients who are looking for access to financial market data. While many of the subscriptions for market intelligence products can be quite sticky, it doesn’t have nearly the same modes as the ratings business.

[00:38:49] Shawn O’Malley: The more I’ve come to learn about S&P, the more I’ve really come to see the company as simply a winner from the inevitable expansion of financial markets. As our world becomes more and more financialized, S&P is really the company sitting in the middle of that in multiple different ways ready to extract value.

[00:39:07] Shawn O’Malley: And they’ve done an incredible job with this. There’s one key metric that is popular among legendary stock investors like Warren Buffett and Terry Smith, and that’s return on capital. As in, how profitable is a company relative to the amount of debt and equity invested into it? With S&P, we can estimate that by looking at the return on capital employed metric.

[00:39:27] Shawn O’Malley: Basically, you can calculate this by dividing a company’s earnings before interest and taxes by the total capital employed, which can be calculated by just subtracting total assets from current liabilities. shareholder’s equity plus long term debt. S&P’s returns on capital employed, on average, over the last 5 years, is an impressive 28 percent per year.

[00:39:49] Shawn O’Malley: This is a capital light business that really spits off free cash flows, which is an accounting term for the money available to companies to use as they please after paying for everything else. It’s similar to the concept of net income, but it accounts for the amount of cash companies actually have on hand, whereas net income includes non cash items like depreciation.

[00:40:09] Shawn O’Malley: With those free cash flows, the company announced a plan in 2022 to repurchase 30 million of its outstanding shares, which amounts to about 9 percent of its total shares outstanding. So far, it has repurchased around 13 million shares and there’s no expiration date on the program. In the first quarter, S&P was a buyer of its own stock at an average price of 433 per share and spent 577 million on quarterly repurchases.

[00:40:35] Shawn O’Malley: For reference, at the time of recording, the stock is trading at about 490 per share. And from 2012 to 2020, S&P repurchased 20 percent of its outstanding share count by returning capital to shareholders via stock buybacks. Between buybacks and dividends, S&P has returned massive amounts of capital to shareholders while its business continues to grow, since it needs comparatively little capital to be reinvested back into it.

[00:40:59] Shawn O’Malley: That’s because its core business units are so sticky and profitable. Management’s previously announced goal has been to return something like 85 percent of free cash flows to shareholders. While management has a strong track record in running the company, it is a bit frustrating that the company’s managers don’t own more of its stock.

[00:41:16] Shawn O’Malley: The combined stakes of management and all the board members is quite modest. I would typically want to see management have more skin in the game, and I also find their compensation structure somewhat concerning. They’re rewarded for engineering growth in revenue and earnings per share, which sounds great but can actually lead to poor investments for the sake of growth at all costs.

[00:41:36] Shawn O’Malley: A better compensation structure might further align management’s interest with shareholders by rewarding management based on the returns on invested capital they’re able to generate. Still, what they’re doing seems to be working, and it’s hard to complain when the company’s returns have been so impressive.

[00:41:51] Shawn O’Malley: Around 60 percent of S&P’s revenues come from the US alone, which isn’t too outsized role that the US plays in global financial markets, but as capital markets develop in the rest of the world, particularly across Asia. There’s considerable opportunity for S&P to expand into new markets. China’s corporate debt market has exploded since 2008, hitting over 120 percent of the country’s GDP.

[00:42:16] Shawn O’Malley: In 2019S&P P became the first foreign owned credit rating agency ever granted access to operate in China and provides ratings on its domestic bonds. So there’s a reason for cautious optimism about S&P’s ability to expand into China. In the company’s most recent quarterly earnings call with investors, they shared some projections for the year.

[00:42:38] Shawn O’Malley: Management has actually largely revised its expectations for growth higher this year, with the ratings business expected to see the strongest revenue growth in 2024, growing 14 to 16 percent, while the index business grows 10 to 12 percent, and market intelligence grows by 6 to 7. 5 percent. Looking at S&P’s current valuation, it is by no means cheap.

[00:42:59] Shawn O’Malley: This is an extremely high quality, well rounded company, and the market knows that. In fact, many on Wall Street may understand the company particularly well from using its products like Capital IQ Pro. Its stock has really run up recently too, up about 23 percent for 2024, and almost 90 percent over the past 5 years, which is a 13.

[00:43:20] Shawn O’Malley: 5 percent compounded return from price appreciation alone, not counting dividends. Today, it trades at a multiple of more than 45 times its earnings over the past year, and 31 times its free cash flows. Price matters in investing, though truly great companies can make your entry price less consequential when investing with a multi decade time horizon.

[00:43:40] Shawn O’Malley: I really can’t get excited about buying this stock at around 490 per share. I’d start to get interested again if it falls below 400, and pretty excited at 350 per share. But even at 350 per share, the stock would be trading at roughly 33 times its earnings per share over the last 12 months, which is high relative to the market average, but more appealing given S&P’s strong history of compounding earnings, sales, and 87 years of steady dividend payments.

[00:44:08] Shawn O’Malley: If the stock falls to around 300, depending on what caused the sell off, I’d probably be buying shares up hand over fist. That would have to be a pretty stark sell off though, and I could easily see it continuing to rise up above 500 per share. It’s impossible to know what will happen in the short term, but based on everything we’ve discussed in this episode, it’s a company I would absolutely love to own if I get an opportunity at the right price.

[00:44:33] Shawn O’Malley: Otherwise, at these levels, I think I can find similarly attractive opportunities with higher expected returns. Anything to add, Daniel?

[00:44:42] Daniel Mahncke: I feel similarly that it’s an attractive company, but the stock is trading well above what I would probably consider fair value for it. It’s just so rare that you find a company with three great businesses.

[00:44:54] Daniel Mahncke: I say three because I’m lumping together market intelligence, mobility, and commodity insights, As all being different variations of data driven businesses. So, I see the company’s three parts as its signature ratings business, its index business, and its data solutions. The index and ratings businesses by far have the strongest modes and quality.

[00:45:19] Daniel Mahncke: But much of the company’s future growth will come from its data businesses, which are more competitive industries with lower margins. In a few different ways, S&P really is a powerful institution underlying much of the financial system. And I agree that if there’s been a chance to buy into the stock at a more attractive price, it’s a company I would love to own.

[00:45:41] Shawn O’Malley: Well said Daniel, and thanks for joining me again. That’s all we have on S&P Global this week. And for context, neither Daniel nor I own shares in S&P, but we do genuinely find the company compelling. Thanks I hope you enjoyed the episode and I’ll leave you with the following quote about investing from the great John Maynard Keynes.

[00:45:59] Shawn O’Malley: I think it’s timely to our conversation about trying to determine the right price to buy into great companies. He says, quote, it is better to be roughly right than precisely wrong. I’ll see you again next week.

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