In some ways, Moody's (MCO -0.92%) personifies the boring financial stock paradigm. If you bring up junk bonds in conversation, many people will walk away, and you may need to find a different party conversation starter.
However, Moody's does have, if not quite cachet, a reputation as the leading bond rating agency. Warren Buffett looks for top companies that participate in leading the U.S. economy, boring or not, and his holding company, Berkshire Hathaway, owns 13.5% of Moody's stock and is its largest investor. It makes up about 2.5% of the Berkshire Hathaway equity portfolio. It may not be the most exciting dinner talk, but Moody's stock has outperformed the S&P 500's gain over the past five years. Let's see why you might want to learn more about this outstanding stock.
What does Moody's do, anyway?
Moody's offers risk assessment, financial information, and analytics services of many kinds, but is primarily known for its bond rating model. It rates various kinds of securities, including all kinds of bonds and notes, asset-backed securities, derivatives, and more. When you evaluate a bond, you'll see a rating of something like Aaa, the highest rating and representing the least credit risk, or B1, representing some speculation, or C, representing a low chance of recovery, with many ratings in between.
As you can imagine, when interest rates are low, money is easy, and everyone is issuing and buying debt, Moody's business thrives. When rate policy tightens, like the current situation, there's less money going around, and fewer companies are issuing debt. When there are fewer bonds to rate, Moody's has less business.
Recently, the tide has turned. Moody's has near-term tailwinds in debt refinancing over the next few years, and as inflation eases and interest rates haven't been increased, experts are feeling better about the stability of the economy and the higher chance of the Federal Reserve lowering rates over the next few months.
Moody's revenue increased 15% year over year in the 2023 third quarter, and earnings per share increased 28%. That's good news coming after pressure last year.
MCO Net Income (Quarterly) data by YCharts.
Why it has a competitive edge
Moody's biggest competitor is S&P Global, which offers similar services. Together they make up about 80% of the bond rating market. There are smaller competitors, but Moody's has a dominant position with sophisticated artificial intelligence-based and trusted models, full of decades of data points and credit modeling in place that are a real barrier to entry. It's also in a highly regulated industry, making it even tougher to break in.
Due to this protective model, Moody's enjoys a strong recurring revenue stream from steady clients with a 90% retention rate. These include many of the largest companies and banks in the U.S. as well as all over the world. Management also says that it's capturing greater market share than the competition in its $30 billion addressable market.
This is a classic Buffett company. It has a long-term competitive edge with strong management that is focused on running a great business, cushioning its leading position. It's highly profitable, with profit margins that reached higher than 40% at peaks in the previous low-interest rate economy. Margin expansion is driven by strong recurring revenue, and it generates high free cash flow. It also pays a growing dividend.
The overlooked market beater
Moody's stock has gained more than double the S&P 500's gain over the past five years.
Despite its prominence as a Buffett company and a significant presence in the Berkshire Hathaway portfolio, it doesn't garner much attention. But those are often precisely the best opportunities because eager investors aren't pushing up the valuation.
Moody's business is already rebounding from the impact of inflation and high interest rates. It has a long growth runway as a leader in its industry with a protective edge, and it has long-term market-beating potential.
