As Warren Buffett can attest, one of the best ways to build wealth involves buying and holding shares of stock in wonderful businesses that compound your investment at a high rate of return over a long period. Companies like Moody's (NYSE:MCO), AutoZone (NYSE:AZO), and PetSmart (NASDAQ:PETM) deliver high profitability, consistent growth, and maintain durable competitive positions year in and year out. These are the kinds of businesses that enable ordinary investors to retire with more savings than they know how to spend.
High profitability is the most crucial aspect of high-return companies. Generally speaking, a company is highly profitable if it generates a double-digit return on capital employed in the business. Moody's, AutoZone, and PetSmart each generate double-digit returns on assets. This means that for every dollar of shareholder capital reinvested in the business, these companies generate at least $0.10 in annual profit.
Moody's averages a 30% return on assets – an incredible return. Unlike AutoZone and PetSmart, Moody's does not rely on hard assets to generate its profits. Instead, its products are largely intangible. Moody's assets are its brand, its people, and its government license to operate as a nationally recognized statistical rating organization, or NRSRO. Together with Standard & Poor's and Fitch, Moody's ratings influence the investments of countless institutional investors. Its future profitability depends on its ability to maintain its government license, the level of capital market activity, and to a far lesser extent, the accuracy of its ratings. Investors have little reason to suspect that Moody's profitability will decline significantly in the future.
In contrast to Moody's, PetSmart and AutoZone generate revenue by owning and selling inventory. This requires a significant investment in working capital. Outside of property and equipment – another big investment that Moody's does not have to make – merchandise inventory is the single largest asset account for these companies.
However, AutoZone stretches out its payments to suppliers so that it actually sells auto parts before it has to pay for them. PetSmart carries only enough inventory to fill its stores, only owning about one-eighth of its necessary annual inventory at any given time. These efficient working capital practices enable AutoZone and PetSmart to earn double-digit returns on assets despite their higher asset needs.
A company's ability to generate high returns on investment is useful insofar as it can continue to invest at high rates of return. Fortunately, all three companies have growth opportunities. PetSmart has experienced the highest rate of growth over the last ten years, followed by AutoZone and Moody's. Although past rates of growth are higher than these companies are likely to generate going forward, each can consistently grow earnings per share for years into the future.
PetSmart is riding the long-term upward trend in pet spending. After more than tripling since 1994, the U.S. pet industry is expected to grow 4% per year through 2018. This provides a strong tailwind for PetSmart in the years ahead.
AutoZone's growth will be more challenging. AutoZone derives the vast majority of its sales from do-it-yourself (DIY) customers, who buy parts to install themselves. However, AutoZone's growth is coming from the do-it-for-me (DIFM) market. AutoZone installs the parts for DIFM customers. AutoZone's DIFM business grew revenue 12.6% in 2013, outpacing the DIY business by a wide margin. DIFM's continued growth is vital to AutoZone's future earnings-per-share growth.
Moody's, a mature cash cow, is the slowest grower in the group. However, its growth is stable and should continue over time. Its growth is largely dependent on capital market activity – especially debt issuances. With interest rates near rock bottom, debt issuances are higher than usual at the moment; U.S. companies sold a record $1.1 trillion of bonds in 2013 , most of which were rated by Moody's. Although debt issuances will probably decline in the coming years as interest rates rise, debt capital market activities tend to balance out over time, giving Moody's a stable source of revenue.
After having established that Moody's, PetSmart, and AutoZone are highly profitable and have consistently grown earnings, the only thing left to check is whether or not these companies can stand the test of time. Each has unique advantages that make them the inevitable market leaders for decades to come.
For instance, Moody's, Standard & Poor's, and Fitch combine for a 95% share of the credit ratings market. Nearly all U.S. and many European corporations are required to pay one of the credit rating agencies to rate their bonds. This provides Moody's with a stable source of income so long as it retains its status as an NRSRO and no additional organizations are given the same designation. More than five years removed from the greatest embarrassment in the industry's history, actions challenging the credit rating oligopoly have yet to be taken. Therefore, Moody's franchise may only be challenged if a similar crisis emerges in the future.
PetSmart and AutoZone derive their durability from superior economies of scale. Although grocery stores carry pet food, none carry the wide selection of premium pet products available at PetSmart. Moreover, PetSmart has a 40% share of the specialty pet market, double that of its closest competitor. As a result, PetSmart buys in higher volume than any other pet-products retailer in the U.S., thereby giving it the most bargaining power.
As the largest auto parts retailer in the U.S, AutoZone's bargaining power is similar to that of PetSmart. Many wholesalers rely on AutoZone for the bulk of their business, giving the latter significant leverage in negotiations. AutoZone extracts such favorable terms from its vendors that it is able to sell its inventory before it has to pay for it. As a result, AutoZone will be able to maintain its outsized profitability for the foreseeable future.
There are many ways to retire rich, but few are more reliable than buying and holding high-compounding stocks. Moody's, PetSmart, and AutoZone are highly profitable, consistently grow earnings, and have durable franchises that enable them to compound shareholder capital at high rates. Investors looking to retire rich should consider owning these fine companies.
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Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Moody's and PetSmart. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.