Manic, Mighty Moody's

Moody's (NYSE:MCO) extended its torrid earnings growth in its second-quarter earnings release. Revenue increased by 14% from the previous year, to $511.4 million. Earnings per share shot up 26%, from $0.47 to $0.59.

That kind of earnings growth undoubtedly makes Warren Buffett a happy investor -- his Berkshire Hathaway (NYSE:BRKa) (NYSE:BRKb) owns more than 16% of Moody's outstanding shares. But did Buffett set aside his legendary investment discipline in order to participate in Moody's sizzling growth? After all, much of the growth at Moody's comes from the development of derivatives markets, and Buffett wrote in his 2002 letter to shareholders that he considers derivative instruments to be "time bombs, both for the parties that deal in them and the economic system."

Far from a potential hazard, Moody's business model is actually a low-risk enterprise. The company makes money primarily by providing ratings for issuers of publicly and privately traded securities, a market it dominates with industry leader Standard & Poor's, a unit of McGraw-Hill (NYSE:MHP). Its role as a rating agency lets Moody's stand back from Buffett's figurative ticking bomb and avoid ongoing economic exposure to the securities it rates.

The dynamics of the securities markets encourage issuers to keep coming to Moody's for ratings. Nearly all investors in fixed-income securities and derivative instruments require a rating from at least one nationally recognized statistical rating organization, such as S&P or Moody's. Investor confidence in the expertise and reputation of the existing rating agencies makes it unlikely that new competitors could challenge the dominant position of today's industry leaders. (S&P has approximately 40% of the ratings business, and Moody's holds 39%.) In other words, this is a market with steady demand, and dynamics that reinforce Moody's current leading position.

And what a business to dominate! Moody's has achieved net margins of nearly 30% over the past several years. Return on equity has exceeded 100% over the past few years; the company has low capital expenditure requirements and has been able to return much of its income to investors through stock buybacks. With its wide moat and high returns on capital, Moody's is actually a consistent fit with Warren Buffett's investment criteria.

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Tom Gardner recommended Moody's in the inaugural issue of Motley Fool Stock Advisor . To see more of Tom and his brother David's market-beating recommendations, try Stock Advisor free for 30 days.

Fool contributor Michael Leibert welcomes your feedback. He does not own shares in any of the companies mentioned in this article.