You know that sweet spot on a tennis racket, one which sends the ball hurtling at your opponent at an incredible velocity? I feel like Moody's (NYSE:MCO) is in that sweet spot, and the ball's being hit by Venus Williams.

After reviewing Moody's prospects, I wouldn't be surprised if there was a worldwide conspiracy to make Moody's more money, because everything seems to be going its way. In the six years since Moody's was spun off from Dun & Bradstreet (NYSE:DNB), the stock has quintupled, which by my calculations would give shareholders about 31% annual returns. BerkshireHathaway (NYSE:BRKa) (NYSE:BRKb), Moody's largest shareholder, has seen its investment skyrocket from $499 million to roughly $3.2 billion.

Trying to understand the basic investment process that led to Berkshire's tremendous success with Moody's is an invaluable exercise.

1. How does this company make money?
I believe every investment inquiry should start with this question. Most of my bad investments have occurred when I didn't really understand how the company made money (or that it didn't make money, period), and I'm sure many former Enron investors concur.

Moody's makes money by issuing credit ratings for debt securities. If you've ever bought a bond (excluding riskless U.S. government bonds), it was most likely rated by Moody's. If a company wants to raise debt, it usually pays Moody's and Standard & Poor's, a unit of McGraw-Hill (NYSE:MHP), a fixed fee to rate the debt. Like a FICO score for an individual's credit rating, this credit rating reflects how capable a company is of paying off the debt.

2. Does this company have a competitive advantage?
Moody's, like virtually every Warren Buffett investment, has a huge economic moat. Berkshire investments tend to be in industries that naturally converge to a few winners. The fashion industry naturally diverges into fragmentation, because customers like variety and have fickle tastes, and there are extremely low barriers to entry (all you need is a sewing machine). On the other hand, other industries, such as computer operating systems, led by Microsoft (NASDAQ:MSFT), converge to a single dominant winner, because it's much more efficient for us all to be using the same operating system.

Moody's operates in such an industry. Think about the SAT, the GMAT, and the LSAT. Universities need a way to judge applicants, and if everyone was taking a different test, it would be impossible to judge one score relative to another. Likewise, investors need a credit rating system, and only need a handful of graders to standardize the grades and make relative comparisons easier. Thus, Moody's, with more than a century of experience, and Standard and Poor's dominate the industry.

3. Does the company have pricing power?
Moody's and Standard and Poor's act as gatekeepers between companies and their money. A company without a credit rating is like a student trying to get into business school without a GPA or GMAT scores. Here's how I imagine that phone conversation would go:

  • Interviewee: No really, I'm really, really smart. I promise.
  • Interviewer: So what's your GPA and GMAT score?
  • Interviewee: Oh, I don't have those, but like I said, I'm super-duper smart.
  • Interviewer: (click)
  • Interviewee: Hello?

Furthermore, Moody's fees are minuscule compared with the amount of money a company might raise in a debt offering. A $50,000 fee is equal to 0.01% of a $500 million bond. If 0.01% stands between a company and $500 million, the company is probably not going to quibble about fees, thus affording Moody's ample pricing power.

4. Is there future competition?
Although regulatory hurdles are diminishing, barriers to entry are still high in the credit rating industry. It's not hard to rate debt: It's hard to get companies to pay you to rate their debt. Companies aren't going to pay a new rating firm to rate their debt because investors only need a couple graders, and most already use Moody's and S&P. Having another grader doesn't increase a company's ability to issue debt; thus, the lack of demand for additional credit rating firms.

5. Are there growth prospects?
The more grades Moody's gives, the more money it makes. Luckily for Moody's, the industry makes it easy for the company to give plenty of grades -- sometimes more than once on the same bond.

A securitization is a bunch of individual loans packaged into a pool and sold off to investors. For example, if Ford lends $20,000 to 10,000 car customers, and doesn't want to hold all these loans, it can securitize them by packaging the loans into an asset-backed security and then sell them off to investors. This literally creates an entirely new market for Moody's. Nobody is going to pay Moody's to rate your neighbor Billy's car loan debt, but if Ford wants to sell $200 million of securitized car loans, it's going to need a debt rating, and it'll pay Moody's to do it.

Even better, these asset-backed securities are often issued in tranches. In a nutshell, this means that, like airline seats, there's a first class, second class, and so on, and each class needs a separate rating. Often, Moody's gets paid twice on securitizations -- once to rate the corporate bonds, and again when the bonds are securitized.

Basically, Moody's benefits as debt markets become more complex and sophisticated, and if history is any guide at all, security markets inevitably do. I used to be an intern on a hedge fund's collateralized debt obligation team, which dealt with things like REMICs (real estate mortgage investment conduits), inverse floaters, and credit default swaps (i.e.: I'll bet you that General Motors doesn't default). In the early '90s, there were 20 types of securitized asset classes. There are now more than 100 types of asset-backed security classes. In other words, it doesn't take a rocket scientist to see that with securitizations, bank loan syndication, credit default swaps, and an army of investment bankers thinking of new ways to slice and dice debt, Moody's should continue to prosper.

Moody's clearly fits the profile of a great company, and like any great company, investors should keep an eye on this one from time to time. All it takes is a single opportunity to buy shares of Moody's at a discount to reap the benefits of a decade worth of superior returns.

For related Foolishness:

Moody's was Tom Gardner's first recommendation in Motley Fool Stock Advisor . Since then, Moody's has outperformed the market by 200%. Click here for a free trial to all of Tom's and David's picks. Berkshire Hathaway and Microsoft are Inside Value recommendations.

Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the abovementioned companies. The Motley Fool has a disclosure policy. Emil appreciates any comments, concerns, and complaints and can be reached at

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.