Publicly Traded Exchanges: How to Beat the House

By Steve Smith  JUN 09, 2009 3:25 PM

Focus on CME, ICE instead of individual equities.


Everyone is well aware of the meltdown in the financial stocks that's resulted from the credit crisis. Less attention has been paid, however, to the fact that the shares of the exchanges on which these stocks, bonds, and all the related options and derivatives trade, have also seen their own valuations cut in half in the last 18 months.

The question is: Do any of the publicly traded exchanges now represent buying opportunities?

Overall, I'm bearish on the group, as the bloom certainly seems to be off the rose. But I'm bullish over 2 names -- CME Group (CME) and Intercontinental Exchange (ICE) -- over the traditional stock exchanges, such as NYSE-Euronext (NYX) and NASDAQ (NDAQ). Before getting to the specifics, let's take a look at the arc and architecture that's led to the rise and fall of this sector of stocks.

Way back in March of 2003, when the US was decimating worthless land to get at the subterranean lubricant that's needed to keep the global economy humming, the Chicago Mercantile Exchange laid out its own version of shock-and-awe by performing an initial public offering to become a publicly traded exchange in the US. And, unlike the debacle in Iraq, it was greeted with flowers, goodwill, and a soaring stock price. Its shares gained some 600% over the next 4 years -- peaking at $710 in late 2007. They now trade around $325 a share.

The CME's IPO was quickly followed in issuance by the New York Stock Exchange, the International Securities Exchange, New York Mercantile Exchange (NMX) and the Intercontinental Exchange. The NASDAQ had been the front runner and was a publicly traded entity since 2002.

The timing in market conditions made these darlings of both investors and momentum traders. It was a perfect storm of a bull market in both stocks and commodities, and the real kicker -- consolidation on a global scale.

And there was a reality behind the rosy outlook: The NYSE merged with Euronext and has taken stakes in a variety of foreign exchanges; the CME bought the Chicago Board of Trade; the NASDAQ purchased the Philadelphia and the Nordic OMX Exchange; and the ISE was purchased by the Deutsche Bourse for a nearly 50% premium.

All the above names saw their share prices ring up triple-digit percentage gains within a matter of 3 years since their IPOs. These increases in volume, consolidation, economies of scale, and the evolution toward an integrated trading platform propelled revenue and earnings growth. Stock Exchanges Too Tied to Financials

Just as easy money in the form of low interest rates propelled the record activity and earnings in investment banks, hedge funds and private-equity firms were also paying top dollar for what are now very discounted assets. These were the very same customers that drove the increase in trading volume at the exchanges -- which inflated their own stock prices and allowed them to pay large premiums to consolidate as a means of gaining market share.

While there's still room for cost-cutting and synergies, what had been an expanding pie of trading volume is no longer growing as quickly. And that was what justified the previous high price-to-earnings ratios that had been awarded to the exchanges.

This is certainly true for equity trading. The latest data for June shows that trading volume in stocks has been basically flat during the first half of 2009.

Not only is the pie not expanding, but the pieces are being sliced ever thinner: Competition from off exchange electronic platforms and ECNs like BATs take market share and drive margins lower.

Deriving Growth

Compare this to volume in options, futures, and other derivatives, which has increased nearly 35% across the board during the first 5 months of 2009. Exchange-traded options are on pace for the sixth consecutive year -- and there's more than a 30% increase in trading volume.

So, if you're looking to invest in an exchange, focus on the ones that have the greatest exposure to derivatives. This leads us back to the CME and ICE, which have seen their shares nearly double from the March lows.

A new catalyst that could drive volume growth and in turn, share price, is the move to list over-the-counter and exotic derivatives -- such as credit default swaps (CDS) -- onto the exchanges. The argument is that this will provide a more liquid market, greater transparency, and third-party clearing, which will reduce counterparty risk.

Establishing a bullish position through the purchase of call options would be a good way to play the continued growth of trading in options and other derivatives.
No positions in stocks mentioned.

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