A business we'd like to hold forever

CME, the world’s largest derivative exchange, has sustainable competitive advantages, high incremental margins, is highly free cash flow generative, and has an attractive growth outlook. It is the type of business that we would like to hold forever.

The sustainable competitive advantages can be traced to its substantial network effects and other scale benefits. As the world’s largest derivative exchange, it is the most capital efficient and cheapest venue to trade derivatives. We believe it has an unassailable competitive position in exchange-traded US interest rates derivatives, many agricultural derivatives, metals derivatives, WTI oil derivatives, and many equity derivatives.

We also believe that CME’s growth outlook has never been better. Over the past few years, the company has aggressively invested in international expansion, the benefits of which are starting to be realised.

In addition, CME is well positioned to benefit from a number of structural tailwinds:

• Growing demand for interest rate derivatives will be underpinned by the dual influence of increased US Treasuries issuance and the Fed winding down its balance sheet.
• Thriving US oil production is driving demand for WTI derivatives.
• A change in hedging accounting rules will enable corporates to use exchange-traded derivatives for hedging purposes.

We also like the fact that CME has some defensive characteristics. Derivative exchanges are positively correlated with market volatility as trading volume increases during these periods. Asset price volatility has been subdued for a number of years and we expect it will inevitably increase, most likely due to the end of QE. CME is one of the few companies we are aware of that benefit from this scenario.

What some investors have overlooked

That is a difficult question to quantify and I am not sure it has been missed by the market. I can, however, provide some insight into where I think we have a different perspective to many others.

We believe a lot of CME’s upside potential lies in FX derivatives. This is an area that is rarely discussed in broker reports and elsewhere.

The global FX market’s daily volume is estimated to be approximately $5T. The vast majority of this volume occurs off exchanges, however, exchanges are a cheaper way to trade these types of securities. CME is currently the world’s largest FX derivative market and its daily FX volume is just $100Bn, or 2% of the total market size. This points to a material growth opportunity should FX trading shift from off-exchange to on-exchange.

Winner takes all

CME has a competitive advantage over its competitors because it is bigger. Scale gives CME superior competitive advantages and reduces its earnings volatility.

Derivative exchanges are characterised by network effects, which mean they tend to be ‘winner takes all markets’ in each underlying security. CME is by far the world’s largest derivatives exchange and in many instances doesn’t have any true direct competitors. In instances where CME does have competitors, it generally wins due to its scale.

These competitive advantages and earnings stability have allowed CME to invest more aggressively than its peers in its underlying business. The company has expanded internationally and most recently it acquired NEX Group in the UK, which we consider an important and strategic acquisition, as it will support ongoing growth of CME’s FX derivative business.

What we expect ahead

All of this comes at price and CME is currently trading on a PE of 25 times 2019 earnings.

Our process dictates selling businesses when they become excessively expensive. Our primary valuation metric is free cash yield and we would be inclined to sell CME if it was trading on less than a 3% free cash flow, which implies a 30x PE.

We’ve held the stock on and off since Pengana International Fund’s inception three years ago, and most recently bought it two months ago after a meeting with CME’s CFO.

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