What is the stock?

US-based options and futures exchange operator CME Group (NASDAQ:CME)

How long have you held the stock?

On and off since the fund’s inception three years ago. Most recently we bought it two months ago after a meeting with the CFO.

What do you like about it? 

CME has sustainable competitive advantages, high incremental margins, is highly free cash flow generative, and has an attractive growth outlook.

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.

Derivative exchanges have high fixed costs but relatively low variable costs and ongoing capital investment requirements. This means the largest operators generate wide margins and healthy free cash flow. As the world’s largest derivatives exchange, this is especially true for CME.

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.

How is it better than its competitors?

CME is better primarily because it is bigger. Scale gives CME superior competitive advantages and reduces its earnings volatility.

Derivative exchanges are characterized 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.

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

What is your target price? Or at what point would you sell it?

CME is the type of business that we would like to hold forever. However, 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.

How much has it added (subtracted) to your overall portfolio over the last 12 months?

It has been a positive contributor.

Is it a liquid stock?

Very liquid. The current market capitalisation of the stock is around US$60 billion.

Where do you see the value?

The area where I think we have a slightly different perspective is that we are very focussed on the FX opportunity. And we think that could create really great value.

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