CME Group, Buy It, Close Your Eyes.

CME Group Stock Chart by YCharts

I am going to give you my biases early on: I own CME stock. I was a member of the CME Board from 1999-2001, and a part of the group that forcefully advocated an investment in technology, along with demutualization. Traded the products there since 1988.

Here is a little analysis on CME Group.

First of all, the world is in fear of inflation. Competitive currency devaluations are occurring almost daily. It is clear to me that the Federal Reserve is going to devalue the dollar and inflate our way out of debt.

If there is a fear of inflation, what does one do? Buy hard assets, invest in companies that can grow and insulate you from inflation, buy farmland. Hard assets have had quite a run. Gold is up, silver is up. Cotton is up, grains are higher. Farmland really never took too much of a dive. If the assets that you want to buy are bid, what do you do?

Look for something else that might replicate or benefit from inflation. What seems like a proxy for all that stuff? CME Group, and ICE.

I don’t own ICE. They don’t trade the lion’s share of CFTC regulated US futures. But almost everything I think about CME can be said for ICE.

The difference between the two is ICE’s cozier relationship with the big banks and ICE management. ICE is a lot more streamlined than CME. ICE also has a more flexible pricing structure than CME. If they decide to compete in like products where they already have established liquidity, it might get interesting.

CME trades 98% of CFTC regulated US futures.  It is important to note that this data doesn’t mean that CME has a monopoly.  They cannot price as a monopolist.  There is tremendous competition.  OTC markets, smaller private markets, and international futures markets compete with them.  ”Hot” money goes wherever action is.  If US markets stagnate, it will find it’s way overseas.  CME is subject to those trends and cannot control them.

CME was hurt badly by the financial crisis.  The stock traded over $700 per share in December of 2007.  Leverage helped it’s business and the continuing deleveraging hurts.  CME also didn’t do exceedingly well in the regulatory wars that happened in 2009.  They didn’t do exceedingly bad either-but the blanks have not been filled in.  CFTC chair Gary Gensler is not a fan of CME, and has consistently been an adversary.  When Brooksley Born was chair, she was tough but fair.  Gensler is looking to collect scalps.

In 2008, the love/hate relationship the banks have with CME came to fore.  An internal memo from the Department of Justice was intentionally released.  It hit the stock $140 in one day.  Over time, if you track government announcements, and announcements by banks and ELX, they track a drop in the stock.  This is a coordinated attack intended to limit CME’s power and reach into OTC markets.  With all the crack researchers at the SEC, it would be interesting to see them look into options trading, shorting of stock, and news releases.  My gut tells me there is a correlation.

Strategically, CME has made some good decisions and bad decisions.  One very good decision was to invest in Brazil.  CME owns a chunk of BM&F, the Brazilian exchange.  As Brazil grows, which it certainly  will, CME”s investment will pay off handsomely.  CME’s decision track on energy futures from 2006-2009 was flawed.  It overspent for the NYMEX exchange, and is paying a price today.  That cost however is sunk, and not relevant to any future analysis.  The one piece of NYMEX that might pay off in the very long run is Clearport, an OTC energy clearinghouse.  If they can redeploy Clearport into currencies and interest rates, it could put CME into the center of world finance. They began clearing interest rate swaps today, so it’s game on.

Today, CME announced that it would begin clearing interest rate swaps. Monitor this, because if it gains traction this will really help all other sectors of CME’s business grow. CME has tried to leverage its clearinghouse in the past, and failed. However the regulatory environment is now changed and we will have to wait and see on this new endeavor.

The other place where I dislike CME’s strategy is their continuing love for utilizing excess capital for stock buybacks.  Stock buybacks are like using sugar as a primary base for nutrition.  No protein in them.  All they do is get execs out of options, and help short term scalpers play the market.  They don’t reward long term shareholders. CME, and it’s shareholders, would be much better off paying a special dividend if it had no use for the cash. Why they continue to line the pockets of investment bankers is beyond me.

CME has a tenuous relationship with the big banks of NYC. They are very wary of CME getting too much power.  The big banks generate a lot of income from OTC markets.  They are able to keep these markets relatively opaque.  If exchanges like CME or ICE gain a toehold in these markets, they will become a lot more transparent.  More transparency means less profitability for the players that control them today.  The other thing is more historical.  The NY bankers never figured out how a bunch of upstarts in Chicago beat them in the financial futures game, and the equity options game.  The NY banks will always push Washington DC  to rewrite/write rules and regs that benefit them to the detriment of Chicago. The current occupant of the White House is more attuned to NYC than Chicago believe it or not.  This is the crux of the push/pull.

Sometimes this schism becomes apparent.  The regulatory fight that occurred last year on Capitol Hill exposed some of those fissures.  Other times, it’s not apparent, but it’s always there.

However, when you look at the future, and especially the future expectations of economic and market actions, CME is the 800 pound gorilla in the room.  CME controls the interest rate futures market.  With inflation coming, interest rates should creep up.  This will force more volume to stream through the interest rate sector of CME.  If rates were to eventually go to historical averages, around 8% on the long bond, volume in CME interest futures could rise exponentially.

CME trades the lion’s share of energy and precious metals products.  These are starting to grow.  When inflation hits, oil prices should skyrocket, and gold/silver ought to be one of the hottest trades on the street.  Volume tends to grow in exponential patterns, not linearly when futures markets grow.

CME has the grain, meat, dairy sectors of the economy.  It trades lumber, so if housing gets hot, lumber futures ought to heat up.  It has the hottest stock indexes as well.

CME trades the currency markets.  However, most of this market is traded off exchange.  It would take a regulatory move to increase volume significantly in currencies.  The volume has increased in currency markets in the past year, but since the Prime Brokerage controls it, volume has not increased exponentially.

It’s important to note that each segment of the CME’s business have a different organizational structure, even though they are similar. Bonds are not like equities are not like currencies are not like grains are not like energy are not like metals are not like meats even though they all have similar traits.

There are other significant strengths.  One is the GLOBEX system.  GLOBEX is simply the best electronic system to trade on in the industry.  It’s stable, easy, fast, and runs 24/7.  The CME clearing house is the best of breed.  It is the backbone of the entire organization.

I also believe that as investors become more sophisticated, options on futures volume will grow. As that options market transitions from pit to screen, the market should grow as well. Currently, most options are traded on the floor the same way they have been traded for hundreds of years.

Looking at the numbers, CME generates enormous profit. If you ever wanted to own an ATM, you can if you buy CME.  Margins from the top line to the bottom line are around 62%!

There are some other risks. One is that CME is beholden to a pricing structure based on antique ideas. Since it still has remnants of the seat structure that was in place from 1849(CBOT)-2002(CME demutualization), it might not be able to adjust nimbly to competitors.
Secondly, with the electrification of the marketplace, CME is not any different than the cash equity side of the market. More and more volume is being done by less and less participants. What happens if they implode on each other or form a pact to destroy CME pricing power? CME B shares have taken a major hit in price over the past year, reflecting this phenomena.
Those risks are inside baseball though and could be rectified with good foresight by the board.

CME should benefit significantly from world wide macro economic trends. The price is underwater this year, off $70 bucks. But, the stock is in strong hands. The market isn’t short the float. Many long time CME shareholders have instructed their brokers not to lend out the shares, limiting the amount that can be floated.

The other potential I could see is acquisition. CME generates so much cash, it might be worthwhile for a private equity firm to take a run at CME if credit markets improved. CME has a global footprint. It’s PE is around 20, but given the exponential growth that should occur, that’s still cheap.

UPDATE
Before the open today(Oct 19, 2010), CME volume was over 3 million contracts. An average day for CME is somewhere between 10M and 12M contracts. Most of that volume is done between 7:20am-3:15pm. Already today they have done 25% of their average-on a day when the stock market is breaking. Imagine what will happen when the Fed begins to raise rates.

tip of the hat to Finance Trends


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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