Warren Buffett has often discussed the "Consumer Monopoly" and the "Toll Bridge" as being two exceptional types of businesses that have the ability to create value for shareholders. The "Toll Bridge" is something that people or businesses have to use to get where they are going because it furnishes access to an essential service. Just as you might have to pay a toll to cross the bridge that takes you to work.
A cluster of these toll bridge companies can be found in the financial services sector and may well present attractive investment possibilities or at least warrant future research. These companies operate stock, commodity, futures, derivatives and options exchanges in addition to related financial services. Every time there is a transaction between a buyer and seller, they profit. Today I will be briefly discussing four dividend paying exchange companies: Nyse-Euronext (NYX), Nasdaq OMX Group (NDAQ), Chicago Board Options Exchange (CBOE) and the CME Group (CME).
My Experience with the Big Board - NYSE-Euronext
Without a doubt, the most well-known exchange in the world is the New York Stock Exchange. The company that owns the exchange, NYSE-Euronext, has expanded its business over the years through mergers into Europe and Asia. I purchased shares in the company in early 2012 at a price around $25. At the time of my purchase, the company was trading below cash per share plus book value ($1.4 and $26.31 respectively) and offered a dividend in excess of 4%, a necessary product and a ubiquitous brand name. It seemed to have everything going for it. By early December, it was the worst performing investment in my portfolio, for reasons that I believe are due to the following factors: uncertainty in the economy of eurozone (where a significant portion the company's business is located), the specter of increased regulations, problems with the technology (to be discussed later) and Hurricane Sandy - an event that caused the exchange to be closed for two consecutive days. Needless to say, after these unanticipated events I was growing skittish.
Through the course of holding NYX I second guessed myself numerous times and in the process learned some valuable lessons about several problems that can potentially impact shareholders of exchanges:
1. Computer Glitches - This almost goes without saying. The Knight Capital (KCG) debacle earlier this year is just one of numerous incidences of computer-related mishaps that loom over this sector of the financial services industry. I was also behind my screen when the Flash Crash happened and have experienced first-hand the dangers of HFT and the negative press coverage that results.
2. Weather Related Issues -- You can't take any tolls when the bridge is out. When an exchange is closed, it's closed. Even though it's rare, the closure of markets due to weather related events like Hurricane Sandy does have an impact on margins in the short term.
3. Regulatory concerns hampering acquisitions or reducing new lines of business - Consolidation and expansion in this industry is often a difficult proposition. The U.S Justice department's concerns about the NYSE-Euronext's merger with Deutsche Boerse quashed the proposed merger and serve as an example of the difficulties involved in exchange consolidation.
I was very pleased to liquidate my shares for a healthy profit after the ICE offer was tendered.
Nasdaq OMX Group
NDAQ owns the Nasdaq, the second largest stock exchange in America and the OMX group, which operates exchanges in Northern Europe and develops financial products used worldwide. NDAQ has a book value of $31 and cash per share of $3 against a current price of $26.48 with a P/E ratio of13.3. The company has also started paying a dividend this year, which at the current price yields 1.96% annually. I would describe Nasdaq as the "Pepsi" (PEP) to the NYSE's "Coke" (KO) - a pair of similar products that are perpetually one and two. If you take a step back you can see that both are not going anywhere and have continued to do well. NDAQ has insider ownership of 18%, a healthy amount. If the ICE bid goes through for NYX, there is a significant chance that NDAQ could have the opportunity to integrate portions of Euronext's business, which will be spun off. Expanding European presence could ultimately drive growth if NDAQ is able to clear European regulatory hurdles.
CBOE Holdings, Inc.
CBOE Holdings is a relative newcomer to the public markets. Headquartered in Chicago, the company offers Equity, Index, ETF/ETN and Futures options. Since going public in 2010, the company has increased its dividend every subsequent year, currently yielding 1.9% and has returned cash to shareholders via a special dividend. The company has no debt, $3.16 book value and $1.84 cash per share against a price of $31.48 for assets totaling $5. The company's high profit margin and return on equity, coupled with the popularity of options trading could account for this significant premium between assets and price. I believe that there is significant regulatory risk in the future for options and derivatives trading and for that reason I believe that paying such a significant premium should be approached with caution due to the risk of regulatory interference.
CME Group Inc.
Operating as an exchange for futures and derivatives, the CME group also operates CME Clearing Services and in 2010 purchased 90% of the Dow Jones indexes. CME also recently completed an acquisition of the Kansas City Board of Trade, the primary venue of exchange for Hard Red Winter Wheat. CME has a P/E ratio of 11.95 and has steadily increased its dividends over the years. It currently yields 3.39% and has returned cash to shareholders via a special dividend last year. The company has $6.24 of cash per share and a book value of $65.45, against a price of $53.22. The company also has .71 cents in cash for every dollar of debt and a robust profit margin, indicating the ability to satisfy a significant portion of its debt obligations in a timely manner.
Common Themes to Exchanges
1. A trend towards consolidation - There has been a large amount of acquisition activity in the past several years. Despite a considerable number of acquisitions, there will always be significant regulatory hurdles to overcome and a high chance of failure. I'd avoid "buying on the rumor" and if an offer was attractive, I would definitely be "selling on the news."
2. Most exchanges have robust profit margins and have diversified into a range of geographic regions and financial products.
3. Endemic regulatory involvement - As a result of the essential services provided by these companies and their potential impact on the world economy and investment community, governments are continuously involved in both their operations and expansion.
I believe that 2013 has the potential to be very interesting for shareholders of exchanges and prospective investors interested in obtaining a "toll bridge" at the right price. If the NYX-ICE merger goes through, the European portions of NYX's business will be spun off. Depending on the terms of this spinoff, there could be an opportunity for investors to purchase shares outright or to anticipate an acquisition by another exchange which could add significant value. If I were to pick a single exchange to further research, it would be CME due to it's large cash holdings, robust dividend and the recent acceptance of the Renmimbi as collateral.