CME Group’s History of Growth and Durable Advantage Not Going Away Any Time Soon

CME is an exceedingly complicated business to understand in some ways but also a simple one. It is at the forefront of risk management and mitigation and a volume-based business that is highly correlated to economic and commodity cycles. While it has an impressive Market Data division that is growing, over two-thirds of revenue comes from Clearing & Transaction Fees. The trend in these areas had been toward expanding margins as the migration away from physical trading has occurred. Indeed CME recently decided not to open trading pits closed because of COVID-19.

CME Group’s History of Growth and Durable Advantage Not Going Away Any Time Soon

Source: Thinkorswim


In our pampered times (relative to the harsh past), we can easily forget that boom and bust used to drive capitalism in a much more forceful way. The equity asset class is an innovation that largely reflects the time in which it was developed. We can often forget, in an age focusing solely on growth many years into the future, that one of the main benefits of the equity asset class is that during bumper years shareholders get a piece of the take through dividends or, more recently, buybacks. When we say pampered, we are speaking, of course, on the larger arc of modernity, not discounting that we just survived an awful pandemic that resulted in millions of people dying. CME Group is an outstanding stock to own. It has the same ubiquitous need that defines utilities; indeed, it is called a Financial Market Utility for regulatory purposes. It also is highly cyclical and a significant beneficiary of economic expansion but also of volatility and instability, which gives it a counter-cyclical component. It’s an established product innovator, and recent developments in this area show management has their finger on the pulse. It also has a very underrated attribute of steady and consistent dividend growth, which has obviously been interrupted by pandemic but should resume with the coming good times.

CME Group’s History of Growth and Durable Advantage Not Going Away Any Time Soon

Source: Company Reports


Though we’ve been through a recent catastrophe, our quality of life and the luxuries and technology that we enjoy allows us a quality and duration of life that far exceeds what was possible for our ancestors. We have a more stable economy less prone to boom and bust than our ancestors as well, and these two facts likely have a lot to do with each other. One of the most underestimated facilitators of this modern stability is probably financial derivatives and the net stability and options for managing risk that they provide. CME’s business is facilitating the management of risk and offering opportunities to a wide variety of clients in various industries for how to do so. However, from its track record of growth, it isn’t too bad at managing risks itself, as it has again proven during the pandemic. A track record of consistent growth through rain and shine is always an appealing attribute in a stock.

CME Group’s History of Growth and Durable Advantage Not Going Away Any Time Soon

The CME Group is the oldest publicly traded derivatives exchange and clearinghouse. In the case of Central Counter-Parties (CCP), age before youth pays off, CME has industry-leading operating margins that look to be moving higher. It was a pioneer in agricultural commodities and making sure that one bad season or harvest didn’t ruin the farm. In a larger sense, that’s still the business it is in today but in a much more complicated way. It is the largest commodities exchange in the world by revenue. It is a heavy hitter and sits at the nexus of global finance. The firm has good international exposure and a history of product innovation, which it is continuing with exciting new and responsible retail-oriented products, including its successful expansion into crypto. The firm had some struggles due to the declining need for its most significant segment in interest rate derivatives, but that will likely change over the coming quarters. Anxious about the Fed and Rates? This is your stock, then. Aimless direction over the past quarters in 2020 appears to be reversing.

CME Group’s History of Growth and Durable Advantage Not Going Away Any Time Soon

Source: Company Reports


A Diversified Cyclical Play Benefitting From Secular Generational Trends and Financialization


Few companies are as cyclical as a volume-based clearinghouse, but it’s not exactly the type of cyclical you’re thinking of. Whatever you think of the coming economic boom, one thing is sure: volatility in commodity prices has significantly increased. CME is a primary beneficiary of these. Agricultural commodities, metals, lumber, dairy products, and meats have all seen across-the-board inflation. Businesses use the contracts sold by this firm to hedge their risks and maintain their margins the best they can given the fluctuations of relevant commodities. The relative price of what this company offers on a philosophical level, like many names from Epicenter sectors, has increased in the anomalous economic environment we live in. One common feature of post-plague economies is shortages and supply-chain disruptions. One thing that hasn’t existed in a post-pandemic economy is the comprehensive suite of risk management solutions and tools that CME offers to mitigate these effects. The very fact our environment is anomalous increases the need for this product. Booming commodity prices require hedges, and so do volatile markets.

CME Group’s History of Growth and Durable Advantage Not Going Away Any Time Soon

Source: Company Reports


CME Had Bumper Year In Equities; Progress May Be More Durable Than Consensus Predicts


It is always lovely when a particular name converges with several of our investing themes. So, will this name benefit from reflation in Energy and other commodities? We think so. However, one bright spot in the 2020 year that was otherwise somewhat marred by headwinds in the interest rate segment was very high growth in the equity segment. According to a recent Charles Schwab survey, about 15% of investors started investing in 2020. CME knows what time it is and captures many users with retail-friendly products like Bitcoin micro futures. We see them capitalizing handsomely, and probably far beyond what consensus expects, from the shift to and rise of millennial investors who have a far greater risk appetite than their predecessors. We think the convergence of a huge well-educated generation with significantly less wealth than their predecessors at the same stage of their development should align nicely with the sophisticated and practical tools that CME offers.

CME Group’s History of Growth and Durable Advantage Not Going Away Any Time Soon

Some observers think this spike in equities business is temporary. However, with stocks reaching their highest level ever, composing 41% of US Household financial assets, we believe this trend may be more durable than initially meets the eye. The generational factors we often cite in markets show the people attaining and inheriting wealth have a higher risk appetite. They favor stocks and crypto over mutual funds and bonds. CME is benefitting from this and seems to know which way the wind is blowing. Millennials don’t buy bonds, they buy stocks and crypto, and the company’s product innovations in both areas suggest they are going to capitalize from the change in preferences associated with the rise of this generation despite the current prominence of the interest rate segment.


Another factor is this; the disdain for financial markets that followed the 2008 crisis has not been repeated this time around. CME’s NEX acquisition should also help boost margins in this area as more OTC business comes its way. Right now, there is also a tremendous amount of money on the sidelines. As this institutional money returns, inevitably, a piece of it goes to CME, who will help these investors hedge their positions and mitigate their risk. For the more aggressive and adventurous, it allows them to augment returns. As the shift toward more and more high-volume and algorithmic trading strategies continues, the Equity segment should continue to benefit, and there’s reason to think there could be more upside here than consensus estimates. Another potentially underestimated asset the company has in this area is their premier educational tools that help them retain customers and boost their customers’ success, creating a virtuous cycle.

CME’s Interest Rate Segment Can Very Easily Go From Albatross To Cash Cow


We are in one of the most uncertain periods for financial markets in recent history. Inflation is rearing its head for the first time in a generation. Unprecedented accommodative Federal Reserve policy continues despite a red hot economy that has clearly made strides toward an approaching robust recovery that will likely exceed pre-pandemic levels in many industries, particularly those whose products and services will enjoy a torrent of pent-up demand. One of the things that challenged the firm in 2020 was inconsistent and sometimes rather paltry volumes in its largest segment, interest rate derivatives. However, if history is any indicator, this weakness will become a strength in the not too distant future, particularly since the typical catalysts that have driven massive volume in the past are approaching on the horizon.


In 2011, when speculation about Fed raising and easing after the GFC started, volumes in the interest rate segment increased. Similarly, in 2017 and 2018, volumes rose significantly, as did benefits to shareholders, when the FOMC raised the federal funds rate seven times in those two years. With expectations of rate hikes and a slew of potential catalysts for increased interest rate and US dollar volatility, the upcoming profits and volumes should not only be pretty sublime but will likely exceed what consensus expects. For example, in 2017, EPS was $11.64, which is about double what has occurred in the subsequent three reporting years.


CME Energy Complex Looks Promising, Crypto Progress Impressive

CME Group’s History of Growth and Durable Advantage Not Going Away Any Time Soon

Source: Fundstrat, Bloomberg


CME’s energy business has been stuck at around $700 million for a while. Last year they put up the second-best year in the history of the commodity business. However, one of the strengths of CME is that they have diversified access to a litany of commodities. Their natural gas market is growing and is expanding energy margins. When you look at the entire year of 2020, the sequential growth of the business year to date is up significantly. If there is ever a year for their commodities business to break out, we think it is 2021.


They are just short of record open interest on WTI futures, which indicates they are making progress in gaining market share at the expense of competitors. In any event, the forces in commodities appear to be strong enough to lift all boats in the space. The momentum, the sequential growth QoQ and the high levels of open interest all point to immense coming strength in the commodities market. Again, CME is running the most sophisticated and diversified physical commodities exchange in the world. The company really couldn’t be in a stronger position to take advantage of continued strength and volatility in commodities. They have also rolled out a new product for ESG called Global Emissions Offset contracts. Good product development that is forward-looking can be seen in their crypto progress as well.


As far as traditional exchanges go, the CME group has also been a leader in adopting cryptocurrency. It has a retail-friendly bent to its products that seems to be attracting and retaining customers. It has been involved in the crypto space for a few years now, and the volumes are not negligible. Their recent introduction of Bitcoin micro futures cracked 100,000 contracts in less than a week! Those contracts represent 1/10 of a Bitcoin and are obviously geared toward retail investors.

CME Group’s History of Growth and Durable Advantage Not Going Away Any Time Soon

Source: CME


Risks And Where We Could Be Wrong


The risks to CME are primarily from a competitive standpoint in our estimation. It is actually insulated from many risks since it directly benefits from them! However, a business that does primarily rely on transaction fees will always have some inflation exposure. This is, of course, mitigated by the fact that investors will use the company’s products to hedge against inflation Pricing and competitive pressure from competent competitors such as NASDAQ, ICE and to a lesser degree, newer fee-less entrants like Robinhood do limit their maneuverability on price, and a long-term headwind is negative pricing pressure on transaction fees. However, the rise of BATS also shows that new entrants can come into the space with a bang.

CME Group’s History of Growth and Durable Advantage Not Going Away Any Time Soon

Source: CME


Generally, one of the biggest risks, not only to the company themselves but also to the entire global financial system, is the risk that the clearinghouses themselves manage. If you thought the big four American banks were Too Big To Fail, well, then the risk dynamics of clearinghouses like CME might be enough to make you lose your composure in public. One of the consequences of the Dodd-Frank Act was that it forced all derivatives to be cleared centrally. CCPs like CME shoulder hundreds of trillions in notional risk, and some major black swan event that breaks their waterfalls and methods for making good on all obligations could essentially cause paper losses that ultimately undermine the credibility of the global financial system. Luckily, these guys are pretty good at their job so far, and this risk seems exceedingly remote. Not remote enough to not mention, though. A Norwegian oil trader breaking S&P’s waterfall highlights this risk.

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