07 April 2011 at 12:01 GMT
What investment is more attractive than having ownership in a natural monopoly producing high returns, has a bright future because of ongoing securitisation and which trades at a reasonable price? None. So, that is why investors should own exchange shares in developed markets.
There is a lot of action in the exchange industry with Deutsche Boerse’s bid for the U.S. iconic symbol NYSE Euronext which has now been trumped by a joined counterbid from NASDAQ OMX Group and IntercontinentalExchange. At the same time, Singapore Exchange’s bid for ASX that kick started the whole consolidation wave in the industry is falling apart. This lured us to look at this industry in order to analyse what investors should make of this consolidation and how to invest in it.
Below we have gathered financial information on the 14 largest publicly traded exchanges in the world. What strikes the eye first is their high market capitalisations despite relatively low revenues compared to other financial firms witnessed by the industry’s average price-to sales ratio of 9.5 compared to 1.4 for the S&P 500 Index. The logic lies in the extremely high EBITDA margins that these companies are operating with which produces high return on capital and equity that again pumps share prices into the sky because everyone wants a piece of heaven; the industry’s earnings per share has also seen a 28.9 percent annual growth rate since 2000 which also supports elevated share prices.
As the exchange industry is divided into several financial instruments so too are valuations. All emerging market exchanges and specialised exchanges such as IntercontinentalExchange (specialised in commodity trading) are trading at very high valuations. Rule number one in investing is never to overpay, so despite a promising outlook for the Hong Kong and BM&FBovespa exchanges their valuation eliminates them as intelligent investments.
Based on the financial data such as, revenue growth, earnings per share growth, EBITDA margin, operating and capital efficiency, return on capital and valuation over an economic earnings cycle, the best companies to be positioned in are Deutsche Boerse, London Stock Exchange Group, TMX Group and Bolsas y Mercados Espanoles. We wanted to add NYSE Euronext because of their conservative valuation but their low operational efficiency discluded them.
It's obvious that this industry has stellar financial metrics and we have now put forth our opinion on how you position yourself. To support the argument that it this industry is a good investment and to reveal what drives it, let us explain the industry dynamics and competitive landscape.
Exchanges facilitate trading of various financial instruments and operate in a very benign competitive market which creates lucrative returns for their shareholders. What characterises the exchange industry is its natural monopoly on trading financial instruments. These first “suppliers” in the industry have been around for hundreds of years and are often chartered by the local governments as the sole exchange. This has created huge cost advantages and the economies of scale make it very difficult for new competitors to enter the market.
The advancement in electronic trading infrastructure systems and growth in derivatives trading have propelled EBITDA margin from 39.2 percent in 2000 to record highs with an industry average of 57.6 percent in 2010 compared to 19.4 percent for the companies listed on the S&P 500 Index.
Consolidation drivers
What is driving this consolidation wave in the exchange industry? To a large extent prices on traditional stock trading have been under pressure for over 10 years, so in order to sustain fat margins exchanges have diversified into the world of derivative trading, such as interest rate swaps, options and futures. This new lucrative segment within the exchange industry has been growing at around 19.1 percent annually since 1998 according to data from the Bank for International Settlements. The biggest risk to the investment is that margins cannot be sustained due to commoditisation of trading technology and financial instruments in the future. Based on the current information and trend it is difficult to foresee a margin collapse but exposure in developed exchanges at conservative valuations mitigates this risk to a certain extent.
New strategies to limit trading costs are also being initiated by the world’s largest money manager, BlackRock, which has built a global trading network that allows trading between internal accounts; so if a client is selling Apple shares and another client is simultaneously buying, then instead of executing the orders over the exchange, shares are simply switched internally in the money managers' systems. This strategy circumvents to a certain extent exchanges' monopolies but these strategies will not marginalise exchanges going forward.
In a historical perspective, the 14 largest exchanges have returned USD adjusted 12.9 percent annualised on an equal weighted basis since the first week of 2006 compared to 0.7 percent for the S&P 500 Index and minus 12.0 percent for the S&P 500 Financial Index. This relative performance speaks for itself. We believe exchanges will continue to outperform the general market because of above market earnings growth fuelled by further securitisation of the global economy, natural monopoly characteristics, and huge economies of scale from technology, derivative trading and ongoing consolidation. As an investor you should not miss the opportunity to gain exposure in this attractive industry.