One of our Industry Focus: Financials listeners recently asked us to talk about investing in exchanges, such as CME Group, Cboe Global Markets, NASDAQ, and more. In this clip, host Jason Moser and Fool.com contributor Matt Frankel, CFP, discuss what investors should know before diving into this space.
A full transcript follows the video.
This video was recorded on Feb. 25, 2019.
Jason Moser: Today, we're going to begin with a listener email. This question comes from Noel Sayers in freezing-cold Edmonton. I tacked on the freezing-cold there, Matt, because that's what he said. He said he was sending the email from freezing-cold Edmonton. Noel says, "Hey team, what do you think about a segment or episode on the stock exchanges sub-sector, including ticker CME, CBOE, ICE, and NDAQ? I'd appreciate comments on the factors that impact these stocks, a comparison of the different company financials, and favorite picks."
Well, Noel, you're in luck, my man! We are going to talk about this today for you. Matt, I'm going to kick this right over to you. I know this is some research that you've recently done into this space. It's an interesting one, for sure. What are the main points that you want to hit here for Noel?
Matt Frankel: The main ways that these companies make money is from trading volume. This is an interesting dynamic in the market. If you have a market that's pretty much slowly going straight up, nothing exciting, low volatility, these companies can actually suffer because trading volumes are low, and that's how they make their money. Like we saw over the past three or four years for the most part, it's been a pretty calm market. When markets start dropping or volatility spikes, these companies can actually start doing better than they were before because people are trading more actively, buying options contracts to hedge positions, things like that. So these companies can actually do better.
The biggest risk, I would say, especially if you think the Democrats are going to start really taking control of the government, is regulation. There's a lot of potential regulations, especially when it comes to futures markets, that people should be on the lookout for.
Having said that, my favorite in the group that you mentioned is CBOE because they have a pretty huge market share in the options market.
Moser: That's the Chicago Mercantile, right?
Frankel: No, it's the Chicago Board Options Exchange.
Frankel: CME is also another good one. They have a very good market share in what they do.
Moser: Oh, you said CBOE! Sorry, we had a little bit of an audio glitch there. CBOE, OK.
Frankel: Well, they're both great!
Moser: OK! [laughs]
Frankel: [laughs] CBOE has about a 70% market share in options. Anytime you have that kind of market share in something where you can actually do well when the market's going down, because of high trading volume, I think it's a pretty good business.
In the financials sector, it's not my favorite space to invest. I think there's better value to be found in commercial banks, some of the smaller banks we've been talking about, and a lot of the "war on cash" stocks, which you didn't want us to talk about, but I just snuck in there. You see how I did that?
Moser: [laughs] Oh, yeah!
Frankel: [laughs] But, having said that, CBOE is, in my opinion, a great business and one that I would not mind owning in my own portfolio.
Moser: Let me ask you a question. You mentioned something at the beginning of this, talking about volume. That makes a lot of sense. These guys want to see more activity. That gives them a chance to make more money. I get that. Obviously, we invest with a bit more of a hope in not trading too terribly much, so I don't know that we would be, on paper, at least, the best customers for these exchanges. But, when we talk about the options index there, we talk about CBOE, it just strikes me that with options, there's inherently more volume when it comes to options based on the strategy that you're employing from the very beginning. Options seem to me to inherently have more volume anyways. No. 1, is that a correct assumption on my part? No. 2, if so, is that what could separate CBOE from these others, the fact that they're going to have inherently more volume anyway?
Frankel: Yeah. It's kind of like how I recommend Walmart as a retailer from time to time, just because they do well in pretty much any market. You're correct that options are a more high-volume activity, even for long-term traders. One of our Fool services recommends options strategies for long-term traders. In that mindset, there's a lot of trading volume that's just options, more so than stocks.
Options strategies are really useful as hedges, especially when times get uncertain, when things are volatile either to the upside or downside. A lot of people try to hedge through options, so you'll see a really big spike in volatility. Some of the more volatile quarters in the market have been CBOE's best quarters. The same can be said for some of these other exchanges you mentioned. Yeah, options is definitely a good play on volatility, but tends to have high-frequency volume anytime.
Moser: I feel like probably, these businesses are pretty safe plays, in the sense that we know they're going to be fairly consistent businesses, as far as the demand for their services. In good times and bad, the markets are going to be open, there's going to be volume, and these companies are going to be doing their thing.
I noticed, it seems like there's a consistent... I don't want to say they're all riddled with debt, I did notice that their balance sheets do carry some debt, some a little bit more than others. It strikes me, they're kind of like a utility in that regard, right? They can get away with doing that because they can rely on a pretty steady flow of business in both good times and bad.
Frankel: Yeah. I'd liken that to almost a commercial bank, in some senses. They have steady revenue coming in from people depositing money and loading out that money. It's a forever business. It's not something that's going to be easily disrupted, unless somebody creates a new stock exchange or a new options exchange, which, the barriers to entry are just huge. But yeah, it's almost like a utility-like income, especially when you get to a 70% market share like I was just talking about with CBOE. It can become utility-like income.
Moser: You mentioned something there in regard to barriers to entry. That's the one thing that stands out to me with these types of businesses. The barriers to entry from a number of perspectives are probably pretty high. From a tech perspective, certainly from a regulatory perspective, it would take a lot of work for a new competitor to jump into that space and really start taking share away from some of these established players. From a competitive advantage perspective, from a competitive positioning perspective, these are businesses I think that hold fairly admirable competitive positions.
Frankel: Definitely. It'd be really tough to, like I said, make an options exchange that significantly steals share from CBOE. Even for someone who's trying to do it with low fees and doesn't care about making a profit, getting past the regulatory headaches and the established relationships in that space, especially... Can you imagine trying to make a competitor to the NASDAQ at this stage?
Moser: [laughs] No.
Frankel: Right? It's something you laugh about. That's how good of an advantage they have. I mentioned competitors, and you laugh about it. That in itself tells you what a good, solid, forever business these are.
Moser: Yeah. We'll move on to the next topic soon, but, it also strikes me -- a lot of times, we look at businesses, they're really big businesses with tremendous balance sheets and tremendous resources. You can have all the money in the world, and it doesn't mean you can go in there and immediately start competing. Finances are just one piece of the puzzle there. I'd imagine, even if you had someone that wanted to go in there and compete, we always like to frame it on the investing team by saying, "OK, I'm going to give you $20 billion. Go in there and compete with these guys. How are you going to do it?" It shows you that money is not the only thing. You look at companies like Facebook or Alphabet, they obviously have very admirable competitive positions in regard to the markets they serve. But money isn't necessarily everything. They can't just go in there and do whatever they want. It still takes some expertise when you're pursuing a given market. That's probably something worth noting with these companies.
Noel, I think that's a great question! I'm glad you asked it. I hope we were able to give you a little bit more insight there as to the market itself. Clearly, Matt thinks a little bit more highly of CBOE than the other names you mentioned, so, hey, you got a recommendation out of it, too, buddy.