The COVID-19 crisis has not been kind to the financial sector. Bank stocks have sold off on fears of credit writedowns, many mortgage REITs (real estate investment trusts) have been forced to deleverage and sell assets to meet margin calls, and other REITs are struggling as tenants are unable to pay rent.
One sector that has escaped much of the fallout has been exchanges -- and particularly CME Group (CME 0.97%). But does that make it a buy?
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The largest financial derivatives exchange in the world
CME Group is a portfolio of exchanges that primarily trade commodities and their derivatives. It includes the Chicago Mercantile Exchange, the Commodity Exchange, the Chicago Board of Trade, and the New York Mercantile Exchange. Add them all together and you have the largest financial derivatives exchange in the world.
The COVID-19 crisis forced CME Group to shut down its floor trading operations and go remote (CME did recently announce that the Eurodollar options pit would reopen in August, while the rest of the exchanges will have to wait until Illinois reaches stage 5 of reopening). While there was a transition period as clients who were primarily pit traders moved to an all-electronic environment, trading volumes were unhurt. In the first quarter, average daily volumes came in at 27 million contracts per day, up 45% from the same quarter the year before. Interest-rate derivatives accounted for about a third of CME's clearing and transaction fees in the period. Energy derivatives and equity index futures and options are other large segments of the business.
Valuation comparison
Most of the U.S.-based exchanges trade at pretty similar valuations. CME has the second-highest price-to-earnings (P/E) ratio of the group, but it also has the top dividend yield. Its P/E ratio is more or less right in the middle of its range over the past five years.
| Company | P/E Ratio | Dividend Yield | 5-Year EPS Growth |
|---|---|---|---|
| CME Group | 26.4 | 2% | 11% |
| Intercontinental Exchange (ICE +0.37%) | 25.3 | 1.3% | 15.7% |
|
Cboe Global Markets (CBOE 0.53%) | 22.3 | 1.4% | 10.6% |
| NASDAQ (NDAQ 0.11%) | 27.1 | 1.7% | 11.2% |
Source: Company filings. P/E and yield data are as of market close on June 16.
Later this year, the Members Exchange is set to launch, which will be a stripped-down, low-fee stock exchange. One of the biggest traders on Wall Street, Virtu Financial, is part of the consortium, so trading volumes for both the Intercontinental Exchange (which owns the New York Stock Exchange) and Nasdaq will fall. This may not have a huge effect on earnings this year, but it will definitely impact them in 2021.
For this reason it is hard to recommend either Intercontinental or Nasdaq versus CME. Cboe (the Chicago Board Options Exchange) has a cheaper multiple but slower growth and a lower yield. If you want to own an exchange, CME is probably the best of the bunch.
Are we at the right point in the economic cycle?
The next question is whether you want to own the stock of an exchange. Certainly things have been dire in the financial sector for the past few months. The economy is turning around, although much will depend on whether we see another wave of COVID-19 cases. If the worst is indeed behind us, then much of the beaten-up financial sector might provide better value. As a general rule, it is hard to love banks until you are sure the writedowns are finished. However, the mortgage REIT sector seems to be in recovery mode, and some of the other REITs might be worth a look as businesses reopen.
The exchanges are great plays when it looks like the economy is rolling over because they have little credit risk. They are defensive financial stocks, almost like public utilities. If the economy is truly turning around, then they could underperform as investors rotate into early-stage cyclical stocks and the other financials.
