When searching for good dividend stocks, the most important questions concern the stability of the dividend. Can the company pay the dividend in good times and bad? Does the company have a competitive advantage that makes it hard for new entrants to replicate its business model? Finally, does the board of directors have a policy guiding how it determines the dividend that is paid?
Let's take a look at how CME Group (CME -2.81%) answers these questions.
The world's dominant derivatives exchange
CME Group is the world's biggest derivatives exchange, encompassing the Chicago Mercantile Exchange, the Chicago Board of Trade, the New York Mercantile Exchanges, and the Commodity Exchange, among others. Investors trade commodity futures and options, currencies, interest rate derivatives, and stock index futures. Since starting out as the Chicago Butter and Egg Board more than a century ago, the company has grown by acquisition over the years, buying the Chicago Board of Trade in 2006 and the New York Mercantile Exchange two years later. Its customer base includes institutional and individual investors, banks, corporations, governments, and central banks.
CME's business model
CME earns most of its money through clearing and transaction fees. Clearing is the business of facilitating transactions, which means ensuring the buyer has the money and the seller has the securities. CME Group also sells its market data to media and trading terminals like Bloomberg and Reuters. While people are most familiar with the S&P 500 futures, CME is best known for interest rate derivatives, especially eurodollars and London Interbank Offered Rate (LIBOR).
CME has a huge competitive moat, as investors are most likely to trade on exchanges where volume and liquidity is the highest. It would not be easy for a competitor to re-create what CME has built. Demand for a risk management tool is generally insensitive to the general economy. This means that CME Group's trading and clearing fees will be relatively stable over time, which is exactly what a dividend investor would want to see. Growth will be driven by the introduction of new products, particularly environmental, social, and governance (ESG) indexes and Secured Overnight Financing Rate (SOFR) contracts, which will be replacing LIBOR.
CME's dividend policy
CME's dividend policy, as stated in its annual report, is to pay a quarterly dividend that works out to be about 50% to 60% of the prior year's earnings, along with a variable end-of-year dividend. Last year, CME paid four quarterly dividends of $0.75 and a variable dividend of $2.50. So between the four quarterly dividends of $3 and the $2.50 variable dividend, CME paid $5.50, which would have worked out to a 3% yield for investors who bought at the beginning of 2019. Currently, CME pays a quarterly dividend of $0.85, and we'll have to see what the variable dividend will be at the end of the year.
Note that last year's dividend came out of $5.91 in earnings per share, which pushed CME's payout ratio to an exceptionally high 93% (payout ratio measures dividends as a percentage of earnings, so we want to see lots of breathing room). That said, the variable dividend doesn't have any formulaic determination, just that it will depend on "operating results, capitalization expenditures, potential merger and acquisition activity and other forms of capital return including regular dividends and share buybacks during the prior year." So basically, you are getting a base yield of 1.9% with some sort of bonus at the end of the year.
CME's intent to pay most of its earnings out as dividends, along with its stable business model, indeed makes it a great dividend stock.