Like most financial stocks, the stock exchanges were beaten up during the stock market sell-off in the early days of the COVID-19 lockdown. While the entire financial sector has bounced off the March lows, it is still down substantially for the year. Credit issues are the big fear for the banks and the real estate investment trusts (REITs), as borrowers and tenants are struggling due to the weakness in the overall economy.
But one financial sector stock that has managed to avoid these issues in 2020 is Nasdaq (NDAQ +0.69%), which operates one of the main U.S. stock exchanges.
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Nasdaq is profitable, but a new competitor has entered the market
Nasdaq operates four basic businesses: Market Services, Corporate Services, Information Services, and Market Technology. Market Services is the bread and butter of the company, which includes trading and clearing operations, and accounted for just under 40% of net revenue in the second quarter. Information Services includes the sale of market data to trading terminals and media. It accounted for 30% of overall revenue last quarter.
Nasdaq's business is highly profitable, with the company earning 34% net income margins. This is because the company has a competitive moat, and it is exceedingly difficult to create a competing exchange that will draw volume. That said, the Members Exchange (MEMX), which is a joint venture among a consortium of Wall Street firms, began trading in late September and traded 1 million shares between seven stocks in its first week.
Volume growth is slowing as volatility declines
During the second quarter ending June 30, cash equity trading volume for Nasdaq increased 63% year over year. As the COVID-19-driven sell-off fades into memory and volatility declines, the rate of growth has slowed. During July and August (September data isn't out yet), cash trading volumes increased 32% year over year. Listed equity options volumes increased 46% year over year during the second quarter, and maintained similar growth levels in July and August.
While trading volumes will ebb and flow, increasing products, especially via new indices, represents a growth opportunity. At the moment, Ethical, Social and Governance (ESG) indices seem to be popular.
Nasdaq is one of the top-performing financial stocks this year
Nasdaq's stock is up roughly 16.5% year to date, and it has outperformed the other major exchanges. The Intercontinental Exchange, which owns the New York Stock Exchange, is up about 10%. Meanwhile, CME Group is down roughly 16.9% and Cboe Global Markets is down 26.7%. Compared to the overall financial sector, Nasdaq's rise compares favorably to the S&P Financial Select SPDR (XLF +0.84%), which is down about 20%.
Attractive valuation, but beware slowing growth
Nasdaq is trading at 21 times expected 2020 earnings per share of $5.90, which is up 18% compared to a year ago. This works out to be a price-to-earnings-growth (PEG) ratio of 1.2, which is attractive. That said, the market expects the company to earn $5.93 per share in 2021, so it clearly views 2020 as a one-off event.
Nasdaq also pays a quarterly dividend of $0.49 per share, which works out to a yield of 1.6%. The company earned $1.45 per share last quarter, so its payout ratio stands at 34%, which is pretty conservative. If growth slows, there may be room for Nasdaq to up its return of capital via dividends and buybacks.
The reason you buy an exchange like Nasdaq is because it has a competitive advantage and has limited credit risk. If you think the economy is at risk of having a double-dip recession, then the exchanges could be a good place to hide out. Otherwise, watch the bank earnings reports coming next week. If the asset writedowns are finished, then expect to see a rotation into the banks, and the exchanges might underperform.
