2020 was a seeming conundrum in financial markets. In the midst of the pandemic, many investors turned a tidy profit. In particular, owners of bitcoin and other cryptocurrencies had a banner year. Bitcoin increased over 300% in value. Congrats if you called it and got in ahead of the boom. And as cryptocurrencies are a scarce resource, there could be more long-term upside in crypto prices.
But I'm not here to make that call. Instead, I'm talking about stocks that will benefit from the long-term increase in usage of digital assets. And CME Group (CME 0.04%) could be the best business for investing in the trend.
More than just a supply and demand discussion
Cryptocurrency prices are not the best measure of how useful a digital currency actually is. Rather, they're a short-term measure of supply and demand. This is the case with any asset price in the short term, stocks included. Think back to your Econ 101 class: All resources are finite in supply, so changes in demand dictate the price of said resource. If demand exceeds supply, then prices go up; if demand dips below available supply, prices go down. Cryptocurrencies -- embodied by bitcoin -- were in very high demand in 2020 relative to the limited supply of digital coins in actual circulation. (Of note, most bitcoins in existence are not actually in circulation, as explained by fellow Fool.com contributor Sean Williams.) In 2018, it was the opposite situation.
But these wild fluctuations in price don't exactly measure digital money's (and the underlying blockchain technology's) usefulness -- that is to say, how many (or how few in this case) consumers and businesses are using bitcoin in their daily activities. For many investors, myself included at the moment, a lack of utility makes cryptocurrencies a hard pass after their epic run in the last year.
But is there a way to bet on the long-term growth in acceptance of digital currency (the true measure of any currency's worth as a storage of value) without needing to worry about wild swings in cryptocurrency prices themselves? Yes, and I think the ticket is CME Group.
Traded, accepted, or otherwise gone mainstream
CME Group is the world's largest marketplace of derivatives contracts -- options and futures (a pre-agreed-upon price for delivery of an asset at a future date) for a long list of things from company stock to commodities like oil and agricultural products to fiat currencies like the U.S. dollar. While derivatives have a bad rap in some investors' minds (thanks to the wild speculation they can help enable), contracts like options and futures have been in use for centuries as a way for people and organizations to manage risk and from which to discover information about expectations within the economy.
By and large, it's for this risk mitigation that options and futures contracts are used. And CME is an efficient and very profitable facilitator of risk transference. The marketplace generated free cash flow (revenue minus cash operating expenses and capital expenditures) of $1.77 billion on revenue of $3.73 billion through the first nine months of 2020 -- an incredible margin of 47%. The company has a nearly two-decade-long track record paying a steadily rising quarterly dividend (currently $0.85 per share each quarter in 2020, yielding 1.8% at Friday's prices) and often pays a special dividend at the end of the year to distribute excess cash. For 2020, the one-time special dividend was $2.50 per share, boosting the stock's effective annual yield to 3.1%.
But what's all this to cryptocurrency? CME launched futures contracts on bitcoin in 2017, expanded the market to include bitcoin futures options in early 2020, and will add a new cryptocurrency marketplace via Ether futures (a unit of Ethereum, the second-largest crypto behind bitcoin) in February 2021. Derivatives contracts on the two largest crypto assets are a big deal if you believe adoption of digital currency will increase over time. Derivatives can help make a market for an asset more stable and could encourage businesses and organizations to accept their use. And CME earns a small fee every time a contract is traded.
For example, let's say a retailer wants to begin accepting bitcoin or Ethereum as a form of payment from customers, but it needs to report financial results and pay its bills (including taxes) in U.S. dollars. Derivatives can help it hedge against loss from possible declines in crypto prices on the revenue it collects. CME is helping make such risk mitigation possible, and adding legitimacy for bitcoin and Ethereum as a form of payment along the way.
By expanding its steadily growing marketplace into digital assets, CME Group could benefit from continual adoption of cryptocurrencies in the economy -- not just yielding its growth from how many investors want to buy or trade the digital currencies themselves at any given point in time. Over the long term, this could be an important area of growth for CME if digital assets like bitcoin and Ethereum gain momentum as a form of payment and blockchain technology finds other areas of use.
It would be a mistake to draw a hard comparison between the current phenomenon occurring with bitcoin prices and bubbles in the past (like, say, the tech bubble of the late 1990s). However, a current lack of mainstream adoption of digital assets gives me pause before investing directly in bitcoin and other cryptocurrencies. That isn't to say there isn't actual use of cryptocurrency in the economy -- and I think there's a very high chance adoption will continue to expand in the decades to come. But if you want to bet digital currency usefulness will increase over time, I think CME Group is a great place to start.