CME Group (CME -2.89%) is a total cash cow. One of the world's largest exchanges for derivatives trading, CME pays an annual dividend yielding 1.8% but has also paid a special dividend at least once every year since 2012. For 2020, that special dividend was an extra $2.50 per share, boosting the stock's trailing 12-month yield to nearly 3%.
Derivatives trading is an old business and isn't going away any time soon. In fact, they're a key component to controlling financial risk, and CME is helping expand the importance of derivatives in new ways. If steady growth and income are what you're after, this stock is worth a look.
An underrated bet on the financial system's plumbing system
"Derivatives" are something of a four-letter word in some people's minds. If misused -- like to speculatively ratchet up exposure to risky investments -- they can very quickly lead to steep losses. For example, some financial institutions were using derivatives during the housing bubble that contributed to the Great Recession.
But derivatives have been around for centuries and are an important way for institutions and investors to control risk. In simple terms, a derivative is simply an agreement between two or more parties for the delivery of an asset at a future date at a predetermined price. Options, futures, and warrants contracts are common examples. For instance, a company that uses oil can guarantee a purchase from an oil producer at an agreed-upon price now for delivery later. The earliest contracts like this date back centuries, used to guarantee pricing and access to agricultural goods.
Today, derivatives contracts are exchanged electronically and are collectively worth trillions of dollars a year -- like the contract trading and guarantee facilitated on CME Group's platform. CME lays claim to the most diverse derivatives marketplace, enabling trading on contracts for agricultural and energy products, metals and commodities, and financial instruments like interest rates, currency exchange, and stocks.
CME is a type of tollbooth business. It earns a small fee every time a contract is made and exchanged on its platform. Contract volume on specific items is extremely volatile, but overall derivatives volume has slowly averaged up over the years as the global economy grows.
CME has a new area it can promote growth, too -- cryptocurrencies. Widely used applications like PayPal and Square's Cash App allow for trading and exchange of digital currencies like Bitcoin. Coinbase Global has been growing rapidly as it facilitates crypto trading. And a growing number of large businesses are investing in the movement too. But an often-overlooked contributor here is CME. The company launched futures and options on Bitcoin and more recently futures for Ethereum, giving institutions and investors a way to hedge against price fluctuation risk. Other new contracts available through CME include lithium (for use in car batteries) and global emissions offset futures (for companies trying to reduce their carbon footprint).
A steady increase in volume equals steady growth
If there's demand for contracts between two parties, there's a good chance CME Group will be there with its electronic trading and data systems. Even as the economy gets reshaped by the digital age, CME is finding new demand for derivatives on new assets. CME's revenue has increased as a result of this steady climb in trading volumes, and the business is consistently very profitable. Free cash flow profit margin was nearly 52% last year, enabling the company to easily dole out that lucrative dividend payment each year.
As could be expected from such a strong performing business, CMS shares trade for a premium -- 15 times trailing 12-month revenue and 29 times trailing 12-month free cash flow at Friday's prices. Given the price tag, I'm not making a call this will be a stock market outperformer in the next year or two. CME is currently priced more like a high-growth fintech upstart than it is a slower but steadier dividend-paying stock.
Nevertheless, over the long term (think five years or more), CME should continue to benefit from rising derivatives contract trading volume and offers a nice quarterly payday to shareholders and an annual bonus if it generates excess cash (which it usually does). If investment income is what you're after, paired with some gradual stock growth potential, add CME Group to your list of companies to do some more digging on.