Up 1,300% Over the Past Decade, This S&P 500 Stock Is Now on Sale

Outperforming the stock market with bonds might sound impossible over the long term. However (allowing for a little creative license), it's been entirely possible to do just that by investing in fixed-income exchange MarketAxess Holdings (MKTX -0.86%), a unique way to gain exposure to and profit from bonds.

With bonds moving more and more into the world of electronic trading, MarketAxess' stock has risen about 1,300% over the past decade. Fueled by its Open Trading platform, the company has built an exchange that grows stronger with each new trader it adds, a classic network effect.

MarketAxess operates what's known as an all-to-all exchange, meaning anyone can trade with anyone else at any time. Investors on its Open Trading platform can anonymously place trades without counterparty restrictions -- a complete transformation compared to the traditional trading method of calling a select few dealers to find bonds.

Thanks to the megatrend of bond digitization; a platform that's becoming more valuable with each new user; and a fresh buying opportunity created by the stock's pullback this year, MarketAxess looks poised to trounce the market's returns over the long term.

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Perfectly positioned for digital bond trading

Even as the world has become more technologically complex by the second, bond trading has been slow to keep up. For example, across the main fixed-income groups that MarketAxess operates in, only U.S. Treasuries are commonly traded electronically.

Data from MarketAxess investor presentation.

As the table above indicates, most bond transactions are still processed the old-fashioned way. However, bond traders' gradual adoption of digital transactions highlights the potential runway remaining for MarketAxess.

Touching on this trend during the company's third-quarter earnings call, CEO Richard McVey said, "That's been one of the themes this year, as the dealer-to-dealer business has moved away from some of the traditional voice brokerage firms, it is now very actively deployed on the electronic trading networks, including our own."

While MarketAxess should see success simply riding this trend toward digital trading, it might have even more significant long-term potential in the massive network it is building throughout this process. For each new firm added to the company's network, the spread between buying and selling prices on bonds inevitably narrows, saving money on both sides. These cost savings only get more robust as the network grows, creating a powerful flywheel effect, which has led to broader adoption of the company's Open Trading platform. 

Currently, MarketAxess has about a 10% share of the primary bond markets that it operates in. However, most of these bonds are not yet digitally traded, increasing the company's implied market share.

While Tradeweb Markets (TW 0.71%) is often considered the company's main competition, it leans more heavily on the rates market than on credit. Furthermore, MarketAxess generated more in free cash flow over the trailing 12 months than Tradeweb had in sales for its entire credit segment.

Open Trading's strengthening network effects

Driven by these cost savings, MarketAxess has seen the number of firms using its Open Trading double to more than 1,600 since 2016. By providing improved bond pricing, MarketAxess has generated more in cost savings for these firms than it has charged them in commissions.

With an average daily volume of $2.9 billion, roughly 30% of the company's total volume trades on the Open Trading platform. But with 97% of total orders available on Open Trading, MarketAxess shows that it intends to continue to build out this network.

By expanding its trading protocols and offering new tools that enable automatically executed trades and live market pricing, MarketAxess quickly becomes a one-stop-shop for bond investors. Furthermore, it is in the process of rolling out Open Trading to the U.S. Treasury and municipal bond markets. 

Lastly, the company is seeing massive growth from the least-digitized segment it serves, emerging markets, which saw 68% annualized Open Trading growth between 2016 and 2020.. With a digital penetration rate of only 10%, the market's digitization upside and high growth rates should be of particular interest to investors.

In fact, between 2016 and 2020, emerging markets grew volume by a 26% compound annual growth rate (CAGR), with Open Trading growing by a blistering 68% CAGR in this same span. With international sales currently accounting for 28% of total revenue, management aims for that segment to trend closer to a 50-50 mix over the long term. 

All this has helped MarketAxess run up a profit margin of nearly 40% and a return on equity of 30%. But the stock has fallen 29% this year as of Wednesday's closing price because of challenging credit markets -- providing investors with an opportunity to buy a historically strong stock.

Outperforming the stock market with bonds

Thanks to the continued adoption of its Open Trading platform and the wide-scale digitization of bonds, MarketAxess offers the opportunity to outperform the stock market through bonds. It will be pivotal to see Open Trading continue becoming the core of the company's offerings, building upon its already powerful network effects.