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2 stock exchanges stand out as stocks
Own a piece of Wall Street? The NYSE starts trading as a stock next month, but you may want to skip that one. Here are two other exchanges worth buying.
By Michael Brush
What's the next best thing to buying a casino? Buying a stock exchange.
Just like gamblers, investors only make money when they place the right bets. And just like casinos -- which make money even though some gamblers do, in fact, win -- stock exchanges always win. In their case, it's by collecting fees on stock trades, both winners and losers.
In the past few years, stock exchanges that once were owned by clubby insiders have sold shares to the public. Next month comes the biggie, as the New York Stock Exchange goes public through its merger with Archipelago Holdings (AX, news, msgs), which will probably be completed some time before the end of March.
And while there are many exchanges to choose from, I've found only two that seem worth buying, and one of those is a bit pricey. Here’s my take on the public exchanges.
Trading places
Nasdaq Stock Market (NDAQ, news, msgs) came public in 2002, but it wasn’t until last year that investors showed any real interest. When they did, the stock shot higher, from $8 to a high of $45 before falling back to $38.
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Why the jump? Nasdaq purchased another exchange called INET, which helped Nasdaq bring back trading volume it had lost in recent years. INET’s state-of-the-art trading platform also put Nasdaq back in the running as a market that can grab share from the New York Stock Exchange.
Here's why Nasdaq will indeed take share from the NYSE. First, a new Securities and Exchange Commission rule, scheduled to take effect later this year, breaks down some barriers that kept a lot of trading of NYSE stocks on the NYSE. Second, while the NYSE still has a certain cache, companies listed on the NYSE may be tempted to jump ship by Nasdaq’s lower listing fees. In December, for example, Charles Schwab (SCHW, news, msgs) dropped its dual listing and decided to list only on the Nasdaq.
At $38, with a sky-high price-earnings multiple of 86, some analysts think Nasdaq shares are fully valued. So the way to play it would be to put it on your watch list and buy it on the dips.
One source of selling pressure may lie just around the corner. For years, the Nasdaq has been a subsidiary of the National Association of Securities Dealers, but it’s in the process of breaking that connection. When NASD sells its 18.7% stake, Nasdaq's share price is likely to fall.
Why not Wall Street?
Here are three reasons you should the skip the NYSE's IPO:
First, NYSE trading of its own listed securities has been in a steady decline, dropping for seven months in a row, says Richard Repetto, an analyst at Sandler O'Neill & Partners.
Next, in other markets -- like those for options and futures -- there’s a clear trend toward electronic trading and away from the NYSE's mainstay floor-based, open-outcry system. That's likely to happen with stocks, too.
Finally, NYSE members are getting a big dollop of shares in the merger that will bring it public. Many of those insiders are likely to cash in as soon as they can, putting pressure on shares.
A bright future for the Merc
Futures contracts give investors the right to buy or sell assets -- currencies, bonds, oil, pork bellies, etc. -- at a set price in the future. In the past, futures were used by businesses that didn't want to tie their fortunes too closely to the price of a commodity. But demand for futures contracts has jumped in recent years as risk-taking hedge funds have become more numerous and as geopolitical risks -- such as Iran's dabbling with nuclear technology -- have made markets more volatile.
Investors have three main ways to play the futures market: Chicago Mercantile Exchange Holdings (CME, news, msgs), CBOT Holdings (BOT, news, msgs) and Intercontinental Exchange (ICE, news, msgs).
All three are in an enviable position, because they are the established markets for certain futures. That makes it harder for anyone to steal their lunch. “In this business, liquidity attracts liquidity,” says James Angel, professor of finance at Georgetown University's McDonough School of Business. “If you have the trading platform that already has most of the major players attached to it, you have a real battle on your hands to come up with a new one.”
Of these three, the Chicago Merc has the best prospects for growth as it continues to steal market share in currency futures from banks. It also has the most diversified business -- offering futures on stock indices, debt instruments, currencies and commodities.
Investors have noticed. Shares of the Chicago Merc have risen above $390 from around $60 at the start of last year. Delaware Investments analyst Christopher Bonavico thinks the long-term opportunities are so great that it’s worth riding out any near-term turbulence that may play out. Big banks now handle much of the demand for currency-futures contracts, for example, but their products are expensive. That should make it easier for the Chicago Merc to grow its business.
In addition to currencies, the Chicago Merc has been rolling out new products like derivatives that offer financial protection against unusual weather events, declines in the value of real estate and unexpected changes in European inflation rates. “People want to hedge all their risks,” says Erick Maronak, chief investment officer at Victory NewBridge. “Owning CME is an investment in a risky and globalizing world.”
The company also has a solid balance sheet and holds more than $800 million in cash, which should make it easier to grow by acquiring other exchanges.
Another option
Like futures, options grant the right to buy or sell an asset at a set price in the future. But with options, you don't own the asset, you own an option to buy or sell the asset.
Options were traditionally the realm of individual investors because the markets were so thin. International Securities Exchange (ISE, news, msgs) helped change all that when it launched an electronic exchange for equity options in 2000. Greater use of options by institutional investors helped push growth at the company in the past two years. “We believe this is still in its infancy,” says Chief Executive Officer David Krell.
The company plans to expand by offering options on more indices, selling market data and creating electronic links to exchanges in Europe and Asia. International Securities Exchange has fixed overhead costs, so any new business can increase earnings dramatically. But at $33.50, the potential is priced in, says Joshua Carter, an analyst at Goldman Sachs, who's also worried about competition stealing the ISE's business.
Pump up the volume (or else)
With any of the exchanges, volume drives profits. An increase of 100,000 contracts a day at the Chicago Merc can add five cents in earnings per share in a quarter. (The exchange trades roughly five million contracts a day.) This is good for investors as volumes grow. The exchanges earn more revenue against a fairly fixed cost base.
But if people turn sour on the markets because of another bear market like the one that followed the technology bubble of 2000, trading volumes will plummet. So will the stock prices of the exchanges.
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