How many times have you heard "You can't beat themarket ," or
that the marginal gain you can expectwill be eaten up by fees
andtaxes ? While it is possible to make market-beating returns, as
regular readers of StreetAuthority will know, I will be the first
to admit it is extremely difficult to do it consistently.
Don't feel too bad. Even million dollarhedge fund managers
rarely beat their indexes and make much of theirmoney on
transaction fees charged to investors. So how can an individual
investor, with even less time available for research, hope to beat
the market?
The answer comes from another industry: gambling. Every gambler
has their own "fool-proof" system, but none have ever been able to
beat the house odds consistently over a period of time. The only
real way to win at the casino is to own the casino.
So how does an investor "own" the market? Hint: It's not by
buying into an endless choice of indexed exchange tradedfunds (
ETFs
). That is the same as buying a basket ofstocks and hoping share
prices increase. But how does an investorprofit from the market
itself?
As it turns out, you can make money off of the trading activity
of other investors and recent news, which could make oneinvestment
an even stronger choice.
Own the House
The
CME Group (Nasdaq: CME)
, the largestfutures exchange in the world, serves the risk
management needs of clients worldwide through futures and options
in four product areas: interest rates,stock indexes, foreign
exchange and commodities.
The company derives itsrevenue from fees associated with trading
and clearing transactions. This means CME and its owners make money
in any market because it gets paid when investors trade, not
whenasset prices go up or down.
The CME Group operates its own clearing house, the mechanism for
settling and guaranteeing transactions, which is a key competitive
advantage and drives higher income as a percentage of revenue. The
company is also the leading exchange for trading euro futures, the
world's most actively tradedfutures contract and thebenchmark for
valuing fixed income securities.
Short-term upside
Rival
IntercontinentalExchange (
ICE
)
recently announced its plannedacquisition of
NYSE Euronext (
NYX
)
, which owns theNew York Stock Exchange (NYSE) . While themerger
will increase competition for the CME Group, especially within the
Europeanderivatives market, I believe the deal is a
short-termbullish factor for shareholders of CME.
It was earlier speculated that the CME might buythe big board
exchange in New York. Withshares of the NYSE relatively expensive
and the difficulty of managing a merger across different products,
the CME Group may ultimately be better off for not buying the
exchange. While competition may increase with fewer players in the
industry, keeping the CME focused on derivatives keeps it focused
in an area where it has a competitive advantage.
The stock yields a regulardividend of 45 cents a share and an
annual variable dividend where it returns extracash to its
shareholders. The most recent variable dividend of $1.30 a share
brings theyield to 7.3% during the past year. Even after paying the
variable dividend, the company will have $1.6 billion of cash on
hand, well over the average amount held during the past four years.
They may have been looking to spend this money in an acquisition,
but with the NYSE now off the table, some of this cash can be
returned to shareholders.
Returning $670 million of this excess cash wouldmean a $2.01 a
share variable dividend next year. Projections for an increase
innet income to $3.58 per share and a 40%payout ratio means the
company will easily meet its regular dividend payout for a an
expected yield of 7% or higher.
Rate futures make up approximately 27% of the company's $2.92
billion in revenue and lower rates means revenue has been weak this
year. The rate environment has decreased theprice multiple for the
CME Group to just 11.2 times trailingearnings , well under the
industry average of 17 times. Trading in rate futures is expected
to increase next year with the CME Group to be theprincipal
beneficiary and an improvement in sentiment to the industry average
would return shares to their upper trading range of $60 per share
and a 20% gain from current prices.
Long-term Success
While I would be happy with a 20% gain on top of a 7% yield, I own
the shares as a long-term position in my portfolio. Revenue has
increased by an annualized 23% during the past decade and should
return to double-digit growth once the interest rate environment
improves.
Even with an 8.7% decrease in revenue due to a drop in trading
activity, the shares have paid a 7.5% yield this year and have
appreciated 3%, bringing double-digit returns to shareholders. The
company's competitive advantage in risk management products means
stable growth even as the industry consolidates going forward. In
addition, new regulations from the Dodd-Frank Act will mandate that
severalderivative products currently trading over-the-counter (OTC)
will need to be made on an exchange, which should help drive
revenue higher.
I own the shares because I like owning the market when the odds
are stacked against the individual investor. Other investors can
speculate if they like, but I will take the stronger bet and own
the house.
Risks to Consider:
The decline in revenue this year is largely from a decrease in
trading on the exchange and the low interest rate environment.
While trading should pick up next year, investors will still most
likely be apprehensive given the weak global economic backdrop.
Lower rates will also remain a factor trading should improve as
rates increase next year.
Action to Take -->
CME Group is a good way to beat the market by owning a share of the
tradingrevenues from investor activity. The shares should pay a
dividend of 7% or higher during the next year and could make a run
back to the upper trading range of $60 per share. This means a 27%
return for shareholders and a way to profit from the market
regardless of where stocks go.