05 April 2019

CME Group is poised for success in a ‘winner takes all’ market (NASDAQ: CME)

CME Group (NASDAQ: CME) is a US-based options and futures exchange operator that has sustainable competitive advantages, high incremental margins, is highly free cash flow generative and has an attractive growth outlook.

Derivative exchanges are characterized by network effects, which mean they tend to be ‘winner takes all’ markets in each underlying security. CME is by far the world’s largest derivatives exchange and in many instances doesn’t have any true direct competitors. In instances where CME does have competitors, it generally wins due to its scale.

These competitive advantages and earnings stability have allowed CME to invest more aggressively than its peers in its underlying business. The company has expanded internationally and most recently it acquired NEX Group in the UK, which we consider an important and strategic acquisition, as it will support ongoing growth of CME’s Foreign Exchange derivative business.

All of this comes at a price and CME is currently trading on a PE of 25 times 2019 earnings.

The company’s sustainable competitive advantages can be traced to its substantial network effects and other scale benefits. As the world’s largest derivative exchange it is the most capital efficient and cheapest venue to trade derivatives. We believe it has an unassailable competitive position in exchange-traded US interest rates derivatives, many agricultural derivatives, metals derivatives, WTI oil derivatives, and many equity derivatives.

We also believe that CME’s growth outlook has never been better. Over the past few years the company has aggressively invested in international expansion, the benefits of which are starting to be realised. In addition, CME is well positioned to benefit from a number of structural tailwinds. Growing demand for interest rate derivatives will be underpinned by the dual influence of increased US Treasuries issuance and the Fed winding down its balance sheet. In addition, thriving US oil production is driving demand for WTI derivatives. We also predict that the change in hedging accounting rules will enable corporates to use exchange-traded derivatives for hedging purposes.

We believe CME Group to be an attractive investment and have chosen to invest in this stock for these main reasons:

  1. Scale: CME is by far the world’s largest derivatives exchange and in many instances doesn’t have any true direct competitors.
  2. Growth: the company has recently expanded internationally.
  3. Efficiency: as the world’s largest derivative exchange CME Group is the most capital efficient and cheapest venue to trade derivatives.
  4. Demand: Use of derivatives is increasing concurrently with advantageous changes in industry regulations and international oil production.

This stock is currently held by the Pengana International Fund.

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This report has been prepared by Pengana Investment Management Ltd (ABN 69 063 081 612), Australian Financial Services Licence No. 219462) (“Pengana”).  This report does not contain any investment recommendation or investment advice and has been prepared without taking account of any person’s objectives, financial situation or needs.  Therefore, before acting on the information in this report a person should consider the appropriateness of the information, having regard to their objectives, financial situation and needs.

Pengana Capital Ltd (ABN 30 103 800 568, Australian financial services license number 226566) is the issuer of units in the Pengana International Equities Fund (ARSN 610 351 641) (“the Fund”).  A Product Disclosure Statement for the Fund (“PDS”) is available and can be obtained by contacting Pengana on (02) 8524 9900.  A person who is considering investing in the Fund should obtain the relevant PDS and should consider the PDS carefully and consult with their financial adviser to determine whether the Fund is appropriate for them before deciding whether to invest in, or to continue to hold, units in the Fund.

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