If you are looking for the best ideas for your portfolio you may want to consider some of Horizon Kinetics top stock picks. In its Q2 2019 investor letter – you can download a copy here – the firm discussed its investment thesis on CME Group Inc. (NASDAQ:CME) stock. CME Group Inc. (NASDAQ:CME) is a global markets company.
In July 2019, Horizon Kinetics had released its Q2 2019 investor letter. CME Group Inc. (NASDAQ:CME) stock has posted a return of -20.3% in the trailing one year period, underperforming the S&P 500 Index which returned 17.5% in the same period. On a year-to-date basis, CME Group Inc. (NASDAQ:CME) stock has fallen by 15.8%.
Let’s take a look at comments made by Horizon Kinetics about CME Group Inc. (NASDAQ:CME) stock in the Q2 2019 investor letter.
“The CME, which has a $62 billion market capitalization, is the largest exchange in the U.S. As primarily a derivatives exchange, the company has a well-diversified offering of futures contracts, including interest rate, agriculture, equity indexes, foreign exchange, metal, and energy (the energy and agriculture segments were expanded greatly through the acquisitions of the Chicago Board of Trade and the New York Mercantile Exchange). The CME also owns a significant equity interest in OneChicago (a single stock futures exchange), 25% of the Bursa Malaysia Derivatives Berhad, 50% of the Dubai Mercantile Exchange, and 27% of S&P/Dow Jones Indices. In late 2018, it also purchased NEX, which operates the BrokerTec trading platform for U.S. Treasuries and other foreign exchange contracts.
Although not widely known by most investors, the CME is a great beneficiary of higher interest rates – to be more specific, volatility in interest rates. In 2018, interest rate futures contracts amounted to 52% of the company’s total daily trading volume, so these contracts have the most impact on its earnings. Institutions frequently hedge interest rate exposure via the futures market, such that an expectation that an increase in rates likely causes more futures contract trading activity (and vice versa in a declining rate environment). This has been evident over the last five years. Amid the Federal Reserve’s near zero interest rate policy in 2014, daily interest rate volume at the CME was 7 million contracts. As this policy reversed a few years later, contract volume reached 9.951 million, a 42% increase over five years. Given that interest rates are still at very low levels, the CME represents a call option on any rate expansion that may occur in the future.
There is also optionality in the company’s bitcoin futures contract. Although trading in this contract recently reached a record in April (slightly over 20,000 daily contracts), it is still not meaningful to the company’s overall volume of over 4 billion contracts annually. However, the adoption and use of bitcoin and other cryptocurrencies is still inconsequential within the global payment and currency systems. If this ever were to change, and bitcoin were to become even a moderately successful form of payment/currency, in our opinion, merchants and other users would use bitcoin futures to hedge exposure, as is similarly done with currency futures and swaps. Over time, this could be a considerable product for the CME. Importantly, the CME contract would likely be the most heavily traded (to the extent the CBOE and other exchanges introduce competing products), having now been established as the most liquid bitcoin future.
In addition to these two earnings considerations, as well as ordinary growth in the existing futures franchise, any one of the company’s investments in exchanges (or index businesses) could become more meaningful and productive assets on the balance sheet. The CME also licenses the use of its GLOBEX trading platform to certain other exchanges, providing yet another income stream.
What CME shares in common with other exchanges is its high-fixed-cost / negligible-variable-cost operating structure. In practical terms, not only can any one of its products trade vastly higher volumes in the right environment, but these increased sales could translate very nearly 100% to an increase in pretax operating income. As well, some of its products with the greatest such potential are countercyclical, such as might occur during periods of interest rate shock, rising commodity prices or credit market deterioration.
Given the dominance of its position in the derivatives trading market, and near unrivaled profitability (61% operating margin), the CME is not a cheap company. It currently trades at 26x the 2019 consensus earnings estimate. While there is intriguing earnings optionality that, presumably, is reflected in this multiple, the potential risk associated with this type of valuation is mitigated through the smaller sizing of the position in our portfolios.”
In Q2 2020, the number of bullish hedge fund positions on CME Group Inc. (NASDAQ:CME) stock decreased by about 3% from the previous quarter (see the chart here), so a number of other hedge fund managers don’t seem to agree with CME’s growth potential. Our calculations showed that CME Group Inc. (NASDAQ:CME) isn’t ranked among the 30 most popular stocks among hedge funds.
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Video: Top 5 Stocks Among Hedge Funds
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Disclosure: None. This article is originally published at Insider Monkey.