The Best Way to Beat the Market? Own it.
How many times have you heard “You can’t beat the market,” or that the marginal gain you can expect will be eaten up by fees and taxes? 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 dollar hedge fund managers rarely beat their indexes and make much of their money on transaction fees charged to investors. So how can an individual investor, with even less time available for research, hope to beat the market?#-ad_banner-#
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 traded funds (ETFs). That is the same as buying a basket of stocks and hoping share prices increase. But how does an investor profit 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 one investment an even stronger choice.
Own the House
The CME Group (Nasdaq: CME), the largest futures 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 its revenue 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 when asset 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 traded futures contract and the benchmark for valuing fixed income securities.
Rival IntercontinentalExchange (NYSE: ICE) recently announced its planned acquisition of NYSE Euronext (NYSE: NYX), which owns the New York Stock Exchange (NYSE). While the merger will increase competition for the CME Group, especially within the European derivatives market, I believe the deal is a short-term bullish factor for shareholders of CME.
It was earlier speculated that the CME might buy the big board exchange in New York. With shares 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 regular dividend of 45 cents a share and an annual variable dividend where it returns extra cash to its shareholders. The most recent variable dividend of $1.30 a share brings the yield 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 would mean a $2.01 a share variable dividend next year. Projections for an increase in net 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 the price multiple for the CME Group to just 11.2 times trailing earnings, well under the industry average of 17 times. Trading in rate futures is expected to increase next year with the CME Group to be the principal 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.
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 several derivative 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 trading revenues 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.