What this Little-Known Metric is Signaling Investors to Buy

Brad Briggs's picture

Monday, September 21, 2009 - 11:24am

by Brad Briggs

It's amazing what a simple metric can tell you about a company.

Especially an unflappably accurate metric. This yardstick cuts to the chase and tells you exactly how well a company performs.

It's in every company's SEC filings.

It's on nearly every financial website.

Most investors skip right over it.

I'm talking about operating margins. It tells you how much a company makes on each dollar it brings in -- before accounting for taxes and interest. The higher the number is, the better.

The only caveat? Consistency. When you look at operating margins, the hallmark of a good stock pick is a consistent or steadily climbing operating margin.

Consider Moody's Investor Service (NYSE: MCO). The company is one of only three players in the credit-ratings business. For years, Moody's had what Warren Buffett refers to as a wide moat -- a sustainable competitive advantage that protects the company's ability to generate profits. But that moat has sprung a leak because of criticism that it couldn't objectively rate securities leading up to the subprime meltdown. This has filtered down to the bottom line at Moody's. Operating margins have declined -25% during the past two years.

One company that has kept its margins steady is CME Group (Nasdaq: CME), the most profitable company in the S&P, with an operating margin of 62%. It also has a near-monopoly in a market that is growing at a scorching pace.

CME Group runs three of the largest futures exchanges in the world: The Chicago Mercantile Exchange -- where the "CME" in its name comes from -- and the New York Mercantile Exchange (the NYMEX) and the Chicago Board of Trade. These marketplaces are where commodities, stock-index futures and major currencies trade.

CME charges a fee for every trade on its exchanges. The more volume these exchanges have, the more fees CME collects. Traders flock to highly liquid exchanges because they offer favorable prices, which gives the company a distinctive advantage. This barrier to entry -- an effective corner on U.S. and currency trading -- is why CME has only one major competitor in the U.S.

Here's another nifty facet of CME's business model: It makes money twice on most of the securities it offers. Many of CME's contracts can't be transferred. That means you can't buy futures on one exchange and sell them on another. There are a million other investors to trade with, but there's only one place to execute the buy and sell orders.

By now you may have heard that the Commodities Futures Trading Commission wants to regulate some commodity and derivative trading. Regulators are worried that speculation has caused higher energy prices. A lack of transparency in the way derivatives are handled has also caused some grief. (Just ask AIG.)

The CFTC wants to limit some trading. Worries that this may affect liquidity on exchanges have weighed on CME's shares. But trading demand for oil, agricultural commodities and metals has soared in recent years, and it's unlikely to let up any time soon.

CME is also aggressively seeking expansion in foreign markets. The company recently announced that it entered talks with Bolsa Mexicana de Valores, the second-largest exchange in Latin America, to acquire a minority stake in the Mexder derivatives exchange. Don't be surprised if CME makes additional deals like this in the future.

Investors should take notice any time Uncle Sam gets involved in Wall Street. But in this case, those fears have CME shares trading for just 20 times earnings. That's about the S&P average right now, but it's cheap for these shares, which have traded for 35 times earnings during the past five years. (The shares need to climb +75% to reach that level.)

A buying opportunity like CME is rarely seen for a company that makes 62 cents for every dollar it brings in. August trading volumes were up +5% from July to 10.2 million contracts a day and will continue to rise once a full recovery takes place.

Brad Briggs does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.