SWEET HOME CHICAGO BOE

SWEET HOME CHICAGO BOE2018-03-06T18:51:55+00:00

2 March, 2018

There are very few stocks that most fund managers would buy and hold for 10 years – with the notable exception of everyone’s darling, Berkshire Hathaway, which famously never ever pays a dividend (with no complaints from the shareholders!).

10 years is a long time to hold a stock, particularly in the era of modern finance. As Arminius has discussed in our previous opinion article “Geldzug: STOCK MARKETS ALWAYS LIVE IN THE PAST” (published 15th June 2017), the real question is not so much which stock will endure the coming decade with robust performance, but what stock can give you exposure to the best performing sector(s) across the next decade. Stock markets’ sectoral composition changes materially over time, to the extent that the leaders and market darlings of today may not quite be the same household names in 10 years time.

Some we remember because we still can’t believe how far they fell from grace (Pets.com, ENRON, Lehman Brothers), others we have almost forgotten due to their entirely forgettable performance (Sears, Avon, Radio Shack). The largest sectors of a stock market are those which have done well in the past. They are made up of companies which have consistently made large profits and raised large amounts of capital. Investors have come to expect that these companies will keep making profits and paying dividends. But most companies don’t survive for long.

So when we see tech companies like Apple, Amazon, Facebook, and Google rising to the top of the US share market, we know that they are there because of how fast they have grown in the last three decades – not because they will be important for the next three decades. When ENRON fell out of the S&P500 in 2001, the once-behemoth company whose products/services included natural gas, electricity, biofuels, pulp, paper, packaging, lumber and… “risk management derivatives”, was replaced in the S&P500 by NVIDIA, a tech company that helps kids’ video cards play HALO faster and make Spartan 117 look better at higher resolutions. The king is dead, long live the king.

To demonstrate how much stock market indices change over time, we observe output from the Credit Suisse Global Investment Returns Yearbook 2017, which is a highly authoritative document on long term returns. It is based on research published in 2002 by three academics, Elroy Dimson, Paul Marsh and Mike Staunton (“DMS”), and progressively updated since then. DMS assembled investment return data from 1900 onwards for as many countries as they could, checking and cleaning all the data in order to ensure that it was accurate and consistent. Credit Suisse now fund and publish the annual update of this data, which now covers 23 countries.

What interests us is not so much that entire industries have almost ceased to exist being represented in the US stock market (“Rail” companies comprised over 60% of the US stock market in 1900; Tobacco companies ~10%) but rather sectors whose constituent representation has not changed materially in almost 120 years.

One such sector is “Banks”, whose % of representation in the US stock market has hardly changed in over a century. In accordance with Arminius’ previously noted observations that the most robust or enduring sectors are made up of companies which have consistently made large profits and raised large amounts of capital, we also place a modern-day caveat on this. We look at which companies service the banking sector (as opposed to merely operating as a bank) and which are going to be adaptable enough in both business model and technology to endure market evolutions. We observe that the 1900 “Telegraph” sector has similarly not changed materially in % of US equity market to 2017’s “Telecoms” sector. However, this sector does not interest us as much as Banks because Banks are less susceptible to the infrequent but brutal quantum leaps in the backbone technology – we at Arminius have worked for investment banks who have at one point in time operated 11 legacy software systems. The US stock market has averaged a return of over 8.0% p.a. since inception and the Banks sector has an almost unchanged proportion contribution to stocks in the market since inception. We like that.

An example of a stock that may give exposure to this is CBOE Global Markets Inc.

Financial markets, for better and at times worse, perpetually offer innovative financial products with varying degrees of (i) complexity and (ii) profitability (sometimes for the clients, always for the banks). The technology shift that we have witnessed in the past decade has been manifold. Open outcry trading pits in Chicago have been replaced with electronic exchanges, big data has become big business and the world’s food sources are now traded by both food companies and hedge funds alike on a daily basis.

The CBOE has proven itself to be an innovative product provider and along with a few notable competitors (such as ICE, which we like also) has the ability to continue to leverage off the financial services backbone of lifeblood requirement for products and services. Recent negative impacts upon CBOE such as the fallout from the VIX explosion of February 2018 have been overplayed by the media. Our own modelling of the VIX suggested that the markets were pricing volatility with the VIX at 50 as if the S&P500 was heading to a crisis far worse than the GFC or Great Recession. Underlying conditions as observed by US and European risk spreads hardly suggested we were about to fall off a cliff. As with most events in financial markets, short term price movements revert to being mere noise, given time.

Our view of CBOE across the next 10 years is supported by empirical data suggesting that stocks, (merely one asset class that CBOE deals in) are able to find support in periods of increasing inflationary expectations. Banks themselves are more profitable as interest rates rise and capital tends to flow to the trading desks as banks become more profitable. As mentioned on Switzer TV on SKY Business Channel in late 2017, Arminius expected that US bond yields would continue to rise through 2018. Clearly our position was borne out by mid February with yields of 10 year US govs reaching 2.95%. We therefore see a supportive environment for CBOE across the next few years and of course following the end of the 36 year bull market in bonds, once the Fed continues its vertical ascent on interest rate rises, inflation will naturally have to rise. In this environment (the first some traders in a generation will have seen) clearly interest rates will need to be hedged, and commodities as an asset class also tend to accompany rises in the inflation level. The US dollar is the world’s largest currency. The US has the world’s largest bond markets. Commodities are priced in US dollars. All products that CBOE provides.

CBOE has 100% revenue exposure to the US. Whilst its competitor ICE only has 60%, we don’t necessarily buy into their “diversification” argument here. Whilst the current administration may make the odd errant comment about a weaker US dollar being good for business, we see no change long term (again, forget the short term noise) to the oft-repeated mantra of the strong US dollar policy. CBOE also only has developed market exposure, so there will be no exposure to fragile fluctuating emerging markets when the shakeout occurs (from the increasing of US interest rates).

We, being a hedge fund, also share the level of interest in CBOE of many other institutions. CBOE is owned 84.5% by “instos”. The institutional shareholding list looks like a who’s who of Wall St, with many names recognisable to the lay man, such as Vanguard, Fidelity, Blackrock, State Street and Goldman Sachs. Other names in the top 10 insto holders which are less well known on Main Street but are very well known on Wall Street include Citadel Advisors and Renaissance Technologies. These two companies are cutting edge firms – a cross between hedge funds, data aggregators and market makers, their businesses comprise many different units but suffice to say that they almost “are” in essence, Wall Street. Firms such as Citadel and Renaissance are relatively new (using the last 30 years as a base) to the world of finance, but will therefore power it (by using products and services provided by firms such as CBOE) for decades to come. Hedge funds, quants, market-making firms utilising products and services provided by CBOE are only going to grow in the future. Do not for a minute mistake these firms for “robo-advice” or “fintech”. These firms are tech heavy, but they operate on the exchanges and in the exchanges and are extremely profitable. When there is a business model that is extremely profitable, other firms will flock to it to replicate those profits until the ability to arbitrage the product away is negated. However, without going into exquisite explanatory detail here, it will be some time before we see the end of electronic exchanges!

CBOE is rated BBB+ by S&P and has debt on issue in the market place for which the coupon rates range between 1.95% and 3.65% which places it amongst all time historical lows for US corporate bond rates.

The company currently pays a 1.0% dividend yield which whilst being below the average yield of an S&P500 company, is acceptable. We posit that this stock would be owned by its shareholders for the expectation of capital appreciation, not dividend harvesting.

Free cash flow has had a notable increase in the last year, but has been robust, with last reported of $336M vs $74M in 2009.

CBOE has outperformed the S&P500 since 2010 (no mean feat, given that it is not a pure tech play such as the FANGs) and we expect it to keep pace with future developments and requirements that financial market participants will place upon it.

Data source: FACTSET

Arminius holds a long position in CBOE.