The Company That Profits Whether Investors Win or Lose
The retail trading "frenzy" continues to grab headlines...
But you may not know that this flood of new retail investors all started early on in the pandemic...
With people stuck at home and sporting events canceled, gamblers turned to "playing" the stock market. This led to increased volatility and trading volumes. And we're still seeing this trend today...
Over the past few weeks, retail trading has been all over financial news. We've seen stories about the price action of Reddit "meme stocks," like GameStop (GME) and AMC Entertainment (AMC). And we've also seen the introduction of exchange-traded funds ("ETFs") picking stocks based off of social media sentiment and the fear of missing out, otherwise known as "FOMO."
These developments have sparked fears of a "bubble" in the market, or at least in some stocks. But these investors' time in the spotlight isn't over just yet...
In a recent report, the UBS equity derivatives team said that the bubble isn't about to bust right now. In fact, the team said that there's still room to run until the "retail bubble" matches the levels of the dot-com bubble in 2000 and the financial crisis in 2008.
Today's company is a way to play the increased volumes and volatility...
CBOE Global Markets (BATS: CBOE) operates as an options exchange in the U.S. The CBOE used to solely derive its revenue streams from options and futures, but with its 2017 acquisition of BATS Global Markets, it has diversified into U.S. equities, European equities, and foreign exchanges.
The CBOE now accounts for 15% of the U.S. equity market volume, though more than 50% of revenues are still related to options.
Retail investors accounted for 20% of the volume of stock trading in 2020, up from 15% in 2019. To CBOE, this surge in retail trading activity is a boon. It doesn't matter whether these traders are making a profit... the CBOE scrapes a little off the top on each and every trade that goes through it.
By matching a buyer to a seller on one of its exchanges, the CBOE receives a transaction fee from the broker. These types of fees make up the CBOE's "transactional revenue." Increased volatility (and hence, volume) means more transactional revenue for CBOE.
And it has a "monopoly" on fear in the markets...
In 1992, the CBOE commissioned Robert Whaley to create a volatility index...
Whaley, who was on sabbatical from Duke University, holed up in a small town near Dijon, France for four months. He analyzed the entire series of index option prices supplied by the CBOE and came up with a formula for the CBOE Volatility Index ("VIX").
The VIX was unveiled in January 1993. It has become the market's so-called "fear gauge." But the VIX doesn't track fear, per se. It gives you the implied volatility of the S&P 500 Index over the next 30 days... basically, the expected range of index values.
See, the CBOE has transactional and non-transactional revenue. And as we said before... transactional revenue is based on trading volume... the higher the better. And volatile markets and high trading volume go hand in hand.
And while volatility and high trading volume provide a huge boost for CBOE's operations, the underlying business is exceptionally strong.
CBOE is capital efficient, meaning it doesn't require big capital expenditures to maintain and expand the business. Operating an exchange is a fantastic business with mile-wide margins. One of the best ways to see this is through CBOE's free cash flow ("FCF").
Remember, FCF is one of our favorite metrics for companies. It's the cash left over after all expenses and capex.
CBOE's FCF margin (FCF as a percentage of net revenues) has averaged 43% over the past three years. And over the last four quarters, its FCF margin was still an astounding 41%. By comparison, the median FCF margin in the S&P 500 is around 13%.
Having plenty of FCF lets CBOE distribute capital to shareholders via dividends and share repurchases.
The company paid a $0.10-per-share quarterly dividend in 2010 and has raised it every year since. Last August, CBOE raised its quarterly dividend by 17% to $0.42.
In 2020, the company returned $520 million to shareholders through dividends and buybacks – a company record. And these shareholder rewards should continue going forward... CBOE also announced that its board has approved another $200 million in share buybacks.
As long as trading volumes and volatility remain elevated, CBOE should continue to benefit. That should serve as a tailwind for the shares.
Sometimes, investing is simple.