Epiphany on the Triborough Bridge

By GABRIEL LOWENBERG. Special to The Globe and Mail, Published Tuesday, June 18, 2013.

Investment inspiration can come from unexpected sources – like the Triborough Bridge into Manhattan, which I often crossed when I was a novice financial analyst more than 20 years ago.

Every driver who wanted to use the bridge (now officially called the Robert F. Kennedy Bridge), had to pay the toll and hand over $3.50 to the attendant in the booth. No pay, no entrance.

bridge-article-xlgEven as a rookie in the investment game, I was struck by the inspired simplicity of the bridge as a business proposition.

By charging a modest sum to people who wanted easy access to and from Manhattan, it guaranteed itself a steady, predictable stream of cash that was essentially immune to competitive threats and technological changes.

The memory has stuck with me and has helped me pick some winning investments. Let me explain.

Public exchanges, on which stocks, bonds, interest-rate futures and commodities trade, are the Triborough Bridges of the investment world. Win or lose on any trade, everyone pays.

Operating an exchange is such a good business that a consortium of Canadian banks, pension funds and investment firms known as Maple Group purchased a large stake in TMX Group, which operates the Toronto Stock Exchange. For the clients of my own firm, I have invested in CME Group Inc., the operator of the Chicago Mercantile Exchange.

My investment thesis for CME is simple.

I cannot tell you if oil is going to outperform gas. I don’t know if platinum will outpace pork bellies. I have no idea – okay, almost no idea – about whether interest-rate futures are a better bet at the long end or the short end of the curve. I hold no opinion on the direction of the yen, the euro or the yuan.

But here’s what I do know. The CME trades them all – interest rates, credit, foreign currencies, energy, metals and nearly everything in the agricultural space. And it gets paid whether the investor behind the transaction makes money or not.

Based on volume, the CME is now the No. 1 exchange for trading derivative securities, not only in the U.S., but globally. CME Group also owns a clutch of other exchanges – the CBOT, NYMEX, COMEX – as well as two clearinghouses for trades, one in the U.S., one in Europe.

How profitable is the business? Very. In 2012, it reported an operating margin of just under 60 per cent. Certain products, such as S&P E-mini futures, are only traded on its exchange. (For oil, agricultural and other commodities, currencies and equities futures, the CME competes against other exchanges, including the Intercontinental Exchange.)

For the quarter ended March, 2013, CME Group earned $718-million (U.S.) in gross revenue and $235-million in profit. That’s a 32-per-cent after-tax net income margin. In my book, any enterprise yielding a net income margin after tax of more than 30 per cent must have a proprietary edge.

The CME functions as a gatekeeper or toll taker for the world’s financial markets. If a brokerage firm, oil producer or treasury department seeks liquidity, or to hedge production, there are only a few games in town. One of them is the CME Group.

The icing on this appetizing cake is the backlog of future business contracts – the so-called open interest – for which buyers or sellers have not yet closed out positions. CME’s open interest has been rising for 18 months. As of May 31, 2013, open interest stood at $2.1-trillion, versus $650-million a year ago. Inevitably, that means future transaction revenue will also have to climb, as those positions are closed out.

There’s another reason I own CME. After the debacle of 2008, the U.S. government moved to centralize the clearance of all derivative securities in the hope of gaining transparency, regulation and oversight. Taking effect in 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act made it mandatory for all credit default and interest-rates swaps to be cleared through a derivative-clearing organization.

CME is one such duly chartered Derivatives Clearing Organization (DCO), registered with the U.S. Commodities Future Trading Commission (CFTC). And, as of September, nearly all organizations will be required to clear derivatives with a designated DCO.

What’s the bottom line? You begin with a thriving commodity-trading business, with a fixed-cost infrastructure. Then you add a mandated legislative change that will inject new revenue, with minimal start-up costs. And then you stir in the first major rise in open interest in a very long time.

The volume of transactions is bound to increase, not just because of rising open interest, but because credit default and interest-rate swaps will be centrally cleared. These increased revenues will incur few incremental costs, yielding significant operating leverage for all shareholders. All of this, to me, is a compelling recipe for share-price appreciation.

As a CME investor, I don’t need to hold an educated opinion on orange juice futures or credit-default swaps. All I care about is that hedge funds, banks, brokerage firms and commodity producers – anyone in pursuit of profits – trade and deposit their toll at the door of the CME Group just like a cab driver getting ready to cross the Triborough Bridge.

©2013 The Globe and Mail Inc. All Rights Reserved.

Read the complete article at The Globe and Mail website: www.theglobeandmail.com

About Gabriel Lowenberg

Gabriel Lowenberg is CEO and president of Lowenberg Investment Counsel Inc., an independent wealth investment management firm. The views and opinion expressed in this article are those of Mr. Lowenberg and do not constitute investment advice.

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