The world is changing fast and to keep up you need local knowledge with global context.
One way of hunting for shares that are likely to outperform the stock market averages is to look for companies with high barriers to entry. These are organisations that have a monopoly in a market because the high costs of setting up and running such a business are beyond the reach of most. Or, perhaps the regulatory system is such that a business has few or no competitors.
One type of industry that has had high barriers to entry is the global stock exchange industry. Paul Whitburn, of RE:CM, explains in this fascinating piece why Hellenic Exchanges was on their radar while other investors looked elsewhere.
Paul highlights that investors should never assume that a business with high barriers to entry will remain that way. Defences around global stock exchanges are eroding.
“But even in the face of declining barriers to entry, it is still possible to invest successfully – as long as one pays a low enough price. We did so in the case of Hellenic Exchanges,” says Paul. – JC
Paul Whitburn, Portfolio Manager
— RECM (@recm) December 12, 2013
The global stock exchange industry is one we’ve commented on before (‘Listed Stock Exchanges – Bubbles & Busts’, REVIEW Volume 18, October 2011). Our clients also earned good returns from investing in the JSE, the stock exchange operator in South Africa.
As with many high quality and monopolistic industries the rating of many regional stock exchanges became overvalued around 2007, trading at extremely high Price-to-Book (P/B) multiples due to the great returns these businesses are able to generate. At the time there were a few small competitors starting to emerge, obviously enticed by the incredible returns on equity (ROEs) generated by the existing monopolistic exchanges. The incumbent exchanges pointed to regulatory hurdles and their superior technology and systems that would keep these competitors at bay.
Our article showed how markets had struggled to value these businesses since they had listed. It also highlighted their ability to generate excellent returns, strong margins and good free cash flow due to their low reinvestment needs. We showed that the Spanish and Greek stock exchanges were trading at the most attractive valuations. These were being largely overlooked for the established and more liquid markets in the US, the UK and Europe, as well as for the greater excitement around the Asian exchanges.
At the time, our favourite investment idea was Greece’s Hellenic Exchanges. The company was trading at the biggest discount to its long-term P/B, while generating an ROE of 17%, paying a dividend of 6% and with net cash reserves equal to 50% of its market capitalisation. With exchanges’ revenue linked to the market capitalisation listed on that exchange, and Greece in the middle of an economic crisis, it was clear that Hellenic Exchange’s revenue would come under pressure.
But the company had managed to cut its cost base and grow other parts of the business such as derivatives, listing fees and data services, all of which generate annuity income. While we felt competition was inevitable, we believed new competitors would focus on other markets before Greece, put off by a high start-up investment, relatively low prospective returns and significant regulatory and tax burdens. There was also the possibility of Greece’s expulsion from the EU, meaning that future cash flows would be received in Drachmas – of uncertain value – rather than Euros.
When we researched the other recent currency debasements in Argentina (2001) and Russia (1998) we found some interesting patterns. While both saw currency depreciation and a significant decline in their stock markets – which had already happened in Greece – stocks in both countries subsequently showed considerable returns for investors, even in hard currency terms.
We concluded by saying that we believed Hellenic Exchanges was a quality asset that was extremely unpopular with earnings at a cyclical low. We consequently built a position in the company in our Global Fund.
What’s happened since then
While Hellenic Exchanges has done well as an investment, we overemphasised the barriers to entry of the old established exchanges and didn’t think competitors such as Chi-X and BATS would make much of a dent in the larger markets. In fact these new competitors seemingly overcame substantial regulatory hurdles by not having large market surveillance departments and by offering services to the large institutional players such as banks for a fraction of the current pricing.
Chi-X, BATS and Arca have gained between 20%-35% market share across Europe, the US and UK with limited overheads and operational costs. New technology and the lack of legacy systems allowed them to execute trades faster than the incumbents and with far lower operating expenses, reducing trading costs. In a financial world where it seems trade speed is more important than common sense and the average holding period of a stock is four months, it’s no surprise that these large clients demand reduced trading costs, and increased trading speed.
We still believe regional stock exchanges possess a barrier to entry through network effects, but this moat has been eroded by the new competitors. The gain of market share by new entrants has not been very profitable, but they have provided price discovery – fast and efficient trading – at low cost to institutional investors who helped them overcome any regulatory hurdles. It’s also important to understand that Chi-X and BATS only compete in the most liquid stocks across exchanges and don’t provide competitive pricing across the entire listed universe. Many of these early competitors in the US and Europe are consolidating through mergers and in some cases the incumbents have acquired these new entrants.
Table 1: Global Exchanges’ Price-to-Earnings (P/E) and P/B
Source: Thomson Reuters Datastream
Today, the valuations of stock exchanges have changed dramatically since their peak in 2007. As with most assets that experience a substantial increase in rating, the bust that inevitably occurs is an overreaction to the current competitive environment. In Table 1 above you’ll note the substantial decline in rating experienced by regional exchanges with industry consolidation having increased over the five year period. Large high quality exchanges such as the LSE and NYSE bottomed with the market in 2008/09, falling to price-to-book ratio’s of 1.5 times and 1 times respectively as investors thought these business models would disappear under the intense competition.
The returns generated by large incumbent exchanges have been above the cost of capital through the cycle indicating that network effects still exist but continue to be eroded. These have subsequently rerated substantially as the incumbent exchanges became more efficient and fought back through lower trading costs and reduced service fees. None have quite rerated to the extent of Hellenic Exchanges.
We visited Greece in July 2011, at a time when the Greek exit and imminent default of the country was seen to be a foregone conclusion. Our experience was one of rolling strikes, riots and stories of many human tragedies as the economy’s GDP had declined 25% from the 2007 peak. We identified Hellenic as one of a few high quality businesses in the region. The exchange is a local monopoly, but small in global terms with 160 listed shares and – at that stage – one tenth of the market capitalisation of the JSE. But then who said good businesses needed to be big?
When we started buying Hellenic, the Athens market index had declined 85% and was trading at a 0.5 times price-to-book ratio. Hellenic generates revenue from trading value, so needless to say revenue had also declined by 80%, as shown in Chart 1. However, management was able to reduce overhead cost to maintain profitability at a very difficult time. From the price at which we started buying, the share price plunged an additional 50% causing the share to trade close to net cash. Our investment process led us to buy more aggressively as the margin of safety increased to levels that justified a larger position in this great business.
At the bottom of the earnings cycle Hellenic still generated returns above the cost of capital and managed to pay an 11% dividend yield – net of the Greek government’s 15% withholding tax. The question we asked was why Chi-X or BATS did not want to compete in the Greek market as returns were so good. Speaking to the head of European market sales at Chi-X the answer was simple – ‘Who the hell would ever want to invest in Greece?’ It seems even hardnosed competitors didn’t want to break down the Greek exchanges monopoly.
Chart 1: Athens Stock Exchange (ASE) Market Capitalisation, Hellenic Exchanges (HXX) Revenue and Athens Index P/B
Source: Thomson Reuters Datastream, RECM
Our clients still own shares in Hellenic Exchanges, but less than they did as the share price increased from a low of €2.00 to the current €6.20, after paying cumulative dividends of €0.45 – a total return of 122% over two years. The economic environment in Greece is far from normal, with GDP declining even further but the Athens market itself has rerated to 1.1 times price-to-book from its 0.5 times low.
What we learned
Global stock exchanges make for an interesting case study as they’re one of the few cases of a strong barrier to entry – in this case, network effects – being eroded by new competitors. This serves as an important reminder that even high quality businesses that generate great returns can have these ‘moats’ breached and it’s important to continue to monitor the longevity of such barriers.
But even in the face of declining barriers to entry, it is still possible to invest successfully – as long as one pays a low enough price. We did so in the case of Hellenic Exchanges.
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