I noted in the Friday File for the Irregulars a few days ago that I’ve been getting more and more questions about bitcoin. And I’m sure that’s no surprise to you… heck, I was even at a birthday party for a friend’s child over the weekend and the few new folks I met, when they learned what I do with my time, also immediately asked about bitcoin. Talk of cryptocurrencies is surely in the air.
So despite the fact that I’ve sold essentially all of my cryptocurrencies, I do still pay attention to them… and I’ll keep writing about these teaser pitches that promise things like “the next bitcoin” or “the backdoor into bitcoin” or “the picks and shovels for bitcoin miners.”
There are lots and lots of bitcoin teaser pitches out there — but I tend to get more questions about Motley Fool teaser pitches than most others, so let’s start there… David Gardner, who has shown a tremendous ability to buy “expensive” stocks (“Rule Breakers,” he calls them) and let his winners ride, has apparently just picked a stock that’s “a potential backdoor to bitcoin profits.”
So what is it? The ad is for Motley Fool Stock Advisor, which David Gardner co-edits with his brother, fellow Motley Fool founder Tom Gardner, and if you don’t feel like subscribing to learn that “secret” we’ll see what the Thinkolator can tell us.
Let’s dig in… here’s the first part of the ad…
“Legendary investor David Gardner unveiled his latest stock pick… and I haven’t been this excited about a brand-new recommendation in a long time!
“Because his latest recommendation is a ‘backdoor’ opportunity into a big trend that’s become the financial story of 2017.
“I’m talking about Bitcoin — which has surged 659% just this year alone creating a new wave of ‘Bitcoin millionaires’ in the process.”
OK… so what else do we learn about this pick?
The ad says that bitcoin is so volatile that it’s “hard to buy and own…” but that this recommendation can capture that upside without the volatility. More hints:
“David Gardner’s newest recommendation is a savvy backdoor way to position your portfolio to capture the upside of the Bitcoin boom…
“This new recommendation — just announced — is creating a way to bring Bitcoin into the mainstream financial world.
“So even if Bitcoin soars another 1,000%… drops 50%… or sits flat for the next year, this company is positioned to profit so long as people are trading the digital currency.”
We all know there’s no such thing as a free lunch, I suppose — so you can think through that and note that yes, perhaps this company’s positioned to profit “as long as people are trading” … but profit how much? Certainly it’s not likely to provide crazy gains like bitcoin has if it’s an indirect and “profit as long as people are trading” investment.
But let’s figure out what the stock is before we get into the criticism… other hints?
“When this company’s new Bitcoin exchange opens in a few short weeks, we believe the volume of Bitcoin trading could soar even higher.”
So what’s the stock? Well, that’s not a lot of clues… but we can throw in some surmising to go with the thinkolating here, and shrink our universe a little bit.
First of all, David Gardner’s making a recommendation for Motley Fool Stock Advisor here, the Motley Fool’s very large flagship newsletter (reportedly more than 250,000 active subscribers)… that means he’s not recommending anything tiny or sketchy or that trades outside the US. This will be a large cap stock… or at least a solid mid-cap with a multibillion-dollar market cap.
And second, he notes that the new Bitcoin exchange opens “in a few short weeks,” which means it’s likely something specific and regulated and well-telegraphed… unlike the seat-of-your-pants behavior that seems typical of the alt-coin exchanges and marketplaces.
Third, the Motley Fool (admirably) has a disclosure policy, so we can double check the major financial exchange operators that might plausibly match these clues, and see which ones the Fool has formally recommended. That cuts it down further.
So what stock is being touted? Thinkolator comes in with 90%+ certainty on this being CME Group (CME), the huge future exchange operator. CME is certainly large enough (market cap of $50 billion), it has announced that it will begin trading bitcoin futures in a couple weeks (on December 18), and as of yesterday it was disclosed as a stock that has been recommended by a Motley Fool newsletter.
Why not 100% certain then? Well, you could make a good argument for CBOE Group (CBOE) as well, the big CME derivatives competitor (to oversimplify: CBOE used to handle options, CME futures, though both have grown dramatically over the years and used their broad, Chicago shoulders to edge into each others’ turf). CBOE has also been a Fool recommendation, it’s also easily large enough (market cap $14 billion), and it has also announced plans to start bitcoin futures trading… in fact, it announced its bitcoin futures after CME did, but also jumped the gun a bit and will start trading eight days before the CME bitcoin futures begin trading.
I don’t know that it will make any difference which one of these competitors gets more bitcoin futures trading volume… they’ll probably both do quite well as institutional investors look to get bitcoin exposure in a regulated exchange where they can do trustworthy hedging (and, importantly, shorting — betting against bitcoin either as a directional bet, or to hedge their bitcoin holdings).
And, frankly, I don’t know whether the addition of futures trading will be good or bad for bitcoin prices in the near term — lots of folks are consumed with Fear Of Missing Out (FOMO) when it comes to bitcoin, and that certainly includes lots of institutional investors. It seems likely to me that it will be devastating for the stupid exchange-traded bitcoin funds like Bitcoin Investment Trust (GBTC), since the huge premium at which those funds trade should evaporate as soon as other ways to access bitcoin on an exchange arrive… and if we are getting regulated futures, then ETFs might not be that far behind.
CBOE’s bitcoin futures pricing will settle for cash based on the price set by Gemini Trust, the bitcoin exchange owned by the Winklevoss twins (Gemini licensed their pricing data to CBOE a while ago, and the Winklevosses have been trying for years, a failed effort so far, to get SEC approval to list a bitcoin ETF). CME’s futures will price daily based on the price (presumably the average) across four major exchanges (Bitstamp, GDAX, itBit and Kraken).
So… what will this do to CME prices? Well, CME is the exchange operator — they don’t make a bet on direction for any of the futures and options contracts they manage, they just take their trading fees off the top and sell access to the exchange and the exchange’s data (about 85% of revenue is from ‘clearing and transaction fees,’ exactly the kind of financial friction that people hope blockchain will help to reduce, another 10% is selling data and information).
Like major competitors Intercontinental Exchange (which owns the competing ICE exchange as well as the NYSE) and CBOE, their margins are very high and their earnings depend more on volume of trading than on direction of trading. Bear markets are fine, unless bear markets make people trade less. CME did collapse in the 2008 crisis, and it’s only this year that they’ve recovered to above that 2007 high… but partly that’s because it got to a pretty crazy valuation in 2007
And, of course, CME and CBOE and Intercontinental Exchange (ICE) are all subject to the pressures that are created by alt-currencies — these big, regulated exchanges where trading is constrained and contained and verified could someday be put out of business by an effective blockchain technology, I suppose… blockchain could dramatically change any transactional business as it becomes more widespread and accepted (by removing the need for escrow and settlement, for example, with ‘smart contracts’). But that won’t be happening overnight, to be sure — exchanges have had their revolution as they’ve moved from floor trading to electronic trading, and that will continue and maybe evolve into blockchain-based trading, but it won’t be immediate and the giants will probably be the ones to bring it forward.
So… is CME worth buying here? Trading is not at record highs, but the stock is (CME, ICE and CBOE are all at new highs), and so it trades at a pretty steep valuation relative to its growth rate. CME is expected by analysts to earn $4.77 this year and $5.35 next year, so at $152 a share you’re paying a current year PE of 32 and a forward PE of 28. That doesn’t sound ludicrous in this environment, I suppose, with so many large cap stocks trading at lofty PE ratios (and with volatility low, which means there’s probably room for increased sales if volatility picks up dramatically)… but it’s surely not cheap. Analysts have CME penciled in for 11% earnings growth over the next five years, so the price/earnings/growth (PEG) ratio is pretty steep at just under 3.
Before the recent “grade inflation” in the markets, I would have said that 1-2 is a mainstream PEG ratio in most sectors, anything under 1 is probably cheap, and anything over 2 better mean you have a reason to think the analysts are dummies. But now, with money still rushing to large cap stocks because it has nowhere else to go, maybe PEG ratios are temporarily irrelevant… we’ll see.
By way of comparison, CBOE has a PEG ratio below 2, mostly because analysts expect much faster growth of 20% a year (the forward PE is 32); ICE has a PEG ratio of about 2, because the current valuation is lower (forward PE is 21, growth expectations are similar to CME’s at about 10%/yr).
If bitcoin becomes “real” and drives substantial institutional trading, I suspect they will all have a role to play… and, frankly, it wouldn’t be surprising if bitcoin futures and derivatives pretty quickly became a larger business than bitcoin itself, so we might have huge institutions trading futures on something for which the fair prices are set by hyperactive teenage traders in Shanghai and Amsterdam (I know, that’s not really true — bitcoin is traded by all kinds of folks… but it is overwhelmingly a “retail” level phenomenon still). Brave new world.
I wouldn’t try to talk you out of CME, or of CBOE or ICE, for that matter — they’re all solid “toll taker” businesses, and while they will probably be disrupted by technology over time they’re also an oligopoly that has proven its ability to absorb competition and embrace technology, they aren’t necessarily destined for decline even as the world changes.
Nor are they destined to make you instantly rich on the back of bitcoin, however. Bitcoin will probably not be a driving force for CME’s earnings next year, most likely, though it may have a measurable impact (much like the proprietary VIX options have been a nice driver for CBOE, I suppose)… I’d assume that market forces will be much more important, like more trading volume in general, or higher volatility, or whatever else lifts animal spirits and gets people shouting “buy” or “sell.”
The biggest concern I have is the concern I have about much of the market, frankly — it’s that real company expectations are flatlining even as the stock soars… this has been a stock surge based on future sentiment, not on actual company performance — CME for most of the past few years has fluctuated around in a pretty narrow range between 24-30X trailing earnings, but has now broken out to 35X trailing earnings, a valuation we haven’t seen for CME since the heady days of early 2008. That doesn’t mean the stock’s about to fall, but it makes me a little nervous.
So I’ll leave you there, dear friends, with one “Bitcoin Backdoor” to chew on… have any interest in CME Group? Or smaller CBOE, for that matter, if you think launching their bitcoin futures a week earlier than CME is going to give them an enduring advantage? Let us know with a comment below.