CME
When a Morningstar analyst evaluates a stock, (s)he categorizes it as either "no moat", "narrow moat", or "wide moat". As any follower of Warren Buffett can guess, the presence of a "moat" serves as a barrier to competition, and a source of pricing power. A business which manufactures a commodity has no moat; a company which manufactures a patented product with an installed base and no good substitutes has a wide moat.

In a recent column, they announce five new wide-moat stocks. One that particularly attracts my attention is the Chicago Merc:

This one's right in our back yard, and it's got one heck of a business. Exchanges tend to benefit from the network effect, which is one of the most powerful types of competitive advantage. In short, the more buyers and sellers who trade on an exchange, the greater the liquidity, and the lower the trading costs. The Merc is in an even better position than some exchanges because its products are not fungible across exchanges. In other words, if you buy a future on the Merc, you have to sell it on the Merc as well. And since the Merc has exclusive contracts for futures based on the S&P 500 and Nasdaq indexes, you can see what a wide moat the firm has built for itself.

There is some competition on the horizon with the Eurex exchange entering the U.S. next year, but we think the threat is overblown, given the Merc's exclusivity contracts. Also, volume growth in futures can be pretty volatile and tough to predict. To mitigate the latter risk, we're assuming essentially flat volumes in equity and interest-rate index products for the next couple of years, after which we're assuming they revert to their long-term growth level of about 20%. Even so, the shares look very reasonably priced to us.

I don't know a lot about the industry (the 20% growth rate sounds pretty bold, but there has been a lot of growth in funky derivatives), but most of the reasoning about the moat-size seems solid, and it's trading at 18 times earnings, which is less expensive than most of the stock market. I'm not ready to endorse it, mostly because -- as I said -- I don't know the business well enough. But it may be worth a look. Dean has pointed me this way before -- maybe he has something to add.
- posted by Steven @ 7:55 AM