Devil’s Advocate Short List for Exchange Stocks

We have spent a good deal of time running various screens over the past few days looking for the occasional name or industry that might be running a bit hot, and could be due for a 20-25% drop if general market weakness or even flatness persists.  A multi-week period of flat to down slightly returns (around 5% or so) is not unlikely while we wait for further evidence of economic strength or deterioration.  Feelings on rate movement are rather split down the middle right now as far as the next direction and the timing; some say hikes, some say cuts are coming AND the timing of such is also in the air.  In times like this the market participants won’t stretch too far in either direction, but intraday volatility may be high.  Even if you remain in a bullish stance, being a good devil’s advocate can be extremely valuable in avoiding names where valuations have grown relatively high.

To that end, there are some pockets that have exhibited a lot of relative strength in the past few months.  If the market settles into a sideways trend while awaiting further economic data, these companies could be ripe for a big up-tick in their short interest ratios.  Some short positions were obviously bolstered just this past week, and each stock has its own tipping point where the aggregate effect starts to take control of short-term price movement in the stock. 

There are many names in consumer discretionary spending and in commodities that hit the screening process but the names that keep coming up near the top of my screen results are the public financial exchanges.  Unfortunately these also represent one of the scarier short opportunity sectors out there.   Take Nymex (NMX) and the InterContinental Exchange (ICE), for instance: ICE fell nearly 16% last week, but still trades at over 27x forward earnings. NMX’s forward multiple is over 35x forward earnings and that is after trading in step with the S&P last week.    These two names do have gaudy valuations, but investors should still beware betting against them blindly.  The ICE-owned NYBOT reported February ‘07 volume growth at 37% over 2006, while Nymex reported 34% y-o-y growth.  Now we know why the valuations are so high. 

CBOT holdings (BOT) was down less than 2% for the week, and currently trades for about 29x forward earnings.  Soon-to-be partner and parent Chicago Mercantile Exchange (CME) was also down less than 2% on the week, having posted total volumes for February 2007 showing their growth clocked in at 27% y-o-y.  Not only do we have peaking volumes in the equity indexes, but the derivative-based exchanges get a combined lift of uncertainty-based volume spikes and internal, organic growth from expansion of their platforms.  Operating margins should benefit nicely as well.  The biggest danger at this point is regulatory or litigation concerns should systems prove faulty in a long-term huge volume environment, should one occur.  We could also see drags on the stocks coming from insider sales and merger integration, and many insiders have already sold or plan to. 

As such earnings estimates for the exchanges will probably widen as opposed to tighten from here, analysts may balk at the challenge for the next quarter or two.  For those who brave it, there may be solid trading opportunities arising from this uncertainty.  It is likely that many have already paid a hard price for betting against these financial exchanges for longer periods of time.  As a last reminder, any recovery in the financials is often followed by a leveraged move in the financial exchange stocks.

We are still screening other names and sectors that we’ll be publishing in the coming days.  If further signs of weakness occur in the broad markets occur, having three or four “shortable” names ready to go would be based on companies that would have not only price level appreciation in our favor (for instance, stocks trading more than 25% above their 200-day ma.) but also some fundamental concerns that could impact 2007 earnings and beyond.  This theme will be the focus of a periodic study of relative valuations at 24/7 while we keep our eyes on the important indicators released over the next few weeks.  We are also screening the risk/reward parameters and results in retailers, hotels, theme parks & entertainment, casinos, gaming, satellite radio, advertising and other sectors for the names that appear most at risk, so stay tuned.  Even if private equity firms are thought to be in hot pursuit, they may wait if things are going to erode and if the risks are for much more downside.

Written by Ryan Barnes and edited by Jon C. Ogg
March 5, 2007

Jon Ogg can be reached at [email protected]; he does not own securities in the companies he covers.