Opportunities Hidden in Plain Sight

We are highlighting a shift in the portfolios reflecting our preference for what we view as a lower-risk investing approach in lieu of the mega cap tech giants. At the end we will explain why we think this approach is a thoughtful alternative to buying “The Magnificent Seven” or the NASDAQ 100 index comprised stocks (QQQs) at such historically high valuations.

HIDDEN IN PLAIN SIGHT

It has been said that if you want to sit in the shade of a tree, the best time to plant the seed was 20 years ago. The second-best time is today. What we are about to cover has been known for a long time, so forgive us if we state the obvious with a sense of discovery.

IN SEARCH OF ASYMMETRY

Most investors seek low risk investments with high return probabilities. Warren Buffett and others have called it seeking a “margin of safety’. Said differently, we want to buy wonderful companies at a fair price and hold them for a long time.

We will be discussing an industry that appears to have favorable business model characteristics and secular tailwinds. The data will illustrate what has happened, and we will share reasons why things might continue in the future. As Charlie Munger has repeatedly observed, people don’t like to change and avoid change whenever they can. Recognizing the opportunity when it presents itself can be tricker than one might imagine.

OUR PREFERRED CHARACTERISTICS

1. Growth persistence
2. Historical profitability
3. Asset light and competitive moats
4. Beneficiary of technology enhancements and increased regulation

The industry we are referring to are securities exchanges. There are dozens around the world and no two are exactly alike, yet many are similar so we will generalize.

HISTORY

Securities exchanges have existed for centuries and in general started as a way to diversify risk. Whether it was to protect bad outcomes from shipping or agriculture to the unknown success of a business venture, exchanges popped up to lay off risk. The same is true today. Though many people feel exchanges are venues to buy, sell or speculate to make money, the initial purpose and ongoing underlying economic justification is to reduce risk.

As economies expanded, new industries and businesses were created. When the industries became large enough, financial products and security exchanges were created as well. In the last 50 years, the expansion of financial products, options, futures, and derivatives has grown rapidly.ⁱ One could conclude, like Samuel Duel did in 1902, “Everything that can be invented has been invented”, but we don’t think so. The trend is toward further financialization, digitization, and tokenization of global assets. If that is the case, the opportunity set could be 10-50 times larger.

CASE STUDY

Private companies and co-ops typically don’t distribute financial results, but in some cases, one can reasonably draw conclusions about profitability from publicly disclosed information.

For example, if a limited issuance of a license or “seat” of an exchange sold for a published price, say $600,000, and a one-year lease for that license was also published, say $80,000, you could infer that the “profit” on that asset was 13.3%. If you added up the annually disclosed sale price of these “seats” and the one-year lease prices, you could also surmise an average return or profit from owing that asset.ⁱⁱ iii iv In this hypothetical case, we observe that the income component of this asset was 13% but does not recognize if the total return was higher or lower.

In the early 2000s, a period of enormous consolidation of securities exchanges began. The privately owned co-op of the NYSE merged with Archipelago Holdings. A few years later it merged with Euronext, and ultimately was purchased by its current owner, a publicly traded company. The same consolidation occurred across regional and national options, futures and commodity exchanges. What happened in Gotham City was happening all over the world. The reason was clear in retrospect. The economies of scale combined with owning a diverse set of incomes streams made for a more stable and profitable business.

BUSINESS MODEL AND POSITIONING

Viewed broadly, security exchanges could be considered an oligopoly of government endorsed businesses that are in a unique position to participate in the global economy and likely to grow as economies expand. Why?

• As more and more assets become financialized, government regulators are likely to encourage or require them to be traded on a regulated security exchange for reasons of stability and safety.
• Areas of specialty exists attracting more participants to the most liquid and cheapest contacts, creating mini-monopolies. However, should a similar type of security or derivative emerge on two exchanges, the volume of trading often increases by participants attempting to arbitrage small price differences.
• As asset light companies, they benefit from cheaper and faster technology. As volumes grow, like software, incremental “sales revenue” is at higher profit margins.

VOLUME ACTIVITY

Like a bridge toll taker, it matters little which direction a car is going to earn the toll. What matters is the volume of traffic. In a similar matter, whether the markets go up or down, as long as in aggregate there is activity, exchanges make money. Periodically, but not frequently, volumes will slow or go down, however, in the last 28 years the average increase in trading volume on the “Big Board” has been 24.3%.^v

Buffett reportedly commented that companies with monopolistic traits, such as a toll bridge, are also wonderful businesses to own. He had to walk back his comments when questioned about the motivations behind his purchase of a Buffalo newspaper in the 1970s.

CONSOLIDATION AND EXPANSION

One of the reasons why the global consolidation of securities exchanges occurred was to add products to diversify and counterbalance normal sector cyclicality. Exchanges added financial and energy futures to their agricultural options and derivatives. As the number and types of financial products emerged, consolidation continued. Virtually every week, new types of tradable securities are being introduced somewhere in the world. Tradable securities like electricity futures that did not exist in 2000, have become legitimate asset classes.^vi Global real estate is a $380T asset that is being transformed.^vii Crypto currency and the blockchain are on the verge of ETF trading, having already been approved for futures trading for more than a year.

On a related note, every financial product and securities contract carries related sale opportunities, not the least of which is data. In the last 30 years or so the value of accurate historical and real time data has exploded. There may be a limit to the number of new financial products created, but in my opinion, it is so far off we don’t think we will see it in my lifetime.

INSTITUTIONAL ADOPTION OF NEW FINANCIAL PRODUCTS

Currency futures were introduced in 1972 to hedge against the free-floating gold price. Financial futures were introduced in 1976 and it took about 15 years for the annual contract volume to reach 100,000. Today it is ten times larger.^viii Stock index futures were introduced in 1982. The point is that adoption takes time, but once leading institutions start using new products that can hedge risk and or lower cost, the rest follow.

Jamie Dimon, CEO of JP Morgan, famously said in 2017 something akin to, anyone who owns cryptocurrency is stupid.^ix Perhaps. However, in 2022, the JP Morgan Wallet received US Patent and Trademark protection for its internally developed blockchain technology and last November executed a blockchain derivative transaction with Blackrock for $780b worth of securities.^x Today, the daily volume exceeds $1b. Blockchain technology is being adopted and every indication suggests that the expansion will continue. Forget about speculating on coins and token. You can and many have lost everything due to crypto scams. However, if regulators force all trading of crypto related activities to a securities exchange, the trading volumes could be significant.

When one examines broad public data, and parses through the noise, trends can emerge.

PRICE VOLITILITY

Be there no doubt, security exchange stock prices will have volatility just like all other stocks. In any given year the price could be up or down 50%, or more. However, when compared to technology companies, the risk/return calculation appears to be more favorable. Tech companies have among the highest failure rate of any industry, as much as 63% of tech companies go broke by one study.^xi That doesn’t include the many thousands of companies that were acquired well after their stock prices peaked or just before bankruptcy.

RELATIVE VALUTATION AND SUSTAINABLE GROWTH

An Arizona State University study concluded 96% of public companies failed to deliver returns that exceeded T-bills.^xii Finding a business model that that stands to benefit from long-term secular trends is the goal. If they are likely to benefit from technological innovation rather than have their existence threatened by it, even better.

In my opinion, as a group, securities exchanges appear to be a “less crowded trade” than the Magnificent Seven and the NASDAQ 100 oriented ETFs. The price one pays for their apparent enduring characteristics may be less than buying shares in another group of highly popular companies. Owning a basket of companies that benefit from an array of economic growth is clearly my preferred approach.

All of these investments take time and nothing is assured. However, if you buy good businesses at fair prices and have patience, every once in a while, you just might be able to find asymmetrical return opportunities.

Christopher F. Poch

Founder & CEO Promethium Advisors LLC 7272 Wisconsin Ave.

Bethesda, MD 20814 pochc@promethiumadvisors.com Direct 202-978-2561

IMPORTANT DISCLOSURES

Advisory services offered through Promethium Advisors, LLC, a Registered Investment Advisor. This material has been prepared for informational purposes only. It does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it.

The views expressed herein are those of the author. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results. Information contained herein has been obtained from sources considered to be reliable, but we do not guarantee their accuracy or completeness.

Please note that the URL(s) or hyperlink(s) in this material is not to a Promethium Advisors LLC website. It was created, operated, and maintained by a different entity. Promethium Advisors LLC is not implying an affiliation, sponsorship, endorsement with/of the third party or that any monitoring is being done of any information contained within the linked site; nor do we guarantee its accuracy or completeness. entity. Promethium Advisors LLC is not responsible for the information contained on the third party web site or the use of or inability to use such site.

Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.

REITs are subject to special risk considerations similar to those associated with the direct ownership of real estate. Real estate valuations may be subject to factors such as changing general and local economic, financial, competitive, and environmental conditions. REITs may not be appropriate for every investor. Dividend income from REITs will generally not be treated as qualified dividend income and therefore will not be eligible for reduced rates of taxation.

Promethium Advisors LLC and its affiliates do not provide tax or legal advice. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond’s maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Equity securities may fluctuate in response to news on companies, industries, market conditions and the general economic environment. Companies cannot assure or guarantee a certain rate of return or dividend yield; they can increase, decrease or totally eliminate their dividends without notice.

Investment advisory services offered through Promethium Advisors, LLC, a Registered Investment Advisor with the U.S. Securities and Exchange Commission. This material is intended for informational purposes only. It should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney or tax advisor. The information contained may have been compiled from third-party sources and is believed to be reliable as of the date of this email.

The investments listed may not be appropriate for all investors. entity. Promethium Advisors LLC recommends that investors independently evaluate particular investments and encourages investors to seek the advice of a financial advisor. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. An investment cannot be made directly in a market index.

i https://www.hbs.edu/ris/Publication%20Files/Growth%20of%20Finance_6ec86a21-8e68-4abc-bb09- 45abaacd7be5.pdf

ii https://www.wsj.com/articles/SB109666138650934027

iii  https://www.researchgate.net/figure/Price-of-Seats-on-the-New-York-Stock-Exchange-1883-1971_fig1_5186301

iv https://web.archive.org/web/20161007144511/http://ir.theice.com/~/m edia/Files/I/Ice-IR/events- presentations/presentation/1q16-investor- presentation.pdf

v NYSE, Horizon Kinetics Contrarian Research Report (June 2005). Exchanges Versus Indices. Factset

vi https://ieeexplore.ieee.org/abstract/document/9076969

vii https://www.costar.com/article/135327380/total-value-of-global- real-estate-hits-3977-trillion

viii https://www.cmegroup.com/files/intro_fut_opt.pdf

ix https://www.cnbc.com/2017/10/13/jamie-dimon-says-people-who- buy-bitcoin-are-stupid.html

x https://www.coindesk.com/business/2023/10/26/jpmorgan-handles- 1b-transactions-daily-in-digital-token-jpm-coin- bloomberg/

xi  https://www.embroker.com/blog/startup-statistics/

xii https://wpcarey.asu.edu/department-finance/faculty-research/do- stocks-outperform-treasury-bills