Why stock exchanges aren't creating value proposition for investors?

Financial performance of stock exchanges across the world suggests no generated value for investors

Students of finance are taught three parameters to evaluate the attractiveness of a business - sustainability of revenues, scalability of business and its ability to retain exclusivity in the space it operates. Even if one of these parameters aren’t met, exercising caution on these businesses is considered prudent. Companies from the airlines, retail, telecommunication sectors and listed stock exchanges outside India stand as examples.

Deutsche Boerse AG, parent company of Frankfurt Stock Exchange - world’s oldest exchanges, now likely to be merged with London Stock Exchange Group has seen its net profits dwindle year after year since 2010. Revenue growth has been flat as well. Performance of London Stock Exchange Group was also weak until three years ago and gathered pace only when it went aggressive on launching new products and leveraging technology to the maximum – steps which were critical to combat the lacklustre trade volumes. But Nasdaq Inc, which owns the Nasdaq (the stock market) in the United States, hasn’t seen the same success with introducing new products. Its revenues have grown just over a per cent since 2010, while net profit growth if not for the support of investment income would have grown lower than seven per cent in this period. 

Hong Kong Stock Exchange & Clearing Limited, which owns the Hang Seng Index of China (and a closer comparison to Indian exchanges) has performed relatively better than those in developed nations. Yet, while its revenues from FY10-15 have increased by 12 per cent, its net profit has increased only by 8.6 per cent in this period. The company’s profitability is also under pressure. Consequently, its market capitalisation grew by only over eight per cent in the past five years, indicating that it hasn’t rewarded much to its investors in the last five years. But interestingly despite poor financials, stocks of a few exchanges witnessed a good spell, particularly in early part of 2016. 

“Large institutional houses across the world pumped in money into stocks of these exchanges as other opportunities within the financial space have been drying up. But, this money is unlikely to last long given the unpredictable nature of their business and the risk associated with them. These stocks haven't done much in the past, and I doubt if they would in the future as well,” a CEO of a foreign brokerage states.

Aswath Damodaran, Professor of Finance at New York University Stern School of Business, has an interesting take on why these businesses won't reward investors. "Having a physical space and invite thousands of people to trade using it is a 17th century proposition. I'm surprised why people would invest in stocks of physical exchanges anymore," he says.

In this background, the cheer behind listing of India’s well-known exchanges – Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) -- needs careful review. That trade volumes haven’t been growing by a healthy number is writing on the wall and is true of both the exchanges. Hence, BSE’s less than three per cent CAGR (compounded annual growth rate) increase in revenues in FY12-16 and net profits, which have declined by 6.7 per cent, doesn’t come as a surprise. NSE’s performance, too hasn’t been great in this period with revenues increasing by just 5.6 per cent CAGR and net profits growing by just about 1.8 per cent. 

Both these exchanges have largely benefited from revenues generated by their relatively stable subsidiaries, which are into the depository business, namely CDSL (owned by BSE) and NSDL (of NSE). CSDL is also gearing up for public issuances, in which case the support from investment income is bound to reduce for BSE. The risk is the same with NSE. 

These investment incomes offer support to meet the operating expenses of the exchanges and also hedge for the declining incomes from their mainstay operations, namely trading revenues. The core business, which includes trading and listing of securities, has grown by just two per cent for BSE and 6 per cent for NSE since FY12. While both the companies are gung ho over their relatively newer streams of revenue such as data solutions, mutual fund distribution and other corporate services, the core business displaying weakness is a concern for investors. Nonetheless, home bred sentiments and the overall positive market sentiments may assure good listing gains for BSE and NSE. But, whether these gains can be sustained looks doubtful if past and peer performance sets the base for extrapolation.

How global exchanges have fared
				5 year CAGR growth (%)#
	CMP ($)	M Cap ($)	PE*	Revenue	Operating Profit	Net Profit
Hong Kong Exchanges & Clearing	23.9	29,272	37.0	11.6	9.7	8.6
Deutsche Boerse AG	80.8	15,849	21.4	0.1	-8.4	-4.5
London Stock Exchange Group	37.5	13,113	44.4	16.8	12.5	16.8
Nasdaq Inc	67.1	11,079	20.0	1.3	6.8	6.9
Japan Exchange Group Inc	14.2	7,791	22.1	25.2	29.0	34.7
ASX	37.0	7,148	22.2	2.2	2.1	2.7
M Cap: Market Capitalisation
* 12 months trailing price earnings
# Compounded from FY10-15 except for London Stock Exchange Group which is FY10-16
Source: Stock exchanges and annual reports
Compiled by BS Research Bureau

Stocks of exchanges Vs their indices
Companies	Returns*	Indices	Returns*
Hong Kong Exchanges & Clearing	-28.0	Hang Seng	2.6
Deutsche Boerse AG	13.3	Deutsche Boerse	12.6
London Stock Exchange Group	-45.5	FTSE 100	4.7
Nasdaq Inc	21.9	NASDAQ Composite Index	14.7
Japan Exchange Group Inc	-49.7	Nikkei 225	16.9
ASX	4.2	AEX	8.7
*Compounded annual returns from Jan 20, 2012 to Jan 20, 2017
Source: Stock exchanges
Compiled by BS Research Bureau