The market has had an astounding 2020 so far, and nowhere was this more true than in the tech sector. People are using tech more than ever in all facets of life. That, in turn, is powering a huge run in tech stocks. Yet the exchange where all this is happening, the Nasdaq (NASDAQ:NDAQ), is barely up. In fact, Nasdaq stock is essentially flat since February.
In a gold rush, there’s great money to be made selling mining equipment. Similarly, if you’re going to have a boom in growth companies, Nasdaq is going to get its share of the pie.
Historically, it certainly has. The Nasdaq’s earnings have more the doubled over the past six years as stocks have rallied. And now, with tech making another surge higher to record levels, it’s an ideal time to get long the stock exchange where the magic is happening.
Nasdaq: It’s More Diversified Than You Realize
At first glance, you might assume that Nasdaq is a simple business. It earns money from companies that list on the exchange, right? And yes, that’s true. However, it does far more than that.
In fact, the Nasdaq has four major revenue streams. According to its latest annual report, the largest segment, market services, accounts for just 36% of revenues. You also have information services at 31%, corporate services at 20%, and market technology bringing in the other 13%. That’s an outstanding level of internal diversification.
A stock exchange such as Nasdaq gets paid from activities that facilitate trading, from corporate events such as initial public offerings, and also information services such as selling data to brokerages and trading firms. On top of that, Nasdaq has built an ancillary business selling related financial technology and service products.
The most exciting of the bunch right now is the data business. The Nasdaq (and the other stock exchanges) are arms dealers in the ever-escalating war among different algorithmic trading shops and high frequency trading firms.
These active traders need the best data and are willing to pay heavily for it. That data, in turn, is a natural monopoly, as there are very few national stock exchanges, and Nasdaq in particular has a bunch of proprietary data.
The Core Business Is Humming Along
While data is obviously a hot market right now, given the rise of high frequency trading, the core market services business is also good. Just look around. The Nasdaq composite just hit a new all-time high a few weeks ago, despite the coronavirus.
It’s not hard to see why, as tech stocks are flying. Cloud and software-as-a-service are particularly in favor; many names in those sectors have doubled or more since the March lows.
This is good for bringing more trading activity and other related business. And that’s not all. Don’t forget that a major reason capital markets exist, after all, is to raise money for companies. When markets are booming that means you’re going to see far more IPOs and also secondary offerings in existing equities.
Who gets paid when a new tech stock sells its shares to the public? If you said the Nasdaq’s shareholders, you’re catching on.
Nasdaq Stock Is Attractively Priced
It’s not hard to find solid growth companies in the current marketplace. In fact, with all the problems that many other sectors are having, investors are rushing into the technology sector. However, it’s much rarer to find a reasonably priced growth stock today.
However, Nasdaq stock is still available at a fine price. Nasdaq earned $4.63 a share in 2019, and analysts forecast that it would earn more than $5.50 in 2020. We’ll see if that comes through or not, given the economic shock. In any case, shares have a forward price-earnings ratio in the low 20s. That’s a great level for Nasdaq. Consider that Nasdaq has grown its earnings 14% per year compounded over the past 10 years.
Nasdaq has also been a massive dividend growth machine. The company initiated its dividend in 2012 at 39 cents a share per year. Since then, it has more than quadrupled its dividend, as it paid out $1.85 per share last year. With a payout ratio of less than 40%, there’s more room for outsized dividend growth — particularly if the 14% per year EPS growth rate continues as well.
Nasdaq Stock Verdict
Nasdaq is an excellent opportunity at current prices. In fact, it’s worth asking why the stock price isn’t higher already, given the compelling growth rate.
I suspect Nasdaq is undervalued now because investors are falsely comparing it to brokerages. The brokers have gotten into a pricing war, with commissions falling to $0 per trade at many places. This has caused stocks like Charles Schwab (NYSE:SCHW) to underperform.
In theory, trading and data fees for the stock exchanges could plummet as well. In practice, this is unlikely as it is far harder to create new stock exchanges that have critical mass. The entrenched players have economic motive to preserve the status quo.
Additionally, some investors fear that Fintech start-ups will disrupt the stock exchanges. So far, however, most start-ups aimed at finance have failed to transform existing systems. Things such as credit card companies, which were supposed to be obsolete by now, instead keep making record profits.
Long story short, Nasdaq is riding two big waves going forward. The first is a fundamental rise in financial sophistication. Traders are using more and more data, and they have to buy it from a few select vendors, including Nasdaq.
The second is that tech stocks are booming. And that may continue for quite a while as the economy reshapes itself in a post Covid-19 world.
All that adds up to record earnings for Nasdaq and a stock price that will keep moving higher.
Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek. At the time of this writing, he owned NDAQ stock.