Time to buy ASX

The sharemarket only throws up occasional opportunities to purchase quality companies at compelling prices, but if you’re patient they do come: last week we had one with Cochlear (albeit briefly) and we’ve got another today with ASX.

After restarting trading today following its rights issue announcement on Tuesday, the stock has fallen 8%. About 60 cents of that, or 1.5%, relates to the fall to the ‘theoretical ex rights price’ of $35.28 (for which shareholders will be compensated with their rights to subscribe for new shares at $30, which can be sold – shares bought from today onwards won't give you the right to subscribe for new shares). The rest is probably a combination of; (a) the very mild earnings downgrade that accompanied the announcement; (b) recognition that capital requirements in the clearing business will have to increase and (c) that the company has dispensed with debt, making its balance sheet ‘inefficient’.

The capital requirements of clearing are certainly increasing, with regulators working to safeguard markets in the aftermath of the global financial crisis. In particular, EU regulations (which ASX Clear (Futures) will need to meet to undertake clearing services for EU participants) are expected to require clearers to be able to withstand the failure of their two largest participants (as opposed to just the single largest required by the RBA). But the additional capital increases barriers to entry, and it's not lazy capital, since it will earn interest (or save it in the case of repaid debt) on top of the returns it will enable ASX to earn clearing trades.

Opportunities

As far as balance sheet efficiency is concerned, we subscribe to the old-fashioned view that quality companies shouldn’t need to spruce up their returns with debt. The real efficiency is to maintain a strong balance sheet so you can take full advantage of opportunities. ASX has done this with the recent construction of a high-speed trading network and liquidity centre and it’s doing it again by entering the market for OTC derivatives clearing.

Sentiment towards ASX has been dampened in recent years by weak markets and competition, but markets go up and they go down (if they didn’t ASX wouldn’t have much of a business) and competition in cash equities clearing has been set back for at least two years – giving ASX more time to plead its case and prepare for competition if necessary.

Based on revised forecasts for 2014, the stock is on a price-earnings ratio of about 17 and a fully franked dividend yield of about 5.4%, which is generous for a company with a bullet-proof balance sheet and mid to high single-digit long-term growth prospects, as described in our three-part series ending with ASX: Competition cuts in - pt 3 on 28 Nov 12 (Long Term Buy – $29.32). As exchange consolidation continues around the world, it’s also likely that the company will eventually merge with an overseas exchange – a prospect which won’t be diminished if the Liberal-National Coalition is elected in September.

We’re raising our Buy price guide to $35 and our Sell price to $55 and nudging our recommended maximum portfolio weighting up to 8%. For shareholders wishing to increase their holdings, the rights issue provides an efficient means of doing so. But those shareholders that don’t want to commit more money can sell their rights to compensate for the issue’s dilution, or let the company do it for them. The retail offer booklet is expected to be available next week. For more details on how rights issues work, please see our Investor’s College article on the subject: Your guide to retail share offers. BUY.

Note: Our Income Portfolio owns shares in ASX.