How Nasdaq Inc Beat the Nasdaq 100

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I joined Nasdaq in the early '90s, and so it was right at the dawn of the internet age. But if I look over the last 27 years, the sea change driven by technology is just incredible. I mean, I think about the amount of volumes that we were handling in the systems back in the '90s and hitting new peaks, but it was in, you know, maybe like the hundreds of millions of orders and messages a day. And now we're handling 62 billion in a day.

Welcome to the Barron's StreetWise Podcast. I'm Jack Howe, and the voice you just heard is Adena Friedman. She's the CEO of Nasdaq. Now, the name Nasdaq can refer to a lot of things, including stock indexes and a stock exchange, but it's also the name of a company that makes money from those things, and increasingly from selling trading technology, data and analytics. And shares of that company, NASDAQ, have multiplied nearly 7 times in value over the past decade. That means, among other things, that NASDAQ the company is outperforming the NASDAQ index. Does that make sense? It will. In a moment, we'll hear more from Adena about the boom in index investing and the run-up in big tech share prices and the future of stock trading. We'll also say a few words about an early forecast for the Christmas shopping season and what it might mean for retail stocks. With me remotely is our audio producer Meta. Hi Meta.

Hey Jack.

Meta, should I plug the live episode that we're doing?

Yes, plug away. I'll find some jazzy music for us.

Ooh, jazzy. Is it smooth jazz? Syncopated rhythms give me anxiety.

I'll find some real nice, like, elevator-friendly jazz for you.

Perfect. Going up. Watch Meta and I do a live episode of this podcast on November 9th at 1:00 PM Eastern time. Yes, I said watch. It's video. We'll hear from Visa CEO Al Kelly. You can ask questions. Sign up for free at events.barrons.com. /Streetwise. Folks are already signing up, you know, on Twitter. A regular listener named Rich writes, "Signed up, but who knows what I'll remember after my colonoscopy." Good luck with that, Rich, and thanks for fitting us into your schedule on November 9th. All right, Meta, Halloween is here. What do we have planned for our Halloween spooktacular episode?

Um, nothing, but I can find a sheet and cut a couple of holes in it and figure something out.

I am not feeling very Halloween-y myself. Maybe it's because we've already been walking around in masks since March, I don't know. Then I think about Thanksgiving that's coming, and I have a lot to be thankful for this year, but Instead of a big meal with extended family, I think we're having a regular meal with immediate family. I call that a normal Thursday. Now here's a fun fact about Thanksgiving. Barron's offices on 48th Street in Manhattan, they have a great view of the Macy's Thanksgiving Day Parade route. Only this year it's not really a parade so much as a socially distanced TV-only performance, and it's being shot down on 34th Street, so you can't see it from Barron's. So since Halloween and Thanksgiving look ho-hum, let's get a head start thinking about Christmas this year, because Christmas shopping, which is an important signal for retail stocks and the economy, looks like it's starting early, like maybe now. In surveys, 42% of consumers say they'll start shopping by November 1st this year. That's 8 percentage points higher than last year, according to a recent report by UBS. It's unclear why people are shopping so early. Maybe they're worried about out-of-stock items if they wait. Maybe they're bored and looking for something to do. Shopping continues to shift online, so it's easy to start early. Whatever the reason, the early start would seem to be a good sign for retail. But UBS doesn't see it that way. In fact, its analyst Jay Soul, who specializes in what are called softline goods like clothing, says he expects holiday spending on those goods to fall more than 10% this year from last year. That's a big drop. He points out that in surveys, 4 out of 10 consumers say the state of the economy will affect their spending this year. That's up from less than 3 out of 10 last year. It's the biggest increase in that number since the global financial crisis more than a decade ago. Okay, so shopping is starting early but maybe coming up short. J predicts that the early start to holiday shopping will cause comparisons against last year to look pretty good in early November. But then the bad news on shopping trends will begin rolling in closer to Thanksgiving. Jay is bearish on shares of department stores— Macy's, Nordstrom, Kohl's. They're already down a lot this year. If Jay is right, even contrarians and deep value investors should probably stay away from these shares, at least for now. I'm intrigued by how early and specific Jay's forecast is, although I have no idea how accurate it will prove. I'm optimistic, but I also like to be realistic. There are two important wildcards to consider. First, retail had a nice bounce back in late summer, partly from pent-up demand, but also likely because of government stimulus. There's talk of a second round of stimulus, which could boost spending, but so far there's no final deal. The second wildcard is, of course, the virus. Regular listeners know I don't do partisan epidemiology. I just read the facts. The number of cases, hospitalizations, and deaths are trending in the wrong direction across a large portion of the U.S., suggesting a difficult winter ahead that could affect commerce in general and holiday shopping specifically. I should note that Jay at UBS remains bullish on what he calls brands that can go it alone without department stores. Those include Nike, Levi's, and Skechers. Also, remember that his analysis is for soft-line goods, not hard-line goods like electronics. Two weeks ago on this podcast, we spoke about the new iPhone. I was a little skeptical about the immediate benefits of so-called 5G or fifth-generation wireless service, and my wife and I have iPhones that are only two years old. But guess what? I ended up ordering two new phones. I won't tell you the name of the carrier I went with, but it rhymes with shmimobile. And they were offering $850 apiece in trade-in money for our old phones, plus cheaper service than my current carrier, which means the new phones will be pretty much free. And I may not be alone in thinking this way. An analyst at Piper Sandler named Harsh Kumar had done survey work ahead of the iPhone launch suggesting so-so demand for upgrades, but once he saw the carrier subsidies this year, He put aside the survey results and made a big boost to his iPhone sales forecast. Bottom line, holiday shopping might be sluggish for department stores, but some retailers will be fine. And I wouldn't be surprised if Apple has a strong quarter and if Shmee Mobile gained market share, although the sudden resurgence of subsidies might not be great in the near term for carrier profits. Meta, do you think people are gonna know who I mean by Shmee Mobile?

I'm not sure. Is it schmearizon you're talking about?

Meta, have you ever heard an investor mention the Qs or the cubes or the triple Q?

Well, I'm not sure about that, but I think some voters have experienced some triple Qs the last couple of days.

Let's not make things political now, Meta.

All right.

The Qs I'm talking about have to do with a stock index called the NASDAQ 100, and it tracks the 100 largest non-financial U.S. companies listed on the NASDAQ stock market, weighted by size. What makes the index so different from, let's say, the S&P 500 index is that the NASDAQ 100 has such a heavy weighting in technology companies Nearly half the portfolio is tech. Almost another 20% is communication services, which you could argue is just more tech. And all of that tech exposure means the index moves like some of the most exciting companies in America and some of the most volatile. That's attractive for traders. They can trade the NASDAQ 100 index using an exchange-traded fund that tracks it. And that fund has gone through a few name changes over the years, but no one really calls it by its name. Everyone calls it by its ticker symbol, QQQ. And those of us who are too busy and important to pronounce the second and third Qs, sometimes we just call it the Qs. During the dot-com stock bubble 20 years ago, QQQ was the most actively traded security. Just this year, an investor in the Qs went up a quick 10% by mid-February. But then was down 20% by late March and then was up more than 40% by the beginning of September. Last I checked, they're still up, but not quite as much, just under 30% for the year. We've spoken on this podcast with many strategists who've helped us make sense of the contrast between soaring stocks, especially tech stocks, and deep economic uncertainty. But what about the companies that make money on all of this trading and volatility? I recently had the chance to speak with the chief of one of the biggest of these companies.

Hi, Jack, this is Adena. How are you?

Hi, Adena. Great. Thanks for making a few minutes to speak with me. That's Adena Friedman, CEO of Nasdaq. Don't be confused by the name. I know a moment ago I mentioned a fund that tracks the Nasdaq 100 index. And I said the index tracks stocks listed on the NASDAQ stock market, but there's a parent company that runs the NASDAQ stock market and that licenses those NASDAQ indexes to fund companies. And that parent company, it's called NASDAQ. I'll refer to it here and there as NASDAQ Inc. to avoid confusion. NASDAQ Inc. trades on NASDAQ, naturally. Under the ticker symbol NDAQ. If you've owned those shares over the past decade, you've made a lovely 21% a year on average. That's 8 points better than you would have done in the S&P 500 index. It's a point better than you would have done in the Q's. Now I know what you're thinking, I won't be able to sleep tonight unless Jack explains the origin of the name NASDAQ going back to the 1930s with old-timey music playing in the background. Well, don't worry, Meta and I are here for you. In the late 1930s, U.S. stock dealers and brokers formed an organization to govern trading in what are called over-the-counter securities, those that don't have formal exchange listings. They call this organization the National Association of Securities Dealers, or NASD. Trading stocks through this network of broker-dealers was awkward. It took a lot of phone calls to figure out who was offering the best price, and during the course of making those phone calls, prices would change. But in 1971, the NASD introduced something remarkable: an automated quotation system. It was a computerized way of compiling prices for everyone to see. Now today, new tech ventures all get romper room names like Smurfler or Snorkelbot, but this is back when companies played it straight with tech names. So instead of calling their new creation Snorkelbot, the NASD called it the National Association of Securities Dealers Automated Quotation System, or NASDAQ. Armed with this data system, NASDAQ evolved into an exchange that makes money on trading, only without the trading floor. And it began competing with longstanding exchanges like the New York and American Stock Exchanges and eventually went its own way, separate from the regulatory group that created it. There's too much history here to cover in detail, but let me mention two things I find striking. First, the tech boom put NASDAQ on the map but also gave rise to its biggest competition. Like all new ventures that compete against incumbents, Nasdaq struggled to gain prestige at first, but in the 1980s it scored listings for companies like Apple and Intel, and in the 1990s it rode a massive tech boom. And before you knew it, everyone was talking about the Qs. But the rise of the internet also made it possible for more startups to get into the business of executing stock trades. So the NASDAQ stock market today faces plenty of competition from companies trying to do to the NASDAQ what the NASDAQ did to the New York Stock Exchange—take market share. The second detail has to do with how NASDAQ Inc. has responded to this threat to its trading revenues by going back to its roots, dealing in data, lots of data, and analytics and technology. In fact, today, most of Nasdaq Inc.'s revenues and profits don't depend on fees for stock trading. Here's Adena on a couple of key acquisitions that helped make that transformation possible.

For instance, back in 2010, we bought a company called SMARTS, which provides surveillance technology to markets. So right before that, we'd actually bought a company called OMX, which provides all the markets many of the markets in the Nordics, but also embedded in that business had a market technology business that provided technology to other marketplaces around the world.

Here's why that's important. Last quarter, NASDAQ Inc reported a 13% increase in revenue from a year ago and 21% growth in earnings per share. Now, if all that came from fees on stock executions, then people like me would say, It's nice and all, but you know, easy come, easy go. When the stock boom stalls, the growth will disappear. Instead, people like me say, wait a minute, barely 1/3 of revenues now come from what NASDAQ calls market services, which includes stock executions. The rest comes from things that don't depend as much on trading activity, sales of data and analytics, and of financial plumbing that makes other stock markets around the world work. And fees from companies for things like listing their shares. All that steady revenue from non-trading sources has convinced investors that NASDAQ can keep prospering even in between stock market booms. They've awarded the stock a rising valuation. Today it trades at 20 times forward earnings estimates. That's double the level it traded at 8 years ago. It helps explain the remarkable returns over the past decade. Adena became CEO of Nasdaq 3 years ago, but she also led its first data division, which was created 20 years ago. She says Nasdaq democratizes its data by giving retail investors access to, for example, real-time quotes, but that it also charges big players for sophisticated data. I asked what kind of data, and if Joe and Sally Saver put in an order to buy or sell a stock, What makes their information so valuable to big players? Can they be confident that they're not made worse off by that data being sold? Adina says both parties win. Joe and Sally get a good execution on their trade, and other players learn how to better position themselves for future trades.

What happens is, instead of the online retail firm actually executing that trade for the investor, that online retail firm is actually sending it to sophisticated broker-dealers who are executing that trade, but that information about the fact that there was a retail investor interested in that stock at that time at that price is valuable for them in terms of managing their positions in the market. And so they therefore will pay the online retail firm to get access to that information. But what they also are doing, by the way, is supplying them instantaneous execution, often at a price at or better than what the investor was expecting.

One key source of recent growth for NASDAQ has been index investing. It earns fees by licensing its indexes to to fund companies who want to create funds based on them. Adena says there's more room for growth in index investing, but that this year has also seen a surge in the opposite of indexing, actively buying and selling stocks to try to beat the indexes. I asked Adena what she thinks will be the biggest changes in her industry in the decade ahead.

The areas that we're most focused on, like most industries today, are certainly the use of the cloud, as the underpinning infrastructure for markets themselves, and not just to support offline data storage and analysis, but to actually leverage the cloud for market operations. I think the second is the ability therefore to handle massive amounts of data that then can drive machine learning and machine intelligence and how that can help on the defensive side, but also how that can help with alpha generation in the marketplace. Alpha generation.

That's Wall Street speak for beating the stock market. If you've ever bought a stock that went up more than the S&P 500, congratulations, you've generated alpha. And if you've never done that, don't worry, just tell your friends that using your own proprietary interpretation of beta, you outperformed on a risk-adjusted basis. Again, congratulations. Last question for Adena: What about roaring tech stocks and the Robinhood bros? You know, some tech stocks have jumped to pretty aggressive valuations, and I keep hearing that's because of the rise of unsophisticated retail traders who chase price momentum using low or no-commission trading accounts like ones from the startup broker Robinhood. When people tell me about these traders, they call them Robinhood bros. I don't know why they're bros, and I don't know what the bros look like, but I picture them with a can of hard seltzer in one hand, smartphone in the other, maybe with a scraggly beard and a ball cap with the Bitcoin symbol on the front. So does Adena attribute soaring tech valuations to Robinhood bros? She doesn't. She says low bond yields have shifted investor preference towards stocks. And by the way, created a boom year for initial public offerings. She also says growth is in short supply, causing investors to pay up for shares of growing companies, and that stocks have become what she calls a tale of two cities— companies that can continue to grow and thrive through the pandemic and those being hurt by it.

I think it's been an interesting time, but I would not say that retail investors are the reason for that. I think the macro backdrop coupled with a broader investor base, but also coupled with an enormous amount of capital that needs to be put to work. And, and equities has become the asset of choice.

Thank you for listening. Meta Lutzoff is our producer. Meta, should we thank the rest of the podcast team? Let's do it. Katie Ferguson, Brian Price, Rebecca Bisdell, and Melissa Haggerty. Thank you. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts.. And if you listen on Apple, please write us a review. If you want to find out about new stories and new podcast episodes, you can follow me on Twitter. That's @jackhowe, H-O-U-G-H. See you next week.

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