April 11, 2011

Brokerage firms

I have started analyzing financial service companies such as Banks, brokerage firms, NBFC etc to find some attractive ideas in this industry. I think financial services as an industry is likely to do well as the Indian economy grows and the average level of income rises with it.

Globally, the financial services industry forms a much larger part of the economy (in some cases too large) than India and acts as the circulatory system of the economy.

The above insight is not unique and does not mean one should go out and purchase any bank or company in the financial services industry.

I have often been asked why I don’t invest or talk much about banks or financial services company. I don’t have any mind block against this sector. I have invested in Karur vyasa bank, ICICI bank and Allahabad bank in the past.

However, any company which works with a high leverage is not an easy decision. The risk management and capital allocation decisions of the management are very crucial. It is easy for the management to make stupid loans or follow risky trading strategies for a long time, before the whole thing blows up (remember Lehman brothers?). In addition, the management can easily cover up the asset quality and the investor will have no clue about it.

Any investment is a finally a bet on the management, but due to the high leverage it assumes a greater importance in the case of financial service companies.

As part of the above analysis, I have started looking at brokerage and capital market related companies. I wrote about geojit securities in an earlier post (see here). I am detailing some thoughts on this industry below. I will follow it up with an analysis of some of the companies in this space.

The business segments for brokerage/ financial services can split along two broad lines

Agency business – This business does not require high amounts of capital and is based on other assets such as distribution network, client relationship etc. It consists of the following sub-segments

Investment banking : This involves advisory and capital market services such as IPO transactions, FPOs, QIP and rights issues. In addition, this also involves other services such as Merger and acquisition advisory, real estate and infrastructure advisory and capital raising services such as debt syndication.

This business is characterized by high competition, low capital investment and the presence of several global companies such as Goldman sachs, Merrill lynch etc.

The key drivers for this business are client relationships and key personnel who have the experience and the network in the business.

Brokerage – Retail, institutional, Wealth management and third party distribution
The brokerage business involves several sub - segments such as retail brokerage services through online and sub-broker channels. Retail brokerage is a fairly fragmented business with a lot of brokers across the country.

The key drivers for this business are an extensive distribution network and a robust technology infrastructure to handle the online and back end processes of the business.

The institutional business uses the same technology infrastructure, but is driven more by client relationships and research capabilities.

Wealth management also uses the same capabilities – strong research capabilities, client/ customer relationships and technology infrastructure to provide various services to higher networth clients.

The third party distribution is a nice addon as it enables the company to earn additional fees from distributing third party products such as mutual funds and insurance etc by using the same assets.

Asset management – PMS, Mutual funds etc
This business involves private asset management – PMS, private equity and mutual funds. This business is a logical extension for brokerages as they can use their research capabilities, distribution infrastructure and client relationships to expand their AUM (asset under management).

The companies charge a certain percentage of the AUM and hence the key factor is to increase the assets being managed.

Capital business – This is a form of lending/ trading kind of business. This business requires large amounts of capital and is closer to traditional banking

Financing – This involves short term loans against equities, client funding for trading etc. Some of the brokerage companies are now expanding into new areas such as Housing finance etc.

This business involves a higher risk than the agency business as the company is assuming credit risk. However the overall risk is controlled by extending credit against some collateral (shares or real estate). This business was traditionally run by banks and other NBFCs. However in the recent past brokerage firms have taken the NBFC license and have started expanding aggressively into this area.

Treasury operations – This involves trading by the firm on its own account. In my view, this is the highest risk part of the company’s business. This is a basically a black box operation. One cannot figure out the level of risk the company is taking to generate the returns. On the upside the returns and profits are very high, however if the company makes the wrong bets, then it can bankrupt the company (as we saw during the financial crisis).

I have given a general overview of the business and some thoughts in the post. I have not quoted any figure or charts for the industry. You can find these numbers in the annual report of any of the brokerage firms.

I will briefly cover the economics of the industry and some companies in the sector in the subsequent posts


Ansh said...

Hi Rohit,
I think very few new players will enter this industry/sector, due to intense competition between the existing players.This sector is also being commoditized, and there is very less differentiation between various brokerages.

The key lies in identifying a good pick among the already listed players. Eventually only those companies which can expand their branches/retail base and which can leverage their brand name will emerge as good investment picks.

valueinvestor2010 said...

Hi Rohitji good to see a new sector however a few important points
1) Bull markets can lead to high trading volumes that give high earnings and a rosy valuation to brokerages.
2)Leverage is often hidden in subsidiaries, special purpose vehicles etc etc. So probably contingent liabilities should be studied
3)Valuing earnings for organizations like investment banks is difficult.You can't multiply units produced x price to get revenue :-))
4)The best financial organizations are firms that have legislative and reputational moats like CRISIL or Mastercard. Not sure about brokerages, investment banks etc.
Thanks, all the best and great work sir :-)

VIKAS KUKS said...

Hi rohit,
My topic for discussion is a bit out of the way, not related to above topic but still pls have a look if its convincing. This is regarding Jocil chemicals, an andhra based company majorly into contract based business, making toilet soaps for ITC, J&J, HUL and others. Its growth has been very average in last 10 years from 60 crs to 330 crs in last 10 years. The attractive part is their stable and clean management and regular dividends and a low financial leverage history. Also their divercification into related fields to increase their effeciency as well as profit margins. They have power generation plants in wind energy and bio gass to generate a constant power supply. The negative part however is lack of pricing power since they are into a non-competitve business and exposed to volatility in raw material prices. However their sale have been increasing and are 3 times their market cap currently. It is trading at par with book value and at an price of 5-6 times trailing year earnings. Just wanted to have your thoughts on the overall picture and future procpects.

Vic said...

Hi Rohit,

Good post, nice to know that you're looking at the opportunities in financial sector as it is bound to benefit from India's growth. I think the retail sector is going to witness more competition.

For example, I have seen DBS Bank (Singapore) is expanding very aggressively, have also seen many initiatives from HDFC, Deutsche Bank, IIFL..I mean from all kind of banks/firms.

Ansh and valueinvestor2010 have made good points. One has to be cautious if it is a tier 2 bank or a brokerage firm because you never know what they're sniffing on. They make money on something but can loose on more on some crazy ideas as they get growth hungry or the competition forces to make risky bets.

I know you take your time to make a decision..:-)



Rohit Chauhan said...

Hi ansh
you are very right. the industry is very fragmented is now consildating. it is now a scale and volume driven business. its becoming quite similar to basic banking in a sense - you dont make much money from plain vanilla products. there have to be additional services and efficiency in the business


Rohit Chauhan said...

hi valueinvestor2010
you are spot on. businesses like crisl are a class apart - crisil is a license to print money :)

i am looking at the entire financial services space - banks, PE firms, brokerage, HFC etc. A lot of these separate companies are now converging. banks are now into broking, Housing finance, investment bank. similar broking firms are becoming nbfc.

its a very competitive space. i think either a very focussed or niche player will do well or we need large players like hdfc or icici which will do well on an overall basis


Rohit Chauhan said...

hi vikas
good to see you back on the blog. i am generally very cautious in the finance space. an aggresive managament can really drive a company to ground.
if a bank or finance company is growing very rapidly, i get cautious and avoid it. on average i may miss some gems, but will avoid the blow up

on taking my time - you are right on target. for all the reading and mulling, i may not even end up with a one idea :)


vinayak said...

Dear Rohit

What is your opinion on YES BANK ?