April 18, 2011

Economics of the brokerage industry

I thought my previous post on the brokerage industry would receive minimal hits as it is quite a dry topic and has no entertainment value. However, I am glad that I have been proven wrong. Considering that a lot of users are interesting in reading such dry topics, I will continue to publish such analysis in the future.

I had given a brief overview of the industry in the previous post. I will try to analyze the economics of the industry in this post

The typical research report (at least the free ones) on industry analysis typically give pages and pages of past and current statistics, without attempting to look at the broader picture or overall dynamics of the industry.

Why is that important?
If one has to make a long term investment in a company, it is crucial to understand the long term economics and direction of the industry and the company in particular. The statistics and various parameters of the industry are just the starting point of the analysis.

Lets try to evaluate the brokerage industry

The brokerage industry is currently characterized by a large number of companies (private or unorganized). In effect it is a fragmented industry with a large number of participants.The industry thus has monopolistic competition (text book term) – a large number of firms selling a slightly differentiated product.

Let analyze the industry based on Michael porter’s five factor model

Barriers to entry
The industry now has a certain level of entry barriers. The primary brokerage firms need to have a certain scale and size as the business involves a high level of fixed costs in the form of technology platform, distribution network and back office operations. In addition brand recognition is also important to attract new customers.

A new entrant in addition to the above also needs a reasonable level of capital to fund the working capital requirements of the business (finance to customers, deposits with exchanges etc).

These scale requirements are increasing constantly and as a result a new entrant will require higher levels of investments in the future to enter the business. As pointed out by ansh in the comments, it is unlikely that we will see many new entrants in the industry. On the contrary, it is likely that the smaller players will exit by selling out or closing shop.
Supplier power – not relevant in most segments except investment banking, where employees control client relationships and hence have to be highly compensated

Buyer power – This is important in the institutional brokerage business which involves high volumes and low brokerage charges. The extent of buyer power is very low to non-existent in all kinds of retail segments

Substitute product – Not applicable

Rivalry determinant – This industry is now in a fairly high growth phase. However the brokerage industry is very cyclical and is impacted by the activity levels in the markets. During the downturns such as 2008-2009 period, the smaller players were squeezed out of the business. As a result there is a constant consolidation happening in the industry.

In summary the industry has moderate to low level of competitive advantage. There is low level of customer lockin and a customer will move his/her business if the brokerage rates are not competitive with the rest of industry. The only competitive advantage for the companies in this sector comes from size and scale which enables them to leverage their size to reduce average costs and thus make a profit on low brokerage margins.

Other points of analysis
In addition to the high fixed costs, the industry has very low marginal cost. As a result the cost of adding an additional customer is low and per transaction costs are limited. Due to this reason, we are seeing a constant pressure on the brokerage rates (similar to telecom which also has a very low marginal cost). This downward pressure on the brokerage rates has intensified the competition in the industry and is resulting in consolidation with the top players.

The basic brokerage business is now sometimes a loss leader to enable the brokerage firm to acquire customers and sell other products such as wealth management services, PMS or third party mutual funds. The agency business is thus a Iow margin, lower risk and a fairly predictable kind of business. This segment will provide adequate returns in the future for a company with scale.

The capital business involving financing is similar to a banking operation and is mainly a lending or a support business for the brokerage operation. This is a high risk and sometimes a high return business. It is easy to grow in this segment by taking large quantities of debt and then investing in high risk assets. However the risk of a black swan or plain old recession wiping out your business is very high.

Finally the treasury business is a trading operation driven by the skills of a select set of individuals. In the same manner business such as investment banking is also a very competitive business driven by key customer relationships. It is difficult to evaluate the competitive advantage in these businesses as it is driven by a few key employees, who can leave and thus take away your revenue streams and profits

I personally prefer low to moderate businesses with above average returns. In view of this preference, I am likely to reject high growth/ high risk businesses in the brokerage space and likely to focus on companies which are focused on the agency business.

18 comments:

Anonymous said...

Hi Rohit,

This is the best description of the brokerage industry I have seen. Though I have been in the industry for nearly 5 years, your post actually helped me understand the symbiotic relationship between various business lines. In fact, the reality is that sometimes these lines just grey out or disappear due to PnL pressures or greed and the paramount goal will be the company's quarterly performance.

Like you have mentioned, these companies can take on unprecedented risks on their books (unbeknownst to the shareholders) in the greed for big short term returns. More often than not, these risks don't reward the shareholders positively. Due to the unknown nature of risks, I prefer to stay away from such brokers (and even banks).

I also agree with you that most of the brokerage services are commoditized and hardly have any pricing power. Now that hedge funds are their major customers, the brokerages just aside and lend their pipes (broker license) to hedge funds to trade on the exchange and make pennies on the dollar for each trade and make up in volume. The innovation here is in coming up with riskier products (like synthetics and CDO's) which can be compared to lighting crackers in your hand - fun for a very short time, and best be thrown as far away as possible very quickly.

Just as an aside, I would like to request a follow-up post on certain niches in the industry like technology or other service providers who may be a good investment option than the industry they cater. One example is Financial Technologies (FT). FT provides the traders terminal (gains annual licensing fees - almost like annuity), provides connectivity to the exchange, provides the technology to the exchange, some times is also exchange itself (like MCX, MCS SX), provides backend like depository etc. So is there enough justification to invest in such anicilliary companies? (Disclaimer - I own FT stock and a big believer in the company).

Vic said...

Hi Rohit,

Most of the renowned brokerage firms like Goldman, Merrill Lynch also earn a decent chunk from mergers, acquisitions, book building etc. It is a continuous revenue stream.

I have seen their subsidiaries doing the same in India.

Is there any reason that you didn't cover this aspect of business?

Thanks,

Vikas

Manoj said...

Hi Rohit,
it's off topic but can u have a look at the post by Mr. Sanjay Bakshi on Piramal Healthcare on his blog? the company has a cash of 517 rs. per share where as it's current price is 430. If we add the great historical performance of the company, it looks like a value investor delight.

Manoj

Vic said...

Hi Rohit,

Come on now, please answer Manoj's query on Piramal. I know you have respect for Pro. Bakshi..:-)

So far I haven't made a single penny on arbitrage ideas. I think these are only suitable for Ninad..:-)

Sorry for hijacking this thread. :-)

PS: I have a position in Piramal.

Anonymous said...

Isn't this like the textile industry when Buffett decided not to continue? A commodity business where you keep cutting the price or investing in technology to stay in place or both.

Looks like it's inherently a business which is not likely to give a good return.

Rohit Chauhan said...

Hi anon
you make a great comment ..ofcourse i always like comments which praise me :)

the 2008 crisis in the US was a case of greed and how banking, broking and other stuff got mixed up with blind risk taking. so in a way all brokerage firms are a black box in that way

i will not lump all banks in the same bucket. some are conservatively and well managed and one can look at them closely

i plan publish analysis of other industries as i continue analysing them - though have not grand plan of specific industries in mind

rgds
rohit

Rohit Chauhan said...

Hi vic
on your question of firms like goldman etc ...i lumped it under investment banking . did not dig deep as it is a business as in the end it is still very individual driven and cant see strong competitive advantages there

these businesses are good for the empolyee, but for shareholders not really great

rgds
rohit

Rohit Chauhan said...

manoj / vic
on piramal healthcare, i think there were earlier comments. i looked at the post and plan to look at the company

on the face it appears an attractive idea, but i have to dig into it and have not done yet. i do respect prof bakshi's views, but will not invest till i am able to analyse and understand it well

rgds
rohit

Rohit Chauhan said...

vic
on arbitrage ..yes off late some of the deals have not worked late. think of it as tution fee ..analyse why they failed. overtime it will work out

happens to everyone, same for me too ..you make money in some and lose in some. hopefully gains will be more than losses

rgds
rohit

Rohit Chauhan said...

Hi anon
yes partly the industry has commodity economics like textile. the difference is that unlike textile as the marginal cost is low, there are scale advantages.

so there will be consolidattion, due to which the few large players will be profitable. the trick is to find the conservative managed player which will grow and expand well

rgds
rohit

Anonymous said...

I guess I wasn't clear on what I meant when I compared it to the textile industy when Buffett didn't continue.

In my mind I had the quote where Buffett said a mediocre business (Guess anything that looks like a commodity would fit in) remains so and how Munger said Buffett was saying he would discontinue the textile operations if there were more innovations in the industry. Basically that whatever improvement there is, will accrue to the customer than the owner.

With technology improvement, with progressive lowering of marginal cost, etc however many people survive after consolidation happens, if it does, they would be spending roughly equal amounts and stay wherever they are and with no way to differentiate their product from the competition it feels like it has to remain a commodity.

Rohit Chauhan said...

Hi anon
i understand your point. The economics of the industry is not great and quite similar to the textile industry.

My main point is that, unlike textile industry - brokerage has other advantages from scale, low capital requirement, associated lines of business such as PMS etc due to which the larger players will do better than a similar large company in the textile space

rgds
rohit

Anonymous said...

Rohit,

Can you please comment on the company - Financial Technologies, I had mentioned in my comment above?

Anonymous said...

I guess you didn't fully get my point. Because if you had, you wouldn't compare it again with the textile industry. The textile industry was used as an example. We can leave it out. If we follow the analogy further, we will be able to find something advantageous in the textile industry which makes up for the advantage you point out for the brokerage industry. The discussion would then go on and on.

The basic point is if improvements in an industry wouldn't benefit the owner but the customer it is no point investing in it. If it's a mediocre business, we should refrain from investing in it. Mediocre business which wouldn't give good returns would be commodity business like the above, ones which are capital intensive, etc.

I would says the quote “When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” talks about the business here. Bakshi wrote about Piramal recently. I guess we can say if Piramal takes on a brokerage business he can't do much. Neither can anybody else, as the quote says.

My conclusion from a discussion of the economics of the brokerage would be that it's best to not invest in it at all. I'll add that, of course, I may be incorrect :)

Rohit Chauhan said...

hi anon
i did not bring up the comparison with the textile business. also the discussion has nuances which we cannot discuss between us via comments.

my key point is this - the economics of brokerage are not great, but not as bad as a textile or maybe a cement/ steel business. as you say, there may be expections to it. the top brokerage firms may give decent results in the long term ..and so may the steel or textile company too. majority of brokerage companies are bound to do badly due to the competitive pressures

in the end we will have difference of opionion which is fine ...i still believe that the brokerage business will not be as bad as some of the other commodity businesses. time will tell

rgds
rohit

Anonymous said...

Firstly, I apologize if I'm being a pain and reiterating the same point again and again.

I agree that it can go either way. How can low margin business with no pricing power would be a good business is something I was not able to imagine. That is, I also assumed that the scale advantages which you mentioned would again be shared within existing players and wouldn't prove to be a advantage.

I read the latest post by Bakshi today. There was a line which indirectly answered what I was looking for but am not able to apply the same for a brokerage company. Since I don't understand the balance sheet, am not able to go further. Can you do the same and see if it makes sense for FT which the other 'anon' had asked.

The line was the following one:
"The big lesson here is that not all low margin businesses are necessarily bad. So next time, you meet someone who tells you that his business has very low margins, ask him or her about its capital turnover ratio, before making any judgments about the quality of the business."

I superficially understand the above line and his post in general but 'capital turnover ratio' is something I feel is out of my reach.

Hope this helps.

Anonymous said...

The economics should consider I guess the cash volumes on exchanges too. If they are low enough long enough, it might break a brokerage.

http://www.financialexpress.com/printer/news/792248/

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