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.

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