CategoryIndustry analysis

• Switching cost due to customer relationships
• Economies of scale
• Small barriers due to specialized skills in specific verticals such as insurance, transportation etc
• Management. This is a key source of competitive advantage in this industry and explains the wide variation of performance between various companies operating in the same sector with the same inputs and under similar conditions.

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

I recently made a discovery – The higher the market goes, the more I get a lot of intellectual thoughts. This is exactly reverse of a lot other people who seem to be finding a lot of good ideas to invest in the market. Well I guess I may have to work a bit harder to find something good …sheesh why isn’t it easy to make money in the market 🙂 ?

All IT stocks overvalued?
I was not precise enough in my previous post. I think some of the large cap IT stocks are fairly valued, if not overvalued and hence there is no margin of safety. That is they are priced for perfection.

The same may not be true for several midcaps, though I think one cannot make a general statement. As I have written in the past, general statement such as ‘market is overvalued or undervalued’ are meaningless and the same holds true for IT stocks too. So let me be more precise – companies like Infosys, Wipro and TCS seem fairly valued.

In case of Mid –cap IT companies like NIIT tech, patni or hexaware it is not as clear, atleast to me.

I typically value stocks using 3 different approaches at the same time. The first approach is the discounted cash flow – try to estimate the future cash flow (or earnings) and then discount them to arrive at a net present value. The second approach is to look at past valuations of the company and compare with the current valuation. The third approach is to look at the relative valuation of the company with others in the same sector.

I try to evaluate a stock on all the three approaches and see if they are pointing in the same direction. A stock may appear undervalued in terms of the DCF value and with reference to other companies in the sector, but appear fairly valued compared with its past valuations.

Now such a situation, which is currently present in case of Mid-cap IT and some cement companies, definitely throws up a key question for me – Why should the market value the mid-cap IT companies at a higher level in the future than it has done in the past ?

A typical case where the market values a company at a higher levels than in the past is when the growth or return on capital of the company has increased and the market now thinks that the company has a much better future and prices it accordingly.

In case of mid-cap IT companies and various other mid-caps, I am grappling with the same question – what is it that I know which the market has not considered, that would cause it to value it more in the future. In some cases it is easy to figure that out, but I am not able to figure it out in case of IT companies.

Hence my statement – Some IT-midcaps may be undervalued depending on your point of view. My point of view is that i can’t think of any unrecognized factors which may cause the market to re-price these companies upwards.

On the contrary I can only think of negative factors, several of which are not yet priced into these stocks. You may have a better insight on factors which may cause the market to value these companies higher and so both us are correct from our respective points of view.

The problem with stock tips
Moving on the next general thought – stock tips. Regular readers to this blog know that I am totally against stock tips. Other than the reason that I think that most of the stock tips are given by the unethical to the unsuspecting, I also believe that such tips do not help in the long run.

It is easy to take stock tips and follow them in a bull market. Even a dart throwing monkey can come up with some profitable ideas (unfortunately I am not as smart as this monkey during bull runs :)) and it would not difficult to follow them. How many of us will have the courage to hold on to such stock tips when the market drops or add to such positions? I cannot speak for others, but I definitely cannot blindly follow others when the market is in a free fall.

The only way one can follow stock tips or such a person is to understand that person’s underlying approach and then have some amount of blind faith on the skills of such a person. So the next time you decide to follow someone else stock picks, remember that you are putting some amount of blind faith in that person, which will be tested when the market drops (which it will sooner or later).

How to get decent return these days?
One of the readers asked me a question on the previous post – how do I make decent return these days when a lot of stocks appear overvalued and fixed income options don’t give much returns?

I don’t have an easy answer – if I had one, don’t you think I would be using it?

The first option is to keep analyzing stocks everyday (as I am doing) and hope that you may hit a few good ideas in due course of time. If you can find a few such ideas, you will have to have the courage to buy such stocks, knowing fully well that such stocks could drop if the market were to drop suddenly.

The other option is to do nothing and sit tight. This option is not easy too as you will have to watch your friends make easy money while you sit like a dumb dodo, doing nothing.

Either of the options are not easy – in one you face the risk of losing money (atleast in the short term) if the market drops and in the other you are foregoing easy money. You have to choose your poison.

It’s not that I have always been a bear on IT companies. I have held NIIT tech, Patni computers and Infosys are various times over the last 5-6 years.

You can see my analysis of NIIT tech here and patni here.

The main reason for my bearishness is simply ‘valuations’. Mid cap companies like NIIT tech or patni and maybe a few others could be slightly undervalued (depending on your point of view), but I find it difficult to see the undervaluation in large caps such as Infosys which are selling over 30 times their current earnings.

A lot of the IT companies are priced for perfection which as we have seen never happens in reality. In the alternative universe of brokers and tipsters, the time to buy IT stocks was in 2000 and now and to sell was in 2008. We do not know how things will turn out in the future, but can clearly say from hindsight that 2000 was the time to sell and 2008 was a decent time to buy.

The advantage (or disadvantage) of having a blog for more than 5+ years is that all your past thoughts and statements are online and can be referred back at any time. In 2008, I felt that IT stocks, especially midcaps were extremely undervalued (some selling for PE of 2 or 3) and hence were a bargain. It was not a macro point of view, but based purely in valuations (you can read the post on it here)

Getting the timing wrong
My decision to start buying into some of the IT midcaps was based on valuations and a belief that the underlying economics of the IT service space was still attractive and the companies would continue to be profitable in the long run.

I had no clue that 2008 and 2009 would be such a disaster ( if I knew, I would have bought put options and retired by now 🙂 ). So clearly, in hindsight the best time to buy was 2009.

However one cannot make investment decision based on hindsight and so mere mortal like me (unlike some of the forecasting gurus ) have to base their decision on current valuations and expectations of reasonable business conditions in the future.

Still no idea of the future
As I have still do not have any special powers of knowing the future, my current view on IT stocks is centered on valuations and some of the long term headwinds faced by the industry such as
– Dollar depreciation : when and by how much …who knows, but more than likely to happen
– Increased costs : If you are an employed with an IT company, a point to remember is that everytime you get a good raise in salary, it comes from the bottom line (no there is no santaclaus paying for your salary)
– Intense competition: From other IT companies which is likely to drive down returns in the long run
– Host of other factors: regulation, slow growth in developed markets etc etc

The point is that the current valuations do not reflect these risks. Ofcourse you can make a point that current valuations for a lot of companies do not reflect the risk – but that is whole different story.

So what to do ?
Nothing much – sell if you think the stocks are overvalued and yes, be prepared to look like a fool if the stocks keep zooming up after you have sold. I have done that for most of my IT stocks and I am fully ready to look like a complete fool.