Financial Services: The growth merchants

Money Today examines the rather underresearched but promising brokerage industry and finds that some firms are financial services powerhouses in the making.

R Sree Ram        Print Edition: April 3, 2008

What’s driving the growth

• Investment banking
• Consumer and infrastructure financing
• Retail participation in equity markets
• Distribution of financial products

Factors to watch out for

• Reach of company ’s network
• Products and services offered
• Talent to handle diverse business
• Investor sentiment in equity markets

The broking industry has come a long way from just serving day traders a few years ago to what it is today—a multi-pronged business providing a range of services from brokering, investment banking, equity research, margin funding, distribution of mutual funds and insurance products, and even good old fashioned moneylending. In the past few years, brokerage houses have acquired a substantial number of long-term customers. While buoyant capital markets and rising incomes have encouraged Indians to route their savings into equity linked products, broking houses have earned bushels of money in commissions and fees. And analysts believe the best is yet to come.

“This seems to be an underserved sector. High savings rate in our economy and low ratio of savings finding their way into equity markets provides a humongous scalability for the sector,” Sandeep Shenoy, a strategist at PINC Research said.

Large broking companies are also moving into what has traditionally been the turf of the banking sector. While broking brings in the biggest chunk of the revenue, it is a volatile business. That’s why analysts expect these companies to focus on non-broking businesses to steady and shore up revenues. “The future of the financial services industry is strong given a growing economy, favourable demographics and an inadequate banking sector,” says Apurva Shah, vicepresident, Prabhudas Lilladher.

An important and growing stream of income is the distribution of mutual funds and insurance policies. While they earn around 2% commission from selling mutual funds, life insurance is more lucrative with 20% commission earned throughout the policy period. The biggest advantage in cross selling is that there is no need to ramp up the workforce or make substantial investments. They just leverage on their existing network. “Distribution is definitely going to be a big business and so would be consumer lending. We could see the emergence of a few strong nonbanking financial companies in a few years,” says Shenoy.

Investment banking is another growth area. Backed by strong research teams, these brokerages have a finger in every pie. They are guiding private equity investments into the country, arranging venture capital and managing public issues—in short, making money in every strata of investment banking. Though growth potential is strong, what investors need to watch out for is the lack of transparency in this industry. There is not much research available on these companies and most leading brokerage houses prefer not to evaluate their peers. Plus, computing the fair valuation is a complex task because most of these companies have interests in several areas.

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Broking business valuations are best captured through enterprise value to sales (EV/sales) as their business or profitability is not dominantly dependent on the underlying assets; instead their sales or growth determines the fair value. While price to book value (P/BV) ratio is a yardstick for lending companies, diversified businesses like Reliance Capital and IDFC are best valued by sum of the parts valuation (SOTP).

In the broking space, India Infoline and Edelweiss are the highly recommended stocks. India Infoline, which has around 4% market share in the broking business, is aggressively venturing into high margin ventures such institutional broking, investment banking and consumer finance business. With a branch network of 675 outlets, analysts expect it to become a one-stop shop for financial products.

Reliance Capital is giving serious competition to established broking houses as well as insurance companies. Going by its explosive growth in the mutual fund and life insurance businesses, analysts expect its revenues to double in 2007-8. The company has also forayed into broking, with more than 3,400 branches and online facilities.

“It has capital to invest (a constraint for many), it has the necessary skills (its management team has experience in these businesses), and it is setting up a broad distribution platform (which is very important, given that most of the financial products are ‘push’ products),” Morgan Stanley noted while arriving at a five-year target price of Rs 4,121 using the SOTP valuation.

Ready to invest in these financial powerhouses of the future? Experts advise investors to stay clear of the sector if they are planning to make quick buck. “There will be a hit in the near-term due to the turmoil in global markets. But we see no problems over a 2-3 year horizon,” says Shah.

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