While share brokers have the expertise in hand-picking stocks to buy on the BSE, stocks of brokerage companies are themselves at the trough. Espirito Santo Investment Bank Research has a ‘buy’ recommendation for Edelweiss and Motilal Oswal Securities

Indian share brokers have underperformed the BSE-200 index since 2011 as all sources of income have been declining. The broking industry is going through challenging times, according to Espirito Santo Investment Bank Research in its market update report. Investment banking (IB) business has been weak given few deals in the market. The broking business market characteristics include:

• • The fee pool peaked at nearly $1bn in 2007 and has been $350-$650 million since, and could be sub-$250 million this year. The third party fee income from distribution has been under pressure due to adverse regulations in life insurance and mutual funds since 2010.

• • Financing business has a high correlation with the stock market and hence it has also been declining significantly.

• • The share of cash volumes seems to have bottomed out (share has remained around 10% for past four quarters) and the intra-segment yields have stagnated.

• • Thus, share brokers have been in challenging times due to low cash volumes and weak IB deals.

According to Espirito Santo Investment Bank Research (ESIBR), Indian share brokers are trading at trough multiples relative to both their history and global peers. ESIBR is not expecting a dramatic recovery, but it thinks the majority of the risks have played out, capacity is coming out and current valuations are too bearish. It says that it recommends ‘buy’ of MOFS (Motilal Oswal) and EDEL (Edelweiss) and highlights MOFS as its preferred pick. Valuations may be depressed without a catalyst for rerating, so these are stocks only for investors with a medium-term outlook.

The challenges faced by share brokers in India include:

• • Low cash volumes

• • Low trading velocity

• • High competitive intensity

• • Low investment banking and other income

• • Low third party distribution income

• • Proposed cap on brokerage, by SEBI

According to ESIBR, given the challenging environment most of the share brokers have seen a huge reduction in their profitability as operating costs have increased considerably. However, some share brokers like Motilal Oswal, due to their variable cost agency structure, have been able to broadly maintain their margins. Also, some share brokers have diversified away from the capital markets to other financial services segments to counter the revenue decline. For example, broking revenue for Edelweiss is low. It is less than 30% of total revenue as against more than 50% in FY11.

In an answer to the question, what could trigger a reversal in trends for the broking companies, ESIBR says the following factors could help in revival of business:

• • Positive macro environment

• • Return of IPOs

• • Revival in asset management and life insurance industry

• • Steps being taken by SEBI to increase the reach of mutual funds and increase retail participation

• • IRDA’s attempt to revive pension products

• • Proposed Rajiv Gandhi Equity Scheme by the finance ministry

While share brokers have expertise in hand-picking stocks to buy on the BSE, stocks of brokerage companies are themselves at the trough. Amidst this irony, Espirito Santo Investment Bank Research has a ‘buy’ recommendation for Edelweiss and Motilal Oswal.