Is it the right time to buy brokerage stocks?

Though the sector is likely to face a tough time in the coming quarters due to the poor market sentiment and structural changes, long-term investors can buy these due to their current low valuations.

Given the current market turmoil and the broader economic crisis, most sectors are in a flux and likely to face challenging times in the near future. Of these, the stock broking sector seems to be the worst affected, with most brokerages quoting close to their five-year lows (see Brokerages in a downturn). Considering that they are unlikely to reach their five-year peaks anytime soon and may rise only in the next few years, does it make sense for investors to buy these stocks? Or should they sell them before the going gets worse? Before we evaluate the stocks that might be worth investing, let us consider the issues plaguing the brokerage sector. 

Core business suffers 
Most brokerages have shown a significant drop in net profit in 2011-12 compared with that in the previous year. The main reason for this is the fall in trading volume, mostly because retail investors have deserted the market and FIIs as well as domestic institutions are in a wait-and-watch mode. Unlike the mutual fund industry, the insurance industry is still collecting some money, but this isn't flowing into the equity market since debt-oriented traditional policies have replaced the market-oriented Ulips as the major driver. Though their institutional broking business is squeezed by the fall in volume, only a few brokerages have actually cut down the costs here. Why? "The cost structure is high in the institutional broking business. If they scale this down during bad times, it will be very difficult to build it back later," says Santosh Singh, analyst at Espirito Santo Securities. 
    The slowdown in the capital market has also affected the other streams of income for stock brokers. Few companies are likely to venture out now with IPOs or secondary market placements. Likewise, there is a marked deceleration in the merger and acquisition sphere as well. 
    Besides the market slowdown, stock brokers are facing multiple challenges in the form of structural changes that are sweeping the industry. First, the competition from foreign players is increasing, especially in the institutional side. Second, the overall volume is shifting from the cash market, which offers a decent brokerage, to the derivatives market, where the brokerage rates are very low. Though the cash market volume picked up during the Jan-Feb period this year, it has gone back to the lows witnessed during Oct-Nov 2011. 
Diversification 
To mitigate the current problems, several companies are tapping other revenue streams and this part of their business is expected to show fair growth in the immediate future. According to a Crisil Ratings report, "New businesses, such as wealth advisory, assetmanagement, insurance distribution and retail lending, will contribute around 50% to the broking houses' profit in 2012-13, compared with about 25% in 2010-11." They are becoming aggressive in retail lending as well. While a significant part of this retail lending—loans against shares, margin funding 
    for trading, IPO financing—is related to their business, they are also entering new areas, such as housing loans and gold loans. "Diversifying in unrelated areas will bring its own share of problems and the brokerages may not be able to achieve big success in areas like housing and gold loans in the current phase of the cycle. The competition is high and the cost of funding for established players is low," says Singh. 
Stock picks 
    Since the fortunes of stock brokers are 
    linked to the market, the upside trigger 
    is possible only when the market picks 
    up. In other words, one can be positive 
    about these stocks only if one is positive 
    about the overall market. The situation is 
    likely in the long term because India can't get back to the 8-9% growth without a robust capital market. Once the market sentiment improves, there will be a marked improvement in the brokerages' net profit (due to the increased stock market activity) making a rerating possible for these counters. Here are the stocks that are likely to do well once the market improves. 
Motilal Oswal Securities 
The company will be a major beneficiary when the trading volume picks up in the future. Singh explains: "Motilal Oswal is a favoured player for any turn in equity volumes since it is a focused brokerage player with a high leverage in the cash market." Since India's cash market volume is close to the lowest level in the past four years, the risk of a further fall is low. This means that this stock should be able to maintain its current profit level even if the capital market sentiment remains relatively weak. 
JM Financial 
This stock is also likely to do well once the current bearish phase is over. "JM Financial is the market leader in IPOs, secondary market placements, M&As, etc, and its security lending business is also growing fast, offering the twin benefits of interest and increased brokerage income," says Tarun Bhatia, senior director, capital markets, Crisil Research. Crisil has given a fair value of 36 to the stock while its current market price is 12. 
India Infoline 
The company has earned good results from diversification. "Though its equity broking business has slowed down due to the lacklustre stock market, other divisions such as financing & investment, and marketing & distribution, are doing exceedingly well. With a network of 1,000 branches in 500 cities, the distribution business should continue to do well in the future," says Tushar Pendharkar, analyst, Right Horizons. The company has also shown growth in the insurance distribution and commodity businesses.