Even though I am a stock broker myself, I have to confess that nobody really likes stock brokers. While our cousins, the investment bankers, are seen as prosperous, powerful dealmakers, we brokers are seen as a scruffy bunch of hustlers. Furthermore, given the extent of the economic downturn over the past four years, it has become fashionable to say that “stock broking is a structurally challenged industry”. Prima facie, the underlying reasons for the sluggish volumes and falling revenues of the industry are easy to see — competition is intense; investors have lost faith in equities; the internet might be disintermediating the conventional bricks and mortar stock broker; and the cost of keeping up with the latest technology is considerable. Since most investors believe all of this, it is not surprising that the share prices of broking firms are down by 80% from their peaks in early 2008. And that, for a contrarian investor like me, is good news.
When I invest, I look for situations where the market has fallen out of love with a sector that is essential for the functioning of our economy. Having identified the sector, I invest a small part of my networth in the best managed company in the sector. It is in this context that I find Motilal Oswal to be an interesting investment proposition.
While it is easy to view stock broking as an unfashionable backwater of financial services, it is highly unlikely that the sector will cease to exist. After all, the business of broking stocks is almost as old as capitalism. Ever since the Dutch East India Company issued shares that were tradeable on the Amsterdam Stock Exchange in 1602, stock brokers have been in business. At the heart of a modern free-market economy is the business of providing and trading risk capital. Without stock brokers, that engine clearly cannot function.
Given that the sector is not going to shrivel up and die, the trick, I believe, is to invest in it at a point in the cycle when the intensity of competition has inflicted the maximum damage on the sector. This usually happens right at the bottom of the economic cycle, which I reckon is H1FY14. Based on what I see happening to my competitors, I reckon at least a dozen substantive brokers have shut shop in Mumbai in CY13 as volumes continue to be weak (cash equities volumes in the Indian market are currently around ₹250,000 crore per month compared with around ₹450,000 crore three years ago). As the economic cycle recovers, and investors feel emboldened enough to buy equities, these volumes should recover. While brokerage revenues rise linearly with volumes, profits rise non-linearly, especially for the frontline brokers, thanks to the high fixed costs associated with IT costs, real estate and research analysts’ salaries.
Motilal Oswal is the best play on this dynamic (of rising volumes leading to disproportionately rising profits). The NSEL debacle notwithstanding, I see it as the best listed stockbroker in India due to: (a) its top flight research team, which also happens to show strong loyalty to the Motilal franchise; (b) its extensive and well-established distribution channel of nearly 1,500 branches across 500 cities; (c) its strong institutional broking business, which helps the firm maintain its robust revenue market share of around 5% even in the teeth of this economic downturn. These strengths mean that while Motilal’s operating margins have fallen over the past three years (from 42% in FY10), these margins are around 35% even now.
The bright side
But, some of you might say, “What about the fact that online stockbroking is fast gaining popularity?” In fact, when I visit the US, I don’t see any bricks and mortar stock brokers on the high streets of that vast country. It feels as if all retail broking has moved online. Even in India, the biggest retail stockbroker today is ICICI Direct, an online brokerage.
In this context, I think the NSEL fiasco is actually a positive for Motilal. While my colleague Aadesh Mehta estimates a one-time hit of ₹50 crore (or around 40% of FY14 operating profits) for Motilal owing to NSEL’s potential default on Motilal’s proprietary positions, episodes such as this make it difficult for online broking to really take off in India. As long as India continues to witness NSEL-type events, retail investors will continue to seek the reassuring presence of a local Motilal branch for their equity investment needs. Trading large amounts of money through a website will stay the province of only the truly tech savvy.
Even after factoring in the NSEL hit and even after assuming that the NSEL episode will almost wipe out the revenues from Motilal’s commodities business, Mehta estimates Motilal’s FY15 earnings per share to be around #9. My experience as a broker and as an investor over the past decade suggests that a well-managed broker should be able to command a 15X forward P/E multiple in a reasonable economic climate. These two items (₹9 and 15X) point to a per share valuation of ₹135 for Motilal Oswal (the firm does not have any debt.) To put this valuation into perspective, at the height of stock market the boom (in the early months of 2008), Motilal’s share price was around ₹430. At the time of writing this column in mid-December 2013, Motilal’s share price is ₹84, suggesting that there is ample upside in this stock as we enter an economic recovery. I prefer to be greedy when others are fearful.
The writer holds the stock in his personal capacity