After many years of lull, the bulls finally came back to the Indian stock markets in the latter part of 2013 in the run up to the general elections. After the Narendra Modi-led single majority government came to power, investor enthusiasm saw a new high. Investors who had shunned the stock markets in the aftermath of the 2008 stock market crash came back to the markets in droves.
As an investor, you might be tempted to consider investing in stock broking companies given that they are direct beneficiaries of bullish sentiments and increased investor participation.
Sure, the stock broking business may have received a boost in the current market scenario. But if that is the only reason you think makes a good case for investing in brokerage businesses, then let us caution you.
Let us consider the business fundamentals of brokerage firms.
Firstly, broking is a highly commoditised business, where the intensity of competition is very high. This means practically no bargaining power.
Secondly, the business is highly cyclical. Since the business depends on trading turnover, bear markets can be tough time for brokers. Particularly, market crashes can wreck havoc to the fortunes of brokers.
Here is proof...
After the 2008 crash, many small players had to shut shop.
The ones that survived diversified into other businesses. As per an article in The Economic Times, today none of the top brokerage firms get more than 10% of their revenues from the broking business. Some areas of diversification include real estate advisory, retail lending, property loans, health cards, gold refining, trading of renewable energy certificates, and so on.
In our view, if companies are forced to diversify into unrelated businesses simply to be able to survive tough times, then the long term durability of such businesses may be highly uncertain and unreliable.
As such, we believe it is best for long term investors to keep away from such business models.