A paper which investigates the investment industry and banks.
Industry The investment industry is composed of a wide variety of firms. The main players include independent full line brokerage firms, investment bank subsidiaries of chartered banks, and discount brokers. Independent full line brokerage firms offer a wide range of services, including underwriting, trading of stocks, advice and research. In essence, the full service brokerage subsidiaries of chartered banks offer the same services, however, banks’ brokerage firms may have a larger pre-established clientele. Finally, the discount brokers are basic stock brokers that perform trades for clients who do not want investment advice. Usually, this service is targeted toward the sophisticated investor who does his/her own research to incur minimal commission fees. Banks entered the investment industry in 1987, whereby they took over full-service brokerages, introduced mutual funds to the banking industry and became part of discount brokering. From this time on, chartered banks have expanded their dominance in the industry by acquiring key players in the industry or branching off into full brokerage services. For example, the brokerage firms for CIBC, Royal Bank, Toronto Dominion Bank, Bank of Nova Scotia and Bank of Montreal are Wood Gundy, RBC Dominion, Evergreen, Scotia McLeod and Nesbitt Burns respectively. In addition, the aforementioned chartered banks have also branched into the discount brokerage sector. As of December 1994, the Securities Industry as a whole included 158 firms, directly employs over 24,000 people, has operating revenue of $5.1 Billion and operating profit of $1.2 Billion (Appendix A). Within this industry the largest firms ranked by revenue are: RBC Dominion Securities ($1 Billion), Midland Walwyn ($480 million), Burns Fry ($416 million) and Nesbitt Thomson ($335 million) (Appendix B). It is evident that the industry is highly concentrated in a small number of companies. The top 4 leaders in the industry accounted for 44% of revenue, while the top 8 was 51%. Industry information from 1993 displays further segregation, between retail, institutional and integrated firms. Integrated retail-institutionalized firms (RBC Dominion Securities, Scotia McLeod, Nesbitt Thomson, Wood Gundy) made up 66% of the industry’s revenue, while strictly institutional firms (First Marathon Securities, Gordon Capital Corp. and Loewer Ondaatje McCutcheon Ltd.) made up 21% and Retail firms (Green Line Investor Services Inc.), 15% (Appendix C). The following analysis will outline the investment dealer’s industry, specifically the life cycle, critical success factor, strengths, weaknesses, target markets and profitability. Life Cycle The demand for investment financial services is expanding. This becomes evident by examining the average increase in revenue which has occurred over the 1990-1994, 5 year span. This amounts to a 114% increase in revenue, ($2.4 Billion and $5.13 Billion), (Appendix A). An additional indication of growth in the investment industry is the fact that the number of firms in the industry has increased from 119 in 1990 to 158 in 1995, and 163 by the second quarter of 1995 (Appendix A). Furthermore, firms are entering the market because they realize the increasing need for investment services as well as the potential for profits. It is obvious that the industry is growing, however the cause for this growth must also be addressed. Firstly, demographics of the Canadian society point towards an aging population. This aging society is comprised of active retired and semi-retired individuals who have knowledge, time and disposable income for investing purposes. Moreover, younger generations who fear the elimination of the existing CPP because of the aging population, are interested in “building a retirement nest egg.” (Fine, p. B21) Secondly, the fact that people want to be more educated about the investments industry, ties into an additional cause for growth in the industry. The market is offering more information to those who want to be part of it. This additional information reduces investors’ fear of not knowing enough, and if they choose to take advantage of the available information they can capitalize on it. Also, more information gives people the perception that they are able to make an increased number of higher quality investment decisions. Finally, the entrance of banks into the industry has increased public interest. First of all, banks carry a great deal of trust which is extremely important to the average investor. Second, banks are higher profile marketers so they reach a larger number of people. In addition, the large number of branches makes the product readily available and easily accessible. Banks also have a large existing customer base to which they can market products, and influence investing. Overall, banks have increased the demand for investment services by creating interest and awareness to people who would otherwise not give extensive consideration to investments. Critical Success Factors The investment industry is very volatile in that the upward trend in today’s market does not guarantee the same trend tomorrow. Investment dealers cannot fully command the direction of their profits. The market they work with, i.e. capital markets, is greatly affected by external factors. Falling stock and bond prices can negatively affect industry profits, because they reduce capital market activity. In addition, volatility is affected by consumer confidence. If unsophisticated investors believe the market is unstable and fail to realize the problem may only be a rumor, then they may all pull out at the same time causing upheaval and drastic downturns in profit. In such a situation, investment dealers have no control over the situation or their profits. Every investor suffers the consequences of volatility. However, even though this volatility exists there are means to attract investors to the capital market, thereby outperforming competitors and increasing revenue derived from service fees. First, the investment dealer must build trust with the investor. This is of extreme importance to the potential client because of the amount and importance of the funds that they are investing. More importantly, trust is needed in order to attract new clients, through word of mouth, and maintain existing ones. Second, the client is greatly concerned with the performance or returns of their portfolio. Even though the market is volatile, the investment dealer is trusted to properly assess their clients’ financial situation, level of risk aversion and investment decisions in order to establish the best portfolio. Their ability to carry out these functions will influence, to a certain degree, the performance of the investment dealer, i.e. through returns. Third, customers want continuous high quality service. This means that in addition to the service provided at the time of the portfolio selection, they also want a relationship with the dealer. Specifically, the customer may want to be kept informed on their portfolio as well as changes which may be occurring in the market. Being able to continue this high quality service will prove to attract many unsophisticated investors and establish a long-term clientele. At this point, it is important to know that the investment dealers must have the expertise to identify which investors want this service and which don’t. Their failure to do this may actually cause the loss of sophisticated investors who do not want to be bothered. In short, “clients said the most important factor in choosing an investment firm was trustworthiness, followed by performance and service” (Roseman, p.B18). Aside from these three factors, the speed of processing transactions has equal importance to a customer. Since prices change very rapidly in this volatile industry, timing is everything,. For this reason, customers would prefer to have immediate accessibility to the trading floor without going through the middleman. Present changes indicate that the industry is headed in this direction. Presently, Instinet Corp. has introduced a new technology, Instinet, which allows foreign securities to be traded through electronic trading terminals thereby bypassing the broker’s responsibility to contact a trader on the costly exchange floor (TSE). The trade would no longer require attendance to the exchange floor, since the transaction could be done electronically at designated institutions. Eventually, investment brokers will have to excel in areas which cannot be replaced by electronic technology, i.e. research, knowledge about the industry and building a trusting rapport with customers. Strengths and Weaknesses The securities industry (and the financial services industry in general) is highly automated and technically advanced. This allows the industry to operate efficiently and cost effectively. The marginal costs of processing a $10 transaction and a $10-billion one are negligible (Campbell, in Dermer: p. 237). Technology gives investors (the clientele) the ability to make transactions easily and quickly. Therefore, investing becomes more attractive because of the relative ease and convenience of trade execution. The cost effectiveness of the industry also allows it to compete abroad with larger brokers thus increasing its customer base. The entrance of banks also boosted competition and led to further reductions in costs. Chartered banks have also given the industry a boost because of their large client base, credibility, high-degree of technology, marketing expertise, and “retail store” environment. Banks can offer an entire array of financial services and instruments which provides a great deal of convenience. Customers can easily open direct trading accounts with their branch and make transfers to and from their savings accounts. This “one-stop shopping” approach has made the securities industry more attractive and strengthened it. Although law prohibits the transfer of financial information about bank clients between banks and their investment dealing subsidiaries (to maintain confidentiality and credibility), the banks can still act as channels of information to potential customers. Toronto Dominion Bank, for instance, offers S.S.Q. points (Sales, Service, and Quality) to their customer service representatives whenever referrals are given for a TD-Green Line (discount broker) or TD-Evergreen (full service) account. In essence, the industry has a large number of indirect employees acting as agents for their services. This creates awareness, and helps boost demand. A growing interest in the industry in terms of education can only help strengthen the industry. In the past year, 21500 students took Canadian Securities Institute programs, this number being 53% higher than the previous year (Fine: p. B21). This translates to a high number of knowledgeable people being employed within the industry. This helps the industry in that customers are better served, and thus they are inclined to invest more due to the fact that they trust the investment dealer. As such, more cash flow into the market means more profits for the investment dealers due to increased commissions. The industry’s dependence on the performance of the securities markets can be considered a weakness. This is because the industry’s main purpose revolves around the stock market itself. Thus if the stock market is lagging, profits will fall due to a lower number and value of transactions. In addition, firms are much less willing to enter a bearish market for new financing. This is also the case when firms are doing well since they may not require increased financing and may not need the services of an investment dealer (for underwriting) (IDA bulletin p2). Unlike banks who have CDIC protecting the accounts of their customers, investors portfolios are in no way secured in terms of value. This creates a negative sentiment towards investing because highly risk averse individuals would rather lock up their money in the bank. Profitability The Brokerage Industry derives the majority of its income from commissions (43% of 1994 revenues), underwriting (21%) and fixed income trading (16%) (Appendices A & D). Since most of the revenue comes from commissions, it is apparent that revenue is largely dependent on volume and value of transactions. Transactions volume and values are dependent on the performance of the stock market. For example between 1992 and 1993, the TSE 300 gained approximately 29% in value. Reported operating profits for 1993 were $1.7 billion ($726 million net), which was up from 1992’s operating profit of $676 million ($253 million) (Appendix A). Between 1993 and 1994 the TSE 300 lost 3% of value and this resulted in a decline in profits during the same period of $500 million ($300 million net). Thus, shifts in the stock market affect the stability of the industry’s profits. Financial Ratios Analysis of important financial ratios can help provide a better picture of the industry as a whole. Examining the quick and current ratios for some of the larger firms in the industry shows that investment dealers have an equal proportion of highly liquid assets to short term liabilities (approx. 1.0). This shows that the firms have little in terms of a maturity mismatch. In addition, accounts receivable as a percent of total assets is quite large (approx. 91% for Fahnestock Viner, and 65% for Midland Walwyn). This shows that the industry relies on its ability to give its clients lines of credit and the ability to finance them. In addition, the high level receivables increases the level of default risk for the industry. Thus, one must look at the quality of these receivables (that is who are these debtors) to evaluate the level of risk to the industry. Furthermore, these receivables can be a source of revenue for the dealers, for example, interest received from margin accounts. Conclusions Based on the above discussion, it is fair to say that the industry has a positive outlook for the future. This can be said despite the industry’s dependence on stock market activity. A growing interest in the industry is proof of this, as the number of firms involved is increasing as well as the number of professionals entering the fields within the investment industry. An additional indication of the industry’s growth is the increased participation of Canadian Banks, combining one of Canada’s most vital industries with the investment industry. As the public becomes more aware of the potential gains from investing, the future of the industry will be reinforced. Long gone are the days when people held large sums of money in static bank accounts. Rather, a changed population (in terms of education, demographics etc.) is seeking a dynamic investment which can earn greater returns than a bank account. Considering this new demand for securities, investment dealers have a greater incentive to devise additional attractive financial instruments in order to attract the undecided. In short, a need for greater returns leads to increased asset demand thereby increasing market activity which in turn will strengthen the investment dealer industry as a whole.