Essay/Term paper: The investment industry

Essay, term paper, research paper:  Economics

The Investment 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.