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The Securities Brokerage Industry is cyclical and comprised of two distinct types of businesses. Brokerages, also known as financial services companies, strive to meet the investing needs of their clients, and exchanges facilitate securities trading. Net profits correlate to the performance of the broader equity market. Some hold up better than their peers during bear markets.

Brokerage Basics

Brokerages are fairly diversified. A big chunk of the top line comes from filling buy and sell orders from clients. There are two ways in which a broker can meet a client's trade request. The broker can act as an intermediary, matching a customer's buy order with a third-party's sell order and vice versa. In this capacity, the broker acts as an agent, receiving a "Commission" (highlighted on the Value Line page). As well, the broker can act as a principal, meeting a customer's order from its own inventory. Revenue from this activity falls under the heading "Principal Transactions"; it may include gains and losses on the brokerage's own investments. We usually classify fee-based revenue as "Other". Fees are calculated as a percentage of a client's assets, and stem from managed mutual funds and specialized, high-net-worth accounts.

Brokerages also report on the top line "Interest Income", consisting of interest earned on investments and dividends, minus interest paid on debt. Lastly, a number companies generate "Investment Banking" revenue through underwriting and advisory services, involving stock or bond offerings and mergers or acquisitions. While Principal Transactions, Interest Income, and Investment Banking revenues are tied to prevailing economic conditions, Commissions can be more stable during down markets, especially if client trading increases.

The largest non-interest expense for full-service brokerages is workforce compensation. Employees are rewarded according to the amount of commission, trading and/or investment banking revenue that they contribute. They may receive either a percentage of revenue generated or a year-end bonus. Discount brokerages limit their compensation exposure by providing electronic services. Full-service brokers provide personalized service and in-house research. Electronic brokers offer more bare-bones service to seasoned clients who are looking to save on fees. (Note: Our reports on electronic brokers follow the standard industrial format.) A brokerage's profitability is determined by trading volume, fees charged, worker compensation and fixed operating costs. In periods of high trading volume, brokers' operating and net margins can easily expand into double-digit territory.

The companies in this industry have varying levels of debt on their balance sheets. Large brokers, doing significant investment banking business, often carry heavy debt burdens with the aim of maximizing leverage. Savvy investments can yield outsized gains, but serious missteps can lead to hefty losses. Companies dependent on commissions tend to be managed conservatively and hold lighter debt balances.

The Function of Exchanges

Exchanges provide a marketplace for traders to buy and sell securities. In years past, trading took place on large open floors, where buyers and sellers engaged in face-to-face transactions. Today, most exchanges utilize electronic systems, which allow for fast, efficient trading. A few still use traditional trading floors, but in conjunction with an electronic system.

Exchanges generate revenue in several ways. Those that concentrate on the equities market collect fees from listed companies. Both equity and derivative exchanges receive a payment for each trade that takes place on their platform. The top lines of these companies perform quite well during volatile markets. Another source of revenue comes from supplying market data to financial information providers. Too, revenue may be produced from developing, marketing and distributing technology used in trading and information processing. Among other means of generating revenue, an exchange may clear third-party or in-house trades.

Compared with those of brokerages, the cost structures of exchanges are more fixed in nature. Operating performance is linked to transaction volume. Margins expand as trading increases, and the reverse is true when activity slows. Reductions in fixed costs enhance operating leverage. Generally, exchanges do not assume heavy debt burdens. Substantial debt, however, will be taken on to complete a promising acquisition. Managements endeavor to quickly lighten the burden with improved cash flow.

This sector of the industry has, indeed, undergone consolidation. Domestic exchanges have merged with foreign bourses to gain diversification. Also, many have acquired small competitors that offer attractive market niches complementing existing operations. For instance, companies that focus on equity trading have expanded the scope of business by acquiring options exchanges.

Conclusion

Given the cyclical nature of this industry, investors have to be willing to endure a healthy dose of volatility. Most Securities Brokerage issues carry above-market Betas (1.00). Since the equities market is a leading indicator of the prospects for the broader economy, investors need to be attuned to the business cycle in order to commit at an opportune time. Though not a big lure, several companies, here, do pay a dividend. All considered, these stocks are best suited to those seeking worthwhile price appreciation potential and able to stomach a sizable helping of volatility.