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China’s biggest broker looks past doldrums with IPO

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China's equity markets are in the gutter but looking up at the heavens. The initial public offering of China Galaxy Securities, the country's biggest broker, is a bet that what has gone down must at some point go back up.

Launching the IPO of a brokerage seems counterintuitive at a time when China's investors are shunning stocks and regulators have imposed an embargo on domestic offerings. Not only have trading volumes in mainland shares fallen 25 per cent in the past year, but commissions have been shrinking too, as more than 110 securities companies scrap over a shrinking prize.

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Investors are thus being asked to focus more on what might be than what was. Galaxy has shed 20 per cent of its staff since 2010, as its pretax profit has fallen by half, and focused instead on bits of its business that aren't in the doldrums. As China's second biggest underwriter of enterprise bonds, Galaxy can at least tap into a market growing at more than 30 per cent a year.

Securities companies in China are basically a leveraged bet on financial reform: even a small opening up of new markets can be significant for their revenue. Take margin trading. After the regulator said it would increase the number of stocks and funds that can be traded with borrowed money to 500 from 280, the amount of stock bought with leverage has shot up. Galaxy's lending to customers increased by 80 per cent in the first quarter of 2013.

That leaves more to play for. Leverage among China's securities firms is only around two times, while global firms like Nomura and Morgan Stanley have leverage multiples in the teens. Galaxy's return on equity of 8.5 per cent is already higher than listed rivals Citic Securities and Haitong – piling on more assets should juice that up.

And if China's stock markets recover in the meantime, Galaxy should benefit more than its peers, since it lacks Citic's large investment bank or Haitong's sizeble asset management business. Whether they will recover is anyone's guess, but then an investor buying into a brokerage IPO in a weak market is nothing if not an optimist.

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