Trading Up: Japan's Midtier Brokerages Catch the Urge to Merge

Potential acquisition targets, however, may not be great investments.
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Electrified by last week's announcement that three Japanese banks had struck an alliance to create the world's largest bank, investors are looking for the rest of the country's financial services firms to start recharging their batteries.

The alliance among

Industrial Bank of Japan

,

Dai-Ichi Kangyo Bank

and

Fuji Bank

not only creates a titan with $1.3 trillion in capital, it also forms a universal financial conglomerate with operations in everything from retail banking to fund management to securities brokering.

That reach is striking fear in the smaller brokerages, which analysts say are about to embark on a mad scramble for mates in order to stay relevant in an environment where both size and specialization will determine success.

"If you don't find a niche, speculation will mount that you need to be reorganized or merged," says Kazunori Jinnai, deputy general manager of equities at

Daiwa SB Capital Markets

, itself a creation of the alliance between

Daiwa Securities

and

Sumitomo Bank

.

The large firms, which traditionally have dominated the industry, have long known this. They've already struck alliances as they fight against domestic and foreign rivals, which are piling into the country in the wake of

Big Bang

financial liberalizations, for the estimated $10 trillion in savings the thrifty Japanese have squirreled away.

Nikko Securities

and America's

Travelers Group

formed a joint venture and

Daiwa Securities

has an array of operations it's running with partner

Sumitomo Bank

.

Smaller brokers, which traditionally have strength outside of the big money centers, are also coming together, although often through the hand of big banks anxious to build a presence in the securities industry.

Universal Securities

,

Taiheiyo Securities

and

Towa Securities

, for example, have been gobbled up by Osaka-based

Sanwa Bank

. And last week's

uber

-alliance will bring

New Japan Securities

and

Wako Securities

under its umbrella.

All this might tempt some investors to sniff around the sector in search of companies that might be potential acquisition targets. The brokerage subindex of the benchmark

Nikkei 225

has risen 21.36% over the past three months, a rise partly driven by speculation over which broker will be next. The Nikkei, by comparison, has risen just 8%.

Holding shares of the midtier brokers, however, may not result in more bang for your yen. Because the brokers' shares are characterized by illiquidity, prices are vulnerable to volatile price swings.

"Individuals are still not going to buy shares in midtier brokerage firms since they don't trust the market, the future of the firm or even their own future because they could be unemployed next year," says David Richards, an analyst at

Goldman Sachs

. The firm does not rate any of the midtier brokerages.

Among the most attractive midtier brokers, analysts say, are those affiliated with brokering giant

Nomura Securities

, Japan's largest broker and a fearsome competitor in both Europe and the U.S. It's the only Japanese brokerage that feels it's strong enough to remain independent.

Nomura, which many believe will convert itself into a holding company, has affiliates like

Kokusai Securities

,

Ichiyoshi Securities

and

Takagi Securities

.

Kokusai is one of the remaining stable and profitable midtier brokers, having a balanced business operation of stock and bond trading, as well as investment trusts. The company, shares of which surged 7.25% to 1,850 yen Friday amid reports

Bank of Tokyo Mitsubishi

was interested in taking a 5% stake, has managed to boost operating profits for the last three consecutive fiscal years.

Even cheaper are lesser-known sisters Ichiyoshi and Takagi, trading around 620 yen and 230 yen respectively. But both firms have not been able to eke out profits over the past two fiscal years.

Consolidation of the industry, of course, may put some brokers out of work in a country already experiencing the worst unemployment it has seen since the end of World War II. But it also underscores the need for banks and brokerages to trim their bloated staffs.

Hopefully, the staffing haircuts won't have to turn into crew cuts.