Financial Recovery Thematic 22nd February 2009

Financial stocks have been hit hard in the wake of the Credit Crisis. Across the financial sector the stock prices of banks, insurance companies and other financial institutions have sold off dramatically.

Investors can not see the wood from the trees, as extreme uncertainty and concern over capital adequacy have shifted the valuation process away from fundamentals. Despite the economic downturn, many insurance companies continue to sell insurance, pay claims and produce positive operation results. We believe that as the markets continue to normalise, investors will once again recognise their true value.

Background:

We argue that confusion with capital adequacy is the main cause of investor uncertainty over financial stocks. In the case of financial institutions, confusion proved lethal when the mere perception of a capital shortfall wiped out the equity of well known financial stocks in a matter of days. Investors are still uncertain about the capital injections from government bail-outs, sovereign funds and private sources.

It is easy to understand why investor uncertainty has reached the point of near panic. A base level of confusion has always existed for financial stocks given the combination of complex accounting rules and the unpredictable impact of decisions made by a patchwork of regulatory bodies.

Unfortunately, an additional source of investor uncertainty has welled up as a result of the dysfunctional capital markets. The abnormally low trading volumes in the current market creates difficulties in pricing assets; or the assets can be priced based on financial models. As a result of inactive markets, the capital adequacy of many financial companies rest, in part, on asset prices based on financial models.