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Some market products look like a triumph of ingenuity over reality – so don’t bank on them. Peter Webb explains why money may make the world go round but financial stocks don’t make his head spin

During the recent turmoil in the markets I have exchanged many thoughts with other investors about which stocks look cheap and which don’t. There is no doubt that banks have been hit hard and there could be some value in these. However, I have generally always declined to invest in certain financial stocks. There are clear reasons why.

When I look at an investment, I look at many aspects of it, but an important part of that assessment is the question: ‘Do I understand the business?’ Can I make a fair judgement on not only its current state but its likely future as well? I then file the investigation into the ‘easy’, ‘difficult’ or ‘too hard’ category. To understand my thoughts on financial stocks lets understand where banks have come from and gone to over time.

A brief history of banks

In the old days, precious metals were currency, being exchanged for goods and services. People lodged their spare gold coins with goldsmiths for safekeeping. This was effectively a warehousing business and the coins were stored on shelves or ‘banks’ as they were called.

‘Bankers’ began to notice that between deposits and withdrawals, only the coins at the front of the shelves moved. So they began to use the ‘spare’ money for their own purposes by lending them out to borrowers.

Borrowers then used these coins, the recipients of those coins then deposited them in their banks and the banks then issued new deposit receipts to them. The receipts, or promissory notes, themselves started being used in lieu of coins, and became the first paper money.

Eventually the discrepancy became so obvious between the number of coins and the amount of gold for which receipts, claims or paper money had been issued – and the number of coins and the amount of gold available to honour them, that many people were questioning the value of the claims and refused to accept paper money in any of its forms – the banking system faced a crisis.

However, governments had also worked out that issuing receipts against gold was a good way to fund wars and other things, so stepped in to create the regulatory and banking systems to ensure the integrity of paper money; the fractional reserve banking system was born.

Over time this evolved further and the modern capital adequacy system evolved, where reserves are no longer required except to the extent needed to fund the bank.

No longer needing to worry about maintaining reserves, banks could now lend without concern for how much they have on deposit. If they lend more than they have on deposit, they simply add to their deposits by borrowing overnight. Banks tot up their net positions and borrow money to balance their capital requirements. Come the morning and the whole process starts again. Lending out spare coins and real assets is now a very distant memory!

There is little underwriting – the lending system now accepts, as we have witnessed, the willingness of governments to ensure the system does not grind to a halt.

Things are much more complex nowadays with derivatives, which often have unknown gains and liabilities. Unlike the traditional lending system, where checks, balances and adequacy are in place, derivatives often offer no real scope for easy valuation.

Valuation? What valuation

Banks can report valuation of financial instruments in a number of ways. At the most basic level, the values come from quoted prices in active markets. Mark to market is the act of assigning a value to a position held in a financial instrument based on the current market price for that instrument. Mark-to-model is to price a position or portfolio at prices determined by using a financial model to estimate value from the similar market prices readily available rather than actual market prices. The final method is to value positions based upon using ‘unobservable inputs’. While companies can’t actually see the changes in the fair values of their assets and liabilities, they’re allowed to book them anyway, based on their own subjective assumptions.

It obviously makes sense to understand how much debt, or potential for debt, a company has when you are buying shares. Try as I might, I find this almost impossible with a lot of financial stocks. Getting an accurate position for these companies requires you to know things that you can’t easily get to grips with. The worrying thing is, neither can most people who deal in these instruments! They are targeted on booking them through the system rather than assessing their true value. There are known examples where both the buyer and seller of these derivatives have booked a profit, which is of course impossible. The markets are starting to learn that the complexity of these types of holdings is also creating unknown potential for problems.

Given the fragility of the situation, valuing the assets and liabilities of quite a few financial stocks has meant that I end up filing them in the ‘too hard’ category; I just can’t make a reasonable stab at working it out. While I may miss a few opportunities, I would much rather miss upside than the potential for significant downside, and it’s that rationale that I suggest you also follow as a longer-term investor.