3 Ways to Preserve Capital

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Amid the current massacre in the credit markets, nearly every financial-services company is getting pounded -- some much worse than others.

Value-oriented investors thrive in these types of panic-driven markets, because they usually provide good opportunities to buy businesses on the cheap. The panic surrounding the salad-oil scandal of the 1960s enabled Warren Buffett to scoop up a large chunk of American Express (NYSE: AXP) for a ridiculously cheap price. During a jittery period in the late 1980s and early 1990s, Fairholme Funds chief and value investor Bruce Berkowitz scooped up Wells Fargo (NYSE: WFC) at a fraction of its intrinsic value. And an industry downturn in shipping helped Buffett student Mohnish Pabrai cash in on Frontline (NYSE: FRO).

Back to basics
Without a doubt, some of the best investment opportunities arise when there is fear and panic in the air. Like Buffett, Berkowitz, and Pabrai, other successful investors have done extremely well by taking advantage of the market's mishaps. And all of them usually understand their investments inside and out, exercising extreme due diligence before pulling the trigger.

It's obvious that the financial-services sector is in a grave state of panic right now. When the dust settles, investors will look back and realize that there were some fantastic companies selling at fractions of their intrinsic value. Yet among such great investments, there's also plenty of toxic waste that investors are better off avoiding. While there's no secret formula for determining the good from the bad, if investors ask themselves three simple questions when attempting to value financial companies, they're a lot less likely to suffer permanent losses of capital.

1. Is it a good business?
2. Are the problems temporary or permanent?
3. Will the business return to historical profitability?

Is it a good business?
The first question is easy when considered on its own. Granted, it's somewhat subjective in nature, but a good business can usually be categorized by brand name, sustainable earnings, and overall duration / competitive advantage.

Companies like Citigroup (NYSE: C) and Freddie Mac (NYSE: FRE) are good businesses. Citigroup benefits from being one of the world's largest financial-services companies, with operations spread out all over. Almost everyone has heard of Citigroup. Freddie Mac is slightly different; I'm not quite sure a large majority would know the company by name, but its unique and differentiated business line has a strong competitive advantage. In my opinion, both of these companies should land on their feet once the current credit market shakes out accordingly. The point remains true: Look for good businesses that are temporarily distressed.

Are the problems temporary or permanent?
While Citigroup's recent market performance suggests it's not immune to the credit turmoil, odds are good that the company's troubles will ultimately be temporary. Citi may take a while to fire on all cylinders again, but the company benefits from its massive scale and global reach. If Citi can't shine as a whole, there are others who feel that sum of the parts are worth more than the whole.

Likewise with Freddie; investors get some relief from the assumed government guarantee the company enjoys, since it's a government-sponsored entity. The stock recently tanked nearly 30% after posting a big quarterly loss, but it soared last week on news of a new capital infusion.

Will the business return to historical profitability?
This question's a bit tougher to answer, especially for someone with a short-term mind-set. Rumor has it that when Buffett was looking at American Express during the salad-oil scandal, he visited local restaurants in Omaha and observed how many customers were still using their American Express cards. Ultimately, Buffett concluded that American Express would not only survive, but also meet and exceed historical levels of profitability. Earnings and cash generation create value, and if seemingly cheap financial companies turn out to be one-trick ponies, they're probably not bargain investments.

Foolish takeaway
Most investors are better off leaving companies like Citigroup and Freddie Mac alone for now. These huge enterprises have many moving parts, and they should only be approached after the most rigorous due diligence.

For me, most financial-services firms get filed in the "too hard" pile. I stick with businesses that I can understand with a high degree of confidence. It doesn't matter that Eddie Lampert, one of the smartest guys around, took a big stake in Citigroup. Lampert is well-known for his intense degree of due diligence, and in the end, he's probably right about Citigroup. But until you can perform your own due diligence, and become comfortable with your facts and reasoning, it's best to keep your discipline and avoid such messy situations.

For further related Foolishness:

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