Exploit the Fearful

Buying when blood is in the streets is terrifying, and it's one of the most difficult things to do as an investor. But it's also one of the most lucrative things you can do. When the fearful mob is "panic selling," you can potentially reap huge profits -- if you can calmly analyze the situation, determine the right path to take, and pick up their shares at a discount.

Consider what you would have made if you'd invested just $1,000 in each of these opportunities:

The common theme linking all these companies is that, at the time, each company was in an industry in crisis.

Crisis investing
In 1990, Citigroup, like most of the major banks of the time, was trying to survive the savings and loan debacle. Interest rates were rising and real estate prices falling. Many savings and loan companies were overleveraged, some were fraudulent, and many were forced into bankruptcy. It was a bad time to be in banking, and Citigroup was hit pretty hard.

Equally scary events plagued the other companies. Johnson & Johnson was facing the Clinton administration's heath-care reform plan, with its potentially huge impacts on the profits of pharmaceutical companies. Altria had to deal with devastating tobacco litigation that had the potential to bankrupt the industry.

Simon Property Group had two major problems. It was a real estate investment trust (REIT) with solid, reliable real estate assets at a time when investors wanted only pie-in-the-sky tech companies. It also owned malls, and the consensus was that that everything would be bought and sold over the Internet and nobody would go shopping any more. Turns out that was wrong. Go figure.

How to find these companies
With these sorts of potential returns, it makes sense for investors to allocate a portion of their investment portfolio toward purchases in "crisis industries." If, by buying these stocks, you can duplicate the success of the four companies in the above table and achieve 20% annually, you'll turn $10,000 into $2.3 million over the course of 30 years. I'd be happy with that.

Of course, the problem with these sorts of high-return examples is that I've purposely selected the companies that did well, and left out the companies that didn't survive the crisis. That doesn't mean it's a failed strategy, but rather that you have to be careful. Our goal at Motley Fool Inside Value is to identify the great investments to buy when blood is in the street. In these situations, we use two techniques to ensure that we're buying the winners, not the dogs.

1. Buy only the bargains
Any time you're investing, and particularly in a crisis, you should buy only the bargains. In other words, calculate the fair value of the company, and buy the stock only if the company is trading at significantly less than its fair value. One way to estimate a stock's fair value is with the Inside Valuediscounted cash flow calculator (available to subscribers or with a free trial).

There are several reasons to buy only the bargains. First, they offer the largest potential return. If such stocks simply return to their fair value, investors will do quite well, and the upside in a turnaround is incredible. Second, buying stocks for less than their fair value provides a margin of safety. If the crisis hits the company harder than you anticipated, you may still be able to make a profit (if you bought at a large enough margin of safety). Third, if the company is overvalued, why would you want to take the risk of owning that company during a crisis? Instead, you can simply look elsewhere for an undervalued company without a crisis -- the risk/reward trade-off is significantly better there.

2. Buy only the strong
When looking to invest when blood is in the street, don't buy second-rate competitors -- look for the strongest companies in the industry. Look for the companies with the strongest financials: those with cash on their balance sheets, little debt, large operating cash flows, good profit margins, and solid returns on equity. Then pick the companies with the strongest competitive positions -- those with well-known brands, excellent distribution systems, or other operational advantages that make life miserable for competitors.

There are two reasons for doing this. First, the strong companies are the ones most likely to survive the crisis. When the crisis passes, these companies will still be standing, and their position will actually be improved because of the wounded competition. Second, the strong companies are the ones most likely to provide exceptional returns over the long term. After buying strong companies at a discount, you can make incredible returns holding these superior businesses for the long term. Just look at Citigroup's 15-year run.

Where to start
At this point, there are several sectors that could present some great investment opportunities. Because of litigation, expiring patents, and fear that drug development pipelines are looking a bit thin, the pharmaceutical industry has been clobbered. Pfizer (NYSE:PFE), one of the most dominant companies in the industry, seems particularly cheap right about now, which in part explains why it is an Inside Value recommendation.

The banking sector has been sold off because of the flat yield curve and fears over a potential housing bubble. Citigroup and Wachovia (NYSE:WB) both look attractive, and they'll pay a decent dividend to investors waiting for a bounce. Finally, after the hurricanes, there may be an opportunity in the insurance sector. Some of the insurers are pretty battered, but high claims one year often lead to high premiums the next. If a hard market does develop, insurers such as St. Paul Travelers (NYSE:STA) and Berkshire Hathaway may reap high profits.

If you're looking for other ideas or want to see how we practice this strategy to identify outstanding investments, check out our Inside Value newsletter. Take us up on our free 30-day trial offer, and you'll have full access to all Inside Value content, including more than 25 stock write-ups and all of the back issues. (That's in addition to the two new picks that fill your inbox every month.) The free trial is no risk, and you might just discover the next Citigroup. To me, it's a no-brainer.

Richard Gibbons, a member of the Inside Value team, wants to travel to St. Paul. He owns shares of Pfizer and Johnson & Johnson as components of his pharmaceutical HOLDRs but none of the other companies discussed in this article. The Motley Fool has a full disclosure policy.