A Scandalous Way to Make Money

Although they're in different companies, stocks in the same industry tend to move together. They tend to sell to the same customers, offer products that compete for the same limited budgets, and face similar regulatory hurdles and shifting customer demands.

Nobody understands this phenomenon better than Warren Buffett.

Part of what made Buffett one of the richest men on the planet was his refusal to invest in new technologies for Berkshire Hathaway when it was a struggling textile business. If anyone were to copycat the innovations, they wouldn't lead to a sustainable competitive advantage. As a result, rather than waste money on enhancements with very limited useful lives, he used those savings to evolve Berkshire into the extremely profitable conglomerate it is today.

Know your business
So when you're picking companies to invest your hard-earned cash in, you need to understand the competitive environment that surrounds them. Without an enduring reason for one company to outshine the others in similar businesses, they'll all tend toward similar long-term returns.

Unless you're an expert in the industry, though, chances are pretty slim that you'll be able to divine that sustainable edge from what's available publicly. After all, most executives know the Buffett story. They figure that the more secret they keep their advantages, the less likely they are to be copied ... and the longer they'll last.

Your backdoor to profits
There is, however, one way you can beat the average returns without being an insider in the industry. All you need to do is find a scandal that knocks the bottom out of a company's stock but won't imperil the long-term health of the company itself. For instance, take a look at these returns from these companies, all in the "Business Equipment" industry:

Notice anything peculiar about that chart? The only company to have both outperformed the S&P and to have earned a decent return over that period was Xerox.

Of course, I picked that date for a reason. April 12, 2002, was the first trading day after the SEC filed suit against Xerox for accounting irregularities. In the midst of the Enron collapse for its accounting fraud, anything having to do with accounting troubles was viewed as a potentially company-ending issue.

A tempest in a teapot
As a result of this happening in the midst of Enron's implosion, the Xerox scandal got far more attention than it likely would have otherwise. If you looked beyond the headlines and analyzed the true impact, it clearly wasn't a company killer. After all, nobody was accusing Xerox of making up revenues the way Enron did -- just of recognizing them too quickly.

A closer investigation would have revealed that, rather than a fatal blow, the issue would be a serious injury but one from which Xerox could fully recover. That turned Xerox into a "wounded elephant" -- a large company that's temporarily out of favor because of a serious but treatable issue.

Take advantage of the panic
Often such wounds provide an opportunity for investors to swoop in, buy up, and profit while the rest of the market panics. In fact, hunting wounded elephants is one of the five ways Motley Fool Inside Value advisor Philip Durell finds his market-beating stock ideas.

Of course, the skeptic in you might be asking why this strategy works -- and if it works so well, why I'm telling you about it. The answer is simple. You get that opportunity to profit from the panic because no mutual fund manager wants to be caught dead holding a large position in a scandal-plagued company. It raises too many questions and leads to redemptions, which can drive down that fund's returns and its manager's personal earnings.

As long as mutual funds control the vast majority of money invested in the market, you'll have the opportunity to profit from institutional investors fleeing wounded elephants. If you're ready to bag your outsized returns from temporarily wounded companies that professionals have fled, then click here join us today at Inside Value free for 30 days.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta did not own shares of any company mentioned in this article. Coinstar is a Hidden Gems choice. Pitney Bowes and Steelcase are Income Investor recommendations. Berkshire Hathaway is an Inside Value selection, as well as a Stock Advisor pick. The Motley Fool owns shares in it as well. The Fool has a disclosure policy.