3 Ways to Preserve Capital

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A year ago, amid the turmoil in the financial markets, nearly every financial-services company got pounded -- some much worse than others.

Value-oriented investors thrive in those 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 Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) CEO Warren Buffett to scoop up a large chunk of American Express (NYSE: AXP) for a ridiculously cheap price. Later, he also made a significant investment in Coca-Cola (NYSE: KO), which performed well for him.

And Buffett isn't the only one to cash in. During a similar 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 back in 2003 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 downturns. 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 was in a grave state of panic last year. Yet when the dust started to settle, investors looked back and realized that there were some smart bargains among the financials, many of which were 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 trying 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, overall duration, and competitive advantage.

Companies like Goldman Sachs (NYSE: GS) and Wells Fargo have good businesses that stand out from many of their peers. Goldman has avoided the fate of Lehman Brothers and Bear Stearns by having a top-notch reputation and taking steps early to bolster its capital reserves. Wells Fargo largely dodged the mortgage bullet despite getting a huge portion of its revenues from California and other formerly hot housing markets. Both of these companies have done a better job than many in weathering the credit market problems. The point remains true: Look for good businesses that are temporarily distressed.

Are the problems temporary or permanent?
For both Goldman and Wells Fargo, odds seem good that their troubles will ultimately start to go away. Wells Fargo will have to work hard to consolidate after its takeover of Wachovia, but the company will benefit from larger market penetration.

Similarly, Goldman's shares have rebounded sharply from their March lows. Although the investment-banking industry may have changed permanently, Goldman has maintained its historically strong position in the industry and aims to capitalize on whatever opportunities arise.

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, Neb., 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.

Of course, Goldman and Wells Fargo face unique challenges now. Wall Street remains under fire, and some banks are getting criticized for not making enough loans available to small businesses. Both of these companies will need to evolve to succeed in the new environment.

When in doubt, preserving capital means passing up some possibly attractive opportunities. Huge companies typically have many moving parts, and they should only be approached after the most rigorous due diligence. If a company lands in your "too hard" pile, then stick with businesses you can understand with a high degree of confidence.

It doesn't matter that Buffett has stakes in Goldman and Wells Fargo -- 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.