Which Financials Will Survive and Thrive?

As the 18th-century English poet Alexander Pope famously wrote, "Fools rush in where angels fear to tread." We've seen evidence of that observation over the past decade, with the dot-com and real estate bubbles being the most prominent.

But after financial stocks largely cratered following the debacles at Bear Stearns, Lehman Brothers, and National City (and sadly, that's only a few of the examples), it appears that fools and angels are fearing the same ground. But should they?

Sorry, Alex
Put simply, when we look back on these times, the current situation with financials will be seen either as a tremendous contrarian-buying opportunity or just the beginning of a long depression in the financial sector.

Even the best minds aren't sure right now which it will be. Although Warren Buffett made a multibillion-dollar investment in Goldman Sachs a few months ago, he was quick to note that his confidence was in Goldman itself and the prospects of the Treasury's bailout plan, and not necessarily an endorsement of the entire financial sector.

As he said in his 2008 Berkshire Hathaway shareholder letter, "You only learn who has been swimming naked when the tide goes out -- and what we are witnessing at some of our largest financial institutions is an ugly sight."

Put some clothes on!
While some of our largest and oldest financials have been running for the bushes in shame, Buffett's purchase of Goldman forces us to ask: Are there any other properly covered financials out there?

The 125,000 members of Motley Fool CAPS think so. They rate their favorite and least-favorite stocks, and their collective wisdom has proved to be quite robust: Our data has shown that four-star and five-star stocks outperform the market.

So what do our CAPS members like? Here are financials that have earned four and five stars -- the highest ratings possible -- from our CAPS community.

Source: Motley Fool CAPS data as of Dec. 19, 2008.

While it is difficult to find traditional banks among the highest rated financials, this data tells me that CAPS investors think some insurers and stock exchanges, which were also beaten-down in recent months, present the best value opportunities in the financial sector.

Conversely, stocks with lowly one- or two-star ratings have underperformed the market and should be handled with extra care. Here are a few financials that are out of favor among the CAPS community.

Source: Motley Fool CAPS data as of Dec. 19, 2008.

These low ratings don't mean that Capital One or KeyCorp will necessarily turn out to be terrible investments, but you should consider their lack of support from the CAPS community as a sign that there might be even more danger ahead.

See, CAPS has been pretty astute in calling some of the worst financial collapses. As far back as April 2007, Fannie Mae, Freddie Mac, and IndyMac were all one-star stocks, and in March of this year, Fool co-founder David Gardner used CAPS data to warn investors to stay away from Lehman, which was a one-star stock at the time. Heeding the CAPS community's advice to at least avoid investing in these companies would have saved you from huge losses.

Don't catch falling knives
Knowing which stocks you should avoid is as valuable as knowing which stocks deserve further research. Remember Buffett's rules of investing:

• Rule No. 1: Don't lose money.
• Rule No. 2: Never forget Rule No. 1.

Instead of sorting through the trash for financials that have deserved their recent markdowns, you're much better off looking for financials that have had very little to do with the toxic subprime mortgages and structured investment vehicles that are causing so many problems today. They'll be the ones that will survive and thrive when the market turns around.

Using our CAPS ratings is an invaluable way to kick-start your research or force you to rethink your investing ideas, because those ratings have proven to have predictive value.

And we're using it, too. Over the past three months at our Motley Fool Pro investment service, we've been using such proprietary CAPS data to both identify new stock ideas and confirm or reject our own ideas. Using $1 million of the Fool's money, we've already purchased a number of stocks and exchange-traded funds, and we've written call and put options -- all to create a well-rounded and robust portfolio.

To learn more about our strategy at Motley Fool Pro, just enter your email address below.