Buying into crisis
Investors often seek opportunities after calamitous news events. But that may be the worst moment to predict the future.
By Ellen McGirt, Fortune senior writer

(Fortune Magazine) -- The recently thwarted plot in Britain to blow up airliners headed for the U.S. was chilling news that put the world back on high alert. But with the fear - for many investors, anyway - came the search for opportunity.

Some evidently found it in a Bloomberg.com article about the newly apparent dangers of liquid explosives. Buried near the end was a reference to a New York-based start-up called TraceGuard Technologies (Charts). The company has developed a machine that it says can detect chemicals used to create explosives hidden in carry-on luggage without opening the bags. The wee bulletin-board stock - its market cap didn't crack $19 million - spiked up 64% on the mention.

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Not bad for a company whose product doesn't exist except in prototype. The machines aren't in any airports and aren't likely to be there anytime soon - they don't have federal approval. Within days reality returned, and TraceGuard's shares plummeted right back to where they'd started.

For anyone hunting a market opportunity in the terror madness, the episode was instructive. A lucky few may have bought and sold at exactly the right moments, earning themselves a bunch of cash and bragging rights at their next barbecue. But the more likely result for an investment in such a stock was a lot less glamorous.

And that is the peril for those who seek opportunity in calamity. Crisis investing may seem savvy, but for most individual investors it's a slightly ghoulish version of stock market gambling.

For starters, information travels too quickly and too widely these days for the average investor to get a leg up after a news event. "Things get priced into stocks very quickly," says Dirk van Dijk, research director of Zacks Investment Research.

And often as not, investors have some information, but not the full picture, says Pete Morici, an economist and professor of business at the University of Maryland. "Crisis investing is extremely difficult for the average investor, who doesn't have the ability to quickly find other information about the consequences of an event."

He cites the Gulf Coast hurricanes as an example: "People grossly overestimated the immediate rebuilding effect of Hurricane Katrina." Some stocks popped - Shaw Group (Charts), an engineering and construction firm, jumped 46% in the two weeks post-Katrina - but more languished.

For example, investors piled into Bermuda-based PXRE Group (Charts), a reinsurer some thought would gain from the higher premiums that often follow disaster. But they were treated to their own storm last February when PXRE's operating units were downgraded by rating agencies after the company reported higher-than-expected hurricane-related losses. The stock tanked by nearly two-thirds in one day and now trades around $4.

Last year's hurricane provides a good question to ask yourself before investing in a crisis: How many events developed exactly as you imagined they would in the days after Katrina?

If you manage to do prodigious research at warp speed, you'll face still another impediment: Many of the best disaster-related investments are tiny cogs in a giant corporation. For example, General Electric's Checkpoint of the Future system, which performs all sorts of scanning without the need to remove objects from luggage, may get a boost from the recent terror news. But even if it becomes a raging success, its contribution to GE's (Charts) profits and stock price would be negligible.

Even a security and defense company can be way too large to feel the impact of a single product. Case in point: L3 Communications (Charts), which is deeply embedded in aerospace and defense, might have seemed like a natural investment after the arrests of the liquibombers. It's developing a technology to detect liquid explosives, just as TraceGuard is. And unlike its tiny putative competitor, L3 has a history of successful products, established relationships with the government, and a distribution system. Nevertheless, investors yawned, and L3's shares barely budged.

What gives? "They lost their charismatic CEO [Frank Lanza, who died] in June and got caught in the stock-option backdating scandal," says Morningstar analyst Marisa Thompson. L3 also failed to be acquired by BAE Systems (Charts), as market watchers had expected.

"They got shorted," Thompson explains, "and the stock is just getting hammered." She's still bullish, but bases that on L3's broader prospects, not its new technology.

For all the dangers in catastrophe investing, there are ways to take advantage of such moments. First, you may get a discount price on a high-quality stock. Markets as a whole often tumble after a crisis. So, for example, if you were considering adding Citigroup (Charts) to your portfolio before 9/11 but balked at paying $42 a share, you could've picked up the same shares a few days later for $36 each. (They trade at $48 today.)

Another way to approach calamity investing is to look past immediate news events and study visible long-term trends that are altering the world. "Smart investors read what's on page A14 and the science news, not just the headlines," says Zacks' van Dijk. Needless to say, it's important to pick companies with strong fundamentals, not ones hoping that a crisis will launch them.

There is still opportunity to invest, for example, in the ongoing uncertainty spawned by everything from Katrina to the recent terror events, says Pat Dorsey, director of stock research at Morningstar. He suggests Berkshire Hathaway B Shares (Charts).

Premiums earned by Berkshire's reinsurance group jumped 47% to $1.15 billion in the second quarter this year, due largely to rising prices and increased demand for catastrophic coverage following last year's storms. That's a trend analysts expect to continue. They praise Berkshire's heft, significant exposure to the reinsurance market, and gilded brand name.

"It's their financial strength," Dorsey says. "No matter what happens, they can write the check on Monday morning. The price of catastrophe insurance will only go up." And even if, somehow, it doesn't, you don't have to worry about the stock having its own catastrophe next week.  Top of page