April 15, 2008 - Some of the smartest investors, or at least ones who have made a lot of money in the past, are buying financial stocks. Big time. They're the ones who bought a large chunk of Washington Mutual and Wachovia Bank. $7 billion worth in WaMu, $8 billion in Wachovia coming soon. (Wachovia raised $3.5 billion through preferred stock only 2 months prior.) But these sharp investors didn't buy stock on the open market. They got theirs in negotiated deals with each bank. And they're not done buying.

Now hedge funds and private equity pools are poring over the financial sector, drooling on the possibilities. They're buying stocks at less than half "stated" book value. The reason for the quote marks is because no one knows what real book value is. Every day it seems to go lower as more loans require write-offs. So even though bank officials can tell you what the book value is today, that doesn't mean anything about tomorrow when more loans show up as delinquent or in default. It's the future that's so tricky, as always.

Remember also that these large pools of funds have lots more money than what they're spending. They have plenty of reserves to wait out this tough time. These investments will most likely pay off, in a big way, when the industry rights itself and is profitable again. When that is is the big question. With no one having that answer, caution is the best approach for individual investors and institutions. That's why the equity and hedge funds can buy at wholesale prices: no one knows exactly where the true value is. Therefore there has to be a margin of safety built in or these institutions won't invest.

If you have the intestinal fortitude to invest in financial stocks, make sure to buy a small amount of each one and vary the type, such as a bank, a thrift, an investment bank, an insurance company. Putting all your money into one stock that seems absolutely at its bottom is almost a sure way to guarantee many sleepless nights for quite some time.

Individual investors can't buy these stocks at the bargain prices institutions can. They can't negotiate better deals than the last tick on the tape. But they can wait and watch. Sometimes they can buy stocks at better than the "smart" money as the stocks drift lower on ever worsening news.

The four required elements to invest in this sector are patience, high tolerance for risk, high diversification, and plenty of extra money to wait it out. If you don't have all four, don't venture into these woods. They're too scary for most.

- Ted Allrich