(FORTUNE Magazine) – An old Rothschild (no relation) investment tip, "buy on the sound of cannons," can be profitably applied to Wall Street today, with lawyers taking over where the cannons left off. Now you can buy on the class action, the fraud probe, the indictment, or criminal charges pending. In cases of corporate hanky-panky, the stock often gets punished far more than the company that's doing the pankying. This gives scandal investors their chance to pick up shares on the cheap. The latest example is Texaco.

With the smoking jellybean caught on tape, Texaco got hit with a grand jury investigation on top of an ongoing discrimination lawsuit. The stock fell $10 in sympathy, causing Texaco to lose $2.6 billion in market value in two weeks. By extracting this penalty in advance, the market was telling us Texaco would eventually pay $2.6 billion for its misbehavior. Smart scandal money was betting the penalty wouldn't be that stiff. The biggest oil spill in history cost Exxon $1 billion in fines and restitution, not including cleanup costs. Texaco put itself in a mess, but hardly a Valdez-size mess.

Investing in legal troubles is based on the theory that big companies have deeper pockets than many people think, and usually manage to avoid the worst by settling. On November 15, Texaco did just that, agreeing to pay $119 million to 1,400 black employees. By then the stock already had rebounded. To take full advantage of a scandal bargain, you can't wait for the settlement. You have to buy while the outcome is still in doubt.

Market value can sometimes help investors figure out how to time a scandal buy. On December 24, 1992, Bristol-Myers Squibb fell $3 a share on the news that a Houston jury had awarded $25 million to a breast-implant plaintiff. This was an immediate loss of $1.5 billion in Bristol's market value, but given the volume of pending litigation, one could easily imagine that Bristol would end up paying more. Then came the Hillary health care scare, and Bristol shed another $6 billion in market value over two months. With the stock down $7.5 billion already, the risk-reward was more favorable. Bristol shares have doubled since.

A company's ability to put its troubles behind it depends on the source of the trouble. Running afoul of the government is generally less hazardous than running afoul of the public. Remember Food Lion? That grocery store chain was under simultaneous investigation by the Labor Department (no big deal) and ABC's PrimeTime Live (a CEO's nightmare). Once you've been accused on camera of deodorizing old beef with bleach and reselling it as fresh, it's hard to bring customers back to the meat counter. Food Lion stock has never quite recovered.

Archer Daniels Midland had all the elements of a perfect scandal play. This was a big company with plenty of clout and no shortage of cash, in trouble with the government for fixing the price of lysine. The public couldn't have cared less--most people had never even heard of lysine. News of Justice Department gumshoes snooping around ADM headquarters dropped the stock price from the $17 level to $14 and change in October 1995. ADM's market value was down $1.5 billion at that point.

The stock was stuck in the mid-teens until last October, when it jumped to $21 3/4 on rumors that a settlement was imminent. ADM agreed to pay a $100 million fine--$1.4 billion lower than the market penalty imposed by Wall Street. People who bought near the low made a tidy 50% in 12 months.

For long-term scandal investors, Philip Morris is a favorite core holding. Disguise Philip Morris as Coca-Cola (now selling at 33 times earnings), and you'd have a $252 stock instead of a $111 stock. That's $70 billion in market value already lost to tobacco litigation overhang. If a less costly settlement is reached, Philip Morris shareholders will pocket the difference.