The following five indicators enable entrepreneurial investors to identify potential opportunities among listed companies.
First indicator: low valuations
First, we look for companies with a valuation that represents only a fraction of their asset reproduction cost.
The theory behind this is simple: regardless of the company's profitability - providing it is realistic in the long term - an industrial activity is worth at least the asset reproduction cost that's needed for its exploitation since this is typically what a competitor or newcomer would have to invest in order to become operational.
In case of little or non-capital-intensive industries, we simply look for companies with a valuation that represents a weak multiple of their profits, while ensuring that we retain a normalized profit for the long cycle - rather than a punctual (and sometimes quite exceptional) profit.
Second indicator: a non-existent institutional competition
In the end, the financial markets obey to the same laws as any other market: their prices fluctuate depending on offer and demand.
When there is more capital ready to be invested (the demand) than there are available shares (the offer), the prices of the latter will logically go up via bids; conversely, when there is little capital available to invest, the share prices adapt to this decline in order to stay competitive.
A good search track consists therefore in identifying those industries that are shunned or left aside by institutional investors. Like for example at the moment the car industry, the North American commercial real estate sector, emerging markets, and offshore hydrocarbon drilling equipment.
Third indicator: index trackers management
Index trackers - systematic and unthinking by nature, which is exactly their forte - sometimes open up surprising opportunities for investors who are on the lookout for inefficiencies.
For example, a company that suspends its dividend - which sometimes happens for perfectly legitimate reasons, like the protection of its balance sheet or to ensure the funding of its growth investments - will automatically be ejected from tracking funds that are focused on returns.
The same dynamic applies when certain companies leave a major index, proceed with a spinoff, etc.
Fourth indicator: extreme pessimism
The media - due to sensationalism and group effect - always amplify the news beyond its real impact.
As a consequence, problems are often presented as if they are a lot worse than they actually are and favorable market conditions are reflected as more sustainable than they will ever be. Financial bubbles are a striking illustration of this kind of mass hysteria.
Getting back to the second indicator mentioned above, when an adverse business activity prevails, like we see today in emerging markets - the mandate of institutional investors changes and prevents them from investing in the concerned sector.
Rather than wanting to fight the competition, entrepreneurial investors can eliminate the competition this way.
Fifth indicator: capitalized to survive
In times of stress, the balance sheet of the companies selected based on the four previous indicators has to prevent bankruptcy and guarantee a long-term survival capacity - meaning an ability to survive a prolonged low cycle.
In these critical moments - such as big financial crises - its the quality of the company's financial position that allows us to evaluate the quality of the management. This is what helps us to distinguish those who have thought ahead from those whove let themselves be taken by surprise.
For the former, crises are a synonym for opportunities: as they are well-capitalized, they benefit from the difficulties of their less cautious competitors - who are generally on the cusp of bankruptcy because theyve got too much debt and run at a loss. As a consequence, well-capitalized companies can acquire them cheaply and hence obtain a strategic position for when the recovery starts.