This Is 1 Blue Chip Investors May Want To Avoid

In Singapore, the term “blue-chip” is commonly used to describe the 30 shares which are part of the stock market benchmark, the Straits Times Index (SGX: ^STI). These companies are often well-established with thriving businesses and are thus thought to be less-risky investments by many investors.

But, that can be an erroneous way of thinking. After all, former blue chip Neptune Orient Lines Ltd (SGX: N03) has been a disappointing investment for investors.

The shipping firm was kicked out of the Straits Times Index on 24 September 2012; investors who bought Neptune Orient Lines’ shares five years ago on 24 September 2007 would have seen a 77% loss by the time 24 September 2012 arrived.

Keeping this thought in mind – that blue chips can still be risky investments despite their somewhat glorified status – which current blue chips might investors want to avoid, or at the very least, tread carefully with?

For answers, we can perhaps turn to an investing checklist created by Pat Dorsey which my colleague Chin Hui Leong had recently shared. Dorsey’s currently the head of the investment firm Dorsey Asset Management and was previously the Director of Equity Research at Morningstar.

Dorsey’s checklist was actually designed to be done in 10 minutes and is meant to help investors quickly and effectively come up with a list of companies which can be worth a deeper look. The checklist has nine points and they are given below:

  1. The firm provides regular financial updates, has a long track record as a publicly-listed entity, and a market capitalisation that isn’t too small.
  2. It has consistently earned an operating profit.
  3. It has generated consistent operating cashflow.
  4. The firm earns a good return on equity.
  5. It has been able to grow its earnings consistently.
  6. It possess a clean balance sheet.
  7. The firm can generates lots of free cash flow.
  8. There are infrequent appearance of one-time charges.
  9. There has not been major dilution of shareholders’ stakes in the firm.

If you’d like more in-depth elaboration as to why these criteria make sense, Hui Leong’s articles would be a great place to start (here they are again: Part 1, Part 2, and Part 3).

Using this checklist, a company that comes out with a “No” response to most or all of the criteria would likely not make for a good investing opportunity. Unfortunately, that’s the situation that Golden Agri-Resources Ltd (SGX: E5H) finds itself in. As of 30 September 2014, the company had a 1.18% weighting in the Straits Times Index.

Golden Agri-Resources, listed since 1999, is a palm oil producer with significant palm oil-related operations in Indonesia. The firm reports its earnings every quarter and has a large market capitalisation of S$5.52 billion. Given this, the company has scored a “Yes” with the first criterion in Dorsey’s checklist.

But as you can see in the chart below, Golden Agri-Resources has not been able to show any consistent growth in its operating income, net income, operating cash flow, and free cash flow over the past decade between 2003 and 2013. Yes, the figures are mostly positive, but a company can’t increase its business value without growth.

So, criteria 2 and 3 would be a “weak yes” at the best, while criteria 5 and 7 are a clear “No.”

Golden Agri-Resources' operating income, operating cashflow, free cashflow, and net income

Source: S&P Capital IQ

In the next chart, we can see how Golden Agri-Resources’ returns on equity and balance sheet have looked like in the 10 years ended 2013. The palm oil producer’s returns on equity have deteriorated significantly since 2008, and came in at just 3.6% in 2013.

As for the balance sheet, the amount of borrowings have been consistently higher than the firm’s cash on hand; in addition, the growth in the firm’s borrowings has significantly outpaced that of its cash holdings in recent years.

Given these, Golden Agri-Resources has scored a “No” for both criteria 4 and 6.

Golden Agri-Resources' return on equity (ROE), total cash, and total borrowings

Source: S&P Capital IQ

We’re down to the last two points on Dorsey’s checklist. For criterion 8, Golden Agri-Resources has actually done well given that it has not recorded any significant one-off charges over the past 10 years.

Golden Agri-Resources' share count

Source: S&P Capital IQ

Coming to the last criterion on Dorsey’s checklist, we can see from the chart immediately above that there’s been a roughly 40% increase in share count between 2013 and 2003. In particular, there were two big jumps in the following periods: 1) Between the end of 2006 and the end of 2007; and 2) between the end of 2008 and the end of 2009.

For the second period, the increase in share count had been due to a rights issue – that can’t really be thought of as a dilutive act. But for the first period, it was due to a private placement Golden Agri-Resources had made. That is dilutive as the company’s share count had increased by 15% between the end of 2006 and the end of 2007.

With that, the score for Dorsey’s last criterion would be a “No.”

A Fool’s take

In a final tally, Golden Agri-Resources has not been up to par with six of Dorsey’s nine criterion.

But, this does not mean that the company would definitely make for a bad investment. After all, changes could be already afoot at the firm which might improve its business results greatly in the future.

That said, given what we’ve seen so far with Golden Agri-Resources, investors interested in the company would need to tread carefully and be fully aware of the risks involved.

For more investing analyses and important updates about the stock market, sign up to The Motley Fool Singapore's free weekly investing newsletter, Take Stock Singapore. Written by David Kuo, it can help you grow your wealth in the years ahead.

Like us on Facebook to follow our latest hot articles.

The Motley Fool's purpose is to help the world invest, better.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any companies mentioned.