Here’s Why Noble Group Limited Is a Blue Chip Investors May Want to Avoid

In our local investing parlance, the term “blue chip” is used to describe the 30 shares which are part of the market benchmark, the Straits Times Index (SGX: ^STI). The term also often carries highly positive connotations amongst investors.

But, that doesn’t mean that a blue chip can’t make for a risky investment. Shipping firm Neptune Orient Lines Ltd (SGX: N03) is a great example of a blue chip which has been a hugely disappointing investment.

The company was removed from the Straits Times Index on 24 September 2012. Investors who had bought shares in Neptune Orient Lines five years prior on 24 September 2007 and held on till the firm ceased to be a blue chip share would have seen their capital decline by almost 80%.

So, keeping in mind the idea that blue chips can still be risky investments despite their elevated status amongst investors, which of the current crop of blue chips might investors want to avoid, or at the very least, tread carefully with?

For answers to my question, we could perhaps look toward an investing checklist created by Pat Dorsey. He’s currently the head of the investment firm Dorsey Asset Management and was previously the Director of Equity Research at Morningstar.

The checklist, which my colleague Chin Hui Leong had recently shared, consists of nine criteria and was designed by Dorsey to be a quick tool. It’s meant to be completed in 10 minutes so that investors can effectively come up with a list of companies which are worthy of a deeper look.

Here’s a brief recap of the nine criteria:

  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).

With the checklist, a company that scores a “No” for most (or all) of the criteria would likely not make for a good investing opportunity. If we work the checklist through the Straits Times Index’s current crop of 30 constituents, commodities trader Noble Group Limited (SGX: N21) would unfortunately be one such company with a mass of “No” scores.

Noble’s in the business of managing global supply chains for agricultural, industrial, and energy products, and has been listed since 1997. The company has quarterly earnings releases, and actually has a large market capitalisation of S$6.87 billion. These characteristics give Noble a “Yes” rating for the first criterion in Dorsey’s checklist.

But as we move further down the list, cracks start to appear. The chart below plots Noble’s changes in operating income, net income, operating cash flow, and free cash flow over the decade ended 2013.

Noble has managed to generate positive operating and net income consistently in those 10 years. But as you can see below, consistent growth isn’t present. As for operating cash flow and free cash flow, both financial measures have been erratic.

As a result, criterion 2 would be a “weak Yes” at best, while criterion 3, 5, and 7 are all a crystal “No.”

Noble's operating income, operating cashflow, free cashflow, and net income

Source: S&P Capital IQ

The next chart below is for Noble’s returns on equity and key balance sheet figures over the 10 year period between 2003 and 2013. Since seeing its return on equity peak at 58% in 2004, the commodities trader has seen the economics of its business deteriorate steadily; Noble’s return on equity has been below 10% since 2011 and that’s not a good performance.

I trust it’s obvious to see that the firm has also seen its balance sheet weaken considerably over the years as the amount of borrowings has grown much higher than cash.

With these, criteria 4 and 6 would also be a “No.”

Noble's return on equity (ROE), total cash, and total borrowings

Source: S&P Capital IQ

Moving on to the last two points on Dorsey’s checklist, criterion 8 is actually where Noble has performed well as the firm has not incurred any significant “other charges” over the years.

Noble's share count

Source: S&P Capital IQ

We’re now at the last point on Dorsey’s checklist. Looking at the chart immediately above, it’s easy to see that Noble has experienced a significant increase in share count over the years; between the end of 2003 and the end of 2013, Noble’s share count actually grew by a whopping 63%.

I can’t determine for sure what happened prior to 2008, but a quick look at Noble Group’s filings with stock exchange operator Singapore Exchange would reveal that the commodities trader has had share placements done in the following years: 2008, 2009, and 2011. Given the prevalence of share placements in Noble’s history, it would be a clear “No” for criterion 9 in Dorsey’s checklist.

A Fool’s take

In a round-up of the scores, Noble has not been up to mark with seven of Dorsey’s nine criteria.

But, none of all the above is meant to point out that Noble would definitely be a poor investment going forward. For instance, positive changes could already be happening at the company which might improve its business results considerably in the future. Or, the company’s shares could be priced way lower than its intrinsic business value; such a scenario would make the firm’s shares a possibly attractive investment on the basis of it being really cheap.

That said, given what we’ve seen with Noble so far, investors interested in the commodities trader would need to tread carefully and be fully aware of the risks involved.

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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.