2 Reasons For Long-Term Investors To Be Cautious About This Blue Chip Stock

Shares of the blue chip commodities trader Noble Group Limited (SGX: N21) have been on a tear recently, climbing by 34% in value over the past month. That soundly beats the 8% gain that the Straits Times Index (SGX: ^STI) has enjoyed.

But, Noble’s short-term spike tells us nothing about what its shares can do over the long-term. For clues to that, investors can perhaps look at the quality of the company’s business, keeping in mind the idea that the long-term performance of a company’s stock is governed by how its business does.

Unfortunately, there are signs that point to Noble Group having a low quality business.

Wisdom from a legend

The signs come from none other than the billionaire investor Warren Buffett, who took control of Berkshire Hathaway in 1965 and has been at the helm since.

While Buffett’s longevity as a corporate chief is perhaps something amazing in its own right, what’s truly outstanding are his achievements as leader of Berkshire: From 1965 to 2015, Buffett has helped grow Berkshire’s book value per share (a proxy for the true value of the firm) at an astounding annual rate of 19.2% per year, which represents a total gain of 798,981%. And, he had done so largely via smart investments in the stock market and astute acquisitions of both private and public companies.

Given his achievements, his views on what makes for a great business may be well worth heeding for investors. In his 2014 Berkshire shareholder’s letter, Buffett had described six criteria that a business needs to meet in order for him to consider it as a potential Berkshire acquisition target. They are:

“(1) Large purchases (at least [US]$75 million of pre-tax earnings unless the business will fit into one of our existing units.),

(2) Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations),

(3) Businesses earning good returns on equity while employing little or no debt,

(4) Management in place (we can’t supply it),

(5) Simple businesses (if there’s lots of technology, we won’t understand it),

(6) An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).”

Not all six are applicable here. In fact, only criteria (2) and (3) are useful for our purposes. Most individual investors are not constrained by the size of a listed business, and so that kicks out criterion (1). For (4) and (6), most publicly-listed companies will already have existing management teams in place and stock prices that are refreshed all the time. Lastly, (5) is merely a reflection of Buffett’s own analytical preferences.

Putting Noble to the test

Let’s take a look at how Noble fares against Buffett’s second and third criteria. Chart 1 below illustrates Noble’s revenue, profit, and operating cash flow over the decade ended 2015. As you can tell, despite the company’s strong revenue growth, it hasn’t been able to generate consistent profits and operating cash flow. It thus seems to me that Noble has failed to demonstrate any consistent earning power.

Chart 1 - Noble's revenue, profit and operating cash flow from 2005 to 2015
Source: S&P Global Market Intelligence

Buffett’s third criterion involves a company’s returns on equity and the strength of its balance sheet and this is where we’d turn to for Noble now. You can see Noble’s returns on equity and net-debt (total borrowings minus cash & equivalents) to equity ratio from 2005 to 2015 in the following chart:

Chart 2 - Noble's return on equity and net-debt to equity ratio from 2005 to 2015
Source: S&P Global Market Intelligence

What’s striking here are two things. First, Noble’s returns on equity have fallen to single-digits in a number of years from 2011 to 2015 – that’s not what a strong return on equity looks like. Second, Noble’s declining returns on equity have happened despite having a high net-debt to equity ratio of around 100% in that block of time. As a reminder, the higher the ratio is, the more debt a company has, all other things being equal.

A Fool’s take

Summing up what we’ve seen, Noble has not only failed to generate consistent profits and cash flows over the past decade, it has also turned in poor returns on equity while having a highly-geared balance sheet.

None of all the above is meant to say that Noble will surely be a poor investment going forward. But, the company’s inability to clear the two Buffett criteria we had looked at is a risk that current and prospective investors of the company may want to note.

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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 owns shares in Berkshire Hathaway.