Failure to recognise vulnerabilities behind my error in Noble

IN 2009, Noble invited analysts to tour its facilities in Argentina. I was then an equity analyst with RBS covering commodity stocks. The chance to visit one of the world's leading commodity traders was hard to ignore.

Noble was like Teflon in the 2008 financial crisis. It was immune to the horrific counterparty risk that shook commodity trading. The company was cash-rich and its cash cycle was just 14 days, which was a tenth of that of its rival Olam.

Richard Elman, its gruff founder, personified Western enterprise in the East. He named the company after Noble House, James Clavell's fictional trading house in Hong Kong. Mr Elman built a massive company from modest origins as middleman in Hong Kong in the 1960s. He initially supplied Chinese steelmakers with iron ore. By 2009, Noble was a vast conglomerate with Australian mines, Brazilian sugar mills and American fuel terminals. It was then a US$35 billion giant with a market capitalisation of US$5 billion.

Along with five analysts from rival firms, I flew to Sydney and then Buenos Aires. From Buenos Aires, we travelled to the lush Argentinian countryside where we saw Noble's massive soybean processing facilities.

The trip was a prelude for a charmed run for Noble. Noble's operating earnings rose 40 per cent in FY2010. The stock doubled over the next five years. It outperformed the S&P GSCI by 83 per cent, powered by the commodity rally. By FY2014, it had revenues of US$85 billion, making it Asia's largest commodity trader.

In February 2015, the music stopped. A mysterious short-seller called Iceberg Research published damning allegations against Noble. This led to a cascading collapse. Noble has since lost 98 per cent of its market value. The company stared at bankruptcy and has since agreed to a humiliating debt for equity restructuring.

When Iceberg's allegations emerged, I defended Noble. I saw it as the "Bargain of the Decade". I was so wrong.

Ironically, the 2008 crisis bore the seeds of Noble's collapse in three ways. My failure to recognise these vulnerabilities was my undoing.

Mark to market

First, mark to market (MTM) accounting was a demon that hastened the 2008 crisis. This is the practice of recording the fair value of an asset or liability based on the current market price, as opposed to the historical cost. The rise or fall of the fair value of an asset appears in the income statement. This practice provides an avenue for commodity traders such as Noble to record higher earnings in rising commodity markets. It also inflates the asset base, providing more collateral for borrowing. Enron, the energy trader that went bust in 2001, was fond of this tactic.

To tighten the scrutiny of commodity firms, the accounting standards encouraged an even more liberal use of MTM accounting after the crisis. Noble used this opportunity to aggressively exploit standards to its benefit in a rising commodity environment.

By FY2014, Noble's fair value gains represented 103 per cent of its equity. This was by far the most aggressive use of fair value gains in the peer group. It amounted to US$5.8 billion in fair value gains, while the fair value losses remained static in FY2009-14.

This meant that Noble's US$2.7 billion of net profit in FY2010-14 did not translate into operating earnings. It also left a gaping hole in its balance sheet in the FY2014-18 bear market for commodities. Noble's travails since FY2015 have been an endless post-facto justification for these fair value gains.

QE-driven boom

Second, quantitative easing drove commodity prices higher. The S&P GSCI doubled from January 2009 to April 2011. Noble and its financiers mistook this QE-driven boom for a structural shift. They believed in a commodity super-cycle where Noble's commodities such as iron ore, coal and soybeans would escalate for a generation.

Noble, egged on by over-zealous banks, abandoned its well-honed skill as an intermediary. Instead, it adopted an asset-heavy strategy. This dramatically exposed the company to commodity price risk. The Fedex of commodities became more of a holder of assets.

With the blowup in commodity prices in FY2014, Noble's return on equity fell from 17 per cent in 2010 to 2 per cent in FY2014. Cashflow disappeared, placing Noble's balance sheet in dire straits.

Explosion in information

Third, more transparency in commodity trading after the crisis has hampered traders. Its advantage in market intelligence has also been restricted by the explosion in information. When Mr Elman begun trading in iron ore to China in the 1970s, airmail was the principal means of communication. Telex machines were considered high tech and fax machines were unheard of. Today's commodity players have infinite sources of information in their palms. Commodity traders, like travel agents, may face obsolescence.

Investors should be wary of these risks.

In Argentina, I met a local congressman who lamented his country's descent. In 1895, Argentina was the richest country in the world as it held prized natural resources such as beef and silver. Over the next 113 years, the country faced poverty and bankruptcy. Argentina was blighted by mismanagement and misfortune. Sadly, Noble's path has mirrored that of Argentina's.