Stock of the Week: This Company Is a Cash-Generating Machine
Alpesh Patel|August 12, 2022
Too many investors fall in love with a stock’s story… and invest on that alone.
For me, the numbers come first. I like to say companies are simply factories for making money. It doesn’t matter what they do, as long as they do it well.
This week, our spotlight is on a company that has not just good financials but also a good story to go with them.
This business services company’s main customer is the U.S. government. And since we know the government will only continue to spend… this company will enjoy a steady stream of revenue for years to come.
The stock meets my proprietary Growth-Value-Income criteria… and hits the ball out of the park with a fantastic CROCI (cash return on capital invested) score.
But even better, investors are getting more reward for the risk they take on by owning the stock – which is rare in this market.
For all those reasons and more, this company is my Stock of the Week.
Check out the latest episode of my video series to get all the details on the company, including its ticker. Click on the image below to watch it.
I’ve got a really good company for you this week.
DLH Holdings (DLHC) caught my eye for a variety of reasons – its financial figures most importantly.
People don’t tend to focus on a company’s financials as much as on its story. I appreciate that. I get that stories sell, but it’s the financials that matter. The story is the last thing I look at.
I look at the financials first because all companies are just factories for making money. I don’t care what they actually do or how they do it.
But let’s look at the story of this company, because it fits with the financials rather well.
DLH Holdings is a provider of technology-enabled business process outsourcing. The company works with several government agencies: the departments of Veteran Affairs, Health and Human Services, and Defense. And those agencies don’t look like they’ll be cutting back on spending anytime soon.
The company operates primarily through prime contracts and also derives revenues from agencies of the federal government.
Look, the government is continuing to spend – whether you agree it should be spending or not. You might feel that in an environment of rising inflation, there should be fiscal tightening and cutbacks. You might feel, politically or ideologically, that the government should be a lot smaller than it is.
Whatever you might feel, we look at these things in terms of the reality of the situation. I don’t let my political or economic views get in the way of being pragmatic and looking at companies.
DLH Holdings reported strong results for the third quarter of 2022. Revenues rose $66.4 million, which was a year-over-year increase of 8%. Sure, it’s not a massive increase, but it’s not bad.
Income from operations has been solid as well.
Let’s take a deep dive into the numbers that I like.
For my Growth-Value-Income rating, if a stock is at a 7 or higher, then it gets the greenlight. That’s the bare minimum score that I’ll consider. And this stock is at a 7, which is fine.
I don’t try to differentiate a 7 from an 8, or an 8 from a 9. Let’s just say, if you hit at least a 7, you’re good enough to get in. And DLH Holdings does.
My GVI rating is my proprietary algorithm, with which I weight valuations more than revenue growth, more than dividend yields. But they’re all in the mix, including cash flow and momentum. They’re weighted by importance, and my algorithm gives me a score.
The rating gives me a quick way to find good companies to examine.
DLH Holdings’ CROCI is 32.8%. That knocks the ball out of the park. For those who are unfamiliar, CROCI is cash return on capital invested. I say it every week, and I’ll say it again… It’s a formula that was invented by Deutsche Bank. It’s now used by Goldman Sachs Wealth Management to showcase and find stocks for its wealthiest clients.
It’s a formula I came across while having lunch with the chairman of Goldman Sachs Asset Management as they were pitching their services to me as a hedge fund CEO.
When I saw the data, I was blown away. Because companies in the top quartile by CROCI generate about a 30% per annum average return. Not every year, and not the same stocks every year. You pick a basket of stocks in the top quartile. And that top quartile, the top 25% of stocks, will average 30%. And then the next year, you’ll pick the next basket.
Sure, they won’t all average 30% every year. And they won’t average 30% as a basket every year. Some years, it might be more, some years less.
This company’s also been doing rather well by another important metric. Very few companies have a Sortino ratio above 1.
Now, Sortino is really important if you’re a hedge fund manager like me, because it’s what we’re asked by our investors to provide before they consider investing in us.
They say, “Well, what’s your Sortino?” It’s a measure of the average return versus the average risk of missing that return, or the volatility around missing it. If it has a Sortino above 1, that’s a rare company. And it means you’ve got more reward for the risk you’re taking on. To give you an example, even Microsoft doesn’t have a Sortino above 1.
Those are the main numbers I look at.
Now, there’s a slight downside to DLH, with volatility at 31%. I don’t like high volatility.
And so far this year, the stock has come off its recent high of roughly $21.
If we dive even deeper into the individual metrics, I’m seeing good CROCI, good return on capital employed and good return on equity. A lot of things being ticked off here.
Turnover and forecast growth are looking strong. Forecast P/E looks relatively cheap.
Borrowing has come off a bit. Operating cash flow is looking strong. Pretax profits are going in the right direction. We’re ticking a heck of a lot of boxes.
When I look at the chart for the stock, I can draw a trendline heading higher toward $21.20. I think the stock will break to the upside of that. It’ll get to that high before year-end and then continue on that upward trend.
I hope you found this analysis and insight helpful. You saw all the things that I look at within my hedge fund: profitability, revenue growth, dividend yields, etc.
Readers of my GVI Investor will be familiar with my Growth-Value-Income criteria, my cash flow criteria and everything else, because I go into a lot more detail in my research service.