Now This Is Secure Growth

04/20/2012 9:00 am EST

Focus: STOCKS

Usually investors look at technology or emerging markets for the most growth, but in this case, it's a company at the foundation of the US national security sector, writes Julie Carnevale of FAST Graphs.

For 50 years, CACI International Inc (CACI) has been serving America by providing in-demand services and solutions for our most vital missions for defense, intelligence, homeland security, and IT government modernization.

Moreover, the company has consistently outgrown the government's defense budget, because of its emphasis on higher growth areas of government services needed to defend our country.

Also, because of the sensitive nature of the services that are provided through contracts ranging from three to five years, we believe the company possesses a very strong moat. The majority of CACI's employees hold high-security clearances that provide natural barriers to entry against outsiders attempting to impinge on their turf.

CACI has a long history of growing earnings in excess of 18% per annum, and produces prodigious amounts of free cash flow. Nevertheless, it appears that fears of a shrinking defense budget have driven their shares to valuations that are unprecedentedly low historically.

Consequently, we believe this high-quality defense company with a niche, offers a good opportunity for investors seeking high-growth at a reasonably low level of risk. We believe the company is well-positioned to continue to grow future earnings at an above-average rate.

We see several opportunities for profit. Organic growth should continue at a mid-teens compounded annual rate, the company's ample cash flows position it for strategic acquisitions, and a price-to-earnings ratio expansion from its current P/E of 11 to a more normal P/E of 18 to 20 is reasonable to expect as investors' anxiety over defense cuts diminish.

Growth stocks are defined as companies with high rates of change of earnings growth, 15% to 20% or better. Growth stocks offer the potential for share prices to rise in lockstep with their profit growth in the long run. Therefore, the PEG ratio formula (price equals growth rate) tends to be the most appropriate formula used to value growth stocks. However, due to the exponential nature of compounding large numbers, PEG ratio forecasts are capped at 40%.

Because of the higher valuation typically awarded to fast growth, growth stocks offer the potential for greater capital appreciation. On the other hand, they also offer higher risk. First of all, they tend to command much higher than average P/E ratios, and second, achieving very high levels of growth is very difficult to sustain.

Consequently, forecasting future earnings growth is more important with high growth stocks than any other class of stock. Also, the average growth stock typically ploughs all of its profits back into the company to fund its future growth, instead of paying dividends.

Years of research and experience have taught us that there are two critically important keys to achieving above-average, long-term shareholder returns at reasonably controlled levels of risk. The first key is earnings growth, or what we like to call the rate of change of earnings growth.

The faster a company can grow its business (i.e. earnings), the larger the income stream it can produce with which to reward shareholders. This is because of the power of compounding, which Albert Einstein was alleged to have called "the most powerful force on earth." Ultimately, both capital appreciation and dividend income will be a function of a company's ability to grow its profits.

The second key is valuation. When a company can be purchased at its intrinsic value based on earnings and cash flow generation, the shareholders' rate of return or long-term capital appreciation will inevitably correlate to and/or equal its earnings growth rate. Overvaluation will lower that rate of return and conversely, undervaluation will increase it.

Consequently, paying strict attention to the valuation you pay to buy a stock is a critical component of both greater return and taking lower risk to achieve it. Because, ironically, when you overpay for even the best business, you simultaneously lower your return potential while increasing your risk of achieving the lower return.

The associated performance results with the earnings and price correlated graph, validates the above discussion regarding the two keys to long-term performance. Notice the impact that valuation (black line above or below orange earnings justified valuation line) had on the following performance results.

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The following graph plots the historically normal P/E ratio (the dark blue line) correlated with ten-year Treasury note interest. Notice that the current price earnings ratio on this quality company is as low as it has been since 1998.

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We believe that CACI is an extremely high-quality defense company with a niche that is currently being unfairly discounted by "Mr. Market."

The company possesses a predictable and consistent opportunity for continued double-digit earnings growth that is significantly in excess of the average company. Nevertheless, it can currently be purchased at a significant discount to the average company.

This company pays no dividends; it is purely an opportunity for growth that can currently be purchased at a significant discount to its True WorthT. Therefore, we suggest that investors seeking high-growth at a reasonable level of risk should dig deeper into this high-quality growth opportunity currently on sale.

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