As rising interest rates cause investors to shift their attention to dividends and value, growth stocks have slipped off people’s watch lists. While others are hunting elsewhere, I’ve found a growth stock to add to my portfolio in July.
The stock has been falling, but the underlying business looks to me like it’s in great shape. It generates strong cash flows, it’s resistant to inflation, and it’s well protected from competitors.
I think that the stock is currently flying under the radar. Its price has been falling, but I think that the underlying business is sound.
The stock is Diploma (LSE:DPLM). It’s not a business that gets much coverage, but the more I look at it, the more I view it as a stock I’d like to buy in July.
The business
Diploma is a distributor of industrial components. Specifically, it supplies seals, wires, and healthcare equipment.
Its customers are businesses that own heavy machinery. Sometimes these machines break and need replacement parts. That’s where Diploma comes in.
When a machine isn’t working, it isn’t making money. So the ability for a distributor to get a component to a customer quickly is crucial.
This is where Diploma really stands out. It maintains a larger inventory than other suppliers and has the infrastructure to get replacement parts to where they need to go quickly, minimising equipment downtime.
Cash generation
According to Warren Buffett, the best businesses are ones that are able to grow their earnings without requiring substantial reinvestment. I think Diploma fits the bill perfectly here.
Since Diploma isn’t involved in manufacturing, it has relatively low reinvestment needs. It therefore doesn’t have to spend its money maintaining factories or equipment of its own.
This results in impressive cash production. With just over £80m in fixed assets, Diploma generates around £116m in operating income, around 90% of which becomes free cash flow.
Low capital expenditures give Diploma a degree of protection from inflation. Not having to spend money in order to grow means that the business is protected from increasing input costs.
Protection
The ability to generate cash is crucial. But it’s also important that a business is able to protect itself from competitors.
Diploma protects its business by establishing dominant positions in specialist niche areas. This makes it difficult for a competitor to take away Diploma’s business.
A dominant position in the markets it operates in means disrupting Diploma’s business is expensive. And the fact that the company operates in niche markets means that the rewards for doing so are limited.
Diploma’s positioning thus gives it protection from competitors. The fact that doing so would likely be expensive for a low return disincentivises other companies from attempting to disrupt Diploma’s business.
A stock I’m looking to buy in July
Diploma’s share price has been falling lately. The stock is down around 35% since the beginning of the year.
I believe this is due to the tighter economic conditions, which might well present a challenge in the near term for Diploma’s business. That’s the biggest risk I see with Diploma shares.
Over time, however, I think that the quality of the business will prevail. The company is flying under the radar at the moment, so I’m looking to be greedy when others are fearful and buy the stock for my portfolio.
