My inflation-beaters screen is currently looking distinctly 'off message'. When I began running the screen at the start of 2012, the risk of QE-induced inflation was very much on the market's mind. But fast forward three years and the talk is all about deflation. Indeed, the idea that the latest round of QE to hit the global economy - the European Central Bank's belated foray into money printing - will even be enough to stave off deflation is considered very debatable. Indeed, while QE has certainly propped up financial institutions, it seems, in the main, to have had little effect on the pay packets of the UK's workforce.
However, the inflation-beaters screen has virtues beyond the task of trying to find stocks that would do well in an above-target-inflation environment. That's because it essentially focuses finding high-quality stocks by looking for companies that boast strong track records for dividend growth and have underlying fundamentals that suggest more growth is on the cards. And importantly, high-quality stocks, even highly priced ones, often outperform whether or not inflation is an issue. The screen also tries to search out more robust companies by only focusing on the FTSE 350 and staying away from more vulnerable smaller companies.
When it comes to reducing risk, size isn't everything, though, and a look at the performance of last year's inflation-beaters attests to this. Up until last year, this screen boasted an extremely strong hit rate for outperformance with only two of the 15 shares picked over the two previous years actually underperforming the market. This year three out of five underperformed. And while the underperformance of Diageo was unremarkable, the two other underperformers were absolute stinkers: Amec Foster Wheeler and ITE. Indeed, the negative contribution of these two shares pushed the overall performance of the five stocks to a negative total return of 5.4 per cent compared with a positive 4.8 per cent from the FTSE 350. This highlights the risks of very focused share selections, which often characterise the more exacting screens I run in this column (see table).
| Name | TIDM | Total return (15 Jan 2014 - 26 Jan 2015) |
|---|---|---|
| Victrex | VCTA | 24% |
| Croda Int'l | CRDA | 20% |
| Diageo | DGE | 1.1% |
| Amec Foster Wheeler | AMFW | -19% |
| ITE Group | ITE | -52% |
| Average | - | -5.4% |
| FTSE 350 | - | 4.8% |
Source: S&P Capital IQ
But with risk also comes reward, and the inflation-beaters screen has actually benefited in previous years from selecting only small numbers of stocks. Indeed, over the three years I have now run the screen the cumulative total return stands at 55.7 per cent compared with 36.0 per cent from the index (see graph). If a one per cent charge is factored in to account for dealing costs the cumulative return drops to 48.1 per cent.
Inflation beaters vs FTSE 350
Source: S&P Capital IQ
The problems last year's stocks encountered can be viewed as largely thematic. Trade show organiser ITE does a lot of its business - almost 60 per cent - in Russia and the sanctions placed on the country by the West along with the rouble's collapse have whacked performance. Meanwhile, oil services company Amec Foster Wheeler has seen its business suffer due to the declining oil price and the knock on effect on activity levels in its end markets.
While there are few ways for a screen to foresee major political events or market events such as an oil-price collapse, I've made two amendments to this year's screen to reflect the changing market mood and address the issues of companies (such as those reliant on the oil price or the Russian economy) that could face radically changed prospects next year.
The first amendment is to drop the requirement that companies generate two thirds of their profits from outside the UK. I originally made this a screening requirement due to the fact that currency debasement normally accompanies periods of high inflation. But, as sterling looks quite strongly supported at the moment due to the UK's relatively tight monetary policy and relatively strong economic growth compared with the rest of the world, it seems fitting to suspend this requirement - at least for this year.
The second change I've made is to insist that companies passing the screen have forecast earnings growth pencilled in for their current financial year and the following financial year. This is to try to capture companies that have seen a major change in their fortunes - my specific concern is about companies with significant exposure to the drop in commodity prices or Russia as such companies should still be boasting strong track records for previously reported years even though their future prospects will have significantly changed. It is unlikely looking at forecasts would have helped last year's screen as the unforeseen issues that hit the portfolio set in later in the year.
The full screening criteria are as follows:
■ A rising dividend in each of the past 10 years. ■ 10-year and five-year compound average dividend growth of 5 per cent or more and growth in the past year of 5 per cent or more. ■ Dividend cover of two times or more. ■ Net debt of less than 2.5 times cash profits. ■ A return on equity of 15 per cent or more. ■ A dividend yield of 2 per cent or more. ■ Forecast earnings growth both this year and next |
The screen's chief concern is quality and it puts minimal emphasis on valuation. The 2 per cent dividend yield requirement (the only valuation criteria) is mainly there simply to make sure the dividend growth that the screen looks for can be considered meaningful. However, despite the screen's free-and-easy approach to the question of value, only three FTSE 350 stocks made it through all the criteria this year. I have provided brief write-ups of these stocks below. Due to the screen delivering such slim pickings, I've also included a table of stocks that passed all but one of the screen's seven tests. There are 20 further stocks that qualify on this basis ordered from highest to lowest yield in the table.
Three dividend growth plays
