Five dividend growth stars

Source: Datastream

The explanation for the strong performance in part hinges on the fundamentals we used to identify inflation-beating stocks – strong dividend growth and high business quality. These themes were rewarded by the market without the spectre of inflation looming ever larger.

The strong results from last year's screen alone make a good case for a re-run. However, the possibility of resurgent inflation is also something that investors may be well served to remain alive to. History suggests that countries that can print their own money and predominantly have debt denominated in that money often end up with high inflation following a build-up of excessive debts. With a change at the helm of the Bank of England due this year and a new debate about the role of the Bank in influencing the economy under way, the issue of inflation could well be high up investors' agendas again this time next year and beyond. Indeed, in his final column for this magazine, Alistair Blair highlighted this as one of his key concerns for the future.

Our 'inflation-beating' screen looks for shares with a long-term record of 5 per cent plus dividend growth, which we use as a key indicator that returns could potentially rise at an inflation-beating rate.We also demand a sound balance sheet and good dividend cover from the selected companies. In addition, the screen focuses on companies that generate more than three-quarters of their income from overseas, as a way to counter the impact of currency debasement that one would expect to accompany high inflation.

Following such a strong run last year by our inflation-beating shares, only five stocks from the FTSE 350 fit all our criteria this time around. Given the scant results, we've also included a list of more UK-focused companies that pass our other tests. The screen's criteria are:

■ 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 (a rough gauge of business quality) of 15 per cent or more.

■ A dividend yield of 2 per cent or more – this is a low bar (below the 2.9 per cent median average of all stocks screened) as dividend growth is our primary concern.

■ At least three-quarters of revenues from outside the UK

FIVE SOLID, FAST-GROWING DIVIDEND YIELDS

Cobham

Defence company Cobham looks as though it is in for a tough year. Reduced defence spending in the US will hurt the group as it gets about 40 per cent of its revenue from across the pond. However, the company has sought to quantify the impact (a 5 to 9 per cent fall in US sales) with a statement it made in November. Despite the drop in sales and an expected fall in higher-margin, war-related sales, the company plans to continue to increase the dividend. Indeed, broker Investec forecasts dividend growth of 10 per cent this year, giving a forecast yield of 4.3 per cent. The company is also targeting new growth markets, such as the Middle East, Asia, South America and commercial work, which should result in a resumption of organic growth by 2014. And it has plans to cut costs by £105m a year. What's more, there are hopes that Cobham's recently appointed chief executive, Bob Murphy, has sought to get all the bad news out of the way early on with the guidance issued in November (Last IC view: Hold, 194p, 13 Nov 2012).

Source: S&P CapitalIQ

Diploma

The focus on three niche distribution businesses – seals, life sciences and controls – has served Diploma well and earned it a reputation for reliability. While there is some cyclicality in its end markets, which accounted for a very strong performance by the seals business in the US last year, it is focused on areas that companies have to spend money on in order to function. Steady growth is the order of the day and the company's strong cash generation pays for investment in the business and acquisitions – three were made last year. Diploma finished its 2012 financial year with net cash of £7.9m, which broker Panmure forecasts will rise to £19.6m by the end of the current year based on Diploma's investment plans. This gives plenty of scope for further acquisitions and perhaps forays into new product areas and regions. Panmure forecasts dividend growth of about 10 per cent both this year and next, giving a forecast yield of 2.8 per cent rising to 3.1 per cent (Last IC view: Buy, 448p, 19 Nov 2012).

Johnson Matthey

Expectations for Johnson Matthey's third-quarter update, which is due at the end of the month, are muted. The company ran into trouble in 2012 due to the fall in the price of the precious metals that it refines, including platinum and palladium. The problem being that there is less demand to refine metals for sale at lower prices and over the third quarter there was little movement in prices. Nevertheless, the emissions technology business, which accounts for 55 per cent of sales, has been trading well. This part of the business, which is involved with the production of catalytic converters, is also underpinned by long-term growth as regulation means more vehicles need to be installed with environmentally friendly technology. The company has also recently been benefiting from the sale of high-margin drug ingredients. Despite the current issues, broker Numis expects dividend growth this year of 7 per cent, giving a yield of 2.5 per cent (Last IC view: Hold, 2,175p, 21 Nov 2012).

Diageo

Drinks giant Diageo is at the forefront of an exciting wave of consolidation in the sector as emerging market players are bought up by their Western counterparts. Following the completion of the 53 per cent purchase of India's United Spirits, more than half of Diageo's sales now come from emerging markets. Sales growth in these regions was 15 per cent in the group's last financial year. The sale of spirits per capita in these markets is often well behind that in the West and there is also a lot of potential to increase the consumption of premium brands in these markets. The growth story and Diageo's strong brands have clear attractions for investors (Last IC view: Buy, 1,692p, 23 Aug 2012).

Victrex

Specialist plastics group Victrex is benefiting from its development of products in some noteworthy growth areas, namely smartphones and tablets, and aviation. Demand for the company’s PEEK product is also strong and capacity is being added. And the company has been doing particularly well in Asia. However, margins have fallen recently due to higher raw material prices and lower sales of its very high margin Invivio products. Meanwhile the current financial year is expected to face headwinds from the lagged effect of last year’s currency movements, which are largely hedged out on the year they occur. There is net cash of £83.9m on the balance sheet and overall the outlook for the group looks pretty solid but there are few reasons for huge excitement. Broker Peel Hunt expects dividend growth of 7 per cent this year and next giving a forecast yield of 2.3 per cent rising to 2.5 per cent (Last IC view: Hold, 1,572p, 11 Dec 2012).

Stocks with more than 25 per cent of sales from UK