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Eight shares to beat inflation

My Inflation Beaters screen has been waiting without joy for nine years for inflation to raise its head.
February 3, 2021
  • Will stimulus mean inflation?
  • Will a strategy based on consistent dividend growth head off inflationary threats?
  • This screen hopes so on both counts, but it has been outperforming in the meantime anyway.

I started to run my Inflation Beaters screen nine years ago, which was probably the last time inflation fears were running higher than they are today. Back then, the reason for heightened concern about inflation was very similar to the reason now: stimulus.

There could be an important distinction between today’s stimulus and the post-credit crunch stimulus. After the credit crunch central banks focused on feeding newly-created money into the banking system to repair banks’ balance sheets. Now, governments (especially in the US) are using-newly created money to replenish consumers' bank accounts. This could lead to a rush of spending once lockdowns around the world end. And maybe, that will wake the sleeping ogre of inflation.  

It’s not hard to understand why the market has latched on to the inflation narrative. Whether or not it will turn out to be true is another matter. This screen has seen too many false dawn to be counting on it. 

Fortunately though, the screen has not needed inflation to outperform the market. That’s because the central test used to see if shares may be able to keep up with inflation is to look for companies with solid dividend growth records. The screen also looks for decent balance sheets and forecast growth. 

The kind of business that consistently grows dividends while maintaining a sound balance sheet, often turns out to be reliable, stable and cash generative. Shares in such companies often perform well over time. Importantly, the dividend yield test used by the screen sets a low bar. That should be useful because excessive focus on high dividend yields tends to mean focusing on mature companies, or those with less-certain growth prospects. 

The tests also incorporate the concept of shareholder yields which adds net share buybacks per share to dividend per share to calculate a yield. This measure of yield acknowledges that buybacks have the same benefit for shareholders as a very tax-efficient dividend reinvestment scheme.

The full screening 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 of 15 per cent or more.

■ A forecast dividend yield of over 2 per cent or a historical shareholder yield over 4 per cent.

■ Forecast earnings growth both this year and next.

While the screen just about beat the index last year, the year was in no way a rip roarer. In fact, this screen has been fairly pedestrian throughout its life. It would be nice to see what happened if there was some inflation. 

12 MONTH PERFORMANCE  
NameTIDMTotal return (4 Feb 2020 - 27 Jan 2021)
Ashtead GroupAHT46%
ComputacenterCCC30%
SafestoreSAFE4.0%
UnileverULVR-0.5%
Hill & SmithHILS-2.1%
DunelmDNLM-4.0%
Paragon BankingPAG-7.3%
BurberryBRBY-15%
Coca-Cola HBCCCH-18%
CompassCPG-27%
BellwayBWY-31%
WH SmithSMWH-35%
FTSE 350--6.8%
Inflation Beaters--4.9%
Source: Thomson Datastream  

 

The cumulative total return over the nine years stands at 116 per cent compared with 72 per cent from the FTSE 350 (the index screened). Meanwhile, if I factor in a 1 per cent annual charge to account for notional dealing costs, the total return drops to 97 per cent. The inclusion of the charge is not meant to suggest the screen should be seen an off-the-shelf portfolio. The results are considered a source of ideas for further research.

This year no shares passed all the screen’s tests. However, eight managed to pass on a weakened criteria requiring them to meet the dividend/shareholder-yield test but allowing them to fail one of the other criteria. Details of the shares can be found in the table below and I’ve taken a closer look at one of them.

EIGHT SHARES TO BEAT INFLATION

Test FailedNameTIDMMkt capNet cash/ Debt(-)*PriceFwd PE (+12 mths)Fwd DY (+12 mths)Shldr yldFCF yld (+12mths)Fwd EPS grth FY+1Fwd EPS grth FY+23-mth mom3-mth Fwd EPS change%
RoECranswickCWK£1,788m-£122m3,402p182.0%1.7%4.4%16%2%0.5%2.2%
Fwd EPS grthSpectrisSXS£3,561m£35m3,063p232.2%2.1%3.5%-37%24%20.3%1.0%
ND/EBITDALegal & GeneralLGEN£15,384m£15,854m258p97.2%7.0%-1%2%31.8%2.9%
10y DPS grthUnileverULVR£116,291m-£20,770m4,423p203.4%3.2%5.7%3%2%-4.8%-0.6%
10y DPS grthRio TintoRIO£73,680m-£6,352m5,909p97.3%5.7%10.1%8%26%31.7%5.0%
10y DPS grthHomeServeHSV£3,629m-£587m1,080p222.6%2.2%4.0%5%14%-7.1%3.0%
10y DPS grthLiontrust Asset MgmtLIO£768m£94m1,260p143.8%-4.4%27%36%-0.8%6.2%
10y DPS grthHikma PharmaHIK£5,696m-£395m2,471p181.6%6.7%-5%15%-3.3%-6.7%

Source: FactSet

Homeserve

Homeserve (HSV) seems to have lost its lustre with investors over the last six months and it was booted out of the FTSE 100 index in November. While lockdown did cause some strain for the business, much of the reason for the weak share price performance hinges on doubts about the company’s growth strategy coupled with the relatively high rating the shares were previously trading at.

Homeserve specialises in providing home repair and maintenance services in the UK (33 per cent of sales and 39 per cent of profit), North America (37 per cent and 39 per cent), France and Spain. It also has a fledgling, loss-making business that generates job leads for vetted trades people. 

A key focus for the group is generating sales through partnerships with utility companies. It’s membership business uses these relationships to sell policies for the service and repair items, such as boilers and pipes. Policies are underwritten to offset risk. Meanwhile, Homeserve uses its network of directly-employed and subcontracted engineers to get jobs done. The company also provides customer services and marketing to support the policies. 

This membership business accounts for over four fifths of revenues. While changes to regulation have in the past caused some upsets, over recent years the model has generally been regarded as providing stable cash flows based on 12-month customer contracts and renewal rates of about 80 per cent.

There are two major growth opportunities the company is trying to pursue. The first is its attempts to take the membership business stateside. The North American operation has seen underlying operating profits race up from £6.4m to £85m over five years. Management has set a milestone target of $230m (£168m). Broker Peel Hunt thinks it could get here in the 2025 financial year. 

North America is considered a particularly interesting market due to its fragmented nature. There are about 50,000 utility companies in the US which means Homeserve could build a powerful market position if it can obtain scale. It is trying to achieve this by winning new utility company partnerships and also by buying up small heating, ventilation, and air conditioning (HVAC) businesses through which it can push policies. 

The rate of acquisition slightly clouds how progress is being achieved. Half-year results in November were a source of disappointment for investors with some signs that organic growth in North America may be slowing. In particular, the number of “partner households” (the number of households served by utility partners) was flat. This has been put down to the fact Homeserve decided to finish a relationship with a large unproductive partner. This was offset by signing many smaller partners that will hopefully generate better revenue. But it looks like the market needs reassurance. The fact the UK business has been losing customers for several years add to the pressure.

The other major growth opportunity for the group is its fledgling Home Expert business. A major focus here is Checkatrade, for which the company has set a milestone profit target of £45m-£90m. This service provides job leads for vetted trades people in the UK. People wanting jobs done submit details on the Checkatrade website in order to receive quotes from trades people that subscribe to the service. 

There are potentially huge profits to be made by Homeserve from being the leading digital go-between in this kind of market, as sites like Rightmove and AutoTrader have proved. However, Homeserve still needs to show it can create the necessary scale to establish a powerful network effect – the effect whereby ever more value is created the more customers and advertisers use the service. In this context, it was unwelcome that lockdown rules have prevented some types of job from taking place as well as reducing demand at times.

The company has also established a Homes Experts presence in France and Spain, and recently spent $140m buying a 79 per cent stake in US business eLocal. eLocal is predominantly a call-based lead generator. It is expected to turn a $10m profit this year and help the division as a whole turn a profit in 2022. It is hoped Checkatrade can break even in 2023. 

The excitement of the growth drive in North America and from Home Experts has been a welcome distraction from the UK membership business. In the UK, Homeserve has been focusing the business  on the customers it can make most money from whilst saying goodbye to those who are always after a discount. This has meant dwindling customer numbers over several years, although some of this has been mitigated by rising income per customer. While recent FCA rulings on the insurance industry are not expected to prove a major issue, they will make policies easier to cancel. Still, the company expects UK customer numbers to stabilise next year.

The company’s acquisition spend has been high (£148m in the 2019 financial year) and net debt to cash profit is at the upper end of the 1 to 2 times target range. Still, debt looks manageable and the business is good at generating cash

With the shares losing a fifth of their value since last August, the shares’ rating looks less toppy. The forecast next-12 months free cash flow yield (FCF as a percentage of enterprise value) of 4 per cent and forecast price/earnings ratio of 22 could prove decent value if faith is restored in the growth plans. That’s certainly true if broker Peel Hunt proves correct in its predictions of  an organic compound annual FCF growth rate of 10 per cent over the next five years. Should investors get back behind the growth story the stability offered by the membership model may also begin to resonate once more. For now, the jury seems out.