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13 stocks to beat inflation

After many false inflationary dawns since I devised my Inflation Busters screen was devised a decade ago, is it finally going to get a decent road test in the economic conditions it was invented to navigate?
13 stocks to beat inflation
  • Is it time for my inflation screen to shine?
  • Is it up to the job?
  • Will any shares meet the criteria?
  • …yes 13, but only after a fair bit of tinkering

Could it finally be time for my Inflation Busters screen to shine? Not since I devised the screen 10 years ago have expectations of a period of high and entrenched inflation been so great.

Maybe this time it really is the real thing. But even if it is, I have some reservations about this screen’s criteria. That’s because there is something the screen ignores which is generally considered the go-to metric to find inflation-resilient businesses: gross margins.

There are two reasons investors often focus on gross margins when considering inflation. First of all, high gross margins suggest a company has pricing power, ie it can charge well above cost for its products and services. Secondly, the same percentage rise in costs is less significant for a company when those costs are a lower proportion of sales – ie when a company has high gross margins.

The reason this screen does not take gross margins into account is a prosaic one. When I devised the criteria, the gross margin data I had to hand was not great and I found it hard to make it work with other tests. To introduce this criteria now would in effect be to create a new screen. Perhaps that’s not a bad idea, but it is something for another column and for my successor to consider.

With gross margins not cutting the screening mustard, I turned to dividend history as a measure of company resilience. Over the past 10 years this screen has managed to generate a decent cumulative total return of 140 per cent versus 100 per cent from the FTSE 350 (the index screened). So despite my grumbles, the results have not been too bad. 

While screens are always meant as a source of ideas rather than off-the-shelf portfolios, if I give a nod to the real world by factoring notional annual costs of 1 per cent, the cumulative total return drops to 116 per cent. The past 12 months, meanwhile, have not been great, as the table below shows. 

12 MONTH PERFORMANCE

12-month performance
NameTIDMTotal Return (3 Feb 2021 - 11 Jan 2022)
CranswickCWK12.6%
SpectrisSXS19.3%
Legal & GeneralLGEN30.1%
UnileverULVR-5.7%
Rio TintoRIO5.7%
HomeserveHSV-22.7%
Liontrust Asset ManagementLIO61.3%
Hikma PharmaceuticalsHIK-9.8%
FTSE 350-18.1%
Inflation Beaters-11.3%
Source: Thomson Datastream

 

 

The exceptional hit to earnings and dividends caused by lockdown has led me to alter the screen’s criteria a bit this year. Notably, tests now look at three-year average return on equity (RoE) rather than just last year’s number. It also compares RoE with the median stock rather than an absolute number. So, too, the dividend-yield test. And the screen’s test for dividend rises over the past year has been removed given so many companies were understandably prudent on this score due to pandemic uncertainties. The 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.

■ Dividend cover of two times or more.

■ Net debt of less than 2.5 times cash profits.

■ A three-year average return on equity greater than the median average.

■ A forecast dividend yield or historical shareholder yield (dividends plus net buybacks per share) higher than the median average.

■ Forecast earnings growth both this year and next.

Even with the adjustments to the criteria, no FTSE 350 stock has passed all the tests. I’ve therefore allowed stocks to pass if they fail one test, as long as it is not the dividend yield test. The reasons I’ve insisted on the yield test being passed is that I think generally speaking the dividend paid by a company should be reasonably significant if the dividend record is to be regarded as a significant measure of its resilience to inflation. 

In total 13 stocks passed the screen on the weakened criteria and a table of the results can be found at the end of the article. I’ve also taken a look at the lowest-valued stock on the list based on a next-12-month price/earnings (PE) ratio. 

 

BAE Systems

Company DetailsNameTIDMDesriptionPrice
BAE Systems plcBAAerospace & Defense580p
Size/DebtMkt CapNet Cash / Debt(-)Net Debt / EbitdaOp Cash/ Ebitda
£18,319m-£3,633m1.6 x49%
ValuationFwd PE (+12mths)Fwd DY (+12mths)FCF yld (+12mths)P/BV
124.5%7.9%2.7
Quality/ GrowthEBIT MarginROCE5yr Sales CAGR5yr EPS CAGR
9.4%15.9%2.8%7.0%
Forecasts/ MomentumFwd EPS grth NTMFwd EPS grth STM3-mth Mom3-mth Fwd EPS change%
6%--2.9%-0.5%
Year End 31 DecSalesPre-tax profitEPSDPS
2018£16.8bn£1.55bn43p22p
2019£18.3bn£1.78bn46p23p
2020£19.3bn£1.77bn47p24p
f'cst 2021£21.3bn£1.90bn47p25p
f'cst 2022£22.2bn£2.02bn50p26p
source: FactSet, adjusted PTP and EPS figures 
NTM = Next Twelve Months  
STM = Second Twelve Months (i.e. one year from now)

 

Defence giant BAE Systems (BA.) looks very cheap based on its forecast free cash flow (FCF), much of which is expected to be returned to shareholders in coming years through dividends and buybacks. Both demand and the balance sheet look decent on first sight and a hefty order book provides visibility. What gives? Is this a major bargain?

As is often the case when valuations are low, investors have their reasons to avoid paying up for the shares. However, the company’s management is trying to make the investment case more palatable and shareholders could benefit.

 

Reasons to be wary

One of the main issues investors in BAE need to grapple with is its so-called 'quality of earnings'. The company operates complex, long-term contracts. This means a lot of reported revenue is based on estimates of how much work has been done on projects, what costs have been incurred and what margin is likely to be achieved. The nature of the business means the income statement is necessarily more subjective than most. The large and erratic differences between historical profits and cash flows (see chart below) are a reflection of this. 

For companies that take on work on such terms, judgments are hard to make and overoptimism is an ever-present temptation. That’s a key reason why there are a litany of companies of this type that have come a cropper; perhaps most famously Carillion.

In the case of BAE Systems, at the end of 2020 (the last reported financial year), the company had trade receivables of £1.6bn (mainly unpaid invoices), contract receivables of £2.6bn (money it thinks it is owed for work done on contracts) and accrued income of £890m (mainly work done that was yet to be invoiced for). This is partially balanced out by contract liabilities (the work it has been paid for and still has to do) of £3.8bn. 

These are large amounts of money relative to last year’s revenue of £19.2bn, and making sure the right assumptions have been made about long-term projects is a challenging job. The history of profit adjustments is not too bad though, suggesting the company’s accounts have tended to get things more right than wrong in the past.

The quality-of-earnings risk also needs to be seen in the context of the significance of major clients and contracts. At the end 2020 the company’s 15 largest contracts accounted for just under half the group’s sales. Nine programmes, meanwhile, had an order backlog in excess of £1bn. That compares with an overall order backlog of £45bn and an order book of £36bn. 

Meanwhile, just three customers account for 70 per cent of revenue. The US Department of Defense makes up 36 per cent, the UK Ministry of Defence 21 per cent and the Kingdom of Saudi Arabia Ministry of Defence 13 per cent. 

Encouragingly, demand from these sources looks fairly strong at the moment. Also, defence makes for defensive earnings, insulated from the broader economic cycle. It is also tempting to take comfort in the fact that we are looking at government-backed, contracted revenue. But as BAE itself points out in its report on key risks, there are also downsides to having such powerful customers: “In the defence and security industries, governments can typically modify contracts for their convenience or terminate them at short notice. Long-term US government contracts, for example, are funded annually and are subject to cancellation if funding appropriations for subsequent periods are not made.”

The group’s cost of sales are also going to feel inflationary pressure. Gross margins are relatively low at about 27 per cent and most of the group’s cost of sales are composed of inputs, sub-contractor payments and wages (see pie chart). The group may disclose more about inflation links in contracts when it reports full-year results in February.

Then there is the pension. The company is sat on £39bn of pension liabilities. The scale of this means small movements in interest rates, inflation, investment values and longevity assumptions can have major implications for the balance sheet. The last reported deficit was £2.4bn, while the last triennial review (the pension measure that really counts) put the funding gap at £1.9bn. And while assumptions about a higher 'discount rate', which is linked long-term government bond yields, benefited the half-year deficit estimate, higher inflation also has negative implications for valuations. There is a lot of hedging in place, though. 

 

Don’t worry

How does a company like this reassure investors? Two key ways are through cash flows and balance sheet strength. 

In terms of the balance sheet, a £1bn payment into the pension in April 2020, funded by the issue of a bond paying 3.4 per cent, has helped. It has no more top-ups to make unless the next triennial review later this year says they’re needed. Meanwhile, net debt does not look egregious.

The company also has a clear target for free cash flow (FCF). It aims to produce £4bn of FCF in the three years to the end of 2023. It beat its previous three-year target of generating FCF of more than £3bn; it managed £3.2bn, ignoring the £1bn pension contribution. 

Forecasts (see chart) are for a far smoother FCF trajectory than shareholders are used to, but given cash flow is inherently lumpy and hard to predict, expectations of a gradual progression should be taken with a pinch of salt even if the overall target shouldn’t. Even if progress is a bit erratic, backing profits with cash over the period should be a big positive. The company has underlined its confidence in cash flows by announcing a £500m buyback last year as well as a 5 per cent increase in the half-year dividend.

One way to keep free cash flow up is to keep investment in the business down. Broker JPMorgan has recently taken umbrage with the group on this score. It downgraded its recommendation on the shares based on the fact that research and development  (R&D) represents less than 1 per cent of sales compared with about 3.5 per cent for peers. That is a big difference and the broker also highlights that BAE's organic growth has been inferior to that of rivals. 

One counter to the R&D concerns is the fact that BAE has a bolt-on acquisition policy that allows it to buy in innovation and expertise. However, in an industry where it pays to be on the cutting-edge, low spending is unwelcome. 

 

Upward and onward

As well as cash flow targets and balance sheet health, other planks in BAE’s plan to woo investors revolve around increasing the efficiency of the business to improve margin while growing the top line. 

Even if things go well, progress is likely to be steady rather than spectacular. BAE is not a real growth play. But the defensive nature of its markets makes it a natural stock for those who like steady-eddy dividend-payers. The complication though, as we’ve seen, is the quality-of-earnings question. 

By the shares' own standards they are currently valued around the middle of the five-year range based on both enterprise value (market cap plus net debt) to sales and dividend yield. But the company is nearly as cheap as it has been in that period based on FCF yield. If cash generation holds up, the shares could do well. What’s more, broadly speaking the defensive nature of end markets means it could make a decent inflation play. 

 

13 stocks to beat inflation
Test FailedNameTIDMMkt capNet cash /debt(-)*PriceFwd PE (+12mths)Fwd DY (+12mths)Shldr yldFCF yld (+12mths)Fwd EPS grth FY+1Fwd EPS grth FY+23-mth Mom3-mth Fwd EPS change%
5% DPS CAGR 5yr & 10yrBAE SystemsBA£18,059m£3,633m571p114.2%4.2%8.0%7%6%-2.5%-0.4%
NTM & STM EPS GrthBunzlBNZL£9,187m£1,676m2,723p182.0%2.4%5.9%-0.5%3%13.6%3.8%
10yr DPS grthComputacenterCCC£3,121m£29m2,734p182.0%3.1%6.6%1%3%4.7%3.3%
10yr DPS grthDunelmDNLM£2,716m£165m1,340p187.5%7.4%5.7%10%2%7.0%5.3%
10yr DPS grthFergusonFERG£27,429m£657m12,450p201.4%2.4%3.9%12%6%21.0%10.7%
10yr DPS grthGames WorkshopGAW£2,855m-£41m8,695p222.5%2.5%5.6%5%7%-11.7%0.8%
10yr DPS grthMondiMNDI£9,029m£1,717m1,859p132.8%2.9%5.9%17%7%5.2%0.9%
10yr DPS grthMoneysupermarket.comMONY£1,159m-£9m216p145.4%5.4%7.3%30%14%5.6%6.2%
Av 3yr RoERathbonesRAT£1,249m-£1,339m2,015p123.7%-2.7%-8%7%7.1%4.3%
10yr DPS grthRotorkROR£2,994m-£144m348p272.5%2.6%2.9%16%9%2.4%-2.3%
5% DPS CAGR 5yr & 10yrSageSGE£8,267m£261m810p302.2%6.3%2.4%13%13%14.5%4.7%
10yr DPS grthSpirent CommunicationsSPT£1,544m-£94m252p201.8%2.3%4.6%6%7%-8.3%3.1%
10yr DPS grthUnileverULVR£100,953m£19,294m3,942p183.8%4.5%6.7%6%5%2.0%0.0%
Source: FactSet            
* FX converted to £