This article was written by Peter Shearlock and published in The IRS Report in December 2011

A decade's growth makes Diploma a value star

How many times have you read that "past performance is no guarantee of future returns"? This warning adorns every packaged investment product that can be sold to the public. In truth, though, the past is often an excellent guide to the future. From picking the right unit trust to punting on the Grand National, past performance can help you weed out the no hopers and focus on the likely winners. And for that reason, value investors could do a lot worse than study the form of Diploma.

A mix of businesses spanning the life sciences, seals and controls industries, Diploma has lifted profits in each of the last 10 years. In the last five, it has grown earnings per share by an average 19%. It has just recorded its 12th successive year of dividend increases. It has invested £90m in acquisitions over the past five years and generated a profit return of over 20% per annum. For all that spending, it is currently sitting on net cash of over £12m.

Given those numbers, you might imagine that Diploma's shares would be accorded a premium rating. You would be wrong. They currently sell for a little under 11 times earnings for the year to end-September 2011. By comparison, the average P/E for the mix of sectors in which Diploma operates is more like 13. Meanwhile, the shares yield a worthwhile 3.9% - ahead of what will doubtless be another dividend increase in 2011/12.

There could be a variety of reasons for this modest rating. Diploma has something of a conglomerate feel to it, with no synergy between the three business areas. Conglomerates are unfashionable. Yet Diploma's diversity of businesses and markets has paid off handsomely since a thorough restructuring a decade ago.

Doubters may argue that the lilfe sciences business, which accounts for just under a third of group revenues, is quite dependent on government-funded health services, most of which are experiencing a cash squeeze. But Diploma's biggest health care market is Canada, where that squeeze was actually relaxed last year.

Then there is the controls business, which accounts for almost exactly one third of group revenue. This is heavily exposed to the defence sector, which, like healthcare, is suffering cuts. Germany is a big market and a review of defence spending there delayed the start of several projects last year in which Diploma's Filcon subsidiary had an interest. For all this, the controls division lifted its profits 12% on the back of buoyant demand from the motor sport, medical equipment and energy sectors.

Diploma released its 2010/11 results only a fortnight or so ago. The statement reads extremely well. Sales grew by more than a quarter and profit before tax by 39% to £44.9m. Margins hit a new high at 19.6% as Diploma delivered more added-value services and benefited fromprior-year cost cuts. Acquisitions contributed to the profit rise but organic profit growth was still impressive at 31%.

Free cash flow fell back a touch but this was due to a rebuilding of stocks from what had been low levels the previous year. The annual dividend is being lifted by a third. The payment is still covered more than twice by earnings.

Diploma owes at least a measure of success to a distinctive management style. The three divisions may have little in common, but each is focused on supplying products and services that are funded through their customers' operating budgets rather than reliant on capital spending decisions. They are also sold with a lot of value-added services and technical support, making for close customer relationships and better margins. The businesses target organic revenue growth of "GDP plus 5% to 6%" over the course of an economic cycle.

Then there is a decentralised management structure that gives the top team at each operating company a lot of freedom. Diploma's line is that this allows decisions to be made by people who know their customers. It also enables the businesses to respond more quickly to changes in their marketplace.

Acquisitions are a key part of the strategy. Some £28m was spent last year, about half of it on a distributor of medical devices to gastro-intestinal endoscopy suites in Canadian hospitals and clinics. Diploma then bought out the minority interest in its own endoscopy business and merged the related businesses to provide a more complete offering to customers. Deals of this kind have been used to fill out the product range in areas perceived as high growth. They have been hugely successful.

Diploma is clearly looking for more deals. It has recently negotiated a £40m bank credit line to supplement its existing cash pile. It says the current uncertain environment is a good one for coaxing owners into selling.

It is also planning for organic growth. It is spending £1m to move three businesses - in the UK, US and Toronto - into new and bigger facilities in the coming months. That speaks volumes for the confidence of Diploma's top management at a time when the general business backdrop is so uncertain.

The shares have been a firm market since the recent figures, but are still nearly a third down from their year's high. The breadth of Diploma's business and the diversity of markets in which it trades give the group a resilience that is normally reserved for much bigger companies. With a decent yield, a strong balance sheet and a proven management team, Diploma has a lot to offer the patient value investor.