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These 2 dividend growth stocks are thrashing the market. They’re not cheap, but I’d buy them

Don’t you just love it when an overlooked share smashes the market? Especially when it is trading in an out-of-favour sector, like retail.

Dunelm Group

Given the squeeze on consumer spending, and the challenge from the internet, home furnishings retailer Dunelm Group (LSE: DNLM) has no right to do as well as it has. Astonishingly, its stock is up 56% in the last three months alone, and my colleague Roland Head is rightfully celebrating. This was his top tip for 2019, and it is up 140% since he highlighted its potential.

He noted that Dunelm was “one of the most profitable firms of its kind”, and it repaid his faith by delivering a 25% increase in annual profits, with a dividend splurge on top.

The Dunelm share price is up another 2% this morning, after its second-quarter trading update showed total like-for-like sales up 5%, which management said reflected strong growth across its total retail system. This was particularly impressive given the strength of the comparative period, when sales rose 10.8%.

Retailers can’t beat the internet, so they have to join it. Dunelm’s store-based Q2 revenues rose just 1.2% to £265.3m, but online sales rose 32.1%. They remain a smaller part of the business, with revenues of £47.7m, but are catching up fast.

Gross margin improved by around 110bps in Q2, due to sourcing gains and lower product markdowns, while management showed its mettle by shunning Black Friday and pre-Christmas discounting.

The FTSE 250 group generates plenty of cash, and low weekly average net debt of £24m allows it to pay out a special dividend of £65m. The yield may seem low at 2.6%, covered 1.8 times, but don’t be fooled, that is mostly down to its rapid share price growth.

Earnings predictions look solid, with growth of 7% and 6% forecast for 2020 and 2021. Some of my colleagues have baulked at the valuation, which is high after recent successes, and that may have trimmed today’s gains. However, at 21.1 times earnings, it isn’t that expensive. With forecast profit before tax expected to hit £83m, up from £70m, it still looks like a buy to me. Just don’t expect it to rise another 140%.

Greggs

Talking of high street retailers bucking the trend, take a look at Greggs (LSE: GRG). Nobody sneers at this purveyor of sausage rolls and iced buns any longer, not now that it has added veganism to its mix (and a healthy dash of social media self-irony too).

The Greggs share price is up almost 40% over three months, and more than 400% over 10 years. The group is ruthless at dumping underperforming stores, clever at where it locates its outlets, and has a talent for social media.

People talk about Greggs. They always did, but with a sneer. The genius marketing of its vegan sausage roll changed all that.

Once again, my colleagues are wary of its toppy valuation, as the FTSE 250 group currently trades at 34.2 times earnings. However, those earnings are set to jump 22% this year, and the forecast valuation is now a less sticky 25.4 times earnings. With revenues forecast to grow by a steady 6% and 7% in 2020 and 2021, Greggs might just pull it off again.

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Harvey Jones has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.