Now more than ever, a comfortable retirement depends on secure, stable investments. Unfortunately, the right stocks for retirement won't just fall into your lap. In this series, I look at 10 measures to show what makes a great retirement-oriented stock.
The defense industry has been a tough place to be lately. With budget cuts and big stresses on the federal government, things have looked bad for Northrop Grumman (NYSE: NOC ) and its defense peers for years. But after a substantial drop in share prices, has the defense industry finally hit bottom? Below, we'll revisit how Northrop Grumman does on our 10-point scale.
The right stocks for retirees
With decades to go before you need to tap your investments, you can take greater risks, weighing the chance of big losses against the potential for mind-blowing returns. But as retirement approaches, you no longer have the luxury of waiting out a downturn.
Sure, you still want good returns, but you also need to manage your risk and protect yourself against bear markets, which can maul your finances at the worst possible time. The right stocks combine both of these elements in a single investment.
When scrutinizing a stock, retirees should look for:
- Size. Most retirees would rather not take a flyer on unproven businesses. Bigger companies may lack their smaller counterparts' growth potential, but they do offer greater security.
- Consistency. While many investors look for fast-growing companies, conservative investors want to see steady, consistent gains in revenue, free cash flow, and other key metrics. Slow growth won't make headlines, but it will help prevent the kind of ugly surprises that suddenly torpedo a stock's share price.
- Stock stability. Conservative retirement investors prefer investments that move less dramatically than typical stocks, and they particularly want to avoid big losses. These investments will give up some gains during bull markets, but they won't fall as far or as fast during bear markets. Beta measures volatility, but we also want a track record of solid performance as well.
- Valuation. No one can afford to pay too much for a stock, even if its prospects are good. Using normalized earnings multiples helps smooth out one-time effects, giving you a longer-term context.
- Dividends. Most of all, retirees look for stocks that can provide income through dividends. Retirees want healthy payouts now and consistent dividend growth over time -- as long as it doesn't jeopardize the company's financial health.
With those factors in mind, let's take a closer look at Northrop Grumman.
What We Want to See
Pass or Fail?
|Size||Market cap > $10 billion||$16 billion||Pass|
|Consistency||Revenue growth > 0% in at least four of five past years||3 years||Fail|
|Free cash flow growth > 0% in at least four of past five years||3 years||Fail|
|Stock stability||Beta < 0.9||1.10||Fail|
|Worst loss in past five years no greater than 20%||(41.2%)||Fail|
|Valuation||Normalized P/E < 18||9.07||Pass|
|Dividends||Current yield > 2%||3.4%||Pass|
|5-year dividend growth > 10%||9.5%||Fail|
|Streak of dividend increases >= 10 years||9 years||Fail|
|Payout ratio < 75%||25.5%||Pass|
|Total score||4 out of 10|
Source: S&P Capital IQ. Total score = number of passes.
Since we looked at Northrop Grumman last year, the company has dropped by two points. Shares have basically broken even, but a drop in free cash flow and slower dividend growth has taken its toll on Northrop's score.
The latest threat to the defense industry comes from sequestration, which refers to the deal that Congress made that provided for automatic cuts in lieu of an agreed-upon solution to the fiscal problems in the budget. So far, the impact has been rather varied. With its commercial aircraft business, Boeing (NYSE: BA ) has emerged almost unscathed, with big gains in revenue and earnings. Even looking at more defense-focused businesses, Lockheed Martin (NYSE: LMT ) and Raytheon (NYSE: RTN ) have been able to grow their earnings. Meanwhile, though, General Dynamics (NYSE: GD ) and Northrop have ended up with the short end of the stick. In its most recent quarterly report released earlier today, Northrop beat estimates despite seeing an 8% drop in net income and 4% lower revenue.
But Northrop does have in-roads into the unmanned vehicle area, which the military seems to like for its life-saving potential. Although Northrop's Global Hawk spy drone project was cut, giving Lockheed's U-2 planes a longer lifespan, victories for the MQ-8 Fire Scout remote helicopter have allowed Northrop to retain its strong position in the unmanned aerial vehicle market. That may be why the company was able to boost its earnings-per-share guidance for the year to a range of $7.05 to $7.25.
For retirees and other conservative investors, a healthy dividend at a low valuation is a combination that's hard to pass up. But unless you're comfortable taking the risk that steadily falling revenue entails, you may prefer to wait until Northrop demonstrates its ability to turn its top and bottom lines around before adding shares to your retirement portfolio.
Finding exactly the right stock to retire with is a tough task, but it's not impossible. Searching for the best candidates will help improve your investing skills, and teach you how to separate the right stocks from the risky ones.
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