Are These the Ultimate Retirement Shares?

LONDON -- The last five years have been tough for those in retirement. Portfolio valuations have been hammered and annuity rates have plunged. There's no sign of things improving anytime soon, either, as the eurozone and the U.K. economy look set to muddle through at best for some years to come.

A great way of protecting yourself from the downturn, however, is by building your retirement fund with shares of large, well-run companies that should grow their earnings steadily over the coming decades. Over time, such investments ought to result in rising dividends and inflation-beating capital growth.

In this series, I'm tracking down the U.K. large-caps that have the potential to beat the FTSE 100 over the long term and support a lower-risk income-generating retirement fund (you can see all of the companies I've covered so far on this page).

Over the few weeks, I've looked at Reed Elsevier  (LSE: REL  ) , Next  (LSE: NXT  ) , Banco Santander  (LSE: BNC  ) , AMEC  (LSE: AMEC  ) and Capita  (LSE: CPI  ) . Although Banco Santander isn't part of the FTSE 100, its shares are traded on the LSE and its £50 billion market capitalization means that if it was a FTSE 100 company, it would be one of the 10 largest companies in the index.

Let's take a look at how each of them scored against my five key retirement share criteria:

Criteria

Santander

Capita

Reed Elsevier

Next

AMEC

Longevity

5/5

2/5

5/5

4/5

5/5

Performance vs. FTSE

2/5

4/5

3/5

5/5

5/5

Financial strength

4/5

3/5

3/5

4/5

4/5

EPS growth

2/5

3/5

3/5

4/5

4/5

Dividend growth

3/5

4/5

3/5

4/5

4/5

Total

16/25

16/25

17/25

21/25

22/25

Banco Santander
Spain's largest bank has a huge retail network in Spain and a significant presence on Britain's high streets -- but the real secret of this bank's apparent resilience to the eurozone crisis is that according to its Q3 2012 results, 50% of its profits come from its operations in Latin America. Spain accounts for just 16% of the bank's profits, while the U.K. contributes 13%.

All of this means that for me, Santander's massive 9.3% dividend yield remains an attractive prospect as a long-term value investment. However, unless your retirement is a long way away -- at least 10 years, perhaps more -- I think that the risks are too great to recommend adding this share to a retirement fund portfolio. The eurozone crisis is far from over and Santander is at the very heart of it, with huge exposure to Spanish government debt, a 4.3% non-performing loan rate and €26.5 billion of Spanish real estate exposure.

Capita
Outsourcing company Capita
 specializes business process outsourcing -- operating an entire service or process for a client. Recent examples include providing back office functions like payroll and HR for councils, and carrying out disability assessments for the new Personal Independence Payment disability benefit. Capita also works with the private sector, but has long relied on big public sector contracts for the core of its business -- an area in which growth could be difficult, over the next few years.

Although Capita's growth has been impressive over the last decade, my review of the company found that its shares now look expensive, its dividend yield below average and its cash flow stretched. A particular worry is the company's ongoing reliance on new debt, while in 2012 it resorted to a share placing to raise a further £275 million. Capita could again be an attractive business for a retirement portfolio, but not at its current valuation.

Reed Elsevier
Trade publisher and exhibition organizer Reed Elsevier has managed to avoid the wider problems that have affected the publishing industry by focusing on highly specialized information services that its customers don't mind paying for. It has boosted profitability via cutting costs in recent years, but the impact of this seems to be tailing off and by its nature will be limited.

Reed Elsevier's yield of 3.1% is in line with the FTSE 100 average and the dividend has broadly kept pace with inflation in recent years. However, its five-year average dividend cover of 1.8 suggests the payout is unlikely to increase much faster, while the company's substantial debt burden remains a drag on free cash flow, thanks to interest costs. On the other hand, Reed Elsevier has attractive profit margins and appears to have a sustainable, if slow-growing, business. As a retirement share, it's a fairly safe choice, but the future returns seem unlikely to beat the index and it isn't cheap, suggesting that you'd do just as well with a FTSE 100 tracker.

NEXT
Clothing retailer NEXT
 needs no introduction and has proved a consistently successful business over the last decade, during which it has delivered a 10-year average trailing total return of 19.2%, more than double the 9.1% provided by the FTSE 100. NEXT's success has been a particular contrast to the lackluster performance of Marks & Spencer's clothing business.

As a retirement share, where dividend income is a key requirement, NEXT offers a strong track record of dividend growth but a low dividend yield -- 2.3% at the time of writing. However, this dividend has grown by 227% over the last ten years, and assuming NEXT maintains a decent level of dividend growth, its yield on cost will steadily rise for existing shareholders. This record of growth could make it an attractive pick if you do not expect to draw any retirement income from your portfolio in the near future.

AMEC
Today's top scorer is engineering services group AMEC, much of whose business is based on providing essential services to the oil and gas industry. AMEC has long since proved the wisdom of a "picks and shovels" approach -- it's easier to make money selling essential services than exploring for resources yourself -- and scored very highly in my original review, earning 22/25.

As a retirement share, AMEC has a lot to offer. It has greater diversity than some of its energy sector peers -- it has a growing nuclear services business, for example -- rendering it less vulnerable to a downturn in the oil and gas industry. AMEC has increased its dividend every year for the last 15 years, and its forward yield of 3.1%, while slightly below the FTSE 100 forward yield of 3.3%, is well covered and likely to continue to grow strongly.

Like all the stocks featured on this page, this year's strong stock market performance has made AMEC more expensive and reduced its income yield, but with a P/E of 15, I believe it remains a reasonably attractive retirement share -- although personally, I would prefer to buy after the market dips, which I expect to happen at some point this year.

An expert tip
Although doing your own research is important, one way of identifying great dividend-paying shares is to study the choices of successful professional investors.

Someone who really understands how to pick shares that deliver sustainable dividend growth is City is fund manager Neil Woodford, whose High Income fund grew by 342% in the 15 years to October 31, 2012, during which time the FTSE All-Share index managed a gain of only 125%. Thanks to his impressive track record, Mr. Woodford had £21 billion of private investors' money under management at the end of October 2012 -- more than any other City manager.

You can learn about Neil Woodford's top holdings and how he generates such fantastic profits in this free Motley Fool report. Many of Woodford's choices look like excellent retirement shares to me and the report explains how he chose some of his biggest holdings.

This report is completely free and I strongly recommend you click here to download "8 Shares Held by Britain's Super Investor" today, as it is available for a limited time only.

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