Is Smith & Nephew the Ultimate Retirement Share?

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 UK 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 the companies I've covered so far on this page).

Today, I'm going to take a look at Smith & Nephew (LSE: SN.L  ) (NYSE: SNN  ) , the maker of replacement joints, prosthetic limbs and other medical technology.

Smith & Nephew vs. FTSE 100
Let's start with a look at how Smith & Nephew has performed against the FTSE 100 over the last 10 years:

Total Returns 2007 2008 2009 2010 2011 10-year trailing average
Smith & Nephew 9.9% -23.3% 47.9% 7.3% -6.0% 6.7%
FTSE 100 7.4% -28.3% 27.3% 12.6% -2.2% 7.1%

Source: Morningstar. (Total return includes both changes to the share price and reinvested dividends. These two ingredients combined are what make it possible for equity portfolios to regularly outperform cash and bonds over the long term.)

The 10-year average trailing total return shows that Smith & Nephew has delivered shareholder returns broadly in-line with the FTSE 100 over the last decade, so could it be a retirement share?

What's the score?
To help me pinpoint suitable investments, I like to score companies on key financial metrics that highlight the characteristics I look for in a retirement share. Let's see how Smith & Nephew shapes up:

Item Value
Year founded 1856
Market cap 5.9 billion pounds
Net debt 88 million pounds
Dividend yield 1.7%
5-year average financials
Operating margin 21%
Interest cover 35x
EPS growth 16.6%
Dividend growth 12.9%
Dividend cover 4.8x

Sources: Morningstar, Digital Look, Smith & Nephew.

Here's how I've scored Smith & Nephew on each of these criteria:

Criteria Comment Score
Longevity 156 years, including 75 on the LSE. 5/5
Performance vs. FTSE It's kept pace with the index over the last decade. 3/5
Financial strength Attractive margins, and this year has seen growing net cash. 4/5
EPS growth Decent earnings growth, but this seems to be slowing. 3/5
Dividend growth Attractive growth, but with a yield that's well below average. 3/5
    Total: 18/25

Smith & Nephew is feeling the impact of global growth headwinds, but has streamlined its operations and has moved from a nominal net debt at the end of 2011 to report a 10% increase in trading profit and net cash of $379 million in its third-quarter results. However, this positive result doesn't disguise the company's lack of underlying growth -- something I think it may be too small to do without.

The reason for this is that despite being a FTSE 100 company, Smith & Nephew is far smaller than some of its U.S.-based peers and is periodically touted as a takeover or merger target. The company's core U.S. market is fairly flat, and it is focused on expanding in emerging markets, in which it delivered 6% underlying growth over the last quarter. However, emerging markets currently only account for 11% of the company's revenues -- whereas Europe, which accounts for 30% of revenues, poses "significant challenges," according to the company's most recent trading update.

On the positive side, Smith & Nephew has an unbroken history of dividend increases stretching back to at least 2000, the earliest year for which I could find data. Dividend growth is almost as important as dividend yield when creating a retirement portfolio, because of the need for your retirement income to keep pace with inflation. Despite this, Smith & Nephew's low payout ratio means that even if you bought the company's shares 10 years ago, your dividend yield on cost -- the current dividend payout divided by your original purchase price -- would only have risen to 3.9%. This is slightly above the FTSE 100 average of 3.3% but compares poorly to the 5.8% yield on cost currently being enjoyed by GlaxoSmithKline shareholders who bought their shares ten years ago.

Despite Smith & Nephew's attractions and its strong record of dividend growth, I think that there are better opportunities elsewhere for a retirement portfolio, one of which is pharmaceutical giant GlaxoSmithKline -- a company in which I own shares, as does one of the City's most successful income investors.

Top pharma income picks
GlaxoSmithKline is one of the eight biggest holdings of City legend Neil Woodford, whose dividend stock picks outperformed the wider index by a staggering 326% in the 15 years to June 2012. Woodford's record helps explain why he manages more private investors' money -- about 20 billion pounds, as of June 2012 -- than any other U.K. fund manager.

The good news is that you can learn about all eight of 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.

Roland Head owns shares in GlaxoSmithKline but does not own shares in Smith & Nephew. The Motley Fool owns shares of Smith & Nephew. The Motley Fool has a disclosure policy.
We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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