Is Next 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 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  (FTSEINDICES: ^FTSE  ) 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 Next  (LSE: NXT  ) , the high street clothes retailer that has comprehensively outperformed its older peer Marks & Spencer in recent years.

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

Total Returns

2008

2009

2010

2011

2012*

10-Yr. Trailing Avg.

Next

(30.1%)

97.9%

(1.7%)

42.7%

37.2%

18.5%

FTSE 100

(28.3%)

27.3%

12.6%

(2.2%)

9.3%

8.2%

Source: Morningstar. *2012 total return to Nov. 30, 2012. Total return includes both changes to the share price and reinvested dividends. These two elements combined are what make it possible for equity portfolios to regularly outperform cash and bonds over the long term.

Next's returns have dwarfed those of the FTSE 100 over the last five years and its 10-year average trailing total return emphasizes how strong its performance has been -- this retailer has delivered more than double the total return of the FTSE 100 over the last ten years.

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 Next shapes up:

Item

Value

Year founded

1864*

Market cap (billion pounds)

6.1

Net debt (million pounds)

553

Dividend Yield

2.5%

5-Year Average Financials

Operating margin

16.2%

Interest cover

18.5 times

EPS growth

11.8%

Dividend growth

12.9%

Dividend cover

3.2 times

Sources: Morningstar, Reuters, Next. *The company was founded as J. Hepworth & Son, a tailor, in 1864. Next was created when Hepworth bought Kendalls' shops in 1981.

Here's how I've scored Next on each of these criteria:

Criteria

Comment

Score

Longevity

148 years in the clothing trade has helped Next grow up fast.

4/5

Performance vs. FTSE

Consistent outperformance.

5/5

Financial strength

Stable, attractive margins, strong interest cover.

4/5

EPS growth

Average double-digit per year earnings growth over last five years.

4/5

Dividend growth

Strong growth, although high cover levels result in below-average yield.

4/5

Total: 21/25

Next's score of 21/25 highlights its attractions as a retirement share. Despite its consistent track record of earnings and dividend growth, it currently trades on a price-to-earnings ratio of 13.8, based on the last 12 months' reported earnings, and has a forecast P/E of 13.4. These are both below the FTSE 100 average, although above some of its more battered sector peers. Admittedly this means that strong share price growth could be unlikely in the short term, but for a retirement portfolio this isn't important -- what is important is the group's skilled management, consistent earnings growth and apparent resilience -- all of which has helped provide sustained dividend growth.

For retirement investors, dividend income is of critical importance. Although Next has a relatively high level of dividend cover and a dividend yield of just 2.5%, it has an impressive track record of dividend growth. Next has never cut its dividend and has only frozen it in one year since 1993, the earliest year for which I could find figures. In 2002, the company paid out 27.5 pence to shareholders, and in 2012, the total payout will have been 90 pence -- a massive 227% increase. I don't know many people whose salaries or pensions have risen by 227% over the last 10 years...

High street retailing conditions are likely to remain demanding, but Next has dealt with this well so far and its online and directory sales channels are likely to help maintain the strength of its brand. The company is expecting to report sales growth of between 3% and 4.5% this year, along with an increase in basic earnings per share of between 10% and 15%. That's a decent result in a year that has seen Marks & Spencer's general merchandise (clothing) sales fall by 2.5%.

I think that Next could be a solid retirement share and wouldn't be deterred by its current price and modest yield -- although I would be tempted to buy into the stock in several phases, in order to capture any temporary weakness that might occur if 2013 turns out to be another tough year.

Top income picks
Doing your own research is important, but another good way of identifying great dividend-paying shares is to study the choices of successful professional investors.

One of the most successful income investors currently working in the City is fund manager Neil Woodford, who manages more money for private investors than any other City manager. Neil Woodford's High Income fund grew by 342% in the 15 years to Oct. 31, 2012, during which time the FTSE All-Share index managed a gain of only 125%.

You can learn about Neil Woodford's top holdings and how he generates such fantastic returns 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 download "8 Shares Held by Britain's Super-Investor" today, as it is available for a limited time only.

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