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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.
Utilities are a traditional favorite for conservative investors seeking stable and reliable dividend income. Delivering electricity to consumers throughout the central part of the U.S., American Electric Power (NYSE: AEP ) seems like a reasonable prospect to cash in on that trend. But is American Electric poised to handle increasing competition among utilities? Below, we'll look at how the company 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 American Electric Power.
What We Want to See
Pass or Fail?
|Size||Market cap > $10 billion||$18.9 billion||Pass|
|Consistency||Revenue growth > 0% in at least four of five past years||4 years||Pass|
|Free cash flow growth > 0% in at least four of past five years||3 years||Fail|
|Stock stability||Beta < 0.9||0.52||Pass|
|Worst loss in past five years no greater than 20%||(25.5%)||Fail|
|Valuation||Normalized P/E < 18||11.91||Pass|
|Dividends||Current yield > 2%||4.8%||Pass|
|5-year dividend growth > 10%||4.5%||Fail|
|Streak of dividend increases >= 10 years||2 years||Fail|
|Payout ratio < 75%||49%||Pass|
|Total score||6 out of 10|
Source: S&P Capital IQ. Total score = number of passes.
With six points, American Electric Power has many but not quite all of the things that conservative investors want in an investment. Even so, the characteristic yield is high, shares trade at a reasonable valuation, and the stock's volatility has been relatively subdued in recent years.
American Electric has two primary business segments. It generates, transmits, and distributes electricity to both retail and wholesale customers. Unlike most utilities, American Electric also has an interesting side business: It operates barges that transport coal and other commodities from the Ohio and Lower Mississippi river valleys, a business it bought from Progress Energy (NYSE: PGN ) back in 2001.
But even utilities don't just offer free money to investors. Increasingly, they come with big regulatory hurdles to overcome. For instance, EPA pollution regulations will force American Electric to shut down nearly a quarter of its coal-fired electric generating plants in the next few years, costing $6 billion to $8 billion. Moreover, the company put plans to open a carbon-capturing plant on hold, shutting off funding from the Department of Energy.
Another threat that American Electric faces is competition. For instance, FirstEnergy (NYSE: FE ) made a big attempt to encourage Midwestern utility customers to shop around, arguing that it has better rates than American Electric as well as other competitors, including Exelon (NYSE: EXC ) and Duke Energy (NYSE: DUK ) . In a price war, American Electric could see pressure on its dividend, although it has a substantial payout ratio cushion to withstand lower margins for at least a while.
In the end, American Electric may have to join the growing trend of consolidation in the industry. With proposed combinations of Exelon with Constellation Energy (NYSE: CEG ) and Duke with Progress Energy, American Electric risks being marginalized if it doesn't find a partner of its own. The company is still in good shape, but retirees and conservative investors can't rely on the historically calm utility sector's reputation to carry American Electric through.
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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If you want to retire rich, you need to be confident that you've got the basics of your investment strategy down pat. See if you're on track by following the "13 Steps to Investing Foolishly."