Watsco (WSO 2.24%) is an under-the-radar company from the industrials sector, and it combines a handful of important characteristics that retirees should love. Some stocks come highly rated by analysts or celebrated by growth-oriented financial media outlets, but those might not be the best investments available for people in their 60s and 70s. Retirement portfolios require a somewhat different approach, and you should keep that in mind when considering the noteworthy merits of Watsco.

What makes a perfect stock for retirees?

Retirees don't have a lot of room for risk or volatility because their current cash needs create a short time horizon. Young 401(k) investors can ride out temporary bear markets as they achieve growth over 20 or 30 years. Older people simply don't share that luxury. If you don't get income from working anymore, you need your savings to supplement Social Security to pay for basic needs and lifestyle. Stability is crucial.

Laughing senior couple sitting on balcony

Image source: Getty Images.

Income is another necessary feature, so a retiree's dream stock should pay a sustainable dividend at a healthy yield. Stocks also offer growth opportunities that are unmatched by other asset classes. Owning stocks in your retirement portfolio is a great way to combat inflation, and it will help expand the asset base that's needed to cover future expenses. Your cash in the bank loses buying power over time, but stock market prices rise along with others in the economy.

Stability and growth

Watsco is the largest distributor of HVAC and refrigeration equipment in the U.S., with roughly 15% market share, which is more than double that of the next highest competitor. The company has over 600 locations and serves nearly 100,000 contractors.

Demand for HVAC equipment has a cyclical element, with building and capital spending driving some activity. However, the bulk of demand is dictated by product replacement cycles. When something goes wrong with heating or air conditioning, people usually get it fixed as soon as possible. Even if HVAC components are functioning properly, many property owners are happy to invest in newer technology that will be more energy- (and cost-) efficient. As a result, Watsco has a rather dominant market position in a fragmented industry with surprisingly predictable cash flow and stable growth drivers. 

Watsco's financial results reflect this position of strength. The company has delivered steady revenue expansion for years, averaging a mid-single-digit rate of expansion. Profits have followed along, rising from $170 million in 2015 to $260 million over the past year, resulting in a 7% five-year compound annual growth rate (CAGR) for earnings per share. Even through the struggles associated with COVID-19, the company returned to growth in the fourth quarter and gained market share.

Watsco isn't going to excite growth investors, but it's a fine slow-and-steady play for retirees. Analyst forecasts are calling for moderate sales growth, which will be slightly outpaced by diluted EPS due to margin expansion. The company's 32.4 forward price-to-earnings ratio and 23.5 enterprise-value-to-EBITDA don't leave much room for valuation-fueled appreciation, but it's not exactly a risky proposition compared to the rest of the market. 

Dividend income

Watsco pays a 2.9% dividend yield, which is respectable by today's standards and viable with respect to the 4% rule. Investors might be nervous to see the 108% payout ratio, meaning the company paid out more in dividends than it made in profits last year. That's obviously not sustainable over the long term.

However, this isn't so worrisome upon further inspection. Watsco reported free cash flow of $350 million in 2020, by the most conservative calculation method. Distributions to shareholders were $266 million, about 76% of the cash the company produced for the full year. As a business that doesn't need to invest heavily in equipment or tech to maintain its position, that's not an alarming number. Moreover, if earnings forecasts are accurate, then the current dividend would fall to around 65% of free cash flow in two years. The current high payout ratio is a risk to keep an eye on, but I think the dividend is secure when we look at context.

Watsco has several desirable characteristics for investors, but don't get carried away if you like it. Remember to diversify and not to rely too heavily on any single company to fulfill your financial needs in retirement. You can't control a company's operations, so going in too heavy on one stock means that you're completely exposed to the risk that something unexpected rises up and spoils your whole plan. Hoping that everything goes smoothly doesn't actually count as planning, because there's no recovering from catastrophe if things go awry.