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 to protect 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 newly promoted FTSE 100 member London Stock Exchange Group (LSE -1.22%) (LDNX.F -3.37%), the company that operates the Main Market and the Alternative Investment Market (AIM) in London, as well as the Mercato Telematico Azionario (MTA) -- the main Italian stock market.
LSE Group vs. FTSE 100
Let's start with a look at how the London Stock Exchange Group has performed as a company against the FTSE 100 over the last 10 years:
| Total Returns | 2008 | 2009 | 2010 | 2011 | 2012 | 10-Yr. Trailing Average |
|---|---|---|---|---|---|---|
| LSE Group | -73% | 45.6% | 20.2% | -1.9% | 40.5% | 17.3% |
| FTSE 100 | -28.3% | 27.3% | 12.6% | -2.2% | 10% | 9.2% |
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.)
Unsurprisingly, London Stock Exchange Group fared very badly in 2008, during the onset of the financial crisis. However, it has recovered strongly since and has outperformed the FTSE 100 by an average of 8.1% per year since 2003.
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 London Stock Exchange shapes up:
| Item | Value |
|---|---|
| Year founded | 2007* |
| Market cap | 3.6 billion pounds |
| Net debt | 481.7 million pounds |
| Dividend Yield | 2.2% |
| 5-Year Average Financials | |
| Operating margin | 35.7% |
| Interest cover | 7.4x |
| EPS growth | 31% |
| Dividend growth | 9.5% |
| Dividend cover | 1.7x |
* London Stock Exchange Group was formed in 2007 through a merger of the Borsa Italiana and London Stock Exchange.
Here's how I've scored LSE Group on each of these criteria:
| Criteria | Comment | Score |
|---|---|---|
| Longevity | The LSE and Borsa Italiana have 200-year-plus histories. | 4/5 |
| Performance vs. FTSE | Very strong. | 4/5 |
| Financial strength | Low debt, high margins, and good cash flow. | 4/5 |
| EPS growth | The last couple of years have seen a strong recovery. | 4/5 |
| Dividend growth | The payout is up 40% on five years ago. | 4/5 |
| Total: 20/25 | ||
In many ways, the London Stock Exchange Group is a data and software company. Financial markets are heavily computerized, and investors depend on software systems for both financial data and executing transactions. In the first half of last year, 42% of LSE Group's revenue came from its Information Services division, which provides real-time data to investment professionals trading London and Italian-listed companies. This business delivered a 49% operating margin last year, while LSE Group's other main income source, its Capital Markets operations (the London and Italian stock markets), delivered a 44% operating margin and 37% of revenues.
LSE Group's high profit margins are due in part to the near-monopoly conditions it enjoys in some areas of its business, where would-be competitors face high barriers to entry. As a result of these high margins, the firm generates a lot of cash -- LSE's free cash flow is usually more than 80% of operating cash flow, enabling it to fund small acquisitions and investments without needing extra debt.
My verdict
Although LSE Group's business is dependent on subscriptions and trading fees, I think that its high margins and lack of direct competition mean that it should be able to afford to absorb periodic downturns without becoming unprofitable. However, the company's shares have risen by 21% so far in 2013 and currently look quite expensive, with a forward price-to-earnings ratio of around 14 and dividend yield of just 2.2%.
If you believe that London's financial markets will continue to be among the biggest and most important in the world, then I think that LSE Group could make a good retirement share, thanks to its very strong cash flow and highly defensible business model -- but now may not be the best time to buy.
2013's top income stock?
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