If you're looking forward to a long and comfortable retirement, you'll need to have enough money to see you through it. Financially speaking, a long retirement means you'll likely need to own stocks, even after you've retired, to provide enough growth potential for your money to last throughout your later years.
That raises a key question: Which types of stocks are appropriate for a retiree to own? Retirees aren't actively contributing new money to their investments and need their portfolios to provide them with the money to cover their costs of living. As a result, retirees would do well to own stocks that are more likely to directly reward them for their risks and less likely to completely evaporate.
What makes a good retiree stock?
There are three key features that make stocks more attractive to retirees: their dividends, their balance sheet, and their valuation. Looking reasonable on all three fronts makes a company's stock worthwhile to consider as part of the stock portion of a retiree's portfolio.
Dividends matter for two reasons: They directly reward shareholders for the financial risks involved in investing, and they provide strong signals of how the company is really performing. Key things to look for in a dividend include:
- Its payout ratio: The less a company is paying out when compared to its earnings, the better covered that dividend is, and the less likely it will be cut. For most stocks, if a dividend payout ratio gets above 75% to 80% of earnings, it's getting into risky territory. Publicly traded partnerships and Real Estate investment trusts often have higher payout ratios driven by their corporate structures, and they provide an exception to that general guideline.
- Its growth trend: Some companies pay a static dividend, but those that regularly increase their dividends provide stronger signals of the underlying health of the business. For instance, if a company forecasts strong growth, but only increases its dividend a token amount, that's likely a signal that the company isn't very confident in that growth projection. A growing dividend is also a stronger direct reward to shareholders for the risks they take in owning the stock.
- Its yield: Your best opportunity is to look for a "Goldilocks" dividend. One that's too low won't be a sufficient reward. On the flip side, if a company's yield is substantially higher than others in its industry, that's often a signal that the market expects its dividend to get cut. A proposed dividend does you no good if you don't actually receive it, and to make matters worse, if a dividend does get cut, the company's stock price often falls in response.
Balance sheets matter because things don't always go as planned, even in the corporate world. A solid balance sheet is what enables a company to survive those times when its plans, the financial market, or the overall economy turn sour. Key things to look for in a balance sheet are:
- Its debt to equity ratio: This measure compares what the company owes (its debt) to what it owns above and beyond that debt (its equity). The judicious use of some debt can be acceptable, but it the debt load climbs too high, it becomes very difficult for a company to survive an unexpected downturn to its business.
- Its current ratio: This measure compares its short-term assets like cash, inventories, and receivables to the liabilities it needs to make good on within the next year. The higher the ratio, the less the likelihood that the company will face a near term liquidity crunch, even if short-term lending dries up, like it did during the recent financial crisis.
- Its cash, equivalents, and short-term investments: This number measures the company's immediate liquidity -- what it has in cash and balance sheet items that can easily be converted to cash with either no or only a small risk of loss from conversion costs. At the very minimum, this number should be enough to cover everyday operations and payables coming due in the immediate future.
Valuations matter because they're the tool by which you can estimate whether you're getting a good deal or not on the companies you're buying portions of when you buy their stocks. All valuations are estimates and based on projections of the future, and they're only as good as the assumptions you make about them, but even with those caveats, they can be useful tools.
The cornerstone of most valuation techniques is something known as a discounted cash flow calculation. In essence, you estimate how much cash the company will generate and when that cash will be generated. Then, you dial back (or "discount") those potential future earnings for the risk that they won't materialize and the time between when you have to make the investment (now) and when those earnings could show up (the future).
The result of all that estimating and projecting is your valuation of the company: what you think it's worth today, based on your projections for its future. Unless you have a working crystal ball, you won't get it perfect, but through practice and by reading companies' quarterly and annual reports, you should develop a good sense of what goes into reasonable assumptions and projections.
As an investor paying attention to valuations, your first goal is to not pay more than a company looks to be worth based on your reasonable projections. Your second goal is to not hold on to a company trading well above what you think it's worth, based on your reasonable projections. Any other decisions are largely a matter of personal preference.
Throw in a splash of diversification -- and make it your strategy
Of course, no projections are perfect, and no company or industry is completely immune to disruptive shocks that threaten its dividend, its balance sheet, its valuation, or even its very existence.
As a result, no matter how adept you get at finding stocks with great dividends, solid balance sheets, and reasonable valuations, you'll want to practice intelligent diversification. By seeking out stocks that meet your other criteria, but that operate in different sectors, you'll better protect your overall portfolio from the failure of any one investment within it.
Those three features of stocks worth owning throughout your retirement provide a solid framework for each of your individual stock selections. When combined with the fundamental portfolio management principle of intelligent diversification, they create a strategy for the stock portion of your investments that you can use throughout your golden years. That gives you the key tools you need to stay invested at least partially in stocks, even after you retire and begin to rely on your portfolio for your spending needs.
Chuck Saletta has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.