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.
A utility serving the nation's heartland might well sound like the perfect conservative retirement stock. American Electric Power (AEP +0.51%) delivers those characteristics to investors, but the utility business isn't quite as safe and boring as it once was. Does the utility make a smart retirement investment? Below, we'll revisit how American Electric Power 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.
|
Factor |
What We Want to See |
Actual |
Pass or Fail? |
|---|---|---|---|
|
Size |
Market cap > $10 billion |
$20.1 billion |
Pass |
|
Consistency |
Revenue growth > 0% in at least four of past five years |
3 years |
Fail |
|
Free cash flow growth > 0% in at least four of past five years |
3 years |
Fail | |
|
Stock stability |
Beta < 0.9 |
0.48 |
Pass |
|
Worst loss in past five years no greater than 20% |
(25.5%) |
Fail | |
|
Valuation |
Normalized P/E < 18 |
14.85 |
Pass |
|
Dividends |
Current yield > 2% |
4.5% |
Pass |
|
5-year dividend growth > 10% |
3.8% |
Fail | |
|
Streak of dividend increases >= 10 years |
3 years |
Fail | |
|
Payout ratio < 75% |
59.1% |
Pass | |
|
Total score |
5 out of 10 |
Source: S&P Capital IQ. Total score = number of passes.
Since we looked at American Electric Power last year, the company has dropped a point as overall revenue fell. The stock has also been pretty lackluster, with just a 5% gain over the past year.
Utilities have long been a refuge for risk-averse investors. With a guaranteed customer base thanks to government regulation and a product that everyone needs, AEP, Exelon (EXC +0.28%), and Public Service Enterprise Group (PEG +0.69%) have impressive dividend yields and reasonable valuations. For its part, AEP has been serving up dividends for more than a century.
Changing conditions in the utility industry, however, have led to some massive changes. With environmental regulation and cheap natural gas adding to net costs, AEP considered earlier this year shutting down a coal-fired plant. It's not the only one, with Southern Company (SO +0.50%) and Duke Energy (DUK +0.33%) also making switches due to low natural gas prices.
AEP is looking beyond merely producing and transmitting electricity. Its gridSMART initiative supports smart-grid ideas that encourage well-timed use of power. AEP has also moved toward using more efficient extra-high-voltage power lines that cut the amount of energy that's wasted during transmission.
For retirees and other conservative investors, AEP's growth struggles are easy to justify in light of the sluggish economy. As a relatively safe play that would still benefit from an economic recovery, AEP would make a reasonable holding for some retirement investors, although most would be well-served looking at some of its fellow utility peers.
Keep searching
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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