Will shares in BAE help you build a FTSE-beating retirement fund?
The last five years have been tough for those in retirement. Portfolio valuations have been hammered, annuity rates have plunged and uncertainty has ruled the roost. There's no sign of things improving any time soon, either, as the eurozone and the UK economy look set to muddle through at best for some years to come.
A great way of protecting 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, especially if you keep the shares within a tax-efficient ISA or SIPP.
It's no coincidence that the world's most successful investor, Warren Buffett, prefers such companies, and recently invested in a large FTSE 100 (UKX) company that fits the bill perfectly (you can find full details in this free report).
In this series, I'm tracking down the UK large caps that have the potential to beat the FTSE over the long term and support a lower-risk income-generating retirement fund. Today, I'm going to take a look at BAE Systems (LSE: BA), the UK's largest defence company.
Indecent exposure
BAE's share price has been in the doldrums for the last few years but the company has remained profitable and pays handsome dividends to its shareholders. Most of BAE's sales come from the UK and USA, while India, Australia and Saudi Arabia are also important markets. Unfortunately, BAE's focus on the US and UK has meant that it has been exposed to recent defence spending cuts and the company's revenue fell by around 15% last year, although profits held firm and things are expected to pick up this year.
Sadly, BAE has not managed to outperform the FTSE 100 over the last 10 years, as these figures show:
| Total Return (TR) | 2007 | 2008 | 2009 | 2010 | 2011 | Trailing 10 yr avg. |
|---|
| BAE Systems TR | 19.8% | -21.6% | -0.6% | -3.6% | -8.2% | 2.9% |
| FTSE 100 TR | 7.4% | -28.3% | 27.3% | 12.6% | -2.2% | 5.9% |
(If you are building up a retirement portfolio, total return is a useful metric for measuring the performance of your stock, as it captures the effects of share price changes 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.)
These figures suggest that BAE felt the full impact of the recession later than the majority of other FTSE 100 companies, but that it is recovering more slowly, too. This makes sense when you consider that most of its income comes from large, public sector contracts, which are agreed well in advance of delivery. Cuts to future contracts take a few years to filter through to BAE's accounts, as can be seen from its below-par performance over the last two years.
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 BAE shapes up:
| Item | Value |
|---|
| Year founded | 1977* |
| Market cap | £9.8bn |
| Net debt | £1.4bn |
5 year average financials |
| Operating margin | 9.5% |
| Interest cover | 8.5x |
| EPS growth | 31% |
| Dividend growth | 10.9% |
| Dividend cover | 2.61x |
| Dividend yield | 4.56% |
*BAE Systems was formed as British Aerospace through the merger of four existing aviation companies.
Here's how I've scored BAE on each of these criteria:
| Criteria | Comment | Score |
|---|
| Longevity | BAE's corporate history only stretches back to 1977, but its component parts are much older and its future as an independent British company seems fairly certain. | 4/5 |
| Performance vs. FTSE | It's lagged the FTSE in recent years but has remained profitable. As long as this continues, the share price will eventually catch up -- and the current 6% dividend yield is ample compensation in the mean time. | 3/5 |
| Financial strength | BAE's debt levels rose five-fold last year, thanks in part to a £500m share buyback. Despite this, net gearing is only 25% and interest cover is generous. BAE also has £2bn in cash. | 4/5 |
| EPS growth | EPS growth has been volatile over the last five years, but the trend is upwards. | 3/5 |
| Dividend growth | BAE has increased its dividend every year since 1999 -- a total increase of 135%. At the same time, dividend cover has remained strong. | 5/5 |
Total: 19/25 |
Dividend excellence has helped BAE Systems to a score of 19/25, a very respectable score that suggests that BAE could be a strong candidate for a retirement fund portfolio. Indeed, it's a share I hold myself.
If you are interested in finding more high-yielding shares, I would strongly suggest you take a look at some of Neil Woodford's choices. Neil is one of the UK's most successful fund managers and specialises in identifying companies with strong income potential. You can find out about eight of Neil's biggest holdings in this free Fool report, "8 Shares Held By Britain's Super Investor", which I strongly recommend, as many of Neil's picks are excellent retirement shares.
Warren Buffett buys British! The legendary investor has recently topped up on his favourite UK blue chip. Discover what he bought -- and the price he paid -- within our latest free report!
Further investment opportunities:
> Roland owns shares in BAE Systems.
