Northrop Grumman: This Old Dog Has Some New Tricks, Shares Look Like A Bargain

Thesis

Northrop Grumman (NOC) conducts most of its business with the U.S. government, principally the Department of Defense. NOC also transacts with foreign governments and makes commercial sales both domestically and overseas. In January 2009, the company reorganized its reported business segments into five, from seven. Its shipbuilding operations were spun off to shareholders in March 2011. The Information & Services segment (23% of 2010 revenue and 21% of segment operating income) provides products and services in the areas of command, control, communications, computers and intelligence (C4I); air and missile defense; airborne reconnaissance; intelligence processing; decision support systems; cybersecurity; information technology; and systems engineering and integration. It consists of three business areas: Defense Systems, Intelligence Systems, and Civil Systems.

NOC is a well run defense company that continues to demonstrate improving operating performance in a difficult environment. The management has been constantly finding ways to create value through a variety of measures including portfolio shaping. Demand for NOC’s military electronics is primarily driven by growth in the U.S. defense budget, which accounts for about 40% of global military weapons spending. Based on U.S. Department of Defense statistics from fiscal 2000 (Oct.) through fiscal 2010, the (weapons) procurement and R&D segments of total U.S. defense budget authority rose at 7.6% and 9.0% compound annual rates, respectively. However, one of the reputed industry analysis firms expects growth in defense budgets to flatten or decline going forward, due to pressure resulting from high U.S. budget deficits and increased entitlements spending.

While the defensiveness will ultimately be the overriding theme for defense stocks in 2012, there are plenty of industry-specific issues at play. The two largest visible catalysts this year are the resolution of sequestration and November’s presidential election. While both have clear implications for defense, the former is largely already priced in and the latter’s influence on defense performance will be more a function of its impact on the broader market than the defense industry itself given the stance that defense stocks will act defensively in 2012.

This year’s relatively weak top-line outlook is offset somewhat by the company’s forecast for ~11.0% segment operating margin. While this margin level represents a 60 bps decline from 2011, it is still ~30 bps higher than the segment operating margin implied by the company’s long-term margin targets for each segment in the context of management’s segment revenue guidance for this year. Operating margin guidance for 2012 for each of the segments is anywhere from 0-100 bps higher than the long-term targets (Aerospace Systems – 11%, Electronic Systems – 13%, Information Systems – 9%, and Technical Services – 8%). In the past, management has noted that its margins could fall below the long-term goals temporarily in a declining sales environment as it restructured and took cost out, and this is therefore a possibility in 2013-2014.

NOC is guiding to GAAP EPS of $6.40-6.70 on sales of $24.7-25.4 bn and a segment operating margin of ~11.0% in

2012. The midpoint of management’s sales guidance implies a 5% y/y sales decline in 2012. Revenue pressure is most acute in NOC’s Technical Services segment, where the midpoint of management’s sales guidance of $2.6-2.7 bn implies a 17% y/y decline. Revenue guidance for the Information Systems and Electronic Systems segments implies 5% and 4% y/y declines at the midpoint, respectively, while the company sees the most support in the Aerospace Systems segment which management is only guiding down 1% y/y at the midpoint.

Q4 EPS of $2.09 exceeded Bloomberg consensus estimate by 42 cents. However, Sales of $6.5 bn in the quarter were down 4% organically y/y, and resulted in a total organic sales decline of 4% for 2011. The sales miss in the quarter was more than offset by segment operating margin of 11.9%, which was 90 bps higher than consensus estimate of 11.0%. Non-operating items including a lower tax rate, $36 mn of other non-operating income, and a lower share count also contributed to the beat. Within the segments, Technical Services was the lone segment to exceed streets’ sales expectation, while the other three segments each missed the sales forecast with the most pronounced miss (-4%) coming in the Aerospace Systems segment. However, operating margins exceeded estimates in every segment with the largest outperformance (+126 bps) occurring in the Information Systems segment. The company was awarded $7.1 bn of new orders in the quarter, resulting in a book-to-bill of 1.09x. However, at the end of the quarter, the total backlog stood at $39.5 bn, down 6% sequentially and 12% y/y.

Management & Stewardship

Northrop boasts of an enviable management with industry stewards from reputed organizations. Wes Bush is the Chairman and CEO of the company. He was elected as the chairman in July 2011 and was named CEO in January 2010. Bush had a long employment history with TRW and moved to Northrop when TRW was acquired by Northrop. Lewis Coleman is a lead independent director with NOC and is the president and CFO with Dreamworks Animation SKG (DWA). His past experience spans across leading financial institutions like Bank of America (BAC) and Wells Fargo (WFC). Kenneth Bedingfield is the VP finance with NOC. Prior to joining NOC, Ken has a 17 year stint with KPMG LLP. Ken leads all aspects of corporate accounting operations including maintenance and enforcement of corporate accounting policies and procedures in accordance with Generally Accepted Accounting Principles (GAAP) and Securities and Exchange Commission requirements, ensuring the integrity of the company’s financial data and reporting. Some of the other key executives include Sid Ashworth, Mark Caylor, Sheila Cheston, Gary Ervin, and Gloria Flach. The insiders of the company hold less than 1% of the company.

Valuation:

NOC is trading at 10x 2013E PAEPS (Pension adjusted EPS) estimate, which remains the richest valuation in the large cap defense coverage universe by a wide margin and represents a 16% premium to the average valuation of its large cap defense peers. The primary driver of the stock’s premium valuation is NOC’s unique position among its peers as a generator of pension income. This attribute leads some investors to pay for NOC’s GAAP EPS and, on that basis, NOC looks much more fairly valued. On 2013E EPS, NOC trades at 9.2x, in line with the 9.2x average of its peers. However, pension-adjusted EPS is a better valuation metric, especially considering investors should pay for pension income. Given NOC’s absolute level of valuation compared to the market, it’s dividend growth rate, and high ROIC we believe the shares are a buy at current levels.

Based on a DCF analysis the intrinsic value of NOC is around $87.

Disclosure: I am long NOC.

Disclaimer: This discussion is for informational purposes and should not be taken as a recommendation to purchase any individual securities. Information within this discussion and investment determination of the author may change due to changes in investment strategy when warranted by changing market conditions, or if a security’s underlying fundamentals or valuation measures change. There is no guarantee that, should market conditions repeat, this security will perform in the same way in the future. There is no guarantee that the opinions expressed herein will be valid beyond the date of this presentation. There can be no assurance that the author will continue to hold this position in companies described herein, and may change any of his position at any time. We use or best efforts to obtain good data in our models, however it can’t be guaranteed that our inputs and data are correct. This is not a recommendation for readers to purchase shares in the above security without consulting your financial professional to discuss your own risk tolerance and objectives.

Lockheed Martin: Include This Weapon In Your Portfolio For Capital Gains

Lockheed Martin (LMT)

Share Price: $89.5
Intrinsic Value: $111
Buy Below: $90
Business description and background:

Lockheed Martin Corporation engages in the research, design, development, manufacture, integration, operation, and sustainment of advanced technology systems and products in the areas of defense, space, intelligence, homeland security, and government information technology in the United States and internationally. The company operates in four segments: Aeronautics, Electronic Systems, and Information Systems & Global Services (IS&GS), and Space Systems. Lockheed Martin Corporation was founded in 1909 and is based in Bethesda, Maryland.

(Source: Yahoo)

Thesis

With estimated 2011 sales of $47 billion, LMT is the world’s largest military weapons maker. In 2010, the company derived 84% of its net sales from the U.S. government, including the Department of Defense (DoD) as well as non-DoD agencies. Sales to foreign governments contributed 15% of net sales (up from 13% in 2009), with 1% of net sales to commercial and other customers. Lockheed Martin conducts business through four operating segments: Aeronautics; Electronic Systems; Space Systems; and Information Systems & Global Services.

The law passed by Congress will cut into planned defense spending significantly, but it is not yet clear how much. In a best case scenario, which would include no further cuts, the base budget will fall slightly from FY11′s $529 bn into the ~$527 bn range in both FY12 and FY13. In the worst case, Congress could fail to agree on further deficit reduction and the bill’s trigger provisions would take effect, in which case the DoD base budget would drop to ~$472 bn in FY13. This will be a dire scenario for the DoD and industry, and therefore it is unlikely to occur, despite the fact that avoiding it means Republicans will likely have to agree to tax increases of some variety (likely the elimination of tax expenditures/deductions) and Democrats to entitlement cuts, which neither side has been willing to do thus far. One can assume a middle of the road outcome and organic growth forecasts in which Congress cuts defense spending by an incremental $180 bn over nine years, which would take the base budget to ~$508 bn in FY13.

LMT had a spectacular year in 2011, returning 21% compared to only 1% for the other defense primes on average. In addition, while not all companies have reported yet, it is likely that LMT, at 2%, will be the only defense prime to deliver y/y organic growth in 2011. The stock no longer looks as cheap as it did entering last year, and with its dividend already at attractive levels it is unlikely that the company will substantially increase its dividend this year as it did last September. With its valuation more in-line with peers, a challenging fundamental outlook, and no clear catalysts may restrict the relative upside for the stock now. In addition, the F-35 program will continue to face a budget threat as long as the fiscal situation remains unsustainable. The budget situation could still rear its head again this year as sequestration is still the law of the land, and as long as this is the case we see continued overhang on the F-35 program

While defense companies face organic sales declines in the coming years, balance sheets should remain strong and cash flows dependable, enabling management teams to continue returning cash to shareholders. Like many other defense companies, Lockheed Martin Corp has also approved up to $1 billion in August 2011 to an existing stock buyback program started in October 2010. The defense company’s board of directors is expected to consider its next share repurchase program this fall. Defense companies have already been willing to return cash over the past several years, though the preferred vehicle-buybacks may be suboptimal, and direct transfers in the form of dividends would be preferable. Repurchases in the current environment is likely to be a bet on future defense budgets. To the extent that companies do return cash, however, it would be better to prefer special dividends to share repurchases. The lack of any substantial special dividends in recent years amidst the large volumes of cash that have been poured into share repurchase maybe a substantial and unnecessary risk to shareholder value. The stocks of the five leading defense large caps (excluding Boeing) now trade 20% below the average price at which they have repurchased stock over the past five years. This share repurchase activity has involved a very substantial use of cash – in total the five companies over the five years have repurchased $32 bn of stock, which for perspective represents 39% of their combined market caps today.

Demand for military equipment and systems are primarily driven by growth in the procurement and R&D sectors of the U.S. defense budget. Based on U.S. Department of Defense statistics, from FY 00 (Oct.) through FY 10, the procurement and R&D budgets within the U.S. defense budget expanded at compound annual rates of 9.0% and 7.6%, respectively. However, Standard & Poor’s expects defense budgets to decline going forward, due to pressure resulting from high U.S. budget deficits and increased entitlement spending.

Return on invested capital, adjusted to exclude a large decline in stockholders’ equity in 2008, was 17.9% in 2010 and 20.0% in 2009. The Aerospace & Defense industry recorded an average return on invested capital of 15.7% in 2010 and 14.6% in 2009. Free cash flow as a percentage of sales was 6.0% in 2010 and 5.1% in 2009, versus an industry average of 6.7% in 2010 and 7.5% in 2009.

Management & Stewardship

Lockheed boasts of a strong and commendable management team with industry stewards. Robert J.Stevens is the Chairman and CEO of Lockheed Martin since April 2005. He is an industry veteran with over 30 years of experience in various organizations within government sectors including but not limited to Mosanto Company, Air Traffic management. Mr. Kubasik has served as President and Chief Operating Officer of LMT since January 2010. He previously served as Executive Vice President – Electronic Systems from September 2007 to December 2009, and as Chief Financial Officer from February 2001 to August 2007. Among its executive vice president’s one can count Ralph D.Heath. Mr. Heath has served as Executive Vice President since January 2005. He previously served as Executive Vice President and General Manager of the F-22 Program from November 2002 to December 2004.

The management and other insiders own around 0.1% of the company.

Valuation

We have used the DCF valuation using conservative estimates to arrive at the fair value of LMT at $111 which represents a 23% premium to its current trading price.

Disclosure: I am long LMT.

Disclaimer: This discussion is for informational purposes and should not be taken as a recommendation to purchase any individual securities. Information within this discussion and investment determination of the author may change due to changes in investment strategy when warranted by changing market conditions, or if a security’s underlying fundamentals or valuation measures change. There is no guarantee that, should market conditions repeat, this security will perform in the same way in the future. There is no guarantee that the opinions expressed herein will be valid beyond the date of this presentation. There can be no assurance that the author will continue to hold this position in companies described herein, and may change any of his position at any time. We use or best efforts to obtain good data in our models, however it can’t be guaranteed that our inputs and data are correct. This is not a recommendation for readers to purchase shares in the above security without consulting your financial professional to discuss your own risk tolerance and objectives.

Raytheon Is Positioned To Soar To New Heights

Raytheon Company (RTN)

Share Price: $50
Intrinsic Value: $69
Buy Below: $52
Business description and background:

Raytheon Company , together with its subsidiaries, provides electronics, mission systems integration, and other capabilities in the areas of sensing, effects, and command, control, communications, and intelligence systems, as well as a range of mission support services in the United States and internationally. The company offers integrated defense systems that include integrated air and missile defense, radar solutions, and naval combat and ship electronic systems; and intelligence and information systems that comprise defense and civil mission, enterprise intelligence, information security, and mission operations solutions, as well as special missions and technologies. Further, it provides space and airborne systems (SAS), such as intelligence, surveillance and reconnaissance systems; tactical airborne systems; space systems; and other SAS product lines. The company was founded in 1922 and is based in Waltham, Massachusetts.

(Source: Yahoo)

Thesis

Raytheon, with estimated 2012 revenues of $25 billion, is the world’s sixth largest military contractor and a leading maker of missiles and radar. It does business through six segments. Raytheon conducts business through integrated defense systems, Intelligence and information systems, Missile systems, Network centric systems, Space & airborne systems and technical services.

Raytheon’s primary missile and military electronics markets are driven by growth in the U.S. defense budget. Based on Department of Defense statistics, from FY 00 (Sep.) through FY 10, the (weapons) procurement and R&D budgets within the U.S. defense budget grew at 9.0% and 7.6% compound annual rates, respectively. We expect growth in defense budgets to flatten out or decline going forward, due to pressure resulting from high U.S. budget deficits and increased entitlements spending.

RTN ended 2011 with the lowest valuation among large cap defense universe despite a strong year-end rally. At 7.9x 2013E PAEPS (Pension Adjusted EPS), RTN trades at a steep discount to the average of the other large cap defense names. Despite decent stock performance in 2011 (9% total return, second best among the peer group behind LMT), RTN has been the cheapest stock among its peers for an extended period. It remains a top pick, and one can expect the valuation gap to narrow this year.

RTN’s international prospects provide the company with a revenue stream that is independent of domestic fiscal concerns and positions the company well relative to peers with less international exposure. With an estimated 25% of 2011E sales derived from international customers, RTN has the largest international sales mix of its peer group. Overall, we forecast a 1% organic revenue decline for RTN in 2012 versus an average 5% decline for its peers and a 3% decline in investment account outlays. This relative top-line strength drives a more attractive earnings profile, and RTN is the only defense prime for which we expect EPS to grow in 2012. RTN’s recent large debt offering and plans to contribute a substantial portion of the proceeds to its pension fund could provide upside to our numbers, and we believe this is in part responsible for the late-year rally of the stock.

RTN provided its initial 2012 guidance and, by and large, the guidance supports the outlook for the business. The company guided toward $24.8 bn of sales at the midpoint which was in-line with street view of a modest decline in the business. Operating margin in 2012 will benefit from reduced net pension expense as a result of the company’s $750 mn contribution in Q4 but the company is guiding for its adjusted operating margin (which excludes pension) to decrease 100 bps from 13.2% in 2011 to 12.2% at the midpoint in 2012. Strong orders both domestically and internationally pushed the backlog to its highest level since 3Q10. At $35.0 bn, backlog was up ~$500 mn both sequentially and since year-end. Missile Systems looks particularly strong and its $2.3 bn of bookings in the quarter (33% of total bookings) were the second largest amount ever for the business. This order strength drove a large sequential increase in the segment’s backlog which also stands ~$370 mn higher than its YE10 level.

The board of directors had authorized a share repurchase plan of up to an additional $2 billion of outstanding stock in July 2011. The buyback program is similar to a $2 billion program announced in March of 2010. As of July 3, the company had spent $1.2 billion on its shares under that program, according to public filings. The buyback program is gaining steam among lot of defense names and Raytheon is not long behind in the race.

For the 10 years ended 2010, RTN generated a compound annual growth rate (CAGR) of 4.2% for sales, 13.7% for earnings from continuing operations, 12.6% for earnings per share, and 3.5% for dividends per share. Return on invested capital (after-tax operating profit as a percentage of long-term debt plus equity) was 14.3% in 2010 and 16.7% in 2009, versus the Aerospace & Defense industry average of 15.7% and 14.6% in the respective years.

Management & Stewardship

Raytheon boasts of a strong management personnel in its comrade. William H. Swanson is the Chairman and CEO of Raytheon. Mr. Swanson has held increasingly responsible management positions, including: President from July 2002 to May 2004; Executive Vice President of Raytheon Company and President of Raytheon’s Electronic Systems business unit from January 2000 to July 2002; Executive Vice President of Raytheon Company and Chairman and CEO of Raytheon Systems Company from January 1998 to January 2000. Mr. Swanson has around 23 years of experience in energy and governmental sectors. Jay B. Stevens is the Senior VP and secretary of general counsel since October 2002. In December 2006, he was also elected as Secretary of the Company. From January 2002 to October 2002, Mr. Stephens served as Associate Attorney General of the United States. From 1997 to 2002, Mr. Stephens was Corporate Vice President and Deputy General Counsel for Honeywell International, Inc. (formerly AlliedSignal, Inc.).

The management at Raytheon, like many other defense companies, holds a very thin position of the company. The management holds around 0.4% of the company.

Valuation

We have used the DCF valuation using conservative estimates to arrive at the fair value of RTN at $69 which represents a 37% premium to current trading price.

Disclosure: I am long RTN.

Disclaimer: This discussion is for informational purposes and should not be taken as a recommendation to purchase any individual securities. Information within this discussion and investment determination of the author may change due to changes in investment strategy when warranted by changing market conditions, or if a security’s underlying fundamentals or valuation measures change. There is no guarantee that, should market conditions repeat, this security will perform in the same way in the future. There is no guarantee that the opinions expressed herein will be valid beyond the date of this presentation. There can be no assurance that the author will continue to hold this position in companies described herein, and may change any of his position at any time. We use or best efforts to obtain good data in our models, however it can’t be guaranteed that our inputs and data are correct. This is not a recommendation for readers to purchase shares in the above security without consulting your financial professional to discuss your own risk tolerance and objectives.

Dow Hits 13,000, But What Next?
By Sarah Morgan

The last time the Dow hit 13,000, stocks quickly proceeded to take a 50% nosedive. But as the index briefly crossed that milestone today, many advisers said the market looks a whole lot safer this time around.

The Dow broke 13,000 several times on Tuesday, before ending the day at 12966, up 16 points. It has certainly been a long road back: While many investors have recovered the money they lost in 2008, others are still struggling to catch up. The average participant in a 401(k) plan broke even between 2007 and 2010, in investment returns alone, according to the most recent available data from Vanguard. However, the range of returns was fairly wide, from a more than 5% loss to greater than 5% gain, and about half of retirement plan participants lost money in those three years.

But it’s not just that market prices are nearly back to pre-crisis levels, say advisers — the market climate has also started to improve. “In the last few years, the market has been so much more news-driven, we’ve had short-term wild and random volatility that makes the markets much more difficult to anticipate,” says Mike McGervey, the president and founder of McGervey Wealth Management. In 2012, that volatility has dropped significantly, with daily market moves being much smaller. McGervey says his technical analysis of recent chart patterns suggests that if the Dow does break through 13,000, stocks will likely post gains in the next quarter, too.

As a result, McGervey says he has been shifting client money into stocks for the past six weeks, and will continue if stocks keep rising. Currently, as much as 80% of his clients’ stock portfolios are in equities (and 20% in cash), up considerably from 2011.

To be sure, not everyone is scooping up stocks right now. Steven Roge, the portfolio manager of R.W. Roge & Company, says corporate profit margins are at historic highs, and predicts they’ll eventually have to return to more normal levels – and bring share prices down with them. “We think returns over the next 10 years will still be fairly muted,” he says. Roge says investors should rebalance their portfolios to take some gains, and reinvest some of the proceeds in bonds.

Nevertheless, more bullish advisers point out that stocks look cheaper than they were last time they hit 13,000. In particular, some tech stocks have steadily grown earnings through the entire credit crisis, says Karl Mills, the president of Jurika, Mills & Keifer. For the quarter ending in June 2008, the S&P 500 had a price-to-earnings ratio of about 25, based on reported earnings; it’s now just 15.6.

Many pros say stocks also seem attractively valued relative to bonds. Buying bonds at today’s low yields pretty much guarantees losing money to inflation over the next decade, says Mills. On the other hand, snapping up stocks at today’s low valuations offers a very good chance of gains over the next decade, he says, with volatility along the way. He also recommends avoiding the hedged products that try to protect against downturns that were so popular last year. “They aren’t going to deliver the kind of returns they need because they have the parking brakes on,” he says. If stocks do fall, he says investors should see it as another buying opportunity.

It must be nice to be Apple (AAPL). Seemingly their biggest problem seems to be where to put their burgeoning cash reserves. At last check they had about $97 billion worth of the ol’ greenback sitting around earning less than 1% in this low interest rate environment. Like mold on my son’s bath toy, this cash horde should grow to a whopping $146 billion over the next twelve months. So what is Apple to do to maximize shareholder value?

The most frequent comment we hear is that they will pay a cash dividend. There is probably some truth to that. However, this wouldn’t be the best use of their capital since we believe Apple shares are currently worth $875 and that intrinsic value goes up every quarter.

Apple’s best option is to initiate a share repurchase plan. We figure they will still want to keep a measly $40 billion around for the occasional acquisition (Greece perhaps?). This leaves Apple with $100 billion to repurchase shares. We assume they will pay around $650 per share, on average, to buy back about 154 million shares, dropping their total share count to 784 million fully diluted. Under this scenario Apple adds an incremental $127 to their share price.

It is fair to say we will be talking about Apple approaching $800 per share in twelve months, especially if they return cash to shareholders. At least that $100 billion dollars will be earning more than Uncle Sam is paying them, regardless of whether or not it is paid out in the form of a dividend or share buy back. One thing is for certain – if they pay out a cash dividend, reinvest it in the cheapest, high-quality stock, that everybody knows about…Apple.

Disclosure: I am long AAPL.

Rosanne Rogé of Eastport recently received a Woman of Distinction Award from Stony Brook University Medical Center’s National Pediatric Multiple Sclerosis Center in recognition of her “tireless commitment” to help improve the lives of children with the autoimmune disease. Rogé is the managing director of Bohemia-based wealth management firm R.W. Rogé & Co.

http://www.newsday.com/long-island/li-life/winner-roseanne-roge-1.3490812

What then?

One option, of course, is to simply withdraw the cash. But if you do that, you will owe tax on the earnings, plus a penalty equal to 10% of the earnings portion of the withdrawal. Fortunately, there are plenty of other ways to use leftover 529 funds without incurring tax or penalties, says Matthew P. McCarthy, head of the education-savings group at Vanguard Group.

After all, avoiding tax is a key benefit of state-sponsored 529 plans, which are named for the section of the federal tax code that created them in 1996. The money, typically invested in mutual funds, grows tax-free, and withdrawals to pay for qualified higher-education expenses generally aren’t subject to taxation.

Weighing the Options

If your intended beneficiary decides not to go to college, be aware that the money in a 529 plan can be used to pay for postsecondary vocational or technical training at schools eligible for financial-aid programs administered by the U.S. Department of Education. This includes schools that teach a variety of trades, such as automotive and aerospace maintenance, hairstyling and computer skills. A tool on the savingforcollege.com website, under “Tools & calculators,” can tell you if a specific school is eligible.

If a child goes to college but graduates without wiping out a 529 account, you can always let the remaining money sit for possible graduate-school expenses.

You also can change the beneficiary of the account, so long as the new recipient is a family member. That might be a sibling or step-sibling of the original beneficiary, for example, or a first cousin. Alternatively, a parent who funded the account may want to take college courses on a part-time basis, or save the money for potential grandchildren. (In rare cases, there may be gift-tax or generation-skipping-tax consequences when you change beneficiaries.)

Say there is money left over in a 529 account because your child got a big scholarship that reduced his or her college costs. In that case, money withdrawn would be subject to tax on the earnings but the 10% penalty would be waived, as long as the withdrawal doesn’t exceed the amount of the scholarship. The penalty on withdrawals also would be waived if the beneficiary dies or becomes disabled.

Unless you need the money in a 529 account for something else, there is no rush to make a decision. In most plans, you can leave funds in the account to grow tax-free indefinitely, as long as there is a living beneficiary. The account owner can change beneficiaries at any time.

However, if the money is likely to stay in the plan for longer than originally expected, review how it is invested. The key is to think about your time horizon and your tolerance for risk. “It’s like any other investment,” says Ron Rogé, a financial planner in Bohemia, N.Y. “If you think you’ll need the money in under three years, look for something stable, like a short-term bond fund. If it’s longer term, look for growth.”

Know the Rules

Most of the more than $130 billion in 529 savings plans is invested in age-based portfolios, where the investment mix becomes more conservative as the beneficiary gets closer to college age. But most plans offer other options. Indiana’s College Choice 529 plan, for instance, includes a U.S. Equity Index Portfolio, an International Portfolio and a Short-Term Bond Index Portfolio, among other options. Alaska has a Total Market Equity Index Portfolio, composed of one stock fund that aims to parallel the performance of the entire U.S. stock market, and an Equity Portfolio, composed of several stock mutual funds.

“There are 3,000 investment options among all the plans,” says Joe Hurley, founder of savingforcollege.com. Almost all states have at least one plan, and an account owner usually can roll over assets from one plan to another—or change investment options—once every 12 months. Some plans charge a fee for rollovers.

Especially when investing for the long term, it is important to designate a successor owner for a 529 plan to ensure assets will be available to the beneficiary if the account owner dies. This can be done when the account is established, or later.

It pays to know the rules of the state plan in which you are invested. While two-thirds of states offer state income-tax deductions or credits for residents who invest in their plans, some, like New York, can move to recapture those benefits if the assets are moved to another state’s plan.

A final thought: If there is no future beneficiary in sight, you may be able to mitigate the tax bite and the penalty by donating proceeds of the account to charity and taking a tax deduction—if you itemize deductions.

By Lynn Brenner

NEW YORK | Wed Jan 25, 2012 4:57pm EST

Six Ways To Maximize Retirement “Sweet Spot” Years

NEW YORK (Reuters) – During your working years, it is usual to focus more on gaining an immediate deduction for retirement account contributions than on how future withdrawals will be taxed. Financial advisers say that as a result, affluent people often retire with a portfolio of huge tax-deferred IRAs and 401(k) accounts — and belatedly realize they must tap the accounts for substantially more than living expenses to cover annual taxes on their withdrawals.

But there is a “sweet spot” — between the ages of 59½ and 70½ — when withdrawals from tax-deferred accounts are penalty-free, but not yet required. Advisers say those 11 years are the ideal time to protect yourself by moving some money into taxable and tax-free accounts instead of continuing to plow it into tax-deferred accounts.

“Most of the time, people are in the same tax bracket in retirement as when they were working, because of money coming out of IRAs and 401(k)s,” says Ronald W. Roge, chairman and chief executive of R. W. Roge & Co., a Bohemia NY financial planning firm. “I tell clients, ‘If you have a $1 million IRA, after federal, state and local taxes, you own about $600,000.’”

Most advisers say tax rates are likely to rise in the future. “In a down market, those big taxable distributions can kill you,” says Eleanor Blayney, a Mclean, Virginia adviser.

With a tax-diversified portfolio, you can plan cost-effective withdrawals, says Barry C. Picker, a Brooklyn New York tax accountant and IRA expert. He lays out an example of how helpful it is to have more than one type of account to draw on:

You retire at 65 with a $1 million IRA and a $500,000 taxable account. Assuming 3 percent annual growth, the accounts will throw off $45,000 of income a year – $30,000 from the IRA and $15,000 from the taxable account. But what if you withdraw the entire $45,000 from the taxable account? You’ve taken $30,000 of principal, so you’re only taxed on $15,000 of income.

Now you’re in a lower bracket, so your Social Security may be only partially taxable. And it may now cost less to transfer money from your IRA into a Roth IRA. That makes your IRA smaller, which may reduce your future required annual distributions.

How can you achieve that kind of flexibility?

1. Don’t assume you should wait until you are 70 years old to withdraw money from your tax-deferred accounts. “After you turn 59½, you need to make an active decision about this every year,” says Joel Isaacson, president of Joel Isaacson & Co., a New York City financial planning firm. High-earners’ taxable income often falls dramatically in the first years of retirement, he says – and it’s often offset by deductions for state and local taxes paid the previous year, mortgage interest and investment management fees. In some cases, new retirees can claim deductions for the cost of starting a small business or consulting practice.

The upshot: In early retirement, you may be able to move money out of your tax-deferred accounts at little or no cost. A retiree in the ‘sweet spot’ may pay a 3.6 percent combined federal and state tax on a $100,000 IRA withdrawal, says Isaacson.

2. Consider small annual Roth conversions after you turn 59½ while you’re still working, especially if your income fluctuates from year to year. “You want to maximize the use of your tax brackets in any given year,” says Robert Schmansky, founder and principal of Clear Financial Advisors in Bloomfield Hills, Michigan. Ask your adviser every year how much additional income you could take without being bumped into the next tax bracket.

3. Seize the opportunity of a down market to convert a hammered IRA into a Roth IRA. The tax bill will be smaller because you’re converting a smaller amount.

4. Find out whether you’re eligible for a state tax break on IRA withdrawals. Hawaii doesn’t tax withdrawals from contributory retirement plans after age 59½, for example. Michigan and New York allow annual tax-free withdrawals of $34,920 and $20,000, respectively. “If you’re a New York City resident, that could save you as much as 15 percent,” says Isaacson. “Maybe that makes it worth taking out $20,000 a year if you can get it at a relatively low federal rate.”

5. Contribute to a Roth 401(k) plan if you have access to one. Later, you’ll transfer it to a Roth IRA. Meantime, your Roth 401(k) contributions still effectively boost your traditional 401(k) account; by law, any employer matching contribution must go into the tax-deferred account.

6. If you’ve maxed out 401(k) contributions, save in a taxable account. “People who want to save outside their employer’s plan often want more tax deferral, so they buy variable annuities,” says Blayney. “But this is an ideal time to set up a taxable account. If we see tax rates moving up, people will get socked in tax-deferred accounts.”

(The author is a Reuters contributor. The opinions expressed

are her own.)

(Editing by Beth Pinsker Gladstone and Andrea Evans)

Paying More for Dividends

Long favored by risk-averse retirees, dividend-paying stocks have been attracting investors of all stripes lately for their high yields and market-trumping returns. But as their popularity grows, even some advisers are starting to ask: Are dividend payers getting too pricey?

Investors poured $31.3 billion into mutual funds and exchange-traded funds that invest in dividend payers last year, nearly five times the amount in 2010, according to researcher Lipper Inc. By comparison, all equity funds and ETFs lost $33.5 billion. The allure? Experts say income-seeking investors have turned to these stocks and funds for their yields, which have trumped those of 10-year Treasurys. Others, they say, were surely chasing performance: Stocks in the Standard & Poor’s 500 index that pay dividends posted a 1.4% total return in 2011, while non-payers fell 7.6%.

That rush, however, is making many dividend payers more expensive, say advisers. Historically, dividend stocks trade at lower price-to-earnings ratios, with the expectation that they’ll grow less quickly than other stocks. While that’s still the case, the gap between payers and non-payers is shrinking: At the end of 2010, the average price-to-earnings ratio of non-payers in the S&P 500 was 37% higher than the average P/E for payers; today it’s 33%. Die-hard dividend devotees are now seeing a lot more short-term traders crowding into their corner of the market. “I’m as big a fan of dividend stocks as I ever have been, but when everybody else starts talking your strategy, you have to be scared,” says Josh Peters, the editor of Morningstar’s DividendInvestor newsletter.

Indeed, analysts say that these higher prices mean that last year’s strong outperformance by dividend stocks might not be repeated. In the utilities sector, for example, “when you start looking at high double digit P/Es, there’s not much room left for gains,” Peters says. Plus, in a rising stock market, these historically slow-and-steady stocks would take a back seat to higher-risk, higher-return growth stocks. “If interest rates go up or the stock market goes on some kind of a speculative binge, then these stocks will get left in the dust,” Peters says.

Even fans note that the growing popularity of dividend stocks’ has started pushing down yields in some high-flying sectors like utilities and tobacco (as stock prices rise, yields fall). Shares of Philip Morris, for example, jumped 35% in 2011, but the stock saw its yield shrink from 4.2% to 3.6%. Likewise, yields for Duke Energy Corporation (DUK: 21.23, -0.07, -0.33%) have fallen from about 5.4% to 4.5% over the past year as shares gained 20%.

Despite these drawbacks, investing pros say that dividend stocks still have plenty to offer long-term investors. Because they tend to be less volatile than non-payers, they tend to lag in a bull market, but hold up better when markets falter, says Howard Silverblatt, the senior index analyst at Standard & Poor’s. “Basically, the dividend acts as an anchor holding the stock in place,” he says. And because many companies increased their dividends over the course of 2011, dividend investors will be getting more income through 2012. “Unless companies cut [their dividends], you almost have to get a double-digit increase this year,” Silverblatt says.

To avoid overpaying for income, advisers say investors should focus on companies that are still growing their dividends, instead of looking for the highest current yields. “Dividend growers are great inflation protection because that yield is increasing every year,” says Steven Roge, a portfolio manager at R.W. Roge & Company. And if the yield is rising, he says the underlying fundamentals of the company are likely improving, too. Roge recommends dividend-growing consumer staples stocks like PepsiCo (PEP: 65.68, -0.60, -0.91%), whose payout has increased by about 22% since 2008, or spice-maker McCormick & Company (MKC: 51.21, -0.30, -0.58%), whose payout is up about 27% in that time.

By Ronald W. Rogé, MS, CFP^®

Steven M. Rogé, CMFC^®

As we wrote this time last year we cautioned of an increased volatility in risky investment assets. We saw increased risk with sovereign debt in Europe and its effect on global economies.  Well, the market honed in on this issue starting in mid-July as we saw the equity markets in the U.S. drop some 20% from their highs.  Yet this only told half the story as smaller company stocks lost nearly 30% in one month.  Foreign stocks took the brunt of the selling as they technically entered a bear market with a loss greater than 30%.

The stock market  rebound in the 4^th quarter helped recover most of the losses domestically, but still wasn’t enough to bring international equities back to breakeven, as they ended the year down about 12%.  Small-cap stocks ended the year down about 4%.

We manage highly diversified globally balanced portfolios. This means as part of our portfolio’s equity mix we owned international stocks and smaller company stocks.  Over the past decade our exposure to these asset classes has helped the performance of our portfolios.  This year was a different story as they provided a drag on the portfolio performance.

Overall the majority of our portfolios were down slightly for the year, worse than a traditional domestic-only equity portfolio, but in-line with most globally balanced indexes.

 Stocks

Globally, it was a negative year for equities.  The S&P 500 finished the year where it had started, and that was about as good as it got in 2011. The MSCI EAFE Index was down about 12%, while the MSCI World Index was down about 5%.

It was a bifurcated market last year with domestic large-cap companies (Dow Jones 30 Stocks) faring particularly well, up about 5.5% for the year, while small-cap ended the year down 4% respectively.

One area that we have been avoiding is emerging markets, down about 20% for the year.  Emerging stock markets are almost always in the press and are easy “stories” (i.e. faster growth, positive demographics, commodities exposure, etc.).  However, in this environment, we continue to believe one doesn’t have to pay a substantial premium for having emerging markets exposure in your portfolio. The companies within the S&P 500 derive approximately 25% of their revenue from emerging markets.  Investor’s in your typical domestic blue chip company can benefit by knowing they own a company with strong capital rights and governing principals while still having exposure to fast growing economies in emerging markets.

Fixed Income

The fixed income markets had a good year. In particular, the relative safe haven status of U.S. Treasuries pushed the Barclays Capital Aggregate Bond Index up almost 8% for the year.  Municipal bonds also fared well as prognosticators view on thousands of municipal failures didn’t come to fruition and subsequently the prices of these bonds rose.

International bond markets were hurt due to worries about European Sovereign debt.  We saw Portugal and Greece get bailed out.  European leaders also negotiated a restructuring of Greek debt.  This is a nice way of saying that Greece is defaulting on its debt.  Subsequently money that had been invested in European bonds flooded the U.S. Treasury market.

Major Market Indexes (Total Return)

Outlook and Strategy

Our outlook for 2012 continues to remain cautious.  While there is plenty to worry about globally, particularly the European financial crisis, Iran, and domestic policy decisions both fiscal and monetary, we can take some comfort that here in the U.S. corporate earnings continued to grow, our economy, while still delicate, is muddling through with positive GDP numbers.

One hopeful item is that it is an election year.  Traditionally, election years are positive for equities.  Since 1928 there have been 21 Presidential elections with only three of those years producing negative returns for the S&P 500.

Another item is unemployment, and while it is currently near 9% it has been very slowly trending down.  A drop in the unemployment rates will be aided over the next decade as the baby boomers begin to retire more steadily.

Until we have more clarity on the U.S. election, domestic policy decisions and the European financial crisis we will remain cautious and flexible.  We expect stock market volatility to remain elevated in the first quarter of 2012.  We believe that by the end of the second quarter, we will begin to have more clarity on these subjects.  When this happens we will be making all the necessary changes to reflect our outlook at that time.

In the meantime, we will remain vigilant and continue with our current strategy, which is focused on getting paid while we wait for more clarity.  This means continued emphasis on dividend paying stocks, less exposure to foreign currency risk and continuing to clip coupons from the bond portion of our portfolios.

As always, we continue to manage risk first and look for return second.  This has been our mantra and has worked well for us during difficult economies, and this year has been one of the toughest.