Author: Gabriel Grego, Zanshin Capital
Model: Buffettian Value
Disclosure: Long JNJ at time of writing
When investing in the stock market, if you are out chasing the latest market fads, chances are you’ll get in trouble. Just ask enthusiastic dot com speculators of the ’90s, or real estate investors of the last decade.
In my opinion, the best way to consistently outperform the market is to overcome the herding instinct. One way to do so is to look in places everybody is running away from. Often you will find only junk there. But, every now and then you will come across some hidden gems. I believe that Johnson & Johnson (NYSE: JNJ) – one of my portfolio holdings – is currently one such gem.
The company is well known. It is composed of three main divisions, all of which enjoy leading positions in their respective fields: pharmaceuticals, consumer products, and medical devices. It has a decade-long legacy of superior management and exceptional returns.
Operational Issues Fixable
J&J’s reputation has been tested repeatedly of late by several large products recalls, mostly originating from apparently widespread manufacturing problems at certain facilities. This created a particularly serious image problem for J&J, as many of the products involved are iconic brands such as Tylenol or Motrin. The issue has attracted the attention of the FDA, which has mandated tight inspections and monitoring at the facilities.
These issues have contributed to a weak stock price performance for the past several years.
I believe that however serious and disturbing J&J’s current problems may be, they are indeed fixable and temporary in nature. We are not talking about a loss of competitive advantage, as happened to Kodak upon the advent of digital photography, or permanent adverse regulation, as was the case with the online gambling industry in the United States.
Rather, J&J has some serious operational difficulties, but enormous financial and managerial resources to overcome them. Now, the only question is, what kind of company are we going to have on our hands once these short-term problems are solved? The answer: a cash machine.
Strong Products, Strong Financials
The industries J&J operates in are mostly blessed with good long-term economics. All will benefit from two important demographic trends, namely emerging markets shifting to westernized health care and consumption patterns, and an aging world population. This means sustained demand for all sorts of drugs and medical devices.
Also, unlike most of its industry peers, J&J no longer suffers from a significant drug patent expiration problem. On the contrary, it has the advantage of a strong pipeline of new drugs hitting the market very soon, several of which have blockbuster potential. Clearly, patent protection is one of the strongest possible competitive advantages, as they can secure hefty returns for many years to come.
Finally, J&J enjoys significant economies of scale due its significant R&D budget and efficiency.
The consumer products divisions, including both products such as shampoos and over-the-counter medications, benefits from high levels of customer loyalty, as many brands have been in existence for decades, promoting strong habit formation. J&J’s sheer size also creates economies of scale in marketing. Although this division suffers from product recalls and diminished consumer spending, I believe these issues are bound to reverse in due time.
The medical devices division also, with all of its present woes, benefits from an aging population and a larger client base thanks to emerging markets. Increased competition should be kept at bay, as there is a significant degree of customer captivity. Ask a surgeon how much time and effort is involved in shifting from one artificial hip product to another, and you’ll discover this involves long retraining and changing of toolsets.
Another huge plus for J&J is its pristine finances. The company boasts a triple-A bond rating, reflecting generous cash generation, large cash reserves, modest leverage, and operating in very stable, noncyclical, and diversified industries.
J&J management and corporate governance is mixed, in my opinion.
On the one hand, you have very established and ingrained management practices with a long history of efficiency and shareholders returns (to the extent that J&J is frequently the subject of case studies for many business schools). On the other hand, there is no single, large shareholder that can vigorously exercise its power over the management team when things go wrong. This potentially can be a problem, and a symptom could very well be the resilience of the current CEO to hold on to his seat despite the number of significant setbacks the company went through.
Finally, valuation. At the present price, given earnings, the balance sheet, and current valuation, I find JNJ to be very compelling going forward, based on my discounted cash flow model.
I believe it is rare to get the chance of investing in an AAA-rated company with this kind of potential upside.
Sources:
Morningstar balance sheet information, as of 5/1/11 http://quicktake.morningstar.com/stocknet/bonds.aspx?symbol=jnj
