Dr. Buffett Has Diagnosed Johnson & Johnson As Too Big To Succeed

| About: Johnson & (JNJ)

We are amazed that Johnson & Johnson's (NYSE:JNJ) shares have held up better than the S&P 500 over the last month. JNJ's shares have only declined by less than 5.2% since peaking at $72.52 on October 18th, while the S&P 500 has decreased by 7.5% during this time period. We can see that Warren Buffett's Berkshire Hathaway (NYSE:BRK.B) has decided to sell its remaining JNJ shares due to ill health on the part of Dr. Buffett. It appears that Dr. Buffett is sick and tired of the company's sclerotic stagnation and has diagnosed the company with Too Big to Succeed syndrome. The only thing that surprises us with regards to this move is what took Berkshire Hathaway six years to sell its position? We can understand why Berkshire invested in JNJ in 2006 as JNJ had solid revenue and profit growth during the first four years of former CEO Bill Weldon's administration. Weldon became CEO of JNJ in April 2002 after four years as Chairman of JNJ's Worldwide Pharmaceutical Group. We divided Weldon's tenure as CEO into two chapters:

  • Chapter 1, April 2002-November 2006: In this time period, cumulative acquisition spending was only $6.2B and JNJ's revenue increased by 65% from 2001 to 2006
  • Chapter 2, December 2006-2012: Cumulative acquisition spending has been $43B in this period yet JNJ's revenue growth has barely budged.

Source: Morningstar Direct

This episode with Berkshire and JNJ is relevant to investors because it shows us that even the best of investors can sometimes hold on to a position for too long. Warren Buffett considers John Maynard Keynes to be an influence on his investment mindset. Keynes was allegedly to have said "when the facts change, he changes his opinion." Regardless of whether Keynes said it or whether it is apocryphal legend attributed to him, the quote has some usefulness, just like any other tool. We think it is a useful maxim that investors should include in their tool-belts but not necessarily wed themselves to it. It is a useful tool when used appropriately but like anything requires proper use. In this case, we believe that the facts surrounding the investment case for JNJ began changing after Berkshire disclosed its JNJ stake in its Q2 2006 13-F Filing. Berkshire was able to keep its stake in JNJ confidential until it filed the Q2 2006 report.

Source: Morningstar Direct

To elaborate further on how the facts changed with regards to JNJ's investment merits because the facts changed with regards to JNJ's business performance. Despite spending $43B on acquisitions from Q4 2006 to Q3 2012, JNJ's revenue growth has barely budged even though it has added $22B of goodwill and intangible assets to its balance sheet. The good news for JNJ is that it still has a net cash position of nearly $3B and gross liquidity of $19.8B. The bad news is that the company's net cash position has declined from $12.7B in Q3 2006 to $3B in Q3 2012 with little to show for it. The worst news for JNJ is that its gross debt has increased from $2.3B in Q3 2006 to $16.85B in Q3 2012. In hindsight, we think that Berkshire would have done fine with its JNJ position if it has sold it at any time before the end of Q3 2008. Although Berkshire would have only generated a single digit annualized total return on its position, at least it would have avoided the indignity of a dead money position for 4 more years. In hindsight, we think JNJ should have taken the cash spent on Weldon's shopping spree and utilized it on dividends and share repurchases.

Source: Morningstar Direct

Although Berkshire has sold all but 492K shares of its JNJ position, Buffett acolyte Ken Fisher of Fisher Asset Management, LLC still has its 10.66M share position. The good news for JNJ stakeholders is that Fisher Asset Management owned $734M worth of JNJ, and JNJ was Fisher's largest individual stock holding and third largest overall holding. The bad news for JNJ shareholders is that Fisher Asset Management's holdings are basically a glorified index fund containing 514 different holdings as of Q3 2012. Other notable institutional shareholders of JNJ include Barrow, Hanley, Mewhinney & Strauss and Grantham, Mayo, Van Otterloo & Co (GMO LLC). GMO owns 25.05M shares of JNJ, which represents a stake of $1.7B at current prices and 0.91% of JNJ's outstanding stock. Barrow, Hanley, Mewhinney & Strauss is the subadvisor for the Vanguard Windsor II mutual fund and owns 16.35M shares of JNJ, which represents a stake of $1.1B at current prices and 0.59% of JNJ's outstanding stock.

In conclusion, Berkshire's history with Johnson & Johnson is a good reminder to investors of the need to cut their losses on an investment. Although JNJ's share price registered a nominal increase during the time Berkshire held it and it paid a steadily increasing dividend, we can expect that it missed Berkshire's internal rate of return expectations. Berkshire's history with Johnson & Johnson also reminds investors that even famous investors do not always get it right. And the most important lesson to investors is that it is important to keep an eye on the financial performance of one's holdings because even the best blue-chips can sometimes generate sagging, somnolent performance. Although JNJ beat the S&P 500 from 2006 to 2012, we don't believe that investors are impressed with that fact considering the S&P 500 only increased by 3.09% from Q2 2006 to November 15th 2012. It's not like JNJ had a high hurdle to overcome. JNJ's annualized 5.39% return during this time period was comparable to BRK.B's 5.44% return and both Berkshire and JNJ underperformed the iShares Barclays U.S. Aggregate ETF's (NYSEARCA:AGG) 6.30% return during this time period.

Source: Morningstar Direct

Disclosure: I am long BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article was written by an analyst at Saibus Research. Saibus Research has not received compensation directly or indirectly for expressing the article’s recommendation. We have no business relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.