One of the central teachings in Buddhist philosophy has to do with the nature of suffering.
"Life is suffering," we were told by Siddhartha Gautama, "And suffering results from a reality that fails to conform to our expectations."
Reality is beyond our control, obviously. But our expectations aren't. By carefully managing them, it's possible to eliminate virtually all of the suffering that life throws our way.
It's an ancient lesson that investors frequently forget. The stock market is a daily source of suffering for us and it doesn't have to be.
In the case of Johnson & Johnson (NYSE:JNJ), it's critical that investors have a proper sense of place. The game has changed since the stock was trading in the $60's last year, a range that it had spent the previous half-decade exploring. If investors don't properly calibrate their expectations for the road ahead, much suffering is in their future.
If you're anything like me and have been following JNJ for a long time, your expectations for Johnson & Johnson were derived from an earlier reality. The last six months have been a delight, but are something of a head scratcher.
What happens from here?
Let's take a look at some objective analysis.
1. The stock is very fairly valued. (OK, it's expensive.)
Johnson & Johnson's current P/E is 21.
Take a guess at what it's average P/E has been for the last decade. Go ahead.
It's 15. That's exactly what I would have guessed and probably what you guessed too.
We can get a bit more fancy with our earnings analysis and plug it into Graham's formula. Here's a quick look at what that looks like:
It's calculating an intrinsic value somewhere in the $70's.
Now, to be fair, I'm using diluted EPS for this. That represents a much more conservative outlook. If you run that again using normal EPS, you'll get an intrinsic value somewhere in the $90's, which sounds more appropriate given today's prices.
But still, this is all assuming a 6.5% earnings growth rate. If we plug in the current price and solve for the growth rate, we come up with 7.25%. At $81.52, that's what kind of growth the market is expecting for JNJ during the next 5 years. As it happens, that's just a bit above what consensus analysts are actually forecasting.
Funny how that works.
To say the stock is inexpensive at these levels requires some fairly aggressive assumptions with respect to earnings growth or continued evaporation of risk aversion. Those things may indeed happen, but keep in mind that those are cyclical forces, not linear ones.
Now let's look a little deeper at the value. I won't bore you with the mechanics of my discounted cash flow analysis. I'll cut straight to the money shot:
Again, if you think JNJ can grow in the 6-7% range, the stock is very fairly priced. Perhaps richly priced depending on what kind of discount rate you want to use. Personally, I'd rather use a discount rate of 10-11% for a stock that I'm projecting to grow at 6.7%. But I'm a conservative cat.
Historically, JNJ has traded at around a 9x Enterprise Value / EBITDA ratio. If we use that historical norm and relate that to our projected future cash flows, we come up with an intrinsic value somewhere in the high $60s. Which makes perfect sense for the JNJ we all knew and loved in the last few years. To justify today's prices up here in the 80's, you have to assume an enterprise value at 11x EBITDA. That's a lot.
Did Johnson & Johnson's core business get magically more valuable and high-growth in the last 6 months than during the last 30 years?
It would certainly have had to in order to justify today's prices relative to an awful lot of historical data.
2. Johnson & Johnson is an income security now.
This is a critical point. The world is absolutely starving for income and under the Q-Infinity regime and bizarrely low yields, investors are getting more creative. During the last few years, they've opened themselves up to dividend equities as an alternative to high quality corporate or sovereign credit.
This is all well and good.
But only if you're Benjamin Graham and don't really care about stock prices.
Another of Graham's legendary teachings was that when it comes to dividend stocks, you should just ignore the price and collect your dividends. After all, does an apartment landlord worry about the price of his building? Not really. He just pays really close attention to rents. It can be enlightening to think of stocks in the same way. Dividend safety becomes so important that it's essentially the only characteristic that matters in one's analysis.
Johnson & Johnson's dividend is as safe as any, and it's a good bet that they'll continue to raise that dividend in the years to come, just as they have in years past. With the bid currently in the stock, investors clearly have little doubt here.
By the same token, stocks that are richly (or even fairly) priced are bad places for capital preservation. This ties into the famous "margin of safety" concept, of course. And that's the teaching Graham is really famous for. If you like to have a 25-50% margin of safety in your stocks, you will not find it here.
If you care about capital preservation at all, go somewhere else for your income. Or wait for some sort of market or individual correction before initiating a position. What, you think it's impossible for JNJ to go down from here?!
Today, Johnson & Johnson yields around 3%. That's in the neighborhood of the 30-yr Treasury and twice the yield of the 10yr. One of my favorite questions to ask is "as an income security, would you rather own US government debt or a stock like Johnson & Johnson for the next decade?"
JNJ offers income comparable to the 30-yr bond, and, depending on how you feel about inflation or volatility, arguably less risk. Even with comparable current income and comparable (though different-flavored) risk, JNJ also offers opportunity for growth in the next few decades. You can't exactly say that about Treasuries.
How different is a stock like JNJ from a piece of high quality corporate paper? Investors are certainly treating it as such, and this could partly explain the stock's rise and popularity in certain circles.
3. The biggest risk right now is interest rates.
Seriously: how much risk is there with JNJ's core business? They make consumer products, drugs, and medical devices. Those are all things I'm bullish on as we begin to sort through the demographic and political realities of the next few decades. It's a very well run company and dominates many of the industries it's in.
Just because there isn't a lot of business risk, doesn't mean that there's no risk entirely. It is a stock, after all, which means JNJ will be subject to the whims of a skittish market. Its price isn't strictly dependent on earnings, but also how much investors are willing to pay for a dollar of those earnings.
As an income security, especially one that is appropriately or richly-valued based on historical fundamental metrics, Johnson & Johnson will be particularly sensitive to interest rates.
This isn't rocket science.
As rates rise, their 3% dividend becomes less attractive.
Then Johnson & Johnson has two choices. They either raise that dividend to keep up, which hurts their ability to reinvest cash and grow their business (upon which the current valuation is dependent, mind you). Or they deal with the consequences of becoming a relatively less attractive source for income. Instead of paying 21x earnings for that, maybe investors would rather pay 15x. Don't forget that a lower stock price is another way to "increase" the dividend yield.
In a philosophical sense, buying a company like Johnson & Johnson is virtually indistinguishable from making a straight-up bet on continued low interest rates.
You're either comfortable with that kind of bet or you aren't.
I mention it because I'm not sure that everybody investing in JNJ right now has asked themselves that. This is a risk that few are discussing now with the stock.
Since we're talking about income, Johnson & Johnson might be one of the best stocks in the world to write covered calls on. If you own it and aren't covering it up every month, now is the time to start.
Theoretically, my favorite targets for covered call writing are companies that are at or above fair value i.e. stocks with little fundamental upside left, yet have had a strong technical run and feature rich option premiums. If you own JNJ or plan on initiating a position, I'd write calls on this puppy all day long.
As an example, the May 85 calls are trading around $0.40. Keeping JNJ covered can tack on an additional 4-6% per year to your 3% dividend. That, my friends, is what an income security looks like! I'd much rather have that than a basket of junk debt.
Lastly, I know you can't really talk about inflation without talking about interest rates, but a company like Johnson & Johnson could be an interesting piece in the inflation puzzle.
I wrote extensively about developing a playbook and specific strategies for protecting your wealth against inflation several weeks ago. Stocks aren't normally a good place to do that. Personally, I don't believe that inflation represents a significant risk for US right now. But that doesn't mean I shouldn't have a strategy at the ready to deal with that risk.
Ignoring low probability events is not risk management.
If you are going to own equities in a high-inflation environment, stocks like Johnson & Johnson whose revenues are tied very closely to wages and prices are as good a bet as any. JNJ had a rough ride in the 1970's, but it made it through better than most. And the stock really performed in the years where inflation ran hottest.
I must mention that I own Johnson & Johnson in my Alpine Advisor Dividend Income portfolio right now. After this analysis, I'm not sure how much longer that'll be the case.
My #1 rule for dividend portfolios is to not chase yield, and that's how I wound up owning JNJ there in the first place. But I also believe in balancing risk and reward, and I can probably grab the same 3% elsewhere without some of the potential headaches.
Johnson & Johnson has always been thought of - rightly - as a defensive stock. But with such a historically rich valuation and a dependency on low interest rates, I'm not sure how defensive this stock really is today. Just because it was defensive last year doesn't mean it still is right now.
The Only Question That Counts
Like any stock, the decision about whether or not to invest in a company like Johnson & Johnson is a personal one. So long as your expectations are properly aligned, you can go into it or avoid it with full confidence. I wonder, however, what the Buddha would have to say about a stock like Johnson & Johnson today?
Probably nothing. In fact, he might even ask what the stock says about us.
What does Johnson & Johnson say about the world today?
If you can answer that question, you'll know everything you need to know about whether it's a buy and when it's a sell.
Additional disclosure: Full disclosure available here: cornicecapital.com/AlpineAdvisor/legal-notice/