What To Do When A Stock Overshoots Fair Value: Parker Hannifin And Johnson And Johnson As Cases

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Includes: JNJ, PH
by: Jim Sloan

Summary

As a value investor, I occasionally encounter the problem of having a major holding overshoot its fair value range.

Almost three years ago I wrote a piece on JNJ and PH saying that they were equally cyclical and prone to the occasional down year; both are now overpriced.

JNJ is a bad choice for call writing; although PH is better, I have more often than not made mistakes in the past writing calls against overpriced positions.

A key factor is embedded tax liability; after looking at cap gain taxes several ways, I see that selling reduces capital and potential dividend income materially.

My carefully considered conclusion: do nothing.

I am a value investor. Maybe a better description would be GARP -- Growth At a Reasonable Price -- but the bottom line is still value. As such, I hold a portfolio which in the aggregate is cheaper by price earnings ratio and most other measures than any of the major averages.

I don't know quite what PE number to attach to the S&P 500. Many analysts will tell you that it is now around 24, but should soon get better with next year's earnings dropping it to 18-19. I'm agnostic about the exact measure. I'm agnostic about earnings prospects for the S&P 500 in the near future. All I know is that if the S&P were a stock, with its likely earnings growth rate, I would not pay even an 18 PE for it.

My own portfolio has an aggregate PE of less than 15. There are, in my view, no dead-in-the-water value traps and no companies with business models under heavy assault. That being said, the average PE of my portfolio is dragged upward by two holdings which have gone up quite a bit from my average purchase price -- Johnson and Johnson (NYSE:JNJ) and Parker Hannifin (NYSE:PH).

I consider both JNJ and PH to be overpriced and would not buy more at the present time except as dividend reinvestment. But what should I do with them? Should I consider lightening up?

The Cases of Johnson and Johnson and Parker Hannifin

Coincidentally, I published this piece seekingalpha.com/article/1850221-compari... with a joint consideration of Johnson and Johnson and Parker Hannifin in November of 2013. My question at that time was whether JNJ was legitimately considered safer and less cyclical than PH. The market certainly thought so then, and thinks so now.

My conclusion was that JNJ was not much less prone to down earnings years than PH. The difference was that earnings variance in PH tends to come as a result of recessionary periods in the business cycle while erratic earnings from JNJ tend to come from product recalls and similar mishaps, which are less regular but equally disruptive. For some reason the market is more willing to look past a year of bad earnings from JNJ. Both companies, it should be said, tend to recover within a year or two and surpass past earnings peaks, moving ahead at their similar moderate rates of growth.

It struck me as interesting then that such measures as beta and option premiums treated PH as the much more risky and volatile company, which I am pretty sure it is not. In fact, the two companies share one of the major current risks because of significant overseas profits subject to currency swings and downturns in Europe and elsewhere. The perceived volatility of PH may make it provide a better option for call writing when clearly overpriced.

Both companies have been around a long time, through widely differing business environments, and both are among the few companies with more than 50 consecutive years of dividend increases. I regard both as having strong moats. In short, there is nothing wrong with the business in either case.

The Trouble With JNJ And PH

The trouble is simple: both JNJ and PH currently sell at a PE rate in excess of 20, roughly 21 for PH, roughly 22 for JNJ. There are all sorts of rationales for this, including comparisons to low safe rates on bonds and other income vehicles. I simply don't pay that much for a moderate grower. Once in a great while I may pay about that much for a faster growing small company, but I am always greatly aware of the risk that rapid earnings growth, like beauty, is fleeting.

You could possibly argue that earnings growth at PH is currently at a trough and will pick up smartly as the economy accelerates and foreign currencies swing back to mean values against the dollar. This would help JNJ only a little, but might help PH a lot. I acknowledge that this may be the case, but it wouldn't persuade me to chase the current price of either with new money.

And if I wouldn't add new money, shouldn't I carefully consider whether to maintain my current commitment? Let me consider some factors.

Writing Calls

First of all, I should say that only a chump would ever consider an option strategy with JNJ. The market's assumption is such steadfast conviction that the great ship JNJ will safely sail up the sea lanes that it offers you very scanty premium. Writing a call on JNJ amounts to tying yourself up for nickels and dimes.

I also have doubts about writing calls on PH. My gut fear is that the market keeps doing roughly what it is doing and PH gains a little traction in earnings. If this happens I am left with a tough decision about buying back call writes at a loss.

But I have a better reason for not writing calls. I buy shares of companies I have conviction about, and I buy at what seems a reasonable price. I have reviewed the several instances in the past when I used call writes on overpriced stocks, and in a very high percentage of cases I would have been better to do nothing at all. Period. Sometimes I should perhaps have set a price point high enough to sell outright.

So no call writing. I know myself.

Me, Myself, And The IRS

Here's the real killer problem. PH is up over 40% from my average purchase price. JNJ is up more than 70%. Another way of putting this is that about 30% of my capital in PH is capital gains, while more than 40% of my capital in JNJ is capital gains. Cashing them in would cost me a considerable amount in taxes. Combining IRS rates with the Obamacare override with Illinois state taxes means that about 7.5% of my capital in PH has to be surrendered in taxes. With JNJ that number is around 10%. On years we hit the level for Alternative Minimum Tax, which happens frequently, the numbers are much higher.

Put that way, it's clear that the part of each stock I actually own (as against the government's share) is 8 to 12 points lower than the market price. It's sort of a cushion to bear in mind. Since the dividends are paid on the whole number of shares, I have a little tougher comparison when thinking of what I would do with the 90% of my present capital which actually came back to me. With the market where it is at present, I already sit on a large cash reserve for lack of obvious opportunities to make value investments.

So the right decision is not clear and obvious. Yes, I bought JNJ because I loved it at 15 or 16 times earnings, but I can make a case for hanging on to it if the rate of return on capital I would get after selling still implied only about a 20 PE. As for PH, I loved it when buying at 12 to 15 times earnings but am willing to wait for future growth to kick in if it is only 18 or so times pretty visible earnings on capital subject to taxes.

They are both, after all, good companies. They aren't going away.

Conclusion

How to deal with holdings that have moved up beyond the top of your fair value band is one of the problems which come up at the present price level of the markets. If the companies continue to produce, the decision is hard. The way to think about it includes a range of options, but the most important consideration, I think, involves considering the amount of your total capital which would be returned to you (as opposed to taxing entities) and the opportunities for investing it elsewhere. My decision with PH and JNJ: do nothing, continue to hold and collect dividends.

Disclosure: I am/we are long JNJ, PH.

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.