Recent Purchase: Johnson & Johnson

| About: Johnson & (JNJ)

Summary

I recently purchased JNJ at $121.64.

I also recently named JNJ my single best investment in today's market for Mike Nadel's #1 Stock In The World series.

In this piece I go into further depth on these decisions.

With Johnson & Johnson (JNJ) recently hitting 52-week lows and falling to the 3% yield threshold, there has been a lot of buzz around the stock recently. Last month, Seeking Alpha published an article in response to Mike Nadel’s #1 Stock in the World series update, and commenters had a lot of good things to say about JNJ. It’s not surprising that investors, many of whom are focused on dividend income/growth, would flock to a high quality name like this (JNJ is one of two companies in the world with an AAA rated balance sheet, Microsoft (NASDAQ:MSFT) is the other) when it’s trading at the cheapest valuation investors have seen in years. Dividend Sensei also recently covered the stock, penning a wonderful bullish piece on the name, claiming that JNJ “Could Crush the Market Over the Next Decade.” I’ve owned JNJ for years, though I recently trimmed the position, locking in strong gains at $130.30 due primarily to the Talc litigation headwinds. I maintained exposure to the majority of my shares; however, I was sitting on nice gains on a lot owned in a retirement account and decided to reduce my exposure (and risk) without tax penalties, waiting to see how things shook out. Well, flash forward a couple of months and JNJ shares seem to have found support in the ~$120 area, so I decided to buy those shares back at a ~6.6% discount to my previous sale.

For the latest episode of the #1 Stock in the World panel, I choose Johnson & Johnson as my answer to the first question he asked panelists: what is the single best company for an investment today? Here’s what I had to say:

It's hard to find a better investment than Johnson & Johnson, and I recently bought shares at $121.64. JNJ has increased its dividend for 56 consecutive years. In terms of reliable EPS growth, it doesn't get much better. (See FAST Graphs illustration below.) JNJ has posted 8%+ EPS growth 4 of the last 5 years, and 2018's figure is expected to represent double-digit growth.

You'd think the market would put a premium on this sort of predictability, right? Well, JNJ is down about 15% from recent highs and is at its lowest P/E ratio since late 2015. I think the talc powder lawsuits have something to do with this, and I still believe that remains a potentially large risk for this company, but all equity positions come with risks.

Looking forward, JNJ is trading with a 15x multiple and a 3% dividend yield. JNJ's 20-year normal P/E ratio is 19.4. I think it's fair to say that this company's best growth days are behind it, so I don't think shares should trade for nearly 20x; however, I do think that 17x is fair.

When you combine JNJ's nearly 3% dividend yield with its EPS growth trajectory and the potential for multiple expansion back toward fair value, it's easy to envision JNJ generating double-digit returns over the next couple of years with relatively little risk.

In this piece I’ll go into a bit more depth on my decision making regarding that purchase and how I arrived at my forward looking projections. But, before I get into the speculative nature of this analysis, let’s focus on what’s real and tangible: my passive income stream. Because I allocated roughly the same amount of money towards the shares which were trading lower, I was able to increase my share count for the same amount of money and therefore, increased the dividend income I expect to receive from JNJ. Timing the market like this doesn’t come without opportunity cost, but I thought the risk was worth the potential reward and I’m happy that this trade worked out well.

I did miss a dividend payment while I was away from the portion of my shares that I sold; however, I’m okay with missing one payment because due to JNJ’s recent dividend increase and the increased shares that I bought with the same wad of cash, this trade has increased my JNJ passive income looking forward by ~8.9%. When I think about making trades like this, I think about using fundamentals to generate organic dividend increases.

Speaking of fundamentals, let’s take a look at a F.A.S.T. Graph to show just how cheap JNJ is relative to the market and its own history. As you can see below, JNJ is trading for ~15.9x ttm earnings and 14.98x 2018 analyst estimates. JNJ hasn’t traded this low since Autumn of 2015. JNJ is certainly no longer the company it once was in terms of growth. With a $325b market cap JNJ appears to be running up against the law of large numbers. For management to attempt to move the needle at this point in time, it would have to take outsized risks and that isn’t what this company is all about. I suspect that the days of reliable double digit annual top-line/EPS growth are a thing of the past and my expectation moving forward is 5-7% bottom-line growth.

Source: F.A.S.T. Graph

Now, this slowing growth isn’t the end of the world, it just means that valuation is more important than ever because it’s unlikely that this company will have the growth necessary to justify high premiums. As you can see in the snapshot below, by locking in prices down here near 52-week lows, I’ve given myself a chance at above average total returns over the medium term. Using the ~6% annual EPS growth that analysts expect looking out to 2020 (which is in-line with my own expectations as well) and a 16.5x multiple, which I deem to be fair for a company with reliable mid-single digit growth, a 3% dividend yield, an illustrious history of dividend growth, and the best balance sheet in the world, we see that I expect to receive a total annual rate of return in the 11.5% range. Long-term, I’ve planned to reach financial freedom with a portfolio that generates ~7% annual returns, so assuming that JNJ meets analyst expectations and the market gravitates towards my fair value estimate, JNJ will help me get there ahead of schedule.

Source: F.A.S.T. Graph

And just for kicks and giggles, let’s just say that the 15.3x average multiple that JNJ has traded with since 2008 (remember, this period of time includes the 08/09 years where the company’s P/E multiple fell to as low as 11x which hurts the decade long average). Assuming that JNJ hits analyst estimates for ~11% growth in 2018 and then ~6% growth through 2020, we’d be looking at a share price of ~$137.50 in December of 2020. When you factor in the dividends received between now and then, that represents an annual ROR of 7.78%, meaning that even including a generational low type bear market scenario, JNJ still has a good chance at meeting the low end of my investment expectation from these valuation levels.

Source: F.A.S.T. Graph

One of my favorite aspects of JNJ as an investment is the broad diversity that it offers investors. Owning JNJ is akin to owning a broader healthcare related ETF. This company operates three main segments: Consumer, Pharmaceutical, and Medical Devices. The company’s revenues are split fairly evenly between the U.S. and international markets. In JNJ’s most recent quarter, the company produced $9.95b of sales in the U.S. and $10.05b in foreign markets (led by Europe, which posted 24.3% growth). Unlike several other well known DGI big pharma/biotech names, JNJ doesn’t rely on just one or two blockbuster drugs for its sales. JNJ had 11 drugs produce at least $1b in sales in 2017 (and a handful of others in the $500m-$999m range).

In a biotech world where companies are constantly facing innovative competition and impending patent cliffs, it's comforting to see such a well diversified pharmaceutical portfolio. What’s more, JNJ’s pipeline appears to be very strong. In the 2017 annual report, management highlighted the fact that they have 8 compounds in development that they expect to file that could generate $1b+ sales by 2021. JNJ made big news in 2017 with its ~$30b acquisition of Actelion, further broadening its scale. At the end of 2017, JNJ had nearly $18b of cash left on the balance sheet, giving the company continued flexibility to grow via M&A should it choose to go that direction. And finally, when you add in the fact that JNJ’s sales are spread across different segments with Consumer Segment producing ~17% of sales and the Medical Devices segment producing ~35% of sales, it’s easy to overlook a lot of the stress that sometimes comes hand in hand when owning bio-techs.

So, at the end of the day, I feel pretty comfortable with JNJ making up a full weighting within my portfolio. Because of the sector that JNJ operates in, I don't view the name as a blind buy and hold, but I am happy to own the shares for the long-term assuming their valuation looks fine. As previously noted, JNJ has an annual dividend increase streak of nearly 60 years and I wholeheartedly expect this company to continue to reward shareholders with strong dividend growth for decades to come. There are certainly companies out there that offer better growth prospects, in terms of capital appreciation and dividend growth; however, there aren't many that offer the broad diversification and balance sheet strength of JNJ.

Disclosure: I am/we are long JNJ.

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.