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The case for J&J

|Includes: Johnson & Johnson (JNJ)

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.com speculators of the ’90s or real estate investors of the last decade.

In my opinion, the best way to consistently outperform the market and make a nice profit is to overcome the herding instinct; and one way is to look in places everybody is running away from. Most often, you will find only junk there. But, every now and then, you will come across some hidden gems. I believe that Johnson & Johnson (J&J) today is 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
Lately, however, its reputation has been tested repeatedly from several large-sized 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 even attracted the attention of the FDA who has apparently mandated tight inspections and monitoring at the facilities.

Needless to say, these issues have contributed to a disappointing stock price performance that is now several years old.

Now, 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 it happened to Kodak upon the advent of digital photography or a 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 also 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, and on the contrary has the advantage of strong pipelines of new drugs hitting the market very soon, several of these have blockbuster potential. Clearly, patent protection is one of the strongest possible competitive advantages as they 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 or over-the-counter medications, is benefiting 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 is suffering from product recalls and diminished consumer spending, I believe these issues are bound to reverse in due time.

The medical devices division too, with all of its present woes, is benefiting from an aging population and a larger client base thanks to emerging markets. Increased competition should be kept at bay since there is a significant degree of customer captivity: just ask a surgeon how time and effort consuming it can be to shift from one artificial hip product to another (it involves long retraining and changing of toolsets).

Another huge plus for J&J is its pristine finances. The company is one of the few in the world to boast a triple-A 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 of J&J frequently being 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. The Earnings Power Value of the company, assuming no growth whatsoever, is somewhere between $55 and $62 per share. This value is calculated by taking 2010 earnings, capitalizing them with a certain discount rate, and adding back cash net of debt. At a present price of $60, factoring in a modest level of organic growth of 3 percent per year, an 18 percent return on invested capital (NASDAQ:ROIC), a 50 percent reinvestment rate, and a 16 exit PE, you get an expected long-term return of approximately 17.5 percent.

I believe it is rare to get the chance of investing in an AAA-rated company with this kind of expected return.

DISCLOSURE: The author is long Johnson & Johnson.