One of the Warren Buffett quotes that gets repeated time and time again is that it’s better to buy a wonderful company at a fair price than a fair company at a wonderful price. It’s a useful piece of wisdom, but often gets used by investors to justify whatever it is they want to buy at a moment (using the adage as mere lip service to valuation). Buying Hershey at $109, Brown-Forman at $90, Colgate-Palmolive at $69, or Realty Income at $52 is NOT an example of buying a wonderful company at a fair price. Those are examples of buying excellent companies at 15-25% premiums to what they are worth.
I’m not saying that is dumb behavior—rather, it’s just important to understand that your thesis with those stocks would be something like this: Hershey is an absolutely excellent company with almost no downside risk defined by a 0.1% chance of going bankrupt in our lifetimes and I think I will do well buying the stock here even if it means my total returns lag the earnings per share growth rate of the company over the next ten to fifteen years. In other words, an optimistic scenario would hold for 10% annual earnings per share growth + 2% dividend -2% P/E ratio compression to result in returns of around 10% for the long haul. If Hershey has a couple years growing 5-6%, I’m going to get around 5-6% annual returns when you include dividends. If that sounds attractive to you, fine. They key is to have the right understanding of the risks you are taking on and probably adjust your expectations.
The reason why Johnson & Johnson has caught my eye today is that the stock is down 4% today because of disappointing earnings performance from its consumer division—its baby care, wound care, and women’s care divisions reported sales declines between 6% and 11% each. I regard this news as noise for two reasons: For the third year since coming out of the Great Recession, Johnson & Johnson has been aggressively raising the prices of its consumer items. It’s not that unusual for consumer divisions to see an initial pushback from customers after raising prices—people pick the item up, see the price, put it back, and continue down the aisle. Eventually the newness of the price wears off, and people come around. Mini-boycotts, if you will, are part of the nature of price increases, and I’m not even sure it’s something to get mad about since it is so common to human nature.
And secondly, the whole point of owning Johnson & Johnson is that it is a diversified behemoth of not only consumer divisions, but medical and pharmaceutical as well. It is filled with components within the company that are doing well—Stelara, a small component of the pharmaceutical division, is growing at 30% annually. The immunology division, which is much larger than Stelara but also a division under the Pharmaceutical label, is growing at 7%. The medical division was more of a mixed bag—vision care down 10%, specialty surgery up 30%, and so on.
Also, the results are somewhat worse than they should appear because the Dollar is strong, and the Euro is weak. When you look at Johnson & Johnson’s breakdown by country, you will see that sales have grown by 7% in the United States and have declined by 8% in Europe. The problem is that sales are measured in dollars—European sales are only down 3-4% when you measure the actual products sold, but the effect becomes exaggerated when you translate the Euros back to United States dollars.
So big picture, where are we? Johnson & Johnson is more flush with cash than it has ever been before. Some of this is out of necessity—it chooses not to repatriate foreign profits because it would have to pay a 35% tax on the cash hoard, so it keeps the cash stashed overseas waiting for growth opportunities to arise when they will. The end result is that Johnson & Johnson’s fortress-like balance sheet continues to grow: it had $21 billion in cash on hand in 2012, $29 billion in 2013, and has now crossed the $33 billion mark. For a $281 billion company, it has 11.74% of its market capitalization in cash alone. This untapped power doesn’t seem to get a lot of coverage from the press, likely because the cash is hard to trace because who has the time to study Johnson & Johnson’s Irish subsidiaries which are stashed with a sizable minority of the short-term bond investments? You gotta love our tax code: Only can America create an incentive scheme that leads executives to hold cash in Ireland and then invest it in U.S. Treasury bonds while waiting for the moment to invest that cash in Europe so as to avoid a 35% tax that would result from bringing that money home and giving the shareholders a massive one-time dividend or something.
The other big picture is that Johnson & Johnson continues to grow, as always. I don’t use that term non-chalantly: Johnson & Johnson has grown its profits during every year for the past 25 years. I don’t know what it’s like to be alive in a year in which Johnson & Johnson hasn’t grown its profits. Johnson & Johnson should make around $6.35 this year compared to $6 in 2014; basically, 5.8% growth. Combine that with a 2.8% dividend, and you’re set for a 8.6% return this year. Not bad for a “down” year. Note, I have no idea if Johnson & Johnson will actually return 8.6% because the P/E valuation of the stock changes every day—what I am instead measuring is the business performance growth plus the cash returned to owners in the form of a dividend that has increased every year since 1963.
These are interesting investing times for me—my favorite four companies in the world that I believe are truly built for the long haul are Exxon, Coca-Cola, Nestle, and Johnson & Johnson. A few others, like Colgate-Palmolive, Hershey, PepsiCo, Procter & Gamble, and Chevron, are so close as to be almost indistinguishable. And yet, despite these amazing economics, each of these four companies currently offer a fair deal or better for people interested in making a long-term investment. Exxon is the best deal, although who knows how much the profits and stock will fluctuate in the near term. Nestle, Coca-Cola, and Johnson & Johnson are sitting there at fair value, while all sorts of junk are trading at modest premiums. Despite six years of stock market advances, there are still places where you can get fair (even good) deals although this analysis says nothing about whether those fairly valued excellent stocks can get even cheaper. I leave that part of the analysis to you.
Originally posted 2015-01-20 13:17:26.
