I understand people who are looking to invest a significant sum of capital into a single stock, take a look at Johnson & Johnson sitting there at $109, and conclude that it would not be the best use of their opportunity cost to buy Johnson & Johnson stock right now. What I don’t understand as much is the chatter from investors that have seen Johnson & Johnson stock experience a bit of a pop in stock price and then respond by either turning off the spigot for a dollar-cost averaging program or selling the stock altogether because it gives off a vibe of being overvalued.
Perhaps my least favorite Wall Street axiom is the saying “You can never go broke taking a profit.” I find it detestable because it has a veneer of credibility–taken literally and technically, it is true. But I dislike the fact that it plays into the familiar psychological bias of ignoring errors of omission and treating them as if they do not exist simply because those types of mistakes don’t show up officially on the balance sheet.
If you sold $10,000 in Nike stock back in 1990 due to a feeling that quick run-ups made it overvalued, there is no one to knock on your day and tell you about the stock being worth $19,300 in 1995; $45,000 in 2000; $89,600 in 2005; $171,000 in 2010; and $501,000 in 2015. If you did sell Nike in the distant past, you might even prefer avoiding any follow-up checks on the price of Nike stock because you don’t want to know how great your error of omission turned out to be over the decades. The comfort is dissonance can be alluring compared to the confrontation with reality that would result in the conclusion “I’d be a whole lot wealthier if I didn’t do X.”
With errors of commission, the mistake is right in your face. If you buy something for $10,000 that falls in value to $5,000 fifteen years later, you have the brokerage statement and position right before your eyes revealing the adverse consequences of your decision-making. It is there. But the subsequent capital appreciation of stocks after you sold them never sits before you to confront.
Why should you brutally confront your errors of omission? Because reality exists whether or not you choose to think about it, verbalize it, learn from it. If you opt for the comfort of pretending that a bad decision never happened, then you have to face the full consequences of bad thing X even if you don’t actively acknowledge it. But, if you choose to confront your bad decision, and modify your future behavior so that you don’t repeat the same errors of omission over and over again, then you will have successfully mitigated bad thing X so that the harm is only 0.5x or 0.75x instead of the full X it would be if you choose to approach life by willfully ignoring your errors of omission.
When Warren Buffett negotiated an incentive contract for Chuck Huggins at See’s Candies, he said to Huggins: “I hope I spend the rest of my life writing you larger and larger checks.” That attitude of letting a good thing roll on, and compound over and over again without penny-wise-yet-pound-foolish intervention, helps to explain why Warren Buffett has been able to extract more than two billion dollars in free cash flow to invest elsewhere from an initial $25 million investment in 1972.
I have a notebook filled with my favorite investing quotes, and one of them from Munger is this: “See’s Candy. It was acquired at a premium over book value and it worked. Hochschild, Kohn, the department store chain, was bought at a discount from book and liquidating value. It didn’t work. Those two things together helped shift our thinking to the idea of paying higher prices for better businesses.”
This extended prelude is my way of saying I don’t understand why someone would willingly sell one of the top five businesses in the world simply because it is at the high end of fair value. And you could even argue that it is trading right in the middle of fair value given the unprecedented strength of its balance sheet. Usually, Johnson & Johnson keeps a few billion in cash on hand and then a total debt level that is a little more than a year’s annual profit.
That aspect of the debt burden remains the same–Johnson & Johnson is carrying $20 billion in debt compared to $16 billion in net profits, but the cash position has absolutely ballooned coming out of the Great Recession. It went from $10 billion to $20 billion, and has since climbed from $29 billion to $37 billion.
It would not surprise me to see Johnson & Johnson make an acquisition in the $5 billion to $15 billion range as soon as the opportunity arises, with the only limitation being that the profits are somewhat locked-up offshores and Johnson & Johnson may not want to engage in any legal but clever accounting maneuvers after seeing the U.S. Treasury Department issue new tax inversion rules while the Allergan-Pfizer deal was nearing completion.
In 2000, Johnson & Johnson made $1.70 in profits and paid out $0.62 in dividends. This year, it is going to make $5.85 per share in profits and will pay out at least $3 in dividends (the Board will probably announce a dividend hike sometime in the next two weeks). That is 8.03% annual earnings per share growth, and 10.36% annual dividend per share growth. There was only one year during this sixteen-year period when Johnson & Johnson didn’t report a year over year earnings increase, and there was a dividend hike during each of these sixteen years (and dividend hikes going back every year to 1963).
This is not an asset that should be discarded. We recently discussed with Kellogg the value of owning something that reliably churns out cash in all business environments, but the advantage of Johnson & Johnson is that it has a superior growth rate attached to it as well. You get earnings per share growth around 8%, plus a dividend.
I started writing about stocks in 2011, and Johnson & Johnson was one of the first corporations that I highlighted favorably. During this time, shareholders collected $2.25 in 2011 dividends, $2.40 in 2012 dividends, $2.59 in 2013 dividends, $2.76 in 2014 dividends, and $2.95 in 2015 dividends. Plus the $0.75 first quarter dividend payment in 2016. That’s $13.70 per share that got collected in a little over five years. The stock’s average trading price in 2011 was a little over $63. Without any dividend reinvestment, you got to collect 21% of your cash back from investing in a corporation that would make anyone’s Top Ten list of best corporations in the world.
And if you reinvested, you actually got to raise your ownership position by 0.28. That is, each Johnson & Johnson share became 1.28 shares of Johnson & Johnson for those that reinvested. A 100 share position grew to 128 shares. With the share price now at $109, the combination of dividend reinvestment mixed with the subsequent capital gains from that dividend reinvestment is an economic value of $30.52. The dramatic difference is because the share price climbed from the $60s to $109, effectively doubling the value of the early dividend reinvestment, and also the rising share count that turbo-charged the amounts of the later dividend payouts.
The point being, a lot of money can be paid by owning something that pays out 3%, grows around 8%, and experiences dutiful reinvestment of the dividends. Despite the pop in price, the earnings quality and earnings growth at Johnson & Johnson is so exemplary that there is no need to worry about overvaluation–it’s still a fine time to keep adding incrementally to your ownership position in the corporation. It is almost axiomatic that great corporations that reliably grow earnings will experience a near perpetual rise in share price to reflect the growing value of the economic engine, but sometimes people act like a nice short-term profit should be an occasion to do something. With some companies, yes. But not with the best in the world. When you own something like Johnson & Johnson, the rising share price is a reflection of your correct thesis statement that the business is excellent and growing earnings.
Originally posted 2016-04-10 19:00:13.