AMM Dividend Letter Issue 23: When Too Much Exposure is Bad for Your Portfolio and Johnson & Johnson (JNJ)
This is from the AMM Dividend Letter released October 8, 2015. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.
Barbara Streisand is a talented artist and is one of only a few people that has an EGOT; she has won an Emmy, a Grammy, an Oscar, and a Tony (honorary award). But did you know that Babs was once Hollywood’s stock trading guru? Even trading money for friends like Donna Karan.
Never mind gold records. Who cares about Academy Awards? Investing–especially in volatile tech stocks–has recently become a consuming hobby for the star of Yentl, Funny Girl, and The Way We Were. She studies business publications like Barron’s and watches CNBC religiously. She has installed a real-time stock-quote service at home. And she wakes up at 6:30 every morning to catch the opening of the East Coast stock markets. (“It’s terrible! I have a natural-born alarm clock that goes off every morning at, like, 6:30. I want to sleep, but I just wake up.”)
Where does the singer-actress-director get her financial ideas? The same places as any investor–from friends, relatives, and daily life. “We go to Starbucks every day, so I buy Starbucks stock,” she explains. (Streisand also gave some Starbucks shares to her longtime housekeeper recently as a birthday gift.) Another pick is Time Warner (the parent company of this magazine), which Streisand has held since 1992. [emphasis added]
One day last summer she and her new husband, actor James Brolin, were cruising off the coast of Greece when Brolin started talking about America Online. Streisand got so excited about the stock that she immediately phoned her broker—from the boat—with a “buy” order. The stock was then $31. Since that call it has quadrupled.
You can guess from the stocks mentioned that all this occurred during the Tech Bubble of the late 1990s. Back then it was easy to look like a stock market genius and becoming a Day Trader was an acceptable career path. Back then stocks only went up, that is until they stopped in 2000. While we aren’t in the go-go era of the late 90s we are all still susceptible to the bias highlighted in the excerpt above.
The mere-exposure effect was discovered by the Psychologist Robert Zajonic. In Jason Zweig’s Your Money & Your Brain, he described this effect as “being in the presence of familiar things (even when we are unaware of them) simply makes us feel better”. What we experience most often, we end up liking the most.
It is why companies spend large amounts on brand awareness advertising. The more you hear and see a brand the more likely you will have good feelings about it and the more likely you will buy their goods.
It also spills over into investing. Peter Lynch famously said “buy what you know” and that is what Barbara Streisand was doing. She drinks Starbucks and uses the internet, therefore the stocks of these two companies are worthwhile investments. However, if you are familiar with a company and its increasingly popular products then a lot of other people are too. The stock becomes a “celebrity stock”. The more exposure investors have to the stock the “safer” it feels and the more willing they are to put increasing amounts of money into the stock.
The price of the stock is bid up so high that the underlying company’s growth can’t match investors’ expectations. The most popular and active stocks on average may have higher returns over a few months as investors feel better and better about the stock. However, over a few years, the most popular stocks tend to underperform the broad market by 2-5 percentage points per year.
The mere-exposure effect prevents people from doing the necessary work of valuing the company and rationally assessing its competitive advantage, market potential, cyclicality, returns on capital, etc.
Mere-Exposure Effect and Employer’s Stock
The other way the mere-exposure effects harms investors is with their employer’s stock. A large portion of U.S. investors has more than 60% of their retirement funds in their employer’s stock. Almost 10% of 401(K) investors have all of their retirement savings in their employer’s stock.
Every day employees are saturated, consciously and sub-consciously, with exposure to their company. All the exposure leads employees to underestimate the risk and overestimate the potential of their employer’s stock. Your company’s stock becomes a “feel good” investment. Like the celebrity stocks mentioned above, people fail to do the necessary work to determine what the underlying value and real potential is for their employer’s stock.
Not every company is an Enron, Worldcom, or Tyco that wiped out the retirement savings of its fully invested employees. But if you’re not doing the necessary financial due diligence then these companies serve as an example to not own too much of your employer’s stock. Usually around 10% is enough. Your current salary and benefits already rely 100% on your current employer. Should 100% of your retirement funds rely on it too?
We can’t completely remove our biases but knowing about them and questioning them helps us make better, more informed, and more rational decisions. Rather than relying on our gut feeling about how “good” a company feels to us.
Dividend Stock in Focus
Johnson & Johnson (JNJ): $*95.08
*price as of the close October 8, 2015
The story of Johnson & Johnson wouldn’t be complete without first acknowledging Sir Joseph Lister. Before he was knighted, Joseph Lister was an English Surgeon. Surgery during this time, the late 1800s, was a dangerous affair with 50% of surgery patients dying and 80% of these deaths attributable to post-surgery infections. Surgery was always the last option in medical care.
The majority of Doctors believed infections were caused by bad air, “Miasma”. Because of this thinking, surgeons didn’t wash their hands. But Joseph Lister read Louis Pasteur’s writings on microorganisms and fermentation and thought they too might play a role in infection. Joseph Lister was further convinced when he noticed that people with simple fractures (bone does not break the skin) usually lived while those with compound fractures (bone breaks the skin) usually died.
Lister started sterilizing his dressings, instruments, hands and the rest of the surgery room using carbolic acid. The infection rate of Joseph Lister’s surgery ward dropped to essentially zero.
Lister then went everywhere he could to extol the benefits of sterile surgery to an extremely skeptical medical establishment. In 1876, at a Joseph Lister speaking engagement in Philadelphia sat Robert Wood Johnson. So inspired by Lister’s speech and discovery, Robert Wood Johnson and his two brothers started Johnson & Johnson to mass produce sterile dressings and sutures.
Business was tough at first, but the potential was there. It was difficult for a Doctor to try sterile surgery techniques as they had to sterilize everything themselves. Pre-made sterile dressings and sutures made it much easier. The biggest hurdle was getting Doctors to understand the benefits of sterile surgery. It took 12 years for sterile surgery to gain major support in the medical community and the main catalyst was Joseph Lister performing live surgeries with none of his patients developing post-surgery infections.
As sterile surgery took off, Johnson & Johnson had positioned themselves to grow with the demand for sterile surgery dressings and supplies. Today J&J is one of the largest and most respected healthcare companies in the world.
Over the last 9 years, Johnson & Johnson has grown their dividend at a compound annual rate of 7.33%.
From S&P Capital IQ. Click image to enlarge.
JNJ’s payout ratio to earnings is 50% and dividends paid are 58% of free cash flow. Johnson & Johnson’s dividend is well covered by both earnings and free cash flow.
Catalysts for Dividend Growth and Price Appreciation:
Johnson & Johnson is seeking approval for 10 new drugs by 2019. Management is expecting each drug to reach at least $1 billion in annual sales. JNJ’s Janssen Pharmaceutical division is also expecting 40 additional uses for new and existing products.
Johnson & Johnson has also launched several new drugs that have already reached blockbuster status and still have room to grow and grab more market share.
Invokana is a once-daily drug for Type 2 diabetes. The drug controls blood sugar levels while reducing the side effects of weight gain and hypoglycemia. According to the latest statistics from the CDC, 11.3 percent of all Americans over the age of 20 have diabetes, and 35 percent of the population – more than one-third – has prediabetes. Express Scripts, a pharmacy benefits management company, expects low double-digit growth in diabetes spending over the next several years.
Xarelto is an anticoagulant and has already achieved blockbuster status with sales over $1.5 billion last year. With all those Xarelto lawsuits, it has taken a 15% share in the anticoagulant market by having more indications than any other drug in its category. Management is launching a new study to see if Xarelto helps embolic stroke victims prevent future strokes. Xarelto also recently earned a designation to prevent clots for people with Acute Coronary Syndrome. Xarelto’s main competition is Warfarin. So far Xarelto has penetrated 1/3rd of the Warfarin market and is aiming for the other 2/3rds.
In oncology, Johnson & Johnson has a 50% share in the blood cancer drug Imbruvica. AbbVie (ABBV) bought the other half when it bought Pharmacyclics. The drug treats chronic lymphocytic leukemia (CLL) and the drug is showing promise of moving up the treatment line to a front-line position where the market potential is even larger. Zytiga is Johnson & Johnson’s drug for prostate cancer. It currently has a 31% market share and the prostate cancer market is expected to grow in the low teens for the next several years.
Mergers & Acquisitions
Johnson & Johnson has $33.9 billion in cash. The company has a triple-A debt rating and a debt/equity ratio of 27%. Johnson & Johnson could expand its balance sheet through low-yielding debt and use its large cash reserve to buy several small pharmaceutical companies or a large one. This last year saw a lot of M&A deals in the biotech sector while Johnson & Johnson sat on the sidelines. Biotech stocks are correcting and Johnson & Johnson has an opportunity to do a purchase at much lower prices and a chance to bolster its drug pipeline even further.
If Johnson & Johnson does not end up buying another company it could use its balance sheet and free cash flow to aggressively buy back shares. JNJ’s ability to generate large amounts of free cash flow means it could easily take on more low-cost debt and drastically reduce its share count. Some estimates say JNJ could raise $50 billion in new debt. At today’s share price, this would reduce shares outstanding by 19%.
Johnson & Johnson could use a boost to its share repurchase plan. Over the last 9 years, JNJ has only reduced its share count by -5.8% an annualized rate of -0.67%. This also makes JNJ a target for activism. More on this below.
Johnson & Johnson is a very large company that operates in 3 segments: Pharmaceuticals, Medical Devices, and Consumer Products. The Pharmaceutical division generates 43.5% of JNJ’s revenues and 54% of before-tax profits. Medical devices produce 37% of revenues and before tax profits. Consumer Products generate 19.5% of JNJ’s revenues and 9% of before-tax profits.
Johnson & Johnson could easily undergo a corporate restructuring and spin-off one or more of its divisions even possibly becoming 3 separate companies. The corporate trend has been towards smaller more focused companies that can make specific strategic decisions and better capital allocation plans rather than being obscured by the overall mass of the parent company.
We give this a low probability of happening. Management seems content on keeping JNJ as is, but this doesn’t mean an activist won’t step in and agitate for change.
At one time, the sheer size of Johnson & Johnson would prevent an activist from successfully building up a large enough equity stake to agitate for change. Today the size of a company is no longer an impediment. Johnson & Johnson’s management has been dismissive to any analyst’s suggestion of a corporate restructuring or even a large share buyback when they should at least consider it for the benefit of its shareholders. Combine a dismissive entrenched management with industry leading, stable, high free cash flow producing businesses and you have a recipe for activism.
Pre-Mortem (Potential Risks to our Thesis):
Remicade is 20% of JNJ’s total pharmaceutical sales as of June 28, 2015. Remicade along with a few other JNJ drugs go off patent next year. The pharmaceutical division generates a large percentage of JNJ’s profits and Remicade is a big portion of that. Johnson & Johnson’s drug pipeline has a lot of promise to replace Remicade’s sales but if it can’t, Remicade will be a large loss.
Remicade is a biologic, a large molecule drug that is made through the use of microorganisms. The drug and the process to make the biologic is the whole product. The entrance of a biosimilar (essentially an off patent version of a biologic) does not take away a large chunk of sales, at least not right away, because efficacy and safety are still an issue with the biosimilar. Additionally, the cost to bring a biosimilar to market is almost the same as bringing a new drug which doesn’t allow for too much of a price reduction from the original biologic.
Poor Capital Allocation
Just because Johnson & Johnson has the capacity to expand its balance sheet to aggressively repurchase it shares doesn’t mean it has to. Even though cheap high-quality companies buying back their stock produces great returns for their shareholders, it doesn’t mean that Johnson & Johnson will choose to allocate capital in this manner. Sound capital allocation is a major part of a CEO’s job description but not all CEOs have the background or the skills to allocate capital soundly.
This is the age in which we live in now. A tweet by a Presidential candidate can send the price of stocks within a certain industry plummeting. The tweet below by Hillary Clinton followed up with her plan for pharmaceutical price controls helped send Biotech stocks lower.
Click image to enlarge.
Johnson & Johnson is a diversified healthcare company and its stock wasn’t affected as much as pure-play biotech companies. However, Johnson & Johnson’s main profit driver is its pharmaceutical business and increased or new government regulation is a potential detriment to future business.
Johnson & Johnson is what we consider a dividend stalwart. It has raised its dividend consistently for decades at a rate far above inflation. We expect JNJ to continue to do so for the foreseeable future. Johnson & Johnson has built and/or purchased a collection of industry-leading businesses that generate large amounts of free cash flow and will continue to do so. This increasing cash flow should provide Johnson & Johnson shareholders with more dividend increases. Even with current negative foreign currency exchange headwinds, we value Johnson & Johnson at $105 per share. Our estimate of intrinsic value would increase if management became more aggressive with its capital allocation plans.
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