“Morningstar Research: Economic Moat 07/19/2016
We believe Johnson & Johnson carries one of the widest moats in the healthcare sector, supported by intellectual property in the drug group, switching costs in the device segment, and strong brand power from the consumer group. The company’s diverse revenue base, strong pipeline, and robust cash flow generation create a very wide economic moat. An extensive salesforce makes J&J a powerful candidate for a smaller biotechnology company looking to partner on a new drug, which strengthens Johnson & Johnson’s ability to bring new products to market.
Johnson & Johnson’s diverse operations are a major pillar supporting the wide moat. The company holds a leadership role in a number of segments, including medical devices, OTC medicines, and several drug markets. Further, the company is not overly dependent on one particular operating segment; the pharmaceutical business, medical device group, and consumer products represent 40%, 40%, and 20% of total sales, respectively. Additionally, within each segment no one product dominates sales, as Pfizer’s Lipitor did. Despite carrying some lower-margin divisions, J&J maintains strong pricing power and has posted gross margins above 68% during the past five years, validating its strong competitive position.”
Finally, after checking numerous research sources, I like to conclude my due diligence by going to the company’s website to see what they have to say about their future. The following excerpts are from Johnson & Johnson 2nd Quarter 2016 Earnings Presentation (1):
One of the areas I am most interested in is the company’s earnings guidance. The following slides and the accompanying F.A.S.T. Graphs™ Forecasting Calculator illustrate that the company guidance and analysts’ estimates are aligned. The 2016 earnings forecast of $6.69 is in the middle of the guidance range provided by Johnson & Johnson.
Johnson & Johnson – Why I’m Not Selling
After running the above return calculations for Johnson & Johnson going forward utilizing various scenarios, I have concluded that I do not consider Johnson & Johnson a compelling investment at today’s valuation. However, I make a distinction between making a buy decision versus a sell decision.
The following historical graphs on Johnson & Johnson are marked with a green dot indicating the day that I bought this blue-chip. With the first graph, I have run a calculation of the rate of return I have achieved on my Johnson & Johnson investment thus far. As you can see, this has been a very profitable holding. Because I purchased the stock when it is undervalued, and considering that it is now moderately overvalued, my results have been better than what the company produced on an operating basis.
With such a nice profit on my investment, it would be very tempting to sell and harvest that return. However, one of my primary reasons for investing in the stock was the company’s impeccable history of increasing their dividend every year. Consequently, if I sold, I would be giving up that future dividend. But as previously suggested, I believe in investing with my eyes wide open.
Therefore, I have run a calculation to see what my rate of return would be if the company reverted to the mean by year-end 2017. Obviously, if that happened it would be lower. On the other hand, I would still be earning a double-digit return. And of course, there is the possibility that Johnson & Johnson’s stock price would maintain its current P/E ratio. Once I’ve established a solid position in a great business like Johnson & Johnson, I am very reluctant to sell unless valuations become extreme. I don’t consider Johnson & Johnson’s current valuation extreme; therefore, I plan on continuing to hold it for a long time.
The Bottom Line
I hope the reader recognizes that the primary message I’m attempting to deliver with the above exercise is to always invest with your eyes wide open. To me this means establishing a reasonable expectation of what the business behind the stock is capable of delivering, and then calculates a reasonable rate of return expectation on that basis. In other words, never invest on just a hope or a prayer.
