As I wrote earlier this year, I’m long-term bullish on this market, but stretched valuations in certain parts of the market, like cloud stocks and social media stocks, are at major risk of blowing up. With many momentum stocks appearing to peter out, investors could do a lot worse than investing in a blue chip stock like Johnson & Johnson (JNJ: ~$98/share) when it’s valued at such a cheap price.
Diversification Leads to Consistent Profits
JNJ sells a massive variety of products from Band-Aids and Tylenol to joint reconstruction products. This diversification gives JNJ’s profits a greater consistency than other companies. When one product struggles, it has others to make up the difference. This consistency explains why JNJ has grown after-tax profit (NOPAT) by 10% compounded annually for the past 15 years. Its NOPAT has not declined in any year over that timeframe.
The diversification of JNJ’s revenue streams is truly impressive. JNJ operates in three segments, Consumer, Pharmaceutical, and Medical Devices. Medical Devices is the largest segment with $28.5 billion in sales (40% of revenues). The largest product within Medical Devices, Orthopaedics, makes up only $9.5 billion, or 13% of total revenues. It also happens to be one of JNJ’s fastest growing product groups, with 22% revenue growth in 2013.
JNJ’s diversified product portfolio gives it a leg up on its competitors, which we can see through its superior return on invested capital (ROIC). JNJ’s ROIC of 15% is higher than competitors like Bristol-Myers Squibb (BMY) at 10%, Pfizer (PFE) at 5%, or Medtronic (MDT) at 13%.
Reported Earnings Understate Profits
People who read my research regularly know that reported earnings are not a good indicator of the core operating profitability of a business. GAAP rules were designed for debt investors, not equity investors, and often include unusual or non-operating items that obscure the true profitability of a company. We’ve made over 57,000 adjustments to reported income statements and balance sheet based on annual reports filed in the last two months. These adjustments are necessary to analyze a company’s true economic earnings.
Figure 1 shows how, in the past two years, JNJ’s reported income has understated its NOPAT, whereas for the rest of its history NOPAT and GAAP net income have been nearly identical. For most companies, NOPAT is regularly higher than net income since it excludes interest expense, but since JNJ has such a large cash pile compared to its debt, interest income and interest expense nearly cancel out. In a regular year, JNJ’s income and NOPAT would be similar, but unusual expenses have artificially depressed JNJ’s accounting earnings.
