Company of the Week – Johnson & Johnson (JNJ)

The company of the week this week is Johnson & Johnson (JNJ), a manufacturer of a range of products in the healthcare field.  As we did last week, we will be looking reviewing the company using Warren Buffett’s approach for the Business & Management Review.  We will also use Benjamin Graham’s overall philosophies to guide our Financial & Value Review.

Business & Management Review

1.  Is the business simple and understandable?

     Though over the years the products and research methods of the company have become more sophisticated as technology has improved, the overall business plan has stayed the same.  The company is in the business of providing products that help improve the quality of life from a health and personal care standpoint.  The company is well diversified across the healthcare industry, but has remained focused on segments related to its overall business plan.

2.  Does the business have a consistent operating history?

     Johnson & Johnson was founded in 1886 and has been a driving force in developing state of the art healthcare solutions ever since.  Dividends have been paid to shareholders every year since 1944, and have increased each year for 44 straight years.  Sales have increased each year for 73 years, and the company has experienced double-digit earnings increases for 21 consecutive years. 

3.  Does the business have favorable long-term prospects?

     The company’s customers will always have a need for healthcare products.  This persistent need is evident in the company’s low beta of about 0.21.  The real question is whether or not the company can continue to grow consistently into the long-term future.  We believe it can.  In the developed world, the average lifespan is increasing as well as the number of elderly overall.  In the developing world, the need for healthcare products will increase as cultures become more open to using the products and economic situations improve for consumers to afford the products.  These two factors combined lead to favorable long-term prospects for Johnson & Johnson and the rest of the pharmaceuticals and healthcare industry.

4.  Is management rational?

     In the latest annual report, management addresses the fact that they had informed shareholders in the previous annual report of their intent to purchase Guidant Corporation.  However, over the year events changed leading to the acquisition price of Guidant to increase significantly.  After the increase, management was remained rational and focused on the needs of shareholders and determined that a purchase was no longer in the interests of their shareholders.  This is very rational behavior among management that is all too often missed in many managers today.  Frequently, managers will become determined that a particular action is best for shareholders, and refuse to reexamine the action as time goes by and the situation changes.  Johnson & Johnson’s management clearly was rational in this situation and can be expected to remain rational in the future.

5.  Is management candid with its shareholders?

     Johnson & Johnson has an extensive investor relations page on their website, which can be found at:  http://www.investor.jnj.com/  We feel that William Weldon, Chairman and CEO, also provides a rather in depth and candid letter to shareholders in the company’s annual reports that is worth mentioning.

6.  Does management resist the institutional imperative?

    The company has a history of being a leader in their industry, and often is the first to develop a new product or approach to healthcare for their customers.  It seems that instead of following the institutional imperative and replicating the performance and processes of other managers, the management at Johnson & Johnson has historically been extremely innovative.
 

Financial and Value Review

Upon our review, we find Johnson & Johnson to be suitable for the enterprising investor following Benjamin Graham’s value investing strategy, but not suitable for the defensive investor.  The company is currently trading at a PE ratio of 23.09 and price to book ratio of 6.29 – other than these two factors, all aspects of the company’s financial situation and our valuation look good.

We believe the company has potential to reach $81/share in the next few years. 

Neither of us held a position in Johnson & Johnson at the time of publication.  Also, please read our disclaimer and Our Methods.

Please discuss this article in our forums.  Your comments help us mold our future articles.

 

Know What you are Paying For

When we buy an item we are not paying for just the item itself. We are paying the people who make the item, the people who transport it, the people who sell it, and countless other things from the space the store takes up to their phone bill. If we were only paying for the value of the item itself, items would be much cheaper. Therefore, it is important to know what else goes into the price. While you may not be able to get the store to tell you how much the crystal chandelier cost or how much they pay the piano player, you can make educated guesses on which stores spend more on things that ultimately the consumer is paying for. Stores that don’t spend as much on overhead can often offer their items for cheaper. For example, I found the same pair of shoes at both Bloomingdales and Carson Pirie Scott. At Bloomingdales they cost $78 dollars; at Carson’s they were $75. While the $3 may not indicate a huge difference in prices, if I had bought six items at Bloomingdales and each were $3 cheaper at Carson’s then I would have spent eighteen more dollars than I needed to. Of course, Carson’s doesn’t sell everything that Bloomingdales does and not everything that they sell the same is cheaper. However, it does bring up an important point, that you aren’t paying for the just the item. The actual value of the shoes is most likely less than half of their cost.

            While some department stores can be more expensive than others, it is also important to realize that some “discount” stores may be more expensive. Last week I wrote about how some generic brands may actually be more expensive because they count on people assuming they are cheaper and buying them without actually checking the price. The same goes for some discount stores. If you walk into one and assume that everything they have must be cheaper than at any store in a mall you will ultimately pay more than you have to. Instead you should know your prices. This doesn’t mean that you should drive all over the place and compare, but rather always keep your eyes open. If you are running a quick errand at one store because you know they have the type of popcorn that you like, you may want to see how much they charge for other food items that you buy regularly such as bread or milk. You don’t have to look for every item but pick one or two and compare their price to what you are paying elsewhere. This will allow you to see prices at other stores without having to actually drive all over the place to do so.

            Last, the most important thing to break down the cost of is any service you might be paying for. This can be anything from having a lawn service to paying for a catered meal. When I asked for a breakdown of the per person cost for my wedding to Ben Clark next summer I was surprised to learn that $24 per person was being charged for alcohol. In total $2880 of our wedding would be used to pay for alcohol. After doing a mental run through of all of the people who don’t drink I found that this would be incredible wasteful. Therefore, we were able to reallocate the money and instead have a much nicer entrée. Having the price broken down for you can be extremely useful in other situations as well. With a lawn service you might find that you are paying for them to use a leaf blower to scatter grass clippings. However, if you live in a windy neighborhood this may not be something that you need. Since most services are package deals we often pay for things that we actually may not need. By breaking the prices down we not only learn exactly what we are paying for but also what we don’t need.

Value Investing Weekly – Issue 3

We speak so favorably of value investing, fundamental analysis and Benajamin Graham it should be noted what in contrast are we speaking of. Our style of investing is the opposite of such types of investing as: technical analysis/trading, momentum trading, or scalping. This issue will go into depth to create an understanding of these forms of investing and why we feel they are inferior to value investing/fundamental research.

First lets look at technical analysis and trading. Technical traders are obsessed with charts and graphs looking at past performance trying to find trends that dictate future results. More specifically, they are looking for signals that will tell them whether to buy or sell the security by analyzing charts These investors will look at peaks and valleys of the chart trying to find signs of resistance and support. For instance if a stock is trading near its support level, a technical investor may perceive this to mean it’s a keen buying opportunity as its near its figurative low. Another tool used is moving averages where averages are calculated to create a smooth line that runs (usually) upwards or downwards of the actual stocks daily closes. This, according to technical investors, speaks of when buying and selling opportunities exist.

We are not discrediting the potential benefits for looking at a stocks past performance via charts and graphs. It creates an interesting picture of the past for the company, but where we respectfully disagree is by allowing past performance to dictate future. Trends are purely that, trends, and cannot guarantee future performance. In addition, by looking purely at technical charts you are neglecting to actually analyze the company, you are only looking at the stock. Remember from our previous issues the distinction between stock and company ownership.

Let us move to momentum trading. With this style of trading, you look for high volume stocks and literally ride the wave and exit before the ride is over. Its pure timing that drives this form of trading and you are literally looking at a chart and volume, sometimes not even paying attention to what company you are investing. This is easy for us to pick apart for the reasons stated prior and the fact that you are essentially picking the good-looking horse to win the race.

Finally, let us speak of scalping and the issues that are raised with this form. This is making hundreds of trades per day by exploiting the bid-ask spread. This is the difference in price between the buyers and the sellers, or the neutral ground between the two. Each trade might only reap a small profit, but multiplied by hundreds a day can potentially generate substantial profits. Again, for the same reasons stated prior we feel this a substandard form of investing.

Concluding, we feel that fundamental/value investing is the best form available, and with the proper research and time spent one can choose stocks accurately and eventually profitably. The greatest investor alive, Warren Buffett, is not a technical investor he follows the teaching of Ben Graham and we have 100% faith in their proven track record and will continue to devote our time to their teachings.   

Credit is due to Investopedia.com for helping in some terms of technical investing

Review of Jon’s Portfolio

This week I added only one stock selection to my portfolio, while keeping cash on the side continuing to look for opportunities that meet my investing criteria. I bought into Radio Shack (RSH), purchasing 335 shares at the closing price on Tuesday (22nd) of $17.87/share. My rationale behind the purchase included the same reasoning as most of all my purchases, a high ROIC, low P/B ratio, and a somewhat healthy dividend yield. The company has a product line mainly pertaining towards electronic equipment and accessories. The main competitors are companies such as Best Buy and Circuit City. Where I feel Radio Shack has the leg up on both of the prior companies is customer ease of purchase and availability of low priced, but high margin items.

The performances of my selections from last week were lackluster, under performing the market as a whole for the week. I still believe in the selection of both, however, and still see growth on the horizon.  

I see no reason to rush into the market prematurely, until I find investments that I find attractive. I cannot remember the quote word for word, but Warren Buffett said something along the lines “if an investor is looking to do something foolish, I will be there to help them along the way”.

Performance:

Ticker
Total Cost
Current Value
%Gain/Loss
AIG
$6,626.05
$6,626.55
0.01%
CHKE
$4,495.47
$4,515.72
0.45%
RSH
$5,996.45
$5,986.45
-0.17%
 
 
 
 
CASH
$82,882.03
 
TOTAL
$17,117.97
$100,010.75
0.10%
 
 
Performance
Weeks Change
Overall
S&P 500
1.07%
1.07%
DJIA
1.01%
1.01%
Portfolio
 
0.10%
0.10%

 


Value Investing Weekly – Issue 2

ValueInvesting Weekly
Issue 2
August 17, 2006

We discussed last week about general ideas in value investing, Ben Graham, Warren Buffett, and the psychology of investing. This week we are going to discuss an example of personal experience regarding speculating and the downfalls of doing so.

My personal experience included a wonderful, well-known stock named Sirius Satellite Radio (SIRI). Allow me to explain how I became involved in this security and the reasons for doing so. In the winter of 2004, I began trading SIRI on a “tip” from a relative, and throughout the course of a few months, I netted a healthy return on purely trading on volume. I felt that it was easy enough to buy the stock in the morning watch it throughout the day, and maybe hold it overnight before getting out for a profit. I became confident of this strategy and before I had ever taken a course was convinced of technical analysis.

Following the signing of big profile broadcasters, most notably Howard Stern, I felt that Sirius was ripe to explode purely because of Stern’s listening base and the potential increase of subscribers. Further, I thought of satellite radio as this generation’s cable television. I personally subscribe to Sirius, and actually really enjoy the programming.  I purchased shares in the fall of 2005 before Stern’s debut in January on Sirius. Instead of following my previous strategy, I decided to go long on Sirius because of my interpretation of expected growth. Grant you at the time, and currently, Sirius was loosing millions of dollars each quarter in trying to acquire subscribers and spur growth of the company. They hired a top notch CEO from Viacom, Mel Karmazin, who had a proven record of accomplishment in terrestrial radio over the years. Everything in my eyes looked great and I was merely waiting for the profits to come rolling in.

Well they did not; I purchased Sirius for a price of $7.12/share, with the closing price of Wednesday (8-16-06) at $3.65/share. I have incurred a net loss of 48.95% over the course of roughly a year and a half. So the questions are “Jon why did you ever buy this stock in the first place, you should have just looked at the financial statements and seen what was going on?”, and “Why did you stay in the position for so long?”

To answer the first question, I fell under the spell of what I call the “speculation potion” by that I mean you place rose colored glasses on and view the potential of a company not seeing the disaster in the waiting. I was convinced that if I didn’t get in on this stock, I would regret it just as I did Chicago Mercantile Exchange (CME), Google (GOOG), and countless others. What I realize now that I didn’t then is that in investing you must develop a strategy and stay the course. Further, as we spoke in last week’s issue, you become an owner of the company, not an owner of the stock. In my mind at the time ownership ended on the screen of my Ameritrade account.

The second question regarded why I didn’t and still haven’t exited my position. This issue is purely psychological as I was adamantly against having a loss and decided to hold the stock until it recovered the losses. I am coming to terms with my poor investment decision and am ready to exit my position. It is similar to Alcoholic’s Anonymous where everyone stands and states “Hi I am_____ and I’m an alcoholic”, well I am standing up and stating that I am a former speculator and am seeking treatment. Just for the record, I by no means am comparing the two; I am merely using this example for comic relief.

Where Sirius will go in the future is beyond me or anyone else, currently their financial position is worse then ever. The ROE for fiscal year 2005 was (265)mil, and its Q2Y2006 EPS where (.87) down from (.83) the quarter prior. Every aspect of Graham’s investing strategies screams to stay away from this stock. Although sales are increasing extraordinary, because of subscriber growth (see article below), expenses rise linearly as well.

Ending, I hope that you all learn something from my painful lesson, do research, think logically, don’t expect to become rich overnight, and never trust other’s judgment and research.

-Jon

ModernGraham.com

WSJ article on Sirius 
Reuters article on Sirius
Discuss this article in our forums. 

Value Investing Weekly – Issue 1

How relevant is value investing in today’s markets? Is there still legitimacy in the theories and practice of such investing? Welcome to the inaugural issue of ValueInvesting Weekly, where we will explore all of these questions, and generate useful ideas that will be beneficial to the investor in the 21st century. These weekly letters will be constructed on the foundation of Benjamin Graham and his legacy of value investing. We look forward to opening an informed and educational dialogue that will benefit all. We encourage you to participate and ask any questions that might arise, or offer any corrections that we overlooked.

ValueInvesting Weekly
Volume 1

As you flip through the channels on cable television, or read the financial pages of newspapers, it is easy to get caught up in the hype that is investing. “Stock ‘A’ surged from 8 to 13 today”, only to be followed by, “Bear markets are going to bring Wall Street to its knees!”. Where does one find the calm within the storm? This is where the concept of value investing creates stability in the investors mind and allows them to think clearly and accurately. Taking a step back first though, allow us to explain and define value investing in simple terms.

Value investing is simply looking for securities that are undervalued for whatever reason, and are currently being traded at a discount in comparison to its true book value. By book value we mean the value of the company as a whole: buildings, inventories, accounts receivable, etc. Finding these securities is not something that is as easy as turning on Cramer on CNBC and having him inform you of what stocks are selling at a discount. Rather, it requires analysis to determine such intrinsic value. Now there are simple ways to get ideas of which stocks might fit into these criteria, such as looking at a company’s working capital. Working capital is the liquid assets of a company, which can be drawn upon by going to the SEC’s webpage (EDGAR) and downloading filings of financial reports and looking for liquid assets. This essentially describes the analytical side of value investing briefly and without digging deep into the theories, but we will address these techniques in later volumes.

Taking value investing into a more psychological setting, let’s consider the greatest investor, Warren Buffett. Warren Buffett was taught by Ben Graham and learned everything he knows of investing from Graham. Buffett learned that investing is not speculating in a company, but becoming an owner with a vested interest. Speculation is looking at a company and off of a hot tip putting hard earned money into a stock – key word here is stock. Investing is intelligently placing your money into a company that you have done research on and are interested in becoming an owner - key word owner. Do you see the difference between the two? Investing is ownership of a company, and speculation is ownership of stock. Again, we are speaking psychologically here, as the two are the same in the fact that you purchase securities whether you are speculating or investing. Buffett never thought of himself as a speculator, but invested in companies that made sense to him because he now owned a piece of that company. Consider the following example: would you want to buy a laundry business that had four competitors on the same street within one mile just because the current owner assures you his business is through the roof? Of course not, but would you want to buy one that is located in the heart of a major metropolitan neighborhood with no other Laundromats in sight? The same thought process can be implemented into investing. Buying a stock that is hyped up without doing any research is as foolish as buying a Laundromat on the current owner’s assurance that it’s a good business. This is why Warren Buffett never did two things: he never bought a stock without researching it, and never bought a stock that he could not understand the business model of the underlying company.

Next week’s issue will begin to look into the theories of value investing deeper, and produce useful ideas of how to implement these into your personal investing.  

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