“Extreme Value” World Dominating Business for October

By Travis Johnson, Stock Gumshoe, October 7, 2010

Today’s tease didn’t come to me directly and I haven’t seen the original ad or letter where it appeared, but this excerpt was forwarded by a large number of folks who appear to have some interest in a good ‘ol blue chip-type investment.

The tease must have been in some kind of subscribers-only letter for the Stansberry folks or one of their affiliates, since it’s for the Extreme Value newsletter that’s edited by Dan Ferris. I have invested in a few teased Ferris ideas in the past, and I generally have a “value” bent when I’m looking at a company for my personal portfolio, so I’m always interested to see what he’s recommending. This appears to be a new pick of his, so let’s dig in:

“In the October issue of Extreme Value, due out today, I’m recommending a World Dominating business that’s selling at a free-cash-flow yield over enterprise value of just a hair less than 10%. It gets 70% of its revenues from products that are either No. 1 or 2 in their markets. It has the No. 1 product in 21 distinct global product categories. It gushes free cash flow, almost $16 billion of it last year. It can borrow money at 2.95% because it’s one of a handful of triple-A rated companies left. It’s got $18 billion in cash and $13 billion in debt, a rock solid financial condition.”

So … perhaps not that tough a stock to suss out, eh? He’s right about there being only a handful of AAA companies left, and, depending on which ratings agency you’re talking about, that also assumes you’ve had at least a mild chainsaw accident and are down to four fingers. He doesn’t even have to tell us the sector to sniff this one out, but he does provide a few more clues:

“Profit margins are consistently thick, with gross profit margins of 70% and net profit margins of 20%. It’s one of the greatest income investments of all-time, having raised its dividend 48 years in a row and at a rate of 13.48% per year over the last 10 years. Investors worry about big companies growing, but 25% of this company’s sales are from products less than five years old. And 50% of its sales are outside the U.S., so it has excellent exposure to more rapidly growing economies of other countries.”

So who is it? Well, I can pretty much guarantee that even if Dan and I acted in unison and urged everyone we know to climb all over the stock, we wouldn’t move the shares one iota … this is one of the bluest of the blue chips and the mega-est of the megacaps, this must be Johnson and Johnson (JNJ)

And if you’re looking for arguments against a JNJ investment, they’re hard to find — the main one is the current bad news flow about recalls of a few OTC pharmaceuticals (children’s medicines and Motrin, I think), which is probably a large part of the reason why the shares are looking pretty cheap (though lots of the blue chippers look pretty cheap right now), and the shares are probably also depressed a bit because of their proposed $2.4 billion acquisition of the rest of Crucell (though there’s a good strategic reason for that acquisition to bolster their vaccine business, and they can pay $2.4 billion and still not have any net debt on their balance sheet if they wish).

It’s worth noting that although Johnson and Johnson is now a pretty nice dividend pick, it has spent much of its life as a growing fortress that was priced as the growth gem it was, with stable and solid returns, an increasingly diversified product mix, and a relatively low (but consistently growing) dividend. Ten years ago JNJ traded for 30X earnings and more than 20X cash flow, and today it’s about 13X earnings and 10X cash flow (the five-year average PE ratio is about 16). Over the past five years the stock has peaked right around $70 a couple times, and fallen below $50 briefly (during the market crash), but has generally traded in the low-$60s most of the time, right where it is now.

The dividend has grown nicely over time, too — and yes, JNJ is one of the few stocks that has consistently increased the dividend every year for nearly 50 years, so it would take an incredible shock to make them disappoint investors by stopping those increases. JNJ is one of the poster children for dividend growth and compounding, if you bought shares ten years ago they would have probably yielded just a little more than 1%, but that dividend has more than tripled and, with compounding, would be giving you a yield on your original investment that probably approaches 10% by now (without compounding it would still be near 5%, the payout is $2.16 a year now and was only 64 cents in 2000).

So there you have it — I’ve seen comments from Ferris that indicate that he has trouble selling subscriptions to his newsletter when he touts boring dividend growth stocks that everyone has already heard of like this “World Dominator,” and I think we probably all know that this isn’t the “sizzle” that gets you excited and fires up the imagination about the new Ferrari you’ll buy or the beach house you’ll pay for with a bag full of cash earned by picking hot junior mining companies and biotechs … but we also all know that there’s a downside to gambling (that “losing” part), and that boring stocks with growing dividends and solid, almost unassailable businesses should probably form the foundation of most portfolios.

That’s not to say JNJ is the perfect stock for everyone, of course — the recalls and the quality control issues at one of their plants, and the political backlash for the way they handled those recalls, might turn out to be bigger issues than I think they are (those recalls are apparently hitting revenue for at least last quarter and this quarter, it appears, but absent some bigger news that I haven’t seen I’m not particularly concerned), and their high margins and growth rely on medical devices and pharmaceuticals, so they face some of the same risks as other big pharma and device companies. That means concerns about maintaining a good pipeline of new products, watching for quality or safety issues, competing with other devices (our knee is better than your knee!), and replacing income lost when drugs go off patent (though they don’t have a particularly frightening patent expiration problem compared to most big pharma companies). If you’re looking at widely diversified healthcare companies another pretty similar option is Novartis (NVS), a stock I have liked and owned over the years (I don’t own it now, nor do I own JNJ stock).

But like I said, you’ve almost certainly heard of Johnson and Johnson — and if you have an index fund you own a pretty nice chunk of it already (JNJ makes up about 1.6% of the S&P and 4.3% of the Dow Jones Industrial Average), so perhaps you’ve got an opinion on the shares — wanna buy JNJ and hope for a few more decades of fabulous compounding from a mega cap company? Think it’s too big or too boring, or see more risk than the price indicates? Let us know with a comment below.

And if you’ve ever subscribed to Extreme Value, click here to let us know what you thought with a brief review — we have a few reviews on file, but haven’t heard anything from new reviewers over the last six months or so. Thanks!