U.S. stocks hit new monthly lows as weak sentiment carried over from the previous session.  Volume was relatively light as traders braced for the coming week’s slate of economic data.

This is my last day writing the Daily Insight, I hope you have enjoyed our time together.  Since we are short on economic releases, I’d like to give you a window into the analysis Acropolis every day on individual companies. 

Before you make the jump to the full Daily Insight, I want to first bring your attention to an Acropolis article written earlier this year by David Ott about our preference for ‘value’ stocks over ‘growth’ stocks.  The article defines growth and value stocks with two examples, provides an overview of the academic underpinnings that support value investing, explains why we believe that value investing is more intuitive than growth investing, and concludes why we still maintain growth stocks in our client portfolios.

Today, I will give you our value case for Johnson & Johnson (JNJ).

Market Activity for August 20, 2010

Making a Case For J&J

J&J’s stock has fallen roughly 12% after the firm recalled several children’s medications due to quality-control issues.  J&J seems to have everything under control now, and the recall did nothing to dim the company’s other attributes.

Starting with their balance sheet, it’s hard to find a higher-quality healthcare firm than J&J.  The firm is one of only four U.S. companies with a coveted AAA credit rating, which gives it a unique advantage in obtaining cheap funding and flexibility to buy companies that add to growth.  With a cash pile equal to about 10% of its entire market capitalization as well as nearly $15 billion in annual cash flow from operations, J&J has plenty of financial flexibility to continue making strategic acquisitions, increasing their dividend, and buying back stock.

It is not the cheapest healthcare firm (as measured by P/E ratio), but J&J still trades at a 38% discount to its 10-year average valuation.  The reason the firm trades at a premium to the healthcare sector is because investors value its diverse revenue base (in which J&J controls the #1 or #2 market share spot in 70% of its products), robust drug pipeline (with 10 potential blockbusters in Phase III development), strong brand names (Tylenol, Band-Aid, Listerine, Splenda, Neutrogena, Acuvue, Sudafed, Rolaids, I could literally go on forever), and exceptional free cash flow generation.

Investors have shunned the Pharmaceutical sector as a whole because of significant patent cliffs that will result in billions of dollars of lost revenue.  J&J’s major expirations last year cost the firm $3 billion in sales, but most of their bad news is over.  Turning promising drugs into winners is no certainty, but with a strong pipeline of new drugs, J&J is well-positioned to grow revenues going forward.

Worried about the impact from the passage of healthcare reform?  Don’t be.  J&J expects healthcare reform to reduce annual revenue by $400 million to $500 million, less than 1% of the company’s overall sales.  The company now expects to earn $4.80 to $4.90 a share this year, a nickel below its previous guidance range.  By the end of the decade, healthcare reform is actually expected to add to pharmaceutical company earnings.

For all of you dividend lovers out there, J&J hiked its quarterly payout by 10.2% this year, marking the 48^th straight annual dividend increase.  Consistent dividend increases are often a good directional signal of future returns. 

And get this: buying J&J stock yields more than buying their bonds!  The firm’s 10-year notes yield just 2.95% compared to the stock yield of 3.68%.  That means that the stock could fall by 6.25% and still beat the bond.  If the company continues to grow the dividend at 10% per year, which they have for the past five years, then the cushion is more like 9%!

With all of the turmoil and uncertainty in markets today, it’s very easy to forget some of the simplest investing rules: Buy good businesses, buy them when they are relatively cheap, and don’t underestimate the power of dividend income over time.

Have a great day!

Sign up to receive the Daily Insight and other Acropolis publications here.

Peter Lazaroff, Investment Analyst

Phone: 636-449-4900