1)JOHNSON & JOHNSON (JNJ)
Strategy: Warren Buffett’s Long-Term Value (The Patient Investor)
Johnson & Johnson is engaged in the research and development, manufacture and sale of a range of products in the healthcare field. Johnson & Johnson has more than 250 operating companies. The Company operates in three segments: Consumer, Pharmaceutical, and Medical Devices and Diagnostics. Sales of the Company's two largest products, RISPERDAL/RISPERDAL CONSTA and PROCRIT/EPREX, accounted for approximately 8% and 6% of Johnson &Johnson’s total revenues, respectively, during the year ended December 31, 2006.
In May 2006, ETHICON, Inc., a Johnson & Johnson company, acquired Vascular Control Systems, Inc., which is focused on developing medical devices to treat fibroids and to control bleeding in obstetric and gynecologic applications. On December 20, 2006, the Company completed the acquisition of the Consumer Healthcare business of Pfizer Inc. In February 2007, the Company completed the acquisition of Conor Medsystems, Inc.
Detailed Analysis
This stock passes Validea’s Patient Investor strategy based on our interpretation of the published criteria of Warren Buffett with a score of 93%. The strategy looks for stocks with consistent long-term track records of earnings growth that also trade at reasonable valuations based on their future growth prospects.
STAGE 1: “Is this a Buffett-type company?”
A bedrock principle for Buffett is that his type of company has a “durable competitive advantage” as compared to being a “price competitive” or “commodity” type of business. Companies with a “durable competitive advantage” are more likely to be found in these sub-industries: Brand Name Fast Food Restaurants, Brand Name Beverages, Brand Name Foods, Brand Name Toiletries and Household Products, Brand Name Clothing, Brand Name Prescription Drugs, Advertising, Advertising Agencies, TV, Newspapers, Magazines, Direct Mail, Repetitive Services for Businesses, Low Cost Producers of Insurance, furniture, or Low Cost Retailers.
While you should be easily able to explain where the company's pricing power comes from (i.e. a strong regional brand image, a business tollgate, its main products are #1 or # 2 in its field and has been on the market for years and hasn’t changed at all, a consumer or business ends up buying the same product many times in a year, etc. or having the lowest production cost among its competition), there are certain figures that one can look at that can qualify the company as having a durable competitive advantage.
LOOK FOR EARNINGS PREDICTABILITY:
[PASSES WARREN BUFFETT’S TEST]Buffett likes companies to have solid, stable earnings that are continually expanding. This allows him to accurately predict future earnings. Annual earnings per share from earliest to most recent were 1.02, 1.02, 1.39, 1.61, 1.84, 2.16, 2.40, 2.74, 3.35, 3.73. Buffett would consider JNJ’s earnings predictable. In fact EPS have increased every year. JNJ’s long term historical EPS growth rate is 14.3%, based on the 10 year average EPS growth rate, and it is expected to grow earnings 9.0% per year in the future, based on the analysts’ consensus estimated long term growth rate. For the purposes of our analysis, we will use the more conservative of the two EPS growth numbers.
LOOK AT THE ABILITY TO PAY OFF DEBT
[PASSES WARREN BUFFETT’S TEST]Buffett likes companies that are conservatively financed. Nonetheless, he has invested in companies with large financing divisions and in firms with rather high levels of debt. JNJ has a debt of 2,012.0 million and earnings of 10,175.5 million, which could be used to pay off the debt in less than two years, which is considered exceptional.
LOOK FOR CONSISTENTLY HIGHER THAN AVERAGE RETURN ON EQUITY:
[PASSES WARREN BUFFETT’S TEST]Buffett likes companies with above average return on equity of at least 15% or better, as this is an indicator that the company has a durable competitive advantage. US corporations have, on average, returned about 12% on equity over the last 30 years. The average ROE for JNJ, over the last ten years, is 24.9%, which is high enough to pass. It is not enough that the average be at least 15%. For each of the last 10 years, with the possible exception of the last fiscal year, the ROE must be at least 10% for Buffett to feel comfortable that the ROE is consistent. In addition, the average ROE over the last 3 years must also exceed 15%. The ROE for the last 10 years, from earliest to latest, is 23.1%, 20.8%, 24.6%, 23.8%, 23.1%, 28.3%, 26.5%, 25.6%, 25.8%, 27.5%, and the average ROE over the last 3 years is 26.3%, thus passing this criterion.
LOOK FOR CONSISTENTLY HIGHER THAN AVERAGE RETURN ON TOTAL CAPITAL:
[PASSES WARREN BUFFETT’S TEST]Because some companies can be financed with debt that is many times their equity, they can show a consistently high ROE, yet still be in unattractive price competitive businesses. To screen this out, for non-financial companies Buffett also requires that the average Return On Total Capital (ROTC) be at least 12% and consistent. In addition, the average ROTC over the last 3 years must also exceed 12%. Return On Total Capital is defined as the net earnings of the business divided by the total capital in the business, both equity and debt. The average ROTC for JNJ, over the last ten years, is 22.4% and the average ROTC over the past 3 years is 24.8%, which is high enough to pass. It is not enough that the average be at least 12%. For each of the last 10 years, with the possible exception of the last fiscal year, the ROTC must be at least 9% for Buffett to feel comfortable that the ROTC is consistent. The ROTC for the last 10 years, from earliest to latest, is 19.9%, 17.6%, 20.5%, 20.6%, 21.2%, 26.0%, 23.9%, 23.7%, 24.5%, 26.1%, thus passing this criterion.
LOOK AT CAPITAL EXPENDITURES:
[PASSES WARREN BUFFETT’S TEST]Buffett likes companies that do not have major capital expenditures. That is, he looks for companies that do not need to spend a ton of money on major upgrades of plant and equipment or on research and development to stay competitive. JNJ’s free cash flow per share of $2.47 is positive, indicating that the company is generating more cash that it is consuming. This is a favorable sign, and so the company passes this criterion.
LOOK AT MANAGEMENT'S USE OF RETAINED EARNINGS:
[PASSES WARREN BUFFETT’S TEST]Buffett likes to see if management has spent retained earnings in a way that benefits shareholders. To figure this out, Buffett takes the total amount of retained earnings over the previous ten years of $13.06 and compares it to the gain in EPS over the same period of $2.71. JNJ’s management has proven it can earn shareholders a 20.8% return on the earnings they kept. This return is more than acceptable to Buffett. Essentially, management is doing a great job putting the retained earnings to work.
HAS THE COMPANY BEEN BUYING BACK SHARES:
[BONUS PASSES WARREN BUFFETT’S TEST]Buffett likes to see falling shares outstanding, which indicates that the company has been repurchasing shares. This indicates that management has been using excess capital to increase shareholder value. JNJ’s shares outstanding have fallen over the past five years from 2,968,300,049 to 2,924,000,000, thus passing this criterion. This is a bonus criterion and will not adversely affect the ability of a stock to pass the strategy as a whole if it is failed.
The preceding concludes Buffett’s qualitative analysis. If and when he gets positive responses to all the above criteria, he would then proceed with a price analysis. The price analysis will determine whether or not the stock should be bought. The following is how he would evaluate JNJ quantitatively.
STAGE 2: “ Should I buy at this price?
“ Although a firm may be a Buffett-type company, he won’t invest in it unless he can get a favorable price that allows him a great long term return.
CALCULATE THE INITIAL RATE OF RETURN: [No Pass/Fail]
Buffett compares his type of stocks to bonds, and likes to see what a company’s initial rate of return is. To calculate the initial rate of return, take the trailing 12-month EPS of $3.48 and divide it by the current market price of $63.36. An investor, purchasing JNJ, could expect to receive a 5.49% initial rate of return. Furthermore, he could expect the rate to increase 9.0% per year, based on the analysts’ consensus estimated long term growth rate, as this is how fast earnings are growing.
COMPARE THE INITIAL RATE OF RETURN WITH THE LONG-TERM TREASURY YIELD: [PASSES WARREN BUFFETT’S TEST]
Buffett favors companies in which the initial rate of return is around the long-term treasury yield. Nonetheless, he has invested in companies with low initial rates of return, as long as the yield is expected to expand rapidly. Currently, the long-term treasury yield is about 5.16%. Compare this with JNJ’s initial yield of 5.49%, which will expand at an annual rate of 9.0%, based on the analysts’ consensus estimated long term growth rate. The company is the better choice, as the initial rate of return is close to or above the long term bond yield and is expanding.
CALCULATE THE FUTURE EPS: [No Pass/Fail]
JNJ currently has a book value of $14.14. It is safe to say that if JNJ can preserve its average rate of return on equity of 24.9% and continues to retain 61.14% of its earnings, it will be able to sustain an earnings growth rate of 15.2% and it will have a book value of $58.33 in ten years. If it can still earn 24.9% on equity in ten years, then expected EPS will be $14.52.
CALCULATE THE FUTURE STOCK PRICE BASED ON THE AVERAGE ROE METHOD: [No Pass/Fail]
Now take the expected future EPS of $14.52 and multiply them by the lower of the 5 year average P/E ratio (20.4) or current P/E ratio (current P/E in this case), which is 18.2 and you get JNJ’s projected future stock price of $264.02.
CALCULATE THE EXPECTED RATE OF RETURN BASED ON THE AVERAGE ROE METHOD: [No Pass/Fail]
Now add in the total expected dividend pool to be paid over the next ten years, which is $22.41. This gives you a total dollar amount of $286.42. These numbers indicate that one could expect to make a 16.3% average annual return on JNJ’s stock at the present time. Buffett would consider this a great return.
CALCULATE THE EXPECTED FUTURE STOCK PRICE BASED ON AVERAGE EPS GROWTH: [No Pass/Fail]
If you take the EPS growth of 9.0%, based on the analysts’ consensus estimated long term growth rate, you can project EPS in ten years to be $8.25. Now multiply EPS in 10 years by the lower of the 5 year average P/E ratio (20.4) or current P/E ratio (current P/E in this case), which is 18.2. This equals the future stock price of $149.91. Add in the total expected dividend pool of $22.41 to get a total dollar amount of $172.32.
CALCULATE THE EXPECTED RETURN USING THE AVERAGE EPS GROWTH METHOD: [No Pass/Fail]
Now you can figure out your expected return based on a current price of $63.36 and the future expected stock price, including the dividend pool, of $172.32. If you were to invest in JNJ at this time, you could expect a 10.5% average annual return on your money. Buffett likes to see a 15% return, and would even go down to 12%.
LOOK AT THE RANGE OF EXPECTED RATE OF RETURN: [PASSES WARREN BUFFETT’S TEST]
Based on the two different methods, you could expect an annual compounding rate of return somewhere between 10.5% and 16.3%. To pinpoint the average return a little better, we have taken an average of the two different methods. Investors could expect an average return of 13.4% on JNJ stock for the next ten years, based on the current fundamentals. Buffett likes to see a 15% return, but nonetheless would accept this return, thus passing the criterion.
2) PEPSICO, INC. (PEP)
Strategy: Warren Buffett’s Long-Term Value (The Patient Investor)
PepsiCo, Inc. (PepsiCo) is a global snack and beverage company. PepsiCo manufactures, markets and sells a variety of salty, sweet and grain-based snacks, carbonated and non-carbonated beverages and foods. The Company is organized into four divisions: Frito-Lay North America, PepsiCo Beverages North America, PepsiCo International and Quaker Foods North America. The Company's North American divisions operate in the United States and Canada. PepsiCo’s international division operates in approximately 200 countries, with its largest operations in Mexico and the United Kingdom.
In September 2006, PepsiCo, Inc. acquired IZZE Beverage Company, a maker of all-natural fruit juices. During the fiscal year ended December 30, 2006 (fiscal 2006), the Company also acquired Stacy’s bagel and pita chips, Duyvis nuts in the Netherlands and Star Foods snacks in Poland. On January 2, 2007, it acquired Naked Juice fruit beverages, and in 2007, completed the acquisition of Bluebird snacks in New Zealand.
Detailed Analysis
This stock passes Validea’s Patient Investor strategy based on our interpretation of the published criteria of Warren Buffett with a score of 93%. The strategy looks for stocks with consistent long-term track records of earnings growth that also trade at reasonable valuations based on their future growth prospects.
3) WALGREEN COMPANY (WAG)
Strategy: Warren Buffett’s Long-Term Value (The Patient Investor)
Walgreen Company (Walgreen) operates retail drugstore chains that are engaged in the retail sale of prescription and non-prescription drugs, and general merchandise. General merchandise includes, among other things, beauty care, personal care, household items, candy, photofinishing, greeting cards, seasonal items and convenience foods. Customers can have prescriptions filled at the drugstore counter, as well as through the mail, by telephone and on the Internet. During the fiscal year ended August 31, 2006 (fiscal 2006), the Company opened or acquired 570 stores after relocations and closings. The total number of stores at August 31, 2006 was 5,461 located in 47 states and Puerto Rico.
The Company made three acquisitions in fiscal 2006, which include Schraft's A Specialty Pharmacy, Medmark Inc. and SeniorMed LLC. In fiscal 2006, Walgreens merged with 76 Happy Harry's stores, primarily in Delaware. In May 2007, the Company acquired Take Care Health Systems.
Detailed Analysis
This stock passes Validea’s Patient Investor strategy based on our interpretation of the published criteria of Warren Buffett with a score of 93%. The strategy looks for stocks with consistent long-term track records of earnings growth that also trade at reasonable valuations based on their future growth prospects.
