Why Peter Lynch Invested in Johnson & Johnson

Peter Lynch’s investment case in Johnson and Johnson was highlighted in the book “Learn to Earn“, which was written by John Rothchild and Peter Lynch himself. This post analyses this investment through excerpts from the book plus insights from the 1993 JNJ Annual Report.

What did Peter Lynch see in Johnson & Johnson’s 1993 annual report which made him invest in the company?

(1) He saw that the stock had been crushed in recent years, but the fundamentals of the business had been steadily improving over that time

Let’s break down this statement below.

The stock was down in recent years

The 1993 annual report was mailed out on March 10, 1994. The first thing you noticed on the inside cover was the fate of the stock over the past couple of years. It had been dropping steadily from about $57 at the end of 1991. At the time the report arrived, the stock had fallen to $39 and five eighths.
John Rothchild in “Learn to Earn”

Here is the page from the 1993 annual report.

Johnson & Johnson 1993 Annual Report, retrieved from annualreports.com

In the past two years, JNJ’s stock had fallen by 30%.

JNJ’s earnings and revenues were steadily increasing over time

For such a great company to have produced such a lousy stock in a rising market, you suspected that something had to be wrong. You scanned the annual report for the bad news, but everywhere you looked, there was good news, much of it summarized on page forty-two. The earnings had gone up steadily for ten years in a row and had quadrupled during that period. The sales had risen steadily as well.
John Rothchild in “Learn to Earn”

Johnson & Johnson 1993 Annual Report, retrieved from annualreports.com

As we can see above, sales and net profits increased significantly over the last decade. Specifically, the compound annual growth rate in sales was 9% and the CAGR in net profit after tax was 14%.

Johnson & Johnson was getting more efficient as a business

Since net profit increased faster than sales, this implies JNJ’s margins were improving, displaying an improvement in their efficiency.

Furthermore, Johnson & Johnson’s efficiency improvements could also be seen through their improvement in revenue per employee.

On page forty-two, you learned that the company had become more productive in recent years. In 1983, Johnson & Johnson, with 77,400 employees, manufactured and sold $6 billion worth of products, while in 1993, with 81,600 employees, it manufactured and sold $14 billion worth of products. That’s more than twice as much manufacturing and selling, with only 4,200 additional employees.
John Rothchild in “Learn to Earn”

Here is the data from the 1993 annual report.

Johnson & Johnson 1993 Annual Report, retrieved from annualreports.com

We can see the improvement in revenue per employee in the graph below.

Johnson & Johnson was buying back stock too, meaning each remaining shareholder owned a larger piece of this growing pie

Johnson & Johnson 1993 Annual Report, retrieved from annualreports.com

From a risk perspective, JNJ had a solid balance sheet too

The balance sheet on page twenty-nine of Johnson & Johnson’s annual report showed that the company had over $900 million in cash and marketable securities, and the company was worth $5.5 billion—its “total equity.” It owed $1.5 billion in long-term debt, a modest amount for a company with $5.5 billion in equity. With this much financial clout, Johnson & Johnson is no threat to go out of business.
John Rothchild in “Learn to Earn”

We can see their balance sheet below.

Johnson & Johnson 1993 Annual Report, retrieved from annualreports.com

Based on the data above, it was clear that Johnson & Johnson was growing as a business, was financially stable and was improving significantly in terms of both brand presence around the world and efficiency.

(2) He saw that the business was strong but wanted to see if he was missing something. In other words, Lynch wanted to analyse the negative case of Johnson & Johnson and use the annual report information to gain comfort with the risks before he invested

The main risk clouding JNJ at the time was regulatory. Here is how it was described in “Learn to Earn”.

The company wasn’t the problem, the “health-care scare” was the problem. In 1993, Congress was debating various health-care-reform proposals, including the ones advanced by the Clinton administration. Investors worried that healthcare companies would suffer if the Clinton proposals became law. So they dumped Johnson & Johnson along with the rest of their health-care stocks. The entire industry took a beating in this period. Some of this concern would have been justified if the Clintons had had their way, but even then Johnson & Johnson would have been affected less than a typical health-care company.

On page fortyone of the annual report, you learned that over 50 percent of Johnson & Johnson’s profits came from its international business—the Clinton proposals couldn’t have affected that. Then on page twenty-six you found out that 20 percent of the company’s profits came from shampoo, Band-Aids, and other consumer items that had nothing to do with pharmaceuticals, which the Clintons had targeted for reform. Either way you sliced it, Johnson & Johnson had a limited exposure to the threat that people were worried about.
John Rothchild in “Learn to Earn”

Here is the data from the annual report, along with pie charts displaying the percentage breakdowns.

Johnson & Johnson 1993 Annual Report, retrieved from annualreports.com
Johnson & Johnson 1993 Annual Report, retrieved from annualreports.com

If 47% of JNJ’s profits were from the U.S. and 55% of this was pharmaceuticals, this means that 26% of JNJ’s total profits were at risk (47% * 55%). This means that if Clinton’s proposal got voted into law and all of these at-risk profits went away (which was unlikely), Johnson & Johnson would still be earning $1.3b in net profit after taxes.

(3) Finally, given JNJ’s strength and growth potential, Peter Lynch saw that the stock was selling for a cheap price
To put this story into a larger context, you compared the price of the stock to the earnings. The company was expected to earn $3.10 in 1994, and $3.60 in 1995, giving it a price/earnings ratio of 12 and 11, respectively. Future earnings are always hard to predict, but Johnson & Johnson had had very predictable results in the past. So, if these estimates turned out to be correct, the stock was cheap.

At the time, the average stock was selling for sixteen times its estimated 1995 earnings. Johnson &Johnson was selling for eleven times its estimated 1995 earnings. And Johnson & Johnson was far better than your average company. It was a terrific company, doing everything right: earnings up, sales up, prospects bright. Despite all this, the stock already had dropped to to $39 and five eighths, and it dropped further, to nearly $36, in the weeks after the report arrived. As hard as it was to believe, you reached the inescapable conclusion: There was nothing wrong with Johnson & Johnson to cause the stock price to go down.
John Rothchild in “Learn to Earn”

If 26% of JNJ’s profits went to zero, assuming the unlikely worst-case scenario occurs where JNJ’s entire U.S. pharmaceuticals business disappears, they would have still been selling for a P/E ratio of 16 on 1994’s earnings!

Furthermore, the 10-year government bond rate in the US was 6.57% at the time. Inversing the P/E ratio gives an earnings yield of 8% if Clinton’s proposals do not materialise and 6% if the worst-case scenario occurs. This means that Lynch was investing in a business that was stable, strong and had significant growth potential ahead, for an earnings yield that was at least equal to the 10-year US treasury!

Lessons from Peter Lynch

(1) The importance of looking at business fundamentals and not the stock price. The lesson is to let Mr Market serve, not instruct investments, as Ben Graham has said!

Lynch saw that earnings, sales and efficiency were increasing whilst shares outstanding were decreasing. He wondered why the stock was down but didn’t let Mr Market instruct his decision and not invest in the company.

(2) Peter Lynch did not ignore the bear case for the stock. The lesson is to always analyse the other side and be able to debunk or be comfortable with any risks presented by the opposite side of the investment

Lynch analysed why the market was pessimistic about Johnson & Johnson. He then debunked the argument knowing that over 70% of Johnson & Johnson’s revenue came from sources that would not be impacted at all by Clinton’s proposed legislation.

This shows the importance of truly deep-diving into all angles of a business before investing in it. Lynch was comfortable that his downside risk was limited since the main risk that was believed by the opposing side of the investment was not very significant in the grand scheme of Johnson & Johnson’s business.

(3) Peter Lynch invested with a Margin of Safety. The lesson is to recognise that price is very important and the success of an investment depends on price, no matter how good the business is.

Thanks for reading!


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