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
Here is the page from the 1993 annual report.
In the past two years, JNJ’s stock had fallen by 30%.
JNJ’s earnings and revenues were steadily increasing over time
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.
Here is the data from the 1993 annual report.
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
From a risk perspective, JNJ had a solid balance sheet too
We can see their balance sheet below.
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”.
Here is the data from the annual report, along with pie charts displaying the percentage breakdowns.
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
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!
- “Learn to Earn” by John Rothchild and Peter Lynch
- 10-year Treasury Rate History – MacroTrends