Johnson & Johnson’s (JNJ) ‘AAA’ dividend safety makes it a candidate for investors with a low tolerance for risk who are looking for a reliable source of income. Having increased its dividend for 58 consecutive years, JNJ meets the Dividend King criteria; a Dividend King is an S&P 500 company with a market capitalization over $3B and a record of raising the annual dividend for at least 50 consecutive years.

It is a holding company whose primary focus is products related to human health and well-being.

JNJ consists of three business segments:

• Consumer Health
• Pharmaceutical
• Medical Devices

Under the JNJ umbrella are multiple operating companies that conduct business in virtually all countries of the world. These companies are engaged in the research and development, manufacture and sale of a broad range of products in the health care field.

Part 1 of JNJ’s FY2020 10-K has a comprehensive overview of the company. In addition, this 2020 Fact Sheet provides a succinct overview of the company.

JNJ – ‘AAA’ Dividend Safety – Risk Profile

Risk-averse investors find JNJ’s AAA rating appealing. This coveted rating is assigned by Moody’s and S&P Global solely to 2 companies: JNJ and Microsoft (MSFT).

Fitch assigned a similar rating but discontinued its coverage of JNJ at the end of August 2019.

These ratings define JNJ as having an EXTREMELY STRONG capacity to meet its financial commitments.

Risk/Return Trade-Off

While JNJ’s credit risk is extremely low, investors need to assess the risk/return trade-off.

The AAA rating undoubtedly leads to highly favorable terms and conditions in JNJ’s credit arrangements. The current environment, however, is such that companies within the High-grade and Upper-medium grade categories can also negotiate attractive credit terms and conditions.

Companies that carry a slightly higher risk than JNJ may offer the potential for far greater investment returns. Their risk, however, is such that they are reasonably safe investments.

Further in this post, I compare JNJ’s historical returns relative to two other low credit risk companies to demonstrate the importance of assessing the risk/return trade-off.

Systematic and Unsystematic Risk

When assessing risk, investors must consider ‘systematic’ and ‘unsystematic’ risks.

Systematic risk applies to an entire market or market segment; all investments have an element of systemic risk. Examples include but are not limited to:

• government collapse;
• risk of war;
• risk of inflation; or
• macro risks such as the COVID-19 pandemic or The Financial Crisis.

It is extremely difficult to protect investments against these risks. This is why it is important to gauge the extent to which the investment can sustain a ‘macro shock’.

Unsystematic risk, however, is a specific or diversifiable risk. Such risk is unique to, for example, a company or a particular industry.

Proper portfolio diversification can mitigate this risk.

Within these two types of risk are:

• Political Risk;
• Country Risk;
• Interest Rate Risk;
• Legal Risk;
• Reinvestment Risk;
• Market Risk;
• Foreign Exchange Risk;
• Inflationary Risk;
• Credit Risk (also known as Default Risk).

Every company has a host of risks and JNJ is no exception to the rule. Pages 13 – 19 in the FY2020 10-K have a good overview of the key risks.

There is no disputing the credit rating agencies view JNJ’s unsystematic risk as low. We, as investors, need to determine whether JNJ meets our respective goals and objectives. Once we determine JNJ is a company in which to invest, we must determine if the current valuation is reasonable.

JNJ – ‘AAA’ Dividend Safety – Current Valuation

On July 21, JNJ reported YTD adjusted diluted EPS of $5.07 and raised FY2021 adjusted diluted EPS guidance to $9.60 – $9.70 from $9.42 – $9.57.

A day before the release of Q2 and YTD results, JNJ’s share price closed at $168.45 and the mid-point of management’s FY2021 adjusted diluted EPS guidance was $9.50. Using these values, the forward adjusted diluted PE was ~17.7.

Now, the forward-adjusted diluted PE is ~18 based on the current ~$175 share price and the ~$9.65 midpoint of amended guidance.

This valuation is marginally less attractive than just before the release of Q2 results.

FY2021 and FY2022 adjusted diluted EPS guidance from 18 brokers and 13 brokers for FY2023 obtained from the two discount brokerage firms I use is:

• FY2021 – a mean of $9.67 and a low/high range of $9.60 – $9.78. Using the current share price and the mean estimate, the forward adjusted diluted PE is ~18.
• FY2022 – a mean of $10.44 and a low/high range of $9.58 – $11.45. Using the current share price and the mean estimate, the forward adjusted diluted PE is ~16.8.
• FY2023 – a mean of $11.13 and a low/high range of $9.97 – $11.71. Using the current share price and the mean estimate, the forward adjusted diluted PE is ~15.7.

By way of comparison, we have the following adjusted diluted PE levels on the day FY2017 – FY2020 results were released.

• On January 26, 2021, JNJ reported FY2020 adjusted diluted EPS of $8.03. On this day, JNJ’s share price closed at $170.48. This gives us an adjusted diluted PE value of ~21.2.

• On January 22, 2020, JNJ reported FY2019 adjusted diluted EPS of $8.68. On this day, JNJ’s share price closed at $148.25. This gives us an adjusted diluted PE value of ~17.1.

• On January 22, 2019, JNJ reported FY2018 adjusted diluted EPS of $8.18. On this day, JNJ’s share price closed at $128.80. This gives us an adjusted diluted PE value of ~15.8.

• On January 23, 2018, JNJ reported FY2018 adjusted diluted EPS of $7.30. On this day, JNJ’s share price closed at $141.83. This gives us an adjusted diluted PE value of ~19.4.

NOTE: These figures are merely for comparison purposes. Determining a company’s valuation is not an exact science.

Using these historical levels, JNJ’s current forward adjusted diluted PE is reasonably comparable to historical levels.

JNJ – ‘AAA’ Dividend Safety – Dividends and Share Repurchases

Dividends and Dividend Yield

I invested in JNJ in ~2001 as part of my plan to exit early from the corporate world. At the time, I looked to JNJ as an investment that would provide a reliable stream of dividend income with dividend increases that would outpace the rate of inflation. This is borne out from a review of JNJ’s dividend history.

Investors can expect the 3rd consecutive $1.06 quarterly dividend in early December. This would lead to a dividend income of $4.19/share in 2021; JNJ typically declares a dividend increase in April following the release of the prior fiscal year’s financial results.

Based on the current ~$175 share price, the dividend yield is ~2.4%.

As a Canadian resident, I incur a 15% dividend withholding tax on the dividends from the shares held in taxable accounts. This lowers the dividend yield to ~2%.

Merely looking at a company’s dividend history is insufficient. We must determine if the company’s future financial results are likely to support ongoing dividend increases.

Many companies might have extremely attractive dividends and dividend yields. A close analysis of the financial results, however, can reveal ‘red flags’. In some cases, the attractive dividends might not be exclusively a return on capital but might be partially/solely a return of capital.

Looking at JNJ’s Consolidated Statement of Cash Flow (page 49 of 157 in JNJ’s FY2020 10-K), we can determine the extent to which JNJ generates Free Cash Flow (FCF).

In FY2020, JNJ generated $23.536B net cash flows from operating activities. Subtract $3.347B in additions to property, plant and equipment and we get FCF of $20.189B. This can be deployed toward debt repayment, acquisitions, share repurchases, dividends, or whatever the Board deems appropriate to enhance shareholder value.

A review of the FY2011- FY2020 10-Ks reflects annual FCF of $11.41, $12.46, $13.82, $15.00, $16.11, $15.54, $17.78, $18.53, $19.92 and $20.19 (in billions of dollars).

Investors can take comfort that Johnson & Johnson (JNJ) is unlikely to experience difficulty in continuing to increase and service its dividend and that the dividend does not include a return of capital component.

Share Repurchases

Looking at the Consolidated Statement of Cash Flow, JNJ consistently repurchases common stock. This does not, however, mean the diluted weighted average number of outstanding shares steadily declines. Share count can increase given that JNJ issues shares annually as part of its various employee compensation programs.

The diluted weighted average number of outstanding shares in FY2011 – FY2020 is: 2,775, 2,813, 2,877, 2,864, 2,813, 2,789, 2,745, 2,729, 2,684, and 2,671 (millions of shares).

Focus On Total Potential Return

Investors would be wise to focus on overall total potential return as opposed to dividend yield and years of consecutive dividend increases. Focusing on dividend metrics can lead to poor investment decisions.

Looking at JNJ’s 5 and 10-year historical performance we see that JNJ’s returns have been somewhat lackluster.

Source: JNJ FY2020 10-K (page 111 of 157)

The following image shows JNJ’s underperformance relative to the S&P500 over the ~21 years I have held shares in my retirement account; I purchased more than $10,000 so the following is solely for illustrative purposes. Despite automatically reinvesting the dividends, the average annual total return has been less than impressive.

www.tickertech.com

If we look at investment opportunities beyond the Pharmaceutical and Healthcare Equipment sectors, we find high-quality companies that can generate far superior returns to those of JNJ and with almost equally high dividend safety.

By way of example, compare JNJ’s overall return relative to Visa (V) and Mastercard (MA) – my largest and second-largest holdings; the following reflect the performance of V and MA relative to JNJ from the date both V and MA went public.

www.tickertech.com

www.tickertech.com

While V’s and MA’s future returns may not be the same as historical levels, I strongly suspect their future total returns will exceed that of JNJ. In fact, I recently disclosed the purchase of additional V and MA shares.

These are merely two examples of why investors should not focus primarily (solely…as many investors do) on dividends. Sometimes companies with razor-thin dividend yields generate superior long-term investor returns because the business generates an attractive return on investment; V’s and MA’s dividend yields are currently under 0.6%.

As much as there is a cachet to having a AAA rating, V and MA are rated highly by Moody’s and S&P Global.

V’s current ratings and outlook are:

• Moody’s – Aa3 (stable)
• S&P Global – AA- (stable)

MA’s current ratings and outlook are:

• Moody’s – A1 (stable)
• S&P Global – A+ (stable)

All ratings are investment-grade with V’s ratings being the lowest tier of the high-grade category. MA’s ratings are one notch lower and are the top tier of the upper-medium grade category.

The ratings define V as having a VERY STRONG capacity to meet its financial commitments and differ from the highest-rated obligors only to a small degree.

MA’s ratings define it as having a STRONG capacity to meet its financial commitments. MA, however, is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.

V’s ratings are 3 notches below those of JNJ and MA’s ratings are 4 notches below those of JNJ. Their credit ratings, however, should be acceptable for most risk-averse investors.

Only you can determine whether V’s and MA’s potential to generate superior long-term investor returns relative to JNJ warrants the extra risk.

In What Type of Account Should JNJ Shares Be Held

If you decide JNJ is a suitable investment, consider the type of account in which you hold your shares; I suspect many investors give little consideration to this matter.

I do not know your personal circumstances and am not offering investment advice. Furthermore, I am unfamiliar with investment accounts outside of Canada and their tax implications. I merely share my personal situation to demonstrate why the type of account used is worthy of consideration.

When I initiated a JNJ position in 2001, I acquired shares in a Registered Retirement Savings Plan (RRSP). My rationale for acquiring JNJ shares through a ‘tax efficient’ account as opposed to a taxable account is that I benefited from a tax deduction. In addition, none of the dividend income derived from my JNJ shares would incur any tax until I withdrew funds from the RRSP.

Years later, I initiated JNJ positions in taxable accounts; I reflect these JNJ positions in my monthly FFJ Portfolio reports. I initiated these positions because after retiring I no longer generated employment income. Since I could no longer make RRSP contributions, I had to acquire shares in taxable accounts if I wanted to increase my JNJ exposure.

Unlike the JNJ shares held in my RRSP, the quarterly dividends from the holdings in the taxable accounts trigger a 15% dividend withholding tax immediately upon distribution. I receive ~$0.90/share and not $1.06/share. As noted earlier, JNJ’s dividend yield for the shares held in taxable accounts is currently ~2%.

The term ‘tax-efficient’ when referring to a RRSP is a misnomer. Contributions to a RRSP are tax-deductible and the value of the investments grow tax-free until they are withdrawn. There is, however, an automatic withholding tax on the value of the withdrawal (tiered structure). The RRSP withdrawal must also be taken into income in the year of withdrawal.

Even if you never make any RRSP withdrawals, the government still ‘extracts its pound of flesh’ at some point. RRSPs must be converted to a Registered Retirement Income Fund (RRIF) no later than the year in which the account holder turns 71 years of age. Once a RRIF is established, there is a formula that stipulates the minimum annual withdrawals.

Depending on the value of the RRIF, the minimum mandatory annual RRIF withdrawals may place the taxpayer in the top income tax bracket.

Such is our case.

From a tax planning perspective, we will make annual RRSP withdrawals over the next decade before the RRSPs must be converted to RRIFs. This is commonly referred to as a ‘RRSP meltdown strategy’.

One of the drawbacks of holding shares in a RRSP is that capital gains, dividends, and interest are all taxed at the same level at the time of withdrawal. This is not the case when shares are held in a taxable account.

As noted earlier, V and MA are our first and second-largest holdings. The bulk of these shares are held in RRSPs so even though capital gains form the vast majority of the appreciation in the total value of these holdings, the sale of these shares and subsequent RRSP withdrawals will be taxed equally at our personal income tax level. Had these shares been held in taxable accounts, we would incur a 15% withholding tax on the quarterly dividends and have to declare the dividend income on our annual tax returns. The capital appreciation at the time of their eventual sale, however, would be taxed at a lower level than dividend income.

One reason an investor may want to hold JNJ shares in a taxable account is the opportunity to employ a conservative use of margin debt. In doing so, an investor can borrow against JNJ shares to acquire attractively valued shares in high-quality companies; the interest is tax-deductible. This is not possible when shares are held in RRSPs or RRIFs.

I am a strong proponent of employing a conservative degree of margin and really am not enamored with margin debt against highly volatile stocks. I view JNJ as the type of company against which you can borrow since its share price typically experiences low volatility.

JNJ – ‘AAA’ Dividend Safety – Final Thoughts

Investors seeking the safety and security of a stream of dividend income from a ‘AAA’ rated stock might want to consider investing in JNJ.

Relatively new investors might want to consider investing in JNJ for the long term as opposed to investing in companies of highly questionable value or because a company has an attractive dividend and dividend yield.

I say this because a permanent impairment to an investor’s capital can be a tough pill to swallow. When this happens in the early stages of an investor’s investment journey, some learn from their mistakes. Others, however, retreat and swear off investing for a very long time.

Investing is a tool to help an investor achieve their objectives and goals. The experience should be rewarding, educational, and pleasant.

An investment in JNJ for the long term might not lead to the maximization of potential investment returns. However, a JNJ investor is likely to experience long-term investment returns that outpace the rate of inflation without the drawback of nerve-wracking volatility.

What we witnessed in March/April 2020 was a sharp and swift pullback. Many investors today, however, have never experienced a prolonged ‘bear market’. ‘Bear markets’ are periods in which to go hunting for shares in attractively valued companies. It is, therefore, incredibly important not to become discouraged at the most inopportune time. It is for this reason that new investors might want to consider a relatively safe JNJ investment.

We are also witnessing ‘frothy’ market conditions; money has flooded into equities because of low returns achievable through other forms of investment. I do not think the current market conditions will last forever. When a market correction occurs, JNJ’s share price is unlikely to be hit to the same extent as the share price of companies whose valuations are totally detached from the underlying business fundamentals.

Having said this, I am not looking to add to my JNJ position.

JNJ was my 10th largest holding when I completed my April 12, 2021 FFJ Portfolio Holdings Review; it was my 7th largest holding when I completed a similar review in mid-August 2020.

The drop in ranking is not because I view anything wrong with JNJ but rather because I am purchasing shares in companies I think will generate long-term total investment returns that will exceed those of JNJ.