Friday, February 06, 1998

Cash-King Portfolio Report
by Tom Gardner ([email protected])

ALEXANDRIA, VA (Feb. 6, 1998) -- The CK Portfolio inched forward this afternoon on the shoulders of gains by Pfizer and Microsoft. Early this afternoon, we purchased our shares of T. Rowe Price (NYSE: TROW) at $67 1/16 per share. Less than one month ago, T. Rowe traded as low as $50 per share -- ack! The market has responded positively both to T. Rowe's fourth-quarter earnings report and news that cash continues to flow into U.S. equity mutual funds. The stock got an additional bump up on positive vibes surrounding the company's decision Wednesday to split its stock 2-for-1. If you own or are thinking of owning T. Rowe Price, take a look at its fourth-quarter earnings on the Web. (Click here: TROW's year-end numbers)

This past week, I've received about a dozen notes asking why it is that the Cash-King portfolio has opted to buy Pfizer (NYSE: PFE) while the Drip Portfolio chose to pick up shares of Johnson & Johnson (NYSE: JNJ) last fall. Why don't the portfolios buy the same stock? Who's right? Who's wrong? And which will outperform the other over the next fifteen years?

First, I have to make it clear that these portfolios are not managed by the same people and that the Motley Fool encourages free thinking by everyone (inside the confines of Fool Global HQ and beyond).

Over in DRIP-ville, Jeff Fischer is applying his brand of logic as he works through the 1,200 common stocks listed on the NYSE, AMEX, and Nasdaq that offer dividend reinvestment plans. Over here in the world of Cash-King, Rob Landley, Phil Weiss, and Al Levit (who will be inking reports through February beginning next week) have been working with me to design our portfolio. Naturally, different minds are going to draw different conclusions. (There's even disagreement inside our portfolio team. Heck, Phil thinks Duke is the best team in college basketball even after they were thumped by North Carolina last night.)

Now, as to the particulars of Johnson & Johnson versus Pfizer, the most important point to be made here is that both are great companies. 101 years ago, Johnson & Johnson was incorporated to begin financing the further development and sale of surgical dressings to reduce the threat of disease and infection in operating rooms. And as the Drip Portfolio explained a few months back, Pfizer provided 90% of the penicillin delivered to Normandy on D-Day.

Both companies have grown primarily out of a societal need. They were not conceived out of the hopes of a small executive team to strike it rich in the public markets. Not surprisingly, both companies have generated extraordinary long-term returns for their partnering shareholders. Just since 1971, while the S&P 500 has grown at an annual rate of 10.7%, Johnson & Johnson has risen at 13.1% per year while Pfizer has grown at a rate of 16.2% per year (all figures do not include dividends).

How do their businesses differ? Johnson & Johnson sells everything from Motrin to Mylanta, from Tylenol to ACUVUE disposable contact lenses. Pfizer is mostly a pharmaceuticals company, with its $2 billion heart drug, Norvasc; its $1 billion depression drug, Zoloft; and its other billion-dollar offering, Procardia, used to treat hypertension.

But why would someone pick Johnson & Johnson over Pfizer, or vice versa?

Johnson & Johnson has a broader mix of products than Pfizer, from toothbrushes to joint replacements. The range of offerings makes its business less risky than Pfizer. The financial model is hedging across the adjacent industries of pharmaceuticals, medical instruments, and consumer products. Only 33% of Johnson & Johnson's business currently comes from the sale of pharmaceuticals. Over at Pfizer, 70% of its business comes via drug sales. So one key difference between the two is in the diversification of their product lines. It's something like the difference between two stock portfolios -- the first with twenty different investments in seven different industries, the second with eight different investments in three different industries.

In purchasing Pfizer, we've decided to invest in the equivalent of that second portfolio. It engenders greater risk, which allows for greater reward. Because your Cash-King researchers believe in Pfizer's business model and its strategic directives, we're willing to assume that additional risk. We believe in Pfizer's concentrated approach on drug development and gleefully await the flurry of its new products over the next decade. If we're wrong, we do still expect attractive returns over the long haul (but probably an underperformance of Johnson and Johnson). But if we're right, we believe we'll be richly rewarded -- quite possibly in excess of all its competitors.

Those divergent expectations make sense to us. After all, even though Johnson & Johnson derives only 33% of its sales from pharmaceuticals, over 58% of the company's earnings come from drug sales. In other words, as you might expect, pharmaceuticals are a significantly more profitable item than are surgical instruments. The proof is in the pudding. Three things stand out to us:

1) Johnson & Johnson's trailing profit margins sit at 14.6%, while Pfizer's are 17.7%.

2) Superior pharmaceutical products naturally "move" more quickly than superior medical instruments. Pfizer's Flow Ratio (defined in our 11 Steps to Cash-King Investing) is 0.92 while Johnson & Johnson's is 1.46.

3) The relationship between cash and long-term debt is slightly more attractive at Pfizer.

Does this dictate that Pfizer is definitely going to outperform Johnson & Johnson over the next 10-15 years? Certainly not. In our opinion, Pfizer is in a financially stronger position than Johnson & Johnson, but its business assumes additional risk for that sterling financial position. Pfizer has concentrated the lion's share of its attention on developing and selling the higher-margin pharmaceuticals. It has narrowed its product mix and forced substantial investment into marketing that line. Johnson & Johnson is in a weaker financial position but has hedged their business with a wide range of offerings and has the power of consumer branding on its side.

Let the horserace begin!

Fools, so much of this depends on your style of investing. With Pfizer, our CK mentality has us willing to assume a little additional business risk as well as a markedly richer valuation (JNJ at 29x earnings, PFE at 48x earnings) for what we believe could prove more rewarding.

With Johnson & Johnson, you have a company that's been around for 101 years, pushing earnings ahead methodically as it diversifies its business. With Pfizer, you have rock-solid financials mixing with a high potential of blockbuster drugs in the pipeline. It really does all come back to your personal investment approach and to the present allocation of your portfolio. These are both Obviously Great Investments (as defined in You Have More Than You Think and The Motley Fool Investment Workbook). I simply couldn't end the weekend without a little book plug.

Good luck out there, let's discuss this more in the message folders, and... have a wonderful weekend, Fools.

Tom Gardner ([email protected])

TODAY'S NUMBERS

Stock  Change    Bid 
 ---------------- 
 MSFT  +2 3/4   158.13 
 PFE   +1 1/4    81.00 
 TROW  +  3/4    66.88 
 
                   Day   Month    Year  History 
         CASH-KI  +0.24%  -0.11%  -0.11%  -0.11% 
         S&P:     +0.89%   3.28%   4.33%   1.11% 
         NASDAQ:  +1.04%   4.63%   7.90%   2.51% 
  
     Rec'd    #  Security     In At       Now    Change 
    2/3/98    12 Microsoft    156.54    158.13     1.01% 
    2/6/98    28T. Rowe Pri    67.35     66.88    -0.70% 
    2/3/98    22 Pfizer        82.30     81.00    -1.58% 
  
     Rec'd    #  Security     In At     Value    Change 
    2/3/98    12 Microsoft   1878.45   1897.50    $19.05 
    2/3/98    22 Pfizer      1810.58   1782.00   -$28.58 
    2/6/98    28T. Rowe Pri  1885.70   1872.50   -$13.20 
  
                               CASH  $14425.27 
                              TOTAL  $19977.27