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Better Buy: Johnson & Johnson Stock or the Entire S&P 500?

By James Brumley - Apr 29, 2021 at 7:52AM

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Investors have been embracing momentum for a while. Is that trend about to reverse?

The S&P 500 Index (^GSPC 0.16%) hit record highs (again) earlier this week, and is up to the tune of 45% over the past 12 months. By contrast, shares of Johnson & Johnson (JNJ -0.77%) are only up about 6% over the same time frame, and are trading where they were in late January. Lawsuits over carcinogens in the company's talcum powder led to billions of dollars worth of claims against it, which naturally weighed on the stock. More recently, a key headwind has been potential problems with its coronavirus vaccine.

However, investors shouldn't buy companies (or index funds) simply based on where they've been -- the more important question to answer is where they are likely to be going. And to predict that, investors have to make forward-looking judgment calls, weighing the potential risks against the potential rewards for all available choices.

In this case, let's narrow the field and compare just two options.

Woman's standing on sidewalk, choosing between two chalk arrows pointing in opposite directions.

Image source: Getty Images.

The case for Johnson & Johnson

If you've been less than impressed with Johnson & Johnson of late, you're not alone. While the Centers for Disease Control and Prevention and the Food and Drug Administration have lifted the brief pause they imposed on the use of its COVID-19 vaccine in the United States, the blood-clotting concerns that led to that suspension this month are still out there. Though many people remain willing to get inoculated with the vaccine, and the risk involved is extremely low, it's likely many who know about the report would prefer an alternative if asked.

This latest trouble for Johnson & Johnson comes as it's also trying to put behind it a raft of lawsuits linked to allegations that the company knew its popular talcum powder was tainted with asbestos, which can cause cancer. In February, the company earmarked $4 billion for prospective legal settlements. The matter remains fluid, but the end is in sight -- and it's not compelling. Then there is the company's potential for a share of liability relating to the nation's opioid crisis (the subject of its own lawsuits) or the logistical headaches it has faced due to the pandemic.

But even with all these potential issues, none change the fact that Johnson & Johnson remains a reliable cash cow that easily supports its steadily growing dividend.

The graphic below puts things in perspective. With its mix of consumer products, prescription drugs, and medical devices, Johnson & Johnson's sales and earnings growth rates before the pandemic were solid, and they are projected to remain so for years to come.

Johnson & Johnson is a reliable cash cow, steadily growing its top and bottom lines to support its dividend.

Data source: Thomson Reuters. Chart by author.

So why is this blue-chip stock lagging the overall market? The company has been beset by brand-damaging revelations for years now, which detract from the "consistency" thesis for buying the stock. However, once the pandemic in the U.S. fades as a health crisis, and the company deals with its legal woes and puts firm numbers on its liabilities, the market is going to remember how much of a juggernaut Johnson & Johnson is.

That time may be coming sooner than later, but even if its resurgence is delayed, the risk of missing out on more upside from J&J shares is greater than the risk of experiencing further downside first.

The case against the S&P 500

That's not the case for the broad market though.

Giving credit where it's due, companies in the index are working their way out of 2020's coronavirus slump. Standard & Poor's estimates this year's Q1's net income for the S&P 500 will be 25% stronger than last year's first-quarter bottom lines, en route to a 45% earnings improvement for the full year. Indeed, large-cap company earnings should reach record levels this year thanks to federal economic stimulus efforts that did what they were designed to do. That's a key reason that Wall Street recovered as quickly as it did, well before any coronavirus vaccines were approved.

Yet the rally has carried stocks too far, too fast, and at the worst possible time.

Ever heard the phrase "sell in May and go away?" Such adages rarely hold up to scrutiny when the data is put to the test. But this one holds water. Gains are still statistically more likely than losses for the month, and for the past few decades, May has delivered very slight average gains for investors. June's average gain is even smaller though, and while July is historically a bit bullish, August and September are typically down months for the market.

Bolstering this calendar-based concern are today's high valuations. The S&P 500's trailing four-quarter P/E ratio (assuming Q1's estimates are on target) stands at 28.8, and at 23.5 times this year's expected profits. The S&P 500 index is priced at 20.2 times next year's projected earnings. While it's not outrageously overvalued, those metrics are above the index's historical average P/E of less than 20 at a time when the market can't afford such a vulnerability. Even by a more contemporary (since the year 2000) average trailing P/E ratio in the mid-20's the market's valuation is strained here.

Stocks are headed into a traditionally slow part of the year technically overbought and fundamentally overvalued. Even if we don't see a drop off in the market over the next several weeks, there's seemingly little upside left to tap while we wait for companies' earnings to catch up with their share prices.

Bottom line

At another time against another backdrop, another conclusion might be drawn. A large part of smart investing is ultimately risk management. Right now, investors may want to scale back on broad-based, marketwide bets and become stock-pickers again -- at least for a while -- because the S&P 500 doesn't offer good enough odds of large enough rewards to justify its risks. The bullish case for Johnson & Johnson and a few other recently underperforming names should become clearer once investors are forced to look for such lower-risk investment options.

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Stocks Mentioned

Johnson & Johnson Stock Quote
Johnson & Johnson
JNJ
$178.14 (-0.77%) $-1.38
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$3,831.39 (0.16%) $6.06

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