Does Johnson & Johnson Still Fit With Warren Buffett's Investing Strategy?

There are few investors in the world with a more chronicled investment history than the Oracle of Omaha, Warren Buffett.

Starting his investment career more than 60 years ago, Warren Buffett's investing strategy managed to turn less than $10,000 in lifetime savings into a net worth of more than $71 billion as of last Friday's close. What Buffett has done throughout the years is amazing, but it's also quite replicable as long as investors are willing to stick with their investments over the long term and focus on buying high-quality businesses, which often pay handsome dividends.

Because of Buffett's success, he's developed quite the following. In fact, Buffett has become such a household name in the investment world that whenever his conglomerate, Berkshire Hathaway (BRK.A -0.59%) (BRK.B -0.74%), buys or sells stock investors take notice, sometimes following suit. Considering Buffett's track record, there have been few reasons over the years to bet against Warren.

Although Berkshire's portfolio is predominantly focused on financials, one healthcare stock that Buffett has been attracted to, and of which his company currently owns 327,100 shares equaling about $35.4 million dollars, is healthcare conglomerate Johnson & Johnson (JNJ 0.05%).

The question, though, is this: With Berkshire Hathaway selling a majority of its stake in J&J over the past seven years (Berkshire once held 61 million shares), does Johnson & Johnson still fit with Warren Buffett's investing strategy?

Reasons why J&J should stay in Buffett's portfolio
Despite Buffett parting ways with a significant chunk of his Johnson & Johnson holdings, there are still plenty of reasons why the Oracle of Omaha may want to consider hanging onto those final 327,100 shares.

For starters, few stocks offer consistent dividend growth like Johnson & Johnson.

Graph by author, Data source: Johnson & Johnson.

For the past 52 years Johnson & Johnson has raised its dividend, to the delight of its shareholders. J&J is currently paying out a delectable 2.6% yield, which is nicely above the S&P 500 average and only marginally lower than a 30-year U.S. Treasury bond. Furthermore, with a full-year payout of $2.80 per share and Street expectations that call for $6.21 in EPS in 2015, J&J's payout ratio is still only 45%, meaning more dividend hikes are probably on the way.

Second, Buffett loves inelastic businesses that can stand the test of time; and Johnson & Johnson certainly offers businesses that hardly even flinch when the U.S. economy dips into recession. J&J is broken into three business segments: pharmaceuticals, medical devices and diagnostics, and consumer products. Its consumer products division might have the slowest growth potential of the three, but sales in this area are highly predictable, which Buffett loves. Further, pricing power among all of J&J's segments is strong. Pharmaceuticals and medical devices are generally non-commoditized businesses, leaving J&J to reap the rewards of price increases.

Another key point is that Buffett likes investing in long-term business trends. The Affordable Care Act, which readers might know best as Obamacare, is expected to dramatically increase preventative care visits in the coming years, as well as boost hospital visits. Although it could take a few years to sort out the costs of implementing this sweeping health reform, the idea is that J&J's segments, including medical devices and diagnostics and pharmaceuticals, should see an increase in demand.

Finally, J&J's management team exudes trust. While I feign to call any company perfect -- and J&J certainly isn't perfect, having agreed to pay $2.2 billion in fines tied to its promotion of Risperdal, Invega, and Natrecor -- J&J's management team is transparent, and there's been very little movement in terms of hiring and departures from top executives.

Reasons why it could be time for Buffett and J&J to part ways
However, there have to be clear reasons why Berkshire Hathaway and Buffett have parted ways with a majority of their J&J shares. Here are a few reasons why I suspect this may have occurred.

First, Johnson & Johnson may be getting too big for its own good. It's possible that J&J could break up into three separate components: a slow-growth, high dividend consumer products company; a slightly faster-growth medical device and diagnostic company; and a high-growth pharmaceutical company. As of now Johnson & Johnson doesn't seem keen on the idea of breaking into separate components. However, Buffett tends to shun companies that get too big or complicated for their own good. If Buffett can't quickly explain what a business does, he tends to avoid it.

Source: Johnson & Johnson.

Secondly, the pharmaceutical business is beginning to play an even bigger role in J&J's growth. For investors, the strength in J&J's drugs approved since 2009 has been a major boon to its share price (and even Buffett would have little grounds to complain here). However, as the importance of the pharmaceutical side of the business grows for J&J, the need for Buffett and his team of money managers at Berkshire to keep up with clinical data at J&J also increases. Buffett has made no qualms about his lack of desire to keep a close eye on clinical data.

Finally, Warren Buffett's investing strategy has always angled his money toward value stocks. Though Johnson & Johnson's current valuation isn't in nosebleed territory, it is trading at nearly a 10-year high in terms of price-to-cash flow, and is at a 10-year high when it comes to price-to-sales. Buffett may simply be viewing J&J as nearing a fair valuation here and pulling some of his chips off the table.

Will J&J stay in Buffett's portfolio?
Personally, I view Johnson & Johnson's size, and not its valuation or growing pharmaceutical business, as the biggest reason why Buffett parted ways with most of his J&J shares. However, I still believe there's enough steady growth potential here that Buffett will hang onto his remaining shares, and perhaps even rebuild the position on a healthy pullback.

Source: Johnson & Johnson.

Specifically, I suspect Buffett will take comfort in the steady growth potential of its consumer products division, as well as the fact that its pharmaceutical portfolio has both longevity (14 new drugs approved since 2009) and diversity. Even when its best-selling drug Remicade cedes way to generic competition in a few years, it won't be a cataclysmic event for J&J since less than 10% of its total revenue year-to-date comes from Remicade.

Overall, with a premier dividend, incredible business diversity, and strong pricing power, I believe Buffett can still hold onto his shares of Johnson & Johnson and sleep easy at night.