M1 Finance : 1-year review

School season has begun here in the US, and as a parent, this usually means busy weekdays. But thankfully, I am going in with an investing strategy specifically catered to this very situation i.e. I can focus on my work and life while my invested capital works in the background to generate more cash.

I mentioned in one of my previous posts regarding how I have been using M1 Finance for my individual brokerage account to manage my dividend portfolio. I have now spent over an year with this firm and I thought it was a good time to sit down and start penning down my thoughts about this brokerage service, things I like about it, things that I don’t quite like as much and looking ahead.

Hopefully, this will serve as a honest review of the brokerage service for someone that is getting started in investing and looking around for a brokerage.

Why did I choose M1 Finance to begin with?

There are plenty of options available to the average retail investor in terms of brokerage services here in the US. Firstly, there are the big-name established brokerage firms that have been around for a long time such as: Vanguard, Fidelity, Charles Schwab, E-Trade etc. Then, there are the relatively newer options such as Robinhood, WeBull, Acorns, M1 Finance etc.

About an year back, I wanted to explore this space a little. I already had exposure to some of the big-name brokerage firms because of some employee-based stock plans, retirement accounts etc. And while these brokerage firms are stable and the services they offer are reliable, the overall experience of investing through them was a little inefficient. For instance, the user-interface (UI) available on the web-portal to the retail investor seems either so dated, or very confusing or just needs some improvement.

In contrast, the new kids-on-the-bloc were offering a refreshing experience in terms of the UI, including better mobile apps, zero-commission fees on trades and also the option of trading with fractional shares. The zero-commission fees on trades, in particular, was a significant game changer and, now, several of the big-name brokerages also offer the same service to the average retail investor. Given that I already had some accounts with the big-name brokerage firms, I decided to give one the newer options a try, and chose M1 Finance based on some initial research.

Another thought that was brewing in my head: While my wife generally has no interest in investments and finance-related matters in general, I did not want to scare here away by using a brokerage whose interface was too verbose, confusing and overwhelming for the first time user. Perhaps, a more beginner-friendly refreshing UI might even ease her into this work, if she wanted to dabble in it for any reason whatsoever.

M1 Finance – quick peek

M1 Finance has a unique approach in terms of how an investor can maintain his/her portfolio. The portfolio is maintained as a “pie”, wherein each pie is a collection of stocks or more pies called “slices”. M1 Finance offers a collection of example pies that the investor can choose from OR the investor is free to build his/her custom pie.

Image Source: M1 Finance

The investor can allocate percentages to each of the “slices” within the pie such that they total to a 100%. The allocations can be changed at any time during the life of the portfolio. When the investor deposits cash into the brokerage account, M1’s algorithm uses the cash to issue trades such that they conform the percentages allocations set by the investor. M1 also offers an “auto-invest” option such that this process can be automated. Whenever a specific allocation percentage goes over the target allocation set by the investor, M1 auto-trading algorithm classifies this slice weighting as overweight and instead invests any new deposited cash towards slice weightings that are underweight.

Trades on M1 can only happen during mornings when the markets open for the day. M1 plus, another tier of membership, offers afternoon trades as well. However, M1 plus membership comes at a cost of $125/year, at the time of writing this post.

M1 offers services such as regular individual brokerage account, Traditional and Roth IRA accounts, custodial accounts, trust accounts etc. They also offer other banking services such as M1 spend (debit card), M1 credit card with 2% cash back that gets automatically reinvested into your investment account, M1 borrow (loans) etc. I have not used any of the other services outside of the investment account.

Source: Reddit

The Good

1. Excellent user-interface: The user-interface for both the website as well as the mobile APP (I have tried iPhone APP) are phenomenal and refreshingly better than some of the big-name counterparts. I have generally never had any issues with the UI and it has operated reliably during the last one year. It is extremely easy to place a trade and very easy to track portfolio performance using their time-weighted return metric. The landing page of your portfolio typically shows a graph of over portfolio’s total worth since the day it was first created. In addition, it is easy to track how much dividends have been earned during the entire lifetime of the portfolio, or simply doing the last week, month or day. It appears that M1 has eliminated a lot of clutter and kept the user-interface simple for the beginner investor.
2. Unique approach to portfolio management: The “pie” based view does take a little while to get used to, but once you get it, it is actually a pretty simple way to manage a portfolio. For instance, your portfolio could be based on something like a lazy 3-fund portfolio i.e. three ETFs or index funds: one corresponding to the total stock market, one to the total bond market and one the international stock market with a percentage split for each of the funds. It makes complete sense to have this represented as a “pie” with each “slice” being one of these three funds. It then becomes very easy to which “slice” has grown to be overweight and where you could deposit your capital to ensure that your target allocations are maintained.
3. Auto-invest: The auto-invest feature is pretty interesting. If I wanted to put my portfolio management into “auto-pilot” mode, I could do so with M1’s auto-invest feature. I would simply need to setup a “auto-deposit” from my banking account such that a fixed amount of cash would be withdrawn each month/week and deposited into my brokerage account. Once the cash lands here, it will be automatically used for trading per the target allocations for each of my stocks/slices. This removes emotion out of the investing and place trades at regular intervals by simply dollar-cost averaging into positions that are underweight.
4. Fractional shares : I think this particular feature is a game-changer. If I can own a piece of Amazon (ticker: AMZN, trading at $3316 at the time of writing) or Google (ticker: GOOGL, trading at $2828 at the time of writing) with just $50, that is not at all a bad deal. There is a good possibility that I may not have enough capital at a given time to own one share of AMZN or GOOGL. A lot of the big-name counterparts still do not offer fractional shares but this is slowly changing.

The Bad

1. Customer Service: The customer service experience with M1 has been a mixed bag. While it was pretty great when I started out with it, there were days when it would be impossible to get a real person to talk to either over the phone or via email. This is a pretty fundamental aspect of a brokerage service. I should be able to reach out and talk to a real person if I have questions about the account, my statements or any feature on the portal.
2. Moving holding between “pies”/”slices”: This is perhaps the most frustrating aspect of M1 Finance. If you add a stock to a particular “pie”, and invest with that configuration, if you have to move the same stock over to a different “pie”, you cannot do so readily and there is a possibility that the act of doing so will cause you to sell the stock and then re-buy it for the same amount in the new pie configuration. This is not ideal for several reasons: this would change by cost-basis for the stock, and would also be classified as a taxable event. To explain this with an example, say I was interested in investing in Visa (ticker: V), but I placed in a pie called “Finance” and bought 10 shares of V. Say I now wanted to move this holding into a new pie called “Technology” (because Visa can be classified as a Technology company as a well), I would not be able to do so without first selling my shares for V from my “Finance” pie and then re-buying shares worth the same amount in my new “Technology” pie. It appears that people have been requesting this feature since the last few years now, but M1 does not really have a clear answer for this.
3. Apex clearing house: M1 uses Apex as their clearing firm on the back-end. While this has not turned out to be a huge problem during the last year, I need to open a separate account with Apex clearing to have access to data regarding my portfolio with M1, such as stock trades placed, cost basis etc. I would rather have this data be made available through M1 itself rather than have to go through a second source of information.
4. FINRA / SIPC: Reputable brokerage firms in the US are all registered members of SIPC and/or FINRA. Per SPIC regulations, M1 Finance can support customer claims of upto $500,000, with $250,000 is cash claims. While M1, through their Apex clearing house, claims to have additional insurance over SIPC coverage, it is not clear if it would be a safe option to maintain your assets with this firm if and when your portfolio exceeds this amount. In comparison, the big-name brokerage firms have been around for a lot more longer and are more reputable and trust-worthy for larger portfolios.
5. Trading windows: As things stand, M1 only allows you to trade stocks at one (two if using M1 plus) time during the day. And this is early in the morning when markets open up. This clearly means that M1 is NOT suitable for day-trading. This is not such a huge deal for me, since I am a long-term investor, Having said that, I would like to have the flexibility to buy stocks when I please or when I sense an opportunity at any stage during the day when the markets are open. I would like decide for myself when to buy or sell a stock rather than have a restriction imposed on me due to my brokerage service.

Summary

I am pretty happy with trying out M1 for a year, but I think the time has come to move my investing journey over to a different brokerage due to the cons I have listed above. At present, Fidelity seems to be offering a good option for a move. They are a firm that has been around for a really long time. So I will have absolutely no concerns about insurance coverage for my assets if it grows into a large value. They have recently updated their user-interface to catch up to the modern age, offer fractional shares (atleast through their mobile app) etc.

Eventually, I would also like to begin trading options to supplement my monthly dividend income. M1 does not offer this option at present, and Fidelity does.

The transfer of assets from M1 will result in a taxable event, since the existing fractional shares will not be transferred and would have to be sold. But this is not so much of a concern for me since this move is the right thing to do from a long-term perspective.

I might return back to M1 Finance for a new account if things improve and if they have actively worked on some of my concerns listed above.

Until next time…

Disclosure: Long V, No positions in AMZN, GOOGL in my dividend portfolio.

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Costco – Deep-dive Analysis

Time for another deep-analysis post. In my last post in this category, related to Johnson and Johnson, I covered one of my “Core” holdings. In this post, I would like to cover a holding from the “Growth” category. As I have stated previously, the “Core” holdings represent the “sleep-well-at-night” category i.e. the foundation of my dividend growth portfolio. On the other hand, the “Growth” category are relatively early in their dividend growth history. These stocks are currently in an aggressive phase of growth and will (hopefully) continue to be in this phase for atleast the next decade or so. Eventually though, these companies will graduate into the “Core” category. But my hope is that, I will be in my retirement by that point in time. 🙂

Alright, enough with the background! Lets dive into the deep analysis for Costco (ticker: COST)

History & background

My first introduction to Costco was when I went to shop there with my room-mates, one of whom was a Costco member. I was a graduate student back then and, like all people in their student-life, very watchful of what I am spending on and eventual load on my wallet. The Costco business model seemed very interesting at first glance: Unlike other big-box retail stores, the store is a warehouse with controlled entry and exit points. The available merchandise is limited, but items could be bought in bulk quantities at a cheaper average cost to the consumer. The catch is that the consumer has to sign up for a Costco yearly membership, and there are three distinct levels of membership with each level having their own perks.

Costco made its humble beginnings when it opened its first warehouse back in September,1983 under the leadership of Jim Sinegal and Jeff Brotman. Among the two founders, I was particularly impressed with Jim Sinegal’s background. From starting out as a grocery bagger in FedMart, he worked his way up the chain to eventually becoming the VP of merchandising and distribution.

A few years ago, I read about Jim in the book titled “The Everything Store” , which was Jeff Bezos’s biography. In a breakfast meeting that Jeff had with Jim, Jim explains Costco’s business model as follows:

Though the selection of products in individual categories is limited, there are copious quantities of everything there – and it is all dirt cheap. Costco buys in bulk and marks up everything at a standard, across-the-the-board 14 percent, even when it could charge more. It doesn’t advertise at all, and earns most of its gross profit from annual membership fees... The membership fee is a one-time pain, but it’s reinforced every time customers walk in and see forty-seven-inch televisions that are two hundred dollars less than anyplace else. It reinforces the value of the concept. Customers know they will find really cheap stuff at Costco.

The other striking thing about shopping at Costco, and this is something that I have noticed across several warehouse locations here in the US, I could visibly tell that the employees there were happy. They must be being treated very well. A little digging around showed why. Here is what Jim Sinegal mentioned in one of the interviews a few years back:

It’s really pretty simple. It’s good business. When you hire good people, and you provide good jobs and good wages and a career, good things are going to happen.. We try to give a message of quality in everything that we do, and we think that that starts with the people. It doesn’t do much good to have a quality image, whether it’s with the facility or whether it’s with the merchandise, if you don’t have real quality people taking care of your customers.

Costco is known to have a better average pay rate for its employees as compared to the larger retail industry. Over 90% of the Costco employees qualify for a employer-sponsored health insurance plan, while the rest of the industry is at about 60%. It is, therefore, no surprise that Costco sees less employee turn-over rate. At the time of writing this, Costco has about 273,000 employees worldwide, operating across 800 or so warehouse locations in the world.

Business Breakdown

As stated previously, Costco uses a membership-based big-box retail store model. Members have access to limited selection of branded and private-label merchandise in larger volumes at lower costs relative to other retail stores. Costco purchases its merchandise directly from the manufacturers, routing them to specific docking points before transporting them directly to the warehouse locations. This distribution model helps them eliminate “the middle men” and helps in lowering distribution costs.

Merchandise is categorized into the following:

• Food and Sundries: including dry foods, packaged foods, groceries, candy, alcoholic beverages, cleaning supplies
• Hardlines: major appliances, electronics, hardware, garden and patio
• Fresh foods: meat, produce, deli and bakery
• Softlines: small appliances and apparel
• Ancillary: gas stations and pharmacy

I did a breakdown of the merchandise sales across these categories since 2015 and this is what I found out:

As one can see, the “Food and Sundries” category drives most of the merchandise sales. However, the sales across all categories are showing an upward trend during this time period.

As a Costco member myself, I can vouch for the quality of the products that I buy from their stores. Even the private label in-house brand, Kirkland Signature, matches the other well-known brands for quality. From my personal experience, this was especially useful when shopping for diapers and wipes. Any parent reading this post can back me up here, the number of diapers and wipes needed when you have a young one is no laughing matter, it can be quite expensive. Costco was a life safer here. I could get the Kirkland diapers and wipes from Costco at a relatively lower cost compared to other well-known brands such as Pampers and Huggies.

Another important detail for the consumer is that Costco has a fantastic return policy on its merchandise sales, 90-day return for all major appliances and no-time limit for the other merch. This makes the entire shopping experience for the consumer very rewarding.

Membership

It is amply clear that maintaining or improving the membership base is a critical metric for Costco. I wanted to explore how Costco was doing in this regard. For this purpose, I analyzed the membership data since 2015.

Year	2015	2016	2017	2018	2019	2020
Total paid members	44600	47600	49400	51600	53900	58100
Worldwide membership renewal rate	88%	88%	87%	88%	88%	88%
US and Canada membership renewal rate	91%	90%	90%	90%	91%	91%

So the total membership base is increasing steadily. From what I could tell, the average YoY growth in total number of paid members is about 6%. However, what is interesting to note is that the membership renewal rate is fairly constant during this period: 88% worldwide and about 91% in US and Canada. This is telling me that the existing members choose to renew more often that not and the number of new members is consistently growing.

I also wanted to analyze the membership fees and how much revenue Costco was earning relative to the total revenue. Here is the data since 2008.

So the membership fees are averaging around the 2.15% of the total revenue since 2008. During the same time frame, total revenue for Costco has grown at a CAGR of nearly 11%. This shows that the membership fees have remained pretty flat for more than a decade. Quite impressive!

Warehouses

I wanted to analyze the warehouse growth for Costco. Since 2010, this is what the data looks like:

Year	2010	2011	2012	2013	2014	2015	2016	2017	2018	2019	2020
Number of warehouses	527	540	592	608	634	663	686	715	741	762	782

So this shows that the average YoY growth in number of warehouses is about 4%. From the last investor presentation, Costco has about 804 warehouses worldwide. About 90% of them are in the US and Canada. About 4% of stores in Europe, about 7% in Asia (Japan, Korea, Taiwan and China) and remaining in Mexico and Australia. This represents a decent geographical spread, however there is scope for growth here as far as expanding into newer geographical markets.

Dividend History

At the time of writing this, Costco has an annual forward dividend yield of 0.71%. So nothing to get excited about there. 0.71% is well below the standard inflation rate. So why would a dividend growth investor choose to invest in Costco? The answer lies in dividend growth rate. Here is what the data looks like for the last decade

3-year Dividend CAGR	12.42%
5-year Dividend CAGR	12.32%
10-year Dividend CAGR	13.36%

So on an average a 12% dividend growth rate, and if the stock is bought at the right value, the yield on cost over the long-run would be phenomenal. If you are curious about this subject, please read my post on yield-on-cost to understand this better.

Apart from the regular quarterly cash dividend, Costco has a practice of occasionally rewarding its shareholders with a “special dividend” every now and then. The most recent special dividend of $10/share was announced last year (2020).

I also analyzed the dividend payout ratio since 2008 and found this:

So the payout ratio is currently hovering around the 30% mark. This mean that there is plenty of runway available to the Costco management to increase their dividends if they choose to do so.

Financial Performance

The central question that a dividend investor is interested in is how safe is the dividend in the long run. To answer this, I look over the company’s financial statements to decipher the following:

• Is the company’s revenue growing?
• How profitable is the company?
• What are the company’s assets and how much does the company owe in the short-run and the long-run?

For Costco, the company’s revenue is growing steadily over the last decade, as seen in the previous section. I also analyzed the Net margin since 2008 and it has remained flat for nearly a decade, this is a sign of a good stable business.

For the same period, Free Cash Flow, which I obtained by using the Cash Flow from Operations less Capital Expenditures, is trending upwards.

I then analyzed the trendlines for assets as compared to liabilities.

In this case, I am looking for trendlines that are diverging apart with assets growing much faster than liabilities. And the above graph reinforces that.

I also looked at the total number of shares outstanding on the filing date for the same time period.

Ideally, I would like to see a trendline that grows downwards. But in this case, I see an trendline in the opposite direction. Share buybacks, when done for the right reasons, will boost shareholder equity. This is not concerning at the moment, but it is something that I will keep an eye on in the long-run.

For my final analysis, I wanted to see how the stock has performed for a long-duration with dividends re-invested as compared to other big-box retailers. For this analysis, I picked Walmart (ticker: WMT) and Target (ticker: TGT). The comparison with Walmart was going to be particularly interesting, since Walmart also highlights how they offer products at a lower-cost to the customer. The model uses a hypothetical $10,000 invested starting at 1995 to present.

Costco has absolutely crushed this with a total return of almost 6800% as compared to Walmart’s 1655%! The comparison between Costco and Target is more closer in this respect with both stores offering relatively similar total returns.

Valuation

At the time of writing this, Costco is trading at a forward Price-to-Earnings ratio of near 41. So right of the bat, it is ridiculously overvalued based on this metric alone. I actually went back through historical data to see the trend in PE ratio since 2008.

So the PE has been trending up and it is at its peak at present. I used two other models to estimate the fair value. I performed a Discounted-Cash-Flow evaluation with a perpetual growth rate of 2.5% and FCF to Profit Margin ratio estimate of ~90%. After accounting for debt and also adding in a margin of safety, my fair value estimate is about $209. I also used a two-stage Dividend discount model evaluation and this yielded a fair value of roughly $266. At the time of writing this, Costco is trading at a price to $447. So clearly, well over my fair value estimates.

Management

I have already talked about Jim Sinegal above. He was the CEO and chairman of board until 2011 and remained on the board until his retirement in 2018. The current CEO and chairman of board of directors, Craig Jelinek, has almost been with Costco since its early days. He started out as a warehouse manager and worked up the ranks to now become the CEO.

Craig has not changed a whole lot of the company’s core founding principles since Jim’s departure. But as far as Costco’s business, he has transformed the company into a retail powerhouse. At the start of 2021, Costco was the 3rd largest global retailer and 14th in the list of Fortune 500 companies, with a market cap of almost $164 billion.

The board of directors also includes a name that most people in the investing community are familiar with, Charlie Munger. Charlie, in numerous interviews, has raved about Costco’s business model and it is not surprising to see why.

As seen through Glassdoor, Costco sees favorable rating amongst its employees with about 90% of them approving of the current CEO.

Risks

Every investment comes with its share of risks, and even a great company like Costco is no different. The biggest risk that Costco faces is its competition with another heavy weight like Amazon. A few years back, when Amazon bought the Whole Foods business, there was a lot of scare amongst investors about what this would mean for other retail giants such as Walmart, Target etc. Based on my research, I think Costco is well-positioned to ward off such threats. It has a unique business model with plenty of scope to grow into new areas and markets.

Summary

Costco is one of my biggest bets in the “Growth” category of my dividend portfolio. I am very bullish about this business and will always be on the lookout for adding to my existing position, whenever such an opportunity presents itself.

Do you own this stock? If yes, does your analysis line up with what I have presented above? Please let me know in the comments below.

Thank you for stopping by and reading this!

Disclosure: Long COST, TGT, no position in WMT at the time of writing this

Monthly Income Update – July 2021

There is a steady uptick in COVID-19 cases due to the delta variant here in the US. Everyone is hopeful that lockdown restrictions do not return, but the current trend is indeed worrying. While that is ongoing, earnings season is in full swing and the stock market is touching new highs every day. My dividend portfolio keeps cranking along at its own pace generating some passive income for me. How did the portfolio fare this month?

Dividend Income Received

During this month, I received dividend income from the following companies:

Company/ETF (Ticker)	Amount
JP Morgan Chase (JPM)	$6.53
T. Rowe Price (TROW)	$15.65
Realty Income (O)	$6.87
CareTrust REIT (CTRE)	$4.52
Stag Industrial Inc. (STAG)	$2.06
Total	$35.63

The dividend income received from TROW was a special dividend declared by the company on the 14th of June. William Stromberg, TROW’s CEO, said the following as a part of the press release for this special dividend announcement: “This special cash dividend is an efficient return of capital to our stockholders and reflects the healthy cash position on our balance sheet. After the special dividend payment, the company’s balance sheet will remain very strong, with ample liquidity to continue to execute on our business strategy. In addition, we believe that the payment of the special cash dividend will not have a material impact on the company’s ability to meet its ongoing financial needs, continue our outstanding dividend record for the foreseeable future, or maintain a buffer against market volatility.”

The other dividend payment from my taxable brokerage account was from JPM. There have been news reports that following the Fed’s stress tests on the major banks in the US, JPM will be hiking their quarterly dividend from $0.90 to $1.00 per share (about a 11% increase). This is still pending approval from the board of directors.

The other payments were from REITs that I hold in my tax-advantaged accounts (HSA, Roth IRA). At the time of writing this, both STAG and O have shown impressive Q2 results.

Bulls/Sells made during this period

I made the following purchases during this month:

Staying in the game purchases: CAT, JNJ, PEP, SO, DUK, TGT, TROW, UNH, V, VZ, WM, XOM, AVGO, CTRE, O, STAG

Other purchases: AAPL, LMT, CLX, MSFT, TXN, MMM, JPM, AFL, ABBV, SCHD

The “staying in the game” purchases are simply dollar-cost averaging into the stocks since the threshold for number of days since the last purchase made had expired (threshold configurable based on category of the holding in my spreadsheet setup). The tranche size is dependent on the current valuation of the stock in question (i.e. smaller tranche size for an overvalued stock).

It is getting very hard to find good value plays in what is an extremely overvalued market.There was a brief period of tech sell-off in July and I used this opportunity to add a few more shares in my Tech pie.

At the time of writing this, CLX just released its Q2 earnings report and missed its non-GAAP EPS by $0.36 and missed revenue by $110M. In addition, CLX also lowered their guidance for organic sales growth and non-GAAP EPS estimates for FY2021. Following this announcement, the stock slid by ~11%. I am hoping that this turns out as an opportunity to add more to my existing position.

I have no sells during this month.

How did your portfolio perform during July? Please let me know in the comments below.

Disclosure: Long all the stocks mentioned in this post.

Article of Interest – July 2021

Time for another addition to the “Articles of interest” category. For those of you that are new to this blog, every month I highlight articles from around the world wide web that I found valuable and learned something interesting from.

So let’s get started!

1. Introducing Behavioral Finance Theory For Individual Investors from Sure Dividend: Sure Dividend is a wonderful site for dividend growth investors with tons of useful information. I have particularly found their “monthly dividend stock in focus” particularly interesting, since they sometimes cover stocks that I had never heard about before. This specific article that I have shared here is a guest post by Artesys online on the site. I have always been intrigued by cognitive biases in individual investors and its impact on their investing- related decisions. I have written about this subject previously on my blog. This article touches on similar topics. I think this is an important subject that does not receive a lot of attention in personal finance discussions. Why so? Because at the end of the day, you are your worst enemy in terms of making objective decisions on investment. When these biases creep in, they cloud your judgement and steer you towards bad investment choices.
2. PPCIan and his video on Merck (ticker: MRK) and its spin-off Organon (ticker: OGN): While this is not an “article” in a strict sense, this still qualifies as great content. Ian Lopuch is one of the OG Dividend growth investors on the Youtube space. His videos go into all kinds of details, giving useful and interesting ways of analyzing businesses. In this specific video, Ian compares MRK and its spin-off OGN with Pfizer (ticker: PFE) and its own spin-off Viatris (ticker: VTRS). This aspect of relative valuation is very helpful in analyzing businesses, especially when they happen to be in domains which are outside the individual investor’s circle of competence. I especially loved the deep-dive into OGN’s balance sheet and the fine print disclaimer about the debt owed to the parent company MRK. This highlights the importance of looking into the company’s SEC filings and perusing the financial statements very closely. While I am not directly interested in MRK, OGN or VTRS at this time, I have PFE on my watchlist and will be analyzing this business before initiating a starting position.

Disclosure: No positions in PFE, MRK, OGN, VTRS

Johnson and Johnson – Deep dive analysis

In this post, I would like to analyze Johnson and Johnson (ticker: JNJ). This is the first of what should be a continuing series of posts, where I attempt to analyze every single holding in my dividend stock portfolio. Before going ahead, I want to state that this is by no means a recommendation to invest in Johnson and Johnson. I am simply sharing my analysis on this company for education. Please read my full disclaimer here. So, lets dive in!

My first introduction to JNJ was through their baby care products such as baby powder and baby shampoo. But very soon, I also noticed some other products around the household that also had a JNJ imprint on it, such as Band-aid, Tylenol etc.

History

JNJ was founded way back in 1886 by three brothers, Robert Wood Johnson, James Wood Johnson and Edward Mead Johnson. It was interesting to read that around this time, the practice of sterilizing equipment prior to a surgery was not common and this is what motivated Robert Wood Johnson to join his brothers into launching this business. Their first line of products included sterile surgical supplies and household medical equipment.

JNJ went public in the year 1944 and around this time, Robert Wood Johnson II drafted what is called the “Credo” document, basically a mission statement for the company. It is interesting that the Credo finds mention on JNJ’s website and their earning’s presentation even to this day and the statements are relevant in today’s context as well.

Since then, JNJ has grown through several acquisitions and is today one of the largest companies in the world in terms of market capitalization. What started as a company with only 14 or so employees, at the timing of writing this, employs over 132,000 people worldwide. Also, as things stand, JNJ is one of only two companies in the US (the other being Microsoft (ticker: MSFT)) that boasts of a AAA credit-rating, a rating higher than that of the U.S. Government. Quite incredible!

Business breakdown

JNJ’s business can be broken down into three primary segments: Pharmaceuticals, Consumer Health and Medical Devices. I found it particularly interesting looking at their recent and past 10-Ks SEC filings that Consumer Health is not the dominant part of their business, even though they have so many strong and well-known brands in the market. From the last 10-K, Consumer Health only represents about 17% of all the overall revenue, with Medical Devices making about 31% and Pharma making up the remaining 52%. Given this broad moat, JNJ is unlike other company in this domain. In fact, it is more like a healthcare ETF in its own right!

I was interested to see how the segments have been performing over the last few years. From what I could tell, most of the revenue growth seemed to be from the Pharmaceuticals segment, with the other two segments appearing relatively flat/tapering down slightly.

JNJ has been consistently spending on R&D, as it should given the very competitive nature of the business they are in. This is something that I am paying a close attention to it in their earnings presentations. From the earnings presentation in their last 10-K, I noticed that their pipeline for regulatory submissions to the US. FDA on the equivalent counterpart in the EU is reasonably full, thus driving growth for the coming few years.

Another noticeable aspect of JNJ’s sales is its geographic spread: while 50% of sales revenue comes from the US, close to 22% of revenue comes from Europe, and a good 18% or so comes from Asia-Pacific and Africa with the remaining coming from the western hemisphere. This diverse international exposure de-risks the business from over exposure to only one geographical market.

Dividend History

JNJ gets a lot of love in the dividend investing community. And it is not surprising to see why. The company has a history of increasing their dividends consecutively for 58 years, at the time of writing this. Just let that sink in for a second. 58 years includes things like the dot-com boom in the late nineties, and then the Great Financial crisis in 2008-2009. The company has been un-affected during all that turmoil and managed to return value back to their shareholders in the form of dividends.

I looked at the more recent dividend history to get a sense of the recent dividend growth rate. Here is what I could glean:

3-year Dividend CAGR	6.23%
5-year Dividend CAGR	6.17%
10-year Dividend CAGR	6.55%

So the dividend growth has been steady over the last decade with no apparent sign of slow-down. The last dividend hike was announced in April this year and it was about 5%.

Financials and Performance

The central question that a dividend investor is interested in is how safe is the dividend in the long run. To answer this, I look over the company’s financial statements to decipher the following:

• Is the company’s revenue growing?
• How profitable is the company?
• What are the company’s assets and how much does the company owe in the short-run and the long-run?

To determine is the revenue is growing, I looked at the basic EPS trend from the period of 2008-2020.

While I can see the revenue growing, the growth rate here seems to be slower than the dividend CAGR seen above. This was further confirmed when I looked at the dividend payout ratio, I could see a gradually increase in payout ratio during the same period. At the time of writing this, JNJ just released strong Q2 results for this year and raised the EPS guidance for the full year. This is a great sign and I am confident that the dividend payout ratio will sneak back into a safer range.

A quick note: For the year 2017, notice that the EPS drops alarmingly in the graph above. This is due to a change in the tax code for that financial year.

While I was on the income statements, I also looked at the Net Margin (Net Income as a percentage of the Revenue). Aside from 2017, the Net Margin seems to be around the 20% mark on an average. A steady Net Margin usually points to a strong and stable business.

From the balance sheet, I took a quick look at the debt to equity and debt to asset ratios. Here is a plot of the total debt/liabilities compared to total assets.

I am generally looking for trendlines that are converging that will prompt me to dig deeper. In this case, the trendlines seem like parallel trains, so nothing to worry about. However, when I looked deeper into the assets I could see that Goodwill is a fairly substantial portion of the total assets and it has been steadily growing in the past decade. This is not a concern at this moment, but this is something that will need to keep a close eye on in the near future.

I then looked at the total shares outstanding trendline. I am looking for a trendline that is trending downwards. Share buybacks when done for the right reasons will boost the equity value of the shareholders and as we can see through the graph above, JNJ is trending in the right direction here.

Finally, I compared JNJ to the overall S&P 500 performance. While capital appreciation is not the central goal of my portfolio, it does matter when it comes to gauging the overall performance of the stock. I have this data thanks to Dividend channel for a period of 1995-present starting with an initial capital of $10,000 and with and without dividends re-invested.

JNJ has clearly outperformed the broader market here, with an average total return of roughly 12% with dividends re-invested. To illustrate the point of why dividends matters, the total return without dividends reinvested comes up to about 10%. It is, therefore, very clear that dividends play a massive role in total returns obtained by the investor.

Management and Other Company details

While the engineer in me likes to breakdown the numbers, analyze data and evaluate business in a quantitative manner, that alone is not enough to understand the inner workings of a business. After all, numbers can only tell you so much. There are real people between those numbers and sometimes it is important to analyze business qualitatively as well.

So in that pursuit, I closely look at the management that runs the business. After all, these people are the face of the company. I listen to them speak during the conference calls and earnings presentations. Furthermore, this team provides the necessary leadership to the organization, motivates employees to perform their day-to-day roles efficiently. If a company has a fantastic balance sheet, but a clown as a CEO, it does not exude a lot of confidence in me as an investor about the long-term prospects of the business.

JNJ has this area pretty well covered though. Their current CEO, Alex Gorsky, has been with JNJ since 1988 rising up the ranks from a sales representative for Janseen Pharmaceutica to marketing, to management and finally the CEO and the chairman of the board. I really like organizations that hire from within, and where management have a long-standing history with their company.

I looked into the company’s outlook through Glassdoor to see how the employees rate working there:

The ratings are generally positive with around 95% of the employees approving of the current CEO.

Fair Value Estimation

For a fair value estimation, I used the Discounted Cash Flow model. For this estimation, I computed the Free-cash flow for a 5-year preceding period by subtracting capital expenditures from the total cash flow from operating activities. For my future cash flow estimation, I assumed a conservative net margin of 18% and computed FCF/net margin estimates based off that. I assumed a terminal growth rate of 2.5% to be on the conservative side. Furthermore, I estimated the required rate of return by using the weighted average cost of capital model (or WACC). Per my estimation, this came up to about 7%. Putting all the numbers together, the fair value of equity today, less debt and adding some margin of safety, is about $162.

At the time of writing this (EOD 8/2/2021), JNJ is trading at a share price of $172.27, so slightly above my estimated fair value above.

Risks

Any deep analysis is not complete without a discussion of risks associated with a stock pick. Even a solid business like JNJ has risks associated with it. With JNJ, as is typical with other companies in the healthcare sector, there are always risks associated with lawsuits due to consumer healthcare products or pharmaceuticals.

A few that come to mind with JNJ, is the lawsuit associated with their baby powder product, where it is alleged that the powder was contaminated with asbestos leading to ovarian cancer. More recently, there were reports of JNJ’s COVID-19 vaccine being linked to blood clots in women. At the time of writing this, JNJ is recalling their Neutrogena line of products related to sun-screens due to the presence of benzene which is considered to be carcinogenic.

Even in the presence of such risks, I am fairly confident that JNJ still has a solid foothold with its business to weather any storm.

Summary

JNJ is one of my “sleep-well at night” stock picks and I am fairly confident that this business will remain relevant in my lifetime at-least. It is for this reason that I have put it in the “Core” category of my dividend portfolio. However, as with all things in life, even a solid company like JNJ will cease to exist one fine day. It is for this reason that I manage a diversified portfolio with stock picks from different sectors.

Disclosure: Long JNJ