Invest in Johnson & Johnson and Still Enjoy Diversification

Investors who like a given stock and have a relatively high degree of conviction in that single company have a choice: They can invest directly in that single stock, or they can buy a sector exchange-trade fund in which that company occupies such a large position.

The ETF structure can smooth out the single-stock risk and provide diversification--even for an investor with fairly strong conviction in a name. On the other hand, investing in the lone stock, can expose an investor to more volatility and event risk, with no diversification whatsoever. Investors should always be able to identify their specific investment thesis. For long-term core positions, there's a good chance that investors can get their desired exposure through ETFs. In the case of a shorter-term tactical bet (or a satellite position), the line can get blurred more, and an individual stock might be a better choice for an investor. But the key is always to match one's thesis with the investment vehicle most closely matching its conclusion.

It is not hard to find examples where buying a sector ETF would have protected investors. An investor in BP BP, which has been reeling from the Deepwater Horizon oil spill in the Gulf of Mexico during the first few months of 2010, would have experienced a painful 29% loss since the beginning of the year. By contrast, a holder of iShares S&P Global Energy IXC, in which BP is the third-largest position at about 5% of assets, would have gained more than 1% over the same interval.

Johnson & Johnson's Recent Challenges
With this in mind, it's worth exploring whether an ETF is an appropriate vehicle to invest in beleaguered health-care behemoth Johnson & Johnson JNJ, which has experienced no shortage of recent woes. Johnson & Johnson has been flayed by a raft of embarrassing product recalls recently that not only have shaken investor confidence in the firm, but also have driven sales down in its consumer business. This, along with sluggish sales growth in its large medical devices division, has led investors and Wall Street to increasingly view Johnson & Johnson as a turnaround.

In the wake of a string of recent recalls of over-the-counter medicines such as Tylenol, Motrin, and Benadryl, sales of nonprescription drugs were down 40% in the third quarter (with total U.S. consumer sales down almost 25% and global consumer sales down about 10%). Other hiccups for this health-care titan as of late include the recalls of contact lenses, faulty blood glucose test strips, and ineffective hip implants. No one should minimize the seriousness of the hit to the drugmaker's image in the minds of consumers. Johnson & Johnson has built a sterling reputation based on product quality and safety: A series of product recalls could make both consumers and investors alike conclude that something is wrong with the company's underlying production process, begin permanently steering clear of its consumer products at a minimum, and potentially avoiding some of its nonconsumer products as well.

On top of all of this, Johnson & Johnson has been experiencing tepid growth in its medical-devices business, which is its largest segment, as the number of hospital procedures worldwide has been negatively affected by weak economic conditions. Probably the brightest spot for Johnson & Johnson in its recent results has been its pharmaceutical division, which has enjoyed successful new product launches and relatively minor patent losses.PAGEBREAK

Through the end of October, Johnson & Johnson's stock price reflected its struggles, with the company falling 1.0% as the broader S&P 500 rose more than 6% for the year.

Despite these challenges, Morningstar's equity analysts remain confident that Johnson & Johnson will right its ship, and they continue to believe that the company's diverse operations and its wide moat--which our equity analysts define as sustainable competitive advantages--should be able to mitigate current problems. An investor with a bullish viewpoint toward Johnson & Johnson could point to a variety of attractive long-term attributes that the company possesses, including its 3%-plus dividend yield, its healthy drug pipeline (which includes several potential blockbuster drugs in late-stage development), its significant free cash flows, and its market-leading positions (it's number one or two in 70% of its products). Moreover, attractive demographic trends (aging baby boomers) should provide a tailwind for the health-care sector, in general.