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.

Plus, we believe that the company is taking these recalls seriously and is working to improve its manufacturing deficiencies and establish better procedures in its plants going forward. And throughout this painful recall process, we continued to be amazed at Johnson & Johnson's general resiliency relative to a much smaller peer like Boston Scientific BSX, whose stock price hasn't recovered from recall issues earlier this year.

Johnson & Johnson is trading at a forward price/earnings ratio of about 12.6 times, a full point and a half below that of the S&P 500. A long-term investor certainly could make the case that given its present valuation and its average 12% annual earnings growth for the past decade, quality is on sale right now.

Using ETFs to Gain Exposure to Johnson & Johnson
For investors who are cautious but nonetheless intrigued by the idea of adding exposure to the bruised Johnson & Johnson in their portfolios while avoiding single-stock risk, an ETF may be the way to go. One of ETFs' greatest benefits, of course, is diversification, and there are several ETFs in particular that offer significant exposure to Johnson & Johnson while at the same time continuing to offer investors exposure to other large, high-quality health-care-related names.

Pharmaceutical HOLDRS--Concentrated and cheap exposure to big pharma
For investors who want the exchange-traded product with the greatest exposure to Johnson & Johnson, we would recommend Pharmaceutical HOLDRS PPH, a fund that is a member of Bank of America's Merrill Lynch subsidiary's HOLDRS family. Like traditional ETFs, PPH trades on an exchange; but unlike ETFs, it does not track an index. Instead, PPH's current holdings are static and reflect the selections that Merrill made at the fund's January 2000 inception.

Given the sheer amount of consolidation in the space, many onetime PPH holdings have been gobbled by other players. Investors interested in taking a trip down memory lane will remember the former publicly traded companies and onetime PPH holdings such as Jones Pharma, Warner-Lambert, Ivax, Advanced Medical Optics, Wyeth, and Schering-Plough. These companies' disappearance has left some of the remaining 15 pharmaceutical stocks in PPH to reach large position sizes. Currently, Johnson & Johnson accounts for 25% of PPH-- meaning it would be a suitable option for investors who want exposure to Johnson & Johnson while still being protected by the 75% of the HOLDRS portfolio that is invested in other big pharma players such as Pfizer PFE (which comprises 19% of assets), Merck MRK (17%), Abbott Laboratories ABT (11%), and Bristol-Myers Squibb BMY (7%).

Given Johnson & Johnson's large position in Pharmaceutical HOLDRS, it should not be surprising that PPH's performance in 2010 so far largely has mirrored Johnson & Johnson's, although PPH has fared slightly better. Through the first 10 months of the year, PPH has been down 0.7%.

Health Care Select Sector SPDR--High quality with lots of big pharma
Another ETF that offers a large but manageable helping of Johnson & Johnson is the Health Care Select Sector SPDR XLV, where it occupies a 14% position as the largest name in the portfolio. XLV, which holds just over 50 health-care names, is a portfolio full of high-quality, North American health-care companies, with about half the assets being big pharma firms. And at a 0.21% fee, XLV is incredibly reasonably priced on both an absolute and a relative basis. Similar to PPH, XLV has lagged broader benchmarks this year, with its stock price up just 0.3% through the first 10 months of 2010.

Vanguard Health Care ETF--Broader portfolio but still inexpensive
Another option for investors would be Vanguard Health Care VHT, where Johnson & Johnson makes up a 12% weighting. Despite Johnson & Johnson's large weighting, the ETF is a much broader (and therefore diversified) portfolio of nearly 300 companies. The diversity, which comes in part in the form of greater exposure to small- and mid-cap stocks (which together make up more than 25% of VHT), has helped to make VHT the best performer in 2010 of the options listed here. Indeed, VHT returned more than 2.5% through the year's first 10 months.

IShares Dow Jones US Health Care--Cheaper options can be found elsewhere
A markedly more expensive option for investors would be iShares Dow Jones US Health Care IYH. Johnson & Johnson comprises nearly a 13% position in the fund, which holds just over 125 companies and tracks the health-care subset of the Dow Jones U.S. Total Market Index. While it's a high-quality portfolio, we would discourage investors from IYH, however, given its 0.48% expense ratio and the fact that the much cheaper XLV and VHT have shown near-perfect correlation with IYH over the past three years. Investors should be able to get identical Johnson & Johnson exposure more cheaply from one of the other funds mentioned above.

Robert Goldsborough is an ETF analyst with Morningstar.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.