ETFs provide a great means to gain exposure to this battered health-care giant.
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
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
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.
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
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
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
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
Vanguard Health Care ETF--Broader portfolio but still inexpensive
Another option for investors would be Vanguard Health Care
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
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.