Why Is J&J So Darn Cheap?

Dorsey: So a name that kind of pops to mind and sort of very obvious to talk about first is J&J, because [to Tom and Charlie] it's a number one holding for one of you, and a number two holding for the other. I'm not going to ask you why you like it, because I mean I think the qualities of J&J are fairly obvious. I think maybe what might be more interesting to talk about is, why is it still so darn cheap?

Forester: I mean, they have had some stumbles of late.

Dorsey: And you're referring to some of the product recalls?

Forester: Right, right. So you've got headline risk, but that's largely at the stock, and when you've got a big diversified company like that, it doesn't really impact earnings all that much. So, I don't think that should be impacting it nearly as much as it is.

I think that since March of '09, people went after beta, people went after the stuff with bad balance sheets and all that, and that's what really has done the best. I think that there tends to be a wave where people chase those things, and then at some point, and I don't know when that is, but at some point, they realize…

Dorsey: ...Send me e-mail when you figure it out...

Forester: Exactly. Maybe it's today. At some point people realize, oh my gosh, I'm at these heights of valuation with these stocks, maybe I need to start going back to the things that have real earnings and are great valuations and great companies. At some point that inflection will happen, and people will shift back into these; it's hard to know when. They don't ring a bell to let us know those things.

But it's amazing to me the type of great companies that we can own, with great balance sheets. Usually, it's the other way around. The ones with great earnings and great balance sheets sell for premiums, not discounts. So, I mean, in some respect it makes my job a little bit easier because, sure, it's a lot easier holding these companies. I'm not worried about, are they going to get downgraded by Moody's or is a bank going to pull their line, or are they going to be able to survive, because these guys have plenty of flexibility. So, in that respect, for the longer term, this is great holding these kind of stocks.

But only because they've lagged a little bit has it been frustrating at all, but we think over the next couple of years or so, if you're not just focused on any one quarter, this is a great place to be and a great place to be for the long run.

Bobrinskoy: Just in terms of explanation, I think you've got to look at two things. You've got to look at flows. So, as big pension funds have been selling stocks, they've been selling large-cap stocks. So, Exxon, J.P. Morgan, J&J have all underperformed.

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Second, there is a big trend, which is government regulation. There are certain industries in which the government has not been helpful over last year or two, and health care and financials and for-profit education would be three examples. So, getting in the way of the government has not been a good place to be.

Then just lastly I'd say that J&J and the whole health-care industry has been a little bit more economically sensitive than we all would have guessed. So people have not replaced that knee or hip because of the tough economy. They may be have been a little more concerned about the high-cost drugs. A number of J&J's businesses are volume sensitive, and volumes have been a little lighter than I think all of us would have expected.

Dorsey: Yep. Health care has been a less defensive sector...

Bobrinskoy: ...That's right...

Dorsey: ...this time around than it has in many, many past precessions.

[Doug,] any opinions on health care in general in terms of what your models are saying?

Ramsey: Our domestic model does find the managed health-care companies pretty attractive, and clearly that's a case of valuation driving that, because there is absolutely no momentum, but I think those are good values.

Dorsey: And these would be companies like United Healthcare, WellPoint?

Ramsey: Exactly, we own all of those, and they are actually the heaviest weight within our domestic model, but I do think it's interesting. I think these low-quality and cyclical names have had the leadership mantle throughout a period in which the economic recovery has been doubted the whole way up, and perversely I think, which is very often the way stock market logic works, I think next year at some point things will strengthen enough, and I'm not necessarily saying unemployment is going to come down, but things will strengthen enough that I think the consensus will migrate to the idea that "Hey, this is a real economic recovery. It's going to be sustainable." But oddly enough, that's typically around the time that those cyclical and lower-quality groups peak out and maybe the latecomers come and say, "Well, the economy is fine. We can now go buy cyclicals." Well, very often that's the time to be buying sort of high-quality defensive things, because the market just moves so much in anticipation of the rest of the economy.