Rule #1 Analysis Blitz #4: Coach (COH)

If you have any ladies in the house, you'll likely have heard of the name, Coach.  No, it has nothing to do with Greyhound, Megabus, or the like.  It has everything to do with what your wife, mother, sister, or girlfriend (or you) carries with her wherever she goes.  Yep, it's her handbag, and Coach makes very many, very expensive (ok, not as expensive as Louis Vuitton or Prada, but still, not your typical Walmart bags), and most importantly, very popular ones.  Between my wife, my mother and her mother, they probably own around 10-15 Coach bags or wallets (no exaggeration)!  Whenever I travel to the US for work and am anywhere near an Outlet mall, I usually pick one up for them (at discount prices, of course).  And it's not just them...my brother's wife, cousin's wife, cousins all like Coach too.  If you also happen to live in the US or Canada and visit any of the more popular outlet malls, you'll find that there is always a line up going into the store on the weekends.  I'm absolutely serious, Coach is a hot brand!  Let's see if the stock is as hot as the product!

Moat

You can download the completed Rule #1 spreadsheet here.

Coach is another Rule #1 company by Big 5 standards.  There are only a few reds and yellows in its 10-year history, and they occurred within the past 2 years, during the Great Recession.  It is entirely forgivable.  Looking at the 5-year and 9-year averages, it's all green and growth is pretty astounding.  It also has no debt at all.  After looking at RIM, Apple, and now Coach, you're starting to get the idea of what a Rule #1 company looks like...a sea of green.

As I have mentioned above, everyone seems to love Coach.  Its products are priced nicely such that they are affordable by the masses, but expensive enough to make for awesome margin for the company.  I don't think Coach has much of a competitor.  If you go to Yahoo Finance, you can see who its competitors are.  The three listed are all private companies: Dooney & Bourke, Kate Spade, and Michael Kors.  I will confess...I'm not a fashion expert...but aside from Michael Kors, I have not heard of the other two companies.  This alone tells you that at least the females of my family do not really particularly like these brands.  I checked out the websites of these companies and I must admit, Kate Spade has some pretty nice handbags, too.  But the story is similar to the Coke-Pepsi story.  Pepsi may have the better tasting drink, but Coke has the brand moat.  So, Coach definitely has the brand moat that can give it the upper hand.

Coach gets a score of 9 for Moat.

Moat Score: 9 / 10

Figure 1: Rule #1 Analysis of Coach (COH)

Margin of Safety

For calculation of the Sticker Price, I used growth rate of 15% and PE ratio of 20.  Coach now has its eyes on Asia and Europe for expansion.  So, this 15% growth number could be higher if Coach is successful there.  From Coach's history, its execution has been fairly flawless. So, I wouldn't be too concerned if you wanted to use a few percentage points higher.  And given that all the lovely ladies I mentioned above are Chinese, I wouldn't be surprised if Coach dominated the Chinese market!

Coach's sticker price is calculated as $50.40, which means the entry price is $25.20.  With the stock price currently at $55.90, the stock is too expensive for us even to start considering!  It is a slightly overpriced stock.  If we were to crank up the growth rate to 20%, the entry price is still only $38.57.  If we had ran this in the summer, the stock would have been in the mid $30s and it may have been a good buying opportunity.  But since then, Coach has had a good quarter and the stock has skyrocketed from $33 to $55.90 in less than 4 months!

The payback time for Coach is 9.8 years, when calculated using a 15% growth rate.  It's close to the upper limit of 10 years.  Coupled with its slightly elevated stock price, I would not recommend stockpiling this stock at its current price.

Therefore, Coach gets a score of 4 for Margin of Safety.

Margin of Safety Score: 4 / 10

Management

Lew Frankfort is the CEO of Coach.  He has been at the helm of the company since 1995, before its spin-off from Sara Lee and before its IPO.  He's brought the company from a relatively unknown brand to what it is today.  Coach is now a bigger company than Sara Lee Corporation by market capitalization, and I think that speaks volumes to Frankfort's leadership.  With his long history and success at Coach, he's already won my vote...but let's continue.

Yahoo Finance shows that Frankfort owns 2.7 million shares of Coach.  That's about $150 million!  If I had to make a hunch, I would probably bet that Frankfort has some interest in running the company well, because if the stock drops to $30, his fortune would shrink to $81 million.  Another vote from me.

Frankfort recently sold about a million shares of company stock in November.  As I mentioned, the stock had a huge run up in the last few months.  So, I don't blame Frankfort for pocketing some profits.  He's probably not a stupid investor either.  He knows, just as we do, that Coach's share price is probably a little overpriced now.  So, Frankfort selling his stock does not necessarily make it a bad thing.  However, keep your eyes open for any future action.  Once Frankfort opens his wallet to buy shares again, you may want in too.  If he sells more, then you may want to reconsider.

I think Coach has solid management in Frankfort based on his long and successful history at Coach.  His large  ownership of company stock is also a plus.  Coach gets an 9 for management.

Management Score: 9 / 10

Meaning

If you are female or have females in the house, then Coach may have a meaning to you.  I've been to a number of Coach outlets and I like what I see.  The handbags, even to me, a fashion sense-less person, are stylish and attractive.  If you can appreciate the handbag business, then look no further and do some more research.

I've tried to dig up some dirt regarding Coach but couldn't find anything substantial. Coach does not manufacture its own products but uses contract manufacturers, mainly in Asia.  In its annual report, it does talk about its business practices, that it performs audits of the manufacturers.  However, we are not privy to seeing what those standards are exactly.  So, even though Coach claims to be a responsible corporate citizen, we don't actually know what that means.  But since there are not many complaints found online, I will take that as a good sign.

Now, I'm just going to split hairs.  One ethical issue I can think of is the use of leather.  As we know, leather comes from cows, and if you're concerned about the killing of cows, then you may want to have a closer look.  I remember seeing a documentary in which the treatment of cows, used as a source of leather, was shown.  Cows were treated very cruelly when they were brought to be slaughtered.  Moreover, in India, where cows are sacred, manufacturers would engage in unethical purchase of cows from poor families.  I don't know if these apply to the manufacturers used by Coach, but it would not be outrageous to assume that they probably do in some cases, maybe unknowingly.

I think Coach is likely an ethical company.  I would not have too much trouble putting my money in this company.  Its products improve the lives of our beloved wives, mothers, sisters, girlfriends, and in turn, that improves our lives.  Coach gets a score of 8 for meaning.

Meaning Score: 8 / 10

Summary

Moat Score: 9 / 10

Margin of Safety Score: 4 / 10

Management Score: 9 / 10

Meaning Score: 8 / 10

OVERALL (not an average): 6 / 10

Coach is a great company to invest in. The only issue is its current high price.  If the stock pulls back, then it'd be your chance to get in!

USCCB Socially Responsible Investment Guidelines - Part 1: Introduction

Hello!  This multi-part series will be on the United States Conference of Catholic Bishop's (USCCB) Socially Responsible Investment Guidelines.  In this post, I will give a brief introduction of what it is exactly.  The following posts will look into the 6 areas that the USCCB's investment policy covers.

What is it?
In the United States, there are 194 Catholic dioceses.  Each diocese is run by an archbishop, and he has auxiliary bishops who help him out.  The USCCB is essentially an organization of all of the Catholic bishops in the US.  It is sort of like the government.  As cynics will note, the Catholic Church is rich and has a huge amount of money at their disposal.  That is probably true, but it is also serving 68 million people in that country!  Just as other organizations with a lot of capital, the USCCB has to invest its money such that it keeps pace with inflation and perhaps grow it as well.  This is where ethical investing or socially responsible investing, as the Conference calls it, comes into play.  The Conference does not own the assets, but rather, they are stewards of the assets of the Church.  So, it must direct these assets to good and morally beneficial use.

The first half of the guideline provides the principles used in the document, and I encourage you to read it.  However, I will not focus on this portion.  I will, however, put emphasis on the second half of the document, which deals with the investment policies themselves.  This part has more relevance to the individual investor when he/she is making an investment decision.

USCCB Investment Policies
I will now list out the "table of contents" for the investment policies:

1. Protecting Human Life
• Abortion
• Contraceptives
• Embryonic Stem Cell / Human Cloning
2. Promoting Human Dignity
• Human Rights
• Racial Discrimination
• Gender Discrimination
• Access to Pharmaceuticals
• Curbing Pornography
3. Reducing Arms Production
• Production and Sale of Weapons
• Antipersonnel Landmines
4. Pursuing Economic Justice
• Labor Standards / Sweatshops
• Affordable Housing / Banking
5. Protecting the Environment
6. Encouraging Corporate Responsibility

In the upcoming posts, I will be dealing with each of these in greater depth, and will try to find examples of companies that work for these causes and also those which against them. Stay tuned!

Rule #1 Analysis Blitz #3: Apple (AAPL)

First off, I apologize for almost missing my weekly commitment of 1 Rule #1 analysis a week.  I had a somewhat good excuse: I caught a bad case of the flu, and had to stay home from work on Thursday.  I'm getting better now, but still constantly coughing through the night!  Anyway...

On my Facebook account, I've set up my Facebook Notes to pull the posts I write from this blog.  My last post on RIM generated manycomments from my friends.  Since RIM was once the largest Canadian company by market capitalization on the Toronto Stock Exchange, naturally, my fellow Canadians have an interest in the company.  In those comments, competition from Apple seemed to be a recurring theme and there was much interest in Apple as well.  So, I have decided to use Apple for my 3rd Rule #1 analysis.  I'm sure a lot of you would like to see this too, as the iPods, iPhones, and iPads have become so omnipresent in our homes these days.

Moat

As usual, you can download the completed spreadsheet here.

Apple has a perfect Big 5s sheet.  The only red is in the 9-year average EPS growth.  It's red because in Year 1, Apple had a negative EPS, losing $0.05/share.  Since then, the EPS has grown impressively at more than 50% per year!  The company is debt free and in fact, has about $40 billion in cash.  By numbers alone, Apple is a top-notch company.  I don't think there are many companies its size ($281 billion market capitalization) that can match its impressive growth!

From a qualitative standpoint, Apple has a wide, wide moat.  Just check out the price of an iPod relative to a similarly spec'd out MP3 player, and you will find out that Apple charges a premium for the iPod.  Yet, the iPod has a large majority of the market share.  Or you hear about Apple/Steve Jobs' (CEO) "distortion field", which is the notion that people being affected by the "distortion field" loves Apple products regardless of what happens.  Take the iPhone 4 antenna issue...Steve Jobs says that "only" 1.7% of iPhone 4s are affected by the bad antenna design.  If you are an engineer, you know that means the iPhone 4 is not even up to 3-sigma quality standard...which is quite terrible.  However, the iPhone 4 had great sales despite this fact.  Another example is the iPad.  Despite what many people think, Apple did not come out with the first tablet.  Archos, for example, a French company, came out with a number of tablets in 2009.  However, when the iPad came out, it changed the world.  Since then, everyone has wanted a tablet, and to be precise, everyone has wanted an iPad.  This is Apple's moat!

The only thing that has come remotely close to challenging Apple's is Google's Android.  For a long time, Apple had been fairly lonely in the smartphone space and no one came close to offering a similar look and feel of the iPhone, until the Motorola Droid came out.  Using Apple's own words, "it changed everything."  In my opinion, the Android platform is not as slick as Apple's iOS, but it does have advantages that are not insignificant.  For example, its latest version of the OS is able to support Flash on its browser.  You can easily use tethering on it.  It is also available on phones from many manufacturers.  People like choice and this may be Apple's only disadvantage, that it can only come out with a few products because it is still just one company.  This is the only place where I see weakness in Apple's moat.  Keep your eyes on this one because it's going to be interesting!

Applet gets a score of 9 on Moat.

Moat Score: 9 / 10

Figure 1: Rule #1 Analysis of Apple (AAPL)

Margin of Safety

From Figure 1, you can see the sticker price of $463.74 from the Rule #1 spreadsheet.  This was using the assumptions of 20% EPS growth for the next few years and a PE ratio of 20.  Analysts estimated the EPS growth to be 16%, but I thought that was a little low, so I had used 20 instead.  The PE ratio of 20 is currently what Apple has and I thought it was a good number to use.

So, Apple at $306 is still underpriced, but not enough for us to start buying with a 50% margin of safety.  If you think the EPS growth will be higher than 20%, say 23.5%, the entry price would be just above $306. If you feel comfortable making that assumption, you're good to go!

The payback time, using the analysts' estimated growth rate, comes out to be 9.0 years.  Again, that's a low estimate.  If we use 20%, the payback time becomes 8.1 years.  I would say it's not too bad of a number to start accumulating the stock if that was your plan.

Apple's stock is probably fairly priced or a little underpriced, but not with a huge safety margin.  I'll give the MOS score a 6 out of 10.

Margin of Safety Score: 6 / 10

Management

Steve Jobs, the CEO of Apple, is the heart and soul of Apple.  He was one of the co-founders of the company, but was ousted in the early 80s. The company, after a few CEOs and losing the personal computer OS war with Microsoft, finally brought Jobs back as their CEO in the late 90s.  With Jobs back at the helm, he introduced the iPod and iTunes, and brought the company back to profitability.  The rest, as they say, is history.  Apple would not be where it is (the second largest company in the US by market capitalization) without Jobs.

From what I read and hear about Steve Jobs, he is arrogant and somewhat of a control freak and perfectionist.  Regardless, I don't think anyone can doubt that he is a brilliant man.  It is by all of these traits that he's been able to steer Apple in its recent trajectory.  However, a few years ago, Jobs was diagnosed with pancreatic cancer.  He underwent surgery and returned to health.  Several years later, he took a leave of absence and had a liver transplant.  As of late, his health seemed to have returned again, but he is still very thin.  His health is definitely a risk for shareholders, particularly because he has been so influential to the company itself.

If Jobs were healthy, I would definitely give Apple a score of 9 or 10, but because of his health concerns, I rate it a score of 8.

Management Score: 8 / 10

Meaning

Apple has received some criticism for its business practices.  One of the higher profile cases was the string of Foxconn employee suicides.  Foxconn is a contract manufacturer for Apple and is alleged to operate with sweatshop conditions in its plants.  It started with one single employee who committed suicide after losing an iPhone prototype.  The media questioned whether this was a result of the Apple secrecy policy that led to violence against this employee and his eventual suicide.  Later in 2010, more than 10 employees at Foxconn committed suicide and Foxconn's business practices were questioned again.  Although Apple was not directly linked with these incidences, it does not totally exonerate it from them, however.

The Human Right's Campaign, a pro-homosexual group, rates Apple very highly in its "Corporate Equality Index".  It basically means that Apple recognizes homosexual unions as equivalent as heterosexual marriages and provides benefits.  This is one issue that I have struggled with myself.  Although our Catholic faith tells us that homosexual acts are sinful, we are called to be compassionate and accepting to homosexuals.  I have absolutely no problem with this.  However, when a company claims to be tolerant by recognizing homosexual unions, is that a compassionate action or is it actually endorsing in homosexuality?  I don't want to discriminate against homosexuals, but is speaking out against homosexual unions a kind of discrimination?  For now, I don't believe it is discrimination.  First, I do not believe that marriage should be redefined.  It has for millennia been defined as a union between a man and a woman.  To illustrate my point, I will use an analogy.  It is similar to a chair being defined as something you sit on that has legs, and usually not higher than waist height.  Now, a group of NBA players who are taller than 7' have come together and started using tables as chairs.  Because of their height and size, tables are more suitable furniture to be used for sitting.  So, they ask that we change the definition of chair to include tables as well.  Therefore, when benefits are not given to homosexual unions, it is not because they are being discriminated against, but rather, it is just not accepting the re-definition of marriage.  For now, I will maintain this stance.  So, Apple gets some points docked for endorsing in this re-definition of marriage.

Lastly, let's return to "Antenna-gate", the iPhone 4 antenna issue.  Clearly, there has been a design flaw with iPhone's antenna.  If there weren't, Apple would not have given away free bumper cases to consumers who bought the phone.  However, I felt that Apple dropped the ball handling this incident.  Instead of just saying, yes, we made a mistake, period, Apple started releasing videos of how other phones would lose reception if gripped in a certain way.  They had missed the point, which was this: many people were complaining about iPhone 4's reception (including Consumer Reports), much more than any other manufacturer.  Instead of admitting the fact, they tried to create an illusion that the issue really wasn't that bad, "just" 1.7% of the phone were affected.  By the way, HTC claims that only 0.016% of owners complained about the Droid Eris' reception (about 100 times less than iPhone 4).

These ethical issues, although I may have made them to sound fairly bad, are actually quite minor.  When you compare these issues to the issues surrounding Johnson and Johnson, you will quickly notice that Apple is probably not that bad.  In any case, Apple's business itself is good for our society.  It has brought incredible innovation and has made life more enjoyable.  Can you imagine a world without touch screens that let you swipe to go to the next photo? or using 2 fingers to zoom in and out of a page?  or iTunes? or iPads?

Meaning Score: 6 / 10

Summary

Moat Score: 9 / 10

Margin of Safety Score: 6 / 10

Management Score: 8 / 10

Meaning Score: 6 / 10

OVERALL (not an average): 7 / 10

The only 2 problems I see with investing in Apple right now is its Margin of Safety and Meaning.  If you buy Apple now and sales for whatever reason comes under analysts' estimates, the stock has a ways to fall.  You also need to understand the ethical issues surrounding the company.  Although they are fairly insignificant, you should still be watchful.

Rule #1 Analysis Blitz #2: Research in Motion (RIMM)

A couple of years back, I bought a few copies of Rule #1 to give out to friends (yes, I liked the book that much!).  One of them was Matthew, my good friend, to whom I introduced my cousin, who he later married.  In return, he introduced my lovely wife, Renee, to me.  Not a bad deal!  So, anyway, I don't think he ever read the book until recently, when he fell ill for a few days and decided that it was time to crack it open.  I was actually quite impressed, because he churned out 8 Rule #1 analyses and sent them to me.  I now present one of them to you, and will also make some comments on the 4 "Ms".

The company in question is Research in Motion (RIM).  It's not a name that is exactly a household name, but its product definitely is.  Do you know which product I'm talking about?  It's none other than the ubiquitous Blackberry!  Not many people (outside Canada) know this, but RIM is a Canadian company, based in Waterloo, Ontario.

At this point, I must digress and tell a story.  It was the year 2001, my friend Archie, my cousin Kelvin, and I went to Europe for our grad trip.  We landed in the London Gatwick airport and the first 3 ads we saw after getting off the plane were of Nortel (now non-existent), Celine Dion, and Blackberry, all of which were products of Canada.  I felt so proud at that moment, and to this day, I still find it quite amusing.

Back to RIM...There has been quite a lot of murmuring going on about RIM.  As you know, Android (Google's smartphone OS) burst onto the scene a couple of years back and is now taking significant market share from RIM.  RIM's stock was recently downgraded by an analyst at Kaufman Brothers.  However, there are some good things happening with the company.  It recently came out with the Blackberry Torch, which sports a new version of its OS and was somewhat well received.  It also announced its PlayBook, its answer to Apple's iPad.  So, let's take a look at what Rule #1 tells us about RIM!

Moat

Before I start, you can download the completed spreadsheet here.

Let's go straight to the Big 5s!  What do we have here?...a sea of green!  That's usually a good sign.  9-year average of annual ROIC is 12.7%, annual sales growth a whopping 59.7%, and annual BVPS growth an impressive 24.4%.  The 9-year average annual EPS growth has a negative number.  Upon some investigation, it was found that 10 years ago, RIM had lost money, which resulted in a negative EPS.  So, the growth number became negative.  Looking at the annual numbers, EPS growth was very green for all years except one...excellent!  The last is free cash flow growth.  Data only extends to 5 years, so there is no 9-year average.  The 5-year average has an "Invalid Data" output.  This happens when something goes wrong with the math.  Checking the numbers, 5 years ago, there was a negative cash flow.  This negative number was the culprit.  So, looking at the individual numbers, cash flow increased from a negative $52 million to $1.6 billion in 5 years.  Awesome!  RIM also has 0 debt!  As far as Big 5 numbers go, RIM scores a perfect 10.

That was the quantitative part.  Now, let's talk qualitative!  As I mentioned above, Android is eating everyone's lunch, maybe with the exception of the iPhone.  RIM's stock has been punished for the last little while.  If you think back about 4 years (before the iPhone came out), when someone said the word, "smartphone", what would come to mind?  It would be a Blackberry...and maybe, just maybe a Palm Treo.  RIM had its moat back then.  There was no other phone that could do email even close to what Blackberries could.  Nowadays, when you think smartphone, you have a myriad of devices including the iPhone, the Droids, the HTCs, etc.  Blackberries have lost their appeal.  Its last stronghold is corporate email, and even that last leg is a little shaky.  Make no mistake, RIM has lost its moat.  It needs to get its mojo back!

RIM does have one thing on its side, and that is a megatrend!  Mobile internet is going to be huge and it will grow to be as large as the internet itself.  There is a fundamental shift from feature phones to smartphones happening right now.  What this means is that even though RIM may be losing market share, its sales (and profits) may continue to grow because more and more people are buying smartphones.  It is not a zero-sum game.

Quantitatively, RIM has all the ingredients for a great moat.  Qualitatively, that moat is already gone.  Given its consistent history, I will rate its moat a 7.

Moat Score: 7 / 10

Figure 1: Rule #1 Analysis of Research in Motion (RIMM)

Margin of Safety

At time of writing, RIM's stock was $58.00.  From Figure 1, we can see that the entry price is $38.23.  The stock is about 50% higher than we would like it to be.  The current PE is only about 12; I'm going to leave it as 15.6 for the analysis.  I think we can be a little more optimistic than the analysts and crank that number up to 17.5%.  That would give us a revised entry price of $50.39.  That's still below the current share price.  If you're going to buy this stock, it's going to be a little risky.

The payback time, however, is looking pretty good at 6.7 years.  This is a difficult one.  Margin of safety is not truly there, but payback time looks good.  It's not absolutely horrible, but not a home run either.  RIM gets a 7 for margin of safety.

Margin of Safety Score: 7 / 10

Management

Management is kind of a fun one here.  RIM has 2 co-CEOs: Jim Balsillie and Mike Lazaridis.  Jim Balsillie is the extravagant guy who busies himself with attempts to buy an NHL team and moving them to Hamilton, Ontario.  Click on the link above and you'll see that 80% of the information on Wikipedia is about his NHL dealings.  Sadly, this character graduated from the same university (University of Toronto) as I did...

Lazaridis is the founder of the company and is the guy who probably does all the work at RIM.  He is in less of the limelight than his partner, Balsillie.  He is quite philanthropic, having founded the Perimeter Institute for Theoretical Physics.  He also gave a big chunk of money to the University of Waterloo.  Anyway...if there's one thing about CEOs, it's that if they are the founder of the company, chances are he's good.  To name a couple of examples, Bill Gates (Microsoft) and Steve Jobs (Apple).  Why is that the case?  It's very simple.  The company is his/her baby and he/she has probably got a pretty big stake in it.

Insider trading information was not readily available on Yahoo Finance or MSN Money.  Not too sure why, but it being a Canadian company may have something to do with it.  So, can't comment on that too much.

Overall, I believe management is quite good, but there's no direct data to support it, except for the fact that the company has ruled the smartphone space for many years.  They are reacting well to competitors with the introduction of the Blackberry Torch and the PlayBook.  I think there's still some juice left in the company.

Management Score: 7 / 10

Meaning

RIM is an easy company to understand.  If you understand how Blackberries work, you already know 95% of what the company does.  You may want to investigate into its competitors, namely Android and iPhone, and how these two platforms are taking market share.  Also, keep you eyes on PlayBook as this could be a significant revenue driver or a significant flop.

As for the ethical aspect of RIM, I see it as fairly neutral.  There was an accounting issue a few years back.  Since then, Jim Basillie had resigned as chairman to be in line with best practices in corporate governance.  From that point on, not much has occurred to make this company suspicious of unethical activities.

The business itself is beneficial to our society.  Blackberries were designed to improve efficiency, even though some may argue that they have caused a whole slew of other problems, including tying employees down to work even on weekends and weeknights.  Business people like them and now, consumers like them too.  I think RIM is a company that contributes positively to society and, therefore, "investable" in this regard.

Meaning Score: 8 / 10

Summary

Moat Score: 7 / 10

Margin of Safety Score: 7 / 10

Management Score: 7 / 10

Meaning Score: 8 / 10

OVERALL (not an average): 7 / 10

All-in-all, RIM would be a good candidate if you're looking for a tech stock.  However, keep 2 things in mind: i) margin of safety - the stock is not overpriced, but it's not very underpriced either, and ii) competitors - watch out for Android.  If you start seeing companies allowing employees to use their Android phones or iPhones to access corporate email, RIM may be on its way to obsolescence.  Keep doing your homework!

Rule #1 Analysis Blitz #1: Johnson & Johnson (JNJ)

The first blog post of my Rule #1 Blitz will be on Johnson and Johnson (Ticker: JNJ), the pharmaceutical/consumer products company with which pretty much everyone on this planet is familiar.  Its more well known products include Tylenol, Band-Aid, Aveeno, Neutrogena, and Johnson's Baby products.  The company has been around for over 100 years, employs more than 100,000 people worldwide, has over 230 subsidiaries, and boast of 47 consecutive years of dividend increases.  In short, this company is no joke!

Moat
So, without further ado, let's jump into our Rule #1 analysis of JNJ (download my spreadsheet here)!  Let's first look at the moat of the company, which is the first of the 3 Ms.  As I briefly stated above, JNJ is a well known company and has a tremendous brand moat.  To evaluate its moat on a quantitative basis, we look at the Big 5s and its debt.  The Big 5s include return on invested capital (ROIC), sales or revenue growth, earnings per share (EPS) growth, book value per share (BVPS) growth, and free cash flow growth.  We want all of those numbers to be 10% or greater.

From the summary chart below, we see that ROIC, BVPS growth, and free cash flow growth are green everywhere - looks good.  A few yellow and red flags are raised in sales and EPS growth.  Let's dig a little more. We see that last year's sales and EPS actually decreased from the previous year.  The year 2009 was not exactly a stellar year for the economy; so, we'll let that go.  The 5-year average numbers look a little better, with sales growth at 5.5% and EPS growth at 9.9%.  I think EPS is just fine, but sales growth seems a little sluggish.  Going back a few more years, the 9-year average for sales growth is 8.7%, which is sufficiently close to the 10%.  The time to pay back its debt with its cash flow is 0.6 years.  Anything under 3 years is fine.  So, this looks fairly good.  I'm not overly concerned about its sales and EPS growth numbers.  We just need to be a little cautious and keep our eyes open.

Moat Score: 7 / 10

Figure 1: Rule #1 Analysis of Johnson and Johnson (JNJ)

Margin of Safety

So, JNJ's moat has a conditional pass.  The remaining 3Ms are meaning, management, and margin of safety.  Meaning and management are qualitative.  Let's continue with margin of safety.  From the figure above, under Sticker Price, you will see what the intrinsic value (or sticker price) is, as calculated by the Rule #1 methodology.  The trailing-twelve-month (ttm) EPS was $4.82.  The growth number used was the lower of the estimated EPS growth and the historical BVPS growth, which was 6.3%.  The price-to-earnings (PE) ratio used was the lower of historical PE and PE estimated from EPS growth, which was 12.6.  Using these numbers, the sticker price was calculated as $27.65.  With a margin of safety of 2, the entry price is $13.83, which is 50% of $27.65.  The share price is $63.88 (at time of writing), which is more than double that of the intrinsic value!  To be fair, we used a fairly low growth number of 6.3%.  So, I went back to my spreadsheet and played with the number a little bit.  Even if we assumed 15% growth, the entry price would still be $31.81.  This stock is waaay overpriced!  If you think about it, it makes sense.  The global economy is still in shambles, and so investors will flock to defensive stocks like J&J.  Further, J&J is a well known and established company.  It will be rare that it will be undervalued by much and go unnoticed.

I'll include a blurb about Payback Time here...at 6.4% annual EPS growth, it'll take 9.6 years for the EPS to accumulate to its present share price.  I'd say it's a little on the high side for you to consider accumulating JNJ stock.

Margin of Safety Score: 1 / 10

Management
Next up is management.  How do you know management (i.e. CEO) is good?  Most of the time, you really can't tell.  However, there are some clues that help us decide.  First and foremost, how are the financials?  Let's face it, businesses exist to make money.  If the CEO can't make money for the company, there's something wrong.  From the Moat section above, he's not doing a bad job.

Second, let's look at his personal interest in the company.  We want to see vested interest, which means stock ownership.  You can find that information on Yahoo Finance easily.  Mr. Weldon owns 259,360 shares of the company stock, approximately $16 million worth.  We can also see what his recent transactions were.  In the past couple of years, Weldon had not made a single large purchase of J&J stock.  That's not a particularly bad sign, but it's not a good one either.  If I knew the company I'm running is going to make lots of money, I'm going to put more money into the company.  His most recent transaction occurred in September, where he exercised his options to purchase 238,100 shares at $50.69, and immediately after, sold it for $58.49 on the open market.  From that transaction, he made about $2 milllion.  Maybe he needed money to buy a mansion, who knows?  But it doesn't exactly give me confidence in him.  It seems like what he did was cashing out.

Management Score: 5 / 10

Meaning
Phil Town explains that a company must have meaning to an investor if he were to invest in it.  What is exactly meant by "meaning"?  It's not simply, "I like the company", type of meaning.  Rather, one needs to understand its business on a high-level and be able to identify the various issues that surrounds the business.  For example, I own First Solar (ticker: FSLR) stock.  It has meaning to me because i) I believe in renewable energy and that it will replace oil as the world's main energy source, ii) I understand First Solar's technological and business strengths compared to other solar players (i.e. its low cost thin film technology and vertically integrated business model), and iii) I am genuinely interested in this sector such that I don't mind reading up on developments on a daily or weekly basis.  It needs to interest you so that keeping up with the latest developments is not a chore.  It should be homework that you enjoy doing!  Therefore, I can't do this analysis for you.  I don't know whether J&J has any meaning to you, but for me, I think it is too diversified of a company for the typical investor to truly understand.  Unless you've worked in the industry before and have a breadth of knowledge, it may be wise to stay away from J&J.

Now, since this is a Catholic investing blog, I wanted to make this section also ethically oriented.  Is this an ethical company?  It is likely that you have heard about the drug recalls that J&J had issued in the past year.  As a result, a number of plants were shut down temporarily and millions of bottles of medication were recalled.  Drug recalls are not uncommon in the pharmaceutical industry, but the way J&J handled the recall was less than ethical.  It was discovered that J&J had hired a contractor to secretly go into retail stores and buy up all of the problematic Motrin products.  This has been dubbed as the "phantom recall".  This action, in my opinion, is absolutely unethical.  Not only were the well-being of consumers jeopardized in the first place, J&J would not assume responsibility and issue a proper recall.

Other ethical issues include i) animal testing, ii) the Propulsid case in the 90s, where hundreds of people died as a result of taking this drug, many of whom were infants, iii) the Ortho Evra "contraceptive", which is in part an abortafacient.  And the list goes on...As I've said before, most pharmaceutical companies will likely have products that, in some way, violates our ethical standards.  I'm not saying that there is no ethical pharma company out there, but it would take a long time to sort through all of them.

Meaning Score: 3 / 10

Summary
So, let's summarize the scores...

Moat Score: 7 / 10
Margin of Safety Score: 1 / 10
Management Score: 5 / 10
Meaning Score: 3 / 10
OVERALL (not an average): 2 / 10

J&J scored badly in the Meaning and Margin of Safety areas.  I believe those two alone should deter you from investing in it.  J&J's numbers aren't bad, but cannot in anyway justify your purchase of its stock!