NEW BRUNSWICK, N.J. (TheStreet) -- Investors who own a portfolio consisting of the 30 stocks that make up the benchmark Dow Jones Industrial Average are heavily dependent on the pharmaceutical industry.
The three largest U.S. drugmakers,
Johnson & Johnson
, are Dow components. Picking up all three could leave investors open to a large amount of risk related to the fate of the drug industry. Choosing the strongest, best-run company from the bunch and betting on it to outperform the others is the most sensible option.
On the surface, it would appear Merck would be the obvious choice. Over the past year, Merck's stock has run up 31%, beating the 29% return of the
and easily trouncing Johnson & Johnson and Pfizer, which have gained 8.7% and 7.1%, respectively. Merck also pays a hefty dividend, currently yielding 4%, better than Pfizer's 3.9% and Johnson & Johnson's 3.1%.
Merck loses its appeal when simple value metrics like price-to-earnings ratio and price-to-free-cash-flow are applied. Merck's P/E ratio is 10.85, above Pfizer's 8.3, but lower than Johnson & Johnson's 13.
In terms of price-to-free-cash-flow, the difference is more dramatic. A P/FCF of 91.1 for the trailing 12 months for Merck is drastically higher than Pfizer and Johnson & Johnson's 9.2 and 14, respectively. Merck is far more expensive compared to the cash generated by its operations than either of its two major rivals.
While Pfizer appears to be the most attractive choice based on valuation, investors must also consider the PEG ratio, which compares the P/E ratio to the expected growth rate. A lower number indicates a greater value as the growth is more in line with the earnings multiple. Pfizer is currently languishing at a rather awful PEG ratio of 3.6, while Johnson & Johnson has a more respectable ratio of 1.86.
Johnson & Johnson is as solid as they come. Over the past five years, the company's stock has appreciated by about 17%, while Pfizer has fallen 9.6% and Merck has risen 51%, sending its valuation out of whack in the process. Johnson & Johnson has slowly and steadily avoided the volatility of its competitors, which has led to a compound annual growth rate (CAGR) for its revenue of 5.2%, more than twice that of Merck's 2.5% and well above Pfizer's lowly 0.04%.
In addition, Johnson & Johnson's diversification has led to consistent earnings despite the tumult of the past few years. Since 2004, the company has had an earnings per share standard deviation of 20.5%, versus 25% for Pfizer and a massively volatile 43.5% for Merck.
Johnson & Johnson has avoided telltale pharmaceutical volatility by diversifying its businesses among three lines. Besides drugs, Johnson & Johnson makes well-known consumer products such as Clean & Clear skin treatment, Aveeno and Lubriderm moisturizers, Listerine mouthwash and Neutrogena soap and shampoo, in addition to medical devices that encompass everything from artificial joints to lab equipment.
After adding the consumer-products subsidiary in the 1920s, Johnson & Johnson expanded to its current three-legged form in the 1960s with the acquisitions of McNeil Laboratories and Cilag. Johnson & Johnson didn't stop there. In recent years, under the direction of current Chief Executive Officer William C. Weldon, the company has plunged into other new businesses and even eroded some of Pfizer's diversification benefits by purchasing its consumer health-care unit in 2006, which added the Listerine, Benadryl and Neosporin brands under Johnson & Johnson's umbrella.
While Merck and Pfizer live and die by their drug pipelines, Johnson & Johnson investors can survive a down cycle in drug creation because of complementary divisions that allow the company to remain profitable even in a dry spell. Looking at a graph of the company's revenue and net income trends resembles the gentle incline of a small hill, while Merck and Pfizer look more like roller coasters.
A sensible approach to debt complements the hedged operations. Johnson & Johnson's debt-to-equity ratio of 0.82 is lower than Pfizer's 1.13 and Merck's 0.93, both of which are sure to increase dramatically due to recent acquisitions.
Johnson & Johnson's tripod approach makes it wonderfully stable. While that may not always translate into fantastic gains, the company won't jack up your portfolio's risk. Consider Johnson & Johnson as the least motion sickness inducing of the three big Dow pharmaceutical stocks.
-- Reported by David MacDougall in Boston.
Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.