Why You Might Swap Your Merck for Johnson & Johnson

NEW YORK ( TheStreet) -- Sometimes when an investor wants exposure to the pharmaceutical and health care sector it's better to buy an exchange-traded fund for the sake of diversity.

Many want to own the best-in-breed or, more specifically, the best-in-the-sector. Yet, what if you're already invested in two of the great ones like Pfizer ( PFE) and Merck ( MRK)?

Your asset allocation strategy may say it's time to sell one and use that cash to buy the Big Kahuna of drugmakers, over-the-counter remedies, medical products and other related consumer goodies.

I'm referring to Johnson & Johnson ( JNJ). With a market cap of more than $246 billion, it's arguably the world's largest health care company.

JNJ has three divisions: pharmaceutical, medical devices, and diagnostics and consumer. Pharmaceutical accounts for 38% of the company's revenue and has been the highlight because of its strong pipeline, especially in oncology and immunology, which helped to drive 12% revenue growth in the second quarter.

Jim Cramer and Stephanie Link at Action Alerts PLUS wrote on Friday, "We see continued strength in these two segments oncology and immunology , but we also believe the company is well positioned for the long term with pipeline opportunities in treatments for cancer, pain, schizophrenia, hepatitis C and HIV."

They also commented that during the second quarter, immunology sales rose by nearly 17% "... driven by strong Remicade sales of 9.8% and solid results from Simponi and Stelara.

"We expect this strength to continue, given the growth in the overall market, expansion into international markets (emerging markets grew 20% in the second quarter) and share gains."

Investors who acted upon their past preference for Merck did quite well when it came to total returns, which included MRK's dividend. The stock peaked on June 4 at $50.16 and has corrected.

MRK is currently selling at a forward (one-year) PE ratio of slightly less than 13. Its price-to-earnings-growth (PEG) ratio (five-year expected) is an unusually high 5.02 which could signal shares are overvalued.

Presently I'd favor JNJ over MRK for the same reasons Cramer and Link do: "We prefer it JNJ to Merck, given its stronger growth and better pipeline, and we like the potential for shareholder value creation, which ultimately led to a spin-out of its consumer segment."

Not that JNJ is a "cheap stock." It's trading at a forward PE of 15 but its PEG ratio is a much more reasonable 2.55. It pays an annual dividend of $2.64, representing a payout ratio of about 55%.

What finally motivated me to go long JNJ was the news Friday that the company is considering selling its diagnostics division. I just love it when the parts are worth spinning off.

Our two previously mentioned research monarchs, whose Action Alert PLUS I subscribe to and read regularly, opined on this juicy bit of news. They wrote that JNJ's management "...could find ways to create shareholder value, believing the consumer business could be spun out.

"We still believe this to be the case, but we are pleasantly surprised to hear that it is considering other options for businesses that are underperforming."

What Link and Cramer meant was the Ortho Clinical Diagnostics unit, which makes blood-screening devices and tests, could be sold for as much as $5 billion (EBITA for this unit is $450 million) and will be marketed to private-equity firms worldwide.

This won't happen anytime soon, but they viewed the news as "... a clear positive, and it is the reason we will build this position further." If you want to know how many shares the duo bought for Cramer's charitable trust, you'll need to subscribe to Action Alerts PLUS .

At the end of the last quarter (ending June 30) JNJ reported year-over-year quarterly earnings growth of over 172%! There were some special circumstances which JNJ reported on July 16.

Net earnings and diluted earnings per share for the second quarter of 2013 were $3.8 billion and $1.33, respectively. The company said the second-quarter results included the gain on the sale of the equity interest in Elan.

Second-quarter 2013 net earnings included after-tax special items of approximately $500 million, related to litigation expenses, integration and transaction costs associated with the acquisition of Synthes and program costs associated with the DePuy ASRTM Hip, according to J&J.

In addition, "Second-quarter 2012 net earnings included after-tax special items of approximately $2.2 billion as shown in the accompanying reconciliation of non-GAAP financial measures. Excluding these special items, net earnings for the current quarter were $4.3 billion and diluted earnings per share were $1.48, representing increases of 17.7% and 13.8%, respectively, as compared to the same period in 2012."

Now let's look at an apples-to-apples comparison between JNJ and MRK. The following one-year chart includes the share prices and the trailing twelve month (TTM) revenue growth numbers. It won't be hard to tell who the clear winner is in both categories.

JNJ Chart JNJ data by YCharts

Consumer products account for 21% of JNJ's total sales, and this segment has continued to perform well since Johnson & Johnson acquired Pfizer's consumer division back in 2007.

My enthusiasm for JNJ also stems from its shareholder-friendly history. It has increased its dividend each year for a half a century, which is partly why it's been one of Warren Buffett's favorites.

Former Chairman and CEO William Weldon owns over 307,000 shares of JNJ as of Feb. 2013. The current JNJ chairman and CEO, Alex Gorsky, owns nearly 70,000 shares.

Many favor JNJ's strength and the diversification of its global businesses. It maintains a strong balance sheet, produces earnings surprises and has rock-solid management execution.

At the Friday close of $87.16, the stock is down almost 8% from recent highs so we have a chance to buy the best on sale. Agreeing with Link and Cramer that a target price of $94 is reasonable, I also favor buying any dips.

You might also consider a trailing stop loss alert system like TradeStops to track the performance of your JNJ shares, protect your profits and to limit your chances of unacceptable losses.

I've tested it and used it for years and I favor it as a stealth way to set trailing stop losses without the chance of being "picked off" by vigilant market-makers. It's also an effective way to keep our emotions out of the investing process.

Wishing you good fortune and best returns!

At the time of publication the author is long JNJ and PFE.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
Marc Courtenay is the founder and owner of Advanced Investor Technologies, LLC, as well as the publisher and editor of www.ChecktheMarkets.com.

Courtenay holds a Master's of Science degree in Psychology from California Polytechnic State University, and is a former senior vice-president of Investments for two major brokerage firms. He's been a fiercely independent investment "investigator" and a consulting contributor to the investment publishing world for over 30 years. In addition to his role as an investment publisher and analyst, he serves as a marketing consultant to the investment media industries.

In his role as a financial editor, he specializes in unique investment strategies, overlooked stock investments, energy and resource companies, precious metals, emerging growth companies, the prudent use of option strategies,real estate related opportunities,wealth preservation, money-saving offers, risk management, tax issues, as well as "the psychology of investing". Because of his training and background in Clinical Counseling and Psychology, he enjoys writing about investor behavior, the ┬┐herd mentality, how to turn investment mistakes into investment breakthroughs and the stock market's behavioral trends and patterns.