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Portfolio Manager Monthly Insights
Adam Gofton, CFA
Vice President, Portfolio Manager
Mackenzie Ivy Foreign Equity Fund
Getting more than what we paid for
There’s a reason why some sayings are repeated over and over; there is truth to them. One such saying is, “You get what you pay for.” Admittedly there is tension between this statement and our investment philosophy of seeking out high-quality businesses at reasonable prices. Why should anything of high quality ever be available for a reasonable price? Our belief is that high quality for a reasonable price can be found when we define quality with attributes that other market participants place less emphasis on. Such lack of emphasis usually occurs either because the attribute is not expected to drive earnings growth in the short-term, or because there is difficulty precisely quantifying the attribute. Examples of quality attributes fitting this bill are strong balance sheets, corporate culture, and economic resilience. We believe these three quality attributes better position companies to absorb shocks and be adaptive in difficult times. We also believe the Ivy team’s emphasis on these three attributes contributes to the typical performance profile of Ivy funds in rocky environments.
To illustrate our approach, we will talk through one of our current top holdings Johnson and Johnson (“JNJ”). Starting on strong balance sheet, JNJ is one of only two companies that carry the top S&P credit rating of AAA (the other being Microsoft which is also a holding in the portfolio). There has been a steady deterioration of credit ratings over the long-term with around 60 companies having the top AAA rating in the 1980s, declining steadily to 15 in the year 2000, and only 2 today. Coinciding with the deterioration of credit ratings, there has been a rise in a vocal cohort of “shareholder value maximizers” that often argue to increase debt levels. While increased debt can drive share prices higher in the short-term, the long-term impact is one of reduced flexibility and reduced capacity to absorb shocks which weighs negatively on our view of quality.
Corporate culture sometimes gets overlooked because it is difficult to quantify. But as we like to say, just because you can’t put culture in a spreadsheet does not mean it’s not important. Specifically, when assessing healthcare companies, we prefer to see patient-oriented cultures because we believe such cultures to have lower risk of drawing regulatory scrutiny. Being on the right side of regulators is important in healthcare because different regulatory bodies impact everything from what a company can sell, to how the product is manufactured, in addition to the price a company is paid. JNJ’s culture is constructive in this manner because the company has had a stakeholder mindset long before it became popular1. JNJ’s former chairman Robert Wood Johnson crafted JNJ’s credo way back in 1943. The credo outlines how JNJ’s first responsibility is to patients, doctors and nurses. By putting patients first, JNJ aligns its business with the interests of the regulators who are also employed to “look out” for patients and mitigates some of the common regulatory risks inherent in the healthcare sector.
While you may agree with the principle that an emphasis on patient outcomes reduces regulatory risks, a good question to ask is wouldn’t every company say they put patients first? We have added confidence that JNJ’s credo is more than just writing on the wall because of an unusual disclosure in JNJ’s proxy. More specifically, we noticed that JNJ began putting the results of a “Credo survey” in its proxy in which 94% of employees participated and 92% agreed that management is ensuring JNJ’s first responsibility is to patients, doctors and nurses. Such an overwhelming majority when combined with our own anecdotal evidence gives us confidence that JNJ’s credo is lived by its employees every day.
We also value economic resilience as part of our company quality assessment. We do not attempt to time economic downturns, but we do prefer companies that carry less forecasting error. An economically resilient business carries a higher degree of predictability given there is less uncertainty with respect to how recent earnings have been influenced by the prevailing economic environment. We have little concern with JNJ given nearly 80% of JNJ’s profits come from its pharma business, with the remainder stemming from medical devices. Demand for JNJ’s products is driven by the overall health needs of society and has limited correlation with the trajectory of the economy.
In the interest of full disclosure, we’d be remiss if we did not mention some of the key risks related to patents and product liability lawsuits currently facing JNJ. With respect to patents, JNJ’s second largest drug Stelara is off patent in United States beginning 1 Jan 2025. From our perspective, this is a math exercise rather than a quality assessment exercise, but the loss of Stelara exclusivity acts as a headwind to near-term earnings estimates which some investors may find undesirable. With respect to product liability, we believe that legal settlements such as the one that is expected with JNJ’s talc lawsuits have become a recurring cost of doing business in the USA for healthcare companies. That being said, the assessment of whether the incident is “bad luck” or part of a pattern of systematic negligence is important to our quality rating. Considering JNJ’s Credo-orientation and its combined factory inspection and product recall track record, we have assessed the incident as bad luck and accounted for it on our estimates, but remain open to new and disconfirming evidence.
While we agree that quality can come at a high price, we believe we can get more than what we paid for by using our long-term orientation which leads us to over-emphasize quality attributes related to strong balance sheets, corporate culture, and economic resilience. Johnson and Johnson as explained above is representative of how we go about balancing quality and price.
Source for credit ratings numbers: AAA Rating Is a Rarity in Business - The New York Times
1 Recall it was only in 2019 that the Business Roundtable which is an association of 200 American CEOs signed a statement formally declaring that their companies will be run for the benefit of all stakeholders, replacing its prior stance which favored shareholder primacy.
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