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Does Johnson & Johnson Pass the Buffett Test?

Many smart investors use checklists to help them vet potential investment ideas. This strategy is even used by famed investor Warren Buffett before he makes multibillion-dollar acquisitions for Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B).

Thankfully, creating an investment checklist of your own isn't all that difficult. In fact, a great starting point is to simply copy Buffett's checklist, which looks like this: 

  1. The company makes at least $75 million in pre-tax earnings
  2. Consistent earnings power, not just future potential
  3. Strong return on equity, with little or no debt
  4. Management in place
  5. A simple business
  6. An offering price

Of course, since individual investors won't be swallowing companies whole like Berkshire does, we can largely ignore the last item on this list. However, the first five criteria that Buffett uses to vet companies can help us determine if a stock would interest him. Knowing that, let's see how healthcare giant Johnson & Johnson (NYSE: JNJ) stacks up against Buffett's checklist. 

Image Source: Getty Images.

1. At least $75 million in pre-tax earnings

Pass

Berkshire Hathaway's annual revenue exceeded $210 billion in 2015, which means that small acquisitions no longer impact Berkshire's financial performance. As such, the first item on his checklist is designed to limit the field of companies to those that are both big and highly profitable.

Johnson & Johnson passes this first test with ease. The company counts more than 250 operating companies in its empire that combine to sell thousands of products in 60 countries around the world. In total, J&J rang up more than $70 billion in annual sales in 2015 and produced more than $19 billion in earnings before taxes.

2. Consistent earnings power, not just future potential

Pass

Buffett likes to own businesses that are capable of cranking out profits even during periods of market stress.

As a leading provider of pharmaceutical, medical device, and consumer goods, J&J sells a wide range of healthcare products that remain in demand no matter what is happening in the global economy. That's how the company was able to maintain its earnings power throughout the great recession.

JNJ Revenue (TTM) data by YCharts

3. Strong return on equity, with little or no debt

Pass

Buffett believes that great companies can generate strong returns on equity without having to pad its balance sheet with debt.

Here's a look at how J&J performs on both of metrics over the previous ten years:

JNJ Return on Equity (TTM) data by YCharts

As you can see, J&J has a long history of producing great returns on equity, which would likely make Buffett smile. However, the company's balance sheet is loaded with nearly $20 billion in debt, which isn't exactly ideal. While that number might give Buffett pause, my hunch is that he would be willing to give the company a passing grade here since J&J is only one of two companies with a AAA credit rating.

4. Management in place

Pass

Johnson & Johnson has greatly benefited over the years from stability in its corner office. In fact, since the company went public in 1944 it has only had seven different CEOs. That's an enviable track record that is indicative of the company's ability to attract and maintain great managers.

The company's current CEO is Alex Gorsky. Gorsky first joined J&J in 1988 as a sales representative in the company's pharmaceutical division. From there he held a variety of roles in sales, marketing, and management, but he ultimately became CEO in 2012.

Under Gorsky's leadership, JNJ's revenue and profits have risen consistently each year. That's allowed the company to outperform the S&P 500 during his tenure:

JNJ Total Return Price data by YCharts

Right behind CEO Gorsky is Dominic Caruso, the company's CFO. Caruso has held his current title for more than a decade, and has played a key role in helping to preserve the company's stellar credit rating.

Both of these leaders are still under age 60, which suggests that the shareholders are in great hands for the foreseeable future.

5. A simple business

Fail

I'll readily admit that this one could easily go either way. On the one hand, you could make that argument that J&J is basically a mutual fund of healthcare companies that sell a wide variety of high-quality products around the world. On the other hand, J&J is so big and complex that it is hard to call its business "simple".

Johnson & Johnson's breaks its business down into three main operating segments: pharmaceutical, medical device, and consumer. Last year, roughly 47% of the company's revenue last year came from pharmaceutical sales, making it the company's most important division. Another 34% of revenue came from medical device sales, and the remainder was from the consumer segment.

Image Source: Getty Images.

Impressively, nearly 70% of the company's revenue came from products where J&J holds a number 1 or number 2 market share. That tells you how strong the company's competitive position is. 

Another fact to applaud is that J&J's revenue is roughly equally split between the U.S. and rest of world. That provides the company with another layer of diversification that helps to make its business quite stable.

Looking ahead, the world's population is aging and getting richer, which should help to ensure that the demand for healthcare remains strong for years to come. That's a great tailwind for companies like J&J that I think Buffett would find attractive. 

Still, given the complexities of the global healthcare market and the company's business, I think the conservative answer is to give J&J a failing grade. 

Is Johnson & Johnson a Buffett stock?

By my math, J&J scores a four out of five on Buffett's checklist, which is an impressive result. Perhaps that's why it isn't surprising to learn that Berkshire actually owns a few hundred thousand shares of J&J's stock.

Clearly, Johnson & Johnson is a Buffett stock -- and maybe one you should consider for yourself, too.

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Brian Feroldi has no position in any stocks mentioned. Like this article? Follow him on Twitter where he goes by the handle 

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The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool recommends Johnson and Johnson. The Motley Fool has a disclosure policy.