We’re selling half of a retail holding to get into an undervalued health care stock
We’re selling half our position, or 2,000 shares, of American Eagle Outfitters (AEO) at roughly $14.19 each, and initiating a position in Johnson & Johnson (JNJ), buying 150 shares at roughly $177.38 each. Following Wednesday’s trades, the portfolio will own 2,000 shares of AEO, decreasing its weighting in the portfolio to 0.99% from 1.96%. J & J’s 150 shares in the portfolio gives it a weighting of about 0.9%. The high grading of our portfolio continued Wednesday morning, with the moves made on American Eagle Outfitters and Johnson & Johnson. As we’ve mentioned, high grading involves a rotation out of stocks that do not fit the current investing environment and in companies that fit our mantra of making stuff and doing things for a profit, returning cash to shareholders through dividends and buybacks, trading at a reasonable valuation — and in this specific case with J & J, are less exposed to discretionary spending. The process comes with some pain. In Wednesday’s case, we’re taking a 60% loss on the American Eagle Outfitters sale, and downgrading the stock to a 2 rating, meaning we’d wait for a pullback before buying any more shares. After studying the quarterly results and listing to the conference calls from Target and Investing Club holding Walmart (WMT), it’s become increasingly clear that a slowdown in apparel began in March due to the shift in consumer spending away from goods and into services. It was also apparent that inflationary pressures were eating into discretionary budgets. Unfortunately, we do not think American Eagle Outfitters has the right inventory for this type of environment. Aerie, one of AEO’s brands, has some of the highest exposure to loungeware for stay-at-home, and it’s made a bet big on swimwear in a time when people are going out more often to go to the office or travel in these later stages of the Covid pandemic. In addition, the freight and transportation headwinds that impacted the industry last quarter do not sound like they have abated, and that could further eat into AEO’s margins. While it’s difficult to sell AEO into Wednesday’s sell-off, we think the move is necessary to take off risk ahead of next week’s earnings report. We’re taking that cash to high-grade the portfolio into Johnson & Johnson. As we discussed Tuesday in our Bullpen refresher , we like the company’s decision to separate its consumer-staple-like Consumer Health business from its faster-growing and best-of-breed Pharmaceutical and Medical Device business. We think this breakup makes a lot of strategic sense as the two independent, market-leading companies will become more focused. Management will be able to move faster and more effectively allocate capital as they navigate different industry trends to meet the needs of their customers and patients. We think J & J has one of the best drug businesses out there, and it’s growing faster than the industry. Last quarter, worldwide adjusted operational sales increased by about 9%, and six assets had double-digit percentage growth in the quarter. Meanwhile, the medical device business has seen recently seen a real resurgence thanks to a recovery in elective procedures that were delayed during the pandemic. For the Consumer Health Business, which has many iconic brands like Neutrogena, Tylenol, Listerine, and Johnson’s family-care line, we think the market may be sleeping on its potential as a consolidator. The business will have every opportunity to double down into faster growing categories like skincare and baby care thanks to its investment-grade profile and balance sheet. Consumer Health driven deals were something it really couldn’t do when it was buried within a larger company as those deals would not have moved the needle and shareholders always wanted to see investment in pharmaceutical and medical technology. We think the consumer business would get a higher multiple as an independent company too. J & J currently trades at 17 times earnings. Clorox, Club holding Procter & Gamble (PG), and Colgate all sell for north of 25 times earnings because this market values consistency and recession-proof businesses. J & J’s consumer business could fetch a multiple closer to those peers. We understand that the breakup is going to be a very long process — the separation is expected to happen in 2023 — and that’s why we like how J & J is paying you to wait with its 2.5% dividend yield. We’re initiating J & J with a price target of $205 per share, roughly 15% higher than where the stock was trading Wednesday morning and representing roughly 20x 2022 consensus earnings per share estimates. (Jim Cramer’s Charitable Trust is long JNJ, AEO, WMT and PG. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.
