Why would you consider buying Johnson & Johnson stock (NYSE:JNJ) at 17 times its trailing earnings when Merck stock (NYSE: MRK) trades at around 13 times? After all, Merck has nearly 10% average revenue growth compared to J&J’s modest 4%, and Merck’s operating cash flow margins are a healthier 33% versus J&J’s 28%. This means more of Merck’s robust top-line growth translates directly into free cash flow, which can be reinvested or returned to shareholders. So, why choose J&J over Merck?
One could argue that J&J offers greater stability, with over a century of established operations. Merck’s impressive recent growth, however, is largely attributed to the success of Keytruda, its blockbuster oncology drug. The concern is that this growth might not be sustainable, especially with increasing competition in the oncology space. See – Merck Stock’s Ticking Keytruda Time Bomb.
Here’s the thing. Merck faces a significant challenge as Keytruda, accounting for nearly half of its revenue, loses U.S. market exclusivity in 2028. The drug’s sales have soared, reaching $29 billion last year, but this reliance sets Merck up for a steep decline.
History shows the dramatic impact of biosimilars: AbbVie’s Humira sales plummeted by nearly 60% in just two years post-patent expiration, and Roche’s Herceptin saw a similar sharp drop. Keytruda’s sales are projected to peak around $36 billion by 2028, but a rapid decline to under $20 billion (or even $15 billion) is highly probable once biosimilar competition begins. This will inevitably slow Merck’s growth and is expected to significantly impact its valuation.
This scenario underscores the importance of building a resilient investment portfolio that balances risk and reward. Our Trefis High Quality (HQ) portfolio exemplifies this approach, having significantly outperformed the S&P 500, Nasdaq, and Russell 2000, clocking in over 91% returns since inception. Balancing risk and reward is precisely why diversifying across multiple stocks is crucial.
Comparing Merck with J&J highlights the critical risk-reward trade-offs in investment decisions. In practice, investment choices are about understanding relative attractiveness. Should you buy J&J stock, keep your money in an interest-earning cash account, or invest in an S&P 500 ETF? You need to assess if the expected return on J&J stock sufficiently outweighs the return on cash, and what downside risk you’re accepting for that potential extra return. Using a specific “anchor” asset, like Merck in this case, serves as a powerful tool to evaluate these risk-reward dynamics.
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