ALSN - Paring My Allison Transmission Investment

Summary

• The financial results here remain quite good, and I like the fact that revenue and profitability are nearly back to pre-pandemic levels.
• Additionally, a reasonable argument could be made to suggest that the shares are not overly expensive even after their recent run up in price.
• The problem for me is that I'm more about preserving capital right now. I also don't love the fact that the yield is much lower than the 10-Year Note.

It’s been just over five months since I added to my Allison Transmission Holdings ( ALSN ) position, the reasons for which were described in an article called “Allison Transmission: A Table Pounding Buy”, and in that time the shares have returned about 26% against a gain of 4.2% for the S&P 500. In this article, I’m not going to brag about that fairly massive market beating return, because I’ve done a great deal of bragging lately, and at some point even someone as socially clueless as myself recognises that such behaviour can get old. Today I want to work out whether or not I want to hold the shares, because a stock trading at $36.35 is, by definition, a less risky investment than the same stock when it’s trading at $45.58. Too many times over the years I’ve seen profits evaporate because I accepted the view that one should not “trade their winners”, and that I should “buy stocks for the long term.” As of now, I buy stocks when I think they’re trading at a discount, and I sell them when I think the market has gotten ahead of itself. The company’s reported financial results since I last reviewed the name, so I’m going to review those and I’ll look at the stock as a thing distinct from the underlying business.

Whether or not we have more leisure time now than at any time in humanity’s past is largely beside the point if we perceive that we’re busier and more stressed than ever. As my small way of helping relieving that feeling in you, my readers, I provide a “thesis statement” paragraph at the beginning of each of my articles for your enjoyment and edification. The purpose of these is to quickly present you the “gist” of my thinking on a given subject while reducing the exposure to the noxious bragging you’re likely going to get if you stick around until the end. You’re welcome. I like Allison Transmission very much, and I’d admit that the shares are not objectively expensive at the moment. I have two concerns, though, one of which is idiosyncratic to me and my demographic cohort. First, I’m bothered by the fact that the dividend yield is nearly 200 basis points lower than the risk free rate. There is risk in any business, even one as wonderful as this one, so I’d expect to be compensated for that. In the relativistic world of investing, where we have many options open to us about where to place our capital, the paltry dividend yield here matters. Second, I’m at that stage of life where I’m more interested in preserving capital than I am about shooting for an extra few points of returns. Written another way, I’m a grumpy old codger, and so I am more interested in protecting what’s mine than I am about trying to earn a few extra points. Thus, I’m going to pare my Allison Transmission investment down to a token. That’s the end of the thesis statement. If you read on from here, that’s on you. I don’t want to read any moaning in the comments section about the fact that I’m an inveterate braggart, or the fact that I spell words like “defence” and “favour” properly.

Financial Snapshot

The most recent financial results have been reasonably good in my view. Compared to the same period in 2021, revenue and net income in 2022 were up by 16.7% and 20% respectively. Earnings per share have exploded higher by 35.4% on the back of a massive stock buyback. Specifically, there were about 104.26 million shares outstanding at the end of Q3 in 2021, and that figure had dropped to 92.49 million by the end of Q3 of 2022. This is how the company managed to grow EPS from 2019 to 2022 in spite of the fact that revenue and net income are now lower than they were in 2019.

The company continues to reward shareholders with dividend increases, and the dividends for the first nine months of 2022 totaled $0.63 per share, up from $0.57 the previous year, and $0.45 on the eve of the pandemic.

Given the financial performance here, I’d be happy to hold my shares, or even add to my position at the right price.

The Stock

My regulars know that I consider the business and the stock to be distinctly different things. This is because the business generates revenue and profits selling commercial and defence fully automated transmissions, while the stock is a speculative instrument that gets traded around based on long-term expectations about the business. Given that the financial statement valuation of the business is "backward-looking" and the stock is a forecast about the distant future, there's an inevitable tension between the two.

Additionally, this stock, like all stocks, can be affected by changes in the overall market. The crowd may change its views about the desirability of "stocks" as an asset class, and that will impact individual stocks to some degree. Let me flesh this idea out a bit by using this investment as an example. I absolutely hate to remind you about this massive market beating return, but I’ll take one for the team and review the results again. My investment has returned about 26% against the S&P 500 which is up about 4.2%. A reasonable sounding, if counterfactual, argument could be made to suggest that some portion of my 26% gain should be attributed to the fact that “stocks” as an asset class are back in favour. Put another way, if the market crashed between then and now, it’s unlikely that I would have achieved this extraordinarily good result.

So, to sum up, the business sells transmissions, while the stock bounces up and down based on the crowd's ever-changing views about the future. The crowd is capricious, because the shares are much more volatile than anything that happens at the actual business. In my view, the only way to successfully trade stocks is to spot the discrepancies between what the crowd is assuming about a given company and subsequent results. I like to buy stocks when the crowd is particularly down in the dumps about a given stock, because those expectations are easier to beat.

Another way of writing "down in the dumps about a given stock" is "cheap." I like to buy cheap stocks because they tend to have more upside potential than downside. This is because much of the bad news has been wrung out of price. As my regulars know, I measure the cheapness of a stock in a few ways, ranging from the simple to the more complex. On the simple side, I look at the relationship of price to some measure of economic value, like sales, earnings, and the like. I like to see a stock trading at a discount to both its own history and the overall market. When last we met Allison Transmission, the shares were trading at a P/E of about 7.83, and sported a dividend yield of about 2.28%. They are now about 13% more expensive, and the dividend yield is about 19% lower per the following:

Source: YCharts

Source: YCharts

I like this business a great deal, but I don’t particularly like the fact that the yield is about 195 basis points lower than the risk free rate. Ideally, I’d want to see the dividend yield higher than the risk free rate, given that there’s obviously some risk present here.

My regulars know that I think ratios can be instructive, but I also want to try to work out what the market is "thinking" about a given investment. If you read my stuff regularly, you know that the way I do this is by turning to the work of Professor Stephen Penman and his book "Accounting for Value." In this book, Penman walks investors through how they can apply some pretty basic math to a standard finance formula in order to work out what the market is "thinking" about a given company's future growth. This involves isolating the "g" (growth) variable in this formula. In case you find Penman's writing a bit opaque, you might want to try "Expectations Investing" by Mauboussin and Rappaport. These two have also introduced the idea of using the stock price itself as a source of information, and we can infer what the market is currently "expecting" about the future. Applying this approach to Allison Transmission at the moment suggests the market is assuming that this company will grow earnings at a rate of ~3.5% in perpetuity. I consider this forecast to be neither optimistic nor pessimistic.

Given all of the above, I’m going to pare my gains, and sell the vast majority of my position. Although I don’t think the shares are egregiously expensive, I just can’t get past the fact that the dividend yield is well below the risk free rate. Although I think the dividend is secure, I think there are far higher yields out there that are even more compelling. I’m at that stage in life where preservation of capital is much more important than trying to squeeze a few more percentages out of my investments, and so I’ll keep only a token investment in Allison Transmission.

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