16 new stocks made our Most Attractive list this month, while 18 new stocks joined the Most Dangerous list. We published September’s Most Attractive and Most Dangerous stocks to members on September 7, 2023.
August Performance Recap
Our Most Attractive Stocks (-2.5%) underperformed the S&P 500 (-0.1%) last month by 2.4%. The best performing large cap stock gained 9% and the best performing small cap stock was up 20%. Overall, 15 out of the 40 Most Attractive stocks outperformed the S&P 500.
Our Most Dangerous Stocks (-4.7%) outperformed the S&P 500 (-0.1%) as a short portfolio last month by 4.6%. The best performing large cap short stock fell by 13% and the best performing small cap short stock fell by 51%. Overall, 18 out of the 29 Most Dangerous stocks outperformed the S&P 500 as shorts.
The Most Attractive/Most Dangerous Model Portfolios outperformed as an equal-weighted long/short portfolio by 2.2%.
This report leverages our cutting-edge Robo-Analyst technology to deliver proven-superior[1] fundamental research and support more cost-effective fulfillment of the fiduciary duty of care.
All of our Most Attractive stocks have high (and rising) return on invested capital (ROIC) and low price to economic book value ratio. Most Dangerous stocks have misleading earnings and long growth appreciation periods implied by their market valuations.
Most Attractive Stocks Feature for September: Allison Transmission Holdings (ALSN)
Allison Transmission Holdings (ALSN: $59/share) is the featured stock from September’s Most Attractive Stocks Model Portfolio. We first made Allison Transmission a Long Idea in June 2020 and the stock remains undervalued.
Allison Transmission has grown revenue by 3% compounded annually and net operating profit after tax (NOPAT) by 5% compounded annually since 2012. Allison Transmission’s NOPAT margin increased from 20% in 2012 to 23% in the trailing twelve months (TTM), and invested capital turns rose from 0.5 to 0.7 over the same time. Rising NOPAT margins and invested capital turns drive Allison Transmission’s return on invested capital (ROIC) from 10% in 2012 to 17% in the TTM.
Figure 1: Allison Transmission’s Revenue and NOPAT Since 2012
Sources: New Constructs, LLC and company filings
Allison Transmission Is Undervalued
At its current price of $59/share, ALSN has a price-to-economic book value (PEBV) ratio of 0.6. This ratio means the market expects Allison Transmission’s NOPAT to permanently decline by 40%. This expectation seems overly pessimistic for a company that has grown NOPAT by 5% compounded annually since 2012.
Even if Allison Transmission’s NOPAT margin falls to 22% (equal to the five-year average compared to 23% over the TTM) and the company’s revenue grows just 2% compounded annually through 2032, the stock would be worth $97/share today – a 64% upside. Should Allison Transmission grow profits more in line with historical levels, the stock has even more upside.
Critical Details Found in Financial Filings by Our Robo-Analyst Technology
Below are specifics on the adjustments we made based on Robo-Analyst findings in Allison Transmission’s 10-Qs and 10-Ks:
Income Statement: we made $227 million in adjustments, with a net effect of removing $87 million in non-operating expenses (3% of revenue). Clients can see all adjustments made to Allison Transmission’s income statement on the GAAP Reconciliation tab on the Ratings page on our website.
Balance Sheet: we made $1.5 billion in adjustments to calculate invested capital with a net decrease of $86 million. One of the most notable adjustments was $1.1 billion in adjustments for deferred tax assets. This adjustment represents 25% of reported net assets. Clients can see all adjustments made to Allison Transmission’s balance sheet on the GAAP Reconciliation tab on the Ratings page on our website.
Valuation: we made $3.2 billion in adjustments, with a net decrease in shareholder value of $2.6 billion. The most notable adjustment was $2.3 billion in total debt. This adjustment represents 44% of Allison Transmission’s market value. Clients can see all adjustments to Allison Transmission’s valuation on the GAAP Reconciliation tab on the Ratings page on our website.
Most Dangerous Stocks Feature: Schrodinger Inc. (SDGR)
Schrodinger Inc. (SDGR: $34/share) is the featured stock from September’s Most Dangerous Stocks Model Portfolio.
Schrodinger has grown revenue 26% compounded annually since 2019 while its NOPAT has fallen from -$38 million in 2019 to -$153 million over the TTM. See Figure 2. NOPAT margin has fallen from -44% in 2019 to -79% in the TTM and the company currently generates a -23% ROIC.
Schrodinger’s economic earnings, the true cash flows of the business which take into account changes to the balance sheet, have fallen from -$48 million in 2019 to -$232 million over the TTM.
Figure 2: Schrodinger’s Revenue and NOPAT Since 2019
Sources: New Constructs, LLC and company filings
SDGR Provides Poor Risk/Reward
Despite its poor fundamentals, Schrodinger’s stock is priced for significant profit growth, and we believe the stock is overvalued.
To justify its current price of $34/share, Schrodinger must improve its NOPAT margin to 15% (up from -79% over the TTM) and grow revenue by 34% compounded annually through 2032. In this scenario, Schrodinger’s NOPAT would equal $507 million in 2032, up from its best ever NOPAT of -$38 million. We think these expectations are overly optimistic.
Even if Schrodinger improves its NOPAT margin to 15% and grows revenue 26% compounded annually through 2032, the stock would be worth no more than $18/share today – a 47% downside to the current stock price.
Each of these scenarios also assumes Schrodinger’s can grow revenue, NOPAT, and FCF without increasing working capital or fixed assets. This assumption is unlikely but allows us to create best case scenarios that demonstrate the high expectations embedded in the current valuation.
Critical Details Found in Financial Filings by Our Robo-Analyst Technology
Below are specifics on the adjustments we made based on Robo-Analyst findings in Schrodinger’s 10-Qs and 10-K:
Income Statement: we made $40 million in adjustments, with a net effect of removing $8 million in non-operating expenses (4% of revenue). Clients can see all adjustments made to Schrodinger’s income statement on the GAAP Reconciliation tab on the Ratings page on our website.
Balance Sheet: we made $57 million in adjustments to calculate invested capital with a net increase of $56 million. One of the most notable adjustments was $19 million in operating leases. This adjustment represented 3% of reported net assets. Clients can see all adjustments made to Schrodinger’s balance sheet on the GAAP Reconciliation tab on the Ratings page on our website.
Valuation: we made $322 million in adjustments, all of which decreased shareholder value. The most notable adjustment to shareholder value was $181 million in outstanding employee stock options. This adjustment represents 9% of Schrodinger’s market value. Clients can see all adjustments to Schrodinger’s valuation on the GAAP Reconciliation tab on the Ratings page on our website.
This article was originally published on September 14, 2023.
Disclosure: David Trainer, Kyle Guske II, Hakan Salt, and Italo Mendonça receive no compensation to write about any specific stock, style, or theme.
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[1] Our research utilizes our Core Earnings, a more reliable measure of profits, as proven in Core Earnings: New Data & Evidence, written by professors at Harvard Business School (HBS) & MIT Sloan and published in The Journal of Financial Economics.