Eric Heyman of the Olstein Strategic Opportunities fund likes beaten-down stocks producing lots of cash flow.

H/T Dataroma

Olstein Strategic Opportunities Fund: Five Unloved But Cash Rich Stock Picks

Small and midsized stocks are often prized for their growth potential, but Eric Heyman sees them as accidents waiting to happen. The co-manager of the Olstein Strategic Opportunities fund, Heyman says that investors’ infatuation with endless growth eventually causes companies to stumble, and that creates opportunities for investors.

“We’re looking to find companies facing temporary problems, or in need of an operational turnaround, or a change in management,” says Heyman. “Companies with strong products or services that have stumbled or hit a wall due to Wall Street’s demand for constant growth.”

To identify the good companies among the basket cases, Heyman performs forensic analysis of financial statements to find free cash flow potential. “Free cash flow is the lifeblood of any business,” he says. “When you start to read two, three, five years back you get a strong understanding about how a company has progressed and where they are in their business cycle.” Potential free cash flow is a key metric in Heyman’s analysis, and all stocks added to the portfolio must be trading at a 30% discount to the managers’ estimate of intrinsic value.

Poring over a company’s financial reports also gives Heyman some insight into whether poor management is holding back a strong underlying business. To evaluate management teams, Heyman looks at balance-sheet management, debt payments, return of capital, and mergers and acquisitions activity, among other indicators. Three small-cap stocks he likes right now are Integra LifeSciences (IART), Wesco International (WCC) and ABM Industries (ABM).

The fund has just $200 million in assets but boasts a strong performance over its eight-year history. Over the past three years the fund has notched average annual returns of 20.64%, putting it in the top 1% of funds in its category, according to Morningstar. Over the same period the Russell 2000 index returned 16.61% per year. Over five years the fund has also beaten the index, while topping 92% of its peers. Barrons.com asked Heyman to share five small-cap stocks he likes right now.

Olstein Strategic Opportunities Fund: Integra LifeSciences

Heyman says the diversified medical device company is in the early innings of a recovery. Integra has strong market positions in a number of areas, particularly neurosurgery. Under previous management the company made a slew of acquisitions, and CEO Peter Arduini is now focused on integrating and consolidating those additions. That plan includes trimming its manufacturing facilities count, reducing its computer systems and selling off noncore businesses. “This is a true operational turnaround,” says Heyman. He believes the company can generate $4 in free cash flow per share compared to the $1.75 expected for 2015, which would bring its shares up to $80 from the current price around $61.

Olstein Strategic Opportunities Fund: Daktronics

Another operational turnaround story, Daktronics (DAKT), manufactures scoreboards, stadium systems and LED signs. Stadiums across the country have been upgrading their display systems to attract younger fans and offer a better gameday experience as ticket prices continue to go up. Cheaper LED chips have also made their products more affordable, drumming up demand. Thus far, Daktronics has struggled to keep up with demand, but Heyman says the problem is fixable and Daktronics is the only full solution provider in the market. He thinks the company, which has a market value of $500 million, could generate 90 cents a share in free cash flow, bringing its shares up to $15. The company is expected to register 55 cents in free cash flow per share this year and is trading at $10.66.

Olstein Strategic Opportunities Fund: ABM Industries

Heyman believes this facilities maintenance company’s free cash flow and earnings are understated. “When we study free cash flow and the balance sheet we see a tremendous amount of excess depreciation or noncash charges that are not coming through in earnings per share reporting.” The company is also expanding into other areas, such as parking and security. He estimates the company has free cash flow share potential of $2.20 per share compared with the 2015 estimate of $1.75. Shares could go to $38 from the current $32.

Olstein Strategic Opportunities Fund: Lifetime Brands

Similar to ABM Industries, Lifetime Brands (LCUT) has 50 cents of excess depreciation that isn’t apparent in earnings reporting, according to Heyman’s analysis. The company is the largest global provider of kitchenware, tabletop ware and housewares, with both its own brands and licensed brands. Its customers include Bed Bath & Beyond, department stores and grocery stores. Heyman thinks the company can generate $1.50 a share, which could put the stock at $22. Shares currently trade at $15.40 and free cash flow per share is expected to be $1.25 this year.

Olstein Strategic Opportunities Fund: Wesco International

A distributor of electrical and industrial products and maintenance, Wesco provides materials, repair and maintenance for industrial and commercial construction companies. Heyman believes that the market has overreacted to the company’s exposure to the energy sector. While Wesco gets 10%-15% of its business from the oil and gas industry, Heyman says the company should benefit from an increase in infrastructure projects. He believes the company can earn $5.63 per share for 2015, compared to the consensus analyst estimate of $5.32.

Olstein Strategic Opportunities Fund: Five Unloved But Cash Rich Stock Picks

See full PDF below.