Dear Fellow Shareholders:
For the quarter ended March 31, 2015, Class C shares of the Olstein All Cap Value Fund returned 1.81% compared to total returns of 0.95% and 1.80% for the S&P 500® Index and the Russell 3000® Index, respectively. For the three-year period ended March 31, 2015, Class C shares of the Olstein All Cap Value Fund had an average annual return of 16.79% compared to total returns of 16.11% and 16.43% for the S&P 500 Index and the Russell 3000 Index, respectively.
Olstein All Cap Value Fund - Market Outlook
The expectation of rising interest rates, the strengthening of the US dollar and weaker-than-expected economic data led to an increase in market volatility during the first quarter of the year. The volatility was further fueled by forecasters’ predictions of a market pullback in the near future. While there are always forecasters predicting the next market correction or downturn (it eventually does occur), we believe it is important to weather market events and periods of short- term volatility by favoring the equities of financially strong companies with stable or growing free cash flow, run by managements that have demonstrated a history of deploying company excess cash to the benefit of shareholders.
Although alluring, we continue to believe that market timing is a low probability game and we are focusing on individual companies whose real economic value is, in our opinion, unrecognized by the market, and obscured by market uncertainty or overshadowed by temporary problems. Over the long run, focusing on companies whose long-term values are unrecognized by the market because of temporary factors has served our shareholders well. We are continuing to find what we believe to be viable undervalued opportunities by focusing on three primary, company-specific factors: (1) a commitment to maintain a strong financial position as evidenced by a solid balance sheet; (2) an ability to generate sustainable free cash flow; and (3) management that intelligently deploys cash balances and free cash flow from operations to increase returns to shareholders. We further believe that by prioritizing these factors, our portfolio of companies should be positioned to compete more advantageously as economic growth accelerates.
Olstein All Cap Value Fund - Our Strategy
From our perspective, Wall Street’s continuing obsessive focus on short-term concerns has increased deviations between stock prices and company valuations in free cash flow in companies not currently in the limelight, affected by short-term factors, or just plain misperception of those companies. Investors negatively reacting to any pessimistic short-term news or event affecting companies that meet our stringent cash flow and balance sheet criteria, which are selling at a discount to our calculation of intrinsic value, can create favorable opportunities for the Fund. We believe our portfolio consists of companies that have an ability to deliver long-term value to their shareholders not currently being recognized by the market. As always, we are focusing on individual companies, their operations and prospects for maintaining or growing sustainable free cash flow, rather than making short-term market calls.
In addition to our focus on a company’s ability to generate sustainable free cash flow, we will continue to emphasize the quality of a company’s earnings. We define the quality of earnings in terms of our assessment of how realistic the financial statements are in portraying economic reality, as well as whether or not the balance sheet’s conservatism is strong enough to weather future storms. By highlighting the quality of a company’s earnings, we seek to accomplish two objectives: (1) to assess the financial risk inherent in each investment opportunity before considering the potential for capital appreciation, and (2) to identify those companies that not only have focused their priorities on weathering the current slow growth economy, but have also laid the groundwork to achieve a substantial strategic advantage for the acceleration of economic growth that we believe is around the corner.
Olstein All Cap Value Fund - Portfolio Review
At March 31, 2015, the Olstein All Cap Value Fund portfolio consisted of 100 holdings with an average weighted market capitalization of $57.42 billion. During the quarter, the Fund initiated positions in nine companies and strategically added to positions in fifteen companies. Over the same time period, the Fund eliminated its holdings in nine companies and strategically decreased its holdings in another six companies. Positions initiated during the last three months include: Alaska Air Group, Citizens Financial Group, HCA, Johnson Controls, Joy Global, Keysight Technologies, Inc., NVIDIA, Oshkosh Corp., and Viacom Inc. Positions eliminated during the past three months include: American Express, Charles River Laboratories Inc., EI du Pont de Nemours, NOW Inc., Quest Diagnostics, Inc., Ross Stores Inc., Teleflex Inc., TJX Companies, Inc., and Whole Foods Market.
Olstein All Cap Value Fund - Monitoring Portfolio Holdings
In the six years that have followed the lows of March 2009, the market’s strong recovery has significantly lifted the fortunes of many companies (as evidenced by the S&P 500 Index’s impressive annualized returns of 19.67% over the six years ending March 31, 2015), we thought it would be helpful to discuss how we monitor the progress of the Fund’s portfolio holdings. While many factors may influence the price of a company’s common stock, we focus on what a company has done, and what we believe needs to do, in order to reach the level of normalized free cash flow that defines our determination of intrinsic value. In addition, for all portfolio holdings we measure the fundamental operating progress of each company to determine whether or not our estimated normalized free cash flow could be achieved within our standard 2-3 year time period, and how the operating progress compares to how quickly the gap (discount) between the stock price and our estimation of intrinsic value should close. Of course, throughout our holding period we take advantage of widening or shrinking discounts by buying and/or selling to adjust the size of our positions to the size of the discount from our calculation of intrinsic value. Intrinsic value is always adjusted to take into account differences between our original calculation of intrinsic value and how a company is progressing toward our original estimate of free cash flow.
Olstein All Cap Value Fund - The Importance of the Investment Thesis
Prior to buying a security for the Fund’s portfolio, we undertake an intensive, forensic analysis of a company’s financial statements, footnotes and other regulatory filings in order to develop a deeper understanding of the stability and reliability of the company’s free cash flow potential under different scenarios. Through this intensive analysis we also construct a roadmap of how a company can achieve the value that we see – whether it is through organic growth, an operational turnaround, a management change, shift in strategy, restructuring a division, debt pay down, buybacks, and/or increased dividend payments, etc. Each research analyst documents their intensive analysis following a specific format that defines the investment idea and investment thesis and includes a description of the company, its operations, products & services, the fundamentals of the company’s business model, industry economics and competitive dynamics, the framework for assessing future operations and cash flows, as well as detailed scenario analyses showing best, worst and likely case for appreciation based on differing future cash flows and economic outcomes. The investment thesis and roadmap to value become important parts of monitoring a company’s progress once it has been added to the Fund’s portfolio.
Olstein All Cap Value Fund - The Road Map to Realizing Value
For many companies, progress towards achieving our required level of normalized free cash flow may come through a series of well-planned and well-executed steps while for others the road map to value often means overcoming strategic challenges or problems through a bolder course of action. Over the life of the Fund we have invested in many of the first type of company – companies with steady, profitable growth that have been affected by short-term issues, misunderstood, overlooked, or underappreciated by the overall market. Usually, over time, the market begins to understand the value of the steady and/or growing free cash flow and reacts to the growth potential of such companies. As market perception changes and these companies approach our projected level of normalized free cash flow, their stock prices usually rise accordingly. Monitoring the progress of misunderstood, underappreciated companies or companies affected by short-term issues is fairly straightforward and focuses on the progress toward our projection of normalized free cash flow and the consistency of management’s ability to continue to execute on successful strategies. For companies facing unique choices or challenges, however, the road to normalized free cash flow is usually longer with numerous twists and turns and highs and lows along the way. Monitoring the progress of such companies requires an unrelenting focus on the most effective turnaround plan for overcoming strategic problems, as well as constant attention to the company’s balance sheet in combination with management’s ability to implement needed changes.
Olstein All Cap Value Fund - Monitoring Turnaround Situations
We frequently invest in compelling opportunities presented by companies that have either reached a critical point in their growth or have stumbled due to Wall Street’s overwhelming expectations for continuous growth. From our perspective, the source of these problems are usually due to one of the following root causes: (1) strategic choices which may result, or have resulted, in profitless growth; (2) economic headwinds or market conditions that may (or have) disrupted or impaired the company’s growth engine; or (3) forays into businesses or product areas far removed from the company’s core competencies.
When analyzing companies facing unique strategic challenges (before making the decision to invest), we look for specific financial, competitive and structural characteristics that signal that problems appear to be temporary and more importantly, can be effectively addressed within a reasonable time frame. Although companies facing temporary problems can usually improve investor perception within a short period of time, an underperforming company steeped in negative sentiment must usually embark on a focused turnaround that forces significant changes to the way it approaches its business. While the interests of diverse stakeholders — equity shareholders, lenders, vendors, customers and employees — influence the development of an underperforming company’s turnaround strategy, the equity markets usually seek convincing signs that a company is undertaking necessary change.
We do not often agree with the market’s collective reaction to a company’s problems; instead we look for specific characteristics to decide if a meaningful transformation can be accomplished within an 18- to 24-month period. Understanding the causes of a company’s performance problems (specifically, the internal and external factors that contributed to the company’s current state) not only allow us to determine if those problems are temporary, they also help us judge which course of action is likely to improve the company’s prospects and provide insight into management’s ability to effect needed change. We focus on balance sheet strength and the cash flow pipeline since we expect the road to value-enhancing normalized free cash flow to be longer and bumpier in these situations.
Olstein All Cap Value Fund - Focus on the Balance Sheet
The foresight to build balance sheets that can withstand tough economic times and an ability to generate free cash flow from operations during all cycles are two of the most important characteristics we look for when considering any stock for the Fund’s portfolio. In turnaround situations, balance sheet strength becomes increasingly important since it enables a company to focus on strategic priorities when addressing problems rather than being forced to adopt short-term survival strategies that may not be in the long-term interests of shareholders. In essence, strong balance sheets enable turnaround companies to weather the storm. Our initial interest when examining balance sheet strength is a calculation of total assets to equity (which is a useful proxy for measuring debt levels relative to equity as well as overall balance sheet conservatism). We also determine how many years it would take for a company to pay down debt from discretionary free cash flow. Our portfolio is dominated by companies in which total assets are less than 2.5 times shareholders’ equity and where debt can be eliminated by discretionary free cash flow in five years or less.
Another balance sheet statistic that we monitor is working capital turnover, which includes analyzing changes in receivables and inventories relative to sales. Through this analysis we look for indications of future earnings accelerations or slowdowns. In addition, we examine comparative inventory and receivable reserves to identify any non-recurring contributions or penalties to current earnings which could be masking normalized earnings. We analyze asset turnover ratios to determine the productivity of a company’s fixed asset base in generating a given level of sales. The higher the number of times that property plant and equipment turns over relative to sales increases a company’s returns on equity, and results in lowering the amount of capital expenditures necessary to generate a given level of sales, thus aiding future free cash flow and accelerating progress towards our estimate of normalized free cash flow.
Olstein All Cap Value Fund - Focus on the Cash Flow Pipeline
As we have said many times before, free cash flow is the lifeblood of a business, and this is especially true for companies facing challenges and problems. The ability of management to take control over the cash flow pipeline and make critical internal investment decisions which are in the long-term interests of the company, rather than temporary “Band-Aids,” often determines the ultimate success of any turnaround strategy. As we monitor the progress of specific portfolio holdings, we expect a company’s articulated strategy to demonstrate the ability to generate or greatly improve free cash flow in two years or less. We focus on how operations will be able to create sustainable free cash flow; the level of investment required to right the company and eventually grow the business; and how much cash should be available to investors as the company stabilizes.
Thus, we focus on how management’s use of cash takes advantage of opportunities: is the company improving its balance sheet; is the company increasing cash reserves; can the company finance certain initiatives internally (using cash flow from operations) to increase its capacity? We focus on the balance sheet and the nature of the company’s debt: has the company reduced leverage in order to provide ammunition for future stumbles or has leverage become a significant element of the company’s business model? We tend to stay away from companies who believe in excess leverage in order to generate above average returns. In addition to debt and cash levels, we focus on other factors as well: can the company reduce the capital intensity of its business model; how well has the company managed inventories and receivables; has the company reduced payables; is the company achieving the best possible terms from suppliers?
Olstein All Cap Value Fund - Signs that Reveal Progress
While the roadmap to normalized free cash flow differs for each investment, the signs of progress we look for are consistent. We look for essential factors that we believe increase the odds of a company reaching our estimate of normalized free cash flow and thus achieving our valuation. This is especially true for companies facing strategic challenges. First, a company has to identify realistic, achievable alternatives for correcting its course and/or achieving growth. It may need to redefine its business boundaries, strategy, operations, financial management and organizational structure. Second, the company must make a priority of not only stabilizing its operations, but must also have an objective of generating and increasing free cash flow on a continuing basis. Third, it will need a capable, skilled management team — which may entail bringing in a new senior management team with specific skills. Fourth, we look to buy the company at a significant discount (30% or more) to our calculation of the company’s intrinsic value, thus providing a measure of downside protection if our investment thesis needs a greater period of time to unfold or in fact does not materialize. Buying at a discount created by negativity tends to reduce the magnitude of future price declines because some of the negativity should already be reflected in the stock’s price. We continue to believe that long-term above average performance is determined more by the magnitude and quantity of the mistakes than by picking a few large winners.
Even if the turnaround characteristics are in place, achieving the desired investment outcome requires commitment, discipline and patience by a company’s management. We measure this commitment via a continuing inferential analysis of the financial statements. We may have to ride out intermittent periods of frustration and excitement as strategic alternatives unfold. In most cases, it can be 12 to 24 months or longer before we see concrete positive results. During this time period, if the company is demonstrating the improvements we believe will help it reach our sustainable and/or growing free cash flow estimates, it is important to not only stay the course during intermittent periods of disappointment and negative market sentiment, but to also react by adding to positions if price discounts widen that are not based on long-term considerations and a company’s normalized ability to produce future free cash flow.
Uncertainty and fear, fueled by troubling news combined with both good and disappointing economic data, usually result in the type of market volatility we see dominate markets from time to time. While market dips often present us with buying opportunities (following our strict stock selection criteria), low stock prices are not the sole criteria for buying companies for the portfolio. Additional criteria include strong balance sheets; well-run operations which have the ability to consistently generate excess free cash flow; and company managements with a disciplined track record of improving the returns of the business and dedicated to increasing value for shareholders.
We believe the best approach for an uneven economic and investment environment is to buy companies that have a continuing ability to generate free cash flow, have little or no debt (or are aggressively paying down debt), and to buy such companies when they are experiencing either short-term problems or plain old misperceptions, at a significant discount to their intrinsic value. The Fund’s portfolio primarily consists of fiscally strong, excess-cash-flow companies whose businesses, in our opinion, are primed to provide suitable returns whether the economic rebound is modest or robust.
We value your trust and remind you that our money is invested alongside yours as we diligently work to accomplish the Fund’s primary objective of long-term capital appreciation.
Robert A. Olstein
Chairman, Chief Investment Officer and Co-Portfolio Manager
Eric R. Heyman