Olstein All Cap Value Fund’s second quarter letter to shareholders for the fiscal year ended June 30, 2014.
Dear Fellow Shareholders:
For the fiscal year ended June 30, 2014, Class C shares of the Olstein All Cap Value Fund appreciated 21.74%, compared to total returns of 24.61% and 25.22% for the S&P 500® Index and the Russell 3000® Index, respectively. For the quarter ended June 30, 2014, Class C shares of the Olstein All Cap Value Fund appreciated 3.39% compared to total returns of 5.23% and 4.87% for the S&P 500 Index and the Russell 3000 Index, respectively.
Olstein All Cap Value Fund: Market Outlook
Despite a sharp contraction in the U.S. economy during the first quarter of the year, as well as rising global tensions due to armed conflict in Eastern Ukraine and in the Middle East, U.S. equity markets continued to chug along with the benchmark S&P 500 Index increasing 7.14% for the first six months of the year. With the strong market run now five years old, some forecasters are warning investors of an imminent pull back or decline. The ability to sell at market tops and buy at market bottoms is the dream of every portfolio manager, as the ability to perform this timing feat should produce meteoric investment returns. Rather than engaging in what we believe is an unachievable and long-term failure strategy of seeking to time when to be in or out of the overall market, our strategy is to pay the right price for stocks of financially strong companies selling at a discount to our calculations of intrinsic value, and to sell stocks when they reach our calculation of intrinsic value. Our proprietary intrinsic valuation method is based on looking behind the numbers of a company’s financial statements to determine a company’s normalized ability to generate and grow free cash flow. If we cannot find companies to purchase at our required discount, we sit with cash until opportunities present themselves. Thus, Olstein All Cap Value Fund’s method of timing is company based, by which the Fund keeps cash until buying opportunities present themselves that offer the Fund an appropriate risk reward ratio and sells holdings when individual stocks reach our calculation of intrinsic value. Thus, the magnitude by which a company’s stock price is below our calculation of a company’s intrinsic value (defined as the discount) determines the amount of our cash holdings. In addition, we adjust the size of our positions according to the magnitude of a stock’s discount. Hopefully, paying the right price for a stock and the ability to hold cash when individual stock prices are judged to be too high to buy, in combination with our commitment to selling fully valued securities, should help the Fund mitigate the impact of overall market declines on the Fund’s portfolio over time.
While many investors are nervous about what they believe is an imminent correction in equity markets or remain sidelined waiting for accelerated economic growth, we are continuing to apply our discipline by investing in the equity securities of companies with stable or growing free cash flow, whose real economic value we believe is unrecognized by the market (obscured by market uncertainty or overshadowed by temporary problems). No methodology works all of the time but our objective is to be right over time.
Olstein All Cap Value Fund’s Strategy
We continue to seek and invest in companies that we believe have an ability to deliver long-term value to shareholders that we believe is not currently recognized by the market. In 2014, we remain focused 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 even under tough economic circumstances; and (3) management that intelligently deploys cash balances and free cash flow from operations to increase returns to shareholders. By prioritizing these factors, our portfolio consists of companies that should be positioned to compete more advantageously as economic growth accelerates.
Against an improving economic backdrop, we also continue to emphasize the quality of a company’s earnings in 2014. By highlighting the quality of a company’s earnings, we seek to accomplish two objectives. First, we assess the financial risk inherent in each investment opportunity before considering the potential for capital appreciation. While many investors are obsessed with short-term market volatility, our primary concern is to avoid or mitigate permanent impairment of capital. We believe our relentless focus on the quality of earnings provides a valuable tool for achieving that objective. Second, we identify those companies that we believe have focused their priorities during the economic recovery to establish the financial wherewithal and internal operating infrastructure to achieve a substantial strategic advantage for the acceleration of economic growth.
Olstein All Cap Value Fund’s Leaders
The stocks which contributed positively to performance for the twelve month reporting period include: Harman International Industries Inc./DE/ (NYSE:HAR), Legg Mason Inc (NYSE:LM), Delta Air Lines, Inc. (NYSE:DAL), Spirit Airlines Incorporated (NASDAQ:SAVE), and Apple Inc. (NASDAQ:AAPL). At the close of the fiscal year, the Fund continued to maintain a position in each of these holdings.
Olstein All Cap Value Fund’s Laggards
Laggards during the twelve month reporting period include: Fairway Group Holdings Corp., Staples, Inc., Coach, Inc., Bed Bath & Beyond, Inc. and Teradata Corporation. During the fiscal year, the Fund eliminated its holding in Fairway Group Holdings Corp (NASDAQ:FWM), Staples, Inc. (NASDAQ:SPLS) and Coach Inc (NYSE:COH). As of the close of the fiscal year, the Fund continued to hold Bed Bath & Beyond, Inc. and Teradata Corporation. Despite Bed Bath & Beyond Inc. (NASDAQ:BBBY)’s recent weak stock performance caused by investor fear that internet-based retailers (particularly Amazon) would cause a permanent deterioration in sales, we believe Bed Bath & Beyond, Inc. can continue to grow its free cash flow, albeit at a slower growth rate. The current stock price, in our opinion, discounts too pessimistic of a scenario in view of the fact that the company continues to generate more than sufficient free cash flow growth and we believe that growth should continue into the foreseeable future. After the close of the fiscal year, the stock has rebounded on news that the company would undertake an aggressive $1.1 billion accelerated stock repurchase program. Similarly, we believe investor sentiment has turned unduly negative on Teradata Corporation (NYSE:TDC), (a long-time holding in the Fund since 2008), based on fears that newer technologies may effectively replace the company. We believe newer technologies will, in fact, complement Teradata Corporation’s data warehousing and analytic capabilities in a growing market segment.
Olstein All Cap Value Fund’s Portfolio Review
We continue to focus on how individual companies have adapted their expectations, strategic plans and operations to recent bumpy economic conditions, and how they have managed their assets to deliver future earnings to investors. Our current portfolio consists of companies that, we believe, have a sustainable competitive operating advantage, discernible balance sheet strength and a management team that emphasizes decisions based on cost of capital calculations and deploys free cash flow to create shareholder value. At June 30, 2014, the Olstein All Cap Value Fund portfolio consisted of 105 holdings with an average weighted market capitalization of $53.12 billion.
During the fiscal year, the Fund initiated positions in 34 companies and strategically added to positions in 13 companies. Over the same time period, the Fund eliminated its holdings in 29 companies and strategically decreased its holdings in another 26 companies. Positions initiated during the fiscal year include: ADT Corp (NYSE:ADT), Ann Inc (NYSE:ANN), Aon Plc (NYSE:AON), AT&T Inc. (NYSE:T),The Bank of New York Mellon Corporation (NYSE:BK) , Comcast Corporation (NASDAQ:CMCSA), Corning Incorporated (NYSE:GLW), CVS Health Corp (NYSE:CVS), Dillard’s, Inc. (NYSE:DDS)., Esterline Technologies Corporation (NYSE:, Fifth Third Bancorp (NASDAQ:FITB), Fossil Group Inc (NASDAQ:FOSL), Greenbrier Companies Inc (NYSE:GBX), Intuitive Surgical, Inc. (NASDAQ:ISRG), Invesco Ltd. (NYSE:IVZ), Itron, Inc. (NASDAQ:ITRI), Marsh & McLennan Companies, Inc. (NYSE:MMC), Masco Corporation (NYSE:MAS), Medtronic, Inc., NOW Inc., Oracle Corporation, Parker-Hannifin Corporation, Ralph Lauren Corporation, Rock-Tenn Company, Sealed Air Corporation, Sensient Technologies Corporation, TE Connectivity Ltd., TRW Automotive Holdings Corp., UniFirst Corporation, UnitedHealth Group Incorporated, URS Corporation, Verizon Communications, Inc., WESCO International, Inc. and Whole Foods Market, Inc. Positions eliminated during the past fiscal year include: Agilent Technologies, Inc., Alaska Air Group, Inc., Analog Devices, Inc., Apache Corporation, The Charles Schwab Corporation, City National Corporation, Coach, Inc., Constellation Brands, Inc., Covidien PLC, Cummins Inc., Diebold, Incorporated, Dover Corporation, Dr Pepper Snapple Group, Inc., Fairway Group Holdings Corp., FedEx Corp., Genuine Parts Company, Henry Schein, Inc., The J.M. Smucker Company, Korn/Ferry International, MasterCard, Inc., MICROS Systems, Inc., Microsemi Corporation, NCR Corporation, Pentair Ltd., Schlumberger Limited, Sonoco Products Company, Staples, Inc., Teradyne, Inc., Thor Industries, Inc. and The Timken Company.
Olstein All Cap Value Fund: Being in the Right Place at the Right Time
From its inception in 1995 through year-end 2013, approximately twenty six of the Olstein All Cap Value Fund’s holdings have been acquired by or merged with other companies. Similarly, over the past nineteen years, numerous Fund holdings have attracted the attention of shareholder activists or private equity investors seeking to unlock value and increase the price of company shares. As value investors who usually have to wait patiently for a company to improve operating results and for the market to ultimately recognize the value we see, these corporate actions not only come as a pleasant surprise, they often allow us to reach our value over a much shorter holding period.
During the first half of the year (and continuing into the first several weeks of July), the Fund has experienced an unusually high number of corporate actions affecting specific portfolio holdings. From early-February through July 17, 2014, fourteen portfolio companies, representing approximately 16% of the Fund’s equity investments, were the subject of significant announcements. These announcements have included five merger & acquisition (“M&A”) deals, two takeover offers, completion of a spinoff, a substantial and accelerated share repurchase plan, and five activist campaigns. The companies affected by these announcements cover a range of industries and sectors, and include: PepsiCo, Inc. (NYSE:PEP), Sensient Technologies Corporation (NYSE:SXT), Ann Inc (NYSE:ANN), Zimmer Holdings, Inc. (NYSE:ZMH), National-Oilwell Varco, Inc. (NYSE:NOV), Express, Inc. (NYSE:EXPR), Covidien plc (NYSE:COV), MICROS Systems, Inc. (NASDAQ:MCRS), PetSmart, Inc. (NASDAQ:PETM), TRW Automotive Holdings Corp. (NYSE:TRW), URS Corp (NYSE:URS), International Game Technology (NYSE:IGT) and Bed Bath & Beyond Inc. (NASDAQ:BBBY). Since our investment process does not seek to determine the exact timing of a potential catalyst or when the market is likely to react positively to strategic alternatives that we believe could improve a company’s prospects, the extraordinary number of favorable events over a six-month period warrants further examination as well as identification of other trends and factors that may have affected the fortunes of these holdings.
Two such trends that we have discussed at length in previous shareholder letters include the sharp increase in both M&A activity and shareholder activist campaigns in the last few years. With the announcement of five definitive merger agreements and two additional acquisition offers during the first half of 2014, the Fund has benefited from the surge in M&A activity. According to FactSet Research, “aggregate deal value during the first half of 2014 was $908 billion, which is only topped by the $961.8 billion spent in the first half of 2007”1. Yet unlike previous M&A booms which occurred at market peaks in 2000 and 2007, the current surge in merger activity is being driven by the low cost of debt, large cash balances on corporate balance sheets, and the sluggish rate of economic recovery.
According to a recent survey of over 1,000 M&A professionals at U.S. corporations, private equity firms and investment banks conducted by accounting firm KPMG, 41% of respondents cited either large cash reserves or the availability of credit on favorable terms as factors most likely to facilitate deal activity in 2014. Further in the survey, when asked if their companies’ deal motivation has changed in the past two years, several respondents said that they were focusing less on cost cutting and more on growth. In fact, 57% of respondents in the KPMG survey cited a growth initiative as the primary reason for motivating deals in 20142. This same rationale – the desire for growth – has motivated the definitive acquisition of five of the Fund’s holdings over the past six months.
Likewise, with five activist situations in the portfolio grabbing headlines, the Fund has also benefited from the increase in shareholder activist activity over the past several years. According to McKinsey & Company, shareholder activists have initiated “an average of 240 campaigns in each of the past three years – more than double the number a decade ago”3. This rate of shareholder activist activity has continued into 2014, as activists have launched 148 public campaigns during the first six months of the year according to FactSet Research.
McKinsey cites, from its analysis of 400 activist campaigns (out of 1,400 launched targeting U.S. companies over the past decade), that fundamental under-performance is the most likely reason to trigger an activist investor. Most often, activists focus on a company’s underperformance relative to industry peers, rather than absolute declines in performance and react specifically to “shareholder returns that have significantly lagged the industry in the previous two years, anemic revenue growth and a growing gap in margins relative to peers”3. This finding echoes our long-standing focus on investing in companies whose real economic value is unrecognized by the market or overshadowed by what we believe to be temporary problems. McKinsey’s finding also brings to mind our detailed discussion of investing in corporate turnarounds in the December 31, 2006 Letter to Shareholders, Investing in Corporate Turnarounds.
Olstein All Cap Value Fund: Approaching Investment Opportunities with the Mindset of Private Investors
When reviewing our investment theses for portfolio holdings affected by recent corporate actions, we note that most of these fourteen companies share several common factors, including a unique product or service niche, competitive strength, clean capital structure and, most importantly, an ability to generate sustainable free cash flow. Understanding and assessing these factors has always been an integral part of our initial and in-depth company analysis and determines the inputs for our valuation analysis. It is through our extensive accounting based looking behind the numbers of financial statements company valuation process (which we discussed at length in our September 30, 2009 Letter to Shareholders,
Evolution of an Investment – From Idea to Portfolio Holding) that we approach a potential portfolio holding in much the same manner as a private equity investor or financial buyer (an acquirer). The similarity of our approach to private investors, especially regarding valuations, is, in our opinion, one of the primary reasons so many of our current holdings have been targeted by private equity investors, corporate acquirers and shareholder activists.
Through our Operating Earnings/Leveraged Buyout (“LBO”) Valuation Method, we analyze the value of a business from the viewpoint of a ‘financial buyer’ – a buyer who expects all investment returns to come from future operations of the business. When using this method to value a company, we assume that we are buying the company through a leveraged buyout. Our analysis assumes that we must borrow the entire amount to acquire the company at existing junk bond rates, which must then be paid from the acquired company’s cash flow. It is extremely important to note that the value a financial buyer would pay for an LBO is closely tied to the potential buyer’s expectation of sales growth rates, their ability to improve operating margins and/or working capital levels, the ability to reduce capital expenditures without negatively affecting the business and its ability to generate higher levels of free cash flow. In essence, we are functioning as private equity investors who own small pieces of companies (thus do not have to pay a premium), who later become the prey of private equity investors seeking to take over the entire company (usually paying a buyout premium) and maximize results via previously identified strategic alternatives.
Similar to a private buyer, once we determine the value of a company based on our estimates of normalized free cash flow, we test our range of valuations against current market reality and the company’s historical earnings performance. We further test our valuations through extensive scenario analysis – best case, worst case, likely case – assigning probabilities to different scenarios to assess the company’s true potential for capital appreciation over our expected holding period, (2-3 years) which, like a private equity investor, is usually much longer than that of the momentum investors typically found in today’s market.
Olstein All Cap Value Fund: The Importance of Free Cash Flow Yield
An important metric for acquirers, private investors and shareholder activists when considering an investment opportunity is free cash flow yield. In simple terms, free cash flow yield is a company’s total free cash flow divided by its market capitalization (or its free cash flow per share divided by its price per share). More importantly, if an investor believes as we do that a company’s free cash flow is the primary determinant of its value as an ongoing enterprise, then free cash flow yield provides a practical measure of expected future returns. We believe that a company with a free cash flow yield well above the risk-free rate of return (three- and five-year U.S. Treasuries are currently providing yields of 0.98% and 1.68%, respectively, per Bloomberg as of July 25, 2014) combined with a demonstrated ability to either reinvest excess cash at higher rates of return than the risk free rate, or use that excess cash to enhance shareholder value should prove to be a superior, high-quality investment over time.
Free cash flow is reported earnings minus capital expenditures plus depreciation and amortization plus or minus changes in working capital. More importantly to both acquirers and activists, free cash flow is a specific concept that allows them to determine the true amount of cash available for discretionary use to enhance the company’s value or to distribute to new owners.
While cash flow yield may indicate a significant potential for capital appreciation, assessing how management has historically used free cash flow to benefit shareholders becomes a critical part of our analysis. We assess our investment as if we own 100% of a company and determine whether management has consistently used free cash flow to improve the company’s financial strength by improving the balance sheet and/or reducing debt levels. We also determine if management has a proven track record of reinvesting in the business at suitable rates of return on investment, or returning free cash to investors through increased dividends or share buybacks. In turn, our assessment of management on these points provides an invaluable context for our valuation models.
Free cash flow is the lifeblood of a business. Companies that generate excess cash flow have the potential to enhance shareholder value by increasing dividend payments, repurchasing company shares, reducing outstanding debt and engaging in strategic acquisitions or attracting the attention of a strategic acquirer. It also provides an insurance policy against making short-term decisions not in the long-term interest of the company during periods of temporary problems or economic uncertainty. For us, superior investment opportunities are found in companies that generate sustainable excess cash flow; that are led by management who use that excess cash in ways that will increase shareholder value; and that the Fund can purchase at a significant discount to our determination of their intrinsic value. Free cash flow yield provides a valuable tool for helping identify and analyze such companies by providing a meaningful way, in an uncertain market environment, to contrast a company’s financial performance – its ability to produce a cash return that benefits shareholders – to the risk free rate. We believe analysis on a company by company basis and not overall market sentiment should concern investors – what cash return an investor can expect to receive from owning the entire business and, whether or not, the return compensates an investor sufficiently in excess of the risk-free rate for the risk of investing in equities. We are excited that long term value oriented private equity investors are pursuing with more vigor the types of investments that we have always specialized in as means to achieving the Fund’s primary investment objective of long-term capital appreciation.
Olstein All Cap Value Fund: Final Thoughts
An extended period of strong market performance similar to what we have experienced since the historic lows of March 9, 2009, brings many investor worries and concerns to the forefront. In one form or another, we have been asked over the past several months, “Is the market too bullish?” “Isn’t the market overdue for a pullback or correction?” Investors that have been on the sidelines avoiding equities since the last market meltdown wonder, “Have I missed the best returns?” “Should I get back into the market or wait for a correction?” Daily headlines cheering or jeering specific economic news (better-than-expected housing sales, lower-than-expected retail sales, disappointing jobs numbers, etc.) have a tendency to pull investors in two conflicting directions – either fueling bullish sentiment or increasing anxiety about what comes next. In many cases, the extremely low returns offered by risk-free alternatives or remaining in cash only compound these worries.
While investors are wise to be wary of market risk, we believe that instead of making equity investment decisions based on market sentiment, the focus should be on identifying opportunities for meaningful capital appreciation presented by individual companies. In this regard, we believe that the most important metric for identifying superior investment opportunities in an uncertain market is a company’s ability to generate sustainable free cash flow.
The Fund is invested in companies that, in our opinion, have the financial strength to ride out unfavorable short-term conditions while at the same time offering favorable long- term business prospects. We value your trust and remind you that our money is invested alongside yours as we work hard to accomplish the Fund’s investment objectives.
|Robert A. Olstein
|Eric R. Heyman
|Chief Investment Officer
|and Co-Portfolio Manager
See full The Olstein All Cap Value Fund’s 2014 Second Quarter Letter to Shareholders in PDF format here.