The Olstein Strategic Opportunities Fund’s letter to shareholders for the third quarter 2014.
Dear Fellow Shareholders:
For the nine months ended September 30, 2014, load-waived Class A shares of the Olstein Strategic Opportunities Fund had a return of 1.89% compared to total returns of 0.28% and 8.34% for the Russell 2500™ Index and the S&P 500® Index, respectively. For the quarter ended September 30, 2014, load-waived Class A shares of the Olstein Strategic Opportunities Fund returned -3.16% compared to returns of -5.35% and 1.13% for the Russell 2500 Index and the S&P 500 Index, respectively.
Olstein Strategic Opportunities Fund: Market Outlook & Strategy
While many investors are nervous about markets in general and the equities of small- to mid-sized companies in particular, we believe there is a strong case for investing in the equity securities of companies whose real economic value is unrecognized by the market, obscured by periods of market uncertainty or overshadowed by temporary problems. We believe that recent market volatility has provided an excellent opportunity to find viable investment opportunities in small- and mid-sized companies which, in our opinion, are not correctly valued by the market as a result of short term factors. In our search for value, we continue to focus on three crucial, 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.
Olstein Strategic Opportunities Fund: Portfolio and Performance Review
At September 30, 2014, the Fund’s portfolio consisted of 53 holdings with an average weighted market capitalization of $3.31 billion. Throughout the quarter ended September 30, 2014, we continued to modify the portfolio in light of the volatility in the overall market. By paying strict attention to our company valuations, we reduced or eliminated positions in which the discounts from our calculation of intrinsic value were no longer large enough to justify the size of our position. At the same time, we increased or added new positions in what we believe to be well run, conservatively capitalized companies selling at a significant discount to our calculation of intrinsic value.
During the quarter, the Fund initiated positions in six companies and strategically added to established positions in another thirteen companies. Positions initiated during the reporting period include: DSW Inc. (NYSE:DSW), First Niagara Financial Group Inc. (NASDAQ:FNFG), Fox Factory Holding Corp (NASDAQ:FOXF), Lifetime Brands Inc (NASDAQ:LCUT), Patterson Companies, Inc. (NASDAQ:PDCO), and WESCO International, Inc. (NYSE:WCC). Over the course of the calendar quarter, the Fund eliminated its holdings in four companies and strategically reduced its holdings in another three companies. The Fund eliminated or reduced its holdings in companies that either reached our valuation levels, or where, in our opinion, changing conditions or new information resulted in additional risk and/or reduced appreciation potential. We redeployed proceeds from such sales into opportunities that we believe offer a more favorable risk/reward profile. During the quarter, the Fund eliminated its holdings in Ann Inc (NYSE:ANN), International Game Technology (NYSE:IGT), UFP Technologies, Inc. (NASDAQ:UFPT), and URS Corp (NYSE:URS).
Two positions eliminated during the quarter, International Game Technology and URS Corp., were companies targeted by strategic acquirers. On July 16, 2014, International Game Technology (IGT) announced that it entered into a definitive merger agreement with GTECH S.p.A., in a deal valued at $6.4 billion. On July 13, 2014, URS Corporation (URS) announced that AECOM would acquire the company for $56.31 per share. The Fund also eliminated its position in specialty retailer Ann Inc (ANN). The disclosure of significant positions in Ann Inc. by a private equity firm and activist investors stoked considerable interest in the company’s stock, causing it to rise to our valuation level in a relatively short period of time. On March 20, 2014, Golden Gate Capital (a private equity firm that specializes in the retailing sector) disclosed a 9.5% equity stake in Ann Inc. Additionally, in August, activist hedge fund Engine Capital, along with hedge fund Partner Red Alder LLC, began a public campaign to push management to conduct a strategic review and possible sale of the company.
Olstein Strategic Opportunities Fund: Review of Activist Holdings
As of September 30, 2014, the Fund was invested in nine activist situations, which represented approximately 20% of the Fund’s equity investments and three of its top ten holdings. In general, these situations fit our definition of an activist investment where an outside investor, usually a hedge fund, private equity investor, or Olstein Capital Management seeks to influence company management to adopt strategic alternatives that we expect to unlock greater shareholder value.
The Fund’s activist holdings as of September 30, 2014, include aerospace and defense products manufacturer, Esterline Technologies Corporation (NYSE:ESL); specialty apparel and accessory retailer, Express, Inc. (NYSE:EXPR); recreational vehicle suspension products manufacturer, Fox Factory Holding Corp (NASDAQ:FOXF); money management firms, Janus Capital Group Inc (NYSE:JNS) and Legg Mason Inc (NYSE:LM); kitchenware and housewares manufacturer, Lifetime Brands Inc. (LCUT); retailer of pet products, PetSmart, Inc. (NASDAQ:PETM); specialty eatery, Potbelly Corp (NASDAQ:PBPB); and flavor and fragrance and color systems manufacturer, Sensient Technologies Corporation (NYSE:SXT).
We continue to monitor the progress of the activist investors involved in these situations as they work to increase shareholder value through a specific plan for improving each company’s results. While each investment is at a different strategic stage, we believe the actions that have been proposed or implemented should increase shareholder value through improved future operating results.
Regarding the progress of activist situations in the Fund’s portfolio, we are pleased to report that during the quarter, three of the Fund’s activist holdings, representing approximately 9% of the Fund’s equity investments at the close of the previous quarter, were the subject of takeover announcements or heightened activist attention. As previously reported, URS Corporation (URS) and International Game Technology (IGT) entered into merger agreements with strategic acquirers during the quarter, resulting in the sale of both companies from the fund’s portfolio as the price of each company’s stock reached our valuation. Specialty retailer, Ann Inc. (ANN), following announcement of a significant private equity investment in March 2014, attracted increased scrutiny from activist investors during the quarter, causing the company’s stock price to rise fairly rapidly to our valuation level. As value investors who usually have to wait patiently for a company to improve operating results and for the market to hopefully recognize the value we see, these acquisitions not only came as a pleasant surprise, they allowed us to reach our value in each company over a much shorter holding period.
Olstein Strategic Opportunities Fund: Value Investors That Think Like Business Owners
The increase in market volatility during the third quarter impacted the prices of small- to mid-sized companies to a greater degree than larger companies. We have found that investor emotions in small- to mid-sized companies run high during periods of market volatility. We believe business fundamentals are more reliable than stock market emotions to base investment decisions. During these periods of downside volatility the Fund seeks to purchase investments in which investor emotions have carried the price of a stock to a material discount to our calculation of intrinsic value based on our detailed analysis of a company’s fundamental operations and financial statements. We are value investors who prefer to think like business owners. When we approach each potential investment (and each existing portfolio holding), we do so as if we own 100% of the company. This approach focuses our investment time horizon on the long-term potential of each business; prioritizes the operating elements of our fundamental company analysis; and allows us to benchmark the performance of companies undertaking needed corrective action against important, business-driven goals, not against market whims or momentum. We seek to separate stock price moves based on short-term investor emotional swings from changing long-term business fundamentals. It is a mindset that is especially helpful in a volatile market considering the type of companies that the Strategic Opportunities Fund invests in – small- to mid-sized companies that face unique strategic choices, challenges and problems.
The chance of downside fluctuations are present in all securities, and spending time analyzing these monthly swings or attempting to minimize these swings by giving up potential positive future return is, for us, a poor use of time and capital. If a company was private and had no public market price, the owners would not be assessing the value of the business on a monthly or quarterly basis. Business valuations fluctuate much less than stock prices. Owners of commercial businesses assess risk on the basis of losing money on operations, not as to whether they would be forced to sell the business at an inopportune time. Similarly, an investor does not lose money because the market price of his portfolio holdings declines on a monthly or quarterly basis. Long-term investors lose money by misjudging the long-term valuation of a business based on its ability to generate and/or grow future normalized free cash flow.
Price fluctuations occur in all securities for many reasons; fluctuations may be cyclical in nature, rooted in misperceptions about the nature of a company’s problems, or due to an over- reaction to company-specific or industry news. Given the fund’s approach to investing in companies facing unique strategic challenges, we are not particularly concerned as to whether or not recent portfolio purchases are currently underperforming the market or may continue to underperform for the next quarter. Although equity markets are driven by short-term performance expectations, our long-term mindset as a business owner allows us to adopt longer time periods to evaluate the success or failure of an investment that, in our opinion, has unrecognized or obscured capital appreciation potential. Our estimation of a company’s long-term ability to generate sustainable free cash flow which we believe is not currently being valued by the market, underlies our conviction to ride out what we believe is short-term underperformance. As business owners, our expectations for a successful turnaround have less to do with the direction and performance of the overall market and more to do with company-specific factors. Although we know from experience that successful turnarounds don’t happen overnight, we do expect specific improvements in operations to occur within a defined period of time (two years or less), notwithstanding the economic environment. Although a turnaround process may not be in full swing, if a company has adopted what we believe is the right strategy to increase shareholder value within two years, we are willing to wait beyond two years for operating results to start improving. However, our ongoing analysis of the company’s financial statements needs to indicate that the company is headed in the right direction and that the current price of the stock is selling at a big enough discount to our calculation of the company’s intrinsic value to sufficiently reward the Fund for taking the risk over a more extended time period.
As value investors we deal with the uncertainty of equity markets and market volatility by remaining focused on company fundamentals, the quality of earnings and a company’s ability to generate free cash flow. Since we value companies based on our assessment of their ability to generate free cash flow, our approach, like that of a business owner, focuses on company fundamentals and operations in all market and economic environments. We not only develop a thorough understanding of how each company’s operations generate sustainable free cash flow under good or bad economic conditions; we also seek to answer a series of questions about the company’s business model, its strategy, its future prospects and its management when faced with uncertain conditions. Our forensic analysis of financial statements is our main source of information.
We believe our ongoing forensic analysis of a company’s public filings and communications serves us well during periods of increased market volatility or economic trouble and is, in our opinion, more useful than short-term economic or market forecasts. When markets become more irrational and volatile, we believe our long-term owner-based mindset (which analyzes the fundamentals) provides us with the necessary knowledge to increase the probability of predicting whether or not the company’s strategy and the sustainability of its performance should result in a successful investment. Our fundamental long-term owner mindset is even more critical when analyzing small- to mid-sized companies facing unique strategic choices and challenges because of the emotional volatility displayed by investors who have unrealistic expectations for growth. We believe that many investors in small- and mid-sized companies tend to overreact to short-term growth disappointments or temporary adverse circumstances.
Olstein Strategic Opportunities Fund: Final Thoughts
We believe that our investment approach, which attempts to avoid long-term impairment of capital while providing shareholders with the potential to realize long-term capital appreciation, is suited to all economic environments. Although unfavorable economic or market conditions may cause short-term downward price movements, we believe that our focus on understanding a company in the same manner as a business owner allows us to better assess its potential to generate sustainable free cash flow and ultimately determine its value.
We are invested in companies that, in our opinion, have the financial strength to ride out current market jitters while offering favorable long-term business prospects. We continue to believe that patience is a value investor’s best friend.
Eric R. Heyman
Robert A. Olstein