The Olstein Strategic Opportunities Fund's 2014 Second Quarter Letter to Shareholders

Author's Avatar
Sep 10, 2014

Dear Fellow Shareholders:

For the fiscal year ended June 30, 2014, load-waived Class A shares of the Olstein Strategic Opportunities Fund had a return of 26.25% compared to total returns of 25.58% for the Russell 2500® Index and 24.61% for the S&P 500® Index. The past fiscal year also marked an important milestone – it was five years ago that equity markets began their strong recovery from the market low of March 9, 2009. For the five years ended June 30, 2014, load-waived Class A shares of the Olstein Strategic Opportunities Fund had an average annual return of 22.31%. Over the same time period, the Russell 2500 Index and the S&P 500 Index and had average annual returns of 21.63% and 18.83%, respectively.

Market Outlook & Strategy

Despite an unexpected contraction in the U.S. economy during the first quarter of the year, as well as rising global tensions due to serious conflicts in Eastern Ukraine and in the Middle East, equity markets continued to chug along with the benchmark Russell 2500 Index increasing 5.95% for the first six months of the year. With the strong market run now five years old, many market forecasters continue to speculate on a market correction or pullback in 2014. Yet, despite a rocky and volatile start to the year, and in light of the resilience of the market and improving economic picture, we believe our portfolio of undervalued small- and mid-sized companies is properly structured to reach the Fund’s capital gains objectives in the current environment.

Although we expect the market for small- to mid-sized equities could be somewhat volatile in the near term as the Fed continues to taper its extraordinary monetary stimulus program, we also expect stronger economic data and improved company performance to highlight the strength of the U.S. economy. As in the past, we believe a key beneficiary of the improved economy will be smaller companies with strong financials and sustainable excess cash flow, whose revenues come mainly from domestic sources and whose stock is not being properly valued by the market according to our metrics.

We believe the market volatility that has characterized the start of 2014 has provided an excellent opportunity to find viable investment opportunities in small- and mid-sized companies. 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.

Our Leaders

The stocks which contributed positively to performance for the twelve month reporting period include: Harman International Industries, Incorporated, Spirit Airlines, Inc., Legg Mason, Inc., Smith & Wesson Holding Corporation and Dillard’s, Inc. As of the close of the fiscal year, the Fund continues to hold each of these companies in the portfolio.

Our Laggards

Laggards during the twelve month reporting period include: Fairway Group Holdings Corp., Potbelly Corporation, URS Corporation, Ethan Allen Interiors Inc. and Arctic Cat Inc. During the fiscal year, the Fund eliminated its holdings in Fairway Group Holdings Corp. The Fund continues to hold Potbelly Corporation, URS Corporation, Ethan Allen Interiors Inc. and Arctic Cat Inc.

Portfolio and Performance Review

At June 30, 2014, the Fund’s portfolio consisted of 51 holdings with an average weighted market capitalization of $3.52 billion. Throughout the fiscal year ended June 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 fiscal year, the Fund initiated positions in twenty- three companies and strategically added to established positions in another eight companies. Positions initiated during the reporting period include: ADT Corp., ANN INC., CECO Environmental Corp., Dillard’s, Inc., Esterline Technologies Corporation, The Greenbrier Companies, Inc., GSI Group Inc., Harmonic Inc., Integra LifeSciences Holding Corporation, Itron, Inc., Kadant Inc., NOW Inc., Nutraceutical International Corporation, PetSmart, Inc., Potbelly Corporation, Sealed Air Corporation, Standard Motor Products, Inc., Steelcase Inc., UFP Technologies, Inc., UniFirst Corporation, URS Corporation and Xylem Inc. Over the course of the fiscal year, the Fund eliminated its holdings in twenty-two companies and strategically reduced its holdings in another six 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 fiscal year, the Fund eliminated its holdings in Alaska Air Group, Inc., City National Corporation, Columbus McKinnon Corporation, DENTSPLY International Inc., Diebold, Incorporated, Fairway Group Holdings Corp., The Finish Line, Inc., Hillenbrand, Inc., Korn/Ferry International, Littelfuse, Inc., Maidenform Brands, Inc., Measurement Specialties, Inc., MICROS Systems, Inc., Microsemi Corporation, Mistras Group, Inc., NCR Corporation, Schweitzer-Mauduit International, Inc., Standex International Corporation, Team, Inc., Teradyne, Inc., Thor Industries, Inc. and The Timken Company.

Review of Activist Holdings

As of June 30, 2014, the Fund was invested in ten activist situations, which represented approximately 27% of the Fund’s equity investments and six of its top ten holdings. In general, these situations fit our definition of an activist investment, where Olstein Capital Management or an outside investor (usually a hedge fund or private equity investor), seeks to influence company management to adopt strategic alternatives that we expect to unlock greater shareholder value.

The Fund’s activist holdings as of June 30, 2014, include women’s apparel retailer, ANN INC., specialty apparel and accessory retailer, Express, Inc., electronic equipment company, Harman International Industries, Incorporated; gaming company, International Game Technology; money management firms, Janus Capital Group, Inc. and Legg Mason, Inc.; retailer of pet products, PetSmart, Inc., specialty eatery, Potbelly Corporation, flavor and fragrance and color systems manufacturer, Sensient Technologies Corporation, and engineering and technical services company, URS Corporation (sold by the Fund in July after receiving a takeover offer at a material premium). We continue to monitor the progress of the company management and outside 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.

With each of our activist situations, one of the most important variables we consider, especially during tough economic times, is “how long do we expect it to take for this company to improve its operations and results?” 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 if we are being sufficiently rewarded for the risk and if our ongoing analysis of the company’s financial statements tell us the company is headed in the right direction.

Regarding the progress of activist situations in the Fund’s portfolio, we are pleased to report that during the last month of the fiscal year (and continuing into the first several weeks of July), the Fund experienced an astounding number of takeover announcements affecting specific activist holdings. From June 12, 2014 through July 16, 2014, four of the Fund’s activist holdings, representing approximately 11% of the Fund’s equity investments, were the subject of takeover announcements. These announcements included three definitive merger & acquisition agreements and one takeover offer.

On June 12, 2014, Express, Inc (EXPR). confirmed that it had received a letter from Sycamore Partners, a private equity firm that owns approximately 9.9% of the company’s outstanding shares, indicating interest in acquiring the company. On June 23, 2014, MICROS Systems, Inc. (MCRS) announced that it has entered into a definitive agreement to be acquired by Oracle Corporation at a premium to the Fund’s cost. Following the news of the announcement, the Fund sold its remaining holdings in MICROS Systems, Inc., believing the acquirer paid a fair price.

On July 13, 2014, URS Corporation (URS) announced the execution of a definitive agreement under which AECOM Technology Corporation will acquire all outstanding shares of URS Corporation again at a premium to the Fund’s average cost. Similarly, on news of this announcement, the Fund sold its remaining holding in URS Corporation as the stock approached our calculation of intrinsic value. On July 16, 2014, International Game Technology (IGT) announced that it has entered into a definitive merger agreement with GTECH S.p.A. for the acquisition of International Game Technology at a premium to the Fund’s cost. Following the announcement, the Fund liquidated its remaining position in International Game Technology based on a small deviation between the stock price and our calculation of intrinsic value. 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, the multiple announcements have not only come as a pleasant surprise, they have also allowed us to reach our value over a shorter than expected holding period.

Dealing With Uncertainty

With the strong market run now more than five years old, many market forecasters continue to speculate on a market correction or pullback during the second half of the year. While there are always some forecasters who seize on short periods of increased market volatility to predict the next market downturn, we believe it is important for investors to weather such market events by focusing on the equities of financially strong companies with stable or growing free cash flow.

Dealing with Uncertainty by Focusing on Fundamentals

As investors in small- to mid-sized companies selling at discounts to our estimate of intrinsic value (brought on by what we deem to be short term problems and challenges), the Fund uses periods of uncertainty to establish new positions or add to positions as public investors sell these companies looking for what they believe are safer options.

In our opinion, one of the best ways to deal with the uncertainty of equity markets is to remain focused on company fundamentals, the quality of earnings and a company’s ability to generate free cash flow as market volatility increase and doomsayers predict the next downturn. Since we value companies based on our assessment of their ability to generate free cash flow, our approach focuses on company fundamentals and operations under both positive and negative economic and/or market environments. We not only develop a thorough understanding of how each company’s operations generate sustainable free cash flow under both good and bad economic conditions, we also seek to also answer a series of questions about the company’s business model, its strategy, its future prospects and its management when faced with uncertain economic conditions.

We develop a thorough understanding of each company through two important analytical approaches: a bottoms-up fundamental analysis of a company’s financial statements (balance sheet, income statement and cash flow statement and footnotes), and an ongoing forensic analysis of regulatory filings and other disclosures (10K, 10Q, proxy filings, annual reports, shareholder letters, public announcements, etc). The objective of our fundamental analysis is to understand the company’s business model and how the company’s operations can generate future free cash flow under all economic scenarios. We also want to determine the level of ongoing investment that is required to maintain or grow the company’s free cash flow and ultimately how much of the cash generated by a company’s operations will be returned to us as investors. The objective of our forensic analysis is to determine if a company’s accounting policies and practices reflect economic reality; to identify and make accounting adjustments that eliminate management’s reporting bias and to identify positive or negative factors that may affect future free cash flow that may not yet be recognized and/or discounted by the investing public.

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 forensic analysis provides us with a competitive advantage and the necessary knowledge to judge the likely success of a company’s strategy to produce sustainable future free cash flow that may not be properly discounted by the stock market. We also believe that such ongoing analysis is especially vital when evaluating and monitoring investments in small- to mid-sized companies facing unique strategic choices and challenges for two reasons: (1) it allows us to assess the nature and likely duration of strategic challenges and/or problems, and (2) it allows us to judge the quality, effectiveness and skill set of the management team in the face of adverse circumstances.

Dealing with Uncertainty by Taking Advantage of Market Volatility

Another way to deal with market uncertainty is to focus on the compelling investment opportunities that rocky market conditions create. Short-term market volatility usually presents significant buying opportunities when short-term problems affecting specific companies are deemed to be permanent by the investing public, and usually results in material deviations between a stock’s price and our estimate of intrinsic value (which is based on a company’s normalized ability to generate free cash flow). During unsettled market conditions, the Fund seeks to ferret out unwarranted stock declines which we believe are based on emotion and negative sentiment. The bearishness creates opportunities to identify quality companies trading at a significant discount to their intrinsic value. If we are correct in ferreting out material discounts, the Fund should be strategically positioned to achieve its investment objectives.

From our perspective, Wall Street’s obsessive focus on short-term concerns has in many cases in the current environment resulted in unwarranted deviations between a stock price and our estimate of the company’s intrinsic value. Investors reacting to the daily noise and news continue to create favorable opportunities for the Olstein Strategic Opportunities Fund to buy companies with solid balance sheets and business models that generate excess cash flow at what we believe are bargain prices. 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 in the Fund, we believe that by focusing on understanding a business, it’s potential to generate sustainable free cash flow and ultimately its value, we can achieve the Fund’s investment objective of long-term capital appreciation. After identifying companies that meet well-defined investment criteria, the Fund seeks to take advantage of market volatility and downward price movements to buy such companies at

advantageous prices that we believe will increase the probability of a successful investment.

Final Thoughts

As investors, we remind you that our challenge is to develop a thorough understanding of how a company’s operations can generate sustainable free cash flow over a complete business cycle – during growing, stagnant, or deteriorating economic conditions. We believe it is also important to understand the role company management plays regarding the future prospects for each of the companies in our portfolio. Our view of management is based on studying the financial statements and looking behind the numbers to assess the realism of their accounting assumptions, the wisdom of past decisions, willingness to discuss problems as well as the strategies to overcome these problems, and, finally, the conservatism of the financials to ride out short-term storms. We do not rely on management interviews. We spend a great deal of time understanding and forecasting how management’s decisions are likely to affect a company’s future free cash flow and ultimately the value of the business. As the second half of 2014 unfolds, we believe those company’s with strong management teams with a proven track record of creating shareholder value over time should have a substantial strategic advantage as economic growth accelerates.

Since we launched the Olstein Strategic Opportunities Fund more than seven years ago, we have identified many small- to mid-sized companies that have successfully navigated the turbulent waters of recession and recovery to adapt, invest, grow and restructure for the future. As we wait for equity markets to regain a balanced perspective and once again focus on company fundamentals, we remind you that, as always, patience provides generous opportunities for the diligent investor. We intend to stay the course since 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 value your trust and continue to invest our money alongside yours

Sincerely,

Eric R. Heyman Robert A. Olstein
Co-Portfolio Manager Chairman,
Chief Investment Officer
and Co-Portfolio Manager

Continue reading here.