May 20, 2016
Dear Fellow Shareholders:
For the quarter ended March 31, 2016, Class C shares of the Olstein All Cap Value Fund appreciated 2.22%. During the same three-month period, the Russell 3000 Value® Index appreciated 1.64% and the Russell 3000® Index appreciated 0.97%. For the three-year period ended March 31, 2016, Class C shares of the Olstein All Cap Value Fund had an average annual return of 8.96%, compared to average annual returns of 9.08% and 11.15% for the Russell 3000 Value Index and the Russell 3000 Index, respectively.
Market Outlook
While many investors are nervous about equity markets, we believe it is extremely important to recognize that there is a big difference between market volatility, specifically, broad downward movements in stock prices, and the fundamental value of a business. It is important to distinguish between the variability of an investment’s value due to temporary market volatility, and the likelihood of permanent impairment of capital. For us, short-term market volatility is less of a concern than the potential for an irreversible loss of capital due to the erosion of a company’s fundamentals over time, or as the result of a poorly timed decision to sell a particular holding by overreacting to stock declines caused by what we believe to be short-term events (including unwarranted negative psychology) having little to do with long-term values. As long-term investors, we do not equate downside price spikes with a decrease in the underlying value of a business; nor do we equate such volatility with increased risk in the business. Of course, we pay attention to volatility by looking at the fundamentals of each holding and determining whether such price moves are warranted by any potential changes to our estimates of a company’s long-term normalized ability to generate and/or grow free cash flow. When we deem downside price volatility is unrelated to long-term fundamentals, we often take advantage of these deviations by adding to our position.
Our Strategy
There are times when the combination of certain events, such as the slowdown in global economic growth and falling oil prices, tend to overwhelm equity markets resulting in periods of increased volatility. We believe recent market volatility highlights the strong case for investing in the equity securities of companies whose real economic value is, in our opinion, unrecognized by the market, obscured by recent market uncertainty, or overshadowed by temporary problems. We continue to find viable long-term investment 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 believe that the downside volatility that dominated markets since the middle of last year has provided us with significant potential opportunities to profit from pessimism as deviations between stock prices and our calculation of company valuations have increased dramatically. Business valuations do not change as rapidly as stock prices, which are supposed to represent a company’s value based on its future ability to generate normalized excess free cash flow.
In 2016, we will continue to seek and invest in companies that we believe have an ability to deliver long-term value to their shareholders that, in many cases, is not currently recognized by the market. Against the current economic backdrop, we also continue to emphasize the quality of a company’s earnings. By highlighting the quality of a company’s earnings, we seek to accomplish two objectives: (1) to identify those companies that not only have focused their priorities during uneven economic times, but have also laid the groundwork to achieve a substantial strategic advantage for the eventual acceleration of economic growth that we foresee, and (2) to assess the financial risk inherent in each investment opportunity before considering the potential for capital appreciation. To reiterate, 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 via an inferential analysis of a company’s financial statements provides the Fund with a valuable tool in its attempt to control risk.
Portfolio Review
At March 31, 2016, the Olstein All Cap Value Fund portfolio consisted of 83 holdings with an average weighted market capitalization of $55.66 billion. During the quarter, the Fund initiated positions in five companies and strategically added to positions in ten 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: Charles River Laboratories International, Inc. (CRL, Financial), FedEx Corp. (FDX, Financial), Michael Kors Holdings Ltd. (KORS, Financial), Walt Disney Co. (DIS, Financial) and Zoetis Inc. (ZTS). Positions eliminated during the past three months include: Dover Corp. (DOV, Financial), Esterline Technologies (ESL, Financial), Exxon Mobil Corp. (XOM, Financial), Itron Inc. (ITRI, Financial), Johnson Controls Inc. (JCI, Financial), Joy Global Inc. (JOY, Financial), MSC Industrial Direct Co., PayPal Holdings Inc., and Vasco Data Security International Inc.
A Rational Approach to a Volatile Market
In many of previous our letters to shareholders, we have extolled the importance of patience and maintaining an investment outlook that does not react to the daily flow of good or bad news. As investors consider the current investment landscape of slower global economic growth, falling commodities prices, and sharp spikes in market volatility, it is important that we repeat the virtues of investor patience, and advocate a mindset that looks beyond the news and noise to focus on long-term investment success. During the last half of 2015 and during the first quarter of this year, the financial and business media have emphasized bad news and a pessimistic outlook that, in the short-term, has weakened investor confidence and rattled equity markets. When caught up in the steady stream of bad news and constant predictions of falling markets, the pessimism often creates unique opportunities to buy quality companies with strong fundamentals at what we believe to be very compelling prices. Our ability to grow our shareholders long-term capital is determined by the opportunities we are able to identify during periods of market pessimism.
Focusing on Companies, Not on the Market
As value investors, we believe that maintaining a long-term perspective in an environment that is maniacally focused on short-term news and events is critical to identifying and properly analyzing investment opportunities that many other investors neglect or fail to see. In our experience, pessimism about the future direction of the overall market takes the investing public’s eyes off the future appreciation potential of companies that are selling at a discount to our calculation of long-term intrinsic value, despite possessing a sustainable competitive advantage, discernible balance sheet strength, and management teams that emphasize decisions based on cost of capital calculations and deploy free cash flow to create shareholder value. Companies with similar characteristics are not only poised to overcome temporary valuation gaps created by market volatility (when and if economic growth accelerates), but are also often in a position to achieve above-average free cash flow growth, creating the potential for above average stock price appreciation.
Although the current global economic environment and pessimistic environment may be enough to cloud an investor’s outlook, we believe the investment landscape is not all gloom and doom. While investors are wise to be wary of risk, we believe that instead of making equity investment allocation decisions based on negative market sentiment, one should focus on identifying companies where there are material deviations between current stock prices and intrinsic values, which should lead to future above-average stock price appreciation. Our investment conclusions are based on an inferential analysis of the financial statements of individual companies. Our goal is to identify mispriced securities based on our assessment of a company’s ability to generate and/or grow normalized future free cash flow which we believe is not being properly valued by the market because of short-term issues. From our perspective, even though the overall market may be basically flat in the future, we see an environment with a significant number of individual investment opportunities that offer the potential for above-average appreciation. We believe the best approach for an uneven economic and investment environment is to buy companies that have the ability to generate free cash flow, have little or no debt or are aggressively paying down debt, and to buy such companies at a significant discount to their intrinsic value.
Focusing on Free Cash Flow in a Challenging Environment
A company’s normalized discounted future free cash flow is the primary determinant of its value as an ongoing enterprise. Thus a company’s ability to adapt to a challenging or stagnant environment by continuing to generate sustainable free cash flow should eventually separate the company from its competition and draw the favorable attention of equity investors. As we have said many times before, free cash flow is the lifeblood of a business. Companies that generate excess cash flow also have the potential to enhance shareholder value by increasing dividend payments, repurchasing company shares, reducing outstanding debt, and engaging in strategic acquisitions. Also, sustainable free cash flow companies are strongly desired by acquirers and/or private equity investors. The focal point of our investment discipline states that superior investment opportunities are found in companies that generate sustainable excess cash flow; that are led by managements who use that excess cash in ways that will increase shareholder value; and present us with an opportunity to buy the stock at a significant discount to our determination of their intrinsic values. We believe free cash flow analysis on a company-by-company basis, and not overall market sentiment, is the key to long-term investment success. We focus on the cash return that the Fund can expect from owning a share of a business, and if that rate of return sufficiently compensates the Fund (in excess of the risk-free rate) for the risk of investing in equities. The last question holds greater importance during an anticipated slowdown at a time when nervous investors may think about avoiding equities. We believe such times have the potential to set up significant above-average long-term investment returns.
Final Thoughts
Uncertainty and fear, fueled by alternating good and bad world events and economic data, usually results in the type of market volatility we are currently experiencing. As value investors, we believe in having a long-term horizon in an environment that is maniacally focused on short-term events and today’s news. We believe that our long-term horizon combined with an in-depth analysis of financial statements should provide the Fund with an advantage, even during the most negative environments. It is our opinion that purchases made in the Fund’s portfolio during the most recent period of extreme market negativity should result in higher future rates of return. The market is a discounting mechanism, and while past performance is not necessarily indicative of future results, it is noteworthy that the seeds of past periods of outperformance were sown during previous periods of extreme volatility in 2008, 2009 and 2011.
While market dips 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.
We value your trust and remind you that our money is invested alongside yours as we work hard to accomplish the Fund’s primary objective of long-term capital appreciation. We look forward to writing to you again at the close of the next quarter.
Sincerely,
Robert A. Olstein
Chairman, Chief Investment Officer and Co-Portfolio Manager
Eric R. Heyman
Co-Portfolio Manager
