Dear Fellow Shareholders:
For the quarter ended March 31, 2016, load-waived Class A shares of the Olstein Strategic Opportunities Fund appreciated 2.48%. During the same three-month period the Russell 2500 Value™ Index appreciated 3.33% and the Russell 2500™ Index appreciated 0.39%. For the three-year period ended March 31, 2016, load waived Class A shares of the Olstein Strategic Opportunities Fund had an average annual return of 7.30%, compared to average annual returns of 7.15% for the Russell 2500 Value Index and 8.16% for the Russell 2500 Index.
Outlook & Strategy
While many investors are nervous about volatility in equity markets, particularly for smaller capitalization companies, we believe it is extremely important to recognize that there is a big difference between market price volatility (specifically, broad downward movements in stock prices), and the fundamental value of a business. It is important to distinguish between the variability of a company’s stock price due to temporary market volatility, and the likelihood of future permanent impairment of capital. For us, short-term market volatility, especially for the equities of small- to mid-sized companies, is less of a concern than the irreversible loss of capital due to the erosion of a company’s business fundamentals over time. In addition, we have to be very careful to avoid overreacting to “in your face” negativity or problems which affect our holdings from time to time, by selling a particular holding prematurely when it turns out the problems were of a short-term nature, and had little to do with the long-term higher valuations we originally predicted. As long-term investors, we don’t equate spikes in short-term market volatility with a decrease in the underlying value of a business, nor do we equate such volatility with increased risk in the business. However, we always look under the hood to determine whether the downturn is warranted by longer-term fundamentals. We base our valuations decisions on longer term business fundamentals, and a company’s ability to generate sustainable, normalized, future free cash flow.
Portfolio Review
At March 31, 2016, the Fund’s portfolio consisted of 38 holdings with an average weighted market capitalization of $2.62 billion. Throughout the reporting period ended March 31, 2016, we continued to modify the portfolio in light of market volatility. 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 reporting period, the Fund initiated positions in four companies and strategically added to established positions in another two companies. Positions initiated during the reporting period include: Charles River Laboratories International Inc. (CRL, Financial), Citizens Financial Group (CFG, Financial), FTD Companies Inc. (FTD, Financial), and WestRock Company (WRK, Financial). During the quarter, the Fund eliminated its holdings in six companies and strategically reduced its holdings in another four 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 reporting period, the Fund eliminated its holdings in: Blount International Inc. (BLT, Financial), Esterline Technologies Corp. (ESL, Financial), Itron Inc. (ITRI, Financial), Joy Global Inc. (JOY, Financial), Standard Motor Products Inc., and VASCO Data Security International, Inc.
Review of Activist Holdings
As of March 31, 2016, the Fund was invested in twelve activist situations, which represented approximately 36% of the Fund’s equity investments, and four of its top ten holdings. The Fund’s activist holdings as of March 31, 2016, include environmental technology company, CECO Environmental; department store operator, Dillard’s Inc.; specialty retailer, DSW Inc.; floral and gift company, FTD Companies; money management firms, Janus Capital Group and Legg Mason Inc.; multi-channel retailer, Land’s End Inc.; kitchenware and housewares manufacturer, Lifetime Brands Inc.; glass container manufacturer, Owens-Illinois; specialty eatery, Potbelly Inc.; specialty retailer of nutritional products, Vitamin Shoppe Inc.; and fast-food restaurant chain, The Wendy’s Company. When there are other activists involved with companies in our portfolio, we monitor the progress of the other activist investors 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 strategic actions that have been proposed or implemented for each of our activist holdings 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.
The Active Pursuit of Above-Average Investment Returns
Following a tough year in 2015 and a bumpy start to the current year with a highly volatile first quarter behind us, we thought it would be helpful to discuss our approach to active management in the small- to mid-capitalization space. We believe that active management, particularly as practiced by investors focused on the unrecognized or misunderstood value of companies, is a rewarding way to achieve above-average long-term investment returns. We also believe that our approach to active management – an approach that seeks to separate those companies with serious structural, financial, or secular problems from undervalued companies (selling at a discount to our calculation of intrinsic value) that are simply not performing to their full potential, or whose potential is not currently recognized by the market – offers distinct advantages for investors seeking above-average capital appreciation, while at the same time mitigating the risks inherent in equity investing. We believe the number and size of your significant losses determine future returns. Thus, the Fund constantly seeks to defend against the possibility of significant permanent losses by investing in what we believe to be fundamentally sound companies that are trading at a substantial discount to our calculation of their intrinsic values. We believe our “consideration of downside risk before assessing upside potential” investment discipline has been the key to our long-term returns.
One of our primary criticisms of passive investing is rooted in the idea that underpins the passive approach, that is, the efficient market theory. The efficient market theory posits that markets are full of rational investors who, armed with all publicly available information, drive the prices of company stocks to their fair valuation. From our experience analyzing and investing in small- to mid-sized companies, we have experienced first-hand that investors are not always rational participants in the market, and markets often undergo extended periods of inefficiency completely divorced from fundamental company valuations. As investors, we don’t assess a company’s potential for capital appreciation based on the momentum of its stock price; but rather on our prediction of a company’s ability to generate future free cash flow. We reach our future estimates of free cash flow after performing a detailed forensic analysis on each company’s financial statements. Our discounted cash flow estimates are the main determinant of our estimated intrinsic value for each company.
More importantly, from our longer-term perspective as value investors, we realize not all market participants (rational or otherwise) treat, analyze, and react to publicly available information in the same manner or from the same perspective. We find that a great deal of market reaction to publicly available information, especially for small- to mid-sized companies, is emotional and more often than not, motivated by short-term performance concerns. As active managers, we seek to exploit these inefficiencies and irrational behavior by basing our valuations, and buy, sell and hold decisions, on company-specific information after performing an inferential analysis of financial statements in order to come up with a specific free cash flow outlook over a three- to five-year investment horizon, rather than on short-term market sentiment.
We are active managers because we believe in the logic of value investing – of buying the common stocks of good businesses at material discounts to our estimate of their intrinsic value. We value companies based on our assessment of their ability to generate free cash flow, and our approach requires that we not only develop a thorough understanding of how each company’s operations generate sustainable free cash flow (know how it works), but also requires that we answer a series of questions about the company’s business model, its strategy, its future prospects and its management (know what you own). We develop a thorough understanding of each company through a bottoms-up fundamental analysis of a company’s financial statements – focusing on the balance sheet, income statement and cash flow statement, and an ongoing forensic analysis of a company’s financial statements, regulatory filings and other disclosures . In addition to the financial statements previously mentioned, we focus on a company’s 10K, 10Q, proxy filings, annual reports, public announcements and other regulatory filings. While the passive investor would assume that all of this publicly available information already factors into the price of a company, we use this information to determine what we believe a company is worth, whether or not the deviation between market price and intrinsic value is material enough to warrant an investment and what the relevant risks of owning its stock are for us as investors.
The objective of our fundamental analysis is to understand the company’s business model and how a company’s operations generate free cash flow. 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. We believe our approach provides us with the necessary knowledge to judge the probable success of a company’s strategy, the sustainability of its performance and the quality of its management team. We also believe our process affords us greater confidence to understand and manage the risks associated with investing in the equity securities of the companies in our portfolio.
Although we use several valuation methods to determine a company’s private market value, they are all based on free cash flow. For us, reliable valuations require a thorough understanding of a company’s accounting and reporting techniques, as well as an assessment of the company’s quality of earnings. In order to estimate sustainable free cash flow, Olstein’s investment team undertakes an intensive, inferential analysis of the historical and current information contained in the company’s publicly disclosed financial statements and accompanying footnotes, shareholder reports and other required disclosures. The goal is to assess a company’s quality of earnings and to alert us to positive or negative factors affecting a company’s future free cash flow that may or may not be recognized by the financial markets. Properly assessing a company’s quality of earnings is important to our valuation methodology because it provides us with reliable estimates about future cash flow that are critical to projecting the future value of a company; a measure of the sensitivity of our valuations to projected and unexpected changes in future cash flow; and an ability to detect early signs as to whether or not a company’s business policies and strategic direction are capable of achieving the financial objectives necessary to reach our calculated values.
Final Thoughts
While we recognize that macro-economic factors and other newsworthy events can exert extreme short-term influence over equity prices from time to time, we are more concerned with how individual companies operate and generate sustainable free cash flow under all types of economic conditions and cycles. We believe it is an important job of company management to adequately anticipate and plan for the impact of macro-economic shifts on their business and ability to generate sustainable free cash flow. From our focused analysis of a company, we judge its resiliency in the face of macro-economic shifts and shocks, and incorporate that judgment into our normalized cash flow projections.
Since we launched the Olstein Strategic Opportunities Fund more than nine years ago, we have identified many small- to mid-sized companies that have successfully navigated turbulent economic times to adapt, invest, grow and restructure for the future. As economic news and events overwhelm equity markets from time to time, we believe it is critical to remain focused on company fundamentals as we wait for equity markets to regain a balanced perspective. We remind you that, as past experience proves, patience can provide generous opportunities for the diligent investor, rather than reacting to every twist and turn affecting equity markets. We intend to stay the course despite all the contradicting opinions regarding the future of equity markets.
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 to help achieve the Fund’s investment objectives. We value your trust and remind you that our funds are invested alongside yours.
Sincerely,
Eric R. Heyman
Co-Portfolio Manager
Robert A. Olstein
Chairman,
Chief Investment Officer
and Co-Portfolio Manager
The above represents the opinion of the Manager, and is not intended to be a forecast of future events, a guarantee of future results, or investment advice. The references to securities are not buy or sell recommendations, but are intended to be descriptive examples of the fund’s investment philosophy and are subject to change. Do not make investments based on the securities referenced. As of 3/31/16, the Olstein Strategic Opportunities Fund maintained a position in the following securities referenced above, and is subject to change: Charles River Laboratories International Inc. (0.1%); Citizens Financial Group (0.4%); FTD Companies Inc. (0.3%); WestRock Company (0.5%); CECO Environmental (0.5%); Dillard’s Inc. (0.6%); DSW Inc. (0.5%); Janus Capital Group (0.6%); Legg Mason Inc. (0.7%); Land’s End Inc. (0.3%); Lifetime Brands Inc. (0.5%); Owens-Illinois (0.6%); Potbelly Inc. (0.6%); Vitamin Shoppe Inc. (0.7%); and The Wendy’s Company (0.6%). As of 3/31/16, the Olstein Strategic Opportunities Fund did not maintain a position in the following securities referenced above, and is subject to change: Blount International Inc., Esterline Technologies Corp., Itron Inc., Joy Global Inc., Standard Motor Products Inc., and VASCO Data Security International, Inc. This information should be preceded or accompanied by a current prospectus, which contains more complete information, including investment objectives, risks, charges and expenses of the Olstein Funds and should be read carefully before investing. A current prospectus may be obtained by calling (800) 799-2113 or visiting the Olstein Funds’ website at www.olsteinfunds.com.
The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. There is no assurance that the fund will achieve its investment objective.
An investment in a portfolio containing small- and mid-cap companies is subject to additional risks, as the share prices of small- and mid-cap companies are often more volatile than those of larger companies due to several factors, including limited trading volumes, products, financial resources, management inexperience and less publicly available information. The activist strategy invests in stocks of underperforming companies and any shareholder activism might not result in a change in performance or corporate governance. These stocks could also experience less liquidity and higher share price and trading volume volatility than stocks of other companies.
