For the fiscal year ended June 30, 2015, Class C shares of the Olstein All Cap Value Fund appreciated 9.24%. During the same twelve month period, the S&P 500® Index appreciated 7.42% and the Russell 3000® Index appre-ciated 7.29%. For the three-year period ended June 30, 2015, Class C shares of the Olstein All Cap Value Fund had an average annual return of 18.35% compared to annualized total returns of 17.31% for the S&P 500® Index and 17.73% for the Russell 3000® Index.
Market Outlook
The ongoing financial crisis in Greece, the slowdown in the Chinese economy and the expected negative impact of rising U.S. interest rates and strengthening U.S. dollar caused an increase in market volatility during the first six months of 2015 fueling forecasters’ predictions of a market pullback. While there are always forecasters predicting the next market correction or down-turn, we believe it is important for investors to weather market events and periods of short-term volatility by favoring the equities of financially strong companies with stable or growing free cash flow, run by managements that have a demonstrated history of deploying cash to the benefit of shareholders.
In the current market, an enormous amount of investor money is flowing into high revenue growth companies with little, if any, free cash flow (e.g., internet, social media, etc.). The money flowing into these high revenue growth companies is coming from the liquidation of industrial stocks that, in our opinion, are temporarily affected by a strong dollar and a less than robust economy (especially overseas), creating what we believe are deep discount stock purchase opportunities with free cash flow yields as high as 10%. In the current environment, there is a strong case for investing in equity securi-ties of companies whose real economic value is unrecognized by the market, obscured by recent market uncertainty or over shadowed by temporary prob-lems. We believe investors can find viable opportunities by focusing on four primary, company-specific factors: (1) a commitment to maintain a strong financial position as evidenced by a solid balance sheet; (2) an ability to gen-erate sustainable free cash flow; (3) management that intelligently deploys cash balances and free cash flow from operations to increase returns to share-holders; and (4) a stock price that is at a discount to intrinsic value because of short-term factors. We further believe that, by prioritizing these factors, we are investing in companies that are positioned to compete more advanta-geously as economic growth accelerates.
Our Strategy
There are times when the combination of certain events, such as the Greek financial crisis and slowdown in the Chinese economy, tend to overwhelm equity markets and hit a value-oriented portfolio, such as the Fund’s, particularly hard causing a period of short-term underperformance. At the same time, however, from our perspective as long-term value investors, the negative reaction during periods of increased market volatility creates many favorable opportunities for the Fund to buy good companies at bargain prices.
Throughout the Fund’s history, Wall Street’s obsessive focus on short-term events and obsession with pouring money into “exciting in your face high growth companies” selling at prices and valuations that have already more than discounted the future growth (reducing the probability of future appreciation), often produced significant opportunities for the Fund to purchase stocks in under the radar with 8% to 10% free cash flow yielding companies being thrown out the window to raise money for the overvalued exciting companies. The Fund usually purchases what we believe are undervalued stocks selling at discounts to our calculation of intrinsic value, during periods of pessimism and underperformance by the company or industry that we deem to be temporary. Before purchasing, we conclude that the bargain prices are not warranted by our estimate of the company’s normalized ability to produce future free cash flow. Buying high growth companies at any price can reduce future returns. Although growth companies are exciting, the price you pay is critical. For example, the stock of Coca Cola (KO, Financial) is still not above its 1998 high stock price (when investors believed it was worth 95 times earnings based on assuming nonstop double digit growth forever). We believe we are currently in one of those periods with many investors buying and selling stocks with little regard for company fundamentals. We, on the other hand, 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 recog-nized by the market. We remain focused on individual companies, their operations and prospects for maintaining or growing sustainable free cash flow. Patience is the most important virtue of a value investor. Forever is an overused word in our industry. Throughout our career, we have seen that whatever is working and/or not working over 3-6 month time periods, the word “forever” is usually attached. Rarely is “forever” true but the word pro-duces both overvalued and undervalued securities in most markets.
Portfolio Review
The Fund’s current portfolio consists of companies that we believe have a sustainable competitive advantage, discernible balance sheet strength, a management team that emphasizes decisions based on cost of capital calcula-tions and deploys free cash flow to create shareholder value and are selling at discounts to our estimate of intrinsic value. We believe companies with these characteristics are poised to eliminate the valuation gaps created by the recent events as the economic growth accelerates.
At June 30, 2015, the Olstein All Cap Value Fund portfolio consisted of 103 holdings with an average weighted market capitalization of $57.57 billion. During the fiscal year, the Fund initiated positions in 30 companies and strategically added to positions in 27 companies. Over the same time period, the Fund eliminated its holdings in 32 companies and strategically decreased its holdings in another 12 companies.
Positions initiated during the last twelve months include: Alaska Air Group, Brady Corporation, Citizens Financial Group, Discovery Communications, Dorman Products, Dover Corp., DSW Inc., First Niagara Financial Group, HCA Inc., Janus Capital Group, JetBlue Airways, Johnson Controls Inc., Joy Global Inc., Keysight Technologies, MasterCard Inc., MSC Industrial Direct Co., NVIDIA Corp., Oshkosh Truck Corp, Owens-Illinois, Packaging Corp of Ameri ca, Patter son Companies, Inc., Pentair Ltd., The Travelers Companies, Twenty-First Century Fox, United Parcel Service, Universal Health Services Inc., Vasco Data Security, Viacom Inc., Visa Inc. and The Wendy’s Company.
Positions eliminated during the past twelve months include: 3M Company, ABB Lt d., Americ an Exp re ss, An n In c. , Aver y Denni son , Baxter International, CR Bard, Inc., CareFusion Corp., Charles River Laboratories Inc ., Cintas Cor p. , Coca -C ol a Co mp any, Dee re & Co. , Dentsp ly International Inc., DuPont, Ethan Allen Interiors, Hormel Foods Corp.,
International Game Technology, Jones Lang LaSalle Inc., McDonalds Corp., Newell Rubbermaid Inc., NOW Inc., PetSmart Inc., Quest Diagnostics, Ross Stores Inc ., Sysco Corp. , Teleflex Inc. , TJX Com pan ies Inc., TRW Automotive Holdings, URS Corp., V F Corp., Walt Disney Company and Whole Foods Market Inc. As previously discussed in shareholder letters for the third and fourth quarters of 2014, the Fund eliminated its positions in CareFusion Corp., International Game Technology, PetSmart, Inc., TRW Automotive Holdings and URS Corp. on very favorable terms as these com-panies were targeted by strategic acquirers during the reporting period.
Our Leaders
The stocks which contributed positively to performance for the twelve-month reporting period include: Sealed Air Corp (SEE, Financial), Universal Health Services (UHS, Financial), UnitedHealth Group (UNH, Financial), Zoetis, Inc. (ZTS, Financial), and Ross Stores (ROST, Financial). At the close of the fiscal year, the Fund continued to hold Sealed Air, Universal Health Services, UnitedHealth Group and Zoetis, Inc. The Fund sold its position in Ross Stores, which it held for a couple of years as the price of the company’s stock reached our valuation level during the fourth quarter of 2014.
Our Laggards
Laggards during the twelve -month reporting period include: National Oilwell Varco (NOV, Financial), Fossil Group (FOSL, Financial), Now, Inc., Vishay Intertechnology and Wesco International. As of the close of the reporting period, the Fund continued to hold National Oilwell Varco, Fossil Group, Vishay Intertechnology and Wesco International in its portfolio. The Fund acquired the equity of NOW as a result of a spinoff from National Oilwell Varco in early June 2014, and held the company’s stock despite falling oil prices during the second half of 2014. The Fund liquidated its position in NOW in February of 2015 as oil prices continued to fall and the outlook for oil remained uncertain.
A Value Investor's Perspective on Turbulent Markets
To a certain degree, investor apprehension and concerns about equity mar-kets are understandable when considering the media’s breathless coverage of negative events. Whether it is the Greek debt crisis, uncertainty about the future of the Eurozone, the economic slowdown in China or the expected negative impact of a strengthening U.S. dollar on corporate earnings, crises and calamities continue to dominate headlines and shake investor confi-dence. It feels like yesterday that the media were warning investors about the future devastating impact of the “Fiscal Cliff” and government shutdown right before the stock market went on a material rise. While we do not minimize the potential worst-case scenarios that any of these events may bring to equity markets, we believe it is more important to distinguish between the variability of an investment’s value due to temporary market volatility and the likelihood of permanent impairment of an investors’ capital. For a value investor, short-term market volatility is less of a concern than the irreversible loss of capital due to the erosion of a company’s fundamentals over time. Another meaningful worry for value investors is a poorly timed decision to sell a particular holding by reacting to short-term events that turned out to be temporary and had little to do with a company’s long-term ability to gen-erate normalized free cash flow and thus its intrinsic value.
Focusing on Factors Conducive to Favorable Performance
In our experience, pessimism about the direction of the overall market often leads investors to make poorly timed asset allocation or sell decisions, blind-ing an investor to the long-term future appreciation potential of companies with a sustainable competitive advantage, discernible balance sheet strength and a management team that effectively adjusts to challenging times to cre-ate meaningful shareholder value. Companies with such characteristics are not only poised to overcome temporary valuation gaps created by market volatility but are usually in a position to achieve greater capital appreciation as market conditions improve and economic activity accelerates. While we believe investors are wise to be wary of risk, we also believe that instead of making investment decisions based on market sentiment, investors should focus on opportunities for meaningful capital appreciation by studying oppor-tunities presente d by individual company fundamentals after a foren sic analysis of financial statements.
From our perspective as value investors, recent market volatility has pro-duced an environment in which there are many individual opportunities that offer investors the potential for above-average capital appreciation. Our quest for value is guided by two prerequisites: (1) a company’s ability to gen-erate sustainable future free cash flow; and (2) securities prices that allow us to buy good companies with solid balance sheets and profitable business models at very advantageous prices. These two require ments guide our investment process and force us to focus on a company’s future prospects and value while capitalizing on current favorable prices.
Uncertainty and volatility usually present opportunities when determining the future value of a company, even under norma l mark et condition s. However, when market downturns or periods of volatility hit equity markets across the board – roughly half of S&P 500 Index companies have negative year-to-date performance through July 28, 2015 – the stocks of many good companies are penalized by negative market sentiment or reduced expecta-tions that have little to do with a company’s underlying financial perform-ance. A company may have the misfortune of being in a sector that has fallen out of favor or may have material revenues in an industr y that is expected to underperform for a period of time. A portion of a company’s business may originate from a country or region suffering from a pullback in economic activity or a company may have exposure to an unfavorable eco-nomic trend such as falling commodities prices. Whatever the reason, investors often feed off of and into broad negative market sentiment to pull back from a broad range of companies without regard for individual company performance or without considering how well individual companies may weather such adversity. Most investors, as always, believe negative trends or positive trends are forever creating pockets of overvaluation and undervalua-tion during all markets.
For value investors, this often short-sighted market dynamic creates ample opportunities to buy great companies at substantial discounts which, in turn, sows the seeds for future potential outperformance. We never know the exact timing of sentiment changes and, thus, our timing is based on the size of the discount from our calculation of long-term intrinsic value rather than trying to gauge the specific date that market sentiment changes. For us, the most important metric for identifying superior investment opportunities in an uncertain market is a company’s ability to generate future sustainable free cash flow. We look to invest in companies with strong balance sheets that have not only have the financial strength to weather periods of economic uncertainty but have also demonstrated an ability to allocate capital wisely during such challenging periods. Because we are so focused on a company’s ability to generate free cash flow during both favorable and unfavorable eco-nomic cycles, we often identify many investment opportunities initially over-looked by the market or disregarded by investors too concerned with the volatility or pessim ism dominating the ‘here and now’. If an investor believes as we do that a company’s ability to generate future free cash flow is the primary determinant of its value as an ongoing enterprise, then a compa-ny’s ability to adapt to a challenging environment and continue to generate sustainable free cash flow will separate it from its competition and eventually draw the favorable attention of equity investors as markets regain a more bal-anced perspective and the company hopefully begins to show signs of its nor-malized ability to generate future free cash flow.
We believe an analysis on a company by company basis and not overall mar-ket sentiment, should concern investors - what is the cash return an investor can expect from owning a share of a business over the next three to five years, and does that return compensate the investor sufficiently in excess of the risk-free rate for the risk of investing in equities? To us, this last question holds greater importance at a time when nervous investors are being told, often quite loudly, to avoid equities and seek safer opportunities. We believe such times have the potential to set up significant above-average long-term investment returns.
Where We Are Now - The Seeds We've Sown
As previously reported in this letter, as of June 30, 2015, the Olstein All Cap Value Fund portfolio consisted of 103 holdings with the Fund initiating 30 holdings and eliminating 32 holdings over the past twelve months. Of these 103 holdings, the Fund has considerable exposure to unusual value opportu-nities whose future prospects, in our opinion, are currently unrecognized, misunderstood, disregarded or undervalued by the current market.
Since the beginning of the fiscal year, 25 of the Fund’s holdings (representing approximately 27% of the Fund’s equity investments) have been the subject of significant announcements, including three merger & acquisition deals, two completed spinoffs as well as a contemplated spinoff; six share repurchase plans, seven substantial dividend increases (four of these dividend increases were announced along with share repurchase programs) and ten activist cam-paigns. We are hopeful that, over our expected holding period, the Fund will benefit from a continuation of these value-creation initiatives as markets regain a surer footing and activist investors look under the microscope for undervalued free cash flow companies affected by temporary conditions.
What made each of the 23 companies mentioned above that were the sub-ject of value enhancing corporate actions appealing to us as value investors were favorable company-specific characteristics (unique product or service niche, competitive strength, and clean capital structure), an ability to gener-ate sustainable free cash flow and stocks trading at a significant discount to our determination of each company’s intrinsic value. While the combina-tion of these factors pointed to significant potential for capital appreciation, our in-depth understanding of each company’s potential usually flew in the face of the short-term collective wisdom regarding its future prospects and that is precisely the reason we were able to buy these companies at material discounts. With a period of market volatility added into the mix, the poten-tial for such unusual value situations was further clouded, and, thus, these companies tend to get hit a little harder over the short-term. As with many of our investments, we usually find ourselves patiently waiting for the rest of the market to recognize and understand a company’s true investment poten-tial before we see the valuation gap close. We usually keep some cash fire-power to add to the positions if the stock prices continue to fall for no apparent long-term value reason. As volatility once again shakes markets, we realize that it may take a little longer for the market to see what we see and remind you that it is the patient investor that usually reaps above-aver-age rewards. The exact timing as to precisely when (or if) an activist or another catalyst strikes is virtually impossible and that is why we believe the Fund is for investors with a 3-5 year investment horizon. Investors trying to time the Fund based on past experience or temporary moves up or down have been mostly wrong in the past and, we believe, will unfortunately con-tinue to do so. No philosophy or discipline works all of the time and, in fact, any attempt to make this happen is a long term failure process.
Final Thoughts
As value investors, we believe in having a long-term horizon in an environ-ment that is maniacally focused on short-term events. We believe that our long-term horizon, in conjunction with our emphasis on an in-depth analysis of financial statements, should provide the Fund with an advantage even during the most negative environments. To repeat, we believe in perform-ance over time and believe that any attempt to perform all of the time would be an impediment to performing over time, especially when the core of our philosophy seeks to buy companies at bargain prices. Battleships do not turn on a dime and bargains usually require patience until being discovered by the investment masses. It is our opinion that purchases made in the Fund’s port-folio during the most recent period of extreme market negativity should result in higher future rates of return. The market is a discounting mecha-nism and, while past performance is not necessarily indicativ e of future results, it is noteworthy that the seeds of past periods of relative outperfor-mance were often sown during previous periods of extreme volatility.
Uncertainty and fear, fueled by troubling news, short-term events and con-flicting economic data usually produces the discounted stock prices we seek to take advantage of. Individual stock and/or market declines or just plain misperception, often present us with buying opportunities, especially if we believe the short-term events are of little consequence to the long-term value. While price declines present us with buying opportunities, low stock prices are not the sole criteria for buying companies for our portfolio under our strict free cash flow value-based stock selection criteria. Additional cri-teria include: strong balance sheets; well-run operations which have the abil-ity to consistently generate excess free cash flow and company managements with a disciplined track record of improving the returns of the business.
We believe the best approach for an uneven economic and investment envi-ronment 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 our assessment of their intrinsic value.
The Fund’s portfolio primarily consists of fiscally strong, excess cash flow companies whose businesses, in our opinion, are primed to provide suitable returns over the long-term.
We value your trust and remind you that our money is invested alongside yours as we work hard to accomplish the Fund’s objective of long-term capi-tal appreciation. We look forward to writing to you again at the close of the next quarter.
Sincerely,
Robert A. Olstein
Chairman and Chief Investment Officer
Eric Heyman
Co-Portfolio Manager
The performance data quoted represents past performance and does not guarantee future results. The Olstein All Cap Value Fund’s Class C average annual return for the one-year, five-year, and ten-year periods ended 6/30/15, assuming reinvestment of dividends and capital gain distributions and deduction of the Olstein All Cap Value Fund’s maximum CDSC of 1% during the one-year period, was 8.24%, 16.11%, and 5.97%, respectively. Per the Fund’s prospectus dated 4/28/15, the expense ratio for the Olstein All Cap Value Fund Class C was 2.28%. Performance and expense ratios for other share classes will vary due to differences in sales charge structure and class expenses. The investment return and principal value of an invest-ment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than per-formance quoted. To obtain performance data current to the most recent month end please go to our website at www.olsteinfunds.com.
