Robert Olstein's Olstein Strategic Opportunities Fund Q4 Commentary

Olstein managers talk about holdings, activist holdings and outlook

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Mar 11, 2016
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February 16, 2016

STAYING FOCUSED ON FREE CASH FLOW

Dear Fellow Shareholders:

For the six-month period ended December 31, 2015, load-waived Class A shares of the Olstein Strategic Opportunities Fund depreciated 14.75%, while, over the same time period, the Russell 2500™ Value Index decreased 7.07% and the Russell 2500 Index decreased 7.36%. For the three years ended December 31, 2015, load-waived Class A shares of the Olstein Strategic Opportunities Fund had an average annual return of 11.08%, compared to average annual returns of 10.51% for the Russell 2500 Value Index and 12.46% for the Russell 2500 Index over the same time period.

Outlook & Strategy

Throughout the Fund’s history, a combination of unfavorable macroeconomic events such as the current slowdown in China’s economic growth, falling oil prices and rising U.S. interest rates, tend to overwhelm equity markets and hit a value-oriented portfolio of small- to mid-sized companies (such as the Fund’s) particularly hard, resulting in short-term underperformance. At the same time however, increased negative market volatility can create favorable opportunities for the Fund to buy good companies at what we believe are bargain prices. In the current environment, many investors are reacting to negative news without regard for company fundamentals. Although we are identifying a plethora of good companies that, in our opinion, are creating long-term value during these challenging times, their value creation is being ignored by a focus on what we believe are short term negative economic events rather than long-term fundamental issues that affect intrinsic values.

Throughout the Fund’s history, Wall Street’s obsessive focus on short-term events has produced significant opportunities for the Fund to profit from pessimism as deviations between stock prices and company valuations increase dramatically. However, patience is required for the price discounts to close when and if it becomes apparent to the general public that a company’s long-term ability to produce normalized free cash flow is not being valued correctly. We 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. We believe it is important 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.

Portfolio and Performance Review

At December 31, 2015, the Fund’s portfolio consisted of 40 holdings with an average weighted market capitalization of $2.10 billion. Throughout the reporting period ended December 31, 2015, 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 six-month period ended December 31, 2015, the Fund initiated positions in three companies and strategically added to established positions in another eight companies. Positions initiated during the reporting period include: Hibbett Sports Inc., Kennametal Inc., and Zebra Technologies Corp.

During the six-month period ended December 31, 2015, the Fund eliminated its holdings in fourteen 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 reporting period, the Fund eliminated its holdings in: The ADT Corp., ABM Industries Inc., Dorman Products Inc., Entegris Inc., Express Inc., First Niagara Financial Group, Fox Factory Holding Corp., Integra LifeSciences Corp., Kadant Inc., Macy’s Inc., Sealed Air Corp., Smith & Wesson Holding Corp., Teradata Corp., and UniFirst Corp.

Our Leaders

The stocks which contributed positively to performance for the six-month reporting period include: Blount International (BLT, Financial), Cynosure Inc. (CYNO, Financial), Standard Motor Products (SMP, Financial), The Wendy’s Company, and Fox Factory Holding Corp. (FOXF, Financial). As of the close of the reporting period the Fund continued to maintain positions in Blount International, Cynosure, Standard Motor Products and The Wendy’s Company. During the reporting period the Fund liquidated its position in Fox Factory Holding Corp as the price of the company’s stock reached our valuation level.

Our Laggards

Laggards during the six-month reporting period included: Joy Global, Spirit Airlines, Dillard’s Inc., Teradata Corp., and Wesco International. During the reporting period, we liquidated our holdings in Teradata Corp because we felt that management’s failure to adequately prepare for shifts in the competitive landscape would adversely affect future sales in general and expected replacement cycle sales in particular. At the close of the reporting period, the Fund continued to maintain positions in Joy Global, Spirit Airlines, Dillard’s and Wesco International.

Review of Activist Holdings

As of December 31, 2015, the Fund was invested in thirteen activist situations, which represented approximately 36% of the Fund’s equity investments, and four 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.

Examples of the Fund’s activist holdings are environmental technology company, CECO Environmental (CECE, Financial); energy and water resources technology and services company, Itron (ITRI, Financial); money management firms, Janus Capital Group (JNS, Financial) and Legg Mason Inc.; multi-channel retailer, Land’s End; kitchenware and housewares manufacturer, Lifetime Brands Inc.; glass container manufacturer, Owens-Illinois; specialty eatery, Potbelly Inc.; specialty retailer of nutritional products, Vitamin Shoppe Inc.; fast-food restaurant chain, The Wendy’s Company; and industrial equipment supplier, WESCO International. We continue to monitor the progress of our activist holdings as the companies and activist investors work to increase shareholder value through a specific plan for improving operating results and free cash flow. 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 free cash flow.

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 free cash flow 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.

Staying Focused on Free Cash Flow

A critical element of our analytical process during periods of excessive market volatility is our ability to identify and separate those factors likely to affect a company’s future prosperity – its future free cash flow – from the excessive noise and fear that characterizes turbulent market environments. We filter and eliminate a great deal of noise, mainly the onslaught of market and top-down economic news, forecasts and data, by focusing on the resiliency of a company’s business model in both favorable and unfavorable economic environments. In this regard, there is one valuation metric in particular that strikes us as extremely important during turbulent times: a company’s free cash flow yield.

For us, current and/or future free cash flow yield is one of the most important metrics for identifying undervalued companies. In simple terms, free cash flow yield is a company’s total free cash flow divided by its market capitalization (or its free cash flow per share divided by its price per share). More importantly, if an investor believes, as we do, that a company’s free cash flow is the primary determinant of its value as an ongoing enterprise, then free cash flow yield provides a practical measure of expected future returns. Free cash flow is the net income of a company plus depreciation and amortization, minus capital expenditures, and finally taking into account the changes in working capital required to run the business. Free cash flow is a specific concept that allows an investor to determine the true amount of cash available for discretionary use by management to enhance shareholder value.

We believe that a company with a free cash flow yield well above the risk-free rate of return (which we define as three-and five-year U.S. Treasuries yields which are, as of February 10, 2016, approximately 0.79% and 1.09%, respectively) combined with a demonstrated ability to either reinvest excess cash at higher rates of return than the risk-free rate, or use that excess cash to enhance shareholder value via share buy backs or increasing dividends, should prove to be a superior, high-quality investment over time. The Fund’s top ten holdings as of December 31, 2015, which account for approximately 37% of equity investments, had an average free cash flow yield of 10.01% as of February 10, 2016.

Calculating free cash flow yield and identifying a suitable number of companies with a cash flow yield well in excess of the risk-free rate (our current target range for cash flow yield is 8% - 10% or greater) for further analysis is the easy part of the process. The more complex analysis lies in the forensic analysis of company financial statements, public filings, shareholder communications and footnotes to determine the quality of a company’s earnings, and make any adjustments to reported earnings that we believe may mask or obscure the company’s true cash flow potential. To reliably estimate a company’s normalized future free cash flow, we must fully understand its business model as well as the success of its strategy, the sustainability of its performance and the impact of management decisions on future cash flow. Our analysis not only seeks to determine how stable a company’s cash flow is, but also if we can estimate its future cash flows with a high degree of predictability. Through our analysis we seek to answer several important questions such as: Does the company’s business model produce consistent results with a predictable cost structure? Does the company have a unique niche relative to its competitors that leads to dependable revenues? Does the company have proven products with a well-defined market?

While cash flow yield may indicate a significant potential for capital appreciation, assessing how management has historically used free cash flow to benefit shareholders becomes a critical part of our analysis as well. We assess whether management has consistently used free cash flow to improve the company’s financial strength by improving the balance sheet or reducing debt levels. We determine if management has a proven track record of reinvesting in the business at suitable rates of return on investment or returning free cash to investors through increased dividends or share buybacks. We assess management by studying their past decisions, future plans, the conservatism and strength of the balance sheet, as well as the economic reality of the financial statements. Our assessment of management is one of our key components we consider when calculating the intrinsic value of a company.

As we have said many times before, free cash flow is the lifeblood of a business and 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. In addition, free cash flow companies often attract private equity and/or acquirers. For us, 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 that we can buy at a significant discount to our determination of their intrinsic value. Free cash flow yield provides a valuable tool for helping identify and analyze such companies by providing a meaningful way, in an uncertain market environment, to contrast a company’s financial performance – its ability to produce a cash return that benefits shareholders – to the risk-free rate. We believe a fundamental financial statement analysis on a company-by-company basis, rather than reacting to overall market sentiment, increases the probability of producing long-term returns for our shareholders. In essence, we focus on the cash return the Fund can expect from owning a share of a business and whether that return compensates the Fund sufficiently (in excess of the risk-free rate) for the risk of investing in it?

Final Thoughts

We are not oblivious to the issues affecting the overall economic environment and outlook, and recognize that macro-economic factors and other newsworthy events can exert extreme short-term influence over equity prices from time to time. However, we are more concerned with how individual companies operate under all types of economic conditions and cycles, and their long-term ability to generate and/or grow future excess cash flow which the market is not valuing correctly. We believe it is an important job of company management to adequately anticipate and plan for the impact of varying macro-economic shifts on their business, and its ability to generate sustainable free cash flow. Based on our forensic analysis of a company’s financial statements, we judge its resiliency in the face of macro-economic shifts and shocks, and incorporate that judgment into our normalized cash flow projections and thus our calculation of intrinsic value.

Since we launched the Olstein Strategic Opportunities Fund more than eight 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. We intend to stay the course, since we are invested in a portfolio of companies that we believe have the financial strength to ride out current market jitters, while offering favorable long-term business prospects that in our opinion are not being properly valued by the market. We value your trust and our money is invested alongside yours.

Sincerely,

Eric R. Heyman

Co-Portfolio Manager

Robert A. Olstein

Chairman,

Chief Investment Officer

and Co-Portfolio Manager

The performance data quoted represents past performance and does not guarantee future results. The Olstein Strategic Opportunities Fund Class A return as of 12/31/15 for the one-year period, five-year period, and since inception (11/1/06), assuming deduction of the maximum Class A sales charge of 5.50%, was -19.13%, 7.88% and 5.85%, respectively. Per the Fund’s 10/31/15 prospectus, the Fund’s Class A expense ratio was 1.60%. Expense ratios for other share classes will vary. Performance for other share classes will vary due to differences in sales charge structure and class expenses. 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. Current performance may be lower or higher than performance quoted. To obtain performance data current to the most recent month end, please visit our website at www.olsteinfunds.com.

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 12/31/15, the Olstein Strategic Opportunities Fund maintained a position in the following securities referenced above, and is subject to change: Hibbett Sports Inc. (0.2%); Kennametal Inc. (0.2%); Zebra Technologies Corp. (0.5%); Blount International (0.3%); Cynosure Inc. (0.3%); Standard Motor Products (0.3%); The Wendy’s Company (0.6%); Joy Global (0.3%); Spirit Airlines Inc. (0.8%); Dillard’s Inc. (0.6%); CECO Environmental Corp. (0.6%); Itron Inc. (0.4%); Janus Capital Group (0.6%); Legg Mason Inc. (0.7%); Lands’ End Inc. (0.3%); Lifetime Brands Inc. (0.4%); Owens-Illinois Inc. (0.5%); Potbelly Corp. (0.5%); Vitamin Shoppe Inc. (0.7%); and Wesco International (0.6%). As of 12/31/15, the Olstein Strategic Opportunities Fund did not maintain a position in the following securities referenced above, and is subject to change: The ADT Corp., ABM Industries Inc., Dorman Products Inc., Entegris Inc., Express Inc., First Niagara Financial Group, Fox Factory Holding Corp., Integra LifeSciences Corp., Kadant Inc., Macy’s Inc., Sealed Air Corp., Smith & Wesson Holding Corp., Teradata Corp., and UniFirst Corp. 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.