DEAR FELLOW SHAREHOLDERS:
For the six-month reporting period ended December 31, 2016, Class C shares of the Olstein All Cap Value Fund appreciated 11.26%. During the same six-month period, the Russell 3000® Value Index appreciated 11.40% and the Russell 3000® Index appreciated 8.79%. For the calendar year ended December 31, 2016, Class C shares of the Olstein All Cap Value Fund appre-ciated 11.53%, while the Russell 3000® Value Index appreciated 18.40% and the Russell 3000® Index appreciated 12.74%1.
MARKET OUTLOOK
Equity markets rebounded strongly during the final two months of the year following the U.S. Presidential and Congressional elections as the bench-mark Russell 3000® Index appreciated 6.51% during November and December of 2016 (Class C shares of the Olstein All Cap Value Fund appre-ciated 6.84% over the same time period). As 2017 unfolds, we expect pock-ets of volatility to continue to affect equity markets as investors adjust to the new administration’s economic, trade and tax policies. Notwithstanding the uncertainty attributable to the shift in policy priorities, we maintain an opti-mistic outlook for our value-oriented approach to equity investing in 2017. We believe it is important to withstand periods of short-term market volatili-ty by favoring the equities of financially strong companies with stable or growing free cash flow that, in our opinion, are not properly valued by the market and are run by managements that have a demonstrated history of deploying cash to the benefit of shareholders.
OUR STRATEGY
Our current portfolio consists of companies that we believe have a sustain-able competitive advantage, discernible balance sheet strength, a manage-ment team that emphasizes decisions based on cost of capital calculations and deploys free cash flow to create shareholder value. We remain focused on individual companies, their operations and prospects for maintaining or growing sustainable free cash flow since, from our perspective as long-term value investors, we recognize that companies generating growing sustainable free cash flow are well positioned to compete more profitably as economic growth improves. 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. As 2017 unfolds, we will continue to focus on those companies that demonstrate a commit-ment to maintain a strong financial position; an ability to generate sustain-able free cash flow; management that intelligently deploys cash to increase returns to shareholders and that we can buy at a significant discount to our determination of their intrinsic value.
PORTFOLIO REVIEW
At December 31, 2016, the Olstein All Cap Value Fund portfolio consisted of 92 holdings with an average weighted market capitalization of $60.46 billion. During the six-month reporting period, the Fund initiated positions in sixteen companies and strategically added to positions in ten companies. Over the same time period, the Fund eliminated its holdings in eleven companies and strategically decreased its holdings in another twenty companies.
Positions initiated during the reporting period include: BorgWarner Inc., Caterpillar Inc., CF Industries Holdings Inc., Coty Inc., Danaher Corp., IBM Corp., The JM Smucker Company, Newell Brands Inc., Nike, Inc., ServiceMaster Global Holdings, Inc., Skechers USA, Inc., Snap-On Inc., Stericycle Inc., VCA Inc., Vista Outdoor Inc., and VWR Corp. Positions eliminated during the past six months include: AT&T Inc., Baker Hughes Inc., Brady Corporation, Ingersoll Rand, Kennametal Inc., Oshkosh Truck Corp., Parker Hannifin Corp., Pentair Ltd., Sensient Technologies Corp., Vishay Intertechnology, Inc., and Xylem Inc.
Our Leaders
The stocks which contributed positively to performance for the six month reporting period include: Citizens Financial Group, Zebra Technologies Corp., Harman International, Fifth Third Bancorp, and the Greenbrier Companies. At the close of the reporting period, the Fund continued to hold all of these companies in its portfolio.v
Our Laggards
Laggards during the six-month reporting period include: Vitamin Shoppe, Inc., Universal Health Services, Coty Inc., CVS Health Corp., and Medtronic plc. At the close of the reporting period, the Fund continued to hold all of these companies in its portfolio.
MARKET DISTORTIONS THAT CREATE UNDERVALUATION
THE “MINDLESS” PASSIVE INVESTMENT REVOLUTION IS CREAT-ING DISTORTIONS WHICH WE BELIEVE BENEFITS OUR “LOOKING BEHIND THE NUMBERS” INVESTMENT DISCIPLINE.
We believe that the current “mindless” passive investment revolution is creat-ing widening opportunities and advantages for active value investors such as the Fund. All kinds of statistics are flaunted by the press, politicians, and gov-ernment bureaucrats to denigrate the ability of stock pickers to select a portfo-lio of stocks that perform well enough to justify the fees charged. There isn’t a day that goes by where the press, academics, or well respected investment gurus suggest that investors abandon active managers and instead invest in low fee, supposedly low risk, automated S&P 500® Index Funds or ETF portfolios. Although the low fees part is factual, we believe the low risk part of the equa-tion could not be further from the truth. One of the main risks of these auto-mated portfolio products is that they must remain fully invested at all times regardless of the fact that the prices of individual stocks in the portfolio have no relationship to the operating fundamentals of the company. No attempt is made to analyze the individual companies in the index fund or ETF in order to determine whether or not individual stock prices within the portfolios are being correctly priced based on fundamentals (such as a company’s normalized ability to generate and grow future excess cash flow), or are being priced on expectations that may be pure fantasy. Perhaps the low fees are enticements to pacify shareholders for taking the risk of investing in “mindless” portfolios, which in the past owned major positions in some of the great frauds of our time (e.g., Enron, World Com, Lucent). We are not saying that index invest-ing or ETF investing should not be part of an investor’s portfolio, but charac-terizing this type of investing as riskless and the only logical choice for investors is an oversimplification, limiting and a mischaracterization of risk.
It is significant to note that the general acceptance of low fee “mindless” investing as the equivalent of investment dogma brings to mind many past experiences whereby the universal acceptance of an investment methodology (as the only way to go) was the right time to exit the universally accepted investment disciplines (e.g., Nifty 50, Dogs of the Dow, Internet bubble, port-folio insurance, etc.). On a positive note, we believe the widespread accept-ance by the investing public of “mindless” investing as the only way to go, is creating valuation distortions throughout the market, giving active fundamen-tal value investors a decided edge to generate above-average future returns.
There are also major flaws in the statistical logic utilized to denigrate all active managers. Rather than look at cumulative long term returns, the “mindless” zealots quote how many mutual funds fail to beat the index in any one year. Investing is not about year to year relative performance, but rather the accumulation of wealth over long periods of time and the risk undertak-en to achieve these absolute returns. Judging relative yearly wins and losses is a misleading statistic. Investing should not be judged similar to a football game. Investing is not about wins and losses but about long term wealth accumulation. If you lose 49-0 in football, the score goes back to zero the next game. If your portfolio gets wiped out in any given year, the penalty is large as you must start the ensuing year with less capital, and a long hill to climb, with a lot “less fuel” (capital) to get up the hill.
The Olstein All Cap Value Fund recently celebrated its 21st birthday towards the end of 2016. Over the more than 21 year period, on a yearly basis the Class C shares relatively outperformed the S&P 500® Index eleven times and under-performed ten times. Yet despite the year to year performance dance, we believe that over the 21 years our investors have been served well in terms of long-term wealth accumulation. As of December 31, 2016, the Class C share of the Fund (launched on September 21, 1995) had an average annual return of 10.04% after all fees since inception compared to an average annual return of 8.56% for the S&P 500® Index (which, of course, incurs no fees) over the same time peri-od. We are not sure about the significance of keeping score as to whether or not we outperformed or underperformed the index in any one year, but we do know the significance of the statistic that an individual investor who invested $10,000 at the Fund’s inception has accumulated $76,612 as of December 31, 2016 (after all fees), whereas a similar $10,000 investment in the S&P 500 Index over the same time period accumulated to $57,441 (before assessing fees)2.
Let us move on to why we believe the almost universal acceptance of low fee “mindless” investing as the best choice, has increased the probability for funda-mental long-term value investors to outperform the stock market averages over future 3-5 year time periods. We believe that the majority of today’s investing public, including analysts, are short-term speculators basing investment deci-sions on the ability to time overall stock market movements, predicting short-term stock price movements based on near term events, or relying on intraday computer driven algorithmic trading. The probability of achieving long-term success by trying to precisely predict when markets or individual stocks are going to move up or down is a low probability endeavor. It has been our expe-rience that very few short-term speculators succeed over long periods of time as a result of either making consistent market predictions or precisely predicting short-term price movements of individual stocks. Short-term correct calls usu-ally attract the headlines, but we believe “turtle type” investing has a higher probability of succeeding than “hare type” investing. “Mindless” investing products (e.g., ETF’s, index investing, etc.) cannot react to the overvaluation or undervaluation created by crowd behavior, and in many cases add fuel to the fire as the investing formulas have momentum characteristics. On the other hand, value investors often succeed because they can value companies on the basis of assessing long-term fundamentals. In our opinion, the most important fundamental is a company’s normalized long-term ability to generate excess free cash flow, and assessing whether or not the current stock price discounts this potential. A discount or undervaluation is usually created by overall negative market psychology or short-term issues affecting the company, its industry or just plain misperception. Value investors need to have the dogged patience to avoid the short-term guessing game (where the ultimate goal is the fantasy of achieving consistent instant gratification) and stay focused on a company’s long-term fundamentals as expressed in a company’s ability to generate and/or grow future free cash flow (which determines its value). A value investor’s next step is to assess whether or not the current stock price is correctly dis-counting the company’s estimated future excess cash flow. Paying the right price is the single biggest determinant of future returns. The key question a value investor must consider is whether or not closing the difference between the current stock price and estimated intrinsic value over an expected time period compensates the manager for taking the risk that the predicted future normalized free cash flow is realized and valued by the investment public as expected. Patience is a difficult trait to adopt in the investment industry (espe-cially in the modern age of short-term momentum and “mindless” investing) but if our projections are correct and we pay the right price, the future gains usually compensate us for this patience. Selling overvalued securities is just as important as buying undervalued securities. We are finding that the current automated “mindless” investing environment is creating more and more pock-ets of undervaluation and overvaluation to act upon.
To repeat, we believe the public’s continued desertion of active value man-agers has created distinct future advantages to patient active value investors such as the Fund. The S&P 500® Index automated index investing portfo-lios require index investors (similar to momentum investors) to purchase more and more of winning stocks as they become a larger percentage of the index portfolio in order to stay in balance with the indexing portfolio. At the same time, stocks which are declining as a result of experiencing short-term problems, or are out of the current limelight, are automatically liquidat-ed by index portfolios as they become a smaller percentage of the index. Stock prices at the top of the S&P 500® Index totem pole often get higher and higher (sometimes without regard to operating fundamentals) as money flows via the momentum type automated formula, whereas stock prices at the lower end of the S&P 500® totem pole often go lower for companies experi-encing problems or not currently in vogue, as the momentum index invest-ing formula forces additional liquidations in order to balance the portfolio to the now lower index weightings for these stocks.
For example, at current prices Netflix and Twenty First Century Fox (FOXA, Financial) have similar market capitalizations. However, we would rather purchase a Twenty First Century Fox at a market capitalization of $56 billion which not only generates $3.0 billion of excess cash flow (available for dividends, stock buy backs, acquisitions, etc.), but also has a valuable long-term film library, TV network affiliates, broadcasting stations, etc. In comparison, Netflix (NFLX, Financial) has a $60 billion market capitalization and bleeds $2 billion per year of negative cash flow in an attempt to come up with valuable shows that can keep their subscribers paying their monthly fee.
It is well known that the odds of producing new successful profitable media shows has been far less than 50% in the past, and the competitive landscape is getting more crowded (Amazon, Hulu, etc.). The Netflix dream is more exciting than the reality, and when we compare the cash flow metrics, film libraries, balance sheets, etc. of Netflix vs. Twenty First Century Fox, we can make little sense as to why the public values both companies similarly. Netflix has had a meteoric stock ride for its investors over the past 5 years. Eventually free cash flow will have to justify its meteoric valuation and the $11 billion of capitalized costs on the balance sheet (and the billions of dol-lars of future liabilities that are not yet on the balance sheet) against future programming revenues. We prefer to take what we believe to be less risk and buy the proven undervalued free cash flow generators such as Twenty First Century Fox, despite the lack of excitement. The heart of the Olstein investment philosophy is the belief that the number and severity of your errors determines long-term performance, not the few big exciting winners. Our experience has been that a boring portfolio of undervalued positive free cash flow companies generates higher long-term returns than taking the risks of investing in a portfolio of “in vogue”, exciting new companies, in new industries, being priced on the basis of expected consistent meteoric growth. In many cases, in order to justify current unrealistic prices, Wall Street ana-lysts often utilize unrealistic metrics (sales growth, number of clicks, adjusted earnings, etc.) rather than free cash flow to justify buying these stocks at bubble prices. It has been our experience that most investments using met-rics other than future free cash flow to value companies, turn out to be investment valuation fantasies with poor long-term returns.
However, as a result of the current focus on “mindless” investing which favors stocks that are going up (which is a form of momentum investing), we are finding many companies selling at a discount to our calculation of intrin-sic value which are being avoided by the investing public because of short-term factors which we believe are not indicative of their long-term ability to generate future free cash flow. We believe that over the past 21 years, we have found that by investing in a portfolio of free cash flow companies sell-ing at a discount to our estimate of intrinsic value (defined by a company’s long term ability to produce normalized future free cash flow), the Fund has been able to achieve its primary objective of long-term capital appreciation.
The other type of “mindless” product that has grown meteorically over the past 10 years is the “mindless” ETFs. Factors other than low fees need to be considered before concluding ETFs are low risk investments. Structurally, ETFs have low relative fees and are publicly traded throughout the trading day which enables its shareholders to buy and sell all day. However, ETFs are complex structures having little, if any, research done following the progress of the individual holdings after the ETF is formed, and are not guaranteed to return net asset value when sold as is generally required by mutual funds. An ETF’s price is subject to supply and demand of the investment public and that partially determines the price at which you buy or sell. One of the biggest benefits advertised by ETF sponsors is the ability to trade ETF shares all day whereas mutual funds can only be bought or sold at net asset values determined at the end of each trading day (4:00 PM). Based on our experi-ence, we doubt that this ability to trade throughout the day is of any benefit other than for the most experienced traders. There have been many studies consistent with our own experience, that peak inflows into mutual funds (which only trade once a day) occur mostly at highs and outflows peak at lows. The ability to trade all day can exacerbate the fact that the general public in a large majority of cases has been on the wrong side of mutual fund trades. We do believe ETFs can be utilized efficiently by sophisticated investors to hedge investment positions and spreads, but I would place a large bet that the general public and their advisors are usually on the wrong side of these trades with sophisticated institutional investors. During the flash crash of 2011, many ETFs experienced downside volatility that had little to do with net asset value and represents yet another element of risk.
In conclusion, government directives and misleading data have hastened the transformation from active management stock picking investments to “mindless” passive investing. Judging mutual fund investments based on how often, on a yearly basis, they beat the market, takes ones eye off what should be the main goal, which we believe is long-term wealth accumulation. Although it may be true that a majority of active managers may not beat the market over time, we believe a majority of doctors, plumbers, carpenters, entertainers, etc. are, at best, average. The normal “Bell Curve” has described this phenomenon for a long time, and this Bell Curve phenome-non does not only exist in the investment industry but in all industries. To give up the hope of finding active managers who pursue long-term wealth accumulation is a total capitulation as there are many good ones around. To repeat, we are not against the concept of index investing or ETF investing as a philosophy, but to conclude they are low risk investments because of lower fees is not even worthy of a discussion. It is obvious to us that being average is better than being below average, but the message to our shareholders is no investment philosophy, including ours, is without flaws or risks. It is up to the financial professionals and their clients to study a fund’s philosophy and select a manager practicing a discipline they believe has a high probability of success. Risk is an important part of that equation and the potential future outcomes and probabilities are more important than just studying past rela-tive short term performance. The most important word is probability as there is no such thing as the sure thing in investing, but probability can only be assessed over long periods of time. Simplistic conclusions based on generalities, using misleading numbers to advocate “mindless” investing with entire investor portfolios is, in our opinion, limiting and misguided. To be above average is the American ideal and to abandon all hope is wrong. Do you really believe the abdication of choice (or automated decision making within portfolios) is the best choice?
FINAL THOUGHTS
Successful long-term active managers will be around for a long time, and all the data produced by the so-called smartest guys in the room and academics at leading universities advising to avoid all active managers is at best short-sight-ed. How many Nobel Prize winners did it take to almost destroy Wall Street via Long Term Capital and their automated formula? We prefer to look behind the numbers of financial statements than believe in automated investing.
Our investment focus will continue to be on finding free cash flow compa-nies selling at prices that we believe are out of sync with a company’s long-term ability to produce normalized free cash flow. Our methodology is to look behind the numbers and disclosures in financial statements to reach conclusions, and our goal is to continue to build long-term wealth for our shareholders. We have not yet figured out how to be right all of the time, and thus our objective is to be right OVER TIME. Stock pickers and active management are not going away. We continue to believe our value invest-ment methodology, which inferentially looks behind the numbers of finan-cial statements to value companies, is at a decided advantage in this era which promotes automated “mindless” investing.
We value your trust and remind you that our money is invested alongside yours.
Sincerely,
Robert A. Olstein Eric Heyman
Chairman and Chief Investment Officer 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 12/31/16, 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 10.53%, 12.79%, and 4.20%, respectively. Per the Fund’s prospectus dated 10/31/16, the expense ratio for the Olstein All Cap Value Fund Class C was 2.26%. 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 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.
