DEAR FELLOW SHAREHOLDERS:
For the six-month reporting period ended December 31, 2016, load-waived Class A shares of the Olstein Strategic Opportunities Fund appreciated 21.31% compared to total returns of 16.09% and 13.09% for the Russell 2500® Value Index and the Russell 2500® Index, respectively. For the cal-endar year ended December 31, 2016, load-waived Class A shares of the Olstein Strategic Opportunities Fund had a return of 20.51% compared to returns of 25.20% for the Russell 2500® Value Index and 17.59% for the Russell 2500® Index over the same time period.1
MARKET OUTLOOK & STRATEGY
Domestic equity markets performed well during the final quarter of the year, finishing with particular strength in the two months following the U.S. Presidential and Congressional elections. This was especially true for the equities of small- to mid-sized companies with the benchmark Russell 2500® Index appreciating 10.61% during the months of November and December 2016 (please note that load-waived Class A shares of the Strategic Opportunities Fund appreciated approximately 13% over the same two-month time period). As 2017 begins with the transition to a new President, we expect pockets 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 a cautiously optimistic outlook for our value-oriented approach to equity investing in 2017, and intend to adhere to our investment disci-pline by continuing our focus on company-specific factors and fundamentals.
PORTFOLIO REVIEW
At December 31, 2016, the Fund’s portfolio consisted of 43 holdings with an average weighted market capitalization of $4.11 billion. During the six-month reporting period, the Fund initiated positions in seven companies and strategically added to established positions in another four companies. Positions initiated during the past quarter include: John B. Sanfillipo & Son, Inc., ServiceMaster Global Holdings Inc., Skechers USA Inc., VCA Inc., Vista Outdoor, Inc., VWR Corp., and Zimmer Biomet Holdings Inc.
During the six-month reporting period, the Fund eliminated its holdings in seven companies and strategically reduced its holdings in another eleven companies. During the reporting period, the Fund eliminated its holdings in: Brady Corporation, John B. Sanfillipo & Son, Inc., Kennametal Inc., Lands’ End Inc., Oshkosh Truck Corp., Sensient Technologies Corp., and Towne Bank. The Fund eliminated or reduced its holdings in companies that either reached our valuation levels, or where changing conditions or new informa-tion resulted, in our opinion, in additional risk or reduced appreciation potential. You will note that during the six-month reporting period the Fund both initiated and liquidated its position in John B. Sanfillipo & Son Inc. The Fund began buying the stock of John B. Sanfillipo & Son, a com-pany that, together with its subsidiaries, processes and distributes peanuts and tree nut products in the United States, on August 5, 2016 at an initial price of $47.71 per share. Over a relatively short period of time, the Fund built a full position in the company at an average cost of $47.11 per share. Within four months of that initial purchase, the price of the company’s stock appreciated dramatically to reach the Fund’s valuation range. The Fund sold the last of its holdings in John B. Sanfillipo & Son Inc. on December 7, 2016 at $68.92 per share and had an average sale price of $65.91 as it liquidated this holding. While the holding period was not typical, the stock appreciat-ed approximately 40% in value.
Our Leaders
The stocks which contributed positively to performance for the six month reporting period include: Citizens Financial Group, Harmonic Inc., Zebra Technologies Corp., CECO Environmental Corp., and Harman International. At the close of the reporting period, the Fund continued to hold all of these companies in its portfolio.
Our Laggards
Laggards during the six-month reporting period include: Vitamin Shoppe, Inc., Patterson Companies Inc., VWR Corp., Lands’ End Inc., and Natus Medical. At the close of the reporting period, the Fund continued to hold Vitamin Shoppe, Patterson Companies, VWR Corp., and Natus Medical. The Fund liquidated its position in Lands’ End due to a turnaround effort that did not unfold as we had anticipated. In fact, the company’s attempt to reinvent itself as a more upscale brand actually alienated some of its core customer base; an unexpected result that severely compromised our investment thesis.
REVIEW OF STRATEGIC OPPORTUNITIES
In each of our previous letters to shareholders, we have included a discussion of the Fund’s activist investments under the heading, “Review of Activist Holdings.” As the Fund passed its tenth anniversary during the reporting period (on November 1, 2016), we decided to broaden our discussion of spe-cific holdings to include a review of all of the Fund’s strategic situations, in addition to activist holdings, that we believe merit attention. As a reminder, we categorize activist investments as situations where we have identified companies that face unique strategic choices, challenges or problems and 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. Going forward, our broader definition of strategic opportunities, in addition to activist investments, will also include situations where compa-nies have adopted specific strategic plans, undergone significant manage-ment changes, announced corporate actions that we expect to significantly improve long-term business value or returned free cash flow to investors through increased dividends, share buybacks or substantial debt paydowns.
As of December 31, 2016, the Fund was invested in thirty-one strategic situa-tions, which represented approximately 73% of the Fund’s equity investments and six of its top ten holdings. The strategic situation that garnered the most attention during the reporting period was long-time holding Harman International (HAR, Financial). On November 14, 2016, Samsung Electronics (XKRX:005930, Financial) announced that it had entered into a definitive agreement to acquire Harman International for $112 per share. In many ways, Harman International represents the essence of the Olstein Strategic Opportunities Fund’s and Olstein’s invest-ment approach (as such, the evolution of Harman from idea to portfolio investment was chronicled extensively in the March 31, 2010 letter to share-holders of the Olstein All Cap Value Fund). For us, Harman was a turn-around story where a new CEO served as a catalyst for sharpening the company’s performance by controlling costs through better supply chain management, realizing purchasing power, consolidating the company’s global manufacturing & engineering footprint, and reducing functional costs while at the same time expanding activities into mid-range markets.
The Fund originated its position in Harman International in September 2009 with an initial purchase at $30.24 per share when the company’s total market capitalization was approximately $2.35 billion. We continued trad-ing around this core position; buying on dips in the price of the company’s stock and selling as the stock reached our valuation levels. With an acquisi-tion price that valued Harman at $8 billion, significantly higher than when we first invested, we reduced our holdings as the company’s stock price rose dramatically following the November 14th announcement. We continued to maintain a position in the company at the close of the reporting period.
Additional strategic holdings as of December 31, 2016, include the Fund’s activist holdings: CECO Environmental, Cynosure, Inc., Dillard’s, DSW Inc., FTD Companies, Inc., Harmonic Inc., Hibbett Sports, Inc., Janus Capital Group, Legg Mason Inc., Lifetime Brands Inc., Owens-Illinois, Potbelly Inc., Miller Industries, SeaWorld Entertainment, Tessera Technologies Inc., VWR International, Vitamin Shoppe Inc., and The Wendy’s Company.
Ten portfolio companies announced actions over the past year that returned free cash flow to investors through share repurchase programs and/or increased dividend payments. Eight of these companies announced substantial share repurchase programs during 2016, including activist holdings Dillard’s and Potbelly Corp., as well as Astronics Corp., Natus Medical, ServiceMaster Global Holdings, Vishay Intertechnology, Wabash National Corp., and Zimmer Biomet Holdings. Four portfolio companies announced increased div-idend payments in 2016 with Bed, Bath & Beyond initiating its first dividend during the year, and Wabash National reinstating a dividend program it sus-pended in 2008. WestRock Company and Zimmer Biomet Holdings both announced substantial increases in dividend payments in 2016.
Eight companies in the portfolio have announced senior leadership changes, usually at the Chief Executive Officer, Chief Financial Officer and/or Chief Marketing & Strategy Officer positions that signal to us the pursuit of specif-ic, favorable growth opportunities and/or a focused commitment to enhanc-ing production capabilities while lowering production costs to achieve or maintain higher operating margins. These companies include activist holdings CECO Environmental, FTD Companies, and Harmonic Inc., as well as Federal Signal Corp., Greenbrier Companies Inc., Novanta Inc., ServiceMaster Global Holdings, and Wesco International Inc.
We continue to monitor the progress of each of these strategic situations as company managements work to increase shareholder value through a specific plan for improving company results or by returning free cash flow to investors. While each investment is at a different strategic stage, we believe the actions that have been proposed or implemented should increase share-holder value through improved future operating results.
BENEFITS OF A FOCUSED APPROACH
Since its launch more than a decade ago, the Olstein Strategic Opportunities Fund has offered investors a distinctive approach to investing in what we believe to be undervalued securities of primarily small- to mid-sized compa-nies that face unique strategic challenges and choices, or are misunderstood or underappreciated by the market. Investing in such turnaround situations or other strategic opportunities is a key factor that differentiates the Olstein Strategic Opportunities Fund from other mutual funds that invest in small-to mid-sized companies. Another key factor that distinguishes the Fund from the vast majority of equity mutual funds is the concentrated number of holdings in its portfolio. Since launching the Fund more than ten years ago, we have maintained a concentrated portfolio of approximately 35 to 45 pri-marily small- to mid-sized companies that we believe offer superior prospects for above-average long-term returns. According to a recent screen of Morningstar’s database, only 6.5% of U.S. equity funds have portfolios with 45 or fewer holdings. Since its inception, the Fund’s portfolio has averaged 41 holdings, with the top 25 holdings over the life of the Fund accounting for approximately 41% of equity investments.
For Value Investors Conviction Matters
The primary objective of our looking-behind-the-numbers, value-based disci-pline is long-term investment performance. In an investment environment dominated by short-term thinking, speculation, emotional reactions and market-driven ‘buy’ and ‘sell’ decisions, we believe it is important to pursue above-average returns through our value-based high-conviction approach to active investment management. Put simply, we believe that adding a hold-ing to the Fund’s portfolio should, first and foremost, be driven by a high level of conviction in the merits of the underlying investment idea. For many portfolio managers and mutual funds, such high conviction investing takes a back seat to other objectives, most notably a requirement to pursue broad diversification and/or the desire to track a benchmark index closely and to mimic the volatility and investment returns of such index. We stren-uously avoid such ‘closet indexing’ in favor of pursuing the benefits of our patient value-based high-conviction approach.
Our value-based approach to high-conviction active investment management is driven by our stock selection process, which favors undervalued free-cash-flow-generating companies vetted through an inferential, “look behind the numbers”analysis of financial statements. In the current investment era, which features “mindless” momentum-based investing, we believe our unique value proposition derives from taking advantage of the mispricing that occurs under the radar. We are able to identify and focus on companies which future free cash flow potential is, in our opinion, incorrectly valued or ignored because of company-specific issues that are in the process of being corrected. In the SMID universe, there are very few mutual funds undertaking the funda-mental research necessary to identify these types of turnaround opportunities.
Our Case for Concentration
A concentrated portfolio not only reflects our commitment to high-convic-tion investing, it also demonstrates a commitment to what works in active investment management. As the investment consulting firm Cambridge Associates concludes in its research paper Hallmarks of Successful Active Equity Managers (2014): “An increasing body of research points to a link between long-term, benchmark-beating performance and two portfolio attributes: high active share, or a portfolio that looks different from its benchmark, and high concentration, or simply a limited number of holdings. The connecting theme is managers that are willing to look different and act with conviction. There is a sensible link between these two attributes and relative performance; managers that deviate from the benchmark deliver dif-ferentiated results.” Similarly, in their research paper, Best Ideas (2010), Randolph B. Cohen (Massachusetts Institute of Technology), Christopher Polk (London School of Economics) and Bernard Silli (Goldman Sachs) conclude that since equity fund managers’ highest conviction investments – “their Best Ideas outperform the market by 1% to 2.5% per quarter depending on the benchmark employed,” they “argue that investors would benefit if managers held more concentrated portfolios.”
In addition to the pursuit of long-term returns, the case for a concentrated portfolio of high-conviction investments also starts with the Fund’s distinc-tive approach that favors investments in companies that face unique strategic challenges and choices. The Fund’s emphasis on finding value in small- to mid-sized companies that face temporary problems or are in need of opera-tional turnarounds demands a level of company- and industry-specific knowl-edge that requires an intensive research and analytical effort that concentrates on a limited number of investments and opportunities.
Our intensive, company-specific analysis focuses on how a company’s opera-tions generate sustainable free cash flow determines how much of the compa-ny’s free cash flow is available to us as investors, and assesses the level of ongoing investment the company requires to maintain and grow free cash flow. Our approach to valuation requires us to determine if a company’s accounting policies reflect the economic reality of the underlying business, to assess the company’s quality of earnings, to make adjustments to reported numbers that eliminate management biases, and to identify positive or negative factors that may affect future free cash flow. These critical aspects of our investment process require such an in-depth understanding of specific companies and those factors that influence the improvement of long-term value of businesses under-going transformation that our collective analytical bandwidth cannot reason-ably extend beyond a concentrated number of portfolio holdings.
Our Approach to Portfolio Construction
Our primary objective when constructing the Fund’s portfolio is to invest in those companies that we believe offer the best prospects for long-term capital appreciation. That is, we strive to invest in those companies that possess the balance sheet strength, competitive advantages, operating efficiencies, and an ability to generate free cash flow and that we believe we can buy at a sub-stantial discount to their intrinsic value. The Fund’s portfolio construction process does not require exposure to any specific company, industry, or sector simply because it represents an important part of an index or benchmark. As a result, portfolio weightings of individual companies will often differ signifi-cantly from their relative benchmark weighting. Our emphasis on determin-ing the size of a holding based upon our conviction means that individual holdings will often exceed their benchmark weighting by a significant amount. By way of example, the top 25 holdings over the Fund’s life accounted for 41.14% of the Fund’s equity investments, yet those same hold-ings only accounted for 1.33% of the Russell 2500® Index holdings.
Patience Is a Virtue
As value investors who recognize that it often takes time for a company’s intrinsic value to emerge, especially for companies overcoming strategic challenges, another key element of our portfolio construction and manage-ment process is our expected holding period. For us, patience is a key factor for achieving investment success. Realizing the desired outcome of an investment in a turnaround situation requires commitment, discipline, and patience. An investor may have to ride out intermittent periods of frustra-tion and excitement as a needed shift in strategy unfolds. In most cases, it can be 12 to 24 months or longer before a turnaround strategy produces con-crete positive results. Thus, as a value investor who’s bought into a potential turnaround, we need to stay the course during periods of disappointment and lingering negative market sentiment if we believe that the strategic actions taken by the company will result in the recognition of our intrinsic value.
Although we readily concede that a concentrated portfolio of holdings that require patience for intrinsic values to emerge may result in more volatility than a benchmark index, we believe that investors can profit handsomely by accepting that short-term movements in the overall market do not accurately reflect the long-term values of individual businesses. In today’s environment, we believe it is critical that investors understand the difference between short-term market movements, price volatility and the risk of per-manent loss of capital. Instead of focusing on short-term price movements of a company’s common stock or overall stock market volatility, we believe it is more important to focus on risks of individual businesses.
Our Thoughts on Risk in a Focused Portfolio
From our perspective, it is more important to develop a thorough under-standing of company operations, its strategy, and the effectiveness of its man-agement team as stewards of the company’s capital. This is especially true for the type of small- to mid-sized companies that we tend to identify as viable investment opportunities – companies that face unique strategic choices, challenges, or problems, often due to Wall Street’s constant pressure for growth. If a company was privately owned and had no public market price, the owners would likely not be assessing the value of the business on a daily, monthly or quarterly basis. Private owners of commercial enterprises assess risk on the basis of losing money on operations, not as to whether or not they would be forced to sell their company at an inopportune time. We approach our assessment of business risk in the same manner — by focusing on how the company’s operations generate free cash flow, as well as those factors we believe are likely to impact future free cash flow.
For small- to mid-sized companies, we are less concerned with overall market volatility and more concerned with predictability of sustainable free cash flow. One of our most important jobs is to develop a thorough understanding of how a company’s operations generate sustainable free cash flow during growing, stagnant or deteriorating economic conditions. During the recent recession, companies that focused on improving working capital management and operating efficiencies to deliver free cash flow not only produced a higher quality of earnings, but also gained a valuable long-term perspective on their business. By optimizing cash flow from operations during a recession, man-agement teams honed company operations to make more intelligent internal investment decisions that are likely, in our opinion, to continue to produce greater earnings and cash flow during the economic recovery.
Seeking Diversification in a Focused Portfolio
Although a focused portfolio of 35 to 45 holdings is likely to exhibit greater volatility than its benchmark index, we believe we can achieve a suitable level of portfolio diversification without increasing the number of holdings. We construct the Fund’s portfolio by seeking an optimal balance of compa-nies that we believe offer a productive combination of free cash flow yields, earnings, returns on equity, balance sheet strength and capital appreciation potential that will contribute to overall out-performance. When construct-ing the Fund’s portfolio, it is our ultimate goal to deliver to our shareholders a portfolio that accentuates our in-depth knowledge of the companies we own, allows us to take advantage of the lack of fundamental research per-formed in the current investment environment, and highlights our keen stock selection skills.
FINAL THOUGHTS
We believe that our distinct approach to investing in primarily small- to mid-sized companies that face unique strategic challenges can deliver above-average long-term investment returns in a focused portfolio of high convic-tion ideas thoroughly scrutinized and evaluated through our intensive analytical process. Since its launch, the Fund has invested in many compa-nies that have overcome negative market sentiment to successfully navigate shifting competitive landscapes, unexpected growing pains, previous unsuc-cessful strategies, and/or troubled economic times to adapt, restructure, invest, and grow for the future.
As we begin a new year, we continue to navigate the ebb and flow of the investment landscape seeking compelling opportunities for the Fund’s portfo-lio. We remind you that our money is invested alongside yours and that we remain committed to achieving the Fund’s primary objective of long-term capital appreciation through this truly unique approach to investing primarily in small- to mid-sized companies.
Sincerely,
Eric R. Heyman Robert A. Olstein
Co-Portfolio Manager Chairman, Chief Investment Officer
and Co-Portfolio Manager
The above represents the opinion of the Manager, and is not intended to be a fore-cast of future events, a guarantee of future results, or investment advice. The ref-erences 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. A full schedule of Fund holdings as of 12/31/16 is contained in this report, and is subject to change.
- The performance data quoted represents past performance and does not guarantee future results. The Olstein Strategic Opportunities Fund Class A return as of 12/31/16 for the one-year, five-year, and ten year periods, assuming deduction of the maximum Class A sales charge of 5.50%, was 13.86%, 13.76% and 6.96%, respectively. Per the Fund’s 10/31/16 prospectus, the gross expense ratio for the Class A share was 1.70%, and the net expense ratio was 1.60% after contractual expense waiver and/or reimbursement. The contractual expense waiver shall remain in effect until at least October 28, 2017. 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. .
