“There is a strong correlation between above-average investment performance and error avoidance. To achieve long-term success, an investor must first consider downside risk before considering the potential for appreciation.” -Robert Olstein
What are we to make of Robert Olstein (Trades, Portfolio), whose All Cap Value Fund dazzled investors by beating the S&P 500 by 22 points in 2000 and by more than 29 points in 2001 but struggled since then? He is also the only manager who has been able to generate an average annual return of 5.1% over the past three years.
Olstein uses accounting-driven and value-oriented strategies to manage risk and find attractive candidates for investment. He has consistently used these approaches since starting his own firm in 1995, approaches that arose out of a previous firm, The Quality of Earnings Report.
The question, then, is his approach still relevant in today’s market?
Who is Olstein?
After earning a Master of Business Administration in accounting and Bachelor of Arts in mathematical statistics from Michigan State University, Olstein worked at Arthur Andersen & Co. and at Scheinman Hochstein & Trotta.
Then he co-founded The Quality of Earnings Report. This was an independent service that used forensic accounting techniques to identify positive and negative issues affecting the future earnings power of a company.
He took the ideas he learned and developed at The Quality of Earnings Report with him when he moved on to Smith Barney in 1981. There, he served as senior portfolio manager and senior vice president and managed both individual and institutional accounts.
In 1995, he left Smith Barney to found Olstein Capital Management LP. He also launched the Olstein All Cap Value Fund the same year.
In the course of his working career, he has become known as a leading expert in corporate disclosure and reporting practices. He has been a recipient of the Financial Analysts Federation’s Graham & Dodd Scoll Award (1973), and speaks frequently on mass media about corporate reporting, accounting practices, valuation techniques and activist investing.
Olstein is currently chairman and chief investment officer of Olstein Capital Management, head portfolio manager of the Olstein All Cap Value Fund and co-portfolio manager of the Olstein Strategic Opportunities Fund.
Olstein comes at investing from an uncommon angle: forensic analysis. He and his firm rip apart financial and other statements to try to find the weak links, the potential problems that could trip up other investors. They also look for the unseen gems that signal good investment opportunities.
What is Olstein Capital Management?
The firm offers investment management services to three categories of clients: registered investment companies, individuals and institutional entities. It is also a registered securities broker-dealer. This facet of the company acts as the principal underwriter and distributor of The Olstein Funds, an affiliated company (based on information in the firm’s Form ADV Part 2A).
In 2006, the company changed its name from Olstein & Associates LP to Olstein Capital Management LP. According to its Form ADV, it had $833,519,071 in net assets under management at the end of first-quarter 2017.
The company offers two funds:
- Olstein All Cap Value Fund Class A (OFALX): Its primary investment objective is long-term capital appreciation, while its secondary objective is income. The fund has $694.29 million in net assets, according to the second-quarter 2017 fact sheet. It is co-managed by Olstein and Eric R. Heyman, who is also executive vice president and director of research at Olstein Capital Management.
- Olstein Strategic Opportunities Fund (OFSFX): It shares the same objectives as the All Cap Value Fund, which is long-term capital appreciation and income. It has net assets of $153.67 million. It, too, lists Heyman and Olstein as co-managers.
The difference between the two funds is spelled out in the Form ADV Part 2A. Essentially, the All Cap Value Fund is a go-anywhere vehicle, while the Strategic Opportunities Fund focuses on small to mid-sized companies. The latter may also "opportunistically" engage as an activist investor.
Both funds follow Olstein's thinking about investing, specifically:
- A correlation between above-average performance and error avoidance.
- Short-term deviations may open up viable opportunities for long-term investors.
- Excess cash flow defines the future of a business.
- Forensic analysis uncovers the quality of a company's earnings.
The company is, not surprisingly, a reflection of its founder’s interest in value investing, digging deep to flush out problems or find opportunities missed by most investors.
What is Olstein’s investing strategy?
The two main prongs of the firm’s strategy are found in the phrases: “accounting-driven” and “value-oriented,” which are articulated in the Form ADV.
The first reflects, of course, Olstein's approach, which dates back to his Quality of Earnings Report days. Accounting-driven also suggests a particular form of analysis, one that varies considerably from a financial analysis.
On a personal note, I took courses in accounting and finance during the same semester while studying for my MBA. I had to challenge my mindset between the classes. Accounting deals with issues in the past, and demands reconciliation down to the penny. In finance classes, on the other hand, we were trying to gauge the future, and solutions often involved estimating to the nearest million dollars—a quantum shift from the exact pennies in accounting.
Accounting-driven analysis, then, can tell a skilled expert like Olstein what a company has done in the past. That might include how well it has used capital, whether its revenue and earnings are trending up or down and how the relationship between market price and intrinsic value has fared in recent years. If the past is prologue, as is often the case among companies in the stock market, then a conscientious observer should gain insight into future performance.
To differentiate between companies, Olstein and team try to divide companies into those with aggressive accounting practices and those with conservative accounting practices. Aggressive companies "may," in Olstein’s wording, be more inclined to report negative earnings and earnings surprises. Conservative companies, on the other hand, may exhibit greater predictability of future earnings and future cash flow.
To this, they add that in assessing a company’s quality of earnings, their objective is not to judge or criticize accounting practices, but to eliminate management’s reporting biases and adjust financial results so they better reflect economic reality.
The second of the two strategic criteria cited in the Form ADV is value-oriented. In discussion of the Olstein All Cap Value Fund, they invest mainly in a diversified portfolio of common stocks they think are "significantly undervalued." Valuations are mainly based on the free cash flow of candidate companies.
They argue the market prices of stocks often drop below a company’s private market value because of a short-term focus or overreaction to such factors as temporary problems, inability to meet quarterly earnings estimates or a negative market psychology.
The goal is to find companies with a cash flow yield (estimated free cash flow divided by market capitalization) that significantly exceeds the yield of three-year U.S. Treasury securities. They believe this gives them a more robust understanding of how adequately they are being compensated for risk, a certitude they would not get by comparing with an equity measure.
In his article “Robert Olstein Divests 3 Retail Holdings in 2nd Quarter,” James Li points to three companies struggling on important metrics, and subsequently sold:
- The Vitamin Shoppe (VSI) has had declining operating and gross margins; indeed, Li reports the company’s operating margin has dropped almost 16% per year on average over the past five years.
- DSW (DSW, Financial), a shoe retailer, is experiencing contracting profit margins and high asset growth when compared to its revenue growth. Its operating margin has declined an average of some 2.5% per year over the past five years.
- Michael Kors' (KORS) operating margin has dropped an average of 4.4% per year over the past five years. Li also notes the company had a revenue reversal of 4.6% in 2017, and offered a weak earnings outlook for the quarter ending June 30.
On the other side of the coin, GuruFocus offers a list of stocks Olstein keeps buying; these are the top 10 on that list:
Olstein focuses on accounting-driven and value-oriented investing; when those two strategic imperatives are combined, the result is a system for managing risk and better earnings consistency. We might also look at this strategy as risk minimization, through a combination of finding "clean" companies and margins of safety.
Current holdings
This GuruFocus chart shows the sectoral preferences of the two Olstein mutual funds:
This table from the Olstein Funds shows the top 10 holdings of the All Cap Value Fund (as distinct from the firm-wide favorites):
The All Cap Value Fund gives a prominent place to tech funds; the first three (and the largest in the fund) are Alphabet Inc. (GOOG, Financial)(GOOGL, Financial), Oracle Corp. (ORCL, Financial) and Apple Inc. (AAPL, Financial). Firm-wide, though, consumer cyclical and industrials are the two biggest sectors.
Olstein’s performance
Over the past decade, the All Cap Value Fund has struggled to keep up with the S&P 500, as shown in this table from GuruFocus:
Note Olstein’s fund fell even more than the S&P during the 2008 crisis, despite a claimed emphasis on error avoidance and risk management.
Since the firm’s inception, however, Olstein has stayed ahead of the S&P 500:
The difference: An outstanding series of years around the dot-com bust.
Two charts from Morningstar illustrate the long-term difference to the All Cap Value Fund because of early and later performance. First a 10-year chart, showing the fund lag both the S&P 500 and the Large Blend category:
And a since-inception chart showing how the fund got the jump on both the Large Blend category and the S&P 500.
In the since-inception chart, we see how the fund’s jump in the three years following the dot-com bust gave it a lead that allows it to stay ahead of the two benchmarks, even though the last 10 years have seen underperformance.
Note that the All Cap Value Fund benchmarks itself against the Russell 3000 index and the Strategic Opportunities fund benchmarks against the Russell 2500. Most investors, though, will want to compare the Olstein Funds with the standard S&P 500 index.
The Olstein system worked very well for one market crisis, but not for another. The S&P 500 posted negative results for three consecutive years in the wake of the dot-com crisis, while the guru clearly outperformed. However, Olstein was hit hard by the 2008 crisis, harder than the S&P benchmark.
Conclusion
To some extent, the All Cap Value Fund has been a victim of the long bull market that began in 2009. It is harder for value funds to find good deals in a rising market.
However, the whole point of sophisticated investment strategies is to put alpha on the table and consistently outperform benchmarks like the S&P 500. Olstein and his team have not managed to do so; over the past three years, they have generated an average annual return of just 5.1%; the S&P 500 returned an average annual return of 8.9% in the same period. In 2008, they lost more than the benchmark.
Still, an outstanding year in 2013 — with a return of almost 36.5%Â — shows Olstein and his firm still have the right stuff for capital appreciation at least some of the time.
Is Olstein still relevant in 2017? That question remains unanswered, but might move closer to resolution if his firm could deliver more consistent results from year to year.
Disclosure: I do not own shares in any of the firms or funds listed in the article, and do not expect to buy any in the next 72 hours.
