Dear Fellow Shareholders:
For the nine months ended September 30, 2014, Class C shares of the Olstein All Cap Value Fund appreciated 5.18%, compared to total returns of 8.34% and 6.95% for the S&P 500® Index and the Russell 3000® Index, respectively. For the quarter ended September 30, 2014, Class C shares of the Olstein All Cap Value Fund appreciated 0.40%., compared to total returns of 1.13% and 0.01% for the for the S&P 500 Index and the Russell 3000 Index, respectively.
Market Outlook
The calm which had prevailed in U.S. equity markets for most of the past three years was disrupted during the third quarter, as the benchmark S&P 500 Index fell during the months of July and September. While there are always forecasters predicting the next market downturn, downturns have always been part of the investment landscape. Although downturns tend to make investors nervous as prices decline, we believe the future returns of the Fund are determined by our strategy during these declines. Of course everybody’s investment fantasy is to sell before market declines and buy before upward moves. However, we have yet to identify any individual or organization that has a proven track record of correct market calls whereby one could profit therefrom. The ability to time markets is the only skill one needs to have to be a very successful investor and thus is an enticing goal. However, we view overall market timing as an attempt to predict the psychology of the crowds, which has a very low probability of being achieved on a repetitive basis. Market timers must make two calls, when to sell and when to get back in. In our opinion, one market call has a low probability of being correct and with two market calls required, the chances of being correct is extremely low. We viewed the recent market decline as an opportunity to buy free cash flow companies at what we believe to be very attractive prices. While many investors are nervous about equity markets or remain sidelined waiting for accelerated economic growth, we believe there is still a strong case for investing in the equity securities of companies whose real economic value is, in our opinion, unrecognized by the market, obscured by periods of market uncertainty or overshadowed by temporary problems. Although the valuation discounts are not at the levels reached in 2009, we are able to identify companies selling at 15-20% discounts from our calculation of their intrinsic value. We are locating undervaluation in mundane businesses generating free cash flows with sound balance sheets that are far removed from the headline exciting stocks in social media, biotech, internet shopping etc., currently being purchased by the investment masses ( who we believe are paying little attention to realistic valuations based on a company’s normalized ability to generate future free cash flow). We remain confident that the current environment is favorable to a long- term value investing discipline.
Our Strategy
With respect to our strategy for the remainder of 2014, we continue to seek and invest in companies that we believe have an ability to deliver long-term value to shareholders that, in many cases, is not currently recognized by the market. We remain focused on three primary, company-specific factors: (1) a commitment to maintain a strong financial position as evidenced by a solid balance sheet; (2) an ability to generate sustainable free cash flow; and (3) management that intelligently deploys cash balances and free cash flow from operations to increase returns to shareholders. We further believe that by prioritizing these factors, we will continue to invest in companies that are positioned to compete more advantageously as economic growth accelerates.
Against an improving economic backdrop, we also continue to emphasize the quality of a company’s earnings in 2014. By highlighting the quality of a company’s earnings, we seek to accomplish two objectives: (1) to identify those companies that not only have focused their priorities during the economic recovery but have also laid the groundwork to achieve a substantial strategic advantage for the inevitable acceleration of economic growth, and (2) to assess the financial risk inherent in each investment opportunity before considering the potential for capital appreciation. We believe that the number and severity of our future investment errors are the most important ingredients determining whether or not we generate above average long term returns. While many investors are obsessed with short-term market volatility, our primary concern is to avoid or mitigate permanent impairment of capital. We believe our relentless focus on the quality of earnings provides a valuable tool for achieving that objective.
Portfolio Review
We continue to focus on how individual companies have adapted their expectations, strategic plans and operations to bumpy economic conditions, and how they have managed their assets to deliver future free cash flow to investors. Our 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 calculations, deploys free cash flow to create shareholder value and is selling at a discount to our calculation of intrinsic value which is based on a company’s normalized ability to generate future free cash flow. On September 30, 2014, the Olstein All Cap Value Fund portfolio consisted of 107 holdings with an average weighted market capitalization of $54.25 billion.
During the quarter, the Fund initiated positions in eight companies and strategically added to positions in sixteen companies. Over the same time period, the Fund eliminated its holdings in six companies and strategically decreased its holdings in another five companies. Positions initiated during the last three months include: Dorman Products, Inc. (DORM), Dover Corp. (DOV), DSW Inc. (DSW), First Niagara Financial Group (FNFG), Packaging Corporation of America (PKG), Patterson Companies, Inc. (PDCO), The Travelers Companies Inc. (TRV), and Universal Health Services Inc (UHS). Positions eliminated during the past quarter include: ABB Ltd. (ABB), Ann Inc. (ANN), Baxter International (BAX), International Game Technology (IGT), TRW Automotive Holdings (TRW), and URS Corporation (URS).
Three of the positions eliminated during the quarter, International Game Technology, TRW Automotive Holdings and URS Corp., were companies targeted by strategic acquirers. On July 16, 2014, International Game Technology (IGT) announced that it entered into a definitive merger agreement with GTECH S.p.A. (MIL:GTK), in a deal valued at $6.4 billion. On July 10, 2014, TRW Automotive Holdings (TRW) confirmed that it has received a preliminary, non-binding proposal from ZF Friedrichshafen AG to acquire the company. Although TRW did not disclose terms at the time of the July announcement, Bloomberg News reported the acquisition value at $110 to $112.50 per TRW share. On July 13, 2014, URS Corporation (URS) announced that AECOM (ACM) would acquire the company for $56.31 per share. As value investors who usually have to wait patiently for a company to improve operating results and for the market to ultimately recognize the value we see, these acquisitions not only came as a pleasant surprise, they allowed us to reach our value in each of these companies over a much shorter holding period.
When Boring Becomes Exciting
While the market pullback (of September and early October), as always, fueled considerable speculation about the outlook for equity investing, it provided us with an opportunity to reflect on the nature of equity markets in general and, more specifically, our affinity for boring companies. Many investors, seeking outsized investment returns, favor widely-held, glamour stocks whose popularity is driven by the promise of high growth rates, especially in revenues. The stocks of these high-flying companies attract a significant number of momentum investors as well as fawning media coverage that, in turn, fuels the momentum as the overall market continues to rise. We, on the other hand, are value investors who avoid the noise surrounding the latest hot trend, and look to buy the common stocks of good businesses that we believe are selling at material discounts to their intrinsic value.
The success of our approach hinges on our ability to find good companies with discernible financial strength, unique business fundamentals, a competitive edge and ability to generate free cash flow, and buy such companies at a significant discount to our determination of their private market value. From our perspective, a company’s stock price often falls below its private market value either due to temporary problems (such as missed earnings estimates, over-reaction to short-term results, or overall negative market sentiment), or because a company’s business and prospects are either misunderstood or overlooked by a market driven by a momentum mentality. In other words, the market often over-penalizes the stocks of companies that have temporarily stumbled or have the misfortune of being boring companies in a momentum-driven market. For us, however, the sharp deviations between the stock prices of boring and/ or misunderstood companies and our determination of their intrinsic value can offer opportunities for significant capital appreciation. We believe the most important factor to consider when purchasing a stock is paying the right price, or buying at a discount to intrinsic value rather than buying in reaction to stock momentum.
When a long running bull market stumbles, as we have seen in September and early October (from its intra-day high on September 19, 2014 to its intra-day low on October 15, 2014, the benchmark S&P 500 Index fell approximately 10%), the shift in investor sentiment, especially among momentum investors, is swift and noticeable. Momentum investors flee the once exciting high-flying companies and may also abandon the market as fear spikes and market volatility increases. The pessimism that drags down the overall market, however, tends to have less of a negative impact on those “boring” companies that have maintained a balance sheet discipline that eschews material leverage; have honed their operations to protect (or in some cases expand) margins; and have built strategic cash balances that can be used to build profitable market share and protect them during extended downturns. In the wake of extreme market gyrations and increased investor nervousness, boring companies become much more interesting and in some cases become exciting.
Even without the short-term market volatility bringing company operations, performance and profitability to the forefront, as value investors we have long favored the investment potential of boring companies. Recently, strategic investors have begun to recognize the values we had previously identified. The extraordinary number of corporate actions affecting specific portfolio holdings in 2014 (that we discussed at great length in our last letter to shareholders) offers noteworthy examples of boring companies that became exciting — especially as the appetite for momentum investing has waned over the past six months. From the beginning of the year through early-October, fifteen stocks in our portfolio, across a range of industries and sectors, were the subject of significant announcements that included mergers, takeover offers, spinoffs, accelerated share repurchases, and multiple activist campaigns. While it is exciting to report such extraordinary news following such a series of favorable corporate events, at the time of our initial purchase, most, if not all, of these companies were either considered “boring” or were suffering the lingering effects of a recent stumble.
What made each of these companies “exciting” to us as value investors, were favorable company-specific characteristics (unique product or service niche, competitive strength, and clean capital structure), an ability to generate sustainable free cash flow, and stocks trading at a significant discount to our determination of each company’s intrinsic value as a result of what we believe were short term events. While, for us, a thorough understanding of the fundamentals of each company and our estimate of its normalized ability to generate future free cash flow pointed to significant potential for capital appreciation, our in-depth understanding of a company’s potential usually flies in the face of the collective wisdom regarding its prospects as a result of the short-term factors affecting the company. Our willingness to buy into what we believe is short-term negativity or misperception allows us to get into many of these boring stocks at bargain basement prices, and often before the excitement begins as private equity investors get involved or the undervalued free cash flow becomes apparent. Our confidence in each situation is based on clues we uncover via our inferential analysis and looking behind the numbers of a company’s financial statements with regard to a company’s ability to generate future normalized free cash flow. As with many of our investments, we usually find ourselves waiting for the rest of the market to recognize and understand a company’s true investment potential before we see the valuation gap close. As the market catches up to our way of thinking in such instances, “boring” companies have a way of become a lot more exciting in a relatively short period of time.
When Markets Become Exciting — Volatility Presents Buying Opportunities
An extended period of strong market performance similar to what we have experienced since the historic lows of March 9, 2009, brings many investor worries and concerns to the surface. One of the biggest concerns weighing on investors is whether or not the market is overdue for a pullback or correction. While we understand this sentiment, we believe this worry is being given too much weight and blurring long-term thinking. While we need to be wary of long-term risk (not the market’s daily movements), we also believe that instead of making equity investment decisions based on market sentiment, we must focus on individual companies and their long-term fundamentals, and whether or not the current prices offer the opportunity to buy mispriced securities that could provide potential for meaningful long-term capital appreciation. In this regard, based on past experience, we continue to believe that periods of market volatility, marked by short-term drops in equity prices, should continue to provide compelling opportunities to buy financially strong, well-managed companies at very favorable prices.
It is our opinion that purchases made in our portfolio during the most recent period of extreme market negativity should result in above average appreciation. The market is a discounting mechanism and while past performance is not necessarily indicative of future results, it is noteworthy that the seeds of past periods of relative outperformance were sown during volatile and extremely emotional down markets in 1998, 2002, 2008 and 2009. As value investors, we believe that having a long- term horizon in an environment that is maniacally focused on short-term events provides the fund with a strategic advantage.
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 to purchase companies that can weather the storms of equity investing and provide the Fund with opportunities to buy outstanding companies at bargain prices.
We are currently invested in companies that, in our opinion, have the financial strength to ride out unfavorable short-term conditions while at the same time offering favorable long-term business prospects. We value your trust and remind you that our money is invested alongside yours as we work hard to accomplish the Fund’s primary objective of long-term capital appreciation.
Sincerely,
| Robert A. Olstein | Eric R. Heyman |
| Chairman, | Co-Portfolio Manager |
| Chief Investment Officer | |
| and Co-Portfolio Manager |
