Olstein Strategic Opportunities Fund: Review of Activist HoldingsVW Staff
Olstein Strategic Opportunities Fund’s letter to shareholders for the year ended December 31, 2014.
Dear Fellow Shareholders:
For the year ended December 31, 2014, load-waived Class A shares of the Olstein Strategic Opportunities Fund appreciated 12.34% compared to total returns of 7.07% and 13.69% for the Russell 2500™ Index and the S&P 500 ® Index, respectively. For the six-month reporting period ended December 31, 2014, load-waived Class A shares of the Olstein Strategic Opportunities Fund appreciated 6.77% compared to total returns of 1.06% for the Russell 2500™ Index and 6.12% for the S&P 500® Index over the same time period.
Olstein Strategic Opportunities Fund: Market Outlook & Strategy
The calm that prevailed in U.S. equity markets for most of the past three years was disrupted by an increase in market volatility during the second half of 2014, as many investors reacted negatively to the planned end of the Fed’s asset purchase program known as quantitative easing, and to rapidly falling oil prices. Yet, despite an increase in market volatility, we are continuing to find opportunities to purchase the equity securities of what we believe to be undervalued small- to mid-sized companies meeting our stringent investment criteria. Although we expect the market for small- to mid-sized equities to continue to be somewhat volatile in the near term, we also expect stronger economic data and improved company performance to highlight the growing strength of the U.S. economy. As in the past, we believe a key beneficiary of the improved economy will be smaller companies whose revenues come mainly from the U.S. market.
With the strong market run more than five years old, many forecasters have been contemplating a market pullback in the near future. While there are always forecasters predicting the next downturn, we believe it is important for investors to weather market events and periods of short term volatility by favoring the equities of financially strong companies, selling at a discount to our calculations of intrinsic value based on its normalized ability to produce stable or growing free cash flow and run by managements that have a demonstrated history of deploying that cash to the benefit of shareholders.
We believe the market volatility that has characterized the start of 2015 provides an excellent opportunity to find viable undervalued investment opportunities in small- and mid-sized companies. In our search for value, we continue to focus on three crucial, 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 which in our opinion is not yet being valued by the market, and (3) management that intelligently deploys cash balances and free cash flow from operations to increase returns to shareholders.
Olstein Strategic Opportunities Fund: Portfolio and Performance Review
At December 31, 2014, the Fund’s portfolio consisted of 49 holdings with an average weighted market capitalization of $3.33 billion. Throughout the reporting period ended December 31, 2014, 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 reporting period, the Fund initiated positions in ten companies and strategically added to established positions in another sixteen companies. Positions initiated during the reporting period include: Blount International, Daktronics, DSW, First Niagara Financial, Fox Factory, Lifetime Brands, Patterson Companies, Wabash National, The Wendy’s Company, and Wesco International . During the reporting period, the Fund eliminated its holdings in twelve 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 quarter, the Fund eliminated its holdings in Aegion, Ann, Avery Dennison, AVX, CareFusion, Charles River Laboratories, Ethan Allen Interiors, International Game Technology, PetSmart, Teleflex, UFP Technologies and URS.
As reported in our last letter to shareholders, URS Corporation and International Game Technolog entered into merger agreements with strategic acquirers during the reporting period, resulting in the sale of both companies from the Fund’s portfolio as the price of each company’s stock reached our valuation. We also sold specialty retailer, Ann Inc. (ANN), following a March 2014 announcement of a significant private equity investor establishing a material position. Increased scrutiny from activist investors during the reporting period caused the company’s stock price to rise fairly rapidly to our valuation level. 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 and private equity investments not only came as a pleasant surprise, they allowed us to reach our value in each company over a much shorter holding period.
Olstein Strategic Opportunities Fund: Leaders
The stocks which contributed positively to performance for the six-month reporting period include: PetSmart, Janus Capital, CareFusion, Sealed Air and Patterson Companies. As of December 31, 2014, the Fund maintained positions in Janus Capital, Sealed Air and Patterson. On December 14, 2014, PetSmart announced that it had entered into definitive agreement to be acquired by private equity firm BC Partners for $83 per share in cash. The Fund sold its holdings in PetSmart as the price of the company’s stock approached the announced acquisition price representing a substantial premium to the Fund’s average cost for PetSmart. Similarly, on October 5, 2014, Becton Dickinson (BDX) announced that it had entered into a definitive agreement to acquire CareFusion for $58 per share. The Fund sold its holdings in CareFusion as the price of the company’s stock approached the announced acquisition price representing a substantial premium to the Fund’s average cost for the company’s stock.
Olstein Strategic Opportunities Fund: Laggards
Laggards during the six month reporting period include: Smith & Wesson Holding, NOW Inc., Potbelly, Aegion and Standard Motor Products. At the close of the reporting period, the Fund continues to hold Smith & Wesson, NOW Inc., Potbelly Corp. and Standard Motor Products in its portfolio. The Fund eliminated its position in industrial goods/infra- structure company Aegion, after we lost confidence in company management and its ability to effectively implement a clear, consistent strategy. We were initially attracted by the company’s prospects, approximately three years ago, as it transitioned from a company whose earnings were dominated by municipal sewer servicing to being a well-rounded pipeline service provider with increased exposure to energy and mining and structural and construction businesses. During the recent stages of this transition, however, management has continued to provide excuses for underperforming business segments and overall poor company performance without articulating a clear strategy for moving forward.
Olstein Strategic Opportunities Fund: Review of Activist Holdings
As of December 31, 2014, the Fund was invested in twelve activist situations, representing approximately 28% of the Fund’s equity investments, and two of its top ten holdings. In general, these situations fit our definition of an activist investment where an outside investor, usually a hedge fund, private equity investor, or Olstein Capital Management seeks to influence company management to adopt strategic alternatives that we expect to unlock greater shareholder value.
The Fund’s activist holdings as of December 31, 2014, include recreational vehicle manufacturer, Arctic Cat, agricultural machine and equipment manufacturer, Blount International (BLT), department store, Dillard’s Inc. (DDS), aerospace and defense products manufacturer, Esterline Technologies, specialty apparel and accessory retailer, Express, recreational vehicle suspension products manufacturer, Fox Factory, money management firms, Janus Capital and Legg Mason; kitchenware and house- wares manufacturer, Lifetime Brands, specialty eatery, Potbelly, specialty retailer of nutritional products, Vitamin Shoppe and fast-food restaurant chain, The Wendy’s. We continue to monitor the operational progress of the companies’ as well as activist investors involved in these situations as they work to increase shareholder value through a specific plan for improving each company’s results. 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 from operations.
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 turnaround s 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 share- holder value within two years, we are willing to wait beyond two years for operating results 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.
Olstein Strategic Opportunities Fund: Outlook for Activist Investing in 2015
The past year proved an excellent year for the Fund, driven in great part by the Fund’s activist holdings. During 2014, an extraordinary number of companies in the Fund’s portfolio – eight companies representing approximately 20% of the Fund’s equity investments – were the subject of corporate actions including activist campaigns and takeover offers. Six of these corporate actions were takeover offers which resulted in buyouts of portfolio companies at a significant premium to the Fund’s average cost of each holding. Additionally, the Fund’s unique approach to value and activist investing received flattering media recognition in an October 14, 2014 article by Reuter’s entitled, “The Mutual Fund that Reads Like a Cheat Sheet for Activists.”
We expect the surge in activist investing of the past two years to continue into 2015. As the economic recovery continues to unfold in a somewhat uneven manner, we expect that equity markets should provide ample opportunities to identify suitable activist situations for the Fund’s portfolio. Four primary reasons lie behind our expectations: (1) record amounts of liquid cash on corporate balance sheets that may represent a significant source of untapped value; (2) a bumpy road to more “normal” operating conditions should result in an increased ability to identify companies having the potential to improve operating results in the not too distant future, but because it has not yet given overt evidence of this improvement, it is not yet being valued according to its normalized ability to produce future free cash flow; (3) louder calls for stronger corporate governance from investors and regulatory bodies alike are likely to increase management responsiveness to shareholders; and (4) a growing commitment of capital to activist strategies and funds. In fact, according to Hedge Fund Research, four prominent activist funds had grown their assets under management by $9.4 billion during the first half of 2014 to a total of $111 billion – gaining more during the first six months of 2014 than during the previous two years combined.
According to FactSet Research, corporate cash balances of non-financial companies in the S&P 500 Index totaled $1.37 trillion at the close of the third quarter of 2014. Although this amount reflected no year-over-year growth in S&P 500 corporate cash balances, it serves as a barometer of the extremely high historical cash balances that sit on many corporate balance sheets. In many cases, a high cash balance may represent an underperforming corporate asset that, when properly deployed, could significantly increase a company’s long-term shareholder value. In 2015, we expect these high cash balances to continue to draw the attention of activist investors seeking alternative uses for cash balances earning extremely low rates of return as well as those activists challenging the mindset of company management teams maintaining high cash balances from a defensive posture.
As the economy improves and markets place greater focus on company fundamentals and operating profits, we expect to see greater emphasis on the value enhancement strategies we favor as an activist investor for those companies that temporarily lag their competitors and peers. We believe that in 2015, as the recession fades into memory, activists will target those companies waiting for overall economic improvement and growth to lift their fortunes and pressure them to improve operating result s. For us, a rise in operational activism – activism that focuses on a company’s operations as opposed to financial engineering or protracted proxy battles – is a welcome development. We also expect that more companies should be receptive to adopting strategic alternatives in order to undertake much-needed turnarounds in hopes of improving their operating results. We believe this will be especially true for companies approached by those activists with a proven track record of helping a company implement successful turnarounds.
From our perspective as investors who focus on small- to mid-sized companies, one of the most interesting expectations for activist investing was discussed in Schulte Roth & Zabel’s recent Shareholder Activism Insight report (October 2014), regarding the size of companies activist expect to target over the next twelve to twenty-four months. The report concluded that more than half of the U.S. activist respondents favor the $250 million to $500 million market cap range while the remaining respondents are split between the $500 million to $750 million range and the less than $250 million range.
Olstein Strategic Opportunities Fund: Approach to Activist Situations
Since its launch in November 2006, the Fund has maintained a significant commitment to activist situations with an average activist exposure of 25% of total equity investments since inception. The Fund’s activist exposure reached a high of 39% of equity investments during the second quarter of 2008 and a low of 7% of equity investments during the second quarter of 2009 (as the Fund committed its capital to compelling value situations created by the market lows of March 2009 in lieu of longer-term activist situations).
Throughout 2015, we will actively seek additional investments for the Fund’s portfolio that fit our approach to activist investing. The criteria for our activist investments includes: companies whose stock prices are significantly below our determination of private market value based on its normalized ability to generate and/or grow future free cash flow; companies that may be over- capitalized; companies with strong brands or franchises but suffering the effects of bad strategic decisions; as well as companies with non-core, underutilized, underperforming or non-productive assets. Even though a potential activist investment may be characterized by one of these attributes, we also look for specific financial characteristics that, from our past experience, strongly favor pursuit of an activist agenda. These financial characteristics include:
- High cash balances and/or conservative balance sheets able to with- stand short term economic or company problems
- Reliable and steady cash flow combined with low returns on invested capital
- Questionable past merger & acquisition activity
- Unrelated businesses or divisions which may have more value as stand-alone entities
- Extremely low valuation multiples
- Consistent earnings underperformance
Although a company may exhibit one or more of these characteristics and we may develop high-conviction recommendations that the problems can be solved, it is important to note that we must first consider the company’s legal, capital and corporate governance structures before deciding if the company is a suitable target for an activist agenda. Most of the activist situations we have successfully worked through were opportunities created by management missteps and were characterized by one or more of the characteristics previously described.
Olstein Strategic Opportunities Fund: Final Thoughts
As investors, we remind you that our challenge is to develop a thorough understanding of how a company’s operations can generate sustainable free cash flow over a complete business cycle – (during growing, stagnant, or deteriorating economic conditions). We believe it is also important to understand the role company management must play regarding the prospects for each of the companies in our portfolio. We spend a great deal of time understanding and forecasting how management’s decisions are likely to affect a company’s future free cash flow and ultimately the value of the business. As 2015 unfolds, we believe those companies with strong management teams having a proven track record of creating shareholder value over time will have a substantial strategic advantage as economic growth accelerates.
Since we launched the Olstein Strategic Opportunities Fund, we have identified many small- to mid-sized companies that have successfully navigated the turbulent waters of recession and recovery to adapt, invest, grow, and restructure for the future. We intend to stay the course as we continue to invest in companies that, in our opinion, have the financial strength to ride out current market jitters while offering favorable long- term business prospect s. We appreciate your trust and remind you that our money is invested alongside yours.
Eric R. Heyman
Robert A. Olstein
Chairman, Chief Investment Officer and Co-Portfolio Manager
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