Olstein Strategic Opportunities: Benefits Of Getting Back To BasicsVW Staff
Olstein Strategic Opportunities Fund letter to shareholders titled, “The Benefits Of Getting ‘Back To Basics’.”
Benefits Of Getting ‘Back To Basics’
Dear Fellow Shareholders:
For the quarter ended March 31, 2015, load-waived Class A shares of the Olstein Strategic Opportunities Fund had a return of 4.82% compared to total returns of 5.17% and 0.95% for the Russell 2500™ Index and the S&P 500® Index, respectively. For the three years ended March 31, 2015, load-waived Class A shares of the Olstein Strategic Opportunities Fund had an average annual return of 20.23% compared to average annual returns of 17.13% and 16.11% for the Russell 2500 Index and S&P 500 Index, respectively.
Olstein Strategic Opportunities – Market Outlook & Strategy
The expectation of rising interest rates, the strengthening of the U.S. dollar and weaker-than-expected economic data led to an increase in market volatility during the first quarter of the year, and fueled forecasters’ predictions of a market pullback in the near future. We believe in weathering market events and periods of short-term volatility, by taking advantage of what we believe is temporary mispricing relative to our calculation of intrinsic values in financially strong companies with stable or growing free cash flow, run by managements that have a demonstrated history of deploying that cash to the benefit of shareholders. Although market prices for small- to mid-sized equities could be somewhat volatile in the near term, we believe that a steadily improving economy is around the corner, which should result in increasing future free cash flows and increasing valuations. In the past, a key beneficiary of an improving U.S. economy has been smaller companies whose revenues are mainly derived from the U.S. market.
Although market volatility has characterized the start of 2015, the volatility is providing an excellent opportunity to find viable investment opportunities in small- and mid-sized companies that we believe are not properly valued in the marketplace. 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 improving sustainable free cash flow; and (3) management that intelligently deploys cash balances and free cash flow from operations to increase returns to shareholders.
Olstein Strategic Opportunities – Portfolio and Performance Review
At March 31, 2015, the Fund’s portfolio consisted of 50 holdings with an average weighted market capitalization of $3.59 billion. Throughout the reporting period ended March 31, 2015, we continued to modify the portfolio by reacting to 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 five companies and strategically added to established positions in another twelve companies. Positions initiated during the reporting period include: Brady Corporation, Federal Signal Corp., Joy Global Inc., Oshkosh Corp., and Owens-Illinois Inc. During the reporting period, the Fund eliminated its holdings in four 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 Arctic Cat Inc., NOW Inc., Nutraceutical International Corp., and Rocky Brands Inc.
Olstein Strategic Opportunities – Review of Activist Holdings
As of March 31, 2015, the Fund was invested in twelve activist holdings, which represented approximately 25% 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 either 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. We would like to call our shareholders attention to an October 2014 article published by Reuters entitled “The Mutual Fund that Reads Like a Cheat Sheet for Activists.” The author highlighted the Olstein Strategic Opportunities Fund’s investment process and stated that the 8 fund holdings targeted by activists or acquired during 2014 was “a significant showing for a smallish fund.”
The Fund’s activist holdings as of March 31, 2015, include agricultural machine and equipment manufacturer, Blount International; environmental technology company, CECO Environmental; department store, Dillard’s Inc.; aerospace and defense products manufacturer, Esterline Technologies Corp.; specialty apparel and accessory retailer, Express Inc.; recreational vehicle suspension products manufacturer, Fox Factory Holding Corp.; money management firms, Janus Capital Group and Legg Mason Inc.; kitchenware and housewares manufacturer, Lifetime Brands Inc.; specialty sandwich shop, Potbelly Inc.; specialty retailer of nutritional products, Vitamin Shoppe Inc.; and fast-food restaurant chain, The Wendy’s Company. We continue to monitor the progress of our activist holdings as to whether or not the companies are responding to the strategic alternatives suggested. While each investment is at a different strategic stage, we believe that if the strategies that have been proposed are implemented, there is a high probability that future operating free cash flows, and ultimately shareholder value, could materially improve.
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 turnarounds 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 shareholder value within two years, we are willing to wait beyond two years for operating results to start improving. However, we assess whether the Fund is being sufficiently rewarded for the risk of waiting for the turnaround, and if our ongoing analysis of the company’s financial statements tells us that the company is headed in the right direction and that the balance sheet is strong enough to fund the company over the time we believe is necessary for the turnaround to occur.
Olstein Strategic Opportunities – The Benefits of Getting “Back to Basics”
In several of our previous letters to shareholders we discussed the ways we analyze, evaluate and monitor companies that have undertaken comprehensive turnaround strategies in order to improve their performance. While the Fund, since its inception, has committed significant capital to such turnaround situations, there is a more subtle type of corporate transformation that has also captured our attention leading to significant investments by the Fund — companies that improve and/or grow their business by getting “back to basics”. We thought it would be helpful to briefly highlight the favorable characteristics we seek in the Fund’s “back to basics” investments.
Olstein Strategic Opportunities – Fiscal Discipline
First and foremost, an effective “back to basics” strategy must emphasize fiscal discipline that seeks to directly improve the company’s profitability. In many cases, we have come to favor companies that have paused or halted expensive growth strategies driven by aggressive acquisitions or rapid expansion plans that have proven to be either unprofitable or produce below average returns, instead of pursuing initiatives that improve either the bottom line and/or produce returns meriting the risk. Instead of serial acquisitions, we mayprefer bolt-on acquisitions that provide thoughtful geographic expansion, product line growth, technological improvements or complementary services, but more importantly, can be quickly and smoothly integrated into the company’s existing infrastructure. Instead of rapid expansion plans that may impair both the company’s balance sheet and its ability to generate free cash flow, we usually prefer deliberate growth that prudently leverages the balance sheet and provides more favorable returns on invested capital.
Many small- to mid-sized companies aborting unsuccessful high growth strategies (which sought to satisfy Wall Street’s demands for continued high growth), impose greater fiscal discipline on the company which catches our attention on a more subtle, but still very important, scale. Some companies may get “back to basics” through reinvestment in research and development efforts looking to develop complementary products with solid returns on investment. Other companies may greatly improve margins by rationalizing manufacturing facilities across the geographies that the business serves, while others may refocus by shedding an unprofitable product line or division that has fueled investor misperceptions about the company’s potential. The imposition of greater fiscal discipline sends a strong signal regarding the company’s priorities and its renewed focus on profitability, and has resulted in many of our past “back to basics” holdings becoming rewarding investments.
Olstein Strategic Opportunities – Customer Focus
From our perspective, another important element of an effective “back to basics” investment strategy is a deliberate effort to refocus on core customer segments. As many small- to mid-sized companies grow, they often seek to appeal to as many customer segments as possible, without anticipating the longer-term negative implications for the company’s overall product lines on its future profitability, as well as the potential negative impact on the organization. In trying to be “all things to all customers,” companies are susceptible to costly product development missteps; frequently fail to offer products that are sufficiently differentiated from competitors’ offerings; proliferate the company’s product line without a strong rationale; compromise product quality; and/or significantly increase production costs.
At a certain point in the quest for above-average growth (usually after a period of disappointing results), companies step back and evaluate how well their existing product offerings meet specific customer needs. This exercise usually involves identifying and understanding who buys their products, why they buy, who are the likely future buyers, and finally, what are the costs of satisfying each segment. In our “back to basics” companies, we need to identify a change to focusing on profitability rather than just market share.
Companies that refocus on core customer segments that contribute to overall company profitability are more likely to establish a rational basis for product pricing and promotional decisions, competitors’ strengths and weaknesses, and finally, the customer whose needs best match the company’s core capabilities. Assessing and correctly rationalizing core customer segments sets a company up for increased profitability, organic revenue growth and free cash flow growth.
Olstein Strategic Opportunities – Reducing Complexity and Rationalizing Costs
Getting “back to basics” also helps cut through the organizational complexity and associated cost structure that tends to increase as small- to mid-sized companies attempt to undergo unsustainable or high-cost periods of rapid growth. As a company becomes more customer-centric through a “back to basics” approach, every business unit, function or process is judged by how effectively and efficiently it adds value to the company’s core customers and their experience without sacrificing the ability to create shareholder value. Parts of the organization that are unable to tailor their capabilities and decisions to not only specific customer needs, but also increasing shareholder value, may be good candidates for reduction or even elimination. Reducing or managing complexity more effectively can not only eliminate unnecessary costs, it can also lead to new sources of profit and a competitive advantage by enhancing the company’s ability to adapt quickly to its changing environment.
Small to mid-sized companies often face intense pressure and unrealistic expectations from Wall Street to demonstrate constant growth. When faced with such pressure, company managements often make the wrong strategic choices, leading to mistakes or temporary setbacks. 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. In this regard, we tend to respond well to those management teams that have acknowledged previous mistakes and have refocused their strategy on key elements of the company’s unique value proposition, that is, those companies that have gone back to pursuing the basics of their success.
Since we launched the Olstein Strategic Opportunities Fund more than eight years ago, 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. Getting “back to basics” to refocus company priorities on profitable strategies has served many small- to mid-sized companies and their long-term investors well during these challenging times. As always, we never get caught up in the temporary twists and turns of “back to basics” companies going through change. We steadfastly focus primarily on company fundamentals and our assessment of the company’s capability to generate future normalized free cash flow. There are usually many twists and turns along the way, but we remind you that, as always, patience can provide generous opportunities for long-term value investors. Our portfolio consists of companies that, in our opinion, have the financial strength to ride out short-term issues, while at the same time offering favorable long-term business prospects.
We value your trust, and remind you that we are invested alongside you as we work diligently to accomplish the Fund’s primary objective of long-term capital appreciation.
Eric R. Heyman
Robert A. Olstein
Chairman, Chief Investment Officer and Co-Portfolio Manager
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