Olstein All Cap Value Fund 2015 Annual LetterVW Staff
Olstein All Cap Value Fund annual letter for the year ended December 31, 2015.
Dear fellow shareholders:
For the calendar year ended December 31, 2015, Class C shares of the Olstein All Cap Value Fund depreciated 9.51%, while the Russell 3000 Value® Index depreciated 4.13% and the Russell 3000® Index appreciated 0.48%. For the six-month period ended December 31, 2015, Class C shares of the Olstein All Cap Value Fund depreciated 9.04%, while the Russell 3000 Value® Index depreciated 3.64% and the Russell 3000® Index depreciated 1.43%. Since the Fund’s inception date of September 21, 1995 through December 31, 2015, Class C shares of the Olstein All Cap Value Fund had an average annual return of 9.97% compared to average annual returns of 8.77% for the Russell 3000 Value® Index and 8.43% for the Russell 3000® Index.
Olstein All Cap Value Fund Oultlook
A slowdown in Chinese economic growth, falling oil prices and rising U.S. interest rates led to a sharp increase in downside market volatility during the second half of 2015 and early months of 2016. While there is never a shortage of market predictions (both positive and negative), in the current environment the bearish predictions outnumber the optimists. Excessive pessimism usually creates opportunities for the Fund to focus on financially strong companies with stable or growing free cash flow, run by managements who deploy cash to the benefit of shareholders and are selling at what we believe to be bargain prices.
The performance data quoted represents past performance and does not guarantee future results. The Olstein All Cap Value Fund’s Class C average annual return for the one-year, five-year, and ten-year periods ended 12/31/15, assuming reinvestment of dividends and capital gain distributions and deduction of the Olstein All Cap Value Fund’s maximum CDSC of 1% during the one-year period, was -10.28%, 9.40%, and 4.47%, respectively. Per the Fund’s prospectus dated 10/31/15, the expense ratio for the Olstein All Cap Value Fund Class C was 2.27%. Performance and expense ratios 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.
As has happened many times over the Fund’s 20 year history, many investors in the current environment are reacting to negative news, often irrationally, with little or no regard for company fundamentals. We understand that in order to get the bargain prices we seek, some type of negativity (whether it be the market, the industry or short-term factors affecting a company) is putting pressure on the price of the security we believe is a bargain. It is extremely difficult to ride out these periods of underperformance, but it is the bargain prices that we often receive during these periods that we believe is
key to helping us achieve our long-term investment objective. We remain focused on individual companies, their operations and prospects for maintaining or growing sustainable free cash flow which we believe is critical to long-term valuations. We are investing in companies that we believe have an ability to deliver long-term value to their shareholders that is not being recognized by the market.
While many investors are nervous about equity markets, we believe it is extremely important to recognize that there is a big difference between market volatility, specifically, broad downward movements in stock prices, and the fundamental value of a business. It is important to distinguish between the variability of an investment’s market price due to temporary market volatility, and the likelihood of permanent impairment of capital as a result of long-term business fundamentals deteriorating. For us, short-term market volatility is less of a concern than the irreversible loss of capital due to the erosion of a company’s business fundamentals. As long-term investors, we don’t equate spikes in short-term market volatility with a decrease in the underlying value of a business; nor do we equate such volatility with increased risk in the business.
From our perspective, we believe recent downside market volatility underscores the strong case for investing in the equity securities of companies whose real economic value is unrecognized by the market, obscured by recent market uncertainty or overshadowed by temporary problems. As a result of the recent market decline we are finding many viable investment opportunities that we believe are undervalued by focusing 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. It is significant to note that undervalued companies generating excess free cash flow add to their fundamental value despite the fact that their stock price has declined. Patience during these periods of irrationality can be quite rewarding if we are correct about a company’s longterm ability to generate normalized excess cash flow not being recognized by the stock market.
There are times when the combination of certain events, such as the slowdown in Chinese economic growth and falling oil prices, tend to overwhelm equity markets and hit a value-oriented portfolio, such as the Fund’s, particularly hard causing a period of underperformance. At the same time, however, as long-term value investors, the negative reaction during periods of increased market volatility often creates many favorable opportunities for the Fund to buy good companies at what we believe are bargain prices.
Throughout the Fund’s history, Wall Street’s obsessive focus on short-term events has produced significant opportunities for the Fund to profit from pessimism as deviations between stock prices and company valuations increase dramatically. We believe we are currently in one of those periods with many investors reacting to negative news, often irrationally with little to no regard for company fundamentals. We, on the other hand, continue to seek and invest in companies that we believe have an ability to deliver long-term value to their shareholders that, in many cases, is not currently recognized by the market or is being hidden by short term problems. We remain focused on individual companies, their operations and prospects for maintaining or growing sustainable free cash flow. We also seek to guard against poorly timed decisions to sell a stock being punished in the stock market as a result of short term problems that we believe have little to do with the long-term intrinsic value of the company. Selling undervalued securities based on problems that are not relevant to long-term valuations is just as bad as buying a value trap. We regard these decisions as serious errors that can affect long-term performance.
Olstein All Cap Value Fund – Portfolio Review
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 and deploys free cash flow to create shareholder value. We believe companies with these characteristics are poised to eliminate the valuation gaps created by the recent uncertainty as the economic growth accelerates.
At December 31, 2015, the Olstein All Cap Value Fund portfolio consisted of 88 holdings with an average weighted market capitalization of $55.66 billion. During the reporting period, the Fund initiated positions in eight companies and strategically added to positions in nineteen companies. Over the same time period, the Fund eliminated its holdings in twenty-three companies and strategically decreased its holdings in another ten companies. Positions initiated during the six month period ended December 31, 2015 include: American Express Company, Coach Inc., Express Scripts Holding Company, Kennametal Inc., PayPal Holdings Inc., Procter & Gamble, WestRock Co., and Zebra Technologies Corp.
Positions eliminated during the six month period ended December 31, 2015 include: ABM Industries, ADT Corp., Alaska Air Group, Chubb Corp., Dorman Products, Entegris Inc., Equifax, First Niagara Financial Group, Fossil Group, HCA Inc., Masco Corp., National Oilwell Varco, NVIDIA Corp., Qualcomm Inc., RockTenn Company, Sealed Air Corp., Smith & Wesson Holding Corp., TE Connectivity Ltd., Teradata Corp., Towers Watson & Co., UniFirst Corp. and Zoetis Inc.
Olstein All Cap Value Fund – Leaders
The stocks which contributed positively to performance for the six-month reporting period include: Delta Airlines, Lowe’s Companies, Inc., Intuitive Surgical Inc., Becton Dickinson and Company and Packaging Corp of America. At December 31, 2015, the Fund continued to hold positions in each of these companies.
Olstein All Cap Value Fund – Laggards
The leading detractors from performance include: Joy Global, Fossil Group, General Electric Company, Spirit Airlines and Dillard’s Inc. As of December 31, 2015, the Fund continued to hold positions in Joy Global, General Electric, Spirit Airlines and Dillard’s. During the reporting period the Fund liquidated its position in Fossil Group
Olstein All Cap Value Fund: “Meet Or Beat” – The Pitfalls Of A Short-Term Focus
Recent investor apprehension regarding equity markets is understandable when considering the media’s relentless coverage of negative events over the past year. Whether it is the slowdown in China’s economic growth, the uncertainty of oil prices, or the negative impact of a strengthening U.S. dollar on corporate earnings, crises continue to dominate headlines and commentary from the financial and business media. Time and again we have seen this unrelenting negative coverage and bombastic commentary rattle investor confidence and prompt irrational behavior that is usually detrimental to long-term wealth creation. In fact, over our twenty-year history we have frequently discussed the pitfalls of short-term thinking and the likelihood of permanent impairment of an investor’s capital due to a poorly-timed, irrational investment decisions rooted in short-term negative thinking.
While we have frequently cautioned about the pitfalls of “short-termism,” we have also seen another trend unfold over our twenty-year history – a disturbing increase in short-term thinking by company managements. In this letter we thought it would be helpful to discuss our thoughts on how company managements contribute to the short-term thinking that currently dominates markets and what companies can do to mitigate the harmful effects of such short-termism on investors and markets.
Olstein All Cap Value Fund – Short-Term Focus Of Earnings Announcements And Earnings Guidance
We believe that two specific corporate reporting practices have greatly influenced and facilitated the harmful short-term mentality that dominates today’s equity markets: over focusing on quarterly earnings numbers and forward-looking earnings guidance statements (quarterly or annually). In particular, the hoopla surrounding quarterly earnings announcements has fostered a “meet or beat” mentality that myopically reduces the measure of company performance and ‘success’ to whether or not the company has met, exceeded or fallen short on one number and one number alone – earnings-per-share (EPS)! Likewise, forward-looking earnings guidance sets the parameters for continuing the “vicious cycle” as companies issue EPS guidance that analysts and institutional investors factor into the consensus estimate target for the next quarterly “meet or beat” cycle of performance measurement. We find this process akin to a dog chasing its tail.
For us, the idea that a single earnings per share number can somehow serve as a reasonable measure of a company’s ability to create sustainable value is simply absurd. Yet it is the hoopla surrounding quarterly earnings announcements that generates a great deal of the noise and speculation about individual company performance that distracts investors from the real drivers of long-term value creation. The short-term “meet-or-beat” mindset of earnings season induces investors to overlook the complexity and realities of individual businesses and their operating environments and often promotes emotional, irrational investor behavior.
From a company’s perspective, the “meet-or-beat” mindset surrounding quarterly earnings also serves as an unwarranted incentive for management to engage in excessive short-term earnings management. Companies that frequently engage in short-term earnings management to meet a consensus EPS estimate, often do so at the expense of longer term value creation. Put simply, repeatedly engaging in earnings management to meet an EPS estimate erodes the quality of earnings and bumps up against an undeniable reality – over time a company’s stated earnings must eventually reconcile to the company’s cash flow.
We are also concerned that the “meet or beat” mindset may cause company management to favor short-term tactics, such as foregoing, postponing or greatly reducing necessary long-term investments or valuable research & development efforts in order to avoid missing an EPS target. We believe this is especially true for those companies facing unique challenges and strategic choices at the same time they are facing pressure to increase the company’s short term stock price from institutional and professional investors. Management teams that surrender to the unrelenting pressure of meeting quarterly expectations to keep their stock price from taking another downward hit may not only drive away stable, long-term investors, they may also expose the company to the agenda of an outside investor (corporate raider or activist investor) seeking a quick run-up in stock price at the expense longterm value creation.
Olstein All Cap Value Fund – Refocusing The Investment Time Horizon
We believe that the key to helping investors refocus their investment time horizon and lengthening their expected holding period for a company’s stock lies in escaping (or avoiding) the dysfunctional earnings guidance trap. Instead of providing earnings guidance, we believe that companies should help shareholders better understand the key long-term drivers of value creation within the business. Management should clearly communicate the strategic plan in place to create value over the next one- to three years and should provide enough information for shareholders and potential investors to adequately understand the company’s plans for growth and how to evaluate the company’s progress in executing those plans. Management’s discussion regarding the company’s prospects and outlook over the next one- to three years should focus primarily on those matters related to long-term value creation, including:
Strategic Plan: Management should communicate a well-articulated, long-term plan for value creation which provides the necessary framework for discussing periodic results as a measure of progress towards longer-term goals. Guided by such a strategic framework, the evaluation of quarterly results would occur in the context of longer-term goals and not assume the reductive short-term “meet or beat” approach that dominates today’s market. Discussion of the company’s strategic plan should focus on the company’s business model, its strengths and vulnerabilities and how it anticipates competitive challenges and exploits opportunities for growth. Management should engage in detailed discussion of current and future issues that could negatively affect the company’s ability to achieve long term goals and the strategic plans that are being implemented to overcome these threats.
Operating Environment: Since companies operate in an ever-changing environment and face both external and internal challenges to executing their strategy, management should candidly discuss how the company has navigated and plans to navigate the dynamic environment over the next one to three years. Such a discussion should focus on: macro-economic fluctuations; important shifts in the geopolitical landscape in which the company operates; potential impediments posed by changing capital markets; rising and receding competitive challenges; vendor/supplier or raw materials-related issues; technological and regulatory developments, sector-specific significant structural shifts; and any other key trends or issues that are likely to affect the company operations and financial results. It is important for management to constantly assess its operating environment and communicate to shareholders and potential investors all information pertinent to assessing the company’s future earnings and free cash flow as well as potential negatives to overcome.
Value Creation and Capital Stewardship Metrics: We believe management’s engagement with shareholders should always focus on the quality of a company’s earnings; that is, the sustainability and predictability of earnings that will result in free cash flow that investors can reasonably anticipate from a well-executed value creation strategy. In addition, potential impediments to reaching goals should also be discussed. We believe too much attention is paid to metrics such as EPS and EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization). As accounting-driven investors, who undertake an indepth forensic analysis of company financial statements, we have seen companies consistently engineer favorable EPS and EBITDA numbers while simultaneously destroying shareholder value (such companies include a rogue’s gallery of corporate scoundrels including Enron, WorldCom, Tyco, etc.). We believe a new model of guidance should focus on metrics that highlight a company’s economic profit, such as: Net Operating Profit after Tax (NOPAT); Weighted Average Cost of Capital (WACC), Return on Invested Capital (ROIC), and most importantly, Free Cash Flow. Management adjusted earnings which adds back stock based compensation and other items and expenses to GAAP reported earnings is a travesty and should be ignored. Believing management adjusted earnings at face value is the equivalent of allowing the fox to guard the hen house.
Accountability: For us, transparency and accountability are crucial elements of any forward-looking guidance that management provides to investors. In this regard we not only favor communications that candidly discuss both negative and positive matters that the company is facing, we also expect a company to clearly communicate who is responsible for improving those operations that are underperforming. By candidly and thoroughly discussing areas for improvement, the company will provide investors the information needed to effectively judge the depth, functional capabilities, and decision-making skills of the company’s management team.
Olstein All Cap Value Fund – A New Approach To Guidance
We believe that replacing the current short-term oriented earnings-per-share guidance approach with a thoughtful discussion of a company’s one- to threeyear outlook focused on a company’s strategic plan, operating environment, key value creation capital stewardship metrics, as well as full discussion of impediments to overcome would appeal to longer-term investors and reduce a great deal of inefficient and harmful short-term thinking currently affecting equity markets. By helping investors better understand their business models, ever-changing operating environments, and plans for value creation, companies can also help investors lengthen their investment horizon, reduce irrational behavior and increase their ability to build wealth over time through thoughtful and informed equity investing. We favor investments in companies with managements who focus on long-term metrics.
As value investors, we believe in having a long-term horizon in an environment that is maniacally focused on short-term events. 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 even during most negative environments. It is our opinion that by continuing to add what we believe to be undervalued free cash flow investments to the Fund’s portfolio, we are increasing the probability of the Fund reaching its primary investment objective of long-term capital 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 previous periods of extreme negative volatility in 2008, 2009 and 2011.
Uncertainty and fear, fueled by troubling news combined with conflicting economic data, usually result in the type of market volatility that overwhelm markets from time to time such as the current period. While market dips may present us with buying opportunities (following our strict stock selection criteria), low stock prices are not the sole criteria for buying companies for the portfolio. Additional criteria include strong balance sheets; well-run operations having the potential to consistently generate excess free cash flow; and company managements with a disciplined track record of improving the returns of the business are also heavily weighed.
We believe the best approach for an uneven economic and investment environment is to buy companies that have the ability to generate free cash flow, have little or no debt or are aggressively paying down debt, and to buy such companies at a significant discount to their intrinsic value during periods of pessimism. We believe that the Fund’s portfolio primarily consists of fiscally strong, excess-cash-flow companies whose businesses, in our opinion, are primed to provide suitable returns over the long term.
We value your trust and remind you that our money is invested alongside yours as we work diligently to accomplish the Fund’s objective of long-term capital appreciation.
Robert A. Olstein
Chairman and Chief Investment Officer