Robert Olstein: Waste Of Time To Debate Market ValuationsVW Staff
Robert Olstein‘s Olstein All Cap Value Fund annual letter to shareholders for the period ended December 2014.
For the year ended December 31, 2014, Class C shares of the Olstein All Cap Value Fund appreciated 15.03% compared to total returns of 13.69% and 12.56% for the S&P 500® Index and the Russell 3000® Index, respectively. For the six-month reporting period ended December 31, 2014, Class C shares of the Olstein All Cap Value Fund returned 9.81% compared to total returns of 6.12% for the S&P 500® Index and 5.25% for the Russell 3000® Index. Since the Fund’s inception date of September 21, 1995 thru December 31, 2014 (19 plus years), the Fund has appreciated at an annualized rate of 11.09% compared to 8.78% and 8.86% for the S&P 500® Index and the Russell 3000® Index, respectively.
Robert Olstein's Olstein All Cap Value Fund: Market Outlook
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. While there are always forecasters predicting the next stock market 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 with stable or growing free cash flow, run by managements that have a demonstrated history of deploying that cash to the benefit of shareholders. The Fund’s analysts and portfolio managers have approximately 100 years of combined stock market research experience but have yet to identify any individual or company who can accurately forecast and time over all market moves with enough degree of regularity to profit therefrom. Ponce de Leon probably had a better chance of discovering the Fountain of Youth.
While investors, the press, market pundits, etc. may be nervous about equity market volatility, we believe it is more productive to identify either; (1) equity securities whose real economic value based on the ability to generate future free cash flow is, in our opinion, unrecognized by the market as a result of short term factors; or (2) to sell equity securities that we believe whose value has currently been recognized by market forces.
Our method of taking advantage of market volatility is to use the downside volatility to purchase securities at prices selling at a material discount to our calculation of intrinsic value (which is based on our estimate of a company’s ability to generate and/or grow free cash flow) and to use the upside volatility to sell securities in which market forces have reduced or closed our estimated valuation discount. Thus, our discipline often results in the Fund buying when the market or individual stocks are declining and selling when the opposite is true.
In the current market, we are finding viable opportunities to purchase investments that we believe meet our investment objectives by focusing on three company specific factors: (1) a commitment to maintain a strong financial position as evidenced by a solid balance sheet; (2) an ability to generate and/or grow future sustainable free cash flow which in our opinion is not being properly valued by the market; and (3) and a management that intelligently deploys cash balances and free cash flow from operations to increase returns to shareholders. We believe that companies prioritizing these factors are in a position to compete more advantageously in all types of economic environments and as a result offers the Fund the appropriate risk/reward tolerances. In the current market (as always), we are also liquidating securities which have reached prices where we believe the market has recognized the underlying intrinsic value of the company and thus no longer possesses an investment edge. If we are unable to find ideas meeting our stringent investment criteria, we sit with cash waiting to seize upon the opportunities that eventually arise. Our cash equivalent position as of December 31, 2014 was approximately 11% of the Fund’s assets. In conclusion, we believe the Fund’s strategy as outlined above increases the probability of the Fund continuing to realize its investment objectives.
Robert Olstein's Olstein All Cap Value Fund: Our Strategy
From our perspective, Wall Street’s obsessive focus on short-term concerns has increased the opportunities to identify potential investments in which material deviations develop between a company’s stock price and our estimate of the company’s intrinsic value. Investors reacting to the daily noise and news and whether or not companies beat earnings estimates, which in a majority of the cases have little to do with long term valuations, continue to create favorable opportunities for the Fund to buy companies with solid balance sheets and business models that generate excess cash flow at what we believe are bargain prices. In 2015, we will continue to remain focused on individual companies, their operations and prospects for maintaining or growing sustainable free cash flow which, in our opinion, are not being properly valued based on current market prices. In addition to our focus on a company’s ability to generate sustainable free cash flow, we continually emphasize the quality of a company’s earnings. By highlighting the quality of a company’s earnings (defined as our assessment of the conservatism and/or economic reality of the financial statements), we seek to accomplish two objectives: (1) to identify those companies that not only have focused their priorities on solidifying the balance sheet during the economic recovery but have also laid the groundwork to achieve a substantial strategic advantage for the eventual acceleration of economic growth; and (2) to assess the financial risk inherent in each investment opportunity before considering the potential for capital appreciation.
Robert Olstein's Olstein All Cap Value Fund: Portfolio Review
Our current portfolio consists of companies that we believe are selling at a discount to our calculation of intrinsic value, 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 events as economic growth accelerates.
At December 31, 2014, the Olstein All Cap Value Fund portfolio consisted of 100 holdings with an average weighted market capitalization of $56.66 billion. During the six-month reporting period, the Fund initiated positions in fifteen companies and strategically added to positions in twenty-seven companies. Over the same time period, the Fund eliminated its holdings in twenty companies and strategically decreased its holdings in another thirteen companies. Positions initiated during the last six months include: Discovery Communications, Dorman Products, Dover, DSW, First Niagara Financial, Janus Capital Group, MasterCard, Owens-Illinois, Packaging Corporation of America, Patterson Companies, Pentair, Twenty-First Century Fox, Universal Health Services and The Wendy’s Company. Positions eliminated during the past six months include: 3M Company, ABB Ltd, Ann Inc., Baxter International, C R Bard, Care Fusion, Cintas, Coca-Cola, Dentsply International, Ethan Allen Interiors, Hormel Foods, International Game Technology, McDonald’s, Newell Rubbermaid, PetSmart, Sysco, TRW Automotive Holdings, URS, V F Corp. and Walt Disney Company.
Robert Olstein's Olstein All Cap Value Fund: Our Leaders
The stocks which contributed positively to performance for the six-month reporting period include: Lowe’s Companies Inc., Ross Stores Inc., PetSmart Inc., Zoetis Inc. and Bed, Bath & Beyond, Inc. At the close of the reporting period, the Fund continued to maintain positions in Lowe’s (LOW), Ross Stores (ROST), Bed, Bath & Beyond (BBBY) and Zoetis. During the reporting period, the Fund eliminated its holding in PetSmart, which was targeted by a strategic acquirer. 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 which represented a substantial premium to the Fund’s average cost for PetSmart.
Robert Olstein's Olstein All Cap Value Fund: Our Laggards
Laggards during the six-moth reporting period include: Smith & Wesson Holding Corp., NOW Inc., National Oilwell Varco Inc., Dover Corp. and Express Inc. As of the close of the reporting period, the Fund continued to hold each of these stocks in its portfolio.
Robert Olstein's Olstein All Cap Value Fund: Our Thoughts On Active Management Versus Seeking To Be Average
With the close of each calendar year, there appear a number of articles and stories in the business press comparing the average returns of active equity managers to passive index funds. The articles highlight the number of managers that underperform (the most well-known index, the S&P 500 Index®) as opposed to emphasizing the number of managers available that have outperformed over long periods of time. Inevitably, these articles come to the conclusion that since the S&P 500 Index® has outperformed a material majority of active equity managers, seeking to identify outperforming active equity managers has proven to be a pointless pursuit. In fact, the articles further conclude that index investing is the only logical choice for all investors because active management will eventually lead to under-performance, and investors do not have the capabilities to select long-term outperforming active managers. The above conclusion is currently accepted as investment dogma which basically says investors should accept being average. The Nobel Prize was recently given to a professor advocating the “efficient market theory” which basically says that all relevant information is in the price of every stock, and everybody is playing with the same information deck and unable to uncover information not yet considered and included in the stock price. The Nobel Prize has given additional credence to the tenet that equity investors should pursue passive index investing as it is virtually impossible to discover information not yet considered as part of the stock price and thus, it is almost impossible to outperform over long time periods. The subtle conclusion is that passive index investing is the only correct way to go. Passive index investing advocates believe that seeking to outperform the market over long periods of time is akin to a dog chasing its tail. More importantly, recent strong inflows into index mutual funds may be the best evidence that investors have adopted the conventional wisdom that active investment management is a futile endeavor. As equity markets have bounced back from the lows experienced in March 2009, an increasing number of investors have opted to invest in passive equity funds and ETFs. According to the Investment Company Institute, from January 2009 through November 2014, domestic index equity mutual funds received $178.2 billion in cumulative net new cash. In contrast, actively managed domestic equity mutual funds experienced a net outflow of $600 billion.1
We could not disagree more with the supporters of the “efficient market theory” and the theory of passive index type investing (accepting the averages is the only wise option for the public), as opposed to pursuing active managers who have practiced long-term fundamental value investment disciplines which have demonstrated long-term market index beating investment returns that are likely to continue “over time” rather than “all of the time”.
Advocating mediocrity or being average is a line of thinking that we believe is defeatist, condescending and against the basic tenets of American business philosophy. We grew up believing and were taught that the opportunity to break away from mediocrity is available to all Americans who are willing to pursue the American dream through hard work and the pursuit of superior knowledge. It is a travesty that so many Wall Street intellectuals and professors at well respected universities charging high tuitions are teaching their students to be average.
Influential academics backed by the press and a material number of financial advisors rarely question the indexing theory (or “being average theory”) resulting in the rise of passive index investing to the level of accepted “investment dogma”. A recent article by a major publication (Wall Street Journal, November 29, 2014, “Stock Indexing Racks Up Another Triumphant Year”) seeking to give further credence to pursuing passive index investing, concluded that the number of mutual funds beating the index through the first 9 months of 2014 reached a new low of 7.6% compared to 38.6% over the last 25 years.
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