07 Sep 2012 Olstein Value Fund - Q2 2012 Commentary ( Portfolio )
he stocks which contributed positively to performance for the twelve-month reporting period included Apple, TJX Companies, Pet Smart, Home Depot and General Electric. Although the majority of investors may see Apple as a “growth” story, we consider Apple a value play based on company fundamentals. With excess cash of approximately $124 per share and an estimated ability to generate free cash flow of $48 per share in 2012, Apple is currently trading at approximately 9½ times free cash flow despite its strong performance during the fiscal year. Pet Smart is a good example of a lesser-known, mid-sized company that not only withstood the economic downturn but grew at above average rates during the early stages of the economic recovery. As the leading specialty retailer that caters to pets, the company continues to effectively exploit this profitable niche while maintaining strong financial discipline.

General Electric is expected to participate in the growth and expansion of global infrastructure, aerospace, transportation, agriculture, water treatment, and healthcare spending with market leading products and services. In addition, GE’s worldwide finance company has been downsized and is now paying material dividends to the parent company. We consider GE more of a global infrastructure and energy story than an improvement of capital story following the downsizing of GE Capital subsequent to the financial crisis. GE’s earnings are now more predictable than before, yet the stock is only priced at a small premium to book value despite an improving return on equity, which is capable of exceeding 12% or more. Now, earnings are driven by the industrial businesses, with diverse and growing end markets in which GE is a worldwide benchmark leader. As investors notice vast improvements in the stability and growth of earnings at GE, we believe our valuation will be realized.

Our Laggards
Laggards during the twelve-month reporting period included Morgan Stanley, Ruby Tuesday, ABB Ltd., Sealed Air, and Whirlpool Corp. In May 2012, the Fund eliminated its positions in Morgan Stanley and JPMorgan when JPMorgan disclosed a $2 billion trading loss from a hedging strategy that backfired. The loss highlighted, in our opinion, that hedging via the derivative market is a high risk endeavor, unpredictable and capable of creating financial turmoil without warning. Although, by eliminating both Morgan Stanley and JPMorgan, we further decreased the Fund’s exposure to Financials (which performed very well during the first six months of our fiscal year ended June 30, 2012), we will continue to avoid global banks with potentially disastrous derivatives exposure, preferring instead to invest in well-run, well-managed banks such as U.S. Bancorp and BB&T Corporation, which have chosen to avoid material derivative exposure. We believe that lower risk banks tend to have more predictable earnings and should sell at higher price/earnings ratios.

The Fund eliminated its position in Ruby Tuesday in April 2012 due to stagnant same-store-sales over successive quarters. While the company’s free cash flow was strong, the economic headwinds and strong competition within the restaurant segment cast doubt on our original thesis. We liquidated the holding to employ the proceeds in other opportunities that we believed offered a better risk-reward profile. The Fund also eliminated its position in Whirlpool Corp. during the reporting period as our outlook for the company deteriorated due to weakened demand, higher market cost and aggressive discounting by global competitors. As of the close of the fiscal year, the Fund continued to hold ABB Ltd. and Sealed Air, which underperformed in the fiscal year ended June 30, 2012, but we believe our intrinsic value is still achievable despite some near term uncertainties. We continue to be believers in our long-term undervalued thesis for both companies despite some recent underperformance.

MARKET OUTLOOK
The European financial crisis exacerbated by high sovereign debt loads has resulted in severe austerity measures, which have weighed heavily on the overall global economy with a dozen European economies, including Great Britain, Italy, the Netherlands, and Spain sliding back into recession during the first half of 2012. Economic contraction across the European continent, a sharp slowdown in China’s growth and renewed concerns about the strength of the U.S. economy not only caused an abrupt end to the six-month equity market rally that began in October 2011, but they also triggered another spell of investor hand-wringing and increased equity market volatility. Despite the deep investor negativity surrounding equity markets during the first six months of calendar year 2012, it is significant to note that both the S&P 500® Index and the Fund’s Class C shares were up in excess of 8% during the first six months of calendar year 2012.

OUR STRATEGY
At this stage of the economic recovery, we believe that many analysts, investors and press remain too focused on short-term issues at the expense of understanding those factors important to long-term company valuations. Against an uncertain economic backdrop, we believe that investors can find some relief and opportunities 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 remain diligently focused on identifying and investing in what we believe are financially sound, well-managed companies with the ability to generate sustainable free cash flow and that are using the cash on initiatives that will allow the company to compete more advantageously in a low-growth environment (including strategic acquisitions) and/or returning cash to investors through increased dividends, stock repurchases or debt pay downs.

PORTFOLIO REVIEW
We continue to focus on how individual companies have adapted their expectations, strategic plans and operations to successfully navigate through these current bumpy economic conditions and to manage their assets to deliver future excess cash flow to investors. The Fund’s 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 generating future excess cash flow (after carefully considering cost of capital calculations) and are committed to utilizing free cash flow to create shareholder value.

At June 30, 2012, the Fund’s portfolio consisted of 81 holdings with an average weighted market capitalization of $50.79 billion. During the reporting period, the Fund initiated positions in 21 companies and strategically added to positions in 8 companies. Over the same time period, the Fund eliminated its holdings in 16 companies and strategically decreased its holdings in another 19 companies. Positions initiated during the fiscal year include: ABM Industries, Apache Corp., BB&T Corp., Dolby Laboratories, Dover Corp., Freeport McMoran Copper & Gold, General Electric Company, Hanesbrands, Korn/Ferry International, Microsemi Corp., National Oilwell Varco, Pentair, Pepsico, Qualcomm, Schlumberger, Snap-On Inc., Spirit Airlines, Staples, U.S. Bancorp, VF Corp., and Western Union. Positions eliminated during the past twelve months include: Adobe Systems, Alliance Bernstein Holding, Ascena Retail Group, WR Berkley Corp., Cintas Corp., Hanover Insurance Group, IBM Corp., JPMorgan Chase, Kimberly Clark, Morgan Stanley, Oshkosh Truck Corp., Procter & Gamble, Quest Diagnostics, Rockwell Collins, Ruby Tuesday and Whirlpool Corp.

GENERATING INVESTMENT RETURNS IN A
LOW-GROWTH ENVIRONMENT
For the third straight year, the summer doldrums have overtaken equity markets as investors worry over fundamental economic issues (European debt crisis, the slowdown in China, low interest rates, potential deflation) and their impact on the global economy. In April, renewed concerns from the European debt crisis (led by Spain) combined with economic contraction across the European continent and a slowdown in China’s growth, reestablished investor concerns about the strength of the global economy and abruptly ended the six-month equity market rally that began last October. In each of the past three years, the same gnawing fear has preyed upon investor sentiment: will the necessary deleveraging of the world economy halt the economic growth that began in mid 2009 causing a double-dip recession led by a consumer spending pull back and thus stifle equity market returns for the foreseeable future?

While we believe investors are right to be concerned with the impact of deleveraging on the global economy and equity markets, we also believe investors should prepare for a new economic and financial reality. From our perspective, the massive debt buildup of the past two decades has necessitated a somewhat painful period of deleveraging and has ushered in an extended period of low to moderate economic growth, low interest rates and a deep fear of equity markets. In light of this new reality, we believe that investors should be more concerned with pursuing an effective investment strategy that helps them achieve specific investment goals in a low-growth environment. We believe the deep fear of equity markets has swung the pendulum too far away from equities and created an almost mindless exuberance for fixed income securities with a complete denial of the potential risks.

In previous letters to shareholders, we have expressed our concern that many investors have either fled equity markets for low-yielding fixed income investments or remained on the sidelines preferring the safety of low- to no-return investments in U.S. Treasuries. We also doubted whether such approaches would prove viable over an extended period of time given the steep declines in net worth most investors experienced in 2008, in combination with the ongoing corrosive effects of inflation that impacts every portfolio and the growing need for greater retirement savings and income from a large swath of investors, specifically retiring baby boomers.

An important question faces the vast majority of investors, “What strategy should I pursue to meet my ever-growing investment needs in a low growth environment?” As we have stated many times before, we believe a thoughtful allocation to equities can help investors reach their goals during these difficult times. More specifically, we believe a meaningful commitment to an equity investment strategy that focuses on which individual companies have adapted their operations to generate sustainable and/or future growth of free cash flow (in the face of challenging economic conditions) yet are being cast aside by the investing public, who believe all companies are doomed to failure in slow economies. Sustainable free cash flow companies, selling at a discount to intrinsic value, offer the potential for above average returns and should serve as the foundation of constructing an equity portfolio during an expected period of low economic growth and low investment returns. The market is a discounting mechanism.

Although we are not in denial as to the many negative issues surrounding the world economy, it is our opinion that, similar to the market drop which began in June of 1990 in reaction to the Savings & Loan crisis (when investors were also very negative and scared) and was soon followed by a 10-year bull market, there are many stocks that have overreacted to the current European debt crisis. We are finding many opportunities to purchase high quality companies with strong balance sheets, attractive free cash flow and dividend yields priced at material discounts to our calculations of intrinsic values.

As previously stated, we prefer companies that generate sustainable free cash flow during challenging economic environments. We believe free cash flow companies can stay the course by making decisions with the purpose of creating long term shareholder value, which includes having the wherewithal to seize upon opportunities that present themselves during tough times. In addition, free cash flow companies provide an element of strength and stability in a very uncertain world. As the U.S. economy has recovered from the Great Recession, many companies have reported sharp growth in free cash flow. According to a recent study from the Georgia Tech Financial Analysis Lab, after reaching a significant low in December 2008, the free cash flow reported by approximately 3,000 U.S. public non-financial-services companies had increased 50% by December 2011.

We believe that one of our most important analytical exercises is to develop a thorough understanding of how a company’s operations generate and/or grow sustainable free cash flow in growing, stagnant, or deteriorating economic conditions. During the recent recession, companies that focused on operating efficiencies and improving working capital management to deliver free cash flow not only produced a higher quality of earnings, but also gained a valuable long-term perspective on their business. By understanding and optimizing cash flow from operations during difficult times, company management can hone operations to make more intelligent internal investment decisions that are likely, in our opinion, to produce greater-than-average earnings in a low-growth environment. However, optimizing cash flow via material reductions in capital expenditures, research and development expenditures and/or marketing and other general and administrative expenditures needs to be analyzed carefully to determine whether these expense reductions were a result of cutting back nonproductive bloated expenditures or a result of the company borrowing from its future in order to stabilize current operations. Cash flow contributions from asset sales (although nonrecurring in nature) also need to be analyzed to determine the longer term effects on future cash flows. Financial engineering and creative accounting are the other items that need to be scrutinized to determine whether current cash flows are being inflated. In the end, the most important measure when valuing a company is the company’s ability to generate and/or grow recurring normalized free cash flow necessary to sustain and grow future operations.

IMPORTANCE OF INFERENTIAL ANALYSIS
To reiterate, history has taught us that one of the best ways to generate above-average investment returns in a low-growth environment is to identify and invest in financially strong companies with a proven track record of generating sustainable free cash flow. We further believe that the key to identifying such companies is to undertake an intensive, inferential analysis of a company’s financial statements, footnotes and other regulatory filings in order to assess what we believe are the company’s normalized cash earnings, the capabilities and fiscal conservatism of the management team and, finally, the quality of earnings. Through our inferential analysis, we seek to develop a deeper understanding of the stability and reliability of the company’s free cash flow potential under different macro-economic scenarios – an extremely important analysis when faced with potential unfavorable economic headwinds.

As we perform our analysis of financial statements, we assess the quality of a company’s earnings and make adjustments to reported earnings in order to eliminate what we believe are management biases or unrealistic assumptions. Our forensic analysis not only allows us to hone important data inputs for our valuation models, it also provides keen insight into factors that may be indicative of future earnings changes, the success of a company’s strategy, the sustainability of its performance and the impact of management decisions on future cash flow. To reliably estimate a company’s normalized future free cash flow, we must fully understand its business model as well as the success of its strategy, the sustainability of its performance and the impact of management decisions on future cash flow. Our analysis not only seeks to determine how stable a company’s cash flow is but also if we can estimate its future cash flows with a high degree of predictability. Our analysis seeks to answer several important questions: Does the company have a unique niche relative to its competitors that leads to dependable revenues? Does the company have proven products with a well-defined market? Does the company’s business model (products and services) have a highly predictable cost structure which leads to fairly consistent cash flows?

During challenging economic times which usually leads to elevated levels of equity market volatility, we believe that our intensive forensic analysis of financial statements provides a unique ability to identify companies with significant potential to outperform the market by affording us:


• a higher probability of more reliable estimates of future cash flow that are critical to projecting the future value of the company


• a gauge of balance sheet strength and the company’s ability to withstand problems that may last longer than originally expected


• the capacity to evaluate the effectiveness of management at creating long-term shareholder value


• an ability to detect early signs as to whether or not a company’s business policies and strategic direction are capable of achieving the financial objectives necessary to reach our calculated values.

If an investor believes as we do that a company’s free cash flow is the primary determinant of its value as an ongoing enterprise, then a company’s ability to adapt to a challenging or stagnant economic environment by continuing to generate sustainable free cash flow should separate the company from its competition and eventually draw the favorable attention of equity investors. During periods of extreme negative psychology such as the current period, investors react to the daily ups and downs of earnings estimates and short-term news rather than differentiating between long-term valuations.

As we have said many times before, free cash flow is the lifeblood of a business and companies that generate excess cash flow also have the potential to enhance shareholder value by increasing dividend payments, repurchasing company shares, reducing outstanding debt, engaging in strategic acquisitions and, finally, represent outstanding takeover candidates. For us, superior investment opportunities are found in companies that not only generate sustainable excess cash flow, but are led by management who use that excess cash in ways that will increase shareholder value over the long run and can be bought at a significant discount to our determination of their intrinsic value because of short-term myopia. Rather than relying on market sentiment which changes on a daily basis, we believe that investors should be concerned about the cash return an investor can expect from owning a share of a business over long periods of time and if that return compensates the investor sufficiently (in excess of the risk-free rate) for the risk of investing in equities. To us, this last question holds greater importance during an anticipated slowdown and at a time when nervous investors are being told, often quite loudly, to avoid equities and seek safer opportunities. For the patient investor, we believe that such times have the potential to set up significant above-average long-term investment returns.