There is a strong correlation between above-average investment performance and error avoidance. To achieve long-term success, an investor must first consider downside risk before considering the potential for appreciation.
A company’s stock price often falls below its private market value due to temporary problems such as missed earnings estimates, over-reaction to short-term results or overall negative market psychology. These short-term deviations may present viable opportunities for the patient, long-term investor.
Excess cash flow is the lifeblood of a business and is the primary determinant of a company's private market value. Companies that generate excess cash flow have the potential to enhance shareholder by increasing dividend payments, repurchasing company shares, reducing outstanding debt, engaging in strategic acquisitions, on withstanding economic downturns without adopting harmful short-term strategies.
Forensic analysis of financial statements reveals the Quality of a company’s Earnings, the success of its strategy, sustainability of its performance and impact of management decisions on future cash flow. Forensic analysis of financial statements is more useful to an investor than management forecasts or earnings guidance.
Emphasizes investments in undervalued equity securities of companies with discernible financial strength, unique business fundamentals, competitive edge and ability to generate free cash flow
Analysis focuses on how a company’s operations generate sustainable free cash flow; how much of that cash is available to investors and the level of ongoing investment required to maintain and grow free cash flow
Valuations based on free cash flow. Reliable valuations require determining if a company’s accounting policies reflect business reality; assessing a company’s Quality of Earnings; accounting adjustments to eliminate management bias, and identifying positive or negative factors that may affect future free cash flow
Period: Q4 2012
Portfolio date: 31 Dec 2012
No. of stocks: 88
Portfolio value: $494,901,000
|Stock||% of portfolio||Shares||Recent activity||Reported Price*|
|hist||HAR - Harman Int'l Industries||2.03||225,000||Add 4.55%||$44.64|
|hist||CSCO - Cisco Systems||1.99||500,000||Reduce 14.24%||$19.65|
|hist||MSFT - Microsoft Corp.||1.99||369,000||$26.73|
|hist||DD - Du Pont (E.I.)||1.96||216,000||Add 15.51%||$44.97|
|hist||M - Macy's Inc.||1.88||239,000||Add 8.88%||$39.02|
|hist||BBBY - Bed Bath & Beyond||1.76||156,000||Add 40.54%||$55.91|
|hist||A - Agilent Technologies||1.72||208,000||Add 1.96%||$40.94|
|hist||LM - Legg Mason||1.69||326,000||Reduce 0.61%||$25.72|
|hist||INTC - Intel Corp.||1.65||395,000||Reduce 13.19%||$20.63|
|hist||ABB - ABB Ltd.||1.64||390,000||Reduce 10.55%||$20.79|
|hist||SCHW - Charles Schwab||1.62||560,000||$14.36|
|hist||JLL - Jones Lang Lasalle Inc.||1.58||93,000||Reduce 7.00%||$83.94|
|hist||SYK - Stryker Corp.||1.54||139,000||Reduce 4.14%||$54.82|
|hist||TFX - Teleflex||1.54||107,000||Reduce 1.83%||$71.31|
|hist||TKR - Timken Co.||1.53||158,000||Reduce 24.40%||$47.83|
|hist||JNJ - Johnson & Johnson||1.50||106,000||$70.10|
|hist||GE - General Electric||1.49||352,000||Reduce 6.13%||$20.99|
|hist||CMI - Cummins Inc.||1.49||68,000||Add 4.62%||$108.35|
|hist||LIFE - Life Technologies Corp.||1.48||149,000||Reduce 6.88%||$49.08|
|hist||IGT - International Game Technology||1.48||518,000||Reduce 20.31%||$14.17|
|hist||SPLS - Staples Inc.||1.46||635,000||$11.40|
|hist||BDX - Becton Dickinson||1.45||92,000||$78.18|
|hist||SAVE - Spirit Airlines||1.44||403,000||Add 17.15%||$17.72|
|hist||TER - Teradyne Inc.||1.43||420,000||Reduce 4.55%||$16.89|
|hist||ZMH - Zimmer Holdings||1.43||106,000||Reduce 9.40%||$66.66|
|hist||USB - U.S. Bancorp||1.42||220,000||Reduce 2.22%||$31.94|
|hist||ADI - Analog Devices||1.42||167,000||$42.06|
|hist||DAL - Delta Air Lines Inc.||1.39||580,000||Reduce 15.33%||$11.87|
|hist||AXP - American Express||1.38||119,000||Add 9.17%||$57.48|
|hist||COH - Coach Inc.||1.35||120,000||Add 17.65%||$55.51|
|hist||DOV - Dover Corp.||1.35||102,000||Reduce 4.67%||$65.71|
|hist||PNR - Pentair Ltd.||1.34||135,000||Reduce 17.68%||$49.15|
|hist||AVY - Avery Dennison Corp.||1.31||185,000||Reduce 13.15%||$34.92|
|hist||EFX - Equifax Inc.||1.31||120,000||Reduce 21.05%||$54.12|
|hist||COV - Covidien Plc.||1.30||111,000||Reduce 1.77%||$57.74|
|hist||DPS - Dr Pepper Snapple Group Inc.||1.30||146,000||$44.18|
|hist||EXPR - Express Inc.||1.28||419,000||Add 15.36%||$15.09|
|hist||CFN - CareFusion Corp.||1.27||220,000||Reduce 20.29%||$28.58|
|hist||IR - Ingersoll-Rand Plc||1.27||131,000||Reduce 22.49%||$47.96|
|hist||TMO - Thermo Fisher Scientific||1.26||98,000||Reduce 17.65%||$63.78|
|hist||XOM - Exxon Mobil Corp.||1.24||71,000||Reduce 11.25%||$86.55|
|hist||FDX - FedEx Corp.||1.20||65,000||Reduce 9.72%||$91.72|
|hist||XRAY - Dentsply International||1.16||145,000||Reduce 3.33%||$39.61|
|hist||NOV - National Oilwell Varco Inc.||1.15||83,000||Add 25.76%||$68.35|
|hist||LOW - Lowe's Cos.||1.13||158,000||Reduce 41.26%||$35.52|
|hist||BBT - BB&T Corp.||1.11||189,000||Add 56.20%||$29.11|
|hist||NWL - Newell Rubbermaid Co.||1.08||240,000||Reduce 41.75%||$22.27|
|hist||AAPL - Apple Inc.||1.08||10,000||Add 42.86%||$533.00|
|hist||STZ - Constellation Brands||1.07||150,000||Reduce 28.57%||$35.39|
|hist||DIS - Walt Disney Co.||1.07||106,000||$49.79|
|hist||MMM - 3M Co.||1.05||56,000||Reduce 3.45%||$92.86|
|hist||SON - Sonoco Products||1.01||168,000||Reduce 8.20%||$29.73|
|hist||BAX - Baxter International Inc.||0.97||72,000||Reduce 40.00%||$66.67|
|hist||ROST - Ross Stores||0.95||87,000||Buy||$54.15|
|hist||PEP - PepsiCo Inc.||0.93||67,000||$68.43|
|hist||MCD - McDonald's Corp.||0.93||52,000||Add 14.29%||$88.21|
|hist||ENTG - Entegris Inc.||0.91||490,000||Add 5.38%||$9.18|
|hist||ABM - ABM Industries||0.89||220,000||$19.95|
|hist||KFY - Korn/Ferry International||0.89||278,000||Reduce 11.18%||$15.86|
|hist||BLK - BlackRock Inc.||0.88||21,000||Reduce 38.24%||$206.71|
|hist||EBAY - eBay Inc.||0.86||83,000||Add 45.61%||$51.02|
|hist||APA - Apache Corp.||0.84||53,000||Add 6.00%||$78.51|
|hist||CRL - Charles River Labs||0.83||109,000||Buy||$37.47|
|hist||VFC - V.F. Corp.||0.82||27,000||Add 8.00%||$150.96|
|hist||BIG - Big Lots Inc.||0.81||140,000||Reduce 4.76%||$28.46|
|hist||MSCC - Microsemi Corp.||0.81||190,000||Reduce 13.64%||$21.04|
|hist||HBI - Hanesbrands Inc.||0.81||112,000||Reduce 17.04%||$35.82|
|hist||HSIC - Schein (Henry) Inc.||0.80||49,000||$80.47|
|hist||GPC - Genuine Parts||0.80||62,000||$63.58|
|hist||SLB - Schlumberger Ltd.||0.77||55,000||$69.29|
|hist||CB - Chubb Corp.||0.75||49,000||Reduce 24.62%||$75.33|
|hist||ACN - Accenture||0.75||56,000||Reduce 3.45%||$66.50|
|hist||MA - Mastercard Inc.||0.71||7,200||$491.25|
|hist||QCOM - QUALCOMM Inc.||0.68||54,000||$62.02|
|hist||KO - Coca Cola Co.||0.66||90,000||$36.26|
|hist||NKE - NIKE Inc.||0.64||61,000||$51.61|
|hist||VSH - Vishay Intertechnology||0.64||300,000||Buy||$10.63|
|hist||DLPH - Delphi Automotive plc||0.64||83,000||Buy||$38.25|
|hist||DE - Deere & Co.||0.63||36,000||$86.42|
|hist||SWHC - Smith & Wesson Hldg Corp.||0.59||347,000||Buy||$8.44|
|hist||XYL - Xylem Inc.||0.57||104,000||Buy||$27.10|
|hist||ALK - Alaska Air Group||0.57||65,000||Reduce 19.75%||$43.09|
|hist||HD - Home Depot||0.50||40,000||Reduce 13.04%||$61.85|
|hist||TJX - TJX Companies Inc.||0.50||58,000||$42.45|
|hist||PETM - PetSmart Inc.||0.48||35,000||$68.34|
|hist||SNA - Snap-On Inc.||0.48||30,000||Reduce 44.44%||$79.00|
|hist||HRL - Hormel Foods Corp.||0.37||58,000||$31.21|
|hist||CYN - City National Corp.||0.28||28,000||Buy||$49.54|
* Reported Price is the price of the security on the portfolio date. This value is significant in that it indicates the portfolio manager's confidence in the stock at that price and suggests at least some level of undervaluation and/or margin of safety.
Sector % analysis
Articles & Commentaries
Despite growing fears regarding the fiscal cliff and lingering doubts about the sluggish pace of economic recovery, the U. S. equity market proved a rewarding choice for investors in 2012. During the last quarter of the year, surprisingly good news regarding the U.S. employment and housing markets, combined with a greater measure of certainty following the Presidential election and an eleventh-hour deal (avoiding the drastic effects of the fiscal cliff), helped U.S. equity markets end the year on a strong note.
While doom, gloom and uncertainty dominated equity market sentiment for most of 2012, the overall economic picture continued to improve throughout the past year. We believe this deliberate progress should continue in 2013 and that signs of real stability, as evidenced by continued growth in employment, improvement in the housing market, increased corporate capital spending, and favorable consumer sentiment could propel equity markets past prerecession highs in 2013. On the negative side of the equation, we acknowledge ￼ that continued economic stagnation in Europe could cast a shadow over global equity markets in 2013, with scrutiny of debt problems in specific countries likely to cause spikes in downside market volatility during the year. In an environment where negative headlines and individual macro events can still trigger sharp volatility in market prices, we believe volatility is our friend.
OUR STRATEGY IN THE CURRENT ENVIRONMENT
We continue to believe that by taking advantage of market volatility and depressed equity prices to purchase strong companies with stable or growing free cash flow and management teams that have proven to be shrewd allocators of capital, investors have the potential to achieve above-average long- term returns. When downside volatility occurs, we will continue to apply our accounting based (looking behind the numbers) free cash flow value discipline to identify companies in which our calculation of intrinsic value materially deviates from current market prices and we believe the upside potential is far greater than the downside risk. On the other hand, when upside volatility results in market prices approaching or exceeding our calculation of intrinsic value and we believe the risk/reward ratio no longer warrants taking the risk of owning a particular equity, we will take our money off the table and hold cash. Our portfolio’s relative cash position is never a call on our belief as to the future direction of the stock market. Our cash position is determined by our ability or inability to discover undervalued equities and our reluctance to increase overall portfolio risk via an undue concentration in any one security. We have no rules with regard to the amount of cash we will hold if suitable undervalued investments are not identified. The market appreciation of the past 4 years has made our job more difficult to uncover materially undervalued securities, but as always, individual stocks often overreact to short-term events and/or news which can produce opportunities to discover undervalued securities possessing long-term appreciation potential (as long as an investor has patience for the clouds to clear).
Although consensus is still predicting slow economic growth and mid single digit market returns going forward, it is increasingly important for investors to find ways to benefit from equity returns as an asset class especially during this period of low fixed income returns and potential bond price risk should future inflation result in firming interest rates. More than four years after the onset of the Great Recession, company balance sheets are in excellent shape with many companies flush with cash and holding little to no, or rapidly decreasing, debt loads. A material number of companies in our portfolio have cash flow yields that are not only considerably higher than current government bond yields, but also have business models we understand and, in our opinion, have positive growth rates attached to them.
We continue to focus on how individual companies have adapted their expectations, strategic plans and operations to recent economic conditions and how they have managed their assets to deliver future earnings to investors. Our current portfolio consists of companies that we believe have discernible balance sheet strength, a sustainable competitive advantage, 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 recent negative market sentiment.
At December 31, 2012, the Olstein All Cap Value Fund portfolio consisted of 88 holdings with an average weighted market capitalization of $44.91 billion.
RISK IN 2013: IN THE ‘NOW’ AND OUT OF THE MARKET?
With the onset of the Great Recession, investors fled equity markets seeking safety in cash and fixed income investments. A great many of these investors, in the interest of preserving capital, have remained sidelined even though equity markets have rebounded strongly from the lows of 2008 and 2009. In fact, from its March 9, 2009 low through December 31, 2012, the benchmark S&P 500® Index has posted a total return of more than 100%, with many value funds increasing by an even larger percentage. Yet, despite this strong performance, a significant number of investors remain on the sidelines immobilized by doom-filled headlines and afraid of a repeat of 2008.
From our perspective, the primary driver of equity market growth since the global financial crisis and market lows of 2008 and 2009 has been an aggressive easy monetary policy in order to jump start the economy and reduce unemployment. It has been the government’s stated objective to keep interest rates as low as possible for as long as possible. In our opinion, the current approach to monetary policy holds real risk for investors who are “in the now” and out of the market, that is, those investors who have sharply increased their holdings in bonds and cash and have decreased their holdings of common stocks. At some point, the aggressive monetary policy of the past four years is likely to trigger an increase in inflation that could negatively impact the value of fixed income and cash holdings. In fact, we believe that counter to past market cycles, an increase in interest rates from these abnormally low levels would be indicative of an increase in economic growth and be bullish for equity returns and bearish for bond returns.
At this stage of the economic recovery, we believe investors should prepare for the long-term effects of the current low-interest rate monetary policy and seek ways to improve investment returns in a low-growth environment. The real possibility of increased inflation combined with the realities of investing in a low-growth economic environment should compel investors to find ways to benefit from both productivity growth and capital appreciation in their portfolios. While many investors are nervous about equity markets or remain sidelined waiting for robust improvement in the economy, we believe there is a strong case for investing in the equity securities of companies whose real economic value is unrecognized by the market, obscured by market uncertainty or overshadowed by temporary problems. We believe our free cash flow accounting-based investment discipline of looking behind the numbers of individual companies to identify undervalued securities has a decided advantage in the current market environment.
While we attribute much of the current under-exposure in equities to macro- economic concerns and doom and gloom scenarios by most investors and the press, we prefer to focus on the undervalued securities of good companies with strong balance sheets and unique business models that generate (or have significant potential to generate) sustainable free cash flow. In addition, we prefer management teams that are deploying their cash balances to either grow through value-added capital expenditures or return excess cash to shareholders through dividends or stock buybacks.
We also believe it is important to identify those companies that not only have correctly focused their priorities in the face of a fragile economic recovery but have also identified options that have created a substantial strategic advantage for what we believe is an eventual inevitable acceleration of economic growth. As we have stated many times, the Fund focuses on a company’s ability to generate normalized free cash flow as the primary determinant of value. In particular, companies that continue to thrive in a challenging or stagnant economic environment eventually draw the favorable attention of investors.
Above-average long-term returns are generated by paying attention to the cash return an investor can expect from owning a share of a business and whether or not the potential return has enough of a premium (to the risk free rate) to compensate an investor for the risks of the company’s business model and to correctly predict its ability to produce normalized free cash flow. Assessing the adequacy of the cash flow return is of greater importance during an uneven economic recovery especially during a time when investors are being told, often quite loudly, to avoid equities and seek safer opportunities. We believe such times have the potential to set up significant above-average long-term investment returns.
Forbes Interview with Eric Heyman of Olstein Strategic Opportunities Fund
Olstein Funds' CEO Bob Olstein talks about the stock market and his investment strategy.
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 9˝ 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.
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.
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.
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.
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
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.
Olstein Capital’s Robert Olstein and Eric Heyman explain where they look first for insight in financial statements, why they started an activist-focused fund, why they’re happy that fundamental value investing isn’t particularly in vogue, and why they believe Sealed Air, Harman International, Dr Pepper Snapple, Intel and Checkpoint Systems are mispriced.
Robert Olstein, chairman of Olstein Capital Management LP, talks about the U.S. stock market, fund holdings and growth opportunities for Harman International Industries Inc.
While the global economy continues to struggle with serious structural problems rooted in the debt build-up that triggered the Great Recession, we believe the investment landscape is not all gloom and doom. At this stage of the economic recovery, we believe investors can find some relief and opportunities in greatly improved corporate financial performance. More than three years from the onset of the Great Recession, most corporate balance sheets are in excellent shape and we have been able to identify many companies flush with cash and holding little to no, or rapidly decreasing, debt loads.
At the same time, we have also identified companies whose cash flow yields, earnings yields, and dividend yields are considerably higher than current government ten-year bond yields. It is also important to realize that the companies and business models behind these yields have growth rates attached to them. We believe the focus in 2012 will shift to how companies are deploying their record cash balances to either grow through value-added capital expenditures or thoughtful M&A activity or return excess cash to shareholders through dividends or stock buybacks.
At this stage of the economic recovery, we believe many analysts, investors and the press remain too focused on short-term factors that may not be relevant to long-term company valuations. The extreme price volatility currently affecting the markets has resulted in a crisis of confidence as to whether or not underlying company fundamentals (operations) will have any relationship to market pricing. Wall Street’s obsessive focus on short-term concerns has created many opportunities for the Fund to take advantage of increasing deviations between stock prices and our estimate of a company’s intrinsic value. Investors reacting to the daily noise and news have created opportunities to buy companies with solid balance sheets and business models that generate excess cash flow even in tough economic times at bargain prices. We believe that 2012 will be characterized by greater investor willingness to identify and invest in companies that have an ability to deliver long-term value to their shareholders that, in many cases, is not currently being recognized by the market.
We continue to focus on how individual companies have adapted their expectations, strategic plans and operations to recent bumpy economic conditions and how they have managed their assets to deliver future earnings to investors. 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 compared to potential returns and deploys free cash flow to create shareholder value. We believe that as the economic recovery eventually accelerates, companies with the aforementioned characteristics are poised to eliminate the valuation gaps created by the recent recession, continuing liquidity concerns, and overall investor negativity.
At December 31, 2011, the Olstein All Cap Value Fund portfolio consisted of 76 holdings with an average weighted market capitalization of $ 50.13 billion. During the reporting period, the Fund initiated positions in eleven companies and strategically added to positions in fifteen companies. Over the same time period, the Fund eliminated its holdings in eleven companies and strategically decreased its holdings in another fourteen companies. Positions initiated during the last six months include: Apache Corp., Atmel Corp., Cliff Natural Resources, Inc., Freeport McMoran Copper & Gold, General Electric Company, Hewlett Packard, Korn/Ferry International, Schlumberger Ltd., Snap-On Inc., Staples, Inc., and U.S. Bancorp. Positions eliminated during the past six months include: Adobe Systems, Inc., AllianceBernstein Holding L.P., W.R. Berkley Corp., Cintas Corp., Hanover Insurance Group, MasterCard Inc., Oshkosh Truck Corp., Proctor & Gamble, Quest Diagnostics, Inc., Rockwell Collins, Inc., and Whirlpool Corp.
Despite all the turbulence in 2011, the Fund’s 3-year average annual return as of January 31, 2012 was 21.13%. However, throughout the year, we continued to read and hear from our shareholders on how bad markets were. Liquidations in equity mutual funds continued throughout the past three year period (mostly at the wrong time) despite the overall positive three year period.
As always, the flames were fanned by the press accentuating the negatives in their daily coverage of the European sovereign debt crisis by comparing the crisis to the 2008 leverage and liquidity crash. The 2011 market was characterized by high volatility which was exacerbated by high frequency traders who are in and out of markets in milliseconds reacting to the events of the day. In most cases, the daily news-driven volatility had little to do with the underlying company’s long-term normalized ability to generate excess cash flow (which eventually determines intrinsic values). The volatility created a lack of confidence as to whether or not company fundamentals had any relationship to long-term market pricing, resulting in a reduction of time horizons over which Wall Street was willing to put their neck on the line, fearing extreme reaction to short term events. Rather than relying on discussing a company’s normalized ability to produce free cash flow over two to three year periods to determine a company’s valuation, Wall Street was focusing on talking about quarterly misses and beats, buying and selling before and after quarterly earnings releases and three day to three month price targets. Investors have reacted to the day-to-day gyrations of the overall market by reducing or selling their equity positions or have remained sidelined from the market out of fear of short-term price movements, especially down ones. In today’s environment, we believe it is critical that investors understand the difference between price volatility and the risk of permanent loss of capital. We believe that it is important to understand how the Fund evaluates a company’s business risk and assesses the probability of a permanent loss of capital (based on comparing our intrinsic value calculations derived from company fundamentals to market prices) rather than focusing on market volatility based on current events as the investment masses are.
Before investing in equity securities or determining the level of commitment to equities in a broader portfolio of investments, an investor must first assess his or her level of risk tolerance — that is, the ability to absorb a permanent loss of capital. To paraphrase value-investing legend Benjamin Graham, “the fact that a decline in the price of a security may occur does not mean the investor is running a true risk of loss.” As Graham points out, the concept of risk should apply only to a loss which is realized through an actual sale of a security or a permanent loss of capital due to a significant deterioration in a company’s financial position or fundamental operations. Graham also points out that a permanent impairment of capital may, more frequently, be due to an investor paying substantially more for a security than its intrinsic worth. “Olstein’s” modus operandi is to pay attention to price, price, price (relative to intrinsic value) before purchasing a security. Good companies can be bad investments if purchased at the wrong price.
Since every equity investment may not perform as expected, an investor must consider whether his or her financial and psychological condition allow the riding out of a market downturn or the falling price of an equity security without engaging in panic selling. Complicating an investor’s ability to determine his or her true level of risk tolerance is the widespread emphasis that many institutional investors, hedge funds (the so-called “smart money crowd”), financial advisors, and the media place on avoiding volatility – that is, the short-term up and down movements in overall market levels or in the price of a security. As a result of this emphasis on avoiding short-term volatility, investors have become more focused on short-term price movements. Risk management has become an exercise in reducing the impact of short-term price movements, especially downward price movements, on a portfolio’s current value. Unfortunately, most methods utilized to avoid volatility involves derivatives and/or leverage which can be lethal when extraordinary events occur (e.g., Long Term Capital collapse in 1998).
The long-term value investor attempts to capitalize on market volatility by buying stocks at bargain prices created by short-term issues that are either cyclical in nature, the result of short-term problems, the reaction to negative market psychology or just plain investor misperception. We are not particularly concerned as to whether or not the Fund’s recent purchases are currently underperforming the market or may continue to underperform for the next quarter. Of more importance to the Fund is whether or not the sustainability of a company’s ability to generate free cash flow buoys our conviction to ride out periods of underperformance during which our stocks are working through what we believe are temporary problems. If there is no negativity or misperception surrounding a stock, what would create the bargain (deviation between market price and intrinsic value) we perceive? When managing the risk of the Fund’s portfolio, we concern ourselves with the probability of loss over three to five year periods, not short term price fluctuations or volatility. We manage the overall risk on a stock-by-stock basis as we build the portfolio. First and foremost, we seek to mitigate risk by buying stocks at prices which, in our opinion, have a low probability two years later of selling for a price which is 20% lower than the price we are currently paying. Thus, we attempt to reduce such downside risk by purchasing companies at prices which we believe already incorporate the belief by the investing public that he short term negativity currently affecting the company should continue for a long period of time or “forever”. However, it is important to note that the Fund could experience a permanent loss of capital in a stock if the circumstances leading to the current undervaluation and underperformance turn out to be longer lasting or more permanent than anticipated (we usually expect a turnaround to occur within two years). More importantly, since our process seeks to accurately estimate sustainable future free cash flows, we are always concerned that our estimates are too optimistic and thus our valuations three to five years hence become unrealistic. When it becomes apparent that our estimates of a company’s normalized ability to produce future free cash flow is wrong (and unfortunately we are wrong a certain percentage of the time), reducing our estimated intrinsic value to a level that no longer offers enough appreciation to take the risk of owning the stock, the stock is sold. To mitigate the impact of incorrect valuations or investing in a classic “value trap,” we seek to buy companies selling at a significant discount to our determination of their intrinsic value. By buying companies at a 30% or greater discount to our determination of their intrinsic value, we seek to mitigate the effects of additional price deterioration when we are wrong.
Instead of focusing on short-term price movements of a company’s common stock, we develop a thorough understanding of company operations, its strategy and the effectiveness of its management team (as stewards of the company’s capital). If a company was privately owned and had no public market price, the owners would not be assessing the value of the business on a daily, monthly or quarterly basis. Owners of commercial enterprises assess risk on the basis of losing money on operations, not as to whether or not they would be forced to sell a company at an inopportune time.
Olstein believes that intrinsic risk is determined by a company’s financial strength, its ability to produce excess cash flow, the quality of earnings (balance sheet strength and the reality of the financial statements portrayal of company fundamentals) and our confidence in the predictability of future excess cash flow based on a company’s unique business fundamentals. We judge portfolio risk on a stock by stock basis. We could care less about conventional measurements of risk (such as Beta-volatility) but care a lot about the probability that an individual stock could lose more than 20% of its value over three to five year periods (permanent loss of capital as opposed to temporary loss).
Our analysis of a company and the risk we believe that we are taking focuses on how its operations generate sustainable free cash flow; the level of ongoing investment required to maintain and/or grow free cash flow and ultimately, how much of the company’s free cash flow is available to us as investors and not stock volatility. Through a forensic analysis of a company’s financial statements, public filings and the footnotes contained therein we deepen our understanding of a company and its potential risks by assessing the quality of its earnings, the success of its strategy, the sustainability of its performance and impact of its management’s decisions on future free cash flow.
We do not have the capability of controlling what the public perceives at any point in time. Perceptions of the investment masses, whether right or wrong, control both market volatility and individual stock volatility. Misperceptions sometimes last longer and create value deviations that are deeper than we expect. However, we are responsible for assessing a company’s business operations, balance sheets and management capabilities; comparing a company’s progress against our estimates of future normalized cash flow (determines a company’s value); and making the necessary adjustments. If the value deviation widens, we buy more and as the deviation narrows we lower our commitment.
Thus Olstein does not define risk according to the volatility of the stock as we have little control over investment perceptions of the masses. As previously stated, we seek to take advantage of downside volatility by buying when we think the price action has little to do with long-term fundamentals. We also sell or reduce positions as valuation gaps narrow or unjustified optimism sets in.
Two stocks in our current portfolio exemplifying our long term philosophy are Sealed Air Corporation (SEE) and Intel Corporation (INTC).
Sealed Air manufacturers specialty packaging such as bubble wrap as well as packaging equipment. The company acquired Diversey Holdings, a global provider of solutions to the cleaning and sanitation market. Although the acquisition should be cash flow accretive during the first years, the market reacted negatively to the debt needed to acquire Diversey and forecast that first year earnings would be dilutive and down because of non-cash amortization charges. Diversey sells its products into the same markets as Sealed Air, which presents material cross selling opportunities. At $28.00 a share, we could understand the negativity but at the current price of $17.21 a share (as of December 31, 2011), we believe that the benefit to future earnings is not being recognized.
A December research report on Sealed Air seemed to be caught up in the short term negativity surrounding the Diversey acquisition without any recognition given to the analyst’s own predictions or the precipitous drop in the stock price. The analyst seemed indifferent toward Sealed Air because earnings would not take off for a few years. His target price was $18 a share based on earnings that would stagnate at $1.75 a share for the next few years. However, at the same time, the analyst projected earnings of $2.60 a share for 2013. We agree that SEE has to prove that the acquisition will benefit shareholders, but if the analyst is correct about 2013 earnings of $ 2.60 a share, we believe that the stock is ridiculously cheap at $17.00. It is significant to note that we believe that buying negativity already built into a stock has the potential to limit downside risk.
Another example of obsessing on short term problems rather than long-term values is Intel Corporation (INTC) currently selling at $24.25 as of December 31, 2011, or ten times expected analysts’ earnings, with a dividend yield of 3.5% and a cap ex and research budget of $15 billion, a major portion of which is aimed at rectifying its lack of product in the growing smart phone and tablet market.
At the same time that analysts are dissing Intel, they are recommending ARM Holdings, a rapidly growing chip development company selling at 60 times estimated earnings because of the dominance of its chips in the smart phone market. To us, ARM represents a stock priced to perfection. There is even chatter that ARM will take market share from Intel in personal computers and servers. A December research report on the ARM/Intel debate ignored the fact that Intel has already committed billions of dollars to become a meaningful participant in the markets in which ARM is enjoying success.
It was only in July that analysts were predicting that Intel’s earnings would peak at $2.00 a share and fall below that number going forward. As of December, even the negative Intel reports, which were concluding that the stock is fully valued at $25.00 a share, were raising their estimates to $2.50-$2.75 a share for 2012. Little credit is being given to the fact that INTC’s more expensive chips, which go into servers, are the backbone of the smart phone and tablet market and their sales are correlated to the number of smart phones in use.
We therefore are confused as to why analysts are not concerned by the high price/earnings ratio of ARM when Intel is going after them with a hydrogen bomb as opposed to a pistol. We are putting our money on Intel, but if we are wrong, we believe that the current negativity surrounding the company in combination with a low price/earnings ratio and protected high dividend yield should limit the downside. It is possible that ARM (an outstanding company) may continue to grow at above-average rates for a long period of time but watch out below if there are some disappointments along the way.
We believe that our methodology, which attempts to avoid long-term impairment of capital and does not react to short-term volatility or events (other than seek to take advantage of these events), penalizes investors with short-term horizons while providing our shareholders with 3 to 5 year time horizons with the potential to realize above-average long-term returns. A long-term investor does not lose money because the stock price of their holdings experience short-term price movements and temporarily decline. The chance of downside fluctuations are present in all securities and spending time analyzing these monthly swings or attempting to minimize these swings by giving up potential positive future long-term returns in our opinion is a poor use of time and capital. As previously stated, it is our opinion that short-term price fluctuations have little to do with the measurement of risk if one’s investment horizon is three years or more. It is our opinion that an astute investor should focus on understanding a business and its potential to generate sustainable free cash flow, which ultimately determines its value. After identifying companies that meet well-defined investment criteria, we believe that an investor should then take advantage of market volatility and downward price movements to buy such companies at advantageous prices that increase the chance of a long-term successful investment.
Robert Olstein, chairman and chief investment officer of Olstein Capital Management in Purchase, N.Y., studies the relationship between companies’ capital expenditures and depreciation expenses, looking for instances in which the two deviate long-term. Olstein says he tries to gauge “whether the depreciation as reported to shareholders is overstating or understating cash earnings”...
At the present time, despite the fact that there are clear signs of economic improvement, many potential equity investors remain sidelined by the drastic shock of the 2008 financial meltdown, the resultant market crash and the cloud created by the persistent high level of unemployment. The pessimism of these sidelined investors has prevented many from participating in the mar- ket’s gains over the past 18 months and investors are still understandably influenced by the dire results of the 2008 markets and future predictions of high unemployment.
However, despite the proverbial “wall of worry” that is currently necessary for the equity markets to climb; we believe that the major determinants of future equity returns are expectations of corporate earnings and consumer confi- dence. It is our opinion that consumer confidence is heavily influenced by expectations about the stability and future direction of employment. A grow- ing sense that the overall economy is improving and creating jobs in 2011 should help consumers feel more secure resulting in increased consumer spending, which accounts for approximately 70% of the U.S. economy. It is important to note, that although consumer confidence remains well below pre-recession levels, the Consumer Confidence Index is at its highest level since November 2008.
Investors who sought safety after the 2008 market collapse by investing in bond funds have begun to lose their safety net. A recent increase in ten-year U.S. treasury interest rates has resulted in capital losses for many bond investors over the last 90 days and investors have begun, albeit so far at a low level, to reverse a three-year trend by switching to equities. Furthermore, we believe a third consecutive year of higher equity returns should restore greater confidence in equity markets and eventually result in material amounts of money currently sitting in money market accounts and low yielding short- term treasuries (our estimate is at least $6 trillion) returning to equity mar- kets. For all of these reasons, we see a favorable stock market environment going forward with the usual corrections along the way. However, we believe investment success will not be indiscriminate and should favor investors who can differentiate between intrinsic company valuations based on free cash flow and current market prices, which are heavily influenced by short-term thinking. In essence, we believe that investors who analyze and interpret financial statements in order to select companies whose intrinsic long-term values are not being properly recognized by the markets (usually as a result of over emphasizing short-term factors or just plain misperceptions) will be amply rewarded over the foreseeable future.
The characteristics we sought out in the companies that currently constitute our portfolio and that we believe provide our portfolio with the potential to generate above average returns in 2011 and going forward include:
1 Large stockpiles of excess cash
2 Business models with a high probability of generating continuing amounts of future excess cash flow
3 Current market prices rooted in some negativity about the company, industry or just plain investor misperception, which result in high current excess free cash flow yields
4 Spending excess cash flow to increase dividends
5 Spending excess cash flow to buy back stock
6 Spending excess cash flow to make strategic acquisitions
7 Spending excess cash flow on growth (future sales expansion) and effi- ciency (improving margins) via higher expenditures on capital projects, research and development, advertising, marketing, etc.
The current attitude reminds me of the negative psychology that persisted in late 1974. Throughout 1974, pessimism dominated investor thoughts and headlines as a severe and prolonged 18-month bear market dragged on and on. With 20/20 hindsight, the final months of 1974 represented a major opportunity to invest in a portfolio of undervalued stocks as the market was going through a bottoming process leading to an eventual upturn in 1975. We believe equities may offer a more compelling investment opportunity for investors today than in 1974. While P/E ratios in 1974 fell to lows of approximately 7 times earnings compared to today’s level of 10 times forward earnings, back in 1974 investors had a viable alternative to equities as 10-year U.S. Treasuries were yielding close to 8%. In today’s environment, however, investments in 10-year U.S. Treasuries are yielding less than 3% and may also be vulnerable to capital losses if the economy strengthens and interest rates rise.
In addition to low P/E ratios, one of the most important factors influencing our outlook for equities over the next 18 to 24 months is the number of high quality companies that fall within our current cash flow yield target of 8% to 10% or greater. With almost $3 trillion currently sitting in money market accounts earning almost zero interest, and at least that same amount, we estimate, in 2-year or shorter duration Treasury securities earning less than 1%, investors should eventually realize that despite negative economic news, investments in companies with cash flow yields of 10% represent an attractive alternative to bonds.
Although overall market returns may be in low single digits or flat for the foreseeable future, prices of many companies have been driven down to levels that we believe offer attractive returns even in a low growth economy. In this regard we believe that the best way to identify superior investment opportunities in an uncertain market is to focus on a company’s ability to generate sustainable free cash flow.
For us, one of the most important metrics for identifying companies that can generate sustainable free cash flow is free cash flow yield. In simple terms free cash flow yield is a company’s total free cash flow divided by its market capitalization (or its free cash flow per share divided by its price per share). More importantly, 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 free cash flow yield provides a practical starting point to estimate expected future returns. We believe that a company with a free cash flow yield well above the risk-free rate of return (three-year and five-year U.S. Treasuries are currently providing yields of 0.75% and 1.50%, respectively; Source: Bloomberg, 8/6/2010), combined with a demonstrated ability either to reinvest excess cash at higher rates of return than the risk free rate or to use that cash to enhance shareholder value, should prove to be a superior, high-quality investment over time.
We expect that over the next year interest rates should start to firm, company earnings should continue to move to the upside with the usual bumps along the way and the economic outlook should continue to improve. Individual stock prices should ebb and flow as quarterly earnings are reported in reaction to the absurd quarterly earnings hit and miss game played by Wall Street analysts which we believe has little to do with long-term valuations. Remember, when companies’ earnings disappoint analysts it is usually the analysts who are wrong, not the companies as it is the analysts estimates. Once investors have concrete evidence that the economic environment has changed, investors will slowly return to equity markets. We believe that as investors re-enter the market, companies that generate sustainable free cash flow and use that cash to benefit shareholders, should capture the attention of equity investors and lead overall market performance.
As the pessimism from the recent recession continues to dominate the investment landscape, investors are slow to adapt to change and believe their most recent experience will repeat forever and act accordingly. Before adapting their investment decisions, investors need concrete and indisputable evidence that the environment has changed Investors are slow to eliminate their most recent experience.
Investors are afraid to commit funds withdrawn from the market during the most recent crash (most of the funds were withdrawn late in the downturn at significant losses) fearing a repeat performance even though there is tangible evidence that business has begun to turn around. Investors should always remember that the market is a discounting mechanism and, as such, is anticipating the future not reacting to what is.
We are buying 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 the aforementioned characteristics are poised to eliminate their valuation gaps created by the recent bear market as the economic recovery eventually accelerates.
Bruce Greenwald, professor of finance and asset management at Columbia Business School, Robert Olstein, chairman of Olstein Capital Management LP, Thomas Russo, a partner at Gardner Russo & Gardner, and David Winters, chief executive officer of Wintergreen Advisers LLC, participate in a panel discussion on value investing. Bloomberg's Betty Liu moderates the event which took place at Columbia Business School in New York...
As stability and/or early signs of recovery unfolded in global markets during the second half of 2009, institutional equity investors began to adopt cautious optimism by spending some of their cash, which resulted in significantly improved market performance off the low of March 9, 2009. Yet despite this rebound, many investors (especially individuals) remain nervous about the prospect of slower economic growth, and continue hoarding their money in short-term U.S. Treasuries and money market funds leading the general public and press to conclude that there is a damper on future equity market returns. Questions about the strength and pace of economic recovery are likely to dominate the first half of 2010 as investors seek objective proof that we have permanently turned the corner before committing safe short-term funds to equities driving positive market returns.
Like many investors, we have seen two schools of thought dominate most of the 2010 market outlook discussion. The more constrained school of thought, often referred to as the “new normal”, predicts a prolonged period of subdued single-digit annual returns for U.S. equity markets, rooted in a slow economic recovery constrained by historically high levels of unemployment. Conversely, there is a more optimistic school of thought that predicts a faster and more vigorous recovery driven, in large part, by pent-up demand, depleted inventories and over-extended replacement cycles. While we recognize merit in both of these scenarios, we believe a singular emphasis on either argument fails to provide the necessary focus for developing an optimal portfolio strategy in 2010.
While both of these schools of thought rely heavily on the presence or absence of bullish sentiment to drive or restrain overall market growth, we continue to focus on how individual companies have adapted their expectations and operations to unfavorable market conditions and how they have managed their assets during the downturn. This information helps us evaluate whether a company has increased the probability of delivering future earnings to investors. It is our opinion that companies that have discernible balance sheet strength, operating flexibility, a sustainable competitive advantage and management teams who weigh cost of capital versus potential returns on investment before making decisions, have a higher probability of outperforming when the economic recovery takes hold. Another important factor we look for in potential stock market leading companies is a history of developing free cash flow to create shareholder value.
While pundits and forecasters may argue about the speed and strength of economic recovery in the United States in 2010, we believe two other factors are likely to take center stage this year. First, it is our opinion that portfolios emphasizing companies having material non-U.S. revenue sources have a higher probability of growing earnings faster than pure domestic companies. Second, we believe that valuations in 2010 and future years will be based on demonstrable free cash flow, rather than unrealistic expectations of future growth prospects.
Our prior letters described that immediately following the collapse of Lehman Brothers in September 2008, we drastically reshaped the Fund’s portfolio and were able to buy at favorable prices many core positions in high quality, strongly capitalized companies (e.g. Microsoft, Coca Cola, Kimberly Clark, Intel, etc.) with wide moat business models and long histories of success and integrity. At the time we acquired these high quality companies with extremely liquid balance sheets, they were selling at unprecedented low multiples of free cash flow, and in certain cases, were selling at prices that were lower than a decade prior.
We not only believe in the defensive posture of such well-capitalized companies, but also believe that their extensive global operations should provide an additional edge to future earnings growth going forward. Our forecast is that non-U.S. economic growth may exceed U.S. GDP growth in 2010 and future years. As of December 31, 2009, twenty four companies, representing 30% of the Fund’s total equity investments, have a market capitalization greater than $25 billion. For these twenty four companies, non-U.S. revenues range from 10% to 94% of total revenues with a collective average of 52% of company revenues derived from non-U.S. operations. For companies with extensive global operations, corporate profit growth could well exceed U.S. GDP growth, especially if significant earnings come from economies that have weathered the downturn well and are likely to bounce back stronger and faster than the U.S. economy.
As previously stated, in addition to the growth potential of mega- and large-cap U.S. companies with global operations, we also believe that as the economic recovery unfolds in 2010, a company’s ability to deliver sustainable free cash flow will drive its stock price instead of speculation about its growth prospects. While P/E multiple expansion accounted for a significant portion of equity returns during the last bull market, we believe that dividends and stable free cash flow are likely to account for the bulk of stock market returns for the foreseeable future. We expect strong, well-run companies will experience more modest earnings growth than in the past. We expect stock market leaders to experience growth rates of 3% to 5% per year versus the 10% to 15% growth rates that investors sought during the previous bull markets. Although lower growth rates going forward may reduce past price earnings ratios, we believe companies that can grow yearly cash flow at 3% to 5% growth rates are going to be the market leaders. The growth companies going forward are going to sell at lower multiples than the 20+ multiples experienced in recent bull markets as a result of the lower growth rates we are predicting. However, once the market adjusts and sorts out the new leaders, price earnings ratios of these new low growth companies should expand from the current 15 times multiples to the 17-18 range. The sector bets of the 2003-2007 bull market are going to be replaced by sustainable low growth free cash flow companies with solid balance sheets. Investors who pay fully-valued prices for established companies expecting double digit growth rates could be disappointed in their future returns.
As John Bogle commented in an op-ed that recently appeared in The Wall Street Journal (January 19, 2010), over the past thirty years “the folly of short-term speculation has replaced the wisdom of long-term investing as the star of capitalism. A ‘rent-a-stock’ system has replaced the earlier ‘own-a-stock’ system. The result – the momentary illusion of the price of a stock took center stage, replacing the enduring reality of the company’s intrinsic value – the discounted value of its future cash flow.” An important tenet of our investment philosophy is the belief that companies that produce excess cash flow after capital expenditures and working capital needs are the companies that build meaningful shareholder value over time by either delivering that free cash flow to investors in the form of dividends or by intelligently re-investing free cash flow into the business to increase the value of shareholder’s equity. We believe that when the reality of the 2010 economic recovery takes hold, investors should place a greater emphasis on analyzing how a company’s operations generate sustainable free cash flow; and determining how much of that free cash flow is, or might be, available to investors.
Some of the widest gulfs between earnings and cash flows, Mr. Olstein said, are showing up the ways companies account for capital ex- penditures. To ensure growth, companies invest in things like new facilities or additional equipment. As time goes on, plants and equipment lose value — the way a car does the moment you drive it away from the dealer — and companies are allowed to write off a portion of these values each year based on management estimates of how long they will generate revenue.
The write-offs are known as depreciation, and the more a company chooses to write off, the greater its earnings are reduced. So managers interested in plumping their profits may depreciate less than they otherwise would or should. Conversely, heavy depreciation amounts can make earnings appear more depressed than the company’s
cash flows indicate.
“It’s an investor’s job to determine the economic realism of management’s assumptions,” Mr. Olstein said. “There is nothing illegal here, but maybe their depreciation assumptions are unrealistic.” One way to assess the accuracy of management’s estimates is to compare, over time, how much a company spends on new plant and equipment and how much it deducts in depreciation each year. Some of the discrepancies that emerge can be temporary, caused by the lag time between an initial invest- ment and subsequent write-downs for depreciation.
Companies in a growth phase, for instance, will show greater capital expenditures than depreciation as they increase investments in plant and equipment.
But that should be only temporary. If such discrepancies appear on a company’s books year in and out, then investors might well question the depreciation assumptions. Investors confronted by large disparities should discount those companies’ earnings by the amount of excess capital expenditures. Such an ex- ercise reveals how much free cash flow is available to stockholders.
Conversely, if depreciation exceeds capital expenditures, Mr. Olstein says that the earnings at these companies are actually better than they appear — and that this shows up in the cash flows.
We believe that the stock market bottom which was reached on March 9, 2009 following a long market slide that began in the fourth quarter of 2007, should not be breached as there are many signs that the current recession is in the process of bottoming. Yet despite cautious optimism about the economy, we also believe it is going to take several years to get back to the market highs reached in 2007 since we expect the economic turnaround to be measured and slow over the next few years.
The worldwide coordinated stimulus has planted the seeds for an economic turnaround which we expect should begin later in the year. As has happened many times in the past, the market has begun to anticipate an economic turnaround, as reflected in recent market performance. Although market returns going forward should be more subdued than during the 2003-2007 period, we believe the current market offers the potential for high single-digit or low double-digit returns from current levels (based on our future expectations for earnings and interest rates), which compares quite favorably to the alternatives in low-yielding treasury bills and money market accounts. Although the large amounts of fiscal stimulus and budget deficits around the world have also triggered serious inflation fears, we do not believe such concerns are warranted at the present time. The large amounts of excess labor and industrial capacity in combination with wage cuts must recede before we become concerned about future inflation. We do not think inflation is a serious concern over the next two years.
It is our belief that current opportunities in equity markets offer a favorable time to begin pursuing these longer-term investment goals. Investors who have recently been burned, or have exited the market, usually express a desire to wait until “markets look better” before re-investing or increasing their commitment to equities. In essence, however, this sentiment reveals a hidden belief that one can “time” the market. We strongly believe the most attempts to time the market regarding “buy” and “sell” decisions interfere with the longterm goals and objectives of equity investing. Attempts to time the stock market require two decisions: when to sell and when to get back in. Unfortunately, most investors get one or both of these decisions wrong and such wrong decisions can lead to compounded errors that result in a pattern of buying closer to market tops and selling near bottoms - a strategy which usually produces disappointing long-term returns. Historically, the majority of market gains have occurred in short-term spurts rather than being evenly spread throughout the year, thus necessitating a consistent percentage allocation to equities in lieu of intervals “in” or “out” of the market. There have been many studies published over the past 40 years demonstrating that the failure to be in the market in just a few of the best days each year can wipe out the long-term objectives of equity investing. These studies indicate why the odds are so poor in attempting to time markets over long periods of time in order to profit there from. During my 43 year career, I have seen many attempts by all kinds of gurus (who have established credibility in the short run by making prescient market calls) to time the markets over extended periods of time based on proprietary formulas which were predicted to produce above average profits for its followers. In my experience, all attempts to time markets with any degree of consistency over long periods of time in order to produce profits, eventually failed. Rather then succumb to the desires of the mass of investors to time markets; we believe it is our mission to find securities to buy that we believe have the ability to either outperform the market or at the very least capture the positive market returns that have been generated over long periods of time. It is significant to note that these positive stock market returns have been generated despite the intermittent bear markets and corrections that occur from time to time.
...many of the sophisticated strategies developed by Wall Street to control short-term volatility, in an attempt to allay investors’ fear of risk, actually subject the investor to additional risks that may be of a greater magnitude than the risks associated with the short-term volatility the investor sought to avoid!
...the current climate, created by abnormal and temporary conditions, and characterized by low stock prices, should result in higher future rates of return. The credit crisis will end and the housing market will stabilize, but no one will ring the bell to alert investors to these positive developments. The market is a discounting mechanism. 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 volatile and extremely emotional down markets in 1998 and 2002. The bottom of a bear market by definition is the point of collective maximum negative sentiment and activity. We have never figured out a method of predicting a market bottom, but we can say that the negativity at the current juncture is at extreme levels. As value investors, we believe in having a long-term horizon in an environment that is maniacally focused on short-term events...