04 Mar 2013 Olstein Value Fund - Q4 2012 Commentary ( Portfolio )
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.