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Strategic in Corporate Turnarounds
Olstein Strategic Opportunities Fund
Interview with: Eric R. Heyman

Author: Ticker Magazine
Last Update: Mar 09, 8:35 AM ET
Investors tend to punish first and ask questions later as soon as small-cap stocks stumble. However, these smaller companies can overcome temporary problems and regain their growth profile if management stays focused on building the business. Eric R. Heyman, portfolio manager of the Olstein Strategic Opportunities Fund, is a patient investor looking for long-term turnaround investment opportunities.

“We believe equity markets tend to overreact and sharply penalize small- to mid-size companies that encounter problems or stumble in the face of Wall Street’s unrelenting expectations for constant growth. The market’s short-term reaction to such situations often creates compelling investment opportunities for the long-term value investor.”
Q: What is the history and mission of the fund?

A: Over its 10-year history, the Olstein Strategic Opportunities Fund has emphasized investments in turnaround situations, where companies face unique strategic challenges. We believe equity markets tend to overreact and sharply penalize small- to mid-size companies that encounter problems or stumble in the face of Wall Street’s unrelenting expectations for constant growth. The market’s short-term reaction to such situations often creates compelling investment opportunities for the long-term value investor.

Q: How is the fund different from its peers?

A: Our fund is different in two ways. First, while most investors tend to think of the fastest growing companies, like a Google or a Facebook, we focus on finding value in companies facing temporary problems or in need of operational turnarounds.

The second differentiator is our focus on the quality of earnings. Our investment process seeks to add value primarily through a bottom-up security selection process. We believe that a forensic analysis of a company’s financial statements—a full understanding of the balance sheet, income statement and regulatory filings and their footnotes—is the best way to understand the quality of its earnings, the success of its strategy, the sustainability of what it is trying to accomplish, and the impact of management’s decisions on cash flows.

We believe that is more useful than management’s forecasts, earnings guidance or personal visits. We think our focus on a company’s ability to generate free cash flow allows us to identify many investment opportunities that are overlooked by the market.

Q: What core principles guide your investment philosophy?

A: We are value investors. So we believe in the logic of buying the common stocks of good businesses at material discounts to their intrinsic value. Our universe of investable stocks includes good companies that are facing adverse competitive, industry or economic issues, or companies that have temporarily faltered and have been, in our opinion, overly punished by the market.

Wall Street exerts considerable pressure, especially on small companies, to meet short-term earnings expectations on a quarter-by-quarter basis, and often fails to perceive a company’s long-term value. It usually reacts to problems by punishing a company’s stock, and that creates compelling opportunities for us. We are a patient investor willing to allow a company the necessary time to correct what we believe is a temporary problem.

We believe excess cash flow is the lifeblood of a business and the primary determinant of its market value. Excess cash flow has the potential to enhance shareholder value through increased dividend payments, repurchasing company shares, reducing outstanding debt, engaging in a strategic acquisition, or withstanding an economic downturn without adopting harmful short-term strategies to the core value of the business.

Our forensic analysis of financial statements helps us make reliable valuations based on future free cash flows; determine if a company’s accounting policies reflect business reality; assess a company’s quality of earnings; make accounting adjustments to eliminate management biases; and identify positive or negative factors that may affect future cash flow. The point is to really determine the economic value of a business.

Q: What is your investment process?

A: We want to thoroughly understand how each company’s operations generate free cash flow because that is what we focus on; we want to understand their business model, strategy, future prospects, and management. We do a bottom-up fundamental analysis of financial statements focusing on the balance sheet and income statement, a cash flow analysis and an ongoing analysis on a regular basis of financial filings and other public disclosures including 10-Ks, 10-Qs, proxy filings, annual reports and public announcements.

We believe we have two organizational strengths: our emphasis on the quality of earnings and our team-driven approach. When we analyze financial statements we make adjustments to their reported earnings to eliminate what we believe are management biases or unrealistic assumptions. Our forensic accounting analysis allows us to hone important data inputs for our valuation models, and also provides keen insights into factors that are vital for success in turnarounds and may be indicative of changes in future earnings. That’s what we mean by the quality of earnings.

Second, we have a team-driven approach. We work within the realm of the Russell 2500 Index; we use either a qualitative bottom-up analysis or a quantitative screening process only to identify untested ideas. But whether an idea is uncovered through a quantitative screen or an obscure trade publication or a government filing, the real work begins with our team doing a forensic analysis of target companies, starting with their financial statements.

We produce a thorough, written analysis and research report that discusses the fundamentals of the company’s business, the industry economic conditions, the competitive dynamics and framework for assessing future operations and cash flow, the assumptions in the underlying valuation. These reports also compare our valuation analysis to historical market prices and provide a detailed scenario analysis showing the best, worst, and likely case for appreciation based on differing future cash flows and economic environments.

Olstein’s initial analysis filters potential investments to eliminate companies that are either fully valued or that have serious structural, financial, or secular problems, rather than those that are simply not performing to their full potential. First a company must successfully pass the initial phase of the analysis by demonstrating normalized free cash flow potential that is not properly valued by the market. Our next step is to develop a deeper understanding of the sustainability and reliability of that free cash flow potential under different scenarios.

An extensive forensic analysis looks at the footnotes and the regulatory filings, to hone what we believe are the company’s normalized cash earnings, the capabilities and the fiscal conservatism of the management team, and finally, the quality of its earnings.

Next comes the detailed analysis using several discounted free cash flow valuation metrics. We test the range of values, the current market reality, and the company’s historical earnings performance. Then we further test our valuations through extensive scenario analysis that assigns probabilities to the best- and worst-case scenarios. We know the economy and the markets don’t stay stagnant; you have to constantly test your thesis and estimates of free cash flow.

Finally, we pitch the stock to the Chief Investment Officer, who ultimately decides if it will be included in the firm’s buy list. Then the portfolio managers determine where and how it fits into the portfolio.

Q: Can you cite an example to illustrate your process?

A: A great example is Harman International Industries, Inc., a provider of audio and infotainment systems for the automotive, consumer, and professional markets. We followed this company for many years, reading shareholder letters and communications from Sidney Harman, the co-founder of Harman Kardon. He was an entrepreneurial visionary in the car stereo and sound systems industry, a guy who really cared about the company, people, and technology. But where he fell short was that he didn’t manage the business for the shareholders.

For us Harman was a turnaround story where a new CEO served as a catalyst for sharpening the company’s performance by controlling costs through better supply chain management, realizing purchasing power, consolidating the company’s global manufacturing & engineering footprint and reducing functional costs while at the same time expanding activities into all auto market segments.

In July 2007 Dinesh Paliwal was hired as president and CEO of Harman International Industries. Paliwal’s view was that Harman was a great business with a great product—but it needed to be managed for the shareholders, too; there has to be a balance. He believed that it was a great company, that info-entertainment is the key to moving your cell phone and your office and your internet connection into a safe car environment. He spent a lot of money and time building relationships with big automotive companies, promising them a full solution with a scalable platform. But Paliwal didn’t stop there; he knew that his product had to be the best product in the vehicle, and it had to be good enough to last for five years. So he started signing long-term contracts and producing a terrific optionality and a reliable product.

With him streamlining the manufacturing process, a money-losing operation slowly but surely started to turn around. Whatever he said he was going to do, he did. Margins increased dramatically. When we bought the stock at $30 we thought it was a $45 stock. In November 2016, Samsung agreed to acquire the company at $112 a share. We continue to reduce the position with the deal expected to close in mid-year.

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Sources: Data collected by 123jump.com and Ticker.com from company press releases, filings and corporate websites. Market data: BATS Exchange. Inc