Strategic in Corporate Turnarounds
Olstein Strategic Opportunities Fund
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.”
That’s a typical Olstein turnaround story, where we were patient and took a long-term view, and the company’s management team backed up everything it promised with quarter-by-quarter improvement. Not every quarter was the best, but we saw the cash flows coming through, and the stock price appreciating over time. Over a six- or seven-year time horizon Harman’s business transformation added incredible intrinsic value, and created wealth and value for its shareholders.
Q: Would you share another example?
Another example is VWR Corporation, a leading provider of products, services and solutions to laboratory and production facilities in the pharmaceutical, biotechnology, industrial, education, government and healthcare industries. VWR is a spin-out from Merck that private equity firm Madison Dearborn Partners took public in October 2014. Madison Dearborn still owns approximately 35% of the Company and continues to reduce their holdings. Since these transactions, VWR has managed to increase its profitability and effectively de-lever the balance sheet. The company continues to focus on de-leveraging though a combination of debt pay and productivity improvements.
What makes VWR attractive to us are its value proposition, diverse product set and attractive market potential. The company’s sales of consumables, chemicals and services that are recurring in nature constitute approximately 80% of total sales. While the distribution of products is at the core of VWR’s revenues, the differentiating factor is the company’s breadth and depth of supply, independence, private label products and customized solutions that effectively outsource client’s non-core functions. The company sells over 1 million SKUs and has more than 100,000 customers across 34 countries with the US representing approximately 55% of revenues. In the fragmented global market for laboratory suppliers, VWR currently has a 9% market share with plenty of room to grow in an industry that is currently over $51 billion in annual sales volume growing at approximately 3% per year globally. The company’s clients are highly dependent on VWR’s products that are key components in critical processes such as new drug development, regulatory and safety testing, and laboratory testing. In addition, some of the products the company offers are subject to complex and stringent regulations that act as a substantial barrier to entry.
We believe that as the company continues to deleverage and capitalizes on the strengths of its business model to grow, its stock will reach our intrinsic value of $35 per share. The company’s stock is currently trading around $26 per share.
Q: How do you construct your portfolio?
Our portfolio is built on a stock-by-stock basis, so each company has to earn a position in the portfolio based on our estimates of free cash flow and what the discounts are. The fund’s portfolio invests in between 35 and 55 holdings—over the past 10 years we have averaged about 43 holdings—but our portfolio is highly concentrated in our top 20 positions.
The top 20 positions usually make up 50% of the portfolio and range between 2.5% to 5% in position size. The rest are smaller positions where we are either reducing the size of the position because it’s getting closer to fully valued, or taking smaller positions because we don’t have that full discount.
Q: What is your buy-and-sell discipline?
Our buy discipline is based on a team effort, an exhaustive review of the analyst’s work by the investment team. We reserve the right to make sure we don’t love any stock. We always treat stocks as an investment based on our intrinsic value and the discount.
We have a strict sell discipline based on cash flow valuations rather than price momentum—that’s the required discipline of a value investor. As holdings reach their valuation levels they are sold and monies are reinvested in existing holdings or new investment ideas, or held in cash until we find something in which to invest. Every portfolio holding, as well as every company listed on the fund’s buy list and watch list, is reviewed and revalued each quarter as the company files quarterly or annual reports, 10-Qs, 10-Ks.
We also monitor each company’s news, its progress toward specific goals, and market conditions or factors likely to affect its performance. We review and reevaluate companies as conditions change or new information is available. Such a reevaluation may result in increasing or decreasing a position, or in some instances it leads to a sale.
Q: Is your portfolio turnover significant?
For the calendar year ended December 31, 2016, the fund’s portfolio turnover was 52.7%, which is about average for the past five years. That doesn’t necessarily mean we are eliminating names altogether, though we may do that if they get to full value or our investment thesis changes. But we also might be taking names up or down based on their discount to intrinsic value.
Q: How do you define and manage risk?
For small and mid-sized companies we are less concerned with overall market volatility and more concerned with the predictability of sustainable free cash flow. So instead of focusing on market risk or reacting to predictions of market movements, we try to reduce the risk of capital impairment by assessing a company’s business and the strength of its balance sheet by identifying the factors likely to affect future cash flow and by buying stock at a significant discount to our determination of the company’s value. We assess business risk by focusing on how the company’s operations generate free cash flow and the factors that are likely to impact future cash flows, as opposed to stock price movements.
We believe the best way to reliably estimate sustainable free cash flow is through a thorough understanding of a company’s operations and strategies, and the effectiveness of the management team as stewards of the company’s capital. This is especially true in small or mid-sized companies that are facing strategic choices and challenges due to Wall Street’s consistent pressure for growth.
Our main concern in managing risk is the probability of permanent loss of capital. We always look at the downside risk first, because it can destroy long-term performance. We manage the overall risk on a stock-by-stock basis as we build the portfolio, through an extensive due- diligence process that helps us understand any dislocation of underlying value. But first and foremost we seek to mitigate risk by buying stocks at a 30% discount to our intrinsic value, where, in our opinion, a lot of the bad news or short-term negativity is already built into the stock price.
While we are willing to take market risk, because that creates opportunity, we avoid company-specific financial risk. We tend to avoid companies that have to adopt short-term strategies. We also watch position size in the portfolio and have a strict sell discipline based on discounts and intrinsic value; that is a big part of risk control. And we are constantly looking at the probability of the risk-reward that each investment presents.
Our process is based on the discount to intrinsic value. So if our intrinsic value is $50 and we buy at $35, as a company gets closer to our intrinsic value we’ll take money off the table, because our risk reward is not the same. And if it falls below, we might add to it. That dictates the position and helps control the risk of an individual investment.
Q: Do you view market capitalization as important?
The Olstein Strategic Opportunities Fund focuses on the small- to mid-capitalization segments of the market because they offer a significant number of investment opportunities that are misunderstood, mischaracterized or simply ignored by many investors. Companies on a growth trajectory that have temporarily stumbled, or need to adapt their strategy through a focused turnaround effort or need an infusion of senior leadership talent to take the company to the next level are great opportunities for us.
It is probably harder for a larger company to maintain a high annual growth rate than it is for a small company—even one facing challenges. Macy’s is a great example of this. When we bought Macy’s years ago, their market cap was around $4 billion before growing, as it overcame its challenges, to $24 billion—its market cap at the time we exited the position. We would love for all of our companies to go from $1 billion to $20 billion.
1 2 More: Mutual Funds Archive