The harsh reality check of the market crash prompted a reevaluation of strategy and the establishment of new rules to control risk
The collapse of Lehman Brothers on Sept. 15, 2008, and the ensuing stock market crash forced Bob Olstein, who has been analyzing companies' financial statements and managing money for 41 years, to change the way he evaluates and invests in stocks. Now, his new rules and focus on "quality" companies have enabled his fund, Olstein All Cap Value (OFALX), to sail ahead of the market's swift recovery.
Olstein, 68, who specializes in examining companies' ability to generate free cash flow, took some wrong turns over the last several years. During the last six months of 2007 through the first half of 2008, he loaded up on financial and technology stocks when they got beaten down. From 2003 through mid-2008, he shunned most energy and commodities stocks that were flying high, according to Morningstar fund analyst Greg Carlson. One prescient move he made was selling AIG (AIG) in late 2007 after spotting $40 billion of exotic mortgage instruments on its books.
But one financial stock fooled him. He was convinced that Citigroup (C) was a good value when he bought in the high 20s, down from 55, given its profitable consumer banking business. "We saw $3 to $4 [per share] in earnings power," he said. "We felt [the selling in Citi stock] was overdone at 18."
That turned out to be a horrible bet. When the U.S. government saved Bear Stearns and then let Lehman fail last September, panic selling by investors punished all stocks, especially financials. "I said, 'Wow, we are wrong—we have to get out'" of financial holdings quickly to prevent more damage, Olstein recalls. Following marathon meetings with his four analysts at Olstein Capital Management's office in Purchase, N.Y., that stretched into the evenings at his home, and two sleepness nights, he eliminated positions in brokerage firms Goldman Sachs Group (GS), Merrill Lynch & Co., Morgan Stanley (MS) and Charles Schwab (SCH). He also dumped credit-card issuer American Express (AXP) and private equity firm Blackstone Group (BX). He reduced the position in Citigroup early in the fourth quarter, then eliminated the stock from the fund in the first three weeks of 2009.
By the end of 2008, Olstein All Cap Value fund had lost 43%, vs. a 37% drop (in total return) for the S&P 500 index. "It was a new experience," recalls Olstein, admitting his ego also got battered along with the performance. "I've been down before, but the fund was down 50% at the low. … I never believed it could happen to me."
What did Olstein learn from this? "My big mistake was not that I bought Citi and financials," he explains. "The mistake was we believed it was O.K. to make money on a leveraged business model." He also bought too much. "I should have controlled the risk a little more by buying less—no more than 1% positions in those stocks."
In turn, Olstein established a couple of new rules for the fund. If a company's total assets are more than 2.5 times shareholder equity, it has too much debt, he says. He'll examine whether the company has enough cash flow to pay off debt.
The second rule, he says, is a company must have enough cash flow to pay off debt within six years.
Seeking Strength Amid Peril
Along with eliminating many financial holdings late last year, Olstein also cut the number of consumer discretionary stocks in the portfolio from 20 at the end of 2007 to 13. And he boosted the allocation to health-care stocks from 9.5% on June 30, 2008, to 16.8% at Dec. 31, 2008 by increasing positions in existing holdings, including Johnson & Johnson (JNJ), Quest Diagnostics (DGX) and Zimmer Holdings (ZMH). He also picked up shares of Charles River Laboratories (CRL), Hospira (HSP), and Thermo Fisher Scientific (TMO).
He also used cash reserves (which averaged 9% to 12% in the fourth quarter) to buy quality companies that have "wide moats" (in other words, "hard to compete with out of the box"), have been generating free cash flow throughout the financial crisis, and have a great balance sheet to withstand any issues. "We had the cash to buy companies that were getting blitzed that shouldn't be getting blitzed," he says. His top 20 holdings include chip giant Intel Intel (INTC), industrial and consumer products maker 3M (MMM), uniform and restroom services provider Cintas (CTAS), and communications equipment maker CommScope (CTV).
Four of Olstein's Top Stocks
Earnings Power (per share, over 2-3 years)
Stock Price Target
Consistent positive cash flow
80% of total revenue is recurring
Wide moat in communications infrastructure
After a terrible 18 months, Olstein's fund has made an impressive comeback. In April, Olstein All Cap Value surged 16% for the month. Year-to-date (through Aug. 14), the fund has risen 21.7%, beating the S&P 500 by about 11 percentage points, after underperforming the benchmark for the last four years. (The fund's annualized returns for 10 years, and since inception on Sept. 21, 1995, through July 31, 2009, were still positive, at 2.7% and almost 9%, respectively.) From the Mar. 9 low of 6, the fund's share price has surged 60%.
"I still like the fund despite some of the mistakes made," says Morningstar's Carlson. "I think he's learned from them." Carlson likes that Olstein has stuck to his investing approach, which emphasizes a company's accounting practices instead of what its executives say about their business. He attributes the fund's recent rebound mostly to its technology holdings. After speaking with Olstein and his analysts in early August, Carlson said that he's "impressed with his team— the analysts there strike me as very sharp." And despite the fund's underperformance last year, there have been no changes in the team, he added.
Carlson added that Olstein's fund now looks more cyclical than other funds that focus on quality stocks, given that it has many retailers in the top 25 holdings such as Home Depot (HD), Macy's (M), and Lowe's (LOW). (Olstein also manages the Olstein Strategic Opportunities Fund (OFSCX), which focuses on small- to mid-cap companies.)
Now that the market has recovered, "the big fast gains have been made," opines Olstein, who says he has built up to 7% cash again because stocks are not as undervalued as they were a few months ago. He believes it will take another four or five years for the market to return to old highs, mainly because many shareholders that sold his fund during the crisis were in their 50s and 60s and are still scared to get back in the markets. "There was a tremendous destruction of wealth," he says. "The guys that got beat up bad are not coming back."
In the meantime, Olstein is hoping to get "a new generation of investors" that will appreciate his rigorous method of picking stocks. Especially after the disasters of 2008, including the promises of consistent low double-digit returns from Bernie Madoff and huge amounts of leverage that were overlooked by investors, Olstein believes that "anyone that forensically looks at balance sheets has an edge now."