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Olstein: Large-Cap Quality Still on Sale

Jason Stipp recently went on the road to check in with some money managers, including Bob Olstein, manager of Olstein All-Cap Value Fund. We talked about opportunities in big-cap stocks, overall market valuations, and lessons learned from the financial crisis.

Jason Stipp: Bob, your fund is an all-cap fund, but it's migrated over the last few years from the mid-cap region to the large-cap region. When you think about where you've been finding attractive opportunities, what about large-caps have you been seeing as good investments right now?

Bob Olstein: For the first time in 25 to 30 years, I've always wanted to own growth companies, especially large-cap growth companies, which are still growing. One of the rare companies that are still growing at 3% to 5% rates, like Coca-Cola, like Procter & Gamble, like Microsoft, where the markets are disappointed that their growth rates have come down, but they are selling at 10 times free cash flow.

We're getting great dividends, 2.5%-3% dividend yields, and not as undervalued as they were in March of 2009, but basically 10%-15%, still undervalued with 2.5%-3% dividend yields and relative safety with their brands, safe wide moats, great difficulty getting into their business. So, Kimberly-Clark, Procter & Gamble and Coca-Cola are basically core holdings in our portfolio right now, but as you know we'll go anywhere any place where we find value.

Stipp: Would you say that part of the reason you're seeing value in large caps is because in a recovery, generally some of the smaller caps will rally harder, and we just haven't seen large caps come up as much as some of the smaller companies, the mid-caps and the small-caps?

Olstein: Well, I am not sure if that's true. Coca-Cola, for example, we bought in the low $40s and the stock is now is up 50%, and yet their earnings power and dividend yield and ability to produce free cash flow is no longer 50% undervalued, but we'll take a 15% undervalued in a very stable company like a Coca-Cola and like a Procter & Gamble, and they are not the 50% undervalued that we can still find in the mid-cap area, but there is significantly less risk, and our fund pays a lot of attention to downside risk.

Stipp: Speaking of stability, our analyst, fund analyst on your fund, Greg Carlson noted that you're really highly prize straightforward balance sheets, and he wrote that your fund sports one of the lowest debt-to-capital ratios in your category.

Can you outline briefly what you demand of a company's balance sheet? What things do you look for? Then on the flip side, what are some red flags when you're looking at a company's balance sheet and financial situation?

Olstein: Well, the first thing we look for in a balance sheet is some conservatism. The first ratio we calculate is 2.5 to 1 total assets to shareholders equity. That is a stable company that is not overly leveraged. We're very concerned about leverage business ratios, because that was where we stumbled in 2008.

We find a lot of value in the banks, but we had too large of a position because when heavy leverage companies fail, the failures are usually greater, and leverage over-accentuates the failure.

So we want a 2.5 to 1. If its above that, it's an exception. We still can find value in higher leveraged companies in 2.5 to 1, but we'll take smaller positions.

The other thing we demand is realistic quality of earnings, and to us quality of earnings, how realistically are the balance sheets and the income statements portraying the economic reality of the underlying business? As you know under GAAP, there is all kinds of assumptions, and some people get aggressive with their assumptions and some people don't, and so we look for economic reality and adjust the balance sheet for GAAP earnings to get to these realistic earnings.

So we demand accounting that discloses everything we need to know, so that we can make our appropriate adjustments.

Red flags that we find are really earnings... the biggest one is earnings exceeding free cash flow, and free cash flow is defined after capex and after changes in working capital. You also look for large amounts of capitalized expenditures. You look for receivables and inventories going much faster than sales.

We are very...we don't talk to management in our process. We look at what management is doing rather than what they are saying, and we look at that via how they report to shareholders and look at three years of financial statements, compare them, and make sure that there is some discussion on company problems, because if there is none, we don't believe it.

Stipp: Risk control is one of the important centerpieces of how you manage your portfolio. Can you talk a little bit about some of the primary things that you look at in managing risks. How has your risk management changed at all since the downturn of the 2008?

Olstein: That's a great question. One of the things that we did and mistake that we made in 2008 was, of course, we didn't predict that Lehman was going to fail. We thought that the bondholders are going to be okay, and we were finding tremendous values in the financials. But one of the mistakes we made is we gravitated too much towards the financials and their leveraged business models.

So, we now have an exception that any business model that we buy for the portfolio that has more than 2.5 to 1 total assets to shareholders equity is an exception. And the portfolio will never have a larger position or buy a larger position--it may get a larger position because it appreciates--more than 1% in any stock that has more than 2.5 to 1. And in addition, the total portfolio will have no more than 10% cumulative exceptions.

So, that's one of the new, very new risk parameters that we've put into the portfolio since 2008. In addition, we only buy companies that generate free cash flow after capex and after working capital needs. Working capital is a key ingredient that a lot of people forget, and if they don't have it now, they have to have it within two years. And if you have free cash flow, only goods thing happen. You raise the dividend, you can make strategic acquisitions and others cannot. You could buy back your own shares.

When bad things happen and bad things happen to every company at some time in their history, they don't have to adopt short-term strategies, which are not in the long-term interest of the company, so that they can stay the line... And finally free cash flow companies are acquired. In our 15 years of running the fund, we've had over 30 companies taken from our portfolio, and we've never bought a rumored acquisition candidate.

Stipp: Bob Olstein, Olstein All Cap Value, thanks for sitting down with us today and for your insights.

Olstein: My pleasure.