An integral element of most institutional investment analysis involves meetings with management in an attempt to gain deeper insight into a company’s strategy and prospects.  One of the most misunderstood tenets of our investment process is our reluctance to meet personally with company management.  We avoid these meetings for two essential reasons (1) to reduce the emotional aspects inherent in investment decision-making, and (2) to avoid focusing on short-term disclosures such as management justifying quarterly earnings misses and beats, which have little to do with long-term values. 

Experienced and novice investors alike realize that fear, hope, and hunches can affect buy, sell and hold decisions.  However, other factors may also exert undue influences over these decisions.  A compelling narrative from a charismatic CEO may overshadow financial data that signals trouble ahead. Favorable short-term results or guidance from an overly optimistic management team may mask unfavorable long-term economic realities.

Our search for value focuses on identifying significant deviations between a stock's current price and our assessment of its intrinsic value. Since we believe that long-term investment success is influenced more from the quantity and severity of our errors rather than in picking “big winners,” it is critical that our analytical process rely on unbiased information to assess downside risk. Management has a vested interest in high company stock prices to maintain or enhance items such as future financing alternatives, stock option values, bonuses, and employment retention.

Companies have broad discretion in reporting GAAP-based earnings, which allows for various assumptions about the future. Because management has a vested interest in presenting company results in the most favorable light, GAAP-reported numbers may include unrealistic accounting assumptions or misleading figures. Since many companies presumably engage in some form of earnings management, we must first evaluate the realism of management’s accounting assumptions and reporting practices to determine the quality of a company’s earnings before estimating the company’s ability to generate and/or grow future free cash flow.

Our calculation of intrinsic value relies heavily on analyzing a company’s future ability to generate and or grow normalized free cash flow.  To increase the probability of accurately predicting future free cash flow, we look behind the numbers of financial statements to assess accounting and reporting practices.  Our analysis includes an assessment of the conservatism of management’s accounting assumptions. We study public financial statements, footnotes, required governmental filings, public announcements and related disclosures to reach our conclusions. 

For most value investors, the primary challenge of investment analysis is to fully understand the factors creating the discount between a company’s intrinsic value and its stock price. It is essential to determine whether these issues are temporary or chronic and what circumstances or events are likely to close the valuation gap. Understanding the causes of the discount helps us distinguish companies with serious structural, financial, or secular problems from those simply not performing to their full potential. 

When evaluating the discount, we first look for specific financial, competitive, and structural characteristics that suggest a company’s problems are temporary and that it is well-positioned to create future shareholder value not currently being recognized by the market. In addition to assessing the competitiveness of its core business and the nature of its problems, we also analyze the quality of the company’s management. Given a significant gap between the company’s stock price and our valuation, we assess management’s decision-making skills, execution capabilities, and track record.

How We Evaluate Company Management 

Focusing on What Management Does, Not What It Says

Although assessing management’s capabilities is critical to determining a company’s value, we do not rely on direct contact with management to evaluate their capability. Instead, we believe an accurate assessment of management’s capabilities and effectiveness should rely less on what management says and focus instead on what management has done and continues to do. A simple and objective method to evaluate a company's management team is to analyze its track record:

  • Has management delivered strong financial results, including sustainable free cash flow, profitable growth, and favorable returns on investment, while increasing long-term shareholder value?
  • Has management created and maintained a balance sheet strong enough to ride out potential storms?
  • What is management’s track record for identifying and managing risks, opportunities, and challenges?
  • How have they responded to industry shifts, market changes, and competition?
  • How have they handled past crises and temporary setbacks?

A Deeper Dive – The Quality of Earnings

A fundamental tenet of our investment philosophy is that a forensic analysis of a company’s financial statements, regulatory filings, and footnotes reveals the quality of its earnings, the success of management’s strategy, the sustainability of their performance and the impact of management decisions on future free cash flow. When assessing management, we examine the economic reality of their financial statements, the conservatism of the balance sheet, the quality and consistency of disclosure practices and the integrity and consistency of its shareholder communications over time.

For a reliable determination of a company’s intrinsic value and to hone the inputs in our valuation models, we believe that a forensic analysis of the company’s balance sheets, income statements and other regulatory filings is more useful than management forecasts and earnings guidance.

As we analyze the financial statements, we assess the quality of earnings and adjust reported earnings to eliminate what we believe are management biases or unrealistic assumptions.

Our key questions:

  • Do the financial statements reflect a commitment to accounting transparency?
  • Is all relevant information for assessing both risk and reward properly disclosed?
  • Are financial statements easy to understand and aligned with economic reality?
  • Are free cash flow and reported earnings comparable?
  • Does the company use accounting maneuvers or make assumptions to inflate earnings or mask disappointments?
  • Are earnings understated by conservative assumptions or non-recurring issues?

Ultimately, in addition to accurately estimating a company’s future free cash flow, our quality-of-earnings analysis also seeks to determine whether key financial metrics, including a company’s return on assets, return on equity, debt to equity ratio, dividend payout ratio, and asset turnover ratios indicate that management focuses on creating value for shareholders and that management’s incentives are aligned with shareholders’ interests.

Credibility and Consistency of Communications

To augment our in-depth analysis of financial statements, we conduct a careful, sometimes skeptical, reading of company communications, press releases, and shareholder letters. These materials provide valuable information, some of which we discern by “reading between the lines.”  Shareholder letters, in particular, usually discuss the company’s recent performance, its future prospects and may provide a more detailed discussion of the strategy that management believes is the right course for the company to pursue. A careful reading of the company’s disclosure helps us to determine whether management understands the importance of financial strength, cash flow, working capital controls and the company’s position within its industry. A good shareholder letter, in our opinion, describes how the company’s strategic planning process anticipates and implements strategies aligned with evolving customer preferences and industry dynamics. Outstanding disclosure provides valuable insight into the quality of management and their enthusiasm for creating meaningful shareholder value over time. 

Whether we are grading the performance of a current portfolio holding or monitoring a potential investment, we read company communications for “heat” -- looking for trigger words or statements that, in our experience, may signal a noteworthy change likely to affect the company’s future value.  While examining shareholder letters, in particular, we seek consistency with prior communications; a realistic discussion of the objectives and expectations for company performance and a discussion of shareholder-focused benchmarks management uses to judge its performance.

A series of thoughtful, honest, credible letters alone doesn’t lead to an investment or stock purchase. Rather, it sparks further analysis focused on the company’s most recent performance as well as projections for future performance and why management believes the company can achieve those projections. As investors who are doggedly focused on free cash flow, we read company communications looking for answers to two questions (1) what positive or negative factors arose during the reporting period that may affect future free cash flow and (2) is management deploying the company’s free cash flow in ways that will benefit long-term shareholders? We also look for clear evidence that key elements of our investment thesis have progressed as we expected during the reporting period. Absent such progress, we look for management disclosures that address the problems or issues that may affect those investment metrics that form the foundation of our thesis. 

Assessing Management During Tough Times

During economic downturns and challenging market conditions, scrutinizing management communications becomes even more critical. Reviewing shareholder letters and other disclosures helps gauge a company’s priorities and the effectiveness of its decisions during difficult times. In the face of economic headwinds, we focus first and foremost on management’s discussion of the company’s financial strength and the potential for short-term decisions to materially affect longer-term value creation. A company’s acknowledgment of economic challenges and its response reveal much about management’s capabilities and credibility. These communications and our analysis of any value-changing issues may prompt a reassessment of our portfolio holdings, which may lead to new purchases or sales. 

Effective Management as a Catalyst for Realizing Value

Evaluating management is one of the most difficult aspects of investment research since many aspects of effective leadership, such as decision-making, strategic vision, and integrity are intangible and often are not reflected in the price of a company’s stock. However, we believe that over time, these traits are ultimately reflected in a company’s operating and financial results.

When analyzing undervalued companies, we sometimes find management teams unable to adapt to shifting economic challenges and evolving market trends. Pressure from Wall Street to sustain revenue growth, even at the expense of profitability, often exacerbates these management weaknesses. Management teams unwilling to assess their performance against previously stated objectives or that are too focused on short-term fixes often fail to unlock a company’s full unrealized long-term value. In many cases, a management team that lacks the expertise needed to succeed in the company’s market or a management team that lacks the appropriate emphasis on returns on invested capital can be improved by adding new team members with the required skills and experience. In other cases, management teams that consistently exhibit poor decision-making and questionable leadership skills may need to be replaced in their entirety.

Over the past thirty years, we have been able to evaluate countless management teams without meeting face-to-face. We are confident that through our proprietary process of looking behind the numbers in financial statements, we are able to identify signs indicative of undervalued securities or potential value traps. Furthermore, we analyze financial statements, public filings and corporate communications for valuable clues as to the capabilities and credibility of management, which, for us, are great indicators of the quality of earnings, the predictability of a company’s future cash flow and ultimately, the potential of a company as an investment. While the cornerstone of our research process is an exhaustive analysis of 10-Q's, 10-K's, footnotes and other public disclosures and regulatory filings, we believe an objective, frank assessment of management’s capabilities is a critical element to understanding a company’s true prospects and ability to create sustainable value. As experience has taught us, approaching future investment decisions (buy, sell, hold or avoid) with a healthy dose of skepticism and an objective view of management capabilities (using an inferential look behind the numbers) increases our probability of discovering undervalued gems to invest in or staying away from potential value traps. The collective experience of our six-person portfolio management/research team (in excess of 150 years) is still waiting for a company to go beyond its scripted presentation and disclose that there are serious issues that could be value-destroying and are difficult to solve.

WE WOULD RATHER SPEND ONE NIGHT ANALYZING THE FINANCIAL STATEMENTS THAN TWO DAYS WITH MANAGEMENT BEFORE MAKING INVESTMENT DECISIONS.  We are proud of our investment discipline’s long-term results (since inception, September 21, 1995), which we partially attribute to our reluctance to rely on management predictions and forecasts.

The preceding commentary represents the opinion of the Manager and is not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should be preceded or accompanied by a current prospectus, which contains more complete information, including investment objectives, risks, charges and expenses of The Olstein Funds and should be read carefully before investing. A current prospectus may be obtained by calling (800) 799-2113 or by visiting the Fund's Website at www.olsteinfunds.com.

Definitions:

Return on Investment: Return on investment (ROI) is a performance measure used to evaluate the efficiency or profitability of an investment or compare the efficiency of a number of different investments. ROI tries to directly measure the amount of return on a particular investment, relative to the investment’s cost.

Return on Assets: Return on assets (ROA) is a financial ratio that indicates how profitable a company is relative to its total assets. Corporate management, analysts, and investors can use the return on assets ratio to determine how efficiently a company uses its resources to generate a profit.

Return on Equity: Return on equity (ROE) is a measure of a company's financial performance. It is calculated by dividing net income by shareholders' equity. Return on equity is considered a gauge of a corporation's profitability and how efficiently it generates those profits. The higher the ROE, the more efficient a company's management is at generating income and growth from its equity financing. 

Debt to Equity: The debt-to-equity (D/E) ratio compares a company’s total liabilities with its shareholder equity.  It is a measure of the degree to which a company is financing its operations with debt rather than its own resources.

Dividend Payout Ratio: The dividend payout ratio is the total amount of dividends that a company pays to shareholders relative to its net income. Put simply, this ratio is the percentage of earnings paid to shareholders via dividends. The amount not paid to shareholders is retained by the company to pay off debt or to reinvest in its core operations.

Asset Turnover Ratio: The asset turnover ratio measures the value of a company's sales or revenues relative to the value of its assets. The asset turnover ratio indicates the efficiency with which a company is using its assets to generate revenue.

Return on Invested Capital: Return on invested capital (ROIC) assesses a company’s efficiency in allocating capital to profitable investments. It is calculated by dividing net operating profit after tax (NOPAT) by invested capital. ROIC gives a sense of how well a company is using its capital to generate profits.

Generally Accepted Accounting Principles (GAAP): The generally accepted accounting principles (GAAP) are a set of accounting rules, standards, and procedures issued and frequently revised by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB). While the rules established under GAAP generally improve the transparency in financial statements, they don't guarantee that a company's financial statements are free from errors or omissions meant to mislead investors. It is important to scrutinize financial statements, as there can still be room for manipulation within the framework of GAAP.