If a typical growth-fund manager says technology stocks are going to pull out of their slump, skeptical investors might recall a story about the boy who cried wolf. When one of the mutual fund industry's most well-known watchdogs says it, maybe, just maybe, it's time to listen.
Since the early 1970s, Robert Olstein, manager of the Olstein Financial Alert Fund, has been a vocal critic of the accounting practices some companies use that make them look financially stronger on paper than they actually are. During the late 1990s, he pointed the finger at technology companies as some of the biggest transgressors. Accounting abracadabra, coupled with the sector's astronomical valuations at the time, went against the grain of a man with a near-religious devotion to buying at bargain levels.
Given all that, Olstein seems like one of the least likely people to dip his toes in tech so soon after the recent bloodbath. Yet because he likes to buy on bad news, that's exactly what he has been doing since late last year, when he began increasing the fund's position insemiconductor stocks such as LSI Logic Corp. and National Semiconductor Corp.
Still wincing from the pain of the technology burnout, many investors aren't ready to jump back in just yet, bargains or no bargains. Even Olstein says that his investments may not pay off for a while and may fall even further before they go up.
But to Olstein, getting in before everyone recognizes a turnaround is critical. "It might take years for this kind of strategy to work out," says the 59-year-old fund manager. "But eventually, stock prices should reflect the inherent value of a business. My job is to be right, not to know when to be right."
To Olstein, being right means finding companies with excess cash flow that are selling at inexpensive levels because investors are tuning them out. "Cash flow is the oil that lubricates the corporate engine," he observes. "With a lot of it, companies can do good things, like buy back shares, raise dividends, invest in themselves, make acquisitions or position themselves as acquisition targets."
Companieswith healthy cash flow span the range from value to growth, from small to large. "The fund cuts across all categories-growth, cyclical, small and large," he says. "We don't discriminate."
Olstein feels that some technology companies, especially those involved in increasing bandwidth, storage and networking capacity, have both excess cash flow and a bright future, despite the market's bleak view of them now. "The current negative psychology surrounding technology in general is overdone when you look at a three- to five-year time horizon," he says. "The Internet infrastructure is not even 50% complete."
Technology isn't his only area of interest. Over the last few months, he has picked up the stocks of Citigroup Inc. and Bank of America, which he believes have been unfairly punished by concerns about the economy. Payless ShoeSource, another recent purchase, is selling at "a significant discount to its private market value."
But his interest in the technology sector is perhaps the most surprising because it is such a far cry from an area he would have considered during 1999 and early 2000. That's when his letters to fund shareholders warned about the dangers of pay-any-price investing and the spreading plague of earnings window dressing.
He also cites accounting tricks, such as front-ending nonrecurring revenue. A software company, for example, might report all the anticipated revenue from a five-year contract in one year.
Purchase-accounting techniques are other common maneuvers with which some companies increase reported earnings by using nonrecurring cost write-offs associated with corporate acquisitions. Some companies also report higher profits to shareholders than they do to the IRS for tax purposes, another no-no.
Olstein also decries the seeming unwillingness among investors to care about how much they were paying for growth. "There is a difference," he warns, "between a great company and a great investment."
Over the years, Olstein has been no stranger to accounting wizardry. A former instructor at Hofstra University with a master's degree in accounting, he co-created a newsletter in the 1970s dedicated to alerting institutional investors to the potential puffery in earnings reports. His mission, he says, was "to puncture the high-flying hot air balloons recommended by other Wall Street analysts." In 1995, he founded the Olstein Financial Alert Fund, whose name comes from its manager's penchant for finding skeletons hidden in corporate balance sheets.
During his 33-year career, he's seen Wall Street fads come and go: the pollution-stock craze of the 1970s, the public's high-rolling taste for gambling stocks in the 1980s and the biotechnology-stock bubble of the early 1990s.
But the tech-stock romp of the late 1990s tested his meddle more than any of them. His warnings, it seemed, fell on deaf ears, as stocks of companies with fuzzy business plans and no earnings continued to soar. "I began thinking that it was time to hang up my shoes, and that I just didn't have a clue about what was going on," he says. He even sold short a few Internet stocks, thinking they couldn't possibly go up any more. They did.
Still, staying out of the market's hottest sector didn't translate into dull performance. In 1999, the fund managed to post a 35% return. The gain came, in part, from a well-placed bet on downtrodden oil-drilling stocks in 1998, soon after the Asian crisis hit. At the time, oil was selling at $10 a barrel, drillers were scaling down operations, and investors were unenthusiastic.
Olstein saw a light at the end of the tunnel. When demand picked up, he reasoned, excess inventories would diminish, prices would pick up, and demand for rigs would follow. So he bought drilling companies with sound balance sheets, little debt and excess cash flow that would be able to ride out the storm. He sold the stocks in 2000 at a substantial gain, helping the fund realize a 13% return for the calendar year.
Olstein admits that, despite such success stories, betting on companies that others shun has its risks. "About one out of every three stocks in the fund doesn't work out, which means they break even or lose some money. But only one out of 100 are absolute disasters, and that's what keeps us out of big trouble."
These days, Olstein seems less intent on blowing the whistle on earnings dirt under corporate fingernails than he has been in the past. "Stocks of accounting transgressors have been punished, so the games these companies play have already been built into the price of their stock," he says. "People just aren't paying as much attention to this stuff anymore."
Besides, he insists, uncovering earnings "cheats" is peripheral to the process of simply finding good companies in which to invest. "I'm not a purist," he says. "We even own companies that I know inflate their earnings. But if we believe that their prices are cheap compared to what we determine are their true earnings, they may still be attractive to us."
The operative word is "cheap." Once a stock no longer is selling at what he considers a discount to market value, Olstein sells it. He also eliminates a stock if the company is not producing the kind of cash flow he anticipated.
That strict sell discipline, plus a volatile market that compresses a stock's price movement into weeks rather than years, has helped produce a higher-than-average portfolio turnover that reached 158% last year. "If we buy a company at $10 a share with a two-year price objective of $15 and the stock reaches $14 within a few weeks, we are going to take some money off the table to buy something selling at a steeper discount. The long-term holders of great companies such as Cisco, Microsoft, Sun Microsystems, which eventually reached unrealistic prices, are probably wishing their funds had more turnover."
To Olstein, the large tax bill that high turnover produces is an unfortunate but necessary by-product of an investment style that pays strict attention to price in order to reduce risk. "We'd rather field questions regarding shareholder frustration over the fund's tax bill than answer questions about poor investment performance," he says.
The fund's cost also may concern advisors, particularly if they are purchasing the retail share classes for smaller clients. Annual fund operating expenses for Class C shares total 2.2%, and the shares carry a contingent deferred sales charge of 2.5% if they're redeemed within a year of the purchase date. The CDSC decreases to 1.25% for second-year redemptions and disappears after two years. Advisor Class shares, which were introduced in September 1999 and account for $125 million of the fund's $750 million in assets, have a 1.45% annual expense ratio and carry no contingent deferred sales charge.