10 Questions With Olstein Financial Alert's Bob Olstein

This skipper trounced peers the past five years by tracking companies' books. What he likes now may surprise you.
By Ian McDonald ,

For Bob Olstein, it's all about the numbers.

The skipper of the

(OFALX) - Get Report

Olstein Financial Alert fund skips chatting up CEOs in favor of burrowing deep into companies' financial statements. This number crunching turns up lots of potential trouble spots, as well as companies that are fundamentally undervalued, according to his math.

Manager: Bob Olstein

Fund: Olstein Financial Alert

Assets: $750 million

Managed Since:
Sept. 21, 1995

1-Year Return: 19.1%/ Beats 48% of Peers

5-Year Return: 24.3%/ Beats 98% of Peers

Expenses: Deferred Load 2.5% and Annual Expenses 2.2%

Top-Three Holdings:J.C. Penney
LSI Logic
National Semiconductor

Sources: Morningstar and Olstein.

This focus on numbers has led to an impressive subset of numbers: a 24.3% average annualized return over the past five years, putting his fund ahead of 98% of its peers.

Given the newfound appreciation for in-depth financial research among Wall Streeters and Main Streeters alike, we thought it high time to confer with Olstein, who's been a numbers man for 32 years. What are the numbers turning up for him? Financials and semiconductor outfits, for starters.

1. Would you mind explaining your approach to value investing?

Olstein:

We think about losing before we think about winning. The first thing we do is go through a checklist of bad accounting and a checklist of what is the true valuation of the company. Our valuation is based on a discounted cash flow model against U.S. Treasuries -- not relative value at all.

We don't talk to management. We make an inferential analysis of financial statements. That's all we look at -- we go back through 10-Qs, 10-Ks,

SEC

documents; we're very financially statement-oriented.

Thirty years ago, I founded a research service called the

Quality of Earnings Report

, which was the first service to ever look behind the numbers and warn institutions.

About funny accounting, right?

Olstein:

You got it, and where they were not telling. There is a high correlation with long-term performance between making the fewest errors, not picking the most winners. Our main defense against risk is only buying companies that either are currently generating excess cash flow, or will in the next three years.

2. Given your approach, what sectors --

Olstein:

We don't do sectors.

OK. What companies are you seeing as values these days?

Olstein:

We're finding most of our values in banks and semiconductors.

We are just straight financial-statement maniacs; just look behind the numbers all day and all night and look for companies that we think are -- based on the next couple years, not on what's going on now -- are discounted cash flow.

For example, we bought the oil stocks back in 1998 and the semi-equipment companies in the middle of the Asian crisis when everybody was saying run. We're buying the semis now and everybody says run.

Laughs. But we were buying the retailers when everybody was saying give it to the Internet, that the retailers are going out of business. We're looking for misperceptions out there, where people are dealing with now and they're not looking at tomorrow.

What is your time horizon?

Olstein:

We value companies over basically a three- to five-year horizon, but we don't go out beyond two years for cash flow.

Let's talk about the banks you like.

Olstein:

Bank of America

(BAC) - Get Report

was one where we thought that, even after building in the reserves, we still could come up with value. We started buying it in the high 30s, low 40s, and the stock's moved appreciably. We still think it's worth another 15% to 20% we think we can get out of the stock.

The stock was just less than $61 at midday Monday.

Another one is

PNC Financial

(PNC) - Get Report

. We got the idea because they sell our fund and they were doing a great job. Sixty percent of their business is now fee-based, recurring business.

We bought that stock in the 40s; the stock is now in the mid-60s

in midday trading Monday, it was at $67.35. In two years, we think we have an $80 to $90 stock.

The average person you talk to gauges their interest in companies like these just by interest rates.

Olstein:

We don't. We realized that in order to buy discounted stocks, you've got to find negativity. You have to focus on it; that's the only way you get discounts. If everything were great, why would anybody be giving them to me at a discount?

Alert Indeed
Olstein's fund beats 98% of its peers over the past five years and isn't too shabby vs. the S&P 500, either

Source: Morningstar. Returns through June 22.

Let's talk about chips.

Olstein:

There's an excess capacity between cities; there's going to be a shortage of broadband within cities, and that build is not even close to taking place.

We think the Internet's only 50% built, and we think storage is another big area. We have to look for chip stocks that cater to those industries -- networking, broadband communications -- where we think there's going to be a tremendous push once this over-inventory situation takes care of itself.

That led you to the likes of LSI Logic (LSI) - Get Report.

Olstein:

Right. They're in communications storage.

This is interesting. More folks who are value investors are looking at tech. But it seems all the negativity that's priced in today assumes that the problems that we have -- the glut of equipment and the slowdown in spending -- will go on in perpetuity.

Olstein:

Right. They always do. Just like they felt on the other side of the coin, when it was going well, that it was going to go on for perpetuity; nothing goes on for perpetuity.

Laughs.

3. On the flip side, what are some areas that you've moved out of this year?

Olstein:

Oil drilling we've moved out of; a lot of the retailers we've moved out of. You know, they started taking on their value.

We have a very strict sell discipline here. Another great stock we had was

J.C. Penney

(JCP) - Get Report

. That is a stock that we still own; it's our biggest position.

We saw new management, we saw a tremendous opportunity. We looked at some of their stores, and we said here's a company that's capable of earning $2 a share when in fact they turn. It had

Eckerd

, which is an undervalued asset.

We bought it down at $10-$11 a share, and that's why it became a big position, but now we still think it's probably worth somewhere between $30 and $40

it traded at $25 midday Monday. It's not the same opportunity, but that's how it became a big position, because we bought it right in the height of all the negativity.

Do you use price targets when you take up positions?

Olstein:

We don't use targets, we use valuations. There's a difference. A lot of these guys have targets -- we don't have targets; we sell at full value. Our value is based on cash returns that will yield us a 50% higher return than U.S. Treasuries.

4. Everybody's suddenly interested in looking more fundamentally at a company's balance sheet and their financials, but very few people really know what they're looking at. What are things that people should really watch out for?

Olstein:

They've got to look at their cash flow vs. reported earnings. They've got to look at their tax books vs. their IRS books.

What are some of the red flags?

Olstein:

Receivables going faster than sales, inventories going faster than sales, cash flow deviating from reported earnings, recurring nonrecurring write-offs.

There are these issues that come up where a company can contort its accounting for a certain amount of time, but eventually, the music ends, right?

Olstein:

You've got it. Very few people I talk to understand the accounting. If you can't understand the accounting, you can't buy the company. It's as simple as that. And that's the biggest lost art on Wall Street. A lot of these money managers and analysts really are not versed in reporting practices.

Value Is Back; Did it Ever Leave?
Investors and pundits wrote off value investing when growth took off in 1998 and 1999, but it's showing its mettle again

Source: Morningstar. Returns through June 22.

5. Let's walk through one example, start to finish, what attracted you to a company --

Olstein:

The

New York Times

(NYT) - Get Report

is a great example.

Here's a company that's gone through excess cap expenditures in the last three-five years. All of a sudden, the cap expenditures slow down. But the depreciation is exceeding the capex. So, we add back the excess depreciation and we came back with 30 or 40 cents more a share in earnings.

Here's a company you know is going through some rough times, but with excess cash flow of $400 million a year. So we're figuring here's 30 to 40 cents a share that was being hidden by the fact that the cap expenditures were under depreciation. That's a simple example of something you'll find.

6. What's a company you've come across recently where you could see someone misinterpreting it as a screaming value, but when you looked at the numbers, you said, this might be a value trap?

Olstein:

Sealed Air

(SEE) - Get Report

. We looked at it and we thought that here was a company that looked like -- in the low 30s, anyway -- it was cheap. When we went and checked the litigation -- they were being thrown into asbestos issues because they had bought a division of

W.R. Grace

, which was in the asbestos business.

Everybody was saying: Look, this is BS, this is too far a reach, there's no liability. But in fact, when we did our investigative work, we found out that this division was owned under the hierarchy of the asbestos division within Grace. So they did some financial engineering to get this out of the company. We were not so sure that, in fact, the long arm of asbestos wasn't going to reach this company. Since we couldn't put a liability on it, we couldn't value the company, and we passed.

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7. What's the biggest mistake an investor can make in this market?

Olstein:

There's too much concern about timing in this business, and being exactly right and when they are exactly right. The horizon in this business has come down to three-five days instead of three-five years; that's the biggest fault.

This is an art: You gotta know how to value a company, and you gotta be able to see out more than three days. You gotta go out and try and see out a couple years.

With the information explosion, there're too many experts out there. The real expertise you need to win in this game is to know how to value a company.

Too many people want to give you targets -- where a stock's going, where it's going to be today and where it's going to be tomorrow. My performance is so far above where it has been for the prior 25 years, prior to the last five years, and that's because I'm playing against these guys who only have two- and three-day horizons.

So, if I'm going to be wrong on semiconductor stocks in three months or four months, that's not an issue to me. The issue is if you wait for a catalyst in an undervalued security, you're going to have a fully valued security.

You can't wait for the catalyst; you've got to anticipate the catalyst.

The other big mistake is buying stocks when you don't know what the hell you're doing. The average investor needs to find a money manager.

If you want to be right over time, you cannot be right all of the time. People make stupid statements like value is out. What you're saying is value is not performing. But if value was always in, how the hell would you get value?

8. If you had to name three stocks to buy and hold for five years, what --

Olstein:

I wouldn't do it.

Interesting. Why not?

Olstein:

I'm better off if I can find 80 or 90 stocks that meet my criteria, better off than finding three.

Because I am wrong a third of the time. Now you say, well, tell me which ones you're going to be wrong on. Well if I could tell you that, I wouldn't buy 'em!

Laughs. I'm going to have one major disaster in my 90 stocks, maybe two. What if it's two out of the three I give you?

OK, what are your three favorite companies?

Olstein:

I'm not giving them to you; you know why? Dan Dorfman, remember him? He backed me up to the wall, and he said give me your best stock in your portfolio and your least favorite. Well, my least favorite got taken over the next day.

9. Your fund's expenses are a little higher than average. Why?

Olstein:

I have a 1% fee like everybody else, but I pay brokers and financial advisers 1%; that's why we're 2%. We don't want turnover in our fund -- when I say turnover, I mean turnover investors. We have a very low turnover of investors. We have to report after fees -- my results are my results.

I don't pick a physician, if I have -- God forbid -- a bad heart, I'm not going to pick him by his fee.

I'll give you a great story.

Former Fidelity Magellan manager Peter Lynch was one of my subscribers to Quality of Earnings Report when he was director of research at Fidelity. He was with Magellan around 1973-74. In those days, they had 7% for expenses. And so I said, I'm not putting my $1,000 or $10,000 in and making $9,300 overnight; his fees are too high.

Well, what a dumb move that was! Thirty times on my money, just because I was worried about 7%. Never worry about a fee -- they're tiebreakers. When I say they're tiebreakers, if you like two disciplines the same, and you have to make a choice, then maybe a fee becomes an issue. But never pick anybody by his fee because in our business, 1% or a half of 1% is not enough to make a difference.

10. You've been watching companies' books for so long. Among the big stocks, is there anybody out there that you've always been a bit uncomfortable with how they've handled their books?

Olstein:

Well, I'm the one who called

Lucent

(LU)

Boston Chicken

. Lucent's books were ridiculous.

What's your take on Lucent today?

Olstein:

No opinion because they're in financial peril, and I don't want to take a chance on financial peril. But, you know, they have some good products and some good divisions; the question is: Is it a financial risk? We don't take financial risk in our firm.

Fund Junkie runs every Monday and Wednesday, as well as occasional dispatches. Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

imcdonald@thestreet.com, but he cannot give specific financial advice.

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