Investing August 17, 2009, 6:42PM EST

Funds: Behind Bob Olstein's Comeback

The harsh reality check of the market crash prompted a reevaluation of strategy and the establishment of new rules to control risk

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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.

Lessons Learned

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.