If you were unable to join our market update, when we discussed Coronavirus, recent market volatility, and our market outlook, you can now listen to the replay by clicking on the player below.


Michelle Swager:  Good morning, everyone. Welcome to the Osterweis market update conference call. My name is Michelle Swager. I'm our Director of Communications and Marketing. Shawn Eubanks is out of the office today. We'd like to welcome you to our market update call with John Osterweis, Larry Cordisco, Carl Kaufman, and Eddy Vataru. At this time all participants are in listen only mode. Later we will conduct a question and answer session. Please note that the conference is being recorded. Before we get started I will get a little disclosure out of the way. Performance data quoted presents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate, so an investor shares, when redeemed, maybe worth more or less than the original cost. Current performance of the funds may be higher or lower than the performance quoted. Performance data, current to the most recent month end, may be obtained by calling Shareholder Services at 866-236-0050 or visiting osterweis.com. With that, I'll hand things over to Carl Kaufman.
Carl Kaufman: Thank you Michelle and thank you for taking time out of your hectic days to join us. The markets, as you have seen, have been a little bit volatile lately and I thought it'd be appropriate to have a call to update you on our thinking and what we feel are the pertinent factors and actions to take. Firstly on COVID, it's on everybody's mind. I think the way to look at this is that it has created a reduction in supply, mostly from Asia, but also destruction of demand. Both of those hurt and they create an economic slowdown. They both will return in time, so we think this will be a slow patch. We've heard it said that when the weather warms up this should abate and what we don't know is whether it comes back in the fall or not. We'll have to wait and see and this is just time and hopefully governments are taking the appropriate actions to stem the tide.
In terms of oil, that added another element over the weekend. This feud is political. Neither party, Saudis or Russians, really do well here with very low oil prices, but we consider it a positive because it is a tax cut on consumers, as they appreciate the lower input prices. This will normalize over time as well. Now if it is indeed a war on frackers, obviously it could dent U.S. supply. I have one comment on this, this is no way to run a cartel. The Fed. You saw they cut by 50 basis points. I think no matter how much they cut, it won't help the Coronavirus. They can provide liquidity once they run out of interest rate ammo, but given what happened in the markets after the cut, I would implore them, no more easing please.
In terms of a recession, which is starting to crop up, if there is a recession, we really need to have fiscal responses because the Fed will be pretty much out of interest rate ammunition. We think that the recession is likely to be shallow because the causes are not really structural, they are exogenous, but they will be fixed in time. We think that while it may be a U-shaped recession, it probably will be shallow and may or may not be short lived. We'll have to wait and see on that. In terms of the markets, I'll let John and Larry speak more to the equity markets, but just as a note, they did start off this decline from all-time highs and at a point in time where the economic growth in the U.S. was doing pretty well. We will obviously come out of this economically, I think faster than Europe or Asia does, but the markets may have been a little overvalued and I think they are coming back to more rational valuations. I'll let John and Larry opine on that.
The last point I want to make is on inflation. Obviously the initial reaction will be to lower inflation, given the demand destruction. As we rebuild supply chains, however, around China and have secondary sources, that could be inflationary as it will increase costs to businesses to have that second source of supply. The question is, do they pass that along or do they eat it in margins? We'll have to wait and see how that transpires. My guess is it's probably a little bit of both. With that, why don't I pass it to Eddy who runs our investment grade fund since there's been a lot of activity there and get his take on the markets and how we should approach that and think about it. Eddy.
Eddy Vataru:  Sure. Thanks Carl. What I find interesting about the move that we've had over the last a week or so is obviously we've seen a lot of headlines and volatility in equities, but we've also seen moves in the rate market, that in my mind, are probably greater in magnitude and severity than we've seen even in equities. It's one thing to have a headline that the Dow is down a thousand points or 2000 points, but on a percentage basis, we're not talking about the biggest moves that we've ever seen. I'm not dismissing how big the move is, but to bring you some perspective on the rate side, we have 30-year Treasuries below 1%, at least we did yesterday. Right now they're at 1.06, but when you think about where the 10-year Treasury was, for example, a week ago, we were about 1% and in just four days we knocked off half of that yield to close yesterday below 50 basis points. These are levels, even when we were at 1%, those are levels we really had never seen and we just had those in a period of three days.
The magnitude of the changes in fixed income are stunning. It's even more stunning when you consider that when you buy a fixed income instrument and enjoy a 50 basis point yield for the next 10 years, that the move that you see in the underlying price in five or 10 minutes time, it can wipe out a year or two years? worth of carry in just that amount of time, so you really need to tread lightly when assessing risk in a fixed income portfolio and understanding kind of where we are. One thing I'd also add is that corporate spreads have widened tremendously in this selloff. We had investment grade corporates below 100 basis points spread to Treasuries as recently as late February and just in the last two days alone they're 43 basis points wider and rested at 171 basis points as of close yesterday. We're not out to the levels that we saw in 2008 and I think we might spend a little bit of time now and perhaps more on the Q&A about trying to draw comparisons between this experience and prior rate market insults. I don't think that this is really much like an '08 event. The reasons are different. The resolution is quite different. 2008 was quite a profound event that was years in the making, that had a very different footprint in terms of lending and it was really one that impacted really all of us in terms of just lending standards and the residential market and so on. There were a lot of impacts there.
This is caused by a transient catalyst. It's highlighting obviously some imbalances and issues in the market, but the resolution to this could be a lot quicker than the one that we have in 2008, it's just a matter of time and hopefully some combination of rate cuts, which themselves won't do very much, but stimulus that could, that I think will be interesting to watch in the days ahead. In terms of just looking at the portfolio, I do think that this move that we've had will create some tremendous opportunities to deploy risk in the coming days and weeks, but again with the caveat that the markets are so volatile in the fixed income side that it's really prudent to kind of keep an eye on headlines and on how the market is actually behaving and size accordingly, as we enter this period of quite heightened volatility that we've seen over the last week and with that I'll turn it over to John.
John Osterweis:  Morning everybody. Our view from the equity market side is very similar to what you just heard from the fixed income side. I mean obviously the market drop was occasioned by this very sudden collapse in oil prices, the Coronavirus economic impact, and the China-related supply disruptions. Combined, in the real world, these events increased deflationary risks and increased recession risks and hit the stock market after a 30% increase in 2019 at a time when earnings growth essentially was zero. In 2019, earnings growth was zero. What we're seeing in the stock market is a very significant, somewhat violent, valuation reset in the face of a significant increase in uncertainty. What it sets up is a polarity in our minds.
Number one, it sets up the probability that deflation is becoming an ever-bigger risk and that has implications for recession and obviously significant earnings problems for a number of companies. On the other hand, in a low interest rate environment like this, stock market valuations are well below what they theoretically could be. And so, the polarity is, how bad are things in the real world and how should stocks be valued? From an investment standpoint, it becomes essential to focus on companies that have very strong demonstrable growing earnings and these would be companies with strong secular tailwinds, company-specific earnings momentum and obviously companies with very strong balance sheets, because if we are in a deflationary environment, you do not want to be over-levered. I'll let Larry talk a little bit more about exactly how we're focused and exactly how we're constructing the portfolio.
Larry Cordisco:  Thanks John. As always, we act, with the Osterweis Fund, with a laser focus on companies that have, as John mentioned, growing earnings and strong secular tailwinds and specifically we like to focus on industry leaders and disrupters with unique competitive advantages and widening moats. Along those lines, we have generally been avoiding pure cyclical companies. We have a low energy exposure in the Fund and also lower-than-average industrial and financial exposure, as those have all been headwinds to the types of companies that we've been typically looking for over the last couple of years. We continue to favor selective technology companies, such as cloud companies and businesses tied to the data center infrastructure spend and healthcare. We like therapeutics companies and companies that make consumable products that go into everyday drug discovery and routine testing. We like consumer staples, though the market has not giving us an opportunity to add to those holdings or increase exposure there. In general, across the entire portfolio, we have a strong bias towards market share gainers. While this applies to our entire portfolio, this is especially important in industries that are lower growth industries. In those industries you'll see our positions in very specific companies that are significant share gainers.
The market is also giving us some opportunities to look at new ideas and specifically we're keying in on managed care, railroads and starting to poke around some of the consumer discretionary areas like lodging and leisure and auto that may present opportunities, though it is very volatile and hard to say, at this point, whether or not there's something there that fits our portfolio. That's basically where we've been positioned and where we continue to focus and an idea of where some of the opportunities may be.
Michelle Swager:  Okay. While we wait for questions, there's a question for you Carl. The question is adding to the panic discussion, are commentators asking will we see bankruptcies in the oil sector? Can you talk about your expectations there and what your energy exposure is?
Carl Kaufman:  Sure. The answer is yes. We can expect bankruptcies. We have been grossly underweight energy since at least the last five years, if not longer. We feel it is in a long-term secular decline. Doesn't mean you're not going to have bull and bear phases, but our exposure there is primarily in the midstream and companies whose clients are top notch, so we don't worry about the credit risk on the other side of our companies. Despite that, they were down like everything else. Yesterday, there was no differentiation at all, but we feel very comfortable. Three of them are LPs and they do pay out pretty sizeable equity dividends that can be cut if need be, but so far they're earning those. If anybody wants more details they can call me later.
Michelle Swager:  Okay. Here's another question for you Carl. With lower interest rates, how does that affect your investment strategies for Strategic Income?
Carl Kaufman:  Well, it makes me less wanting to buy investment grade, that's for sure, but it does make us get a little more defensive. We have cash waiting to deploy and we have been deploying some of it here as credit spreads widen out because lower interest rates typically are a predecessor to economic weakness. We are being very diligent in terms of selecting what companies we do buy and as I said, we have been deploying it, but there has not been the panicked selling that we would have expected given the optics of the averages. We have seen certainly hectic selling and energy, especially in fracking E&P, and in midstream as well, but we have not seen it in the general marketplace. Many names that we have wanted to buy where we have smaller positions have just not come in. They've come in maybe a little bit, half a point, a point or two, but not the type of declines we've seen in the rest of the market.
Michelle Swager:  Eddy, while we're waiting for a question, one of our questioners had an interesting observation that he went to re-fi his mortgage and they were actually quoting a half a point higher than they were in the summer. You have any thoughts on the mortgage market in this type of environment?
Carl Kaufman:  I think he needs a new broker.
Eddy Vataru:  I was going to say. My anecdote, I can give you my own story, which is kind of interesting. I just refinanced my own home a couple of months ago and my mortgage broker emailed me over the weekend and said, hey, I can knock another eighth off of your rate if you want. No cost, et cetera. Do you want to do it because the paperwork has already been done? I did. I guess I was at a bit of an advantage in that regard. That redoing alone, with all the credit work done is... That's all done and the mortgage broker gets to claim volume and everybody wins. One thing that's important to note is that even though rates have fallen tremendously on the treasury side, mortgage spreads have widened at the same time. The all in mortgage rate itself hasn't declined that much. I did say yes by the way, of course I would take the eighth of a point and probably look to get a little bit more out of it by the time the whole process ends.
The reality is that even though, like I said, the 10-Year's fallen probably a hundred basis points in a month, mortgage rates haven't fallen 100 basis points in a month and I think you're not alone in being disappointed that you would assume a one to one relationship, but this was very common when we have rate moves like this where the primary secondary spread, basically the spread between where primary rates are, where Treasuries ultimately are and where you can actually borrow, widen at the same time. Part of the reason for that is that banks and lenders are capacity constrained and they basically have some level at which they can offer rates, call it 3% on 30 or fixed, for conforming balance loans right now. Mathematically they could offer 2.5%, but they don't have to. They have all the demand they need at 3% and if we were to stay at these levels for a while, if the 10-Year were to stay below 1% for a protracted period of time, you could easily see lower mortgage rates down the road as the market settles into a new equilibrium, but for now and as always, when you have a big rate move, the change in mortgage rates is not instantaneous and there is a lag and a cushion that's provided by banks.
Carl Kaufman:  Thank you very much everyone for calling in. If you think of any questions, you can either call Shawn and can get them to us and we'll get them answered. Thank you very much.
Michelle Swager:  Thank you.

Performance data quoted represents past performance and does not guarantee future results.

The information presented in these rebroadcasts represents the opinions of Osterweis Capital Management and are not intended to be a forecast of future events, a guarantee of future results, nor investment advice. The rebroadcasts are distributed for informational purposes only and are not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. Holdings are subject to change and are not a recommendation to buy or sell any security. Current and future holdings are subject to risk.

Holdings may change at any time due to ongoing portfolio management. References to specific investments should not be construed as a recommendation to buy or sell the securities. Current and future holdings are subject to risk.

Fed refers to Federal Reserve.

The Dow Jones Industrial Average (DJIA) is an index that tracks 30 large, publicly-owned companies trading on the New York Stock Exchange (NYSE) and the NASDAQ.

Spread refers to the difference between two prices, rates, or yields.

Investment grade includes bonds with high and medium credit quality assigned by a rating agency.

Yield is the income return on an investment, such as the interest or dividends received from holding a particular security.

Earnings growth is the annual rate of growth of earnings from investments.

A limited partnership (LP) is a partnership made up of two or more partners. The general partner oversees and runs the business while limited partners do not partake in managing the business. However, the general partner has unlimited liability for the debt, and any limited partners have limited liability up to the amount of their investment.

E&P refers to exploration and production.

A basis point is a unit that is equal to 1/100th of 1%.

Diversification does not assure a profit or protect against a loss.

Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC. [44306]