Published on October 31, 2022

If you were unable to join our quarterly webinar, watch the replay to hear updates on the Osterweis Fund and Osterweis Growth & Income Fund.


Mark Schug: Good morning everyone. My name is Mark Schug and I am the Northeast Regional Investment Consultant at Osterweis. Shawn Eubanks is out of the office today. We would like to welcome you to our quarterly webinar for the Osterweis Fund and Osterweis Growth and Income Fund.

During the webinar, John Osterweis and Larry Cordisco will review the funds and our economic outlook. After that, Greg Hermanski will review the top and bottom contributors, and then Larry will cover new and exited positions. We will then have a question and answer session. Please feel free to submit your questions in the Q&A during the webinar. John, let's start off with your thoughts on the market and outlook going forward.

John Osterweis: Okay, well good morning everybody. Welcome. Just to put things in context, as you know, over the 40-year period from 1982 to 2022, we experienced unusual disinflation, which was really caused by two forces, which we've talked about many, many times. One being technology, which is inherently deflationary, and the other was globalization and particularly the opening up of China, which really provided a supply shock of almost unlimited cheap labor. And this, in particular, kept a lid on wages domestically, and actually in other countries as well. And so, between this supply shock in terms of cheap labor and the impact of technology, we experienced four decades of lower and lower inflation. The net result was that interest rates, which had been hovering around 14% on the 10-year in the early eighties, dropped to below 1%. And concomitant with that, equity valuations rose from about eight times to more like 25 times on average. Rough numbers.

All that reversed recently. China, as you all know, is experiencing some labor shortages. We are also experiencing labor shortages domestically. And so there's been a very sudden dramatic shift in the whole labor equation with wages going up. And this, in our mind, has basically turned the 40-year disinflation thesis on its head, and we're now looking at some more sustained higher inflation. Add to that the supply chain disruption from Covid, add to that the shock from the war in Ukraine, and what's that done to grain and hydrocarbon costs, and there's been a very significant upsurge in inflation and the Fed moved aggressively, maybe not as aggressively as they should, but aggressively from trying to promote full employment during the Covid lockdown to really fighting inflation. And so, we've moved to tight money, interest rates are up, and lo and behold, equity valuations have come under significant pressure.

As a result of the Fed tightening, there's also considerable concern about what the long term growth, or at least the short term growth outlook is for the U.S. economy. People are worried about economic slowdown, or even recession, as a result of the Fed actions. And so the market has had to deal with both declining valuations and concern over what earnings might look like over the next couple years.

So we've had a pretty sharp selloff in the market. What we've done about it is we've raised a bit of cash, i.e., reduced our equity exposure. We have shifted our focus more towards companies with sustainable dividends and most particularly with growing dividends. And we've tried in this intersection of value and growth to be a bit more value-oriented than we had been for a while. We'd been feeling that the growth was probably the more, the scarcer part of the equation. Now we've said value is the scarcer part, so we've shifted our security selection from just companies that grow to companies that can actually grow dividends, et cetera.

We've also obviously put a great deal of emphasis on companies that are leading dominant companies in their industry and would have pricing power in this kind of environment. Because obviously with cost going up, being able to pass those along is quite important.

So Mark, maybe you could go to the next slide.

Mark Schug: Sure. Thanks John. Can you briefly review performance for the Osterweis Fund?

John Osterweis: Yeah. Performance last quarter, we were down 5.9% versus 4.9 for the S&P. We're also lagging a bit year-to-date in the 1-year, And our strategy over time has added value. So we're a little disappointed with near term performance, but I think we're set up for a good long-term performance coming out of this.

Mark Schug: Okay. Great. Thanks John.

John Osterweis: Yeah.

Mark Schug: And Greg, can you just take us through top and bottom contributors for the quarter- and year-to-date?

Greg Hermanski: Yeah, thanks John. Thanks Mark. Good morning everyone. As you can see on the slide, that the top and bottom contributors for the third quarter and year-to-date, in an environment like we've been discussing with rising inflation and a slowing economy, it's not a big surprise that our top contributors in 2022 have generally been our more defensive stocks, which have less discretionary spending exposure. So for example, Dollar General, a growing discount merchandise retailer, has done really well. Progressive Insurance, Waste Connections, a waste disposal company, and CVS, a healthcare-focused insurance and retailer, have been among our top contributors. In the third quarter, Ross stores, a discount clothing retailer, was one of our best performers. And it further fits the theme of defensive, non-discretionary stocks performing well in this market.

On the bottom contributor side, this year it's been largely technology companies, and we still like these stocks long term. We focus on tech companies that have very strong competitive positions, that generate strong free cash flow, and have secular growth tailwinds. And examples of that would be Alphabet or Google, Microsoft, Amazon, those are leading players in the advertising market as well as the cloud computing industries. AMD has been taking significant semiconductor market share, and they continue to launch new products, stay ahead of their competitors like Intel, and that's providing further opportunities to drive share gains as well as drive their earnings growth over time.

And then another company that struggled in the most recent quarter is Adobe. They announced the acquisition of a private company called Figma, which people didn't know very well. And at a recent investor day, management addressed the new acquisition. And we believe that not only does this acquisition have an opportunity to significantly expand Adobe's market, but also to accelerate their growth rate. Management also discussed some internally developed innovation that they're adding to their core products, which included artificial intelligence. We believe that's going to increase the moat around Adobe's core business. And then finally, we continue to be believe that the company Adobe, which generates significant free cash flow and it trades at a reasonable multiple is very attractive. So while some of these technology stocks have struggled year-to-date, we view them very attractively long term.

So now I'll turn the call over to Larry to discuss other upgrades in our portfolio, new and exited stocks in the quarter.

Mark Schug: Great, thank you, Greg. Appreciate that. Larry, can you take us through new and exited positions?

Larry Cordisco: Yeah, thanks Mark. The stock market, it's an interesting spot here. It's simultaneously presenting opportunities and it's also exposing a lot of risks. So we've been active during the quarter, both trimming names where we see less upside or more risk, but we've also added some names where we see really nice opportunities. And there are a lot of situations where valuation's becoming pretty attractive for investors with a three-to-five year view like ourselves. So some of our new positions are Airbus, it's obviously one of the largest airplane manufacturing companies in the world. It's benefiting from a resurgence and recovery in the aerospace cycle. And it's, over the long term, been taking market share in the narrow-body segment from Boeing, and narrow bodies are the largest part of the commercial aerospace industry.

We also added Analog Devices. ADI - Analog - is one of the market leaders in analog semiconductors. We really like the industry. It's structurally undersupplied if you think about where a lot of the capacity is gone to semiconductor growth, it's been on real leading edge data center type companies, which has left a lot of structural undersupply in the analog space. That equals pricing power for the market leaders, of which ADI is one of them. And we also think Analog Devices is a great play on industrial automation and the rising content of semiconductors in autos.

In the quarter we added EastGroup, it's one of the leading industrial warehouse REITs. It's got a very strong position in growing demographic areas and it's a beneficiary of secular tailwinds, like e-commerce and reshoring. It's got really strong pricing power and we expect this to potentially be a beneficiary of inflation over time as real estate costs and renting costs continue to rise.

We also added L3Harris Technologies. This is a leading defense contractor with a very strong competency in communications and technology equipment. We see this as a leader with tailwinds in both the improving defense spending environment and a mix towards electronics is rising within the defense budgets. And those are both benefiting L3Harris over time.

During the quarter we exited three positions. The first is Generac. We were worried about the sustainability of demand for the home generator market. We had seen a lot of demand get pulled forward during Covid, and that time also coincided with a number of natural disaster situations with hurricanes, fires, and freezes in Texas. So we were worried about the pull forward of demand and the sustainability of demand for those products.

We also sold Spirit Airlines, Aerosystems, excuse me. This is really just a swap out for Airbus. And we talk about the opportunities that are being presented in the market. And this is a relatively, we found or believe Airbus to be a relatively more attractive opportunity on a risk/reward basis as opposed to Spirit. And finally, we sold Aptiv during the quarter. Aptiv is a leading provider of electric systems for the automobile industry. It's a very well-run company, but we do have concerns over end-market demand given the fact that car prices are rising pretty significantly, as are the financing costs. And so, we do have concerns over the combination of Aptiv's valuation plus what the end market demand may look like over time.

And with that I'll hand it back to you, Mark.

Mark Schug: Okay. Appreciate it, Larry. Why don't we turn our focus to the Growth & Income Fund. John, do you want to take us through positioning and performance?

John Osterweis: Sure. So just to remind everybody, the Growth & Income Fund is designed to produce growing income over time through a combination of companies that pay growing dividends and high yield bonds to add to bulk up our current income in that fund. As you can see, the Fund slightly outperformed the market this quarter and has done so this year as well. It's one of these funds that we're very excited about, because I think in this kind of environment, the return that you get from dividends may be a very large part of total return for some time to come.

Anyway, we ended the quarter with about 62% equity, 20% fixed income, and 12% cash. So with that, let's turn it over to Q&A.

Mark Schug: Okay, super. Thanks John. While we wait for questions to come in, maybe I'll just throw one out there. Larry, for you, you've written about deglobalization as an emerging long term trend. Any implications for the long term inflation outlook? And are there any particular positions in the portfolio that are tied to this trend?

Larry Cordisco: Yeah, thanks Mark. Yeah, and John touched on this at the beginning of the call, because it's an issue that really sits at the forefront of our minds, and we think it's probably a longer term headwind. And as John mentioned, inflation is probably going to go down from where it is today, but probably is going to be much higher than it had been post the Great Financial Crisis. So somewhere in between. And that's really a huge implication of this deglobalization trend. And John talked about the China labor situation having basically reversed here. And they're also, between women entering the workforce and Eastern Europe becoming an accessible labor market, basically in the timeframe John discussed, the labor market doubled globally, right? And that's not happening anymore.

So the implications, as I mentioned, are inflation longer term. We think it stays a little bit higher. And we also think that, given the lack of cheap labor available globally and what we've seen with supply chains during Covid, there is a lot of talk and a lot of action actually behind reshoring manufacturing and supply chains.

And so, a couple names that we have in the portfolio that tie into that specifically, well the first, as I mentioned, EastGroup is a new position that's definitely tied to reshoring, as well as e-commerce. But there's a reshoring tailwind to that story as companies need to warehouse more of their inventories and supply chains locally. We also own Lincoln Electric, which is one of the leading welding companies globally. That's based in Cleveland, Ohio. But as you think about the need to invest in infrastructure to support this deglobalization, it's basically they are a very good play on that. And they're also a very good play, because they're one of the leading robotic welding companies in the world. So when you think about the need to do welding, but you don't have as big a labor force, and again that touches on this sort of underlying inflation theme that we think about, robotic welding adoption we think will be a really a big thing going forward.

So those are a couple examples I think that tie on the globalization theme or de-globalization theme pretty well, Mark.

Mark Schug: Okay, thank you Larry. The other big picture theme that would seem to be affected by the recent Inflation Reduction Act is clean energy, giving the tax credits. How are you playing this particular theme?

Larry Cordisco: Yeah, we have a couple interesting names in our portfolio. The first is, actually I'll go to Lincoln Electric. I'll hit on that since I just mentioned it. If you think about the investments in hydrogen processing, wind energy, and carbon capture, all those things require a lot of welding work. So Lincoln Electric is in the middle of that sort of trend. It's also in the middle of the electric vehicle trend because not only does it make the robotic welding arms that go into new vehicle production, of which electric vehicles are right in that sweet spot, but they also now have their own electric charging network that they're starting to commercialize. So there's a couple different ways Lincoln's involved in this.

Another name that I think is really interesting is Air Products. Air Products is one of the main industrial gas companies globally, but well obviously with a very big footprint in the United States, and they are tied to clean energy in two ways. The first is they are investing billions of dollars in hydrogen processing plants around the globe. So if you go to Europe, you may see public transportation options that are run on hydrogen. That hydrogen comes from plants that may be Air Products producing that hydrogen that's used in those fleets. They are planning on investing billions of dollars more over the next 10 years, and they expect to get a 10% return on capital on those investments, which will be a very significant driver for earnings growth. The one other place where air products benefits from clean energy is carbon capture, and they're working with very large refining and petrochemical companies right now on carbon capture technologies that again, they expect to get a nice return on. So that's a company that's very well-positioned to really grow its business basically on this tailwind of clean energy.

Mark Schug: Yeah, that's really interesting. Thanks Larry. I don't see any other questions or raised hands. Larry or John, would you like to leave us with any parting words of wisdom?

John Osterweis: I think we've pretty well covered our views, but if people have residual questions, please feel free to call us. We're here.

Mark Schug: Thank you, and thanks everyone for joining. And we'll talk to you soon.

John Osterweis: Thank you all.

Greg Hermanski: Thanks.

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The Osterweis Fund may invest in medium and smaller sized companies, which involve additional risks such as limited liquidity and greater volatility. The Fund may invest in foreign and emerging market securities, which involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks may increase for emerging markets. The Fund may invest in Master Limited Partnerships, which involve risk related to energy prices, demand and changes in tax code. The Fund may invest in debt securities that are un-rated or rated below investment grade. Lower-rated securities may present an increased possibility of default, price volatility or illiquidity compared to higher-rated securities. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities.

The Osterweis Growth & Income Fund may invest in small- and mid-capitalization companies, which tend to have limited liquidity and greater price volatility than large-capitalization companies. The Fund may invest in foreign and emerging market securities, which involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks may increase for emerging markets. The Fund may invest in Master Limited Partnerships, which involve risk related to energy prices, demand and changes in tax code. The Fund may invest in debt securities that are un-rated or rated below investment grade. Lower-rated securities may present an increased possibility of default, price volatility or illiquidity compared to higher-rated securities. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. From time to time, the Fund may have concentrated positions in one or more sectors subjecting the Fund to sector emphasis risk. Investments in preferred securities typically have an inverse relationship with changes in the prevailing interest rate. Investments in asset-backed and mortgage-backed securities include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments.

Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC. [OSTE-20221025-0653]