Published on November 3, 2021

If you were unable to join our quarterly webinar, watch the replay to hear updates on the Osterweis Fund and Osterweis Growth & Income Fund (formerly named Strategic Investment Fund).


Shawn: Good morning, everyone. My name is Shawn Eubanks, and I'm the Director of Business Development at Osterweis Capital Management. We'd like to welcome you to our quarterly webinar for the Osterweis Fund and the Osterweis Growth & Income Fund. During the webinar, Larry Cordisco will review the funds and our economic outlook. After that, Nael will review top and bottom contributors, and then new and exited positions. We'll then have a question and answer session. Please feel free to submit your questions at any time during the webinar. This webinar is being recorded. Larry, if maybe we could start off with your thoughts on the market and outlook going forward.

Larry: Thank you, Shawn. Well, the third quarter was a volatile market, although it traded largely in a pretty tight range, and I think it was largely flat from the beginning to the end of the quarter. And what we think is that the market appears to be struggling with whether the economy is experiencing a growth pause, versus just a downturn in growth due to expiring stimulus and the Delta variant and supply chain issues, or whether it's, again, more of a structural problem with just growth going into a different gear that's lower.

That leads us to think about whether or not some of these factors, which are getting a lot of attention these days, especially inflation are more structural or more transitory, which is becoming one of the favorite words. And in fact, we hear a lot of talk about people who are nervous looking forward, about whether or not the longer-term inflation outlook is more persistent or even stagflationary. And we think that's a really interesting market debate, but we remain somewhat skeptical about the inflation outlook being more secular or structural long-term, because there are a lot of deflationary forces that we still think need to be considered.

And specifically, what we're thinking about are just the long-term secular impact of technology and productivity. That's something you didn't see in the 1970s, or have available as much in the 1970s. There are policies in China that are getting a lot of attention now that are meant to dampen demand for housing. And infrastructure development, china has been one of the major buyers of commodities for a long time, and so if their growth rate goes down a bit, we think that's probably something that will dampen inflation. We still have aging demographics. Western societies and China are all getting older. And finally you have a lot of debt out there and debt is structurally a deflationary force. So these things need to be considered in relation to the inflation outlook. And we think that they are real powerful counterbalances to what we're seeing in the global economy today.

So as we think about what kind of economy we're going towards, again, we don't think it's very 1970s style stagflation or inflation, but we think it's probably more likely to be a 1990s style environment, where you might have a bit higher inflation, especially with real wages remaining sticky and growing, but you are also set up to have a very nice growth outlook. Specifically, we see opportunities in infrastructure investment and supply chains. I think the global situation we have with supply chains now have laid bare some of the real structural problems with just-in-time inventory. A lot of investments are going to have to go into reshoring and investing in those supply chains so that we can get beyond these issues and not experience them again. We think there's a lot of opportunity for energy investment, especially alternative energy.

Right now, there is a real tight match between supply and demand and energy, and as the global economy continues to grow, that mismatch is going to just expand, and so there's a lot of need for energy investment. And those are just a couple examples of why we think there's probably a pretty strong outlook. And I guess I would add that consumers look flush with cash, they want to spend when they can. So generally speaking, we're pretty optimistic that the economy is in pretty good shape. And we see a nice mix between growth and inflation probably tapering down in terms of the actual inflation numbers over the next year or so.

As we think about all that, it doesn't change our investment strategy, which is to invest in high quality companies that have secular tailwinds and competitive advantages. Though we are looking more to change the mix, to take advantage of some of these opportunities, in infrastructure and supply chains, and Nael will touch on that a little bit later in the call. So with that, Shawn, I'll hand it back to you.

Shawn: Great. Thank you very much, Larry. I was hoping maybe you could just spend a little bit of time briefly reviewing the performance for the Osterweis Fund.

Larry: Yeah. During the quarter, the Osterweis Fund was down about one and a half percent. It lagged the S&P 500, which was up about half a percent or a bit more. One of the big influences there is that the large cap FAANG stocks did especially well during the quarter..

Shawn: Okay. Thank you. Nael, while we're still talking about the Osterweis Fund, can you review top and bottom contributors for the quarter and year-to-date?

Nael: Sure. So happy to do that. If we look at the top contributors quarter-to-date, you see Monolithic Power, Danaher, Alphabet, Old Dominion, AMD, and the same is true year-to-date, slightly different mix of companies. Really the theme across all of them is exactly what Larry just touched on, which is these are really high quality businesses. They tend to be dominant businesses, and/or businesses that are disrupting or taking share from another sector. As a result, these are all high growth businesses, very highly profitable, often profits are growing faster than revenue. And frankly in the quarter, these companies all just continue doing what they're doing and our thesis is playing out. So that covers the top five. I think that's the recurring theme.

In terms of the bottom five contributors, just to focus on FedEx first. FedEx is a parcel delivery business that we're all familiar with, and the thesis around that has been that we will see a surge in demand. Obviously Covid catalyzed it, but omnichannel in general is creating a bunch of extra demand. It's a highly consolidated industry. They have pricing power, but in order to have profitable growth, you need it to manage your costs. And in the most recent quarter, FedEx had some trouble managing its costs, and as a result, it took a hit in terms of profitability and share price.

Alibaba is a very different story. It's a dominant internet business in China. Fundamentals are relatively strong; however, the political environment in China really changed dramatically, particularly over the last several months. And as a result, the market reappraised the value of a lot of Chinese technology businesses as the Chinese government took actions to reign them in and potentially control profit. So multiples came down that hurt Alibaba. We'll touch on FedEx and Alibaba in a moment. As for Zendesk, T-Mobile, Union Pacific, I would say, they all face unique temporary headwinds that we think will resolve in the near term. So that really covers the contributors both top and bottom. We can move on the new and exited positions if you want.

Shawn: Oh, that's great. Thank you, Nael. If you can cover those as well, that'd be great.

Nael: Sure. So in terms of the new positions, on the left here, Boston Scientific, it's a healthcare device, medical device business that we've followed for years. And it's been a very successful rollout that acquired these high quality medical device businesses, integrated them to the platform cross-sold, and grown as a result. And the reason we had an opportunity to pick up some shares in Boston Scientific is that as a result of Covid, utilization of procedures, basically moved below-trend, and so that created a bit of an opportunity. Our view is that this is a business that organically should grow mid to high single digits, but we think actually it could materially exceed that because of acquisitions that they'll continue to do. So you get the benefit of basically a ramp back up post-Covid and then growing at a higher-than-expected rate.

And we've actually seen that play out a little bit since we've initiated position, is they announced a pretty what we think of attractive acquisition of material size recently. CVS is the pharmacy company we all know. They have a huge footprint of pharmacies across the country, but they also have become a vertically integrated business, where they own a very large pharmacy benefit manager, and now they own Aetna, which is a large healthcare company.

And we think the company is using its new unique position to grow that insurance business and drive membership into CVS stores, and as a result, you get a bunch of synergies that should turn what... When we first invested, it was about 10 times earnings business, trading, expecting low single digit earnings growth. We think that that could, as this transformation takes hold, become a mid-single digit to even double-digit earnings growth story. Over time, multiple will follow and cash flows will follow as well.

In terms of liquidated positions, Alibaba, we just thought that risk that I just touched on was too great to expose clients to in terms of political situation. So we decided to liquidate that position. FedEx, we like the parcel sector, but we just decided that they are not the right player in terms of cost management and supply chain control. So we exited that position. And then Micron and Novartis, we frankly just found better uses of capital. So we decide to sell those positions as well.

Shawn: Thank you, Nael. Let's transition to the Growth & Income Fund if that's okay. Larry, can you talk a little bit about the role that you think this fund can play in investors' portfolios and then talk about the performance in long-term and short-term?

Larry: Yeah. Thanks Shawn. Well, we believe this fund, it's a really unique fund and it can fill a need in the market by providing both current income and long-term appreciation. And based on the most recent income distribution, the current yield of just over two and a half percent compares very favorably, both to opportunities in the fixed income market and the yield on the S&P 500. And so if you think of the big picture of this fund, it focuses on delivering consistent income, and this is particularly important for pre-retirees and retirees while also appreciating over time.

And it emphasizes growth opportunities, especially dividend growth. It's more difficult to lose money when a company is growing and growing its dividend. And consistent dividend increases over time, provide a really nice return on an investor's cost basis, which again, compares quite favorably to what you can do in the fixed income markets. The fund, similar to the Osterweis Fund, emphasizes market leaders and disrupters. We're always looking for unique business models. And from an investment income, fixed income perspective, we don't limit it to investment grade.

In a low-yield environment, it's important to strategically allocate the fixed income exposure, and our fixed income team here is quite skilled at that. Finally, similar to our overall firm philosophy, we concentrate on our best ideas. We do believe an over-diversified portfolio can limit performance over time. As you can see from the performance during the quarter, the fund underperformed its blended benchmark, the S&P 500 and the Aggregate Bond Index, just slightly. We ended the quarter with 68% equity, 28% fixed income, and 5% cash. And I'll hand it back to you, Shawn, to continue the call.

Shawn: Okay, well, great. So just as a reminder, please feel free to add any questions in the chat. And while we're waiting, Nael, I know you've been discussing supply chain and onshoring recently as it relates to our portfolio, and I was hoping maybe you could share your thoughts on those topics.

Nael: Sure. Larry actually touched a bit on this, but what we've observed is that over the last 30 years, supply chains have moved offshore, and the idea is you have this kind of just-in-time inventory, and that creates huge efficiencies in terms of profits, in terms of cash flows, and you have moved supply chains to Asia, to Latin America, Central America. And over the last few years, though, especially with the tariff war with China, we started seeing that these supply chains were coming under pressure, but you can see the trend in a really interesting chart. If you look at inventory's percentage of GDP over time, over the last 30 years, it went from about 14% to now about 9%.

So that trend is very evident. Covid, as Larry said, it laid bare the shortcomings in this approach. It makes a lot of sense in terms of efficiencies, but it also creates problems when you have big demand surges, and then on top of that, you have omnichannel and e-commerce really pushing supply chains. So we think that what started as a little bit of maybe a rumble a few years ago is turning into something more structural. And we're not saying that it's going to reverse entirely, that inventory is going to go back to 30-year low levels, but we do think that supply chains will be reconfigured to some extent.

And as that relates to our portfolio, there're several companies that would be beneficiaries. So Union Pacific is one of the two major Western rails. They have obviously, significant exposure to the ports here in Oakland, down in Long Beach and, and all the way out through the middle of the country to Chicago, and they would be a direct beneficiary, as you see this onshoring. Then Old Dominion Freight Line is a Western truckload company we've known for years. They have a major nation-wide footprint.

They've seen the benefits of this actually, going back to a few years, but certainly in the last several months, they've seen a real uptick in demand, as we're starting to see this trend reverse. And then PS Business Parks, it's an industrial real estate business that we've long tracked and owned for about a year now, and they have really high quality last mile infill real estate for industrial uses throughout the Bay Area, down through Southern California, out through Houston and Dallas, right by the ports and airports, through Miami, and then up through Baltimore by the ports there. And so they are a direct beneficiary of this trend, and they're seeing real pricing power and real demand for their space..

Shawn: Thanks Nael. Larry many advisors are struggling with finding income for their clients in this low interest rate environment. I know we experienced that with our private clients as well. Can you talk about a couple of the income-oriented holdings in the Growth & Income Fund and why you think they're poised to deliver rising dividends over time?

Larry: Sure, Shawn, that's a great question. I'll highlight two. One is Analog Devices. It's a semiconductor company. They just recently closed an acquisition of Maxim, another semiconductor company. And if you look at generally where Analog Devices has positioned its business, it's tied to a number of very powerful secular trends. First of all, is the rising use of semiconductors. But if you look more specifically at the sub-markets or specific markets or analog, I'm sorry, where Analog Devices is targeting, is focused.

Automobiles is a really big one. It's about 20% of their revenue exposure now, and the semiconductor content in automobiles is basically doubling. It's about $500 now, a reference point, it was about $300 five years ago, and that's going to be going to over a thousand dollars over time. So if you think about this tailwind and other markets like Internet of Things, Analog Devices is very well positioned to grow revenue mid-to-high single digits over the long-term, expand margins and increase its dividends. And so if you look at its current yield, which is around one and a half percent or so, we expect dividends to grow high single digits over a long period of time.

And against that cost basis is really going to be a powerful return tool for investors. A second company I would highlight is Hannon Armstrong. Hannon Armstrong, basically is a financer of alternative energy projects. Alternative energy is growing, whether it's solar panels, winds, wind power, or companies investing for better control systems inside their buildings to be more efficient for power, Hannon finances all of those things. And so if you think about that secular tailwind and the demand for investment, for alternative energy and energy efficiency, we think Hannon Armstrong is very well positioned to grow its dividend over time. So those are two examples of companies that we focused on with the income growth strategy that I think are pretty instructive for how we think about things.

Shawn: Great. Thank you, Larry. So I'm not seeing any questions in our Q&A at this point, but do you have any closing comments?

Larry: No. I just want to emphasize, I think that what we're doing here with focusing on these high quality companies, is really a fantastic long-term strategy. I feel very good about how we position the portfolio, and I think I'll just sign off that we're pretty optimistic about what we see with the economy and where we see earnings growth going in the next year.

Shawn: Thank you. And thanks to all of our participants for joining today.

Opinions expressed are subject to change, are not intended to be a forecast of future events, a guarantee of future results, nor investment advice.

The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance. The index does not incur expenses, is not available for investment, and includes the reinvestment of dividends.

The 60/40 blend is composed of 60% Standard & Poor’s 500 Index (S&P) and 40% Bloomberg U.S. Aggregate Bond Index (BC Agg) and assumes monthly rebalancing. The S&P is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance. The BC Agg is an unmanaged index that is widely regarded as a standard for measuring U.S. investment grade bond market performance.

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Mutual fund investing involves risk. Principal loss is possible.

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. The Fund may also make investments in derivatives that may involve certain costs and risks such as those related to liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Leverage may cause an increase or decrease in the value of the portfolio securities to be magnified and the Fund to be more volatile than if leverage was not used. 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-20211028-0361]