Published on May 3, 2021

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

Transcript

Shawn Eubanks: Good morning, everyone. My name is Shawn Eubanks and I'm the director of business development at Osterweis Capital. We'd like to welcome you to our quarterly webinar for the Osterweis Fund and the Osterweis Strategic Investment Fund. As a reminder, this webinar is being recorded.

During the webinar, John Osterweis will review the funds and our economic outlook. After that, Greg will review top and bottom contributors as well as new and exited positions. And then Larry will go into more detail on a couple of our holdings. We'll then have a question and answer session. So please feel free to submit your questions at any point during the webinar. I'll now turn over the webinar to John Osterweis. John?

John Osterweis: Well, good morning, everybody. As I think you all know, the first quarter was a somewhat schizophrenic period for the stock market, where, on the one hand, the market became infatuated with reopening plays, and on the other hand would swing back to faith in the old stalwart growth stocks that had performed so well in 2020.

As part of this, there were concerns about rising inflation, which in turn would put some upward pressure on interest rates. It was some speculative activity, particularly around Bitcoin, SPACs, surge in biotech companies. So it was an interesting transitional quarter.

What we think is really going on is, as more and more people become vaccinated, the economy is clearly reopening and there is a very significant growth in economic activity. This clearly benefits companies with more cyclical exposure. It also is accompanied by some very clear signs of inflation. We see that in various commodities. I think probably everybody on the call is knows that lumber prices are up almost threefold. There are bottlenecks in transportation, which has caused transportation costs to go up.

And so the question really is how sustained will the above-average growth be? How sustained will the current surge in inflation be? And what happens as we get back to more normal kinds of economic growth? Our view is that we will get probably a one to two year acceleration in economic activity, that we will see inflation heat up for a while, but then as the bottlenecks are opened up in the economy, the forces of technology and globalization, particularly technology, will reassert themselves and push inflation back down.

We know that the Fed is comfortable with inflation rising above 2% for a while. So we know that monetary policy will remain quite accommodating. We know that there is massive fiscal stimulus coming down the road. And we also know that the consumer is flush with cash and eager to get out and start spending and leading a more normal life. So short term, we see very significant, very significant pickup in economic growth and inflation. But again, ultimately, we get back to more normal conditions.

We've been focusing on high quality companies, both long-term secular winners, and to some extent of strong companies with a cyclical bias. We insist on owning companies with clean and strong balance sheets, with strong competitive advantages, and with accelerating earnings and accelerating cash flow.

We remain constructive on the market, even though valuations are not cheap by historic standards. We think interest rates will remain towards the lower end of where they've been historically. And with strong growth, these lower interest rates can support current valuations. You can switch to the next slide please.

The quarter we were up about four and a half percent. A little behind the market, which was up about 6.2. This was because we had a slight underweighting in the more cyclical parts of the market. But I think ultimately the strong secular growers that have been the foundation for the portfolio will reassert themselves and I think will produce outsized performance for us. If you look at the long term, we've produced very solid results over a very, very long period. And I think what we're doing will continue to produce those results.

So with that, let me turn it over to Greg to talk about top and bottom positions.

Greg: Great. Thanks, John. Good morning, everybody. You can see on the slide, the top and bottom contributors for the first quarter and the last 12 months. During the quarter, a common trait among our best performing stocks is that they're seeing an acceleration in their businesses. In the first quarter, Micron, Applied Materials, JP Morgan, and Alphabet were all repeat top performers from the fourth quarter, as the businesses are continuing to benefit from the rebounding economy. And then Old Dominion Freight Lines, which is an LPL shipping business, was also a top performer in the quarter. And ODFL is benefiting from the rebounding economy, strong pricing power, and demand for e-commerce.

If we look at the bottom contributors in the first quarter, I'd put them into two different buckets. The first bucket includes Charter Communications, AMD, and Zendesk. And despite these companies underperforming in the quarter a little bit, we view it as a pause. They've had very strong performance for the last 12 months, and we expect that to continue. The other bucket includes LiveRamp and Alibaba. And these stocks are relatively new positions that we believe are in the process of overcoming some controversies that will unlock value for the portfolio.

Speaking of new positions, I'd like to briefly discuss some names that we added in the quarter. As previously mentioned, we added Alibaba to the portfolio. Baba has e-commerce cloud hosting and digital businesses that remind us a lot of dominant U.S. franchises like Amazon, Netflix, and Square. And similarly to the U.S. businesses, Baba benefits from strong secular growth tailwinds and strong market position in China.

Recent Chinese regulatory investigations have been a headwind for the stock, but we believe that these issues will be resolved, and that this is an opportunity. And this will ultimately allow value to be unlocked from the stock as investors focus on their dominant businesses and their strong growth profile.

We also added International Flavors and Fragrance during the quarter. IFF provides critical flavors, ingredients, and fragrances to CPG companies. We believe that the revenue growth at IFF will accelerate from both the near term restocking due to the pandemic, as well as strong secular growth trends for healthy natural products. The company recently acquired DuPont's ingredients business, which further adds steps to their high value product lineup that serves the fast growing end markets.

Pioneer Natural Resources was also added during the first quarter. We believe that Pioneer has some of the best E&P assets in the U.S. And as a result, they're a low cost producer and they generate significant free cash flow with current oil prices. We believe that Pioneer's fundamentals are well positioned to accelerate as the U.S. economy rebounds.

And then finally, we added T-Mobile. T-Mobile is the number two provider of wireless services in the U.S. We believe that T-Mobile's premium wireless spectrum will become a critical advantage as 5G networks are rolled out. T-Mobile's advantaged 5G network that should enable the company to accelerate market share gains, increase profit margins, and generate a significant amount of free cashflow over the next five years.

So now I'll turn the call over to Larry to discuss the fund position in stocks that we exited during the quarter. Larry.

Larry: Thanks, Greg. During the quarter, we exited positions in Becton Dickinson, Coresite Realty, and IHS Markit. All three are fine companies, but they all three lack catalysts to accelerating fundamentals, which is incredibly important in the current environment, given the recovery dynamics in the U.S. economy and in the global economy.

I'd just like to add, I guess, a couple of points on portfolio positioning as well. And John alluded to a number of these things earlier, but I'm going to go in a little bit more detail. We do think the current environment is more favorable to cyclical companies, especially compared to the prior 5 to 10 years, which were a pretty low growth environment. And, as a response, we've been steadily positioning the portfolio to reflect that.

Today, our allocation to cyclically sensitive companies, and I'd call those industrials, banks, materials, and consumer-focused companies, is about 2X, or twice what it was prior to the pandemic. But I really want to make an important point about those companies that we own.

Those positions are very consistent with our overall strategy. All of those companies are market leaders with strong, competitive advantages, especially with respect to scale advantages. And that's important for two reasons.

First, if inflation ends up being stronger for longer, we believe these companies are well positioned to pass those higher input costs along and thus be able to preserve their margins. And second, if the economy does revert to a lower growth trajectory after the Covid recovery, we think these companies are share gainers. They're relatively more defensive, and they should hold up better in a decelerating growth environment, if that's what the economy ends up doing. So we basically think it's a good mix of offense and defense. And over the long run, these are companies that should continue to compound nicely, their earnings growth.

 

We believe the Strategic Investment Fund can provide an opportunity for equity like returns while seeking to mitigate downside risks through the use of the strategic income strategy. During the quarter, the fund outperformed its blended benchmark of 60% S&P 500 and 40% Barclay's Aggregate Bond Index. We ended the quarter with 71% equity and 28% fixed income. This reflects a very strong equity performance.

And at this point, we can open for Q and A and again, you can ask any questions through the Q and A window or by clicking the raise your hand icon.

Shawn Eubanks: Thanks, Larry. While we're waiting for questions, I thought I would ask you, I know you've been putting together a presentation on the market for an FPA group later today. Are there any thoughts you want to share from that presentation you're working on?

Larry: Yeah. Thanks, Shawn. First, as John mentioned, I don't know if you want to call it a schizophrenic quarter or whatever, but the first quarter of '21 has just been quite remarkable in the equity markets. And there's been significant outperformance coming from deep value, cyclical names, high beta stocks, companies with negligible earnings.

This is pretty common at this point in the recovery cycle, but we kind of take the view and certainly the way that the equity markets are responding to the earnings season so far, I think we're taking the view that the trade here has been significant, but that trade looks like it's ending. And the market's starting to really look forward to companies that have more sustainable growth prospects.

Now, I think the jury still out as to whether this baton handoff will go back to growth names and an economy like we saw before; more low growth, or if there's a more permanent sort of handoff to value names and cyclicals over time. There are a lot of mixed messages on this. For example, as John mentioned, inflation is popping significantly, but if you look at the 10-year yield, those rates remain below pre Covid levels. So certainly the bond market doesn't appear to be forecasting any sustained period of outsized inflation or growth.

We've positioned the portfolio in two ways. As I've mentioned, we do have a higher allocation to cyclicals, but all are high quality companies with the ability to generate significant cashflow. The other attribute is we've looked to own names that can combine the benefits of both a cyclical recovery and a secular trend. And I'll give you a few examples.

For example, Aptiv is a holding in the portfolio. That company is extremely well positioned to benefit from increasing electric vehicle adoption. But it also will benefit from a cyclical recovery in auto sales, which are currently depressed due to the global semiconductor shortage.

Google is another example. Digital advertising and cloud services are two of the most powerful trends today, but advertising was affected significantly by the pandemic. And now we're seeing the rebound, as you can tell from Google's earnings report last night. Both of these names are sort of what we would call sneaky recovery plays again, where you can combine both a secular theme and a cyclical recovery.

But I'll finish with this thought, which is something that we hit on often because it's important to us. Whatever this sort of near term trade or a longer-term trends favor, we will stick with companies with strong, competitive advantages and secular tailwinds. And we seek to buy those companies at attractive valuations and that approach isn't going to change. Thanks for that question, Shawn.

Shawn Eubanks: Yeah. Thank you. I'm looking forward to the presentation later today. So it looks like we don't have any questions at this point. Any final comments, John or Larry or Greg?

Larry: No. I just want to thank everyone for joining us or listening to the replay. And certainly if anyone ever has questions about our investment process, portfolio positioning or any other questions, feel free to reach out to us. We're more than happy to interact at any time.

Shawn Eubanks: Thank you all.


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 Barclays 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.

These indices do not incur expenses and are not available for investment. These indices include reinvestment of dividends and/or interest income.

Performance data quoted represent past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the Osterweis Fund may be higher or lower than the performance quoted.

Click here to view Fund performance.

Holdings and sector allocations 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 by the Osterweis Fund or Osterweis Capital Management.

The Fund’s top 10 holdings may be viewed by clicking here.

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A special purpose acquisition company (SPAC) is a company with no commercial operations that is formed strictly to raise capital through an initial public offering (IPO) for the purpose of acquiring an existing company. Also known as “blank check companies,” SPACs have been around for decades.

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

Fed is short for Federal Reserve.

Cash flow measures the cash generating capability of a company by adding non-cash charges (e.g. depreciation) and interest expense to pretax income.

Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain and expand the company’s asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.

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

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

Duration measures the sensitivity of a fixed income security’s price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.

One cannot invest directly in an index.

Earnings growth is not a measure of future performance.

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 Strategic Investment 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-20210428-0204]