Published on July 28, 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.

Transcript

Shawn Eubanks: Good morning, everyone. My name's 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. This webinar is being recorded.

Today, John Osterweis and Larry Cordisco will review the funds and our economic outlook. And then after that, Nael Fakhry will review the top and bottom contributors, and then Larry will cover new and exited positions. We'll then have a question and answer session at the end, so please feel free to submit your questions in the Q&A area during the webinar. John, let's start off with your thoughts on the market outlook.

John Osterweis: Okay. Good morning, everybody. Thanks for joining us. As you all know, the S&P is down nearly 20% for the year due to concerns over rising inflation, Fed tightening, and a slowing economy. Additionally, we think another explanation for the market decline is what we call the "Great Normalization," or the unwinding of the Covid economy. The pandemic created several distinct but related economic distortions, including excess liquidity, abnormally strong demand, and unusually low interest rates, and each one of these is in the process of finding a new equilibrium in real time. For equities, the combination of the Great Normalization and higher interest rates has triggered a sea change in market valuation. The S&P 500's valuation is compressed from 22x earnings to currently 16x earnings.

While most investors have focused on inflation and higher interest rates as the main cause for this P/E, or multiple, compression, we believe that risk premiums have also contributed, likely due to concerns over the direction of the economy and persistent geopolitical issues. Now, the consumer is pivoting away from discretionary items into staples, which is another aspect of the Great Normalization. During the pandemic, demand for big-ticket items like TVs, furniture, and so on were artificially high as consumers were flush with stimulus cash and had nowhere else to spend their money.

Now the mindset has changed significantly. Consumers are battling inflation, particularly higher energy and food costs, and they're mostly concerned about covering basic expenses. It's a very, very different spending environment. We would not be surprised to see the aggressive Fed tightening depress the already slowing economy more quickly than in the past, but whatever happens, we remain committed to the idea that globalization is waning. And, said another way, the supply shock of cheap overseas labor is pretty much over, and as a result, we now face structurally higher labor costs due to, to some extent, labor shortages. So, expect higher inflation going forward and therefore somewhat higher interest rates than we've experienced in recent years.

We continue to manage the portfolio in a cautious manner, but the flip side is we're rapidly seeing opportunities to add to positions in industry-leading companies at very attractive valuations. Larry and Nael can talk more about what we're looking for and where we're seeing opportunities.

Shawn Eubanks: Thanks, John. Before we get to Larry and Nael, can you briefly review the performance of the Osterweis Fund?

John Osterweis: Certainly. For the quarter, the Osterweis Fund was down 15.18%, modestly outperforming the S&P 500, which was down 16.1. In this environment, we continue to believe that it is critical to focus on being in the right companies over the long term, and Larry and Nael obviously will give you some details. As you can see, our approach to investing has proven valuable over time, and I expect coming out of this bear market, will prove successful again.

Shawn Eubanks: Thank you. Okay. Nael, can you review top and bottom contributors for the quarter and year-to-date, please?

Nael Fakhry: Sure. I'll start with the top contributors quarter-to-date, starting with Dollar General. There's actually a continuous theme on the quarter-to-date contributors. Dollar General just saw the benefit of continued growth in its consumables business, which is 75% of their sales, and that contrasted with a lot of other retailers. PS Business Parks is an industrial real estate company that was acquired by Blackstone, so that was acquired at a significant premium, and that saw a big benefit to our performance. Pioneer is an energy company. Larry will discuss it. It's actually since been sold, but they benefited from significantly higher energy prices, and they continue to operate in a capital-efficient way, returning capital. So they really benefited from the rise in energy prices.

And then Sysco really was ... it's the food service distribution business. They've handled inflation extremely well, plus they've benefited from the return to restaurants, the return to travel, kind of the shift from, as John was describing earlier, consumables to services. And then Progressive is really the beneficiary of a much more profitable business this year. They had some headwinds last year, and they've shown, especially with the most recent quarterly report, that they continue to make progress in terms of improving profitability.

On a year-to-date basis, we touched on Pioneer, Progressive. We touched on all of these. J&J is really the only one that differs. It's been very stable, very reliable for a long period of time, and that's an area that people gravitate towards, and at a time when equities are being hit. So it benefited, and continues to benefit, year-to-date.

In terms of the detractors, there's definitely a theme, and that would be technology. So if you look at both quarter-to-date and year-to-date, Alphabet, Amazon, and Microsoft make both lists. And really, it's not actually necessarily valuation, because the valuations across these companies span from downright cheap to more expensive, if you just look at it statistically. But technology companies have been hit kind of across the board, and AMD has also been hit year-to-date. So, this downdraft across technology has been significant, but we're starting to see, we think, kind of the wheat being separated from the chaff, and we continue to like the companies we've picked because we think they should continue to grow profits despite some of the headwinds, and the valuations are reasonable.

Sticking to the quarter-to-date, Union Pacific really had some service issues earlier in the year related to supply chain and labor, and then fuel obviously a bit, because fuel costs went up. But you know, appears that we've bottomed in 2Q and things are continuing to improve, and they actually just reported their second quarter this morning, and that message seems pretty clear.

For Spirit, They pushed out their ramp-up of 737s, but then that's been pushed out into 2023. Aptiv is the one that's been impacted by near-term supply chain issues, and longer-term, some demand concerns, if the consumer is weakening. And that's been one of the bottom contributors year-to-date, so I'll pass it back to you, Shawn.

Shawn Eubanks: Thanks Nael. Larry, maybe I can have you talk about the new and liquidated positions in the quarter.

Larry Cordisco: Thanks, Shawn. During the quarter, we were able to pick up some new names at attractive valuations. And as John mentioned, we're seeing an increasing number of industry leaders that are falling into this category, so we have been sharpening our pencils quite a bit recently. Generac, it's a home generator business that benefits from a desire to secure an energy source that's off the electrical grid, so this benefits from work-from-home desires, global warming and fires and hurricanes, where energy sources, because of weather concerns, are a little less reliable. It's absolutely the leader in this business, and it has, I think, a long-term tailwind in this, and we expect earnings to continue to grow.

IBM is a well-known company. It's in the process of engineering a significant transformation. The company is very well-positioned to serve large enterprises as they try to manage multi-cloud and hybrid cloud environments. Managing these multi-cloud environments has become very expensive over the last couple years. And IBM's ownership of Red Hat, an enterprise software company that's a data center operating system, positions the company extremely well. We think the 5% dividend should provide a "margin of safety" as well.

And Lamar is one of the largest outdoor advertising companies in the United States. It's geographically positioned to benefit from the long-term migration patterns we've seen to Sunbelt areas and is in the process operationally, and this has been going on for a number of years, of converting its billboards from the more traditional format that we all are accustomed to seeing to digital formats that are becoming more and more common. And they're able to monetize those digital formats at a much higher rate. Historically, outdoor advertising has proven to be one of the more recession-resistant areas of advertising, and the stock pays a 5% dividend. So again, it's the type of valuation that we think provides a very solid "margin of safety" for the company.

When you look at our activity during the quarter where we trim names, there's really three categories that are very common. Either the valuations were higher than we were comfortable with, especially in a rising interest rate and Fed-tightening environment. The names were more cyclical than we wanted as the economy was slowing, or there was just some nit with the business model. You know, Bright Horizons is one of those where we found the business model maybe to be a little less durable than we wanted, so we moved on from those types of companies.

Going forward, and this is a broken record sort of thing, because we continue to be very consistent, that we're looking for companies that are market leaders. They may be experiencing temporary headwinds and often are, which make their valuations more attractive to us. We like to emphasize growth, and especially growing dividends. And we put a lot of emphasis on, especially in the current environment, an ability to either have scale advantages and/or pricing power to offset a lot of the inflationary pressures that we see in the real economy.

So with that, Shawn, I'll hand it back to you.

Shawn Eubanks: That's great. Thank you, Larry. John, maybe we can transition to the Growth & Income Fund. Can you discuss that for a bit?

John Osterweis: Sure. We use a combination of dividend-paying equities, although occasionally we'll have some equities that don't pay dividends, but for the most part, dividend-paying equities where there is significant growth going forward and where the company has a history of steadily-increasing dividends. We match that with some exposure to shorter term high yield to give us somewhat higher income currently.

And as you can see, the fund has delivered very attractive, solid returns over time. During the quarter, the fund was down with the rest of the stock and the bond markets, but it did slightly outperform its blended benchmark of 60% S&P, 40% Bloomberg U.S. Aggregate Bond Index. We ended the quarter with 61% equity, 25% fixed income, and 14% cash. So with that, let's open up for Q&A.

Shawn Eubanks: Thanks, John. We did have a question come in ahead of the webinar, and maybe Larry, you can answer this, "Can you talk about J.P. Morgan's latest earnings report? I know they're seen as an economic bellwether, and they materially increased their loan loss reserves during the quarter, suggesting that they're anticipating more pain ahead. Can you provide some color around the results, and is it as bad as the headlines make it sound? And does it impact your overall thinking about the economic environment going forward?"

Larry Cordisco: Yeah. Thanks, Shawn. And you know, we don't own J.P. Morgan, but as you said, it is a bellwether company and absolutely worth discussing, and it did take a large reserve against its loans, over a billion. But it's sort of worth noting that banks these days are required, by accounting standards, when they see a period of economic slowing growth or a deceleration in the economy, they really are required to get ahead of their credit issues that would be anticipated in the future. So yes, it's up. They have to get ahead of the curve. We all see the economy is slowing.

And the other thing to take into account is how low the loan loss provisions were going into this year. All the banks will be taking higher provisions. All the banks had very low provisions last year. In fact, they released loss reserves across the board last year, which was a real buffet, or a real tailwind, I should say, to earnings growth for banks. So, we're in the process of normalizing that, and it's part of the Great Normalization that John spoke to.

Whether or not it's highly concerning for the economy, this is sort of, we have to wait and see. And I think this is one of the reasons that the equity markets in general are sort of in this limbo, this trading range that we've seen for the last couple months. We all know the economy's decelerating. We all know the Fed is tightening. J.P. Morgan knows that its credit costs are probably going higher, so it has to reserve ahead of time. But none of us know the pace of the deceleration, none of us know the ultimate landing point for the economy, and so I think that this is a wait-and-see sort of situation.

I suspect that over the next couple quarters, we're going to have a lot more clarity about whether or not the Fed can engineer a soft landing or the economy goes through a harder landing, but this is a time-based sort of process. And net-net, I don't think there's anything incredibly concerning to think about with J.P. Morgan's approach to the world. I think it's very consistent with the rest of the banks, and just like J.P. Morgan, we're all going to be waiting to see if things stabilize or get worse going forward.

Shawn Eubanks: Thank you, Larry. John, you spoke a little bit about the decline in globalization. Do you think that's reflective of just the political environment or the pandemic, or a combination of both, or what other factors do you think could be leading to that?

John Osterweis: I think the main reason is more demographic, in that you've got aging labor forces in China, in the U.S., and other developed countries, and there really is not any longer this unlimited pool of cheap labor. You're seeing labor costs go up in China, and the result is, particularly in the U.S. where there's a significant amount of reshoring, where operations that were sent overseas are now coming back here, there's a pretty high demand for labor. Covid has obviously contributed to this, because there are certain jobs that people basically don't want anymore, or fewer people want it. And so, restaurants are having trouble finding staff. Hotels are having trouble finding staff. So I'd say the biggest reason is more demographic, not political.

The secondary reason would be the distortions from Covid, and people's sense of their safety or lack thereof. But there's definitely been a massive change in labor. I mean, one example is you see unions gaining more traction today than they have, I'd say, in the last 30 years. So, labor costs are going up. That means inflation probably runs a little hotter than it has in the past, and it should mean that interest rates run higher than they've had over the last, say, 10 years or so.

Shawn Eubanks: Thanks, John. That's really helpful. We don't have any additional questions at this point. Any closing comments from the team?

John Osterweis: I think one thing we've been focused on is trying to populate the portfolio with companies that we think will grow steadily over time, will not be particularly affected by a short-term economic slowdown. And so, as a combination of valuations having come down and the prospect of future growth over the next three to five years, it ultimately will mean that these stocks are very attractive and poised to do well as investments. So, that would be my only closing remark.

Shawn Eubanks: Thank you, John, and thanks Larry and Nael for joining us today, and thanks for everyone for joining our webinar today. Thank you.


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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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-20220715-0559]