Published on May 29, 2024

The Osterweis Growth & Income strategy is designed to deliver equity-like returns while also providing consistent and growing income. Using a flexible and conservative — but somewhat unconventional combination of assets — we have created a single solution that addresses multiple investment objectives and also limits volatility and tax exposure.

A Differentiated Solution to an Age-Old Problem

Perhaps the greatest challenge most investors face is how to generate stable, growing income while at the same time enabling their principal to grow over time. Too much emphasis on current income can limit the potential growth of principal. Too much emphasis on principal growth usually entails very low current income. Over nearly 40 years we have refined a flexible approach to this problem, allowing us to optimize the competing goals of income and growth. 

Rather than defining our goal as how best to balance the trade-off between income and growth, we redefine the goal as how best to achieve long-term income growth. By steadily growing income, we expect to achieve both greater total income over time and material capital appreciation. 

To do this, we employ a flexible approach that relies mostly on high quality equities with growing dividends, coupled with attractive fixed income positions, especially short duration high yield bonds. 

The use of short duration high yield bonds for our fixed income allocation enables us to include some lower-yielding equities with significant growth potential, while still maintaining above-average overall portfolio income. We believe this approach enables us to create an optimal blend of current income, income growth, and principal growth, all while dampening volatility and managing tax liabilities.

Equities: Quality Growth

We focus not on companies with the highest dividend yields, but rather companies with the ability to consistently grow their dividends over time. In fact, our concentrated equity portfolio tends to sport a dividend yield comparable to that of the S&P 500, but with a higher growth rate.

Quality Growth Matters

Quality Growth companies enjoy stable to improving returns on capital and typically have stable or improving revenue growth and margins. We focus on a select few companies that do not rely on excessive financial leverage. Critically, they generate substantial free cash flow through an economic cycle.

Additionally, we emphasize Quality Growth companies that benefit from secular growth trends. As we have discussed in the past, companies that operate in structurally growing sectors of the economy should have an easier time growing, especially during soft economic periods. And if the companies are differentiated and have durable competitive advantages, these businesses can enjoy attractive margin and return profiles, enabling them to grow free cash flow over time.

Dividends Do Not Lie

Extensive long-term studies by Ned Davis Research show that companies that pay growing dividends tend to deliver better returns than the broader market with less volatility. Such companies typically have only modest payouts, enabling them to reinvest cash flow to achieve future growth that then supports bigger future dividends.

Source: © Copyright 2023 Ned Davis Research, Inc. Past performance does not guarantee future results. Indices are unmanaged and not available for direct investment. For illustrative purposes only.

The ability to pay a growing dividend for years, and even decades, often reflects business quality and durability. Companies that pay modest but consistent and growing dividends tend to focus on growth, maintain well-capitalized balance sheets, and avoid highly speculative areas of the economy. They also often operate in sectors with relatively stable demand, and they focus on the long-term.

Perhaps most importantly, dividends do not lie – companies that pay growing dividends almost by definition must generate significant and growing free cash flow, the bedrock of value creation for equities.

Portfolio Construction Should Further Mitigate Volatility

While historical evidence shows that dividend growth companies tend to deliver higher returns with less volatility, we believe that careful portfolio construction can further dampen volatility. We segment our equity portfolio across three categories: defensives, compounders, and offensives. By weighting compounders and defensives at 70-80% of the portfolio, we seek to further reduce volatility.

Defensives (30-50%) Companies that can generate profits in most any economic environment. 
Compounders (30-40%) Modestly cyclical companies that provide high-demand products & services.
Offensives (20-30%) Cyclical businesses that are also experiencing secular growth.

We define defensives as companies that can generate earnings and free cash flow growth in virtually any environment because they sell a product or service that is necessary every day, regardless of the economy. Think waste collection, consumer staples like toothpaste and mouthwash, or healthcare services.

We view compounders as businesses that might face some modest cyclicality but are equally necessary to businesses and consumers on a daily basis. These businesses may see a slowdown in growth during an economic soft patch, but they are much more resilient than the broader economy. Sectors like auto insurance, enterprise software, and medical devices all fit the framework of compounders.

Lastly, offensives are businesses that may operate in more cyclical industries but still enjoy secular growth. These companies can grow at very rapid rates during periods of economic expansion, but they can see profits temporarily contract during recessions. Offensive sectors include semiconductors, certain transportation sectors, and digital advertising.

Given our Quality Growth approach, we choose companies that are dominant in their industry or sector and enjoy significant competitive advantages that enable market share growth and pricing power. Therefore, even if a company faces periods of economic softness, it should fare better than the average business.

Fixed Income: Shorter-Term High Yield, with Flexibility

In our view, shorter-term high yield bonds pair particularly well with dividend growth stocks as part of an income-generating strategy, though we also believe it is important to stay flexible. Short-dated non-investment grade bonds are effective because they tend to generate higher income than dividend paying stocks, increasing the overall portfolio yield compared to an equity-only portfolio. Likewise, they normally pay higher coupons than their investment grade counterparts — even those with longer maturities — so they are a great fit for portfolios designed to generate income. In addition, as we discuss below, they dampen volatility (vs. equities) and reduce interest rate risk. 

At the same time, we are always looking for the areas of the fixed income market that have the most attractive risk/reward characteristics, regardless of credit rating, sector, or maturity, so we will occasionally invest in Treasuries and/or investment grade bonds. We are careful not to stretch for yield, but we are opportunistic when good values present themselves.

Short-Duration High Yield: An Effective Approach to Managing Risk

Fixed income holdings reduce overall portfolio volatility. We utilize the same approach as our Strategic Income strategy, which is flexible and tends to focus on shorter-term high yield bonds. As you can see from the scatterplot below, this approach has been successful. The x-axis plots the downside capture ratio, which measures how an investment performs during falling markets. A lower number is better, as it indicates the portfolio is less correlated with changes in the market. The y-axis plots the upside capture ratio, which of course is the opposite, and a higher number is better.

Past performance does not guarantee future results. The depicted upside/downside capture reflects the fixed income portfolio component (excluding cash & equivalents) of the representative account for the Growth & Income composite. It is based on net returns calculated by applying 1/12th of the representative’s actual total annualized expenses (as of each month end) to each monthly gross return of the fixed income portfolio component of the representative account. The upside/downside capture reflecting performance results for the entire representative account of the Growth & Income composite is available upon request. Please see the disclosures and standardized performance for the composite as of the most recent quarter end on page 8. Please see disclosures located at end of this piece for additional information on upside/downside market capture. Source: eVestment and Osterweis Capital Management. eVestment US High Yield Fixed Income: 149 members.

Since inception, the downside capture of the fixed income portion of the representative Growth & Income account is decidedly lower than the high yield index and most peers in the eVestment U.S. High Yield Fixed Income universe. At the same time, the upside capture is still strong.

In addition, shorter-term high yield bonds are exposed to less interest rate risk than investment grade bonds of comparable maturity. Interest rate risk, also known as duration, decreases as maturities fall and yields rise. They also carry less credit risk than similarly rated longer maturity issues, as the issuing company may already have cash on its balance sheet sufficient to pay off the shorter maturity bond, and there is less risk of something going wrong for the company than there is for longer maturity bonds.

Flexibility Provides Opportunity

We also make a point of staying flexible, so we are able to adjust our holdings should market conditions change. For example, when macro risks appear particularly elevated, we generally increase our allocation to short-duration Treasuries. Alternately, when it is apparent that the Federal Reserve plans to cut rates, we look to invest in longer-duration Treasuries to capture the impact of lower future rates.
 
Our demonstrated ability to be flexible within the fixed income portion of our portfolio further differentiates the strategy and enables us to not only strive to protect portfolios but also benefit from periods of economic stress.

Tax Efficiency Matters

Given our multi-decade history of managing client portfolios for high net worth families, tax considerations are often paramount. 

We seek to own companies for the long term. This not only enables our quality businesses to grow and create value over time, but it helps with tax management as long-term capital gains tax take effect over ordinary income tax rates. Given that long-term capital gains tax rates can be much lower than ordinary income tax rates, a patient long-term approach can be much more tax efficient. Furthermore, we are highly conscious of using tax loss harvesting when appropriate.

The Desired Outcome: Consistent Growth and Income

We carefully construct our equity and fixed income portfolios with an eye towards generating equity-like returns over time, with both income generation and significant capital appreciation. 

Our equity portfolio targets a minimum of 8-10% annual earnings and free cash flow growth, and we complement that with fixed income investments that enhance total portfolio income. This combination of yield and growth is designed to deliver attractive, consistent returns over the long term.

The following chart plots the cumulative growth of $100,000 from the account's inception in 2010 through December 31, 2023, using three different reinvestment scenarios. The bar graph that follows shows the annual income distribution investors would have received at the end of 2011 and how those distributions would have grown based on the same reinvestment scenarios. As you can see, regardless of the reinvestment strategy, the account generated a healthy income stream while still appreciating meaningfully over time. (Note that the figures below do not reflect any impact of taxes. Please see disclosures for the Growth & Income composite's performance.)

*Cumulative un-reinvested distributions are $49,909 in the Cap Gains Reinvested scenario and $96,225 in the Nothing Reinvested scenario.

Performance data quoted represent past performance; past performance does not guarantee future results. The data is for a representative account that is a pooled vehicle from which realized income and capital gains are distributed annually.  

The above chart illustrates the performance of a hypothetical $100,000 investment made during the period noted above and with different approaches to taking distributions. The chart does not reflect the effect of any applicable taxes. Source: Osterweis Capital Management 

The above chart illustrates the 12-month income generated by a $100,000 investment made at the representative account’s inception (8/31/2010) as of 12/31/2011 and as of 12/31/2023 assuming various reinvestment scenarios. The data is for a representative account that is a pooled vehicle from which realized income and capital gains are distributed annually. Performance data quoted represent past performance; past performance does not guarantee future results. Source: Osterweis Capital Management

Conclusion

We believe that marrying our distinct approaches on the equity and fixed income sides of the portfolio should continue to generate a highly compelling combination of growth and income, allowing all types of clients, including retirees, endowments, foundations, and high net worth families, to achieve their financial objectives. Furthermore, the strategy's lower volatility (compared to a pure equity portfolio) should provide some downside protection during periods of market stress.

John Osterweis

Founder, Chairman & Co-Chief Investment Officer – Core Equity

Carl Kaufman

Co-President, Co-Chief Executive Officer, Chief Investment Officer – Strategic Income & Managing Director – Fixed Income

Gregory Hermanski

Co-Chief Investment Officer – Core Equity

Nael Fakhry

Co-Chief Investment Officer – Core Equity

Growth & Income Composite (as of 3/31/24)

  QTD YTD 1 YR 3 YR 5 YR 7 YR 10 YR 15 YR 20 YR INCEP
(10/1/2010)
Growth & Income Composite (gross) 6.77% 6.77% 17.77% 5.84% 10.52% 9.54% 7.95% 10.99% 8.72% 11.17%
Growth & Income Composite (net) 6.58 6.58 16.88 5.01 9.65 8.71 7.15 10.15 7.81 10.13
60% S&P 500 Index/40% Bloomberg U.S. Aggregate Bond Index 5.94 5.94 17.97 5.94 9.30 9.01 8.52 10.53 7.52 8.31
Swipe Table for Full Data

Past performance does not guarantee future results.

Rates of return for periods greater than one year are annualized. The information given for these composites is historic and should not be taken as an indication of future performance. Performance returns are presented both before and after the deduction of advisory fees. Account returns are calculated using a time-weighted return method. Account returns reflect the reinvestment of dividends and other income and the deduction of brokerage fees and other commissions, if any, but do not reflect the deduction of certain other expenses such as custodial fees. Monthly composite returns are calculated by weighting account returns by beginning market value. Net returns reflect the deduction of actual advisory fees.

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

Source for any Bloomberg index is Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg owns all proprietary rights in the Bloomberg Indices. Bloomberg does not approve or endorse this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The fee schedule is as follows: 1.25% on the first $10 million, 1.00% on the next $15 million up to $25 million, and 0.75% in excess of $25 million. A discounted, institutional rate is available.

Clients invested in growth & income separately managed accounts are subject to various risks including potential loss of principal, general market risk, small and medium-sized company risk, foreign securities and emerging markets risk, default risk, interest rate risk, inflation risk and liquidity risk. Additionally, there is a risk that we do not manage the asset allocation strategy successfully. For a complete discussion of the risks involved, please see our Form ADV Brochure and refer to Item 8.

The Growth & Income Composite includes all fee-paying portfolios that seek to generate current income while maintaining exposure to equities. Accounts are predominately invested in equity and fixed income securities as well as mutual funds and cash equivalents. OCM typically has discretion to modify the allocation between these security types. Individual account performance will vary from the composite performance due to differences in individual holdings, cash flows, etc.

References to specific companies, market sectors, or investment themes herein do not constitute recommendations to buy or sell any particular securities.

There can be no assurance that any specific security, strategy, or product referenced directly or indirectly in this commentary will be profitable in the future or suitable for your financial circumstances. Due to various factors, including changes to market conditions and/or applicable laws, this content may no longer reflect our current advice or opinion. You should not assume any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from Osterweis Capital Management.

Holdings and sector allocations may change at any time due to ongoing portfolio management. You can view complete holdings for a representative account for the Osterweis Growth & Income strategy as of the most recent quarter end here.

Diversification does not assure a profit, nor does it protect against a loss in a declining market.

ICE BofA U.S. High Yield Index tracks the performance of U.S. dollar denominated below-investment grade corporate debt publicly issued in the U.S. domestic market. This index reflects transaction costs.

Effective 6/30/22, the ICE indices reflect transactions costs. Any ICE index data referenced herein is the property of ICE Data Indices, LLC, its affiliates (“ICE Data”) and/or its Third Party Suppliers and has been licensed for use by Osterweis Capital Management. ICE Data and its Third Party Suppliers accept no liability in connection with its use. See https://www.osterweis.com/glossary for a full copy of the Disclaimer.

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.

The downside market capture ratio is calculated by dividing the portfolio’s return when the benchmark (Bloomberg U.S. Aggregate) performance is negative by the return of the benchmark during the same periods.

The upside market capture ratio is calculated by dividing the portfolio’s return when the benchmark (Bloomberg U.S. Aggregate) performance is positive by the return of the benchmark during the same periods.

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

Lipper’s High Yield Funds peer group classification includes funds that aim at high (relative) current yield from fixed income securities, have no quality or maturity restrictions, and tend to invest in lower-grade debt issues.

eVestment Alliance, LLC and its affiliated entities (collectively, “eVestment”) collect information directly from investment management firms and other sources believed to be reliable; however, eVestment does not guarantee or warrant the accuracy, timeliness, or completeness of the information provided and is not responsible for any errors or omissions. Performance results may be provided with additional disclosures available on eVestment’s systems and other important considerations such as fees that may be applicable. Not for general distribution and limited distribution may only be made pursuant to client’s agreement terms. * All categories not necessarily included, Totals may not equal 100%. Copyright 2012-2023 eVestment Alliance, LLC. All Rights Reserved.

Any tax or legal information provided is merely a summary of our understanding and interpretation of some of the current income tax regulations and is not exhaustive. Investors must consult their tax advisor or legal counsel for advice and information concerning their particular situation. Neither the strategy nor any of its representatives may give legal or tax advice.