Published on January 26, 2024

If you were unable to join our quarterly webinar on January 25, listen to the replay to hear updates from Portfolio Managers John Osterweis, Nael Fakhry, and Carl Kaufman.

During the webinar, Chris Zand moderated a discussion about recent market activity and trends, portfolio positioning, and the investment team’s outlook.


Chris Zand: Hello, and thank you for joining us today for the Osterweis quarterly call where we will discuss recent market activity and trends, our portfolio positioning, and our outlook for 2024. I'm Chris Zand and I'll be moderating a panel discussion today featuring Chief Investment Officers John Osterweis, Carl Kaufman, and Nael Fakhry. Please feel free to enter questions into the Q&A as we go through today's discussion and at the end of our discussion we'll also open up Q&A further at that point. With that, let's begin. John, I'd like to start with you and get your perspective on 2023. Coming into last year, investor sentiment was quite low with the vast majority of economists predicting we would enter a recession, and the only question really being when that would happen. Fast-forward to today, and not only was there no recession, but both the economy and the market performed quite well, albeit with some volatility. How do you explain the economy's resilience and why do you think markets did so much better than expected?

John Osterweis: Well, thanks Chris and welcome everybody. I think that the simple explanation for last year probably all ties back into Covid and the dislocations that occurred because of Covid and then the recovery coming out of Covid. The dislocations coming out of Covid as you know were related to supply chain issues and people leaving the workforce, all of which, as we started to come out of Covid, led to some quite strong inflationary pressures. There were labor shortages, there were parts shortages, et cetera, et cetera, et cetera, and there was some fear that we were getting into a wage-price spiral.

As we evolved and recovered from Covid, the supply chain disruption kind of disappeared and inflation started to come down. As we entered the year inflation was high, the Fed was aggressively raising interest rates, that led to a banking crisis for banks that were not prepared for higher interest rates, and as you know, a couple of very prominent banks went under. But as we moved forward and particularly late in '23, when the Fed essentially put rate increases on pause and then ultimately started talking about rate decreases, the market did quite well. It's this whole arc of higher inflation, then lower inflation, and the anticipation of ultimately lower interest rates. I think all of that kind of led to what we saw last year, which was great pessimism early in the year, and then obviously a much more optimistic outlook in markets towards the end of the year.

Chris Zand: Thanks John. Very helpful. Staying on the topic of interest rates and inflation, where do you think the Fed is in its fight with inflation at this point? CPI has retreated from above 9% to a low 3% range now, so I'd love to get your take on that. As a follow on question, I'm curious if you think the Fed's tightening program is the primary reason that inflation decelerated so rapidly over the last 12 to 15 months?

John Osterweis: Yeah, to answer the first question, I think the Fed tightening was a contributor to lower inflation, but I actually think that the biggest contributor was the recovery and the return to normalcy post-Covid. As far as where the Fed is, I mean obviously they would like to see inflation closer to 2%, so they're likely to retain higher rates for a bit longer, but I don't think these rates are punitive at this point.

Chris Zand: Thanks John. Staying on the topic of interest rates a bit more, we've now had more than a full year of higher interest rates. Do you think we should be worried at all about the economy if rates end up staying elevated?

John Osterweis: I don't think the current rates are all that elevated, and I don't think monetary conditions are all that tight at this point. I think the economy can continue to grow maybe at a slightly slower pace, but I don't think the current monetary conditions are necessarily going to spark a recession.

Chris Zand: Thanks John. Very helpful. Carl, I'd like to turn to you now and get your thoughts on these same topics. Do you agree with John's comments about the economy and the Fed?

Carl Kaufman: Pretty much so. Although I might give the Fed slightly lower marks because their overly loose policies helped contribute to the inflation in the first place, but otherwise we're pretty much on the same page. So far, they're doing a reasonably good job at minimizing the damage caused by higher rates. I don't know if they're doing a good job, but the economy seems to be adjusting. I also agree that the economy does remain on solid footing despite the higher rate environment. I mean consumers are still spending. You saw the fourth quarter GDP number at 3.3% this morning for the fourth quarter, and so it may be a little longer before the Fed can cut rates. As John pointed out, inflation is still above its 2% target, but I don't think they cut the minute it gets to 2%. They're going to need to see that over a bit of time just to make sure it stays there because keep in mind, if they do cut rates, that's stimulative and that could cause inflation to come back.

Chris Zand: Thanks Carl. Very helpful. What are your thoughts about the fixed income markets in terms of how they performed in 2023?

Carl Kaufman: Well, certainly they were a positive surprise, pleasantly positive surprise, at least on the corporate side. The corporate high yield non-investment grade was very positive. Interestingly, some parts of the fixed income market did not follow suit, namely the Treasury and investment grade market. You can look at the slide that we will put up which shows the returns of the market over the last couple of years. You can see that if you look at the last, first of all for 2023, the returns in the fourth quarter were pretty incredible. If you compare it to the first nine months of the year, you can see that it was much greater or equal to the first nine months of the year. But if you look at the last two years combined, you're basically back to your starting point at the end of 2021 with the exception of investment grade bonds, which are still down 8%, and that's a result of having started from a very low base with zero interest rates and raising them to near a long-term average. The real question is where do we go from here?

Chris Zand: Thanks, Carl. Now as we enter 2024, we're seeing attractive bond yields and the prospect of rate cuts, which would be supportive of bond prices. Could you discuss how we're positioning fixed income investments for this environment?

Carl Kaufman: Sure. As many of you know, we tend to be a little more "err on the side of caution," so for a while we've been leaning into the inverted yield curve. We tend to take what the market gives us rather than looking for a bet to make, as it were. Given that rates are higher at the shorter end of the curve, this allows us to capture yields that are a little bit less than the general market, but gives us a lot more flexibility if there is an event or an air pocket where we can transition out of that and then layer in higher rates. Now if rates do remain high, we'll still generate solid returns, and if the rally of course reverses and we get a meaningful correction, we'll be in a great position to lock in higher rates and longer-dated bonds. If the Fed actually does cut rates, we'll look to extend our maturity profile then as well. Our basic philosophy is to look for the safest way to invest in the most attractive areas of the market, so the inverted yield curve has been a blessing for us.

Chris Zand: Thanks, Carl, very helpful. Let's turn back to the equity side of the portfolio now. Nael, this question's for you. One of the unusual features of 2023 was that for most of the year, the market leadership was heavily concentrated among seven mega cap technology companies, the so-called "Magnificent Seven" - Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla. Collectively, they accounted for nearly 60% of the S&P 500's gains last year. I have a two-part question for you. First, can you talk about how we've approached investing in these companies specifically? And second, what do they mean for the market given their significant valuation?

Nael Fakhry: Sure. I mean at first blush, the strong performance of the Magnificent Seven seems like a classic case of momentum over fundamentals. But in reality, there's some good reasons that the companies have done so well and their stock prices have done well. We do a look-through analysis where we look at the seven companies and compare them to the broader S&P, and we look at them in terms of their fundamentals. What you can see is that in aggregate they grow about three times the rate of growth of the broader S&P from a revenue standpoint. They have much higher profitability than the broader S&P and they have much higher returns on capital. Meanwhile, their balance sheets are really clean. In fact, they have net cash, more cash than they do debt, which is the inverse of the S&P, which has more debt than cash. That's particularly important in a high interest rate environment.

What do these fundamentals mean? We think that they reflect a durable competitive advantage for many of these companies and it reflects the fact that they operate in industries with secular tailwinds, so their popularity actually has some merit. However, we've always said that valuation matters, and in the case of the Magnificent Seven, if you look at them on a price-to-earnings basis, they're trading a little over 30x 2024 estimated earnings versus the rest, which were trading around 19x, so they've got over 50% earnings premium. In addition, fundamentals matter, not just valuation, and some of them, we would argue of those seven companies are vulnerable to increasing competition. You could see declining or decelerating revenue growth. We're invested in three of the seven companies we've held for a while, Google or Alphabet, Amazon obviously, and Microsoft, and we like those companies. We could always invest in some of the others, but as always, we're going to focus on business quality and valuation.

Chris Zand: Thanks, Nael. Do you think these seven companies will continue to dominate the market in 2024 as they did last year?

Nael Fakhry: It's not totally clear over what timeframe. Obviously as Carl and John pointed out, Q4 saw broadening of the market. We're glad to see that. That's not... year-to-date, you've actually seen the Magnificent Seven outperform the broader market, so it's a bit of a going a step backwards. If you look historically over the past 20 and 30 years, the equal weighted index has performed roughly in line with the market cap weighted S&P 500, and we think that trend is likely to resume over time. That could be because the valuation premium starts eroding and/or some of these companies start to stumble. If you look back historically, just to take seven top companies because that's what the Magnificent Seven is comprised of, if you look at the top seven components of the S&P 500 twenty-five years ago, there's only one company that's still in the top seven today, and that's Microsoft. That's actually the number one.

That would tell you that other companies like Merck and Coca-Cola that were in the top seven, they're still around and they're doing well, but they didn't drive the performance, and so it's unlikely that all of them will continue to operate as well as they have looking out over a long timeframe. It's also worth noting that the market concentration that we're seeing, we think it actually supports active management. Owning the index is easy and it's fun when the market's going up, but narrow markets can be dangerous when the fundamentals deteriorate and valuation's extended.

Chris Zand: Thanks, Nael. Can you discuss how we are positioning client portfolios for the year ahead? Are you still focusing on Quality Growth themes?

Nael Fakhry: Yeah, we've been a broken record on that front, but yes, our Quality Growth framework is really important. We like what we call Quality Growth companies as we've said in the past because they should protect on the downside but also allow for upside participation as long as we apply valuation discipline to that quality growth framework. Again, these companies have durable competitive advantages. That's where we always start. But they also, they're operating in industries with structural growth that can drive revenue growth and profit growth over time, and because of their durable competitive advantages, they have high and/or improving margins and returns on capital. That means that often free cash flow growth is faster than top line revenue growth.

Lastly, they avoid relying on debt to fund growth, which is really important in terms of downside protection. One theme that we've been talking a little bit more about and that makes us I think a little bit unique relative to other managers with a quality tilt is our interest in quality cyclical growth companies. These are Quality Growth companies that just operate in more cyclical industries, but these are industries that are growing over time structurally. Other managers may avoid these companies and these industries because they don't want to get caught in the cycle, but we actually view the cycle as an opportunity because valuation can become attractive in an industry that gets tossed out.

Chris Zand: Thanks, Nael. Now are there any particular sectors that come to mind as you think about the opportunity in Quality Cyclical Growth?

Nael Fakhry: Yeah, there are definitely several. Some that we've had some success in would be semiconductors, parts of transportation like LTL, rails, digital advertising, but those are just a few industries. We've also looked at distributors, industrial distributors, and aggregates and other industries. We've had success investing in these Quality Cyclical Growth companies. Again, we love that we can use the volatility to our advantage because more short-term oriented managers might sell these shares and our longer term perspective could allow us to buy companies at good valuations. What that means is that we get a company where the valuation is compressed, and if we're right, the earnings and free cash flow inflect and even accelerate, and then the multiple also expands, and that can be very powerful over time.

Chris Zand: That's great. Thanks Nael. Very helpful perspective. I'd like to ask the panel one more question before we open things up to the audience. As I'm sure everyone knows, we are in a presidential election year and while still too early to know for sure who will be on the ballot, most are expecting the election will be a rematch between Trump and Biden. November is still almost a year away, but I'd be curious to ask the panelists, do you think the outcome will have much impact on the markets? Last year, obviously there was a lot of back and forth with respect to government shutdowns. That seemed to have worked itself out, but clearly things will get more charged as we move through the year, so I'd love to get everyone's take on that.

Carl Kaufman: I'll start. Typically, elections gather a lot of people's attention and focus. There's a lot of energy spent trying to analyze every small micro move that happens in each campaign over the course of it. But in reality, what really matters to markets is the underlying economy and fundamentals and investor sentiment. We have found that election results typically affect markets for the very short term, and so I'm not spending too much time worrying about it until it happens. Then we can analyze what will happen.

Chris Zand: Thanks, Carl. John, your thoughts?

John Osterweis: I might just jump in and say that typically investors think that Republicans are good for business and good for markets and Democrats sort of the opposite. The actual fact is that markets have done extremely well under the Democrats. One of my concerns in this election is that Trump is unpredictable and erratic and markets tend to dislike uncertainty. Whatever you may say about Biden, the economy's been improving and the markets have done well, so I might be a little concerned about a Trump presidency just because of the extreme unpredictability as to what he will say and ultimately what he will do or accomplish, so I'd leave it at that.

Chris Zand: Fabulous. Thanks John. Very helpful.

Carl Kaufman: I would just like one addendum. I think markets have done well and they've done poorly under both parties.

John Osterweis: Yes, agreed. Agreed.

Chris Zand: Excellent. John, before we turn to the Q&A, any final thoughts before we wrap up the panel section?

John Osterweis: I have one thought. As Nael said, our focus has been on quality growth and then to a growing extent recently on more cyclical aspects of quality growth. I'd say there's a third area where we're looking, and that is companies that don't necessarily appear to be high quality but have a very high quality component to them. With some modest reconfiguration where management might get rid of the underperforming divisions and focus attention on the really high quality divisions, you could see an inside out growth story. We haven't found a lot of those recently, but it's something we're looking for. Occasionally you may see a company crop up in the portfolio that may, on the surface, not look as high quality as we say, but where we think ultimately with some rejiggering might emerge as a very high quality name, so I'll leave it at that.

Chris Zand: Very helpful. Thank you John. We'll turn now to our Q&A section of today's presentation. If you have questions, please enter them into the Q&A box or you can raise your hand. Before we get into the questions, I just want to remind our audience that the Private Client team is here and open to meeting with you virtually or in person should you have any questions about your portfolio, be interested in developing a financial plan, 529 plans, or a general asset allocation questions either for the investments here or looking at things more broadly. We'll now open the floor up to the audience. If you have any questions, please enter them. We did receive one during the presentation initially, so I'd like to start with that one. The question is, do you see the Fed being firm on their 2% inflation target or could you see them being more comfortable with a sustained inflation rate closer to 3%? How important is the inflation target compared to the broader range of economic metrics?

Carl Kaufman: I'll take that one. I think that they will be firm on that 2% target. They've been talking about it for so long that changing it now will seem like they're changing the target to fit the real world rather than waiting for the real world to get to what they have supported as their target for a long time. But as I said before, I think you have to reach that target and stay there for a while before they end. Of course, they're unpredictable, but they have a long history of overstaying their welcome and they have a long history of not being preemptive.

Chris Zand: Thanks Carl. Okay, we will move on to the next question. The conflict in the Middle East continues to simmer and it has created shipping lane disruptions that are beginning to impact commercial traffic. The question is, do you see this escalating or materially impacting inflation in the year ahead?

Carl Kaufman: I would say not materially. Shipping is still a very small component of finished goods prices. It will cause some delays and may raise some prices, but there are alternatives which take longer. You have to go around the horn. It's both the Suez Canal, Red Sea, and also the Panama because of the drought down there. You've got two of them going on right now and it doesn't seem to be hurting yet. We'll have to wait and see, but right now we don't think it will be a major force on inflation.

Chris Zand: Great. Thank you Carl. Well, that was our last question, so at this point I'd like to thank John, Carl, and Nael for all their helpful insights. Thank you all for joining us today. As always, please let us know if you have any feedback or questions about today's discussion or your own portfolio. We'd love to hear from you. Take care and enjoy the rest of your day. Goodbye. Thank you.

Carl Kaufman: Thank you Chris.

John Osterweis: Thank you all.

Nael Fakhry: Thank you.

Core Equity Composite (as of 12/31/23)

In our Core Equity accounts Osterweis has the discretion to decrease or increase equity exposure in an effort to reduce risk.

  QTD YTD 1 YR 3 YR 5 YR 7 YR 10 YR 15 YR 20 YR INCEP
Core Equity Composite (gross) 13.59% 22.16% 22.16% 5.13% 13.73% 10.93% 8.57% 11.55% 9.33% 11.25%
Core Equity Composite (net) 13.30 20.97 20.97 4.11 12.62 9.84 7.49 10.45 8.22 10.10
S&P 500 Index 11.69 26.29 26.29 10.00 15.69 13.42 12.03 13.97 9.69 10.15
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 monthly, 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, which may vary between accounts due to portfolio size, client type, or other factors. From 1/1/2021 onward, net returns also reflect mutual fund fee waivers in certain periods.

The Standard & Poor’s 500 Index (S&P 500) is an unmanaged index and is widely regarded as the standard for measuring U.S. stock market performance. This index does not incur expenses and is not available for investment. Index returns reflect the reinvestment of dividends. The S&P 500 Index data are provided for comparison of the composite’s performance to the performance of the stock market in general. The S&P 500 Index performance is not, however, directly comparable to the composites’ performance because accounts in the composites generally invest by using a portfolio of 30-40 stocks and the S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring U.S. stock market performance.

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 rate is available for tax-free institutions, eleemosynary accounts and large institutions.

Clients invested in separately managed core equity 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 and default risk. For a complete discussion of the risks involved, please see our Form ADV Brochure and refer to Item 8.

The Core Equity Composite includes all fee-paying separately managed accounts that are predominantly invested in equity securities, and for which OCM has the discretion to increase and decrease equity exposure in an effort to reduce risk. The non-equity portion of the account may be invested in cash equivalents, fixed income securities, or mutual funds. 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 Core Equity strategy as of the most recent quarter end here.

Merck, Coca-Cola, Apple, Meta, Nvidia, or Tesla were not held in the Core Equity Composite as of 12/31/2023.

The S&P 500 Equal Weighted Index is an unmanaged index composed of the stocks held in the S&P 500 Index using an equal-weighted approach instead of market cap-weighted.

The 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.

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 OCM. ICE Data and its Third Party Suppliers accept no liability in connection with its use. See for a full copy of the Disclaimer.
These indices do not incur expenses (unless otherwise noted) and are not available for investment.

The Bloomberg U.S. Aggregate Bond Index is an unmanaged index that is widely regarded as the standard for measuring U.S. investment grade bond market performance.

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.

Consumer Price Index (CPI) reflects the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care.

Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period.

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

A yield curve is a graph that plots bond yields vs. maturities, at a set point in time, assuming the bonds have equal credit quality. In the U.S., the yield curve generally refers to that of Treasuries.

Investment grade bonds are those with high and medium credit quality as determined by ratings agencies.

Return of capital is return from an investment that is not considered income. This occurs when some or all of the money an investor has in an investment is paid back to him or her, thus decreasing the value of the investment.

Price-to-Earnings (P/E) Ratio is the ratio of a company’s stock price to its twelve months’ earnings per share.

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.

Earnings growth is the annual rate of growth of earnings from investments.

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

Diversification does not assure a profit or protect against a loss.