Published on February 1, 2023

If you were unable to join our quarterly webinar on January 26th, listen to the replay to hear updates from Portfolio Managers John Osterweis, Greg Hermanski, 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.


Michelle: Thank you for joining the Osterweis fourth quarter webinar. This webinar is being recorded and all participants are in listen only mode. At the end of the prepared Q&A, we will open the discussion for audience questions. This is a general call. If you have questions specific to your account, please contact our Private Client Group. Holdings discussed may not be held in all accounts due to client restrictions, et cetera. Holdings are subject to change and are not a recommendation to buy or sell any security. Current and future holdings are subject to risk. Chris, you may begin.

Chris Zand: Thank you, Michelle. Hello and thank you all 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 2023. I'm Chris Zand and I'm happy to have you joining us today. Before we get started, we'd like to give you a couple updates. Larry Cordisco decided to leave the firm at the end of last year. Larry was a valued member of our team and we do wish him success in his next pursuit. Since then, the firm has promoted longtime portfolio managers, Greg Hermanski and Nael Fakhry to co-leads alongside John. Greg and Nael have both worked hand-in-hand with John for over 10 years on the core equity team and the transition has been quite seamless. Greg and Nael are also with us for today's presentation. As always, we'll be joined by John Osterweis and Carl Kaufman as well.

With that, let's begin. Now the fourth quarter finally provided a rally after what was a very, very difficult year. Inflation continued to decline and expectations started to rise that the Fed may wrap up its rate hike cycle a little ahead of schedule. The S&P 500 gained 7.6% during the period, but was still down about 18.1% for the year. John, I'd like to start with you and get your thoughts on why the markets were so challenged throughout last year.

John Osterweis: Okay, thank you. I will do that. Welcome everybody. Before I answer that question, I'd just like to say how happy I am that we've promoted Nael and Greg. I've seen these guys perform year in and year out in analyzing companies and making investments, and I'd say they're both real senior pros and very disciplined investors, and I look forward to working even more closely with them as the three of us are the really the three senior portfolio managers. As far as 2022, it is very clear that last year was all about a massive uptick in inflation and the Fed's response to that by tightening monetary supply and raising interest rates. As all of you know who followed us over the years, we had 20 or 30 years of very subdued inflation because of the twin effects of globalization, which really meant the tapping into a vast pool of cheap Chinese labor, and the effect of technology.

The effect of globalization is we think pretty much behind us. China's population is actually shrinking. Their working age population is shrinking faster and we've got a similar problem in Europe, where the working age population is aging out. Structurally, from a demographic standpoint, there should be more labor shortages than we're used to and somewhat higher upward pressure on wage rates. Adding to that, last year, of course, were the disruptions from the Covid-related shutdowns in China and other supply chain Covid-related disruptions, and of course the war in Ukraine that led to upward pressure on grain prices and energy prices.

Part of the inflationary equation is transitory and part we think is structural. When the Fed raises interest rates that tends, at some point, to slow the economy down. There was and still is concern about whether the U.S. economy is going to tip over into recession and obviously that would have implications as far as corporate profits. As a result of higher interest rates, of course, equity valuations get hit and the S&P was down 18% last year, and with higher interest rates, bonds get hit and so total return on various bond indexes was somewhere between 13 and 15%. There was really no place to hide last year. It was quite tough.

Chris Zand: Thanks, John. With all those headwinds, why do you think the markets rallied in the fourth quarter? We know inflation continued to decelerate during the period, but it's still well above the 2% target and the Fed certainly has remained committed to keeping rates elevated.

John Osterweis: Yeah, I think what happened in the fourth quarter and what's happening in the first quarter as well is what we call the second derivative effect. That is inflation started to roll over, obviously down from its peak, and that implied that the Fed would not be raising interest rates as aggressively, so they'd still be raising rates but at a slower pace, which translated into the second derivative would be positive. I think it's that kind of response, things, instead of getting worse, we're actually probably getting better. Whether this is a false start is the big question. We still have inflation that needs to be controlled. The Fed is still going to be raising interest rates, although perhaps at a slower pace, and there's still a giant question as to where earnings are going to end up this year and into next year. It's hard to say if this is a false dawn or the beginning of a real bottoming out process.

Chris Zand: Thanks, John. I mean, a bit of a segue way then into my next question, looking into 2023 now, as you said, on the one hand the Fed could remain hawkish, which could keep pressure on equities. On the other hand, valuations are down, many companies are still growing on the top line and also taking on aggressive cost saving measures such as laying off workers. Based on where things are now, are you leaning a little more towards a bullish sentiment or more towards a bearish sentiment?

John Osterweis: I think it depends to some extent on what day you ask that question. These are not easily answered questions as to where earnings are going to end up, how high interest rates are ultimately going to go, where inflation's going to end up, et cetera. We are reasonably constructive long term, because stocks have come down and valuations are clearly much more reasonable than they were last year. And as Greg and Nael will discuss, I think at some length, we're really focusing on certain kinds of companies, very high quality companies that can grow, sustain their dividends, grow their dividends, et cetera. Because I think it's easier to make decisions about what companies you want to be in for the next three-to-five years than it is to answer some of these macro questions with any degree of certainty.

Chris Zand: Thanks, John. Very helpful. With that, let's actually bring Greg and Nael into the conversation. Nael, I'd like to start with you, given John's outlook for potentially slower growth, and considering all the changes to the economy over the last 12 months, how is the team approaching portfolio construction in this environment?

Nael Fakhry: Well, thanks for having me. I'd say our goals are twofold. One is, and this has been true for a long time, really since the origin of the firm, we want to position the portfolio to withstand near-term risks of inflation and a slow economy. In other words, downside protection. That's always key and obviously inflation and a slow economy are top of mind today. The other goal is to be able to participate in the upside should the market bounce back at some point this year. To do this I'd say we're renewing our focus on companies with strong fundamentals that are underpinned by a durable competitive advantage. We often call these companies "quality growth" companies and we're looking at several key variables. The first I would say is market dominance.

These dominant companies tend to have better returns on capital, they exhibit pricing power, they have attractive margins and these characteristics are really important in an inflationary environment. They protect the company and its profit pools. Secondly, we're looking for companies with clean balance sheets and significant free cash flow degeneration. Again, these are critical in an uncertain economic period with rising rates. Third, growing dividends. This is a signal when you have a company that can pay a growing cash dividend over a long period of time, it's a signal of a long-term focus by management to signal that the company is well-managed and prudently managed and that the business is well capitalized.

We also are looking for companies with secular tailwinds. We prefer companies that have these secular tailwinds because what that really means is the company can reinvest at high returns on capital to drive future growth. We started with market dominance and one of the factors there is returns on capital. If you can reinvest at high returns and incrementally even higher returns, that's what drives this really strong growth even through weak economic periods. Then lastly, but certainly very important as well, is attractive valuation, particularly in a new higher rate environment that we're operating in and that we think we're going to be in for some period. We definitely prefer companies with lower valuations. You have to be more valuation-sensitive in this environment.

Chris Zand: Thank you, Nael. Very helpful. Greg, let's turn to you next. With the backdrop that Nael just provided, can you take us through some of the positions that we've added or even exited over the last few months? I know we've been putting more emphasis on being defensive, so maybe you could spend a little time talking about how that works in practice.

Greg Hermanski: Yeah, we have increased the defensiveness of our portfolios. In practice, we spend a lot of time looking at our portfolio construction and we want to make sure that we have enough defensive companies and what we call defensive compounders to ensure that the portfolios have a solid foundation in case we get market choppiness. We call it defensive compounders. These are the quality growth companies that Nael was just talking about, but these are the ones that tend to have less cyclical businesses and more recurring revenue. To further strengthen our defensive foundation this quarter, given the uncertainty and the economic outlook, we reduced our exposure to cyclicality and interest rate and credit risk.

We did that by selling Bank of America and PNC Bank as well as LECO, which is a leading industrial welding company. Then on the flip side, we increased our defensiveness by adding Brown & Brown, which is an insurance broker. These businesses tend to have recurring revenue business models and have strong growth opportunities ahead of them. Then we also added Becton Dickinson, which is a medical device company that sells consumables like needles and syringes. Then we also increased some of our position sizes with less cyclical stock, so companies like L3Harris, which is a defense company, and Sysco, which is a food distributor.

Chris Zand: Thanks, Greg. Now I also know that the team is always on the lookout, opportunistic names as well, and got to imagine with last year's selloff, some opportunities must have been created on the opportunistic side. Could you talk a little bit more about how that fits into the approach and some of the recent positions that may fit into that category?

Greg Hermanski: Yeah, I think the key word is really "opportunistic." Our approach has always been to find high quality businesses that sell off for one reason or another. Sometimes things are temporary, but we want to make sure that it's either going to be short-term in nature or good visibility on how issues can be fixed. But we like to find great companies that have great long-term prospects, and this year we found several of them in 2022. A good example would be Avantor. Most people probably don't know Avantor by name, but it's a company that was founded in 1904. It's been around for over a hundred years. It distributes instruments, research products, and chemicals to the life science and the industrial industries. They're also a leading supplier in the growing bioproduction industry, which is growing kind of mid-teens, and 85% of their business is recurring in nature.

Then during 2022, the stock declined significantly, at one point over 50%, due to inventory issues from the ending of the pandemic and some other short-term issues that they had with a couple recent acquisitions that they did. And that pulled back the stock, and we bought it based on the thesis that the bioproduction business, which they had problems with last year, will normalize in the near term and it's going to resume its strong growth over time. Then their core business will grow as they add more proprietary products and services to their distribution business. And that's going to boost the sales growth and the operating margins and free cash flow over time.

Then finally, we believe that the recent acquisitions that they have some issues with, their issues are going to be temporary and they're ultimately going to prove to be very complementary to the core business and also help growth. In short, we're really excited that we're opportunistically able to add a company that's a really strong high quality franchise that's well-positioned for growth over time at a very reasonable multiple and on a significant pullback in the stock price. I think Nael also had some opportunities to buy some stocks this year, so we let him talk about those.

Nael Fakhry: Sure. Thanks, Greg. I mean, one other company is one you've all heard of, Target, which exactly kind of as Greg just explained, is we would argue as a classic Osterweis stock in many ways. It's a great business that recently stubbed its toe, and we increased our stake in the business last year. Its roots actually go back to 1902 and as you all know, it's one of the largest retailers in the U.S. We would argue it has an irreplaceable portfolio. It's largely owned real estate in the best locations near consumers, with about 2,000 stores and the company's private label business, which is about over 30, maybe 35% of sales now and its brand attract customers for everyday basic staples but also discretionary purchases at very good prices. The company has run the business efficiently and very profitably, which has enabled 50 years of consecutive dividend increases through multiple recessions, inflationary and deflationary periods, the rise of very effective competitors like Walmart and Amazon, and Target has flourished through all of that. The key metric we track at Target is revenue-per-foot. It's up almost 50% versus 2017 and the main driver of the higher sales per foot at Target is the unique approach they take to online, whereby they fulfill nearly all of their online sales from their existing stores at little incremental cost. It's a big advantage they have by virtue of that footprint that I started with. As a result, online is now 20% almost of sales versus about zero just a few years back, and the company generates $440 of sales per foot versus just $300 a few years back. We think profitability, because you're just generating almost 50% sales per foot more than you were a few years back, profitability should move higher and margins should exceed the historical levels of five to 6%, which should drive higher earnings and free cash flow.

The stock languished over the past 12 months because of some temporary inventory issues that arose, you probably read about them last year when Target and others basically over-ordered inventory because of supply chain constraints and a shift in consumer behavior that hit the company. The result was that margins fell to multi-decade lows, a situation we see mostly resolving this year and continuing to improve in the next couple years. We believe that as the margins normalize and Target capitalizes on its much higher and still growing revenue per foot, profitability should dramatically improve, which would obviously help shareholders, and we think Target will be restored as a retail stalwart with 20% or better returns on capital, very modest financial leverage, and a long runway for future growth.

Chris Zand: Thanks, Nael. Thanks, Greg. Very interesting stories. Let's turn to fixed income next. Carl, what's your take on 2022? Certainly the fixed income market experienced significant volatility throughout the year, though it rallied a bit in the fourth quarter.

Carl Kaufman: Thank you, Chris. 2022 is the year I think we'd all like to forget. Bonds had a very similar year to stocks, trading down. Many of the same factors that John talked about were in play for us. The Fed raising interest rates, economy somewhat weakening. On a relative basis, '22 was a lot worse for fixed income than it was for equity, even though on an absolute basis the Barclays Agg only lost 13% versus the S&P's loss of 18%, but it was the worst year ever for the Agg, and this goes back to when the U.S. was in terms of Treasury performance, it was the worst year since the U.S. was an emerging market in 1788.

I think it's no surprise that when you start with all-time record low yields and you raise rates 450, 500 basis points, you're going to get some pain because there's no coupon support. Part of that is the Fed's doing, and the rest maybe Congress is doing with all the fiscal stimulus we had after Covid, turning into inflation. Treasuries, which are normally considered risk-free, were down 12 and change percent last year, but that's in the rear-looking window. I think now they have some decent yields to them. As the equity team has found, we have found some value there as well.

Chris Zand: Thanks, Carl. Now despite those headwinds, our unique approach to fixed income, once again performed much better than the benchmarks. What would you say were some of the contributors to our success during such a difficult year?

Carl Kaufman: Well, as you know, we tend to keep our duration a little lower than the general market. That means our sensitivity to interest rates is much lower, and that worked even better than usual this year, because rates went up and bond prices went down. We didn't go down as much, so that helped. We're also, the fact that we're in shorter-dated bonds helped us a little bit more than usual this year because the yield curve is inverted, meaning that rates at the shorter end of the curve were higher than the long end of the curve. We were able to garner some higher yielding bonds in very good companies or in investment grade credits, commercial paper and the like, rather than going out and taking more risk and not getting that much more yield. We took advantage of the selloffs during the year to add some longer-dated bonds at decent coupons. We can base load returns going forward and we look to do that if we have another correction going forward.

Chris Zand: Thanks, Carl. What are your expectations for 2023? The yield curve's been inverted now for a few months, which is generally regarded as a signal that a recession could be coming. Is that how you're viewing it?

Carl Kaufman: Not necessarily. I'm not going to say it's different this time because it never is, but I agree with John that a slowdown is the most likely outcome. It's already happening, but that's not the same as a recession. We're still looking for the so-called soft landing, and the key reason for that is the labor market remains relatively healthy. Consumer spending, as you know, is about 70% of our economy. If unemployment doesn't get out of hand, the economy should adjust to higher rates. We did for 200 years before we went to zero interest rates. I think we can do it again. Onshoring, green energy, retiring baby boomers should keep the labor market strong. We're seeing shortages in workers not only in the U.S. but also in China and some other, and Europe, more developed economies.

I think it will remain relatively tight and wages will remain relatively healthy, and that should keep spending at least from going into a deep hole. Clearly overleveraged companies could get into trouble, but they should be the exception, as most companies have refinanced their debt in the last few years when rates were very low with low coupons and long maturities. As a matter of fact, I think 18% of the market matures in the next three years, which is a very low maturity wall.

Chris Zand: That makes sense. How about positioning, Carl? Any changes to the way the team is positioning the fixed income portfolio for 2023?

Carl Kaufman: Yeah. I mean, it's a continuation of what we have been doing. For the most part, we're taking our cues from the Fed. They are still talking hawkish, they're still talking a couple of more increases. We're not going to go buy 30-year Treasuries here. They've already had a little bit of a move, but as long as they remain hawkish and keep raising rates, our current positioning makes sense. Once they signal that they are done raising, question is how long do they just keep them high? We'll start to add some duration and buy longer-dated bonds. We start cutting rates because the economy has slowed more than they intended, we'll get even more aggressive with longer-dated Treasuries and things that are more sensitive to interest rates. Regardless, we are focusing on companies that manage leverage responsibly and generate to free cash flow as they should be able to service their debts even if rates remain elevated.

Chris Zand: Thank you, Carl. Very helpful. I've got just one more question for the panel and then we'll look to open it up to the audience for a Q&A. There's been a lot of talk about the debt ceiling more recently and it seems that Congress is bracing potentially for a fight. For those of you that haven't been following, on the one side, Democrats are looking to raise the debt ceiling while Republicans are insisting that the Federal government cut spending before any agreement can be reached on the debt ceiling. The two sides are pretty far apart at the moment. My question to the panel is, are you concerned about this situation right now?

Carl Kaufman: I'll start. I'm not sure if my colleagues have a different view. I'm not too worried about it yet. I mean, we've seen this movie before. They do take the game of chicken a little far sometimes as they did in 2018, in 2000... previously where they did shut down parks and things like that. They have a long and storied history, this is Congress, of engaging in high stakes debates and they do find a compromise at the 11th hour typically. Hopefully that happens again, but the Republicans are pushing for spending cuts that have already demonstrated they're willing to cause a little disruption to achieve their objectives. But let's keep in mind that they are arguing over money that has already been spent. Future spending and future budgets are really what they will be arguing about going forward. This is really about what's already been spent, which has gotten the debt ceiling where it is today. I'll let anybody else chime in.

John Osterweis: I think Carl summarized it quite well. I don't think I have anything to add.

Chris Zand: All right. Thank you very much. Before we think open things up to the audience, I just want to remind everyone that it's with the start of the New Year, it's a great time to review your financial situation, make sure things are in order. We're happy to meet with you in person at our office or virtually. If that's something that's of interest to you, we'd love to get together, review your plan or prepare one for you if you haven't had one done already. With that, let's open things up to the audience now. We do have a few questions that were emailed prior to today's session, so we'll start with those. The first one's actually about inflation. John, I'll throw this one over to you. Why did inflation get so out of control so quickly after really being a non-factor in the economy since the 1970s?

John Osterweis: Yeah, it was really a perfect storm where the ... Remember the two things that kept inflation in check were the impact of globalization and the tidal wave of cheap labor that offered us, and second, technology. The globalization impact pretty much ended with the aging of the Chinese labor force, the fact that most, an awful lot of labor in China had moved from the country into the cities, et cetera, et cetera, et cetera, and you had a similar demographic effect of aging workforce in Europe. Then when you add in Covid and the shutdowns, there were some incredible short-term effects. Nael and I were talking earlier, he pointed out that a million people died of Covid in the U.S. A lot of those were younger and part of the labor force. Then you had a diminution in immigration, and you had people who said, "Thank you very much for these Covid payments. I'm retiring. I don't need to work. I don't need to expose myself to Covid."

There was a pretty significant labor shortage that suddenly sprung up last year. Some of it more trend and others more just acute. Then of course with all the Covid problems, you had supply chain disruptions and shortages of needed components, which added to cost pressure. Then the Ukraine war added to cost pressure on the grain and energy front. It was a pretty much a perfect storm of longer-term trends changing and short-term events pumping up inflation.

Chris Zand: Thanks, John. Here's another question. Can you talk about how the end of China's zero Covid policy is impacting the global economy?

Carl Kaufman: Sure, I'll take that one. It's potentially a mixed bag. Clearly unsnarling supply lines as production ramps up is one factor, so availability of goods from China, but internally, the country has been locked up for quite some time under their zero Covid policy. As people in China domestically get out and start spending and traveling, the demand for energy and other commodity goods is going to go up. The prices of those are probably going to go up. Unsnarling supply chains maybe helps ease inflation, but the other causes inflation. I'd say it's probably a neutral for a while, but we'll have to see which side ends up winning.

Chris Zand: Thanks, Carl. I've got one more question. Things seem to be escalating in Ukraine more recently. Does that present any concerns to you?

John Osterweis: I'll take a stab at it. I mean, of course. The Russians have a tendency to grind things out over years, so I don't think the Ukrainian invasion or war is going to end anytime soon. What that means in terms of grain availability from Ukraine, what it means in terms of energy availability from Russia is anybody's guess. But I don't think this is something that's going to resolve quickly.

Chris Zand: Thanks, John. It looks like we actually had one more question come through. This will be our last question. The dollar rose 12% in 2022. What are your expectations for this year?

Carl Kaufman: I don't think you're going to see that repeat. Part of that has to do with the U.S. being one of the more aggressive, or clearly the reserve currency raising rates. As you raise rates, your currency usually goes up because people want to invest in dollars or in your currency. What we're seeing now is the European Central Bank is getting more aggressive about raising rates, and also we have finally, a handoff at the Bank of Japan, Central Bank of Japan this year, and they have spent a trillion dollars defending the 10-year rate in their yield curve management, and that's unsustainable. They probably let rates go up. It may not be that the dollar is weak per se, but that the other currencies are strong versus the dollar. I don't think that is going to continue.

Chris Zand: Thank you, Carl. All right, well, that was our last question. I'd like to thank you, John, Carl, Nael, and Greg for all your helpful insights today. And thanks to all of you for joining us. As always, let us know if you have any feedback or questions about today's discussions. We'd love to hear from you. Take care and enjoy the rest of your day. Goodbye for now.

Performance data quoted represents past performance and does not guarantee future results.

The Osterweis Core Equity Composite’s net returns over the one-year, five-year, ten-year, and 20-year periods ending December 31, 2022 were -21.67%, 6.84%, 8.55%, and 8.71%, respectively, compared to -18.11%, 9.42%, 12.56%, and 9.80% for the S&P 500 Index over the same periods.

The information presented in these rebroadcasts represents the opinions of Osterweis Capital Management and are not intended to be a forecast of future events, a guarantee of future results, nor investment advice. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

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 holdings for a representative account for the Osterweis Core Equity strategy as of the most recent quarter end here.

The Russell 2000 Growth Index is a market capitalization weighted index representing the small cap growth segment of U.S. equities.

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 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.

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.

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.

Treasuries (including bonds, notes, and bills) are securities sold by the federal government to consumers and investors to fund its operations. They are all backed by “the full faith and credit of the United States government” and thus are considered free of default risk.

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

Coupon is the interest rate stated on a bond when it’s issued. The coupon is typically paid semiannually.

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.

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.

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.