Quarterly Webinar Replay

Chris Zand: 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 2026.

I'm Chris Zand, and we're happy to be connecting with you all today. Joining me for today's discussion are Chief Investment Officers, John Osterweis, Carl Kaufman, Nael Fakhry, and Greg Hermanski. As always, feel free to enter questions into our Q&A at any time during the presentation.

With that, let's go ahead and get started. John, I'd like to start with you. 2025 is in the books and it was another strong year for most asset classes, but it was also fraught with economic uncertainty at different times. Can you start by sharing your perspective on what we experienced in 2025?

John Osterweis: Thank you, Chris, and happy new year everybody. As Chris said, last year ended up as a strong year, but there were lots of dramatic moments such as Liberation Day, and the introduction of high tariffs, continued conflict in Ukraine, the Israel-Gaza War, extended government shutdown, lingering inflation, disruptive immigration policies.

At the end of the day, none of that seemed to matter too much, because the economy was strong, remained strong, and as you all know, the Fed began to cut interest rates, which was very supportive of higher asset prices. By the end of the year, the market finished at an all-time high, and other markets around the world were also very strong. It was quite a year.

Chris Zand: Thanks, John. It was definitely a noisy year, but also a good year, as you said. I'd be curious to hear, what do you anticipate for this coming year, 2026?

John Osterweis: I think it's more of the same: lots of geopolitical turmoil, whether it's Venezuela, Iran, Greenland, maybe Cuba. We're also seeing an administration take on the Fed, which may ultimately backfire, but that's a little drama. ICE activity in lots of cities is causing unrest.

But, the reality is the economy keeps chugging along to a large extent driven by AI investment, which is real and ongoing. Unemployment remains low. Inflation seems to be tame at the moment. The credit markets are still robust. GDP continues to expand. Lower taxes will probably be a bit of a tailwind. And who knows on interest rates, but in all probability, they could go down.

As long as all this is in place, I think the markets will look through the geopolitical turmoil and probably work higher.

Chris Zand: Thanks, John. Very helpful. Carl, I'd like to turn to you now. John had earlier mentioned the situation with the Fed. Can you catch us up on what's going on there and talk a little bit about why it's so important?

Carl Kaufman: Sure. Good afternoon. Welcome, everybody. The Fed has been under a lot of pressure lately from the White House to cut rates, for most of the past year. They did so last year. The administration has repeatedly called for lower rates. They've attempted to remove a board member, Lisa Cook, by bringing mortgage fraud charges. Seems a bit ironic to me.

The case is due to go to the Supreme Court this year. They have tried to stuff as many openings with partisan members as they can to cut rates. More recently, the DOJ opened an investigation into Jay Powell's handling of the building renovation project. A lot has happened since this administration took office.

Our view on this is pretty straightforward. We think an independent [Fed] is essential for healthy, well-functioning markets. As you know, the Fed has a dual mandate: stable prices, and full employment. They need the flexibility and independence to set rates based on data and not political pressure.

The stakes are fairly high. Lower rates are not the right move in a healthy, somewhat inflationary economy. They would just add fuel to the fire and could make things worse down the road. Right now, the leading candidate seems to be Kevin Warsh, who on record is saying he does support lower rates. Rick Rieder has been entering the picture recently.

Keep in mind that the Fed does have a board and they do vote. So unless you have a distinct majority on the board of the Fed, it's unlikely that they would just bow down and forego all their training as economists to do what the White House wants to do. We're just hoping the administration does back off a bit and let the Fed do their job, regardless of who sits on the board.

Chris Zand: Thanks, Carl. Yes, that would be nice. A follow-on question for you. Can you talk a little bit about where we are with inflation, given how important it is to Fed policy?

Carl Kaufman: Sure. Inflation continues to moderate, albeit at a very slow pace, still above the Fed's 2% market. I think it started the year at around three. It's now at about 2.7, so it's come down. That's manageable. Tariffs have not been as harmful as expected, which is a pleasant surprise.

For now, the markets are assuming the Fed will not drop rates at their next meeting, but we'll have to wait and see what the betting markets say. The economy seems healthy enough that a cut is not necessary. As John mentioned earlier, the Fed did cut in 2025, three times. It seems that excess liquidity is not finding its way into the general economy, but rather into financial asset prices.

This is why we do not need more rate cuts and easier policies at this time. I'll leave it at that.

Chris Zand: Thanks, Carl. Very helpful. Let's change gears now and bring Nael into the conversation. Nael, in our latest quarterly outlook, we discussed the bifurcated equity market that features two distinct cohorts. Could you spend a few minutes explaining this concept to our viewers?

Nael Fakhry: Sure. Happy to do so. Basically, as you said, we think that there's a bifurcated market, and the fault line is really around AI companies. There are those companies that directly or indirectly benefit from AI, or at least are perceived to be beneficiaries, and then there's everyone else. We actually think there are compelling investment opportunities across both camps. But looking back, there's been a pretty stark divergence in returns in terms of the AI companies and the non-AI companies.

As kind of a rough and maybe crude proxy, you can look at the S&P Equal Weighted Index over the past three years and compare it to the Equal Weighted Index. What you see is that... The Cap Weighted Index is the index you see in the news and hear about in the news every day, and it's dependent on market cap. So the larger companies have bigger size and there's no cap.

The Equal Weight Index is the same 500 companies, and they have equal weight regardless of their market cap. That gives you a sense of the average company. Of course, that Market Cap Weighted Index, the one that is weighted by market cap, is going to be more influenced by the big hyperscalers of the tech companies, meaning the AI companies. That one more reflects the impact of AI.

What you've seen over the last three years is that the S&P 500 market cap return has been 23% on an annualized basis, which is a really high rate of return over that period of time. The Equal Weighted Index has annualized 13%, which is also actually really high, but clearly lagging. What this divergence tells you is that a narrow sector of the economy, really AI companies, are driving returns and driving that divergence.

As you can see, you should be able to see the slide that's up here, if you go back and you look at the Market Cap Weighted S&P versus the Equal Cap Weighted, the multiple has been right on top of each other historically. Sometimes one is higher than the other, but they're very closely tied at the hip.

Since early 2023, really with the rollout of ChatGPT, which was November of 2022, which kind of kicked off this whole AI boom, you've seen this divergence and the Cap Weighted Index, the one that's much more influenced by the AI companies, the multiple has really expanded and departed from its historical relationship. That reflects a lot of excitement for the AI companies.

I don't want to overstate the case because if you look at the earnings growth that's come out of the Market Cap Weighted Index, last year it was about 14%. That obviously indicates strong growth. If you look at the Equal Weighted Index, earnings growth was about 5%, and that indicates more uneven growth. Some companies are growing substantially, whether or not they're related to AI, some are growing okay, and then some are actually contracting year over year.

The AI companies are clearly growing faster on average. Non-AI companies, it's a broader set of outcomes. What we're trying to do is we're trying to own companies... We're agnostic. We're trying to own companies that fit our quality growth framework, regardless of whether they are involved in AI or not.

Our quality growth framework, just as a reminder, centers on trying to find companies with a durable competitive advantage that you see in the form of growing free cash flow, companies that can reinvest to drive future growth, and companies that have really good governance.

If we can find companies that fit that framework at attractive valuations and own a concentrated basket, that's what we're trying to do, regardless of what bucket they fall into.

Chris Zand: Very fascinating, Nael. Thank you. I suspect most people have a pretty good feel for what is happening in terms of the boom in AI, but I think it'd be helpful to talk a bit more about our approach there. Greg, could you share some thoughts?

Greg Hermanski: Sure. Good afternoon, everyone. We've been investing in AI-related companies for quite some time, even before it became mainstream in 2022. We view the technology as being revolutionary, and we've seen an impact on the results of our companies that we've owned for a long time like Google, Microsoft, and Amazon.

We think it's important to be involved in these companies because of the huge transformational opportunity that lies ahead. That having been said, we're wary of becoming overly concentrated in AI stocks, and it's something that we call stacking risk. An example of stacking risk would be owning companies in different industries that seem to be not related, but whose results are actually tied to each other.

For an example, an AI risk stack would include owning not just well-understood AI-related companies like data centers, OpenAI, Google, Microsoft, Anthropic, Nvidia, but it also includes owning companies that make connectors, electrical equipment, testing equipment, HVAC equipment, utilities. That's a risk stack that's all tied together.

We are trying to be careful that our portfolio is diversified with both well-positioned AI-related stocks, but also other traditional quality growth companies that are not tied to AI, in case there's hiccups in the rollout of AI, like we saw during the dotcom boom. In addition, we're focused on AI-related stocks that we believe have reasonable valuations given their growth outlooks, the free cash flow generation that we expect them to have, return on invested capital, and the durability of their business models.

We believe that being discerning in our choices will help us realize the most upside with the least downside. A couple of AI-related stocks that we like, one of them would be Synopsys. Synopsys is a company we added last year on a pullback. They're one of just a few companies that make software to design semiconductors.

As companies are looking for more custom, efficient AI-centric chips, Synopsys is benefiting real-time. Recently, they also bought a company called Ansys, which makes tools to help design full systems. As AI develops over time, they're well positioned to benefit from the growth in both semiconductors as well as automation and robotic system design.

Another company that we like is Keysight. It's a company we've actually owned for quite a while. They make test and measurement equipment for communications industry, semiconductors, industrial equipment, as well as aerospace. With the build-out of data centers for AI, it's helping them accelerate their communications test and measurement business as well as their semiconductor businesses.

The acceleration from AI is helping to add to their business opportunities. They already have strong moats. They have a great long-term growth opportunity ahead of them, and they have an opportunity to expand margins and accelerate their earnings growth.

Chris Zand: Thanks, Greg. Very helpful. Nael, I'd like to come back to you and get your thoughts on the non-AI part of the market and specifically where we're seeing opportunities there.

Nael Fakhry: Sure. Yeah. The non-AI part of the economy obviously spans a wide range of sectors. There's no one sector. I'd say one consistent theme that we've seen is that many of these companies have been hurt by tariffs, which have really just elongated the inflation cycle that Carl was touching on earlier. Then the higher rates that are starting to kick in as companies have to refinance debt, that's starting to bite some companies.

Now, there are a certain set of companies and businesses that are able to push price and pass along price increases, and just deal with these headwinds, whether it's interest rates or whatever it might be, much more effectively because they have pricing power, because they have scale. In fact, they're able to take share from the other companies that have been weakened and even hobbled by these headwinds of inflation, and rates, and that kind of thing.

And so again, those fit our quality growth framework. We found some really good opportunities in Financials, Industrials, Consumer, Health Care. We found opportunities across the board. Again, every case, they fit our quality growth framework, they're generating growing free cash flow.

A few examples would be one, Brown & Brown. This is a dominant insurance broker. If you think about insurance, it's pretty non-discretionary. They are brokering insurance to small and medium businesses primarily, but also to individuals in some cases. You are required to have insurance in most cases. This is a company we've owned for several years. The valuation really got a bit extended, so we trimmed it back.

More recently, we think it's pretty compelling because the earnings are set to accelerate and we think the multiple should expand. Another one would be AutoZone. This is a very dominant auto parts retailer, also primarily non-discretionary. You need your car, you need to fix your car if you need to get to work or live your life. You're either going to go to AutoZone or you're going to go to O'Reilly in all likelihood.

They are aggressively investing to capture a higher growth category within auto parts retail, and they're seeing a payoff. They're actually seeing very strong accelerating revenue growth, but they're investing in order to capture, that's dented profitability growth. We think we're a couple quarters away from the inflection, and that should drive accelerating earnings and multiple expansion.

Then I'll throw out one more. Terreno, which is a small industrial real estate player. They own really high quality industrial real estate in six coastal markets. This is a company that we scooped up in the April tariff selloff of last year that got hit. We think that the earnings are going to exhibit a lot of stability, and maybe some acceleration here.

Also, the company benefits from long-term tailwinds in terms of logistics, and e-commerce, and nearshoring and reshoring. This is a company that should also see multiple expansion. If you think about it, it's a broad set of businesses across a bunch of different end markets, and we're seeing some really good opportunities. We're actually pretty excited both about some of these AI opportunities, but also outside of AI.

Chris Zand: Great. Thanks, Nael. Thanks, Greg, for those insights. John, just like to come back to you and get your thoughts on our current portfolio positioning overall, given this backdrop.

John Osterweis: Okay. Well, I think you'll all be absolutely shocked and floored by my answer. Given all of the geopolitical uncertainty and some of the other uncertainties that we have to deal with, we are maniacally focused on quality companies. We think you need to own very high quality companies that can benefit from some of this turmoil, can benefit when other companies in their industries get hurt by some of the things that are going on.

As Greg and Nael have both articulated, quality growth is our mantra. Just to repeat, quality growth companies tend to have durable competitive advantages, which protect the companies and allow them to grow under different circumstances. These companies have an ability to grow faster than GDP, they're often riding secular tailwinds, and they're companies with good governance.

Within that, we own both offensive and defensive names, that is offensive names being ones that we expect to really grow dramatically, or dramatically faster, than the overall economy, and defensive companies that can continue to grow and thrive under very adverse circumstances. So quality, quality, quality in this market.

Chris Zand: Thanks, John. Very helpful. Carl, staying with that theme, could you also spend a couple of minutes talking about how our fixed income portfolios are positioned?

Carl Kaufman: Sure. I think you'll be equally as shocked when I tell you we have plenty of dry powder. We're keeping duration low. We are finding some names that are a little longer opportunistically, but we're reluctant to go out on the maturity spectrum at this time because as you saw recently, rates are going up at the long end.

We want to wait to see how that shakes out with all the fiscal deficit spending that's going on before we make a move there. I think there's better opportunities ahead.

Chris Zand: Great, Carl, thank you. Okay. I've got one last question for the panel before we'll turn to our Q&A, and it's about a topic that most of us probably have never really thought of until most recently, and that's Greenland. I'll open up this question to the whole group. What impact do you think that U.S. policy towards Greenland might have on the markets?

Carl Kaufman: Well, Chris, as it was with Liberation Day, a news item just hit the tape from the New York Times saying that the U.S. will be given sovereignty over small pockets of Greenlandic land where Washington can build military bases. It's similar to what the UK has with Cyprus, they're regarded as British territory. I don't know if this is the final say on it, but clearly it has caused upheavals in diplomatic circles. Denmark has clearly been fighting back. I think they've come to an agreement. As you saw earlier today, those 10% tariffs on European countries were pulled back. So another TACO by our administration.

Chris Zand: Great, Carl. Thanks for that update. Very informative. Okay. We're about to turn to our Q&A portion of the presentation. Any final thoughts from our panelists?

John Osterweis: I think as we've said, we understand the uncertainties and we've positioned the portfolio accordingly, so we'll keep reading headlines and making changes if need be.

Carl Kaufman: Yeah, that just about sums it up. There's plenty of static in the background, but for now, the economy is solid. Corporate earnings are good, and that's the most important thing. That's what people can control. You can't control what is going on in a lot of areas of our lives these days.

Chris Zand: Great. Thank you, John. Thank you, Carl. If you have any questions, please enter them into the Q&A box or you can raise your hand. I'm going to be opening the floor up to the audience now. While we're waiting for some questions to come through, I wanted to mention I have been having a lot of conversations with clients about how to handle concentrated stock positions with significant embedded gains.

If that's on your mind or an issue you're navigating, please let us know. We do have multiple investment strategies designed to deal with this specific scenario in a tax-efficient manner. With that, we have our first question. There's been continued discussion that tariffs will cause inflation, but if tariff revenue goes to the government and pays down debt rather than increasing spending, isn't that essentially taking liquidity out of the economy, which is inherently deflationary?

Carl Kaufman: I can take that one. Tariffs so far have yielded about $200 billion to the government. That's on a $31 trillion economy. Still fairly small, and they've all been paid for by the importing companies so far. They've clearly passed along some of that in price increases.

I think tariffs affect goods. They don't affect services. Services are a large part of our economy, and I don't think that those prices are coming down anytime soon. So yes, theoretically it does take some money away from demand as you pay more for goods, and people are more focused on prices than the rate of inflation.

They don't go to the store thinking, "Oh my God, prices are up 3%." They go to the store and they see a price that's 30, 40, 50% higher than it was five years ago, and that's what they react to. I don't know if those are coming down anytime soon.

Chris Zand: Great. Thank you, Carl. Here's our next question. Can the market rally continue for a fourth consecutive year?

Carl Kaufman: I'll go 50/50 on that.

John Osterweis: Yeah. The answer is it can continue. The question should be, will it continue?

Carl Kaufman: I think the first half will probably be okay because there is a lot of stimulus coming from the tax, or refunds and the tax breaks. Beyond that, it's anybody's guess. You've got the midterms and a lot of posturing, there's going to be a lot of news, and a lot of noise. I don't know whether that lights a fuse one way or another.

Chris Zand: Great. Thank you. Thank you both. Next question. How far will the Federal Reserve cut rates?

Carl Kaufman: It's a very good question. I have no idea, but I would say no more than 350 or 375 basis points from here. I don't think they'd go to zero again. It's not needed.

Chris Zand: Excellent. Thank you, Carl. Next question. What will the 2026 midterm elections mean for the markets?

Carl Kaufman: I think if history is a guide, nothing. I mean, the markets are unfazed by anything these days. It really doesn't matter what goes on. I think expectations of a Democratic shift of power in the House are baked in. I think there's probably a 50% chance that they might get the Senate too, but that's baked in. That's kind of the betting stance now. Anything drastically different from that might have a day or two impact as most elections typically do. John, any thoughts on that?

John Osterweis: I mean, I think when you look at the economy, there is such momentum, particularly around AI and the huge investment cycle that the economy's not going to fall off a cliff. It's hard to say how it all ends up, but the markets really look at what's going on in the economy as opposed to some of the noise.

Chris Zand: Okay. Well, that was our final question. If there are no other questions at this time, I'd like to thank all of our panelists for their time today, and for all of you for joining us. John, any closing comments?

John Osterweis: No, I think we've pretty much summed up what we know and what we don't know, and you have a good idea of what we're doing about it, so upwards and onwards.

Chris Zand: All right. Well, thank you all for joining us. Have a great day.