Published on August 1, 2023

If you were unable to join our quarterly webinar on July 27th, 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.


Chris Zand: Thank you all for joining us today for the Osterweis quarterly update, where we will discuss recent market activity and trends, our portfolio positioning, and our outlook for the remainder of 2023. I'm Chris Zand, and I'll be moderating a panel discussion today featuring Chief Investment Officers John Osterweis, Carl Kaufman, Greg Hermanski, and Nael Fakhry. Please feel free to enter any questions you have into the Q&A as we go through today's discussion. Okay, so with that, let's begin. The second quarter was a calm and productive stretch for the markets, particularly compared to the banking turmoil from last quarter and the steep losses in 2022. Equities continued to show positive performance led by U.S. growth stocks and hopes of an imminent end to the monetary tightening policy we've been seeing. John, as always, I'd like to start with you and get your take on why it was such a favorable quarter.

John Osterweis: Thanks Chris, and welcome everybody. I think what happened in the second quarter was to some extent an absence of bad news. We moved past the banking crisis, we moved past the debate over the debt ceiling. We saw inflation starting to come down, the Fed willing to pause its monetary tightening, and there was a sense that the Fed might actually achieve a soft landing, which is a big debate whether they do or don't, who knows? But the prospects of recession have clearly been pushed out, it is a widely anticipated recession that just seems to always be a quarter, or two, or three away. And so there's this sense that maybe things are okay.

The other thing is that corporate earnings have tended to surprise on the upside, because since there has been this anticipation of a recession, companies have gotten leaner and they've cut costs, and so the extent they actually have volume gains or revenue gains, margins have expanded a bit beyond what people might have anticipated, and so have earnings. So you sum it all up, and you then had some excitement over artificial intelligence, or AI, and the large tech companies that are going to be the major players in AI really led the market. And in fact, one of the things we'll discuss today, is the fact that most of the gains in the first half were attributable to about seven major tech stocks. And that the market hadn't yet broadened out, although it is starting to broaden out now. So I think that kind of sums it up, Chris.

Chris Zand: John, very helpful. It seems like investors are starting to feel a little more confident about the economy, but I know we are proceeding cautiously. What are some of the warning signs that we're paying close attention to?

John Osterweis: Well, we're obviously looking at the course of inflation and whether inflation remains sticky. One of the things that concerns us is the fact that the labor markets are still rather tight and there's upper pressure on wages, which would suggest that inflation does have some persistence. Second thing is interest rates; how high will the Fed have to push interest rates to get inflation back towards 2%? It's still running considerably higher than 2%. So how high does the Fed have to raise rates? How long are they going to keep rates up? And what effect do the higher interest rates have on companies that need to refinance? And so we think there's some maybe ticking time bombs out there where companies that have to refinance are going to refinance at much higher interest rates, and that may put real pressure on these companies. So a number of factors like that.

Chris Zand: Thanks, John, very helpful, and a very interesting perspective. I mean, to the outside observer, it could easily appear as though we're in the midst of a broad rally underpinned by a very healthy economy, but clearly there are some reasons for concern. Earlier you had mentioned that there's some good reasons for optimism as well. Could you talk a bit about those, and I know it's hard to predict, but what's your sense of how the Fed is looking in terms of being able to pull off a soft landing?

John Osterweis: I think the question of the soft landing is one that's very hard to really answer. The Fed raises interest rates in order to slow the economy and ultimately push us into recession in order to create slack in the economy that allows inflation to come down. So whether they can bring inflation down without a recession I think is problematic, and it's a great unknown. The second in terms of optimism, we are seeing inflation coming down, we're seeing the Fed not pushing interest rates up too dramatically at this point. We're seeing corporate earnings in many cases come in above expectations, largely because of the cost-cutting that companies have gone through. And then of course there are parts of the economy that are growing exceptionally well, things like AI are just burgeoning. And the question is, who's going to benefit from that? But tech tends to have a salutatory effect on, not only the producers of it, but also the users of it. So there are lots of parts of the economy that look just great, regardless of what you think about the overall macro picture.

Chris Zand: Thanks John, very helpful. Carl, let's turn to you now and get a quick update on the fixed income side. The investment grade market lost about a percent in the last quarter, while the high-yield market did a little bit better. Could you give us a quick recap on how fixed income markets performed in the second quarter?

Carl Kaufman: That's correct. High yield did well, which is generally the case when equity markets do well. Investment grade, as you said, did struggle a little, that's mostly because interest rates increased, and as rates rise, bond prices fall in investment grade; there's a very high correlation there. Overall, fixed income markets were in pretty good shape last quarter for all the reasons that John mentioned earlier, which is earnings have been okay, the economy is still chugging along. I mean, it's slowing a little bit, but the recent GDP shows that it's still very healthy. Issuance increased, so we got a little extra supply versus the previous quarter, and that has continued into the third. And companies were still able to access the markets to both finance their operations and refinance debt.

Chris Zand: Thanks Carl, let's turn to the Fed next. What do you make of the fact that the Fed raised rates again this week, particularly after pausing in June?

Carl Kaufman: Well, they did indicate in June that this was a pause, not a stop. So we have to take them at their word, and they proved themselves out this week. I think when you see the unemployment numbers that we've been seeing, and the labor market strength, and all the other indicators that are pretty good, inflation is probably not going to pull back very quickly to 2% without higher rates. So they did raise yesterday, they stopped giving forward guidance, so we have no idea what they're going to do in September. They have resorted back to the "data-dependent" line, if you will. But we still agree that they're certainly closer to the end of the tightening cycle than the beginning, but we also think that they keep rates elevated for longer. They pretty much said they don't plan on cutting this year, so we know till year-end they're going to be at least at the levels they are now. And today I think the bond market has started... to believe them, because the entire yield curve got above 4% today.

Chris Zand: I see. We've now been in an elevated interest rate environment for about a year, how do you think the economy's adjusting to this new reality? John mentioned some positive data, particularly around the labor market, and consumer spending has been holding up relatively well. But I'd love to get your take on how the economy's adjusting to this new environment.

Carl Kaufman: The economy seems to be doing quite well, in terms of adjusting to the higher rates. Keep in mind that most CFOs did their job the last five plus years, in taking advantage of the low interest rates and fixing their debt maturities out pretty far. Only about 20% of the high-yield market matures in the next three years, and in the next year it's only about 2%. So there's really no near-term catalyst, except for very few companies that need to refinance in the next year. And a lot of those are much bigger companies that fell to non-investment grade, like Ford Motor Company for example. They have a huge debt stack, they have a huge cash hoard, they'll have no problem accessing the markets. So I think that's one of the positives that has helped companies cope. In terms of companies that are highly indebted and have debt coming up, they're going to have to pay more, clearly. But I think the Fed is taking a very measured approach, and they're not surprising anybody. And if they break something, it'll be a slow crack rather than a smashing vase.

Chris Zand: Thanks, Carl. I'd like to pivot the conversation now to portfolio positioning. Nael, I'd like to start with you, given John's outlook, which is somewhat optimistic but also a little cautious, how are we positioning client portfolios in this current environment?

Nael Fakhry: Sure. So as John pointed out, there's still some unknowns. So we want to stay defensive, and we've positioned portfolios to withstand the near-term risks. Given that the economy could still slow, and some of these risks could play out. And inflation while it's coming in, could return, it could start reaccelerating given wage pressures. So we've constructed portfolios with defensive businesses that we think should generate stable revenues, and growing profits, and significant free cash flow in most environments. You've probably heard us talk about this in the past, Quality Growth businesses is how we describe these companies. And these are businesses where there's some sort of a durable competitive advantage. And as a result, the companies tend to either have pricing power, or can gain market share. In a rare few cases, they can do both. And as a result, these are companies that can grow earnings and free cash flow through most environments, including through inflationary periods.

And obviously it was a really good test over the last year and a half or so, we saw that play out in many cases. These are also companies that tend to be well capitalized. They generally in most cases pay growing cash dividends, although in a few cases these are companies that just generate tons of cash and use the excess cash beyond reinvestment to buy back stock. Most of the companies actually do both. And they have really good management, and they benefit from secular tailwinds that we've enumerated and discussed in the past. So our view is that the best course of action, particularly when you've got this kind of uncertainty, is to own these kinds of Quality Growth businesses; they should protect in down markets, while also participating in market rallies. We essentially view a Quality Growth portfolio as an all-weather approach.

Chris Zand: Thanks, Nael. I'm curious, do you have any additional thoughts about the second quarter's narrow rally. With just a handful of mega cap technology stocks making up most of the gains, could the strong market returns be masking weakness in the broader economy? And just as a follow on, has that influenced our portfolio positioning at all?

Nael Fakhry: Yeah, so just to give a little bit of detail, through the middle of June, The Magnificent Seven, Nvidia, Tesla, Meta, Apple, Amazon, Google, Microsoft, they accounted for about 30% of the S&P 500, which did raise real concerns for us, because we haven't seen that level of concentration since the 1970s. And when you have such a narrow market, if it's not supported by fundamentals and it doesn't broaden, you could have any one company basically take down the market. Now, we do own three of the businesses among those seven, and we own them in size in most portfolios. So we don't think it's all hype, but you do have to be cautious when you see that level of concentration.

And as John alluded to earlier, the economy clearly... And Carl as well, actually. The economy clearly is not in recession right now, we just saw the Q2 GDP number this morning. And earnings from companies are actually better than expected. So the rally has broadened, and we think that's reflective of a healthy economy, or certainly one that's healthier than was perceived.

But having said that, we don't think it's prudent to chase these companies at these levels, you don't want to chase all of them. But some subset of them, the ones we own, we think they're actually priced at anywhere from reasonable to actually really attractive levels in some cases. And there's very significant earnings and free cash flow, and growth of earnings and free cash flow underpinning these companies. So we're always going to be cautious when we see these really high levels of concentration that we saw, that were particularly acute as of month and a half ago, that have kind of abated. And we're glad and thankful to see that the market rally has broadened as earnings have improved, and broad economic data has come out showing that things are getting better.

Chris Zand: Thanks, Nael. Greg, I'd like to turn to you next. During the second quarter, growth-oriented sectors outperformed while energy underperformed. I know we've added a few names to the portfolio and increased our weighting in others, can you touch on some of the portfolio activity during the second quarter?

Greg Hermanski: Sure, Chris. We actually only bought one new name this quarter, and that name was Agilent. We've talked in the past about wanting to be opportunistic in our approach, and this quarter is an example of us being willing to be patient and wait for opportunities to come to us. Agilent I think is a great example of the type of company that we want to add into the portfolios. The stock had declined significantly from its highs due to destocking as part of the Covid pandemic.

But not only do we like the company because we think the destocking is temporary and it'll move on pretty quickly, but Agilent has proven strong management, they have a resilient business with a lot of competitive advantage and big moats, almost 60% of their business is recurring in nature. And then they generate strong returns on invested capital that have been growing over the last few years. They generate strong free cash flow, they use that free cash flow to do bolt-on M&As, which helps to both grow the revenue of the business and expand the margin. So Agilent is exactly the type of business that we want to own. We try to be opportunistic, and we'll wait for these type of businesses to become attractive.

Also, during the quarter we added to our Micron position. It's been a difficult time for the memory producers, because they're significantly oversupplied right now. But we think we're nearing the bottom of the cycle and demand is starting to increase. And so as supply comes into balance with demand, we expect the pricing to increase and that's going to drive revenue, the profitability, and the free cash flow for the company. In addition to this for Micron, we think that the next cycle could be stronger than they've ever seen in the past. And part of that is because their memory has a very high attach rate to AI servers, and so that's a new market for them. So not only will we see a recovery in the core business, but we have the AI business that we think will add to their demand and drive incremental margins and profitability even further.

And then I was also going to touch on a couple other stocks that we own in portfolios, Avantor and Danaher, they're pretty topical right now. They're also companies that have suffered through the post-Covid destocking. They have a bioproduction business, which has been where we've seen the biggest issues for them as far as destocking. But we think that there's a chance that comes to an end and gets cleared out by the end of the year. And the reason this is important, their bioproduction business is meaningful for the companies. Historically, it's grown at a mid-teens rate, but these are fantastic businesses. They have competitive and regulatory moats around them, and they have very good long-term prospects. When a drug is approved and uses one of their processes, it's very hard from a regulatory perspective to change it. So they end up with a recurring revenue stream that can last 20 years or so, so fantastic businesses. So we're really focused on when those businesses kind of bottom, and we think that's coming up. And so those are businesses that we want to own into the next cycle.

Chris Zand: Thanks, Greg. Following up on that, on our last call you specifically identified several sectors that you thought were compelling over the near-to-medium term, and one of those was aerospace. Which I was hoping maybe you could talk a little bit more about today, what's been happening in the industry as well as in our portfolios.

Greg Hermanski: Yeah, sure. Aerospace has done really well. There's been a return to travel that's been very strong this summer. In fact, Safran yesterday on their earnings call mentioned that the narrow-body market, so flights, are now trending above pre-pandemic levels. As a result of this Safran and Airbus, a couple of the stocks that we own in portfolios, are nearing all-time highs as production levels are starting to increase.

At the Paris Air Show this summer, there were record levels of new orders for airplanes, so the backlog of pretty much all of the major players is extending out significantly. So for many plane models, this is extending out into the next decade, so in the 2030s. So we see the combination of extremely, extremely strong demand, and improvement in the supply chain driving record production for these companies. And we also think that this is going to be a very long cycle, and the companies will have an opportunity to reach record revenue levels, EPS levels, and free cash flow levels. And just to give you one example, in the case of Airbus, earnings have already accelerated off the bottoms. But we think over the next three years they could increase by another 75% or more. So we continue to love aerospace.

Chris Zand: Thanks, Greg. Very helpful, thank you. Staying on the topic of portfolio positioning, Carl, can you quickly tell us what's happening on the fixed income side of portfolios?

Carl Kaufman: Sure. We're staying relatively defensive, that should come as no surprise to people who know us. We are overweighting the shorter term to take advantage of the inverted yield curve, and one of the nuances there is that we were buying a fair amount of commercial paper at very good rates, but those companies that were issuing paper have decided to use the yield curve against us and issue 3-year paper because it's cheaper than issuing 1-month commercial paper. So for the last three, four months, we have also been buying 3, 6, 9-month paper at yields higher than the commercial paper, but still not long enough to get hurt by the curve. So we're still being very patient, and we're waiting for fatter pitches. The bond markets have had a reasonable rally since last September, so we'll wait for a pullback. I've never gone through a period in my life without one.

Chris Zand: Thank you, Carl. Very helpful. One more question for the panel before we open it up to the audience. What do you make of the increased dialogue with China? Treasury Secretary Yellen was recently there, as well as John Kerry, our climate liaison. Do you think that relations are starting to show signs of improvement?

Carl Kaufman: I'll take this one to start. It's definitely good that we are still talking, especially about climate I suppose. However, the Chinese economy is really struggling, particularly compared to what it's done over the past few decades. So this always makes me nervous, because war seems to be an easy answer for countries when their economy is failing and unemployment is rising. So I hope that doesn't hasten their desire to reclaim Taiwan, by force if necessary. But we're certainly monitoring, there's nothing we can do about it but hope that calmer and saner minds prevail.

Chris Zand: Thank you, Carl. I think at this point what we'll do is open up questions to the audience. I do want to remind everyone that this is a great time of year to review your portfolio and overall financial picture to make sure things are in order. We are happy to meet with you, whether it be virtually or in our office, to go over anything that may have changed in your lives, or take a fresh holistic look at your overall wealth picture. So with that, I'd like to open things up to the audience. We do have a few questions that came in earlier today, as well as a few that were submitted during our conversation, so we'll get to those first. And the very first question is for you, Carl, when do you think the yield curve will stop being inverted, and what do you think it'll look like when it finally normalizes?

Carl Kaufman: I think it's going to be on Wednesday, but I just don't know the week, month, or year. What's really sort of interesting here, is that the yield curve remains very inverted, although it steepened quite a bit today. And I hope it doesn't last as long as this, but when Europe went to negative interest rates, some people thought it was abhorrent, some people thought it was not normal, it wouldn't last very long, but it lasted a very long time. So the question remains, when will the markets believe that inflation is going to be higher for longer and the Fed is going to keep rates higher for longer, and that is going to be not high enough to be a detriment to growth?

So I think what's going to happen is it either happens one of two ways. Either short-term rates come down and long-term rates sort of stay where they are. Or long-term rates rise, and short-term rates kind of stay where they are. And there's a fulcrum in there, generally 7 to 10 years. I think it's probably going to be a combination of the two, but I think it'll be more long rates rising before short rates fall. I just don't know when it's going to happen. So the inverted yield curve could become the new normal until it isn't anymore.

Chris Zand: Great, thank you, Carl. Here's a question that came in during today's conversation. Wondering your thoughts and exposure to real estate in general, and specifically commercial real estate.

Carl Kaufman: , this is one area of the economy that got way overdone. Cap rates were ridiculously low, in the threes, when money was free or people were paying people to take money. And that was not sustainable. That has corrected, Covid certainly exacerbated that move. And now we're getting into more normalized pricing for office buildings, especially Class B in the major metropolitan areas. I think Class A will still be okay, Class A I think is still mostly owned by funds rather than bank direct loans.

It's going to take some time, but I think as people drift back to work and drift back to downtowns, I think we'll eventually get back to a more normalized, albeit more sanely priced commercial real estate market. In terms of other real estate, there's a shortage of homes. I mean, so many people have mortgages that are very cheap. If they don't have to move, they're not going to, and that's the problem. There's not enough single family homes to go around, or condos, and there are a lot of buyers. So we're seeing excellent results from our home builders, who are pretty much selling everything they can build. But costs have gone up, so they are raising prices. In terms of downtown, I'll let everybody else comment.

Nael Fakhry: Yeah, I would just add, Carl, to what you said. There's definitely obviously pain in the office part of the real estate market, and that'll persist. Actually this year should be the first year where total inventory of office in the history of the country actually declines year-over-year. And even going back through the Great Depression, it doesn't appear that you saw that based on the data we have. So like every market, it's going to work itself out eventually, but there's a lot of pain that's going to be had by participants, whether it's the lenders or the equity owners. You just mentioned single family homes, I'd also add industrial real estate, that's the one area where we do have exposure and we're big believers. And the reason for that, we've talked a bit about this in the past, you've got to pick the right industrial real estate, but if you own the kind of small tenant, last mile infill real estate in the best locations, you're benefiting from secular tailwinds in terms of both e-commerce and nearshoring/onshoring.

Those are just structurally driving demand higher, those two forces, or three forces, depending on how you want to cut it. And meanwhile, in those last mile infill locations in big metros, particularly the Sun Belt, big believers there. You have population growth, that's another force of demand. But you also have declining supply, because a lot of local municipalities and others don't want to zone for industrial. It just doesn't employ many people.

But it's critical. You can't run in an omnichannel business, you can't run a traditional retail business, you can't run a distribution business, if you don't have that access. So you have this supply/demand imbalance that means pricing is really, really strong. So based on what we talked about it, all of those kind of attributes fit the Quality Growth companies we talk about, in terms of pricing, power, durable competitive advantage, secular tailwinds, all of that. And I'd say the last thing is, you want to have light leverage. So to the extent that we have any real estate exposure, the one company that we own has actually significantly de-levered its balance sheet. And as a result, actually really well-capitalized. Which again, from real estate in general, but especially these days, not always the case. So you really have to pick your spots and be very discerning, and that's what we're trying to do, but a lot of pain to be had elsewhere.

Chris Zand: Thank you, Carl. Thank you, Nael. Earlier, Greg, you are discussing a pharma company when we were on the topic of portfolio positioning. Can you confirm if that was Avantor that you were referring to?

Greg Hermanski: So actually I was not referring to a pharma company. I was referring to two companies, one was Danaher and was one was Avantor. Both of those companies sell into the pharmaceutical industry, so they make products that are used to produce biotech drugs. And actually we like these companies better than we do pharmaceuticals, from a business model perspective. There's limited competition in the companies that sell into this area, so these are major players. And then instead of making a bet on a specific drug, they sell all the equipment that goes into making it. So for example, Lilly and Biogen are coming out with Alzheimer's drugs, which will probably be very large drugs. We don't have to decide who's going to have the better drug or who's going to win in the market; they're supplying all of the production capabilities to the pharmaceutical companies.

And so as demand goes up, we're kind of locked in for the next 10, 15, 20 years to that production. And so we prefer being kind of the "picks and shovel" suppliers with limited competition, high regulatory burdens or regulatory requirements, which keeps people out of the business. And just... I'll spend one minute. We've been able to add to these positions because during the Covid period of time, a lot of pharmaceutical companies were buying this equipment for vaccines. And then as Covid ended, they had excess supplies of the vaccines. That equipment to make the vaccines, that's running it down. And so now as we get through that, we believe that we're going to see a natural growth rate of in the mid-teens for these companies. So it's a really powerful business model, and we think that we're getting close to the bottom for these companies.

Chris Zand: Thank you, Greg, very helpful. That was our last question, so I want to thank you, John, Carl, Greg, and Nael for your helpful insights. And thank you all for joining us today. As always, 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. And from all of us here, thank you and enjoy the rest of your day.

Core Equity Composite (as of 6/30/23)

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) 5.76% 11.67% 12.55% 10.01% 10.20% 10.25% 9.18% 8.84% 9.77% 11.12%
Core Equity Composite (net) 5.50 11.13 11.47 8.94 9.13 9.17 8.09 7.76 8.66 9.97
S&P 500 Index 8.74 16.89 19.59 14.60 12.31 13.38 12.86 10.88 10.04 10.04
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.

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Ford Motor Company, Nvidia, Tesla, Meta, Apple, Lilly, and Biogen were not held in the Core Equity Composite as of 6/30/2023.

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.

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

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.

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 Per Share (EPS) is a company’s earnings per outstanding share of common stock.

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