Quarterly Webinar Replay

Chris: 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 the remainder of the year. I'm Chris Zand and today I'll be moderating a panel discussion featuring Chief Investment Officers, John Osterweis, Carl Kaufman, Nael Fakhry, and Greg Hermanski. Please feel free to enter questions into the Q&A as we go through the discussion today. So with that, let's begin. John, as always, I'd like to start by asking you for your big-picture thoughts on the economy. Now, despite elevated interest rates, it seems like conditions are still mostly favorable. Equities extended their rally in the first quarter, and more importantly, the market broadened out, all of which would generally indicate strong and healthy fundamentals. At the same time, it appears inflation is proving to be more stubborn than most of us would've hoped. What's your assessment of the situation?

John: Thank you Chris, and welcome everybody. I think Chris, you articulated the state of affairs very well. As you know, there's been a much-anticipated recession that simply hasn't happened. The economy keeps chugging along. Inflation is down from its peak, but it's still above where the Fed wants it. So the Fed has been holding interest rates constant but not at such a high level that it's torpedoed the economy and I think the Fed is likely to maintain this posture of steady rates until they see inflation down to the 2% where they would like it.

Chris: Thanks John. Very helpful. As a follow-up, why do you think the economy has held up so much better than everyone expected and why haven't higher interest rates been more of a problem?

John: I think higher interest rates have not been a problem because they're simply not too high, probably somewhere where they ought to be, which is higher than the zero band where they had been hovering, but they're not excessively restricted. So monetary conditions are not particularly restrictive. I think the economy has been strong because the consumer has been strong and as you know, the consumer is roughly two thirds of the economy. Unemployment is below 4%, which is quite low, so people have money and because the stock market's up, you've had a bit of a wealth effect at the higher end. So I think consumer spending's been strong. Then there's been a fair amount of growth in certain sectors of the economy like AI, cloud, et cetera, where there's been significant investment and then there's been legislation, that's been very stimulative, whether it's the CHIPS Act or the Climate Act or whatever. There's been a lot of fiscal stimulus in the economy. So all of that combined suggests that things will keep rolling along for a while.

Chris: Thanks, John. Obviously a healthy economy is great news. At the same time it seems like it might be making the Fed's job a little bit harder. On the one hand, a strong economy gives the Fed more time in its battle with inflation. On the other, strong economies are inflationary by nature, which makes it tougher to get inflation down under control.

John: Well, obviously the strong economy does put a little fuel under inflation, by the way, as [do] wars. And we do have some significant conflicts now around the world. Having said that, the Fed has indicated quite strongly that it is going to be data-dependent and is not going to lower interest rates until they see inflation much closer to its target. And with the economy rolling along, the Fed has no real incentive to lower interest rates at this point. So from an investment standpoint, what I think that means is that the stock market, if it's going to continue to go up, is not going to go up because of rising valuations, but will go up because of rising earnings. So I think the market, given this interest rate environment, this market is going to be very dominated by earnings and earnings outlook.

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

Carl: I pretty much agree with everything John said. I'll just add one tidbit about inflation, which is definitely lingering longer than the Fed was hoping. One of the economists we like, Strategas Research, has created their own version of the CPI called the "Common Man CPI." It's a subset of the official CPI basket, but it contains things they believe are must-have purchases rather than discretionary items. Unfortunately, that index is still higher than the official one, so we're definitely in the higher-for-longer camp when it comes to interest rates at this point.

Chris: Thanks Carl. So with that backdrop, maybe you could spend a little time talking about how we're positioning fixed income portfolios given the team's interest rate outlook. And I know we significantly outperformed the Barclays Aggregate Index [Bloomberg U.S. Aggregate Index] in the first quarter and our trailing 12-month numbers looked even better. So maybe as a follow on, you could talk a little bit about how we've been able to do that, especially as the 10-Year Treasury yields have been climbing during most of that time.

Carl: Well, as you know Chris, it's a bit of magic. As we've been saying for a while, we're continuing to lean into the inverted yield curve and that has allowed us to capture yields that are pretty much inline, a little bit lower than the general high-yield market, but with a lot less volatility and a lot more flexibility. And as always, keeping an allocation to cash and equivalents high during periods where we think valuations are maybe a little bit, not cheap, I'm not going to say they're rich, but they're not cheap. We have kept the balance of the portfolio in sort of non-investment-grade bonds of companies that we are very comfortable with and are pretty strongly positioned. We're basically well-positioned for a wide range of potential outcomes. If short-term rates remain high, as we expect, we should continue to generate solid returns. If longer term rates continue to drift higher as they have been lately, we're largely protected because of our short-term positioning.

On the other hand, if the market unexpectedly hits an air pocket and we get some volatility, we're also in a good position to lock in longer dated bonds at cheaper prices, because we can use our cash just to step in and buy. So if the Fed actually does begin to cut rates, we'll look to extend our maturity profile then as well. The basic philosophy is to look for the safest way to invest in the most attractive areas of the market, so the inverted curve has been a blessing for us.

Chris: Thank you, Carl, very helpful. I'd like to bring the conversation now back to the equity side of the portfolio and turn to you Nael. We've been talking a lot about our focus on Quality Growth companies, which has certainly been working well in the current market. But I'm wondering if you expect the prospect of higher interest rates for longer to be an issue even with such a strong economy?

Nael: Thanks, Chris. I mean the short answer is, no we don't think that high interest rates should really negatively impact our companies and in fact could actually help. So as a quick reminder, we define Quality Growth companies as having three characteristics. So a durable competitive advantage, that's the first characteristic. A long runway for growth through reinvestment that allows growth at or above GDP. And then thirdly, excellent management. So those are kind of three characteristics that we view as key to a Quality Growth company. And there are a handful of really key metrics we always look for in our companies to validate whether they really are Quality Growth, significant free cash flow generation, pricing power and strong balance sheets. And if you think about each of those from the perspective of rates, if you have strength in each, then you're well positioned.

Strong free cash flow generation means our companies are self-funding and therefore can handle debt service without a hiccup. Pricing power means the companies can offset cost inflation by raising price and thus protect or even expand margins, which we've seen in many of our companies. And then obviously strong balance sheets mean that debt is not a big part of the capital structure and companies aren't reliant on external capital to grow.

We actually touched on this a second ago, but we actually think the higher rates could be a benefit for our companies and we're seeing it real time in many cases because competitors are often distracted managing their balance sheets and trying to fix them and also just managing rising interest expense, the actual dollar expense, and especially if they haven't managed their balance sheet properly coming into this and have floating rate debt and debt that's maturing near terms, they're kind of distracted by all of that.

Meanwhile, our companies in most cases are actually investing to take market share. They're also acquiring other businesses as private equity has been forced to step back and, for the first time in probably almost 15 years now, many of our companies are actually enjoying earning very meaningful interest income on cash balances, which just makes them stronger. So, in many ways actually, this kind of persistent interest, it's not a really higher interest rate environment, but this persistent elevated interest rate environment is actually helpful given the kind of Quality Growth bent that we have.

Greg: And Chris, maybe I can add something to that too. Part of our Quality Growth strategy is finding quality companies that have a cyclical dimension. So, in the context of a strong and improving economy that you mentioned, when we find a company that meets our rigorous Quality Growth criteria and we believe that the company is at a point in the cycle where its growth is about to accelerate, it can be a very appealing stock setup. And post-Covid, we found several of those opportunities too.

Chris: Thanks Greg. Thanks Nael. That's very helpful. Now let me ask a follow-up question. I know the team looks as well at companies that are experiencing secular growth, which is different than cyclical growth. Can you remind the audience what secular growth means and talk about the secular growth themes that are influencing the portfolio today?

Greg: Yeah, I can take that Chris. I think that's a really important question. Opportunities in cyclical quality companies as we were just discussing, they tend to be lumpy and opportunistic and we don't want it to be dependent exclusively on companies that can only grow when the economy is expanding. And so really our bread and butter is investing in companies that can grow in any environment and secular growers provide that opportunity. So going back, secular growth, it refers to durable structural changes in the economy that really tend to go in one direction, they don't backtrack. Examples would be the transition from horse and buggies to cars, from train travel to airplane travel, from wired phones to smartphones. These are textbook examples of secular growth.

Another example would be online shopping. It wasn't long ago that we had to go to a store to buy what we wanted and now we can go to Amazon or a different e-commerce company and get whatever we want quickly. So we like investing in secular growth trends. They tend to be really powerful. They tend to be sustainable forces that drive real growth regardless of the economic environment. And so talking about some of our investments within our portfolios, a lot of them lie in the technology sector. Obviously artificial intelligence is a new dominant secular trend in the economy today. We have investments in Microsoft who has an investment in OpenAI, which owns ChatGPT, and we also have an investment in Google. These are two of the giants in the space. They were among the first movers in AI and they're really benefiting from that. We also have a position in Adobe, which is using AI and it augments their entire product suite that they offer to clients. So they're seeing benefits from AI as well.

In addition, other secular trends that we've invested behind that would include things like the transition to cloud computing and digital advertising. Amazon and Google are both dominant players in both of those secular trends. And then just briefly outside of technology, we also have secular growth investments in Bioprocessing where companies including Danaher and ThermoFisher, what we're invested in, they sell products that are accelerating pharma's move from small molecule drugs to more effective biologic and cell and gene therapy drugs. And then finally, to give you an example of how duration kind of plays into these secular growth opportunities, we're continued to invest in the decades-long secular growth theme around commercial aerospace.

Chris: Thanks for that, Greg. Very helpful. Now another aspect of the strategy, which I don't think we've talked much about is the subset of Quality Growth companies that expand primarily through mergers and acquisitions. Nael, can you explain how that works?

Nael: Sure. So, as we discussed earlier, Quality Growth companies have a durable competitive advantage. They have a runway to reinvest in order to drive growth and they have good management. That's how we define them. That second leg of the stool, the reinvestment, the opportunity to reinvest to drive growth, it can be organic where you're investing in capital expenditures, marketing in order to capture growth or it can be inorganic, i.e., buying other companies. And we find that when a company can do both, reinvestment in the core business and then systematic tuck-in acquisitions, that can be a very powerful combination because those systematic tuck-in acquisitions are relatively low risk. You're not doing one-off massive deals, you're doing small deals year in, year out with your retained cashflow. You can integrate them, the revenue from those acquired companies can bolster your existing top-line revenue.

But to the extent that you can also not only remove duplicative costs but also just improve the business by virtue of being a really good business standalone. So integrating these smaller businesses, you can really improve the operating margins of these acquired businesses and therefore have a bigger impact to the bottom line, therefore drive even faster profit growth from these acquisitions. And we have several of these companies in the portfolio.

Chris: That's great. Nael, could you give us an example of one?

Nael: Sure. One that's kind of top-of-mind is Ametek. So this is a company you've probably outside of our portfolio, you probably never have heard of, for our listeners. And so the company goes back, it's got a really interesting colorful history, but it traces its origins back almost 100 years to 1930. And the company really, it has thousands of products. It's really hard to describe exactly and very concisely what it does, but I think the best description is that it's a manufacturer of highly engineered, niche products that serve a mission-critical role, across a really broad range of end markets. And I would describe it as having two competitive advantages. One, Ametek operates in these really small markets, so they're like 2 to $300 million in size, which is really small. They intentionally avoid large markets because they don't want to have competition and they tend to be the dominant player. They're usually number one or number two, they have 25 to 30% share. So they operate in these really kind of small niche markets where they're the dominant player.

And then secondly, they take a very unique approach. It's very decentralized and they incorporate something called the Ametek Growth Model, which is basically a business culture around continuous improvement. So examples of their products would be, again, these are very highly engineered unique products, but the optics used here in the Bay Area at Lawrence Livermore Laboratory, the optics for actually creating fusion energy and doing the research around it, those optics are manufactured by Zygo, which is an Ametek company or something maybe a little more mundane, but maybe not, the push-pull wire for flight control on commercial jets. So this is a really, it's a specialty metal. It's about four one hundredths of an inch in diameter. It's really a niche unique product, but obviously these are mission-critical and they're super important components of major systems that cost tons of money. So think about a commercial jet. I mean this might cost tens or even hundreds of millions of dollars. This push-pull wire that Ametek manufactures is mission-critical, but a really small part of the cost.

So what Ametek is doing is they're running their business, but they're routinely acquiring kind of adjacent product lines and adjacent businesses. They improve the businesses by cross-selling and getting into new markets for the businesses they acquire, but they also pull out redundant costs and just improve the operations of the business. As a result, they build more cash flow when they acquire these businesses and then they can therefore invest more in the business and their kind of core existing business and then go out and buy even more. So it's kind this virtuous cycle.

And couple of facts I always think are amazing and reflect the power of this model of Ametek, for example, is that U.S. Gauge was a business they acquired in 1944 and then they do pressure and temperature gauges. And then Lamb Electric they bought in 1955. So we're going back decades, 80 years in the case of U.S. Gauge. Well, by acquiring these companies, Ametek is still the dominant player in each category for temperature and pressure gauges for these small motors that go into vacuums and other appliances. So these are acquisitions they did decades ago and they continuously reinvested in the businesses and then built around them through continued acquisition and decades later are still dominant.

And so if you look at the history of the company, they've grown revenues over, you can go back to 1955 and they've grown revenues at about 8% on a compounded annual growth rate basis. And that's been through organic investment, but also through these acquisitions, inorganic investment. And meanwhile, profits have grown substantially faster. So if you look at the past roughly 20 years, the company's grown profits at around 14, 15% every year through the cycle. And so we think at Ametek, there's lots of future runway for continued organic growth, but also inorganic growth through acquisition. And I think that's a good example of this approach that we like.

Chris: Thanks Nael, very helpful. And actually a great segue into my next question, which is about our core equity outlook from this quarter. The team wrote about how consolidation across the economy has affected the entire investment landscape as well as our own approach to portfolio construction. Could you expand on that concept with the audience?

John: Yeah, I'd be happy to. So for those of you who have been clients for many decades, you'll remember that when we first started the company about 40 years ago, our portfolios tended to look like mid cap, they had a mid-cap focus. If you fast-forward to today, the portfolio tends to be more large cap and even mega cap. And why is that? Well, about 20 or 25 years ago, something called the Internet sprung up and has become a very important critical part of the U.S. economy and companies that are involved in the Internet, either big tech companies like Google, Amazon, et cetera, are the sorts of companies that benefit from scale. And so what we've found is that particularly in the tech industry, scale is really important. My favorite example is if you want to do the social media stuff, you want to be on the platform where everybody else is on.

23:09

Chris: Thanks, John. Very fascinating. You can read more about this concept in our latest core equity outlook, which I encourage you all to read. The team did a great job explaining how this transition actually came about. I'd like to ask one more question before we turn to our Q&A. There are a lot of headlines out there these days to choose from, domestically, internationally, and geopolitically. And one that's come up often in recent client conversations is how the Mideast conflict may potentially impact markets. I'd like to open this up to our entire panel and see what your thoughts are.

Carl: I can start. It's hard to say. Clearly the markets have not been scared by it and have not reacted meaningfully to it. I think it depends on how much it escalates. We certainly have ebbs and flows there. As long as it stays relatively regional, hopefully the effects will be modest, but we've already experienced some economic impact when the Houthis started bombing ships coming out of the Red Sea. Certainly the disruption of commercial shipping is not a good thing for inflation. Seems the worst of that has blown over for now. Oil prices, although they moved up some, it is sort of the start of driving season, so that has a seasonal effect as well. We're seeing it here in California certainly. So I hate to be ambiguous, but we're just going to have to wait and see.

John: Yeah, I would add that ever since I've been in the investment business, conflict in the Middle East has been a risk that people have identified and rightly so. I mean, what's going on today is obviously tragic, but what interests me is that the Sunni Arab nations seem to want to have peace with Israel and trade with Israel and get along with Israel, and it's Iran that is the bad guy here. And whether that gets out of hand or stays under control, as Carl said, is a $64,000 question. But as long as there's conflict, I think there is some upward pressure on inflation. Obviously, you've got conflict in Ukraine as well and you've got all the uncertainties of the U.S. presidential election coming up. So there's lots to worry about, but I think the focus really should be more on what is going on domestically within our economy, because there's a lot of dynamism there that will keep going on despite all of these risks and potential disruptions.

Chris: Thanks Carl. Thanks John. Any other final thoughts before we turn it over to the audience?

John: No, I think we've pretty much covered it. So I thank you all for your interest and loyalty.

Chris: Great, thank you very much. If you have questions, please enter them into the Q&A box or you can raise your hand using our Zoom conference interface. And before we get to the questions, I just want to remind everyone that we are happy to meet with you either virtually or in person, to discuss your portfolios, develop a financial plan, or even review estate planning considerations. So with that, let me open it up to the floor now for questions. We'll start with one that came in while we were talking. This question reads, "You mentioned that yields on the 10-Year Treasury have been increasing for most of the past year, but the Fed has been holding short rates constant during that period. Why are long rates going up if the short rate is static?"

Carl: Last year there was certainly a partial consensus view that we were going to be entering a recession. So when that happens, typically rates come down and the 10-Year and other longer-dated bonds, were being bought by these people to get ahead of that move. Since that hasn't happened, the rates, those bets, if you want to call them that, have reversed and the bonds have come back down, i.e., the yields have gone back up. So I think there is a growing consensus that we probably won't get Fed easing anytime soon. And by that I mean in the next quarter or so, so rates have sort of drifted back up.

Chris: Thank you, Carl. One other question that came through. A popular theme over the past few years was infrastructure spending as a potential driver of growth domestically in the U.S. Do you anticipate that to continue being the case in the coming years?

Carl: My view is, I've been hearing about this, the shovel-ready project since 2009. There's certainly a need. I think there is funding. I think that we will get it, but it's not going to be the panacea that just lifts all boats.

Nael: Yeah, and I would say that in some, John had mentioned the CHIPS Act and some other programs, I think there's spending that's now been allocated and you're actually seeing the companies get it, to build out semiconductor fabs, to build out data centers. And then you're seeing separate from the technology spend, you're also seeing from some of the other bills that have come through, spending on just bridge infrastructure and other things, you're seeing that benefit, the aggregates companies, for example. So you're seeing it in the fundamentals of many of these companies, and part of it is coming from stimulus from the government. Part of it is just the pull, the demand side where companies need to invest because consumers are demanding these products and their customers are demanding these products.

Chris: Thanks Nael. Thanks Carl. Well, that appears to be our last question today, so I'll take a moment now to thank John, Carl, Nael and Greg for all their helpful insights. And thank all of you for joining us today. As always, let us know if you have any feedback or questions about today's discussion or your own portfolio. Take care and enjoy the rest of your day. Goodbye.