Q: How has the fund evolved over the years?
The Osterweis Strategic Investment Fund (OSTVX) is a dynamically balanced fund, launched on August 31, 2010. It combines our expertise in managing both equities and fixed income.
When we decided to launch the fund, we were also running a long/short hedge fund. We were looking for a way to deliver similar risk/return characteristics without the cost or complexity of a hedge fund. Our first instinct was that a simple 60/40 portfolio might work. The idea was that equities would provide growth, while bonds would provide income and a hedge.
We looked at historical returns of a static 60/40 blend, and although the results were compelling, we decided that it made more sense to make the allocation between stocks and bonds flexible. So our fund has the ability to vary the ratio between stocks and bonds within a range of 25/75. That means we can hold up to 75% equities and 25% fixed income, and vice-versa. We thought this was important in terms of both allowing us to potentially avoid risk and take advantage of opportunities.
Another difference from a traditional 60/40 blend was that we wanted the ability to migrate between investment grade and high yield bonds, depending on the interest rate and the credit cycles. We thought the combination of a flexible allocation combined with a non-traditional fixed-income approach would provide a more powerful alternative than either the standard 60/40 blend or a traditional long/short hedge fund strategy, and so far it’s worked well.
One of our favorite features of the fund is its versatility. It is an excellent one-stop shop for a small pension account or endowment because it is dynamically diversified. It could also be a great option for anyone seeking hedged exposure to the equity markets – particularly individuals looking for low maintenance portfolios, such as first time investors and parents looking to establish accounts for their children. And of course we think it is a very compelling alternative to hedge funds.
So that’s the origin of this fund. It is designed for clients who want broad diversification but with the dynamic ability to move between stocks and bonds, and between investment grade and credit-sensitive bonds on the fixed-income side.
Q: What core beliefs guide your investment philosophy?
We have three primary goals. Our first goal is to try to not lose money. The second goal is to produce a decent absolute return for clients. And the third goal is to beat the benchmark. However, we are more interested in producing absolute returns than beating a benchmark.
So, the main driver for our portfolio decisions is producing sustainable absolute returns. If we are at the bottom of a bear market and see a turning point, we could be quite aggressive and position ourselves near the 75% limit on equities. On the other hand, if we believe that we are near the top of a bull market, we could focus more on investment grade bonds. In the middle, we would make more modest allocations, which would depend on our view of the economy and the markets and, more importantly, on our bottom-up views of specific opportunities and risks.
Within the fixed-income universe, we always have an eye on rates. In a rising rate environment, we try to keep duration shorter to minimize any drawdown of principal. In a more stable or declining rate environment, we are willing to push our duration further out.
Q: How does that philosophy translate into the investment process?
We have an investment committee that sets the allocation parameters. On the equity side, we have four analysts who spend their time on bottom-up stock selection. We have a very rigorous analytical and decision-making process that is focused on finding great or improving companies with good management where we have a differentiated view and there is an asymmetric return profile.
On the fixed-income side, every investment is selected bottom-up. We look at the investment merits of each security to find the ones with the best risk-adjusted return. The goal is to provide not only solid yield, but also balance and stability to that component of the portfolio. The process is influenced by the fact that every security has substantially different performance characteristics. For example, the securities in the portfolio have maturity of six months to eight years.
We make decisions based on what we currently have and need in the fund. In that process, we look at everything from a fundamental perspective. Is it a business that we would like to own or a business that can go away easily? Are we getting paid appropriately for the business risk and for the tenure over which we expect to own the security? That analysis is also based on the current rates and on our forecast for their direction.
Our goal is to truncate and eliminate as much downside as possible because we focus on absolute return. As a result, our portfolio effective duration is approximately 2.1, which is substantially shorter than the duration of the indices. We are primarily invested in high yield right now, and high-yield indices have duration in the low to mid 4s. So, the composition of our fund is much more defensive than the composition a typical high-yield index.
The fixed-income research process is not necessarily more complicated than the equity research, but it involves complex analysis of each situation. We have more discrete endpoints for each case along the curve, and we constantly try to make sure that the securities will deliver the desired aggregate performance, given our big picture views.
Q: How are macroeconomic views incorporated in your strategy?
We focus mostly on the U.S. but we also take into account global developments. We examine all the critical trends in terms of expected growth, investment, new industries, etc. Then we try to assess what has already been discounted for, or what the market is missing.
On the equity side, we identify industries with significant changes in the opportunities. For example, several years ago regulations on utilities and energy changed dramatically, so utilities were forced to open up their distribution to independent power producers. All of a sudden there was an independent power industry created.
The same development happened in cell towers, where multiple service providers wanted 10 or 12 towers in a given city, so the city would ask them to co-locate their antennae on a common site. At that point, owning towers was not a competitive advantage for the service providers so they began to sell them to independent tower operators. The regulations essentially created a new industry. We’re always interested in those types of structural shifts, regardless of the macro economy.
Q: Would you discuss one or two examples that illustrate your process?
In fixed income, one particular name that we own is Alliance Data Systems Corporation, a provider of loyalty and marketing services. It has a coupon that pays 6.375 percent, an equity market cap of about $14 billion, and current yield of slightly over 5 percent. At the same time, in the broader high-yield market, the average maturity is about seven to eight years, while the average coupon is around five.
So, we have a well-known public company with accounting transparency and a large equity market cap cushion, and we feel comfortable that the business is going to be around and we’ll be paid back. Also, we are getting that five-percent yield with maturity of just over two years, without the sensitivity to interest rates.
Initially, the basis of the investment was the free cash flow. When we analyze debt securities, our core question is whether we are confident in the business and whether it generates free cash flow. We don’t necessarily want them to be able to refinance in two years, but we make sure that the business generates enough cash to continually de-lever and pay the debt back. Alliance Data Systems generates $2 billion annually in free cash flow and we are getting paid a great rate for such quality.
An equity holding with similar downside risk and upside potential would be NextEra Energy and its subsidiary Florida Power & Light. It is a regulated utility, but we got interested mainly because it is the largest developer and operator of wind and solar power in the country, which is unregulated. For us, it is a constant theme to find a company that looks like a dull, yield-oriented company, but actually has considerable growth. To the casual observer, NextEra looks like a regulated utility, but it is the unregulated, dynamic, and rapidly growing side of the business that should drive its earnings and cash flow going forward.
Q: What other factors influence your selection process?
The foundation for almost all our equity investments is the ability to generate free cash. We may be involved in a company that is currently in a huge spending cycle and not cash flow positive, but has a business that will become massively cash flow positive once that spending cycle is over. Over the years, we have owned cable TV and satellite companies that are spending for building out their systems, but once the systems are up and running, they turn into cash generators. So, we try to identify changes in cash flow and profit, or situations where a company may be doing poorly, but we see a significant positive change in the future.
Within the fixed-income portfolio, we sometimes invest in convertibles. The convertible market used to be big, but has shrunk significantly over the last 10 years. We believe that right now it is overlooked, so sprinkling convertibles into the portfolio can add some attractive equity-like returns. We are interested in securities with strong fundamental characteristics and the right structural characteristics that would give us the equity sensitivity that we desire.
Q: How is your research team organized? Who makes the decision to include a name in the portfolio?
On the equity side, we have four key analysts and me, as lead portfolio manager and chief investment officer. The analysts are focused along industry lines with some overlap, so in some cases more than one analyst will cover the same company. The senior analyst is our Director of Equity Research and is responsible for maintaining the analytic discipline that we require.
Generally, we make consensus-based buying decisions, where one or two analysts present a stock, do the work, and run it back and forth among the whole group. Then a decision is made to add it or not. On the portfolio side, I maintain veto power. I can decide on the size of the position and how aggressively to buy it.
For exits, either the sponsoring analyst or I can unilaterally sell a position. So, if the analyst who presented and researched the stock decides he no longer likes it, he can pretty much dictate the position to be sold.
As a group, we look at allocations across industries and sectors to make sure that we are not making overly concentrated bets. For instance, if we think interest rates are going up, we tend to de-emphasize yield-oriented stocks across multiple industries.
On the fixed-income side, there are three team members with an average of 30 years of experience each. Although they approach their analyses from different perspectives, ultimately they are looking for the same types of cash-flow generating businesses that our equity analysts seek. Before a purchase decision is made, each of us looks at every individual name and we come to a decision together. That’s somewhat unusual in the industry, but it ensures that none of us has vested interest in a name.
Q: Would you describe your portfolio construction process?
On the equity side, we typically own 30 to 40 names. The limits for individual and industry position sizes vary depending on the quality of the company and where we are in a market cycle. Obviously, if we have 25% equity exposure, the average position size would be less than 1% of the portfolio. But, if we have 75% equity exposure, the average position size would be between 2% and 3%, while the maximum would be a bit higher, but not extreme.
On the fixed-income side, we are more broadly diversified with about 75 names in the portfolio. We have a few specific industries that we actually avoid, such as exploration & production, energy services, or biotech. We have limited exposure to healthcare and very small exposure to retail. These are industries that we feel are too nuanced in certain cases, while in other cases they are just not reliable cash flow generators.
Q: Do you focus more on asset allocation or on security selection?
In some respects, security selection should be paramount - we should identify and buy securities or equities that can grow and prosper regardless of the economic environment.
On the other hand, we know that markets are vulnerable. When the market is deeply undervalued or extremely overvalued, we need to allocate accordingly to help produce more steady absolute returns.
Those may seem like two contradictory threads, but they are both there. The process involves two disciplines – first, to decide the aggregate exposure, and second, to make sure that the specific equities we own are of the quality and nature that would work in the long run.
On the fixed-income side, there should never be one or two names, or huge winners that carry the entire portfolio. We look for positive returns in 85 out of the 85 names, but those returns may vary with the maturity and the coupon of each security. We try to keep the portfolio as simple as possible to make sure that we have securities in the shorter end that pay a nice coupon, as well as securities that will be able to deliver sound results over a longer cycle.
Q: How do you define and manage risk?
The biggest focus of our risk management approach is avoiding permanent loss of capital. We always look for certain qualities in our investments - getting paid back on the bond side and growing businesses on the equity side. The least important aspect is keeping up with a benchmark.
With fixed income, we examine four key risks. The first one is business risk, which involves looking at every company we own to make sure it is performing in the expected way, both individually and within the context of the economy. We manage that risk through diligent analysis of the businesses. We get to know many of our management teams really well because we have long-term holdings.
The second one is credit risk. Specifically, we verify that the company’s capital structure is reasonable and that the business generates enough free cash flow to continue to pay its obligations. To some degree, that dictates the market’s perception of the spread at which the paper should trade and definitely impacts pricing.
Third, we analyze market risk and figure out how to try to protect ourselves from volatility and the exogenous factors that could affect our investments. We manage credit and market-related risks by examining our ratings buckets and making sure we don’t get too tilted towards weaker-rated securities that could perform poorly in a difficult market.
Finally, we monitor interest rate risk, which we manage by controlling our portfolio’s maturity and duration.
On the equity side, the two generic risks are fundamental business risk and valuation risk. Our general approach to equity selection is looking for companies with perceived fundamental risks, but also with a clear path towards the elimination of those risks. The great thing about that approach is that in the case of perceived risk, the valuation is often quite low. So we can buy future growth at very attractive valuations, as opposed to just finding a growth stock and paying a high price to own it. If that growth slows down, the stock comes under huge pressure.
Overall, we like to develop an asymmetry in terms of high growth and low valuation. There are many ways for that to happen, such as new management or reorganizations. It could be a company with a dominant business that is under pressure, but with some rapidly growing, under-the-radar divisions. When the perceived dominant position shrinks but the high growth verticals succeed (resulting in unexpectedly high earnings), Wall Street is typically taken by surprise, while we’ve already purchased the stock at a very attractive valuation. That’s the essence of our approach to equity selection.
