Q: What is the history of the company and the fund?
Osterweis Capital is an investment advisor for high net worth individuals and endowments. In 2002, the firm’s founder felt our clients needed more fixed-income exposure, which led to the development of our strategy and launch of the Osterweis Strategic Income Fund.
We have a common-sense approach to money management and do whatever makes sense at any point in the cycle. But since our clientele doesn’t like to worry, we try to find the least risky way of playing the most attractive parts of the market.
Q: What is your investment philosophy?
The fund’s philosophy is to not lose money and deliver performance over time by trying to minimize downside risk and to capture most of the market upswing. We believe that by avoiding the “style box” trap and having the flexibility to invest in multiple classes of bonds, we can manage the fund in such a way as to emphasize the most attractive sector at any given time. By strategically shifting out of overvalued assets, we strive to minimize potential risk and produce better returns over time.
Our philosophy has always revolved around having an absolute return mandate and mindset. If we do not like the markets, we do not have to invest. The fund is unconstrained, so no one insists we be fully invested; we can be defensive and protect assets.
Over the years I’ve learned to not be afraid of cash and to use it as a tactical asset. Some investors buy something that is relatively cheap but absolutely rich just to stay invested. For example, when other investors do not like the market in general, they may buy a bond yielding 4% for 6 years because everything else is yielding 3.5%. We will not do that. When there is not enough yield for the risk, we prefer cash. This is a luxury the fund has because it is benchmark-agnostic. Though measured against the Bloomberg Barclays Aggregate, we are not required to hew to it.
Our investible universe essentially includes the entire bond market, beginning with sovereigns and working down to convertibles; basically it is Treasuries, corporates, high-yield, convertibles and preferreds. We also invest in international companies but typically buy only U.S. dollar-denominated bonds. Other people can play the currency game, but we stick to what we know. We also avoid mortgage backed securities since that is not an area of expertise for us.
Q: In this environment of low rates, how do you evaluate risks and rewards?
We are always looking at risk when evaluating opportunities. Take Treasuries or sovereigns, for example. If yields are quite low in general, the risk is that rates will rise. Even though that risk is low, it is still a risk with a large consequence – much like skydiving. The risk of a parachute not opening may be low, but the result of that low-risk venture is not desirable.
If I am not going to be paid to take a risk, I will not take it. For this reason, sovereigns have been eliminated from the portfolio. The last time we bought Treasury notes/bonds was in early 2007; we were basically out of those by September of 2008 and have not returned, because the yields are too low and the risks too high. Given that the effective yield for the Treasury market1 in the U.S. is 1.4% and duration is 6.5, it would take about 4.5 years to make money back if rates rose 1%.
Going down the quality ladder takes us to investment-grade corporate bonds2 and I ask, “Am I getting paid there to take that risk?” The answer is no – it does not make sense at this point. The effective yield is 2.9% and the duration is 7.2, so it would take about 2.5 years to make it back on a 1% increase in rates.
I turn next to the high-yield market3, with a yield of 6.2% and duration of 4.2. This is better; at least we have a potential cushion if rates start to rise.
The fund does not have any duration restrictions so we have the flexibility to focus on the most attractive area of the high yield market. Right now we like short-dated high-yield4. The effective yield is 6.5%, which is actually slightly higher than the high yield market as a whole given a slightly inverted curve, and the duration is only 1.6. With the shorter duration high yield bonds we may get a larger potential cushion and also a higher yield.
Q: What is your investment strategy and process? Where do you find opportunities across different sectors?
We always start by looking at the investment universe and then focus on the areas that we think offer the most attractive risk/reward trade-off. The macro would currently tell us to stay away from Treasuries and investment grade and start looking in the high-yield and possibly convertible markets if we find a good, fairly priced equity – which is rare these days because the market is fairly rich and tight.
Our portfolio currently has about 75 companies and we know them all quite well. Other funds might sample the high-yield market with perhaps 300 to 500 names while trying to avoid the most obvious clunkers. Their aim is usually to perform in line with the high yield index, for good or bad. We do it differently, with deep dives and high-conviction ideas, looking at companies one by one and doing equity-like research. One question we always ask ourselves is if a company went away, would its clients notice or care? If the answer is no, we are generally less interested.
The tight focus of our portfolio means we get to know the companies well because we own their bonds over the long term. When we buy a bond we expect to hold it to maturity. In the past fiscal year, the fund’s turnover was only around 30%.
Another way we differ from other funds is we take larger positions, which typically means that we become the largest holder of the tranche of bonds we buy. This grants us greater access to management. In addition, we often get involved in the refinancing of that debt when it comes time and will talk to management and bankers about terms for the new bonds. Though our positions are large, they rarely exceed 2% of the portfolio. This is one way we manage risk. Larger positions are taken in the companies in which we have the highest degree of confidence. For example, at quarter-end our largest position was just over 4% – almost twice as large as our next largest position.
This 4% position is in a 9.25% coupon bond offered by Rite Aid Corporation, the retail drugstore chain. We expect it will be refinanced as soon as the Department of Justice decides whether Walgreens Boots Alliance Inc. can proceed with its takeover. In the meantime, we are clipping 9.25% coupons far longer than we expected to, so we are happy.
When analyzing a company, several factors are considered, including allocation of capital. We think stock buybacks and dividends are not a good use of capital and prefer companies that consider their debt and are careful about it, rather than ones that are constantly trying to pump up their stock price by issuing what they believe to be “free money.” Other important factors are free cash flow and sustainability in the business model.
We are also patient. As we try to deliver better returns, we wait for the right price and always have a price in mind when we look at a company and decide what yield is appropriate for a bond. Being disciplined about entry and exit prices helps mitigate risk in the portfolio, although it is mostly mark-to-market risk, rather than default risk. We have not had a bond default in the portfolio yet.
Q: How do you apply your research process?
Our research process also differs from that of many investment management firms. Instead of everyone doing their work and reporting up to a lead portfolio manager who makes the final judgment calls, our team of three seasoned fixed-income professionals works together. We all research every name in the portfolio together, we participate in the update calls together, and when we have a meeting with management, we like to have all three of us in the room or on the phone. Then we compare notes and decide sizing, pricing, etc.
An example of our research process can be seen in a Canadian company we own, GFL Environmental Inc. (“GFL”), a waste management company and trash hauler. We like the business because it is fairly straightforward to understand, and, if managed well, could be quite profitable.
GFL filed a deal in the U.S. in U.S. dollars to finance an acquisition. It was not a big company at the time but had made great strides in capturing market share from the two incumbents, Waste Management, Inc. and Waste Connections Inc., formerly known as Progressive Waste.
The reason GFL captured share was twofold: it did not have the overhead of a Waste Management nor did it have legacy landfills that the other two companies had. Unlike the U.S., Canada does not allow waste companies to subsidize disposal contracts with profits from their landfills. With increased recycling these days, landfills are generally a loss maker, not a profit maker.
These factors allowed GFL to underbid its competitors and still make money. It also made a lot of acquisitions the others were not interested in, either because the acquisitions were too small or they simply could not bid competitively because of their overhead. As a result, GFL grew quickly and has good equity sponsors. We also liked that GFL put a lot of equity into its acquisitions.
After meeting with GFL and getting to know the management, we took a position. At one point, the company had all the contracts in Toronto and Montreal but did not yet own Quebec. When an opportunity arose to acquire a company and get all of Quebec in the process, the CEO asked for our advice on financing the acquisition.
We suggested he do an add-on or similar deal, because GFL would be a bigger company after this acquisition. He ended up doing another underwriting and we participated.
The markets were a bit more difficult than they anticipated, and the pricing got very attractive for us. The first deal came at 8-7/8% coupon, with the bonds maturing in 2020. This was trading around par when the second deal was announced. The second deal was originally supposed to be in that same general area, but a bit longer, so 2021.
We ended up receiving a 9-7/8% coupon, and our bonds got knocked down initially because of the relative pricing. But because we believed in the company, we were happy to buy more. Fast forward to today: the 7-7/8% coupon bond is trading at 105-½ and the 9-7/8% coupon bond that they had trouble getting done is trading at 110-¾.
Q: Can you discuss another example?
Baker International, for instance, is a private company whose bonds we own. It is a specialized engineering, construction and architectural firm that manages and builds secure real estate for government and corporations overseas. The firm built the embassy in Baghdad, engineering and designing all the security for that complex.
Because it is private, it is not the easiest company to get to know. Only people on its approved list get its financials.
Baker has both an operating company (Opco) bond and a holding company (Holdco) bond. We own both. In the recent sell off, the Opco was trading in the low 80s and the Holdco got down into the high 60s. These bonds were not acting the way we would have expected given the fundamentals of their business. When they reported earnings earlier this year, it turns out that we were correct on the fundamentals; they had had a very strong quarter and the outlook remained bright. It has beat on revenue growth, profitability, and free cash flow. One of the things we also learned on that call is that management personally bought roughly $20 million of the Holdco bonds in the 60s.
For some reason the bonds did not move in price after the earnings call, which seemed odd, because typically we find that when management puts their own money into a bond, it is usually viewed positively. As a result, we swapped some of the higher-priced Opco bonds into the lower-priced, higher-yielding Holdco bonds. Today we are happy with where the bonds are trading.
Q: How do you define and manage risk?
In fixed income, two risks must always be balanced. One is interest rate risk the other is credit risk. These are mostly mark-to-market, i.e., timing risks. On a mark-to-market basis, investors could be dead wrong – say they stretch for yield and decide to buy that Italian 50-year bond being issued right now at 2.85%. If inflation shows up and that bond starts trading at 5% yield, they will lose a lot of money, but only if they sell. If they wait 50 years they should get their money back. No worries.
For us, interest rate risk is fairly simple—there must be a real absolute return, or we simply avoid the sector. On the credit side, we do not adhere to the premise that certain risks should be taken solely on the hope that if they survive, the yield will be great. If a dealer were to say to us, “yeah, but this yields 13%,” if we do not like the company, it is not going in the fund even if it yields 50%.
The other risk is credit risk; company fortunes ebb and flow. When they ebb, there is a mark-to-market risk. More importantly, however, is the potential for permanent loss of capital, for instance in a restructuring where investors do not get back 100 cents on the dollar.
We focus on both types of risk, and it always comes back to what are we getting paid to take a risk. A lot of our risk management is done on the front end by doing the research and getting comfortable with the business model and the management team, and that helps to mitigate much of the risk.
In terms of portfolio risk, we take a fundamental approach to risk-management. As part of that, we consider position size as important because we are a buy-and-hold investor. In smaller companies with theses that are not fully proven, we take smaller positions. But in a solid company like GFL with free cash flow and a solid financial position, we might take a bigger position.
Also, we do not like opacity – the various shades of difficulty accessing management, what they tell you and how hard is it to get to them. As a result, we avoid situations where there may be a problem easily accessing management.
Using cash opportunistically is another way to manage risk in the portfolio. We do not have a set range; during market rallies it builds and during corrections we look to invest it.
When there is a big sell-off, we mitigate risk by buying great companies at cheap prices. This allows us to avoid the uncertainty of second- and third-tier companies, because the top-tier ones may give the same yield. In 2008, we were able to buy some bonds issued by great companies with double-digit yielding paper at the time.
Because the banks have pulled back in their market making activities, liquidity risk has been an issue with regulators and market participants lately. We remain aware of liquidity in our underlying issues but do not let it rule our decisions as we are not a relative value investor, continually swapping one issue for another to gain a few basis points of yield. We are buy-and-hold investors, so companies with more variability in their results tend to be underweighted.
