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Recovery Anemic, Bumpy--but Still Proceeding

Though jobs and credit continue to be scarce, we are still on the path of a slow recovery, say Osterweis managers Carl Kaufman and Matthew Berler.

Esther Pak, assistant site editor, 07/08/2011

Carl Kaufman and Matthew Berler are portfolio managers of Osterweis Strategic Investment OSTVX, a balanced fund that can hold as little as 25% to as much as 75% in stocks with the balance in fixed income. 

They recently answered our questions about their current stance on the state of the economic recovery, where on the market-capitalization spectrum they were finding the most opportunities, and areas of the market where they were seeing limited downside and substantial upside potential. They also commented on investor fears over credit risk versus interest-rate risk and discussed the role the fund could play in an investor's portfolio.

1. This fund's allocations to stocks and bonds can vary widely. For whom would such an investment be most appropriate, and how would such a fund be best used in a portfolio? Is it designed to be a stand-alone offering or held as part of a broad portfolio alongside dedicated stock and bond holdings?
That is a question we get asked all the time. We think that Osterweis Strategic Investment can play a role in most portfolios. The fund pairs our core equity and fixed-income strategies in a format that allows us to strategically move the allocation heavier to stocks or bonds based on our macro outlook as well as the relative attractiveness of individual securities.

We think we can add value in the fund in three different ways: individual security selection, sector weightings, and risk avoidance within both the equity and fixed-income portfolios by tilting the broader portfolio toward either equities or fixed income at the appropriate parts of the cycle.

For investors looking for a single one-stop investment, Osterweis Strategic Investment might be a good fit. We would like to think that investors could invest their long-term retirement, college-savings dollars, and so on into the fund and have confidence that the fund has the potential to provide attractive absolute returns during a full market cycle. Many investors don't have the time or inclination to rebalance their portfolios, and we can take care of that for them.

Looking at the fund a different way, it is a great option for investors looking for an absolute-return-oriented satellite holding to complement other core positions. Although some investors might look at the fund as a traditional, statically positioned balanced fund, by adding the flexibility to shift the assets between equities and fixed income, we think we can add value to the portfolio. Additionally, we can also dynamically rotate between investment-grade and below-investment-grade fixed-income investments allowing us to play both offense and defense with these investments depending on whether we feel risks are economic- or interest-rate-based.

2. As of your most recently available portfolio, which featured upward of 65% of stocks, you appeared to be expecting a slow but steady economic recovery. Have recent economic data changed your viewpoint? Why or why not?
Since the start of the recovery, we have said that it would be anemic and subject to bumps along the way. During the second quarter, the road to recovery seemed to be littered with short-term bumps, including a barrage of bad weather in the United States and supply chain disruptions from the Japan earthquake and tsunami, resulting in a manufacturing slowdown. Additionally, rising gas prices have put pressure on consumer spending. The good news is that we see these as temporary factors, and we expect to see higher growth rates in the second half of the year.

Corporations continue to do well. Many are enjoying higher profits as a result of aggressive cost-cutting. They also have greatly improved their balance sheets. This suggests that even with a modest pace of economic expansion, corporations could generally do well, potentially enjoying strong profits and generating unusual amounts of free cash flow. Some of this cash might find its way into increased capital investment, debt repayment, higher dividends, share repurchases, and greater merger and acquisition activity. Additionally, with U.S. companies' increased exposure to emerging markets, we believe many companies should benefit from growth outside of the U.S.

That said, the picture is not entirely rosy. We are still cognizant of the various risks that the economy continues to face. Jobs and credit continue to be scarce for the general population, and there is no denying that the Federal Reserve has a challenge in continuing to support the recovery without creating an inflationary spiral. We also expect to see continued layoffs as state and local governments struggle with balancing their budgets.

Taking all of this into account, we still believe we are on the path of a slow recovery, and we therefore remain constructive on equities. We are also keeping our fixed-income portfolio duration short in anticipation of rising interest rates at some point in the future.

3. You've long invested in stocks of all capitalizations. Are you finding your most compelling opportunities in the large-, mid-, or small-cap spaces these days?
We are not market-cap-oriented investors and believe that the ability to source ideas across all market caps provides us with the best opportunity to avoid bubbles and fads and potentially generate attractive long-term equity returns over the long term. Although we generally feel that large-cap valuations are currently more attractive than mid- and small caps, we have been adding holdings across the market-cap spectrum.

As we look to add any stock to the portfolio, we are looking to find strong companies that are underappreciated by the market and that have identifiable catalysts for growth. A security might be undervalued because of a larger trend (for example, large caps lagging small caps) or an industry/security-specific issue. Either situation can provide us with an opportunity to buy.

In the first quarter we added large caps Kraft Foods KFT and Kinder Morgan KMI. We also added small and mid-caps Regal Entertainment Group RGC and Spirit Aerosystems SPR. In late 2010 we saw a lot of opportunity in the large-cap tech sector, and we added Microsoft MSFT and Hewlett-Packard HPQ. Both of these firms were trading at very attractive valuations, and we believe that they can grow in the future.

4. The fund strives to take a contrarian tack. With both stock and bond markets looking pretty fairly valued at present, are there any areas of the market where you see more "limited downside and materially unrecognizable upside potential"?
The stock market looks attractively valued, while the bond market looks pretty fairly valued with perhaps some segments of the bond market being overvalued. Certain areas of the market look a little frothy in terms of the recent Internet related IPOs such as LinkedIn LNKD, Pandora Media P, and Groupon, but a case can be made that the broad market is attractively valued. Based on current consensus estimates for 2011, the S&P 500 is trading at the lowest multiple since 1991 other than the six months following the collapse of Lehman Brothers and a brief period in 1995. Clearly the stock market is skeptical that earnings estimates will be met as the global economy slows in the coming months. Stocks that appear both attractively valued and that have the best chance of meeting or beating estimates in our mind are the larger, more diversified multinational companies as well as noneconomically sensitive companies that have pricing power.

In our minds, the key to finding securities that offer limited downside and underappreciated upside potential is in-depth, fundamental research focused on finding companies that are undergoing fundamental transformations that the market has yet to appreciate. The key is to look past the news of the moment and focus on what factors could drive a company's margins, earnings, and cash flows meaningfully higher in the coming years. We find that management changes, asset and balance sheet restructurings, mergers, and new product launches often represent potential positive discontinuities in future financial results. We often find turnarounds of lagging companies interesting. Not only is there large potential margin improvement in such situations, but often the stock market has given up on such laggards, and as a result the shares can be purchased at attractive valuations. We have been able to find many such candidates across many different sectors of the market during the past six to 12 months.

In fixed income, there is not much margin for error in investment-grade bonds if interest rates spike. Longer-dated high-yield paper is also fairly valued and offers little protection against an extended economic soft patch. We are finding value in high-coupon bonds of stronger companies where we feel the likelihood of being refinanced is high. We also like shorter-maturity paper, as well. We are always willing to forgo a bit of return when valuations get stretched in an attempt to preserve capital for a better buying opportunity and to generate positive returns through the economic cycle.

5. In your view, are investors more fearful of credit risk or interest-rate risk? Which worry is more overblown? How do the bond and equity sleeves of this fund either balance or inform one another in mitigating both?
Based on what we are seeing, we think investors are generally more fearful of credit risk. With the 10-year Treasury and many U.S. investment-grade bonds yielding less than some inflation measures suggesting a negative real return, we worry that the market is complacent about the potential for rising rates. Interest rates are closer to a bottom than a top. The question is: when do they reverse?

We worry that the market does not fully appreciate the potential loss of capital that can occur in a rising-rate environment. Because of our concerns about potentially rising rates, we are keeping the effective duration of our fixed-income portfolio in the two- to three-year range, possibly lower over time, and are looking to exploit opportunities in the below-investment-grade market. Through our deep, fundamental credit research, we think we can identify issues from companies with good balance sheets paying relatively attractive rates. Additionally, we are looking at convertible issues that should benefit from the slowly improving economy.

The Osterweis Strategic Investment Fund may invest in small- and mid-capitalization companies which tend to have limited liquidity and greater price volatility than large-capitalization companies. The Fund may invest in foreign securities which will involve greater volatility and political, economic and currency risks and differences in accounting methods. The Fund may invest in Master Limited Partnerships which involve risk related to energy prices and demand. The Fund may invest in debt securities that are un-rated or rated below investment grade. Such lower-rated securities may present an increased possibility of default, price volatility or illiquidity compared to higher-rated securities. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities.

The Osterweis Strategic Investment Fund is available by prospectus only. The Fund's investment objectives, risks, charges and expenses must be considered carefully before investing. The summary and statutory prospectuses contain this and other important information about the Fund. You may obtain a prospectus by calling toll free at (866) 236-0050, or visiting www.osterweis.com. Please read the prospectus carefully before investing to ensure the Fund is appropriate for your goals and risk tolerance.

As of 3/31/2011, The Osterweis Strategic Investment Fund held Kraft (1.87%), Kinder Morgan (1.89%), Spirit Aerosystems (1.40%), Regal Entertainment (1.26%), Microsoft (1.97%) and Hewlett Packard (1.45%). The Fund did not hold LinkedIn, Pandora or Groupon. Fund holdings and sector allocations are subject to change and are not recommendations to buy or sell any security.

Current and future holdings are subject to risk.

The S&P 500 Index is an unmanaged index which is widely regarded as the standard for measuring large-cap U.S. stock market performance. You cannot invest directly in an index.

The fund is not intended to outperform stock and bonds during strong market rallies.

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.

Duration: Measures the potential volatility of the price of a debt security, or the aggregate market value of a portfolio of debt securities, prior to maturity. Securities with longer durations generally have more volatile prices than securities of comparable quality with shorter durations.

Opinions expressed are subject to change at any time, are not guaranteed and should not be considered investment advice.

The Osterweis Funds are distributed by Quasar Distributors LLC. [6/11]

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