Tue, 27 May 2014
The current low-inflation, low-interest-rate environment could foster another two-plus years of double-digit total returns for investors, says Silver-rated Osterweis Fund manager Matt Berler.
Jason Stipp: I'm Jason Stipp for Morningstar.
As the market rally continues, investors may be wondering about the risks and opportunities on the table today. We're checking in with Matt Berler, president and CEO of Osterweis Capital and manager on the Silver-rated Osterweis Fund to get his take on the landscape.
Thanks for joining me, Matt.
Matt Berler: My pleasure.
Stipp: One of the reasons clients look to your fund is to protect on the downside in addition to finding opportunities. When you are looking at your opportunity set today and how you've deployed your capital, how much cash you've raised, what does that say about your outlook generally for where we are in the market, given that we have seen quite strong performance over the last several years.
Berler: We're obviously very pleased, as are our clients, with how rewarding the last couple of years have been. We still see a fair amount of opportunity. If we look at the companies that we own today in our portfolio, they are performing very nicely, in terms of executing on their business plans and strategies and delivering solid earnings and cash flow growth, and doing interesting things with that cash flow. My guess is that the broader economic backdrop in which our companies operate is solid. It's not wildly exciting, but nor is it as weak as some people fear.
We think that we're probably midway through an unusually long, drawn-out, somewhat painful economic recovery. The positive side of that is that we've enjoyed now a number of years of non-inflationary, low-interest-rate GDP growth, and we think that will continue for another couple or three years, providing the opportunity for many companies to continue to crank out very nice earnings and cash flow growth.
Importantly--and this is what a lot of people discount--is that those earnings and cash flows are going to grow probably in a relatively low-interest-rate environment, which means the stock market has the potential to keep putting higher multiples on that growth. So, we're quite constructive with where we are in the economic cycle, the strength of corporate profits and cash flows for our companies, and for the S&P as a whole. I think S&P earnings, which were up 2% in the first quarter of this year--affected partly by the weather, partly by weakness in the emerging markets--will probably end up growing 4% to 6% this year. So nothing great, but still pretty solid, and you could probably see another 4% to 6% next year as well.
If you add on top of that growth a 2% dividend and just one multiple point of further P/E multiple expansion, you could end up with another year or two of double-digit type total returns for shareholders.
So yes, the stock market has come a long way in the last five years, but we don't think it's over.
Stipp: While the economic recovery has been painful for a lot of citizens, it's actually not a bad environment--in fact it could be a good environment--for stock investors.
Berler: That's exactly right. And you are not going to read that very often in the newspapers, but what has probably been pretty painful for Main Street has been very rewarding for the equity and the fixed-income markets. This combination of slow economic growth, reasonable growth in corporate profits, low inflation, and low interest rates has really created a sweet spot, or Goldilocks conditions, for financial assets. And unless everybody is missing something, that backdrop probably remains the case for another one to two years, maybe longer.
The recent rally in Treasury prices, the drop in yield, seems to be signaling that the economy is not taking off and inflation is not accelerating, which is a good thing. Steady growth, low-inflation growth, is very positive for equity investors.
Stipp: I'd like to talk to you about risk, because risk is one of the important things that you keep your eye on. In an environment where the market has been doing really well, and we've had steady and better than good results from companies for a while, it can be harder to see the risks. Some of the risks that you might see at a fundamental level are easier to hide or not as easy to notice.
When you're looking at individual companies, what signals do you get that we might be entering an environment that could be tougher? How do you keep your eye on the risk ball, when the results have been pretty good?
Berler: I think you are absolutely right. Two years ago when we made a major call that we thought U.S. equities were undervalued, underappreciated, and out-of-favor, that was an easier call to make than it is today, after the big move that we've seen in equity markets in the last two years.
If you step back and look at the 32% rise in the S&P 500 last year, in 2013, the vast majority of that rise was powered by an expansion in the valuation, or P/E multiple, of the stock market. It wasn't a function of earnings growth.
So what it reflected was a collective relaxation in people's sense of risk. Now I think a lot of that was appropriate. I think the sense of risk was heightened coming out of the '08-'09 financial debacle. That sense of risk stayed elevated all the way through 2011 with the euro crisis and the downgrading of the U.S. government credit rating, if you recall. And then the high-stakes political battles in Washington, D.C., in 2012. All of that has receded, and the risk is that people do become complacent, which I think is what you're highlighting.
Our approach to managing that ever-present risk is to be very focused on the kinds of companies we own, high-quality companies that have the kind of businesses that will withstand economic ups and downs and the wiggles and waggles, that generate consistent free cash flow. And also to be constantly on the guard that our sense that the favorable conditions I discussed with you a minute ago may be vanishing.
One of the things we watch really closely is interest rates, particularly the yield curve. If our sense is that the economy is overheating, and the Federal Reserve is going to have to respond more dramatically than people think by raising short-term interest rates over the next 12 to 24 months more dramatically, more quickly than people think, that could create a new set of risks and that could cause us to dial back our optimism today and our equity exposure.
Stipp: You talk about the kinds of companies that you look for. Are you finding those kinds of companies in any particular areas? Do you have a bigger cap tilt now than you had before because of where you're finding the criteria that best meet your process?
Berler: The answer is yes and yes.
Yes, we tend to find opportunity in clusters, but again, it's usually a function of bottom-up [research]. In 2010 and 2011, we found a lot of really high-quality, interesting, attractively valued health-care companies, because of the massive uncertainty that was hanging over the health-care industry in the U.S. related to the Affordable Care Act and what it might mean for companies and their profitability. We found a lot of opportunities to buy health-care stocks back then, many of which we still own. The way we manage risk when we have a big industry concentration like we do today in health care is to make sure that we're diversified across the spectrum of different kinds of health-care providers, whether it's large-cap pharma, small-cap pharma, diagnostics, devices, and services.
Another area where we have a lot of exposure is energy infrastructure. We actually turned cautious to bearish on the commodity-price outlook for natural gas five to six years ago when we started to appreciate the magnitude of the hydrocarbons that could be released from the newly discovered shale, or the newly accessible shale deposits around the United States. But we turned very bullish on the companies that were going to have to build the infrastructure to process and transport all of those new hydrocarbon flows to markets.
Stipp: So pipelines …
Berler: Exactly. Pipelines and processing companies.
Then a third area that we have a lot of exposure to that we've built up over the last couple of years could broadly be defined as consumer discretionary, but particularly in the media and entertainment area. We have a number of companies that range from sort of old-economy stocks like Cinemark, which is the third-largest operator of movie theaters in the United States and the largest operator of movie theaters in Latin America, to Viacom to Charter Communications, DirecTV, which has been in the news quite a bit in the last few weeks.
We have a number of those companies that are doing very, very well--generating terrific free cash flow--and we think the market has yet to price in the strength and value of those franchises.
Stipp: Last question for you. Operationally, John Osterweis of your company is looking to step down as CIO in 2017. When you think about preserving a process and a culture at a firm like yours, a small firm, what steps do you take to make sure that when certain key players leave the company that the process persists?
Berler: John founded the company 31 years ago, and from the day he opened the doors of the firm, he was very clear about what the value proposition was for clients. We have stayed true to that discipline ever since, and we have inculcated those values into everybody who joins the firm.
It's particularly important, obviously, that we do this with the investment team, so that the integrity of our investment process is embedded into each person. To some extent the people you hire have to have the DNA that aligns with the values and discipline that we use to manage money. But to some extent, you then have to mold and shape that DNA. So, through lots of daily and weekly interaction as a team and one-on-one, we're constantly trying to make sure that everybody has a clear sense of how to pick stocks and manage the portfolio.
And then you have to build a bench. So part of the reason I'm here is that I started to get groomed by John probably six or seven years ago to step into the role that I'm playing today. Then we're grooming other folks behind me who are going to be able to step in.
2017 actually is not a magic date. That was a date that John and I chose because he'll turn 75. And he came into his 70s full of energy and enthusiasm for the business and still on top of his game. Most people will exit their 70s, the decade of their 70s, with less vigor than they had when they entered. I'm just stating the obvious. So we picked the midpoint for John and for our clients to say, look, we have a plan. It's out there five years from the point we started the transition. It gives us a lot of time to, as a firm, grow into the different roles that John has been playing, but that doesn't mean that John goes away; his every intention is to stay for much longer.
Stipp: Matt Berler, a manager on the Silver-rated Osterweis Fund, thanks for joining me today and for your insights.
Berler: Thank you very much. It's my pleasure.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.