Osterweis Hunting for Undiscovered Quality

Cosan, we bought earlier this year after they announced a major strategic initiative in the form of a joint venture with Shell down in Brazil, where they, Cosan, were going to combine their fuel distribution business with Shell's fuel distribution business. Together, they will become a very strong number-three player to the number-one, Petrobras and number-two, Ultrapar.

We think that this new joint venture with Shell will transform Cosan from being largely a commodity sugarcane and ethanol company into being now a largely downstream fuel distribution company with a lot of, by the way, interesting co-generation growth opportunities over the next three to five years. The result will be that, the majority of its earnings and cash flows will come from this less cyclical, steadier, free-cash-flow-generating fuel distribution business compared to the more volatile commodity business.

It will also, along the way over the next two to three years, create a tremendous amount of operating synergies, cost savings, and lead to a lot of free cash flow that will allow the company to de-lever, also improving its credit profile and quality profile.

Culloton: So your definition of quality also would include companies that may not necessarily look like quality companies if you were to look at its trailing returns or its trailing returns on equity or assets, or trailing profitability, but something that might improve going forward.

How do you get a handle on emerging quality or hidden quality?

Osterweis: Well, you're absolutely right. I mean, one of the major themes always with us is companies that have been and are relatively low quality that are undergoing a transformation to much higher quality. And that is often occasioned by new management coming in and cleaning up a company. It can be occasioned by existing management reorganizing the company, selling off poor-quality divisions, focusing on their best business. It can be a function of an industry going from a very scattered, diversified, competitive industry to more of an oligopoly.

So there are a lot of factors that we look at, some of which are predictable, others of which one has to look at and monitor on a continual basis.

But I think that one of the key strengths of our firm is this ability to look at a company and see it two years down the road as something major has happened to reconfigure the company.

Berler: This is a really important point, and it's core to what we do. We're trying to find the companies that have not yet been recognized as good companies because we're able to buy them at cheap valuations when expectations, market expectations, are very low. In other words, where the risk is low and where the opportunity is terrific, as opposed to buying companies that the stock market already knows are good companies, where expectations are high and valuations are high, which in our mind suggests that there is not a lot of upside in those types of companies. And there could be a lot of downside if they stumble.

So we're really trying to find that former group of undiscovered companies because of that risk reward, trade-off looks asymmetrical, very favorable to us.