Jason Stipp: I'm Jason Stipp for Morningstar. With volatile energy prices, a weak economy, and valuations that might be looking full, there's nothing short for investors to worry about in the market today. Here to offer his take is John Osterweis, founder, chairman and CIO of Osterweis Capital Management.
Thanks for joining me today, John.
John Osterweis: Thank you, Jason.
Stipp: Let's start in fixed income. You invest in fixed income in a couple of the strategies at Osterweis, and I want to talk about credit versus duration. It was a good bet for active managers to take on credit risk coming out of the credit crisis, and a lot of active managers do look quite different than the index because of that. Your thoughts, though, today on credit risk versus interest rate risk. Is credit risk still a good bet generally today for bond investors?
Osterweis: We think it's a very good bet. There is no question that at some point interest rates will go up--maybe later than people have thought--but interest rates are at historically low levels. And to think that they won't go up would expose you to an incredible amount of interest rate risk.
On the other hand, credit is still good. The economy is still expanding, corporate balance sheets are in great shape. The weaker credits, as you mentioned, since '09 have been able to refinance and lower their interest costs. If you think about a below-investment-grade credit, it was having to pay 8%, 9%, 10% interest. Today they've squeezed that down to maybe 5%--effectively, in many cases, cutting interest costs quite dramatically, maybe even in half, which is like deleveraging from a cash flow standpoint.
So, we think credit is still the place to be. There are pockets of credit risk that we find unacceptable. For instance, we avoided the energy sector, particularly the highly levered exploration and production companies, where a decline in the price of oil would put them in a fairly difficult situation. That's an area of the high-yield market that's been pretty dangerous. But the rest of the high-yield market has really been fine.
So we're very focused on credit, but short duration. Our duration is under two years, because we want to avoid the interest rate risk and benefit from the credit exposure.
Stipp: You mentioned energy, and I'd like to speak about energy … on the equity side, because you also invest in energy companies, but not necessarily the E&P companies. You also look at things like MLPs. What's your take on the energy situation right now--where there are values and where you're staying away?
Osterweis: Historically, as you said, we have focused more on the MLPs on the theory that oil prices are hard to predict and when they were up at $100, maybe they were vulnerable to some disappointment. But it is very clear that with the real explosion in the amount of oil and gas found in unconventional shale, an awful lot of oil and gas had to be transported and stored and that fed right into the MLP argument.
We still think that's a great place to be. We do think oil probably is somewhere near a bottom, but we're not interested in making commodity bets at this point.
Stipp: Would you be willing to say that oil won't be at $100 again? Is there a lower normal now when we do get back to normal?
Osterweis: Yes, we think it's a lower normal, and whether it's $60 to $80, who knows exactly?
Stipp: One question on MLPs. Do those look like a value today? A lot of our readers are very interested in MLPs and have been for a while. What's the valuation look like on those companies?
Osterweis: Obviously, they've been discovered. But the good MLPs also have a lot of growth. They are not dirt cheap, but they're still good value, and we still have a very large exposure to them.
Stipp: Let's talk about the implications of lower energy prices on the economy. A lot of folks thought lower energy prices mean more money in consumers' wallets, which it will. But will they spend that? Will we get a boost from the lower energy prices with spending in other sectors?
Osterweis: Good question. Clearly, the consumer is better off with lower energy prices, and what we saw recently is consumers saving that--their [energy] savings. They didn't spend it. But ultimately, our thought is, it will get spent, and the consumer will feel more comfortable with a little more money in the bank.
Stipp: Since we are on the economy: GDP did not look great for the first quarter, and we could talk about Fed in a moment, but what's your thought on the fundamental strength of the economy? Is this a blip because of weather and some other issues and not really reflective of the strength of the economy? Are you looking over a longer time period to get a better sense of that potentially?
Osterweis: We're definitely looking over a longer time period. The first quarter, obviously, had a weather impact. It had a big impact from the energy area, where energy capital spending was way down, something like 40% or 50%, and that had an impact. The stronger dollar also hurt our exports--that had an impact.
But our feeling is, we're in, and have been in, and remain in, and will continue to be in a slow-growth, low-inflationary kind of expansion. So this last quarter was a little weaker than you'd expect. There have been other quarters that had been a little stronger. We're probably at a 2%-2.5% growth pattern.
Stipp: The market has almost obsessively been watching the Fed and thinking about when the Fed is going to raise rates. From your perspective, and from a long-term investor's perspective, how do you think about the Fed's actions? We can talk about whether it might be sooner or later based on recent data, but for long-term investors, does it make a huge difference when the Fed begins to raise rates?
Osterweis: No. We think it makes no difference. A lot of investors are obsessed with the idea that when interest rates go up, that's bad for the stock market. And the reality is, they are dead wrong on that.
The Fed is going to raise interest rates reflecting the strength, or non-strength or weakness, in the economy. If the economy is strong, the Fed will have more incentive to raise rates. If the economy is relatively weak, the Fed will have less incentive to raise rates. The last thing the Fed wants to do is create a recession right now.
As long as the economy is growing, and inflation isn't a problem, any increase in interest rates caused by the Fed should be a good sign, not a bad sign. And the history is that stocks actually will go up in a period of moderately rising interest rates.
Where you should get worried is where inflation becomes a problem, and the Fed then wants to raise interest rates to choke off the economy and drive inflation back down. So until inflation becomes a problem, any increase in rates caused by Fed tightening shouldn't be a problem.
Stipp: You mentioned in a recent update you wrote that we're in this Goldilocks economy, and slow growth, as you mentioned, is a part of that. People think slow growth is a negative thing. It means we're not as strong as we want to be, but it's maybe not necessarily a bad thing if it's slow and steady growth, right?
Osterweis: Correct. That's been our thesis all along; slow, steady, low-inflation.
Stipp: And the combination of those means that stocks can have a period where perhaps we're not seeing overinvestment and having highs and then having to come back down.
You're saying inflation will be the thing to keep an eye on, and currently, in your view, inflation is under control?
Osterweis: Under control.
Stipp: Last question for you is more of valuation-oriented. If we're in this Goldilocks environment, we do know that over the last several years, stocks have certainly performed quite well. So as investment pickers, what's your opportunity set look like? Are you finding good places to put money to work? It is a lot harder than it was before? Or is it just really a matter of getting down in the fundamentals and finding individual opportunities?
Osterweis: I think it's all of the above. The opportunity set is not as big as it was four or five years ago, clearly. But there are still pockets of opportunity, and if you dig around, you can find them. There are always situations where some company is misunderstood and is much cheaper than it should be relative to its peers, or other investments. We are finding situations that interest us and we're finding a steady flow of new ideas.
Stipp: John, great to check in with you on the state of the economy and the stock market. Thanks for joining me today.
Osterweis: Thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.