Osterweis Hunting for Undiscovered Quality

Dan Culloton: We hear a lot from several quarters that high-quality equity is on sale today in the market. Would you concur with that?

John Osterweis: By all means. Some of the really best companies in terms of quality, balance sheet quality, are selling cheap relative to the S&P, and we think there has been a bit of a speculative frenzy in the market coming out of the '08 debacle; low-quality stocks have really soared, and high quality has been left behind.

So, one of the themes in the portfolio is very high quality companies with steady growth, dividend-paying capability, ability to grow dividend. We think at some point the market will react to that.

Matthew Berler: We've had a view for quite some time that this economic recovery was going to be slow by historical standards. It was going to have a lot of fits and starts, and that the result for corporate profits was going to be that we'd have, over time, after the initial bounce off the bottom that we saw last year and early this year, fairly modest corporate profit growth.

As a result, we're really trying to focus on companies that have the kind of business models that can generate top-line and bottom-line earnings growth and good strong free cash flows in a slow growth economy. And we think those kinds of companies are relatively undervalued compared to the more cyclical names that had more recovery and momentum coming out of the recession last year.

Dan Culloton: And then when we look at the equity side of the portfolio, we see quite a few names that fit that description of global high-quality companies, companies that would fit anybody's definition of high quality like J&J and Nestle. There is also companies in there like Cosan, a Brazilian sugarcane producer and ethanol producer, which seems to be more tied, on the face of it, to much more cyclical forces. How is that high quality, and how does that fit your definition of quality?

Berler: Cosan is one of those companies that, like a number of companies in our portfolio over time, that if you'll look at them in the rearview mirror, they don't look so high quality. But we buy them when we think they are going through a transformation process--at the end of which they will emerge as a much higher quality, less cyclical, higher multiple and, hopefully, higher growth company as well, and we think Cosan fits that bill.

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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.