Valuations are not compelling for the market as a whole, but selectively there are some real bargains, says manager John Osterweis. He makes the case for three portfolio holdings, including REIT Newcastle.
Dan Culloton: Recognizing, of course, that while you're macro aware, that you're a bottom-up stock picker, you look at the portfolio, and reflecting on what you just said, it doesn't hold a lot of cash, probably the least amount of cash that's held in recent memory. But yet the portfolio is still very selective. So it's not like you're finding a wide range of opportunities out there. It's still a very focused portfolio. You don't seem to add or subtract a lot of holdings between quarters. So is it safe to assume that, while you think valuations are OK, there not a lot of screaming bargains out there?
John Osterweis: I think, in general, valuations are OK; on a gross basis they are not compelling for the market as a whole, but selectively there are some real bargains. When we find them, we move them into the portfolio.
Culloton: One of those was a REIT, Newcastle. Perhaps you could talk a bit about what attracted you to that area. REITs has been an area that's been actually, up until recently, very popular. What made this particular REIT a value choice?
Osterweis: What was interesting about Newcastle is they were essentially in two businesses. One, holding residential mortgages and holding mortgage servicing rights. The other side was some CMOs that they owned, and underneath that, an exposure to senior living. They split the company into two; one side, which now uses a different name, has the mortgages and mortgage servicing rights. The other side has the CMOs and senior living.
To just look at this CMO/senior living side, which is called Newcastle, the company is going to be gradually liquidating the CMOs and building up their presence in senior living, and through their process, we think, can start to move their dividend up from around where it is today, roughly $0.50 a share, to maybe as high as $0.80 over the next few years. We think if they do that, the stock, instead of trading at a 10% yield, might trade at a significantly lower yield. Between the rising dividend and the stock trading at a lower yield, the stock could be quite interesting.
Culloton: I'd like to ask also about a stock that's been in the portfolio for a long time that has done very, very well; that's Valeant Pharmaceuticals. It recently made another big acquisition of Bausch & Lomb, and has run up in price. You still think it's an attractive holding at this point. Why?
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Osterweis: We still like Valeant a lot. We think it's still a relatively very cheap stock, given their extraordinary growth rate. We think the Bausch deal will add considerably to earnings as they take out duplicative overhead and start to streamline the company. Earnings might be as high as $12 a share in a few years, and the stock currently is in the high $80s. We think that's a pretty good bet to make.
The other thing that Bausch does is it gives Valeant a major presence in ophthalmology to go along with their presence in dermatology and a couple of other therapeutic areas. So Valeant is gradually becoming a powerhouse in certain therapeutic areas and in certain geographies. It's a company that is able to generate a lot of cash. It's extremely well run, extremely imaginative and creative, and one we still like a lot.
Culloton: So despite the appreciation, on your estimate of its forward earnings, you're looking at a high single-digit multiple.
Osterweis: Yes.
Culloton: And still a lot of upside.
They took on a lot of debt to fund that Bausch & Lomb acquisition. Is there any sign that the discipline that has helped this company grow through acquisition is somehow breaking down?
Osterweis: I don't think so. I think that the debt that they are taking on is appropriate given the company's cash flow, and it's not a debt that's going to strangle them.
Culloton: Let's ask about one stock that hasn't done so well recently, and that's Oracle, a smaller position in your portfolio. One that's somewhat controversial given the … perceived competition it faces from a lot of up-and-comers in the database and the cloud technologies.
You still think that there's some value there, and that there's actually a lower risk of downside than you might normally expect from a technology company that has a lot of competition.
Osterweis: Yes, we could be wrong in this assessment, but the core that we're looking at is their huge presence in database management, and the fact that that is an embedded service that businesses rely on and they can't easily rip out because somebody comes along with a greater, cheaper, faster database. You simply can't just rip out databases. And that business, as you know, has a sales cycle and then a maintenance cycle, and the maintenance cycle is very long and very steady.
Where they are somewhat more vulnerable to competition is in the applications, but interestingly in a lot of these applications, if Oracle were to lose to a competitor, the competitor might turn around and have to incorporate Oracle's database into their solution, so that Oracle may lose on the application side, but they'll gain a client on the database side, and so it's not an either/or kind of situation.
Oracle has, of course, been investing quite a bit into the cloud, and time will tell whether they're as competitive as some of the startups, but our belief is there's a very, very strong steady cash flow there. The stock is trading at 9 or 10 times free cash flow. If there's any pickup in growth, this could be quite a good stock, and on the flipside, if we're wrong, it's probably a very slow bleed down, so there's not a lot of risk in the company that, I should add, is buying back quite a bit of stock each year.
Culloton: And recently increased its dividend.
Osterweis: And recently doubled its dividend.
