Quarterly Webinar Replay

Chris Zand: Hello, and thank you for joining us today for the Osterweis quarterly call, where we will discuss recent market activity and trends, our portfolio positioning, and our outlook for the remainder of 2024. I'm Chris Zand, and I'll be moderating a panel discussion today featuring Chief Investment Officers John Osterweis, Carl Kaufman, Nael Fakhry, and Greg Hermanski. And with that, let's go ahead and begin.

John, as always, I'd like to start with you by getting your big-picture view on the economy and the markets. Since the start of 2023, the S&P 500 has returned 28.5%, a level that I think has exceeded most people's expectations, particularly given the fact that we've been in the midst of an aggressive Fed tightening regime throughout this whole time.

Why do you think equities have done so well over that stretch, and what has given you and the team at Osterweis the confidence to stay invested throughout this entire period, given all the potential headwinds? For those of you who may not remember, investor sentiment heading into 2023 was quite pessimistic, with most observers expecting an imminent recession due to higher interest rates.

John Osterweis: Well, hello, everybody, and welcome. Chris, there are really two questions here. One is, what was driving the stock market? And two, what was driving the broader economy? And I think the simple answer is that the broader economy was still recovering from the Covid dislocations and was subject to considerable fiscal stimulus, particularly the CHIPS Act and the other major initiatives from the Biden administration, and it was also swept up in AI and all of the attendant activity surrounding AI.

And so, there was a lot that was driving the economy. And although the Fed did raise interest rates and did some quantitative tightening, in our opinion, neither the higher rates nor the quantitative tightening was enough to throw the economy into recession, and we did not see signs of imminent recession. And so, we remained reasonably constructive on the outlook for the economy starting in 2023.

The stock market is really a tale of two cities, as I think everybody knows. One is, you had the Magnificent 7, big, incredible tech companies, that accounted for the bulk of the rise in the market and were clearly the strongest part of the market. Chris said market was up about 28% from the start of 2023. The equal-weighted S&P was up roughly half that.

Chris Zand: Thanks, John. Very helpful. Let's talk briefly about the second quarter in particular. It was an unusual stretch in the sense that the S&P continued its upward trajectory, up a little over 4%, but the big gains were concentrated in just a couple large technology stocks. And at the same time, small and mid cap indexes returned a negative return for the period. Normally, equity markets tend to move in the same direction generally. So, what do you think exactly happened in the second quarter that caused the markets to disagree with one another?

John Osterweis: Well, I think this is actually not atypical of markets where you get performance concentrated in certain areas that people get very excited about. And what's happening since the second quarter, as rates have started to come down, is the market has broadened out. So small cap, growthier names are starting to benefit, and the Magnificent 7 are starting to get hurt. So, I think you're seeing a broadening out and a return to more normal conditions.

Chris Zand: Very helpful. Thanks, John. That's a good segue to my next question, actually. Taking a step back, what's your take on the general current economic landscape right now, and what's your sense on inflation? Any idea on why it's taking so long to get back to the 2% mark?

John Osterweis: Yeah. I think, well, 2% was a hard number to get to. I think the reason it's taking so long to get there is that the economy has been very strong, and we've had extremely low unemployment, which means that there are labor shortages in large parts of the economy. And so, labor costs have been going up. Other input costs have gone up. Companies have a reasonable, strong pricing power. And so, there's been a bit of a wage-price spiral that's been hard to tame, basically.

And we're starting to see some easing up in the economy. Demand for labor has eased up, so there's a little bit of a creep in unemployment, so less pressure on wages. The bottlenecks from Covid are starting to ease. And so, we're generally seeing some signs of softening. I think the house view here is that we do not see an imminent recession, but we would not be at all surprised to see the economy's growth rate slow down a bit. And the question will be, how does that translate into profits, and then how does that translate ultimately into the behavior of the stock market?

Chris Zand: Thanks, John. Very helpful. Carl, can I get your thoughts on the same question? I'm curious if the fixed income markets are sending different signals than the equity market.

Carl Kaufman: Thank you, Chris, and thank you, everyone. I completely agree with John's assessment, but I think there's a few nuances in the bond market that people may not be aware of. Clearly, in addition to raising rates, the Fed has been engaged in a tactic called quantitative tightening, which is another tool in their anti-inflation toolbox.

And many of you have heard of quantitative easing, which is when the Fed lowers rates and buys Treasuries in the open market directly from banks, and that money finds its way into the economy. In practice, more money in the economy should lead to stronger purchases. And in the simplest terms, when the money supply grows, inflation should grow. So, they pretty much did a lot of that. It's unclear whether that was actually the catalyst for the inflation that we had. I think it was probably not the main catalyst. Japan has been doing it for decades.

However, the flip side of that coin is quantitative tightening, and that is when the Treasury or the Fed lets their portfolio roll off, meaning that the money comes back to them from the economy, which shrinks the money supply. Theoretically, less money out there should mean that prices contract and the economy contracts a little bit. And so far, that really hasn't happened to any great extent. We are seeing some slowing, but I think that's natural and not due to QT. So, it's a fairly technical thing, but we'll see. There's generally a lag to these actions. So maybe we are entering that period after the lag where things are slowing down.

Chris Zand: Thanks, Carl. Now, we discussed what happened in the equity markets during the second quarter, but what about fixed income? I know investment grade bonds didn't have a great quarter, but high yield did a bit better?

Carl Kaufman: Yes. Second quarter was basically an extension of the past few quarters, actually pretty boring for us. But it sounds funny to say, but the truth is that fixed income markets really haven't been doing much but grinding a little tighter and a little higher every day, every week, every month. And clearly, the yield difference between the short end of the curve and the long end of the curve is near historic lows, mostly because the Fed has kept short rates elevated for over a year now.

And at the same time, the spreads, which are the yield over Treasuries that are demanded by investors, remained tight because there seems to be an insatiable demand for yield. Add to that people making bets that if the Fed does cut, rates will fall, which has a disproportionate effect on the price of longer-dated bonds than it does on shorter-dated bonds.

So the Agg did eke out a negligible gain of 0.1% in the quarter, and the high yield market did a little better, returning 1.1%. So, most of the returns were due to accrued interest and some spread tightening, which are already near very long-term lows, but rates were generally unchanged in the second quarter.

Chris Zand: Thanks, Carl. Very helpful. Where do you see the bond market going from here? And as a follow up, could you talk a little bit about our portfolio positioning with respect to fixed income?

Carl Kaufman: Sure. We hate to position the portfolio based on expectations, but we typically take what the market gives us. But we think the current conditions are likely to persist for at least a few more months, maybe a couple of more quarters. We'll have to see. We've had some encouraging monthly inflation data recently, but we're still well above the Fed's 2% annual target.

Until that changes, we expect rates to stay near where they are. You might see a cut in September. The Fed has been very clear that the decision to cut will be based on the data, particularly as long as the labor markets are holding up. Sure, the unemployment rate has gone up a little bit, but it's still near historically low levels.

So we expect conditions to remain as they are in the near future, and possibly longer. We'll have to wait and see. So, we're continuing to lean into the short end of the yield curve, because you're getting very similar yields to the longer term without the risk. And we've been doing that for a while now and waiting for the market to hit an iceberg and give us an opportunity to buy longer-dated bonds at much higher yields than they are today.

Chris Zand: Thanks, Carl. You may have hinted at this a little bit, but maybe you could expand on some of the benefits of focusing on shorter duration bonds. I know our fixed income strategy has performed very well during this environment. So obviously, the returns are good, but I understand there's some other advantages as well.

Carl Kaufman: Well, particularly when you have an inverted yield curve, you're taking the bird in hand versus two in the bush, basically. And our focus on the short end has allowed us to capture yields that are a little bit less than the general market, high-yield market, but with a lot more flexibility. We feel that we are well-positioned for a wide range of potential outcomes.

So in the short term, if rates remain high, we continue to generate solid returns. If the longer-term rates drift higher, as they have been this week, as they went back down again today, pretty volatile, but we're largely protected because of our short-term positioning. If the market unexpectedly hits an air pocket and we get some volatility, our bonds are much less volatile than the market.

As they roll off and create cash, we can buy longer-term bonds at attractive prices. So, if the Fed actually does begin to cut rates, we'll look to extend our maturities, if they're attractive. But our basic approach is to, as I said, look for the least risky way to invest in the most attractive areas of the market. So, the inverted yield curve has been very good for us.

Chris Zand: Thank you, Carl. That's great. Let's come back to the equity side of the portfolio. Greg, John discussed earlier the narrow market leadership during the second quarter. Can you talk a little bit about how, right as this third quarter started, things appear to be changing, and maybe expand on how the portfolio is currently positioned given the current conditions?

Greg Hermanski: Sure, Chris. As John mentioned, the last few weeks, we have seen a broadening of the market more generally, and we think some of that shifting in the market has come from some of the things that we've been watching pretty closely this year. One of those is cost inflation at a company level, and the other is economic growth around the world.

And as the years unfolded, we've seen more and more signs of lower inflation. John mentioned lower wages, less pricing power for some of the companies than they were expecting, and some slower global economic growth in general. In the U.S., as John mentioned, it seems to be that the economy is holding on pretty well, so that looks okay.

But overall, the chances of the Fed easing rates look to have gone up. So, rates have come down. And as a result, we think people are taking a look at their portfolio and making sure they're positioned for the new environment. And we're doing the same thing. Before I get to portfolio positioning, just to remind everybody that as fundamental investors, we're really focused on buying businesses that have tangible opportunities to drive income growth, and then we look to own companies that are at a reasonable valuation.

And so, having said that, we've made a number of changes to our portfolio over the last few months, and we've used our confidence and ability of the companies to grow their income, as well as the multiple that they're trading at as our lens to evaluate the portfolio. So, the result of our work, we've ended up selling or trimming some of our stocks that actually have been some of our better stocks over time.

They've had significant increases in their revenue growth rates, significant increases in their operating margins, but the opportunity for that to continue to expand has reduced. And because the stocks have done so well, the multiples have tended to go up quite a bit. And so, examples of that would be like Boston Scientific and Microsoft, really great companies that are well-positioned, but much more expensive than when we originally bought them, and there's a lot higher expectations in those stocks.

We've also trimmed the last few months three of our semiconductor stocks, so Micron, AMAT, and AMD. They've been great stocks over the last 18 months or so, but they reached the low end of our target prices. And so, we started to trim some of those positions, even though there is a case that they could go significantly higher over time.

On the flip side, we're actually kind of excited to say that we found several opportunities to add stocks that are trading at lower-than-market multiples that we think can grow double digits over the next few years. And so, we've been adding or buying new positions in AutoZone, UnitedHealth, Becton Dickinson, Keysight, Airbus, and Accenture. So quite a few names there that we're excited to be adding to.

And so, in general, our portfolio positioning, we think that these trades have made us a little more defensive in general. But still, these are companies that can grow very solid growth rates. Multiples are attractive. And we think that, potentially, if the market broadens, Fed lowers rates, that it positions us better for that broadening market.

Chris Zand: Thanks, Greg. Very helpful. Speaking about higher multiple companies, Nael, I thought it'd be interesting for you to talk about the surge in capital expenditures among some of the large AI companies. The level of investment seems quite aggressive.

Nael Fakhry: Sure. Happy to do it. So, these companies, Microsoft, Meta, Alphabet, Amazon, we call them the hyperscalers. These are huge tech companies. They gave us updates in the first quarter, and it was what we view as a seminal shift in their capital spending that we think really needs to be understood and carefully analyzed. They're all dramatically increasing their capital spending on the cloud specifically.

Part of that is from just underlying IT demand, but the bulk of the increase is driven by AI, artificial intelligence, demand. And these companies are all at the same time substantially increasing their investment in the hardware and the infrastructure that's needed to support AI on a massive scale. And in total, the investment in the cloud for those four companies has jumped from last year just under $120 billion to what we think will be about $180 billion this year. So, we're talking about a 50% year-over-year increase across the board.

And these companies have raised... In individual cases, they've raised CapEx at a 50% rate on a year-over-year basis in the past. So, there's precedent for this in terms of percentage, but the dollar amount, the dollar baseline off of which they're raising their spend is so high that a 50% increase on that is just... We're talking about massive dollars, incremental dollars.

And Google and Microsoft, just to be specific about those two, or Alphabet and Microsoft, they're spending about 15 to 20% of their consolidated revenue on cloud CapEx. You compare that to auto manufacturers or energy companies that spend 5 to 10%, typically, of revenues on CapEx. That just gives you a sense of the magnitude of the spend. So, we really need to scrutinize and carefully track the incremental returns on the spend and ensure that the returns are attractive and that they're additive to cash flow over time.

Chris Zand: Thanks, Nael. Those are some staggering figures. Obviously, these companies think it's a worthwhile investment. Can you talk a little bit about why it's happening now and what the potential implications could be?

Nael Fakhry: Sure. I mean, they're trying to establish themselves as the leaders in artificial intelligence, and this requires building and optimizing these large language models or LLMs. And to train and optimize these LLMs at scale requires huge amounts of computing power, and therefore servers, data centers, specialized chips manufactured by these companies, like NVIDIA, AMD, Broadcom, and others.

And so, that's why they're spending it. And just earlier this week, actually, a couple of days ago, both Alphabet and Meta or Facebook, Google and Facebook, their CEOs were interviewed and asked, "How are you thinking about the spend?" And they said, "Look, there's actually a risk to underinvesting, because you don't want to get left behind. You want to build these models and optimize them and get them out there before others do."

So they're clearly being very aggressive and forceful about the spend, and this is a key question we'll be discussing. Is the return on this investment going to be adequate? It's what I just referenced. And a couple things to point out. One is that if you look at the hyperscalers that we own, Amazon, Microsoft, Alphabet, if you look at their capital allocation historically, it's been really, really effective.

Now, we're talking about a new industry, a new sector in terms of AI to some extent, but these companies have actually been investing in AI for years and years, and they've been implementing and incorporating them into their products. The other point, though, is that in addition to being smart cap allocators historically, they do have products that touch billions of people.

And therefore, we think these companies are more likely to be able to implement and monetize this AI investment across their products. But again, just like we do with all our companies, we always talk about quality growth companies and how we really care about the incremental returns on capital. It's super important here just because of the incremental spend and just how jaw-dropping an increase in dollar spend there is here.

Chris Zand: Thanks, Nael. Very helpful. Staying on the topic of artificial intelligence, there's no doubt AI has now become pretty much a household term. And even though applications like ChatGPT or Google's Bard are still relatively new, the idea of AI entering social life has really gone mainstream. I'd love to get your thoughts on where you think we are in the life cycle for AI and how things will evolve from here. And I'll open this up to both you and Greg.

Greg Hermanski: I can start with that one. I think the first part of the question is easier than the second part. I think pretty clearly, we're really early in the life cycle for AI. AI is clearly a really powerful technology, can do really cool things, create images, create videos, summarize data. It can be used as a chatbot to help answer questions. It helps with computer coding.

But there's a lot of questions and things that we don't know, and that's going to impact how it evolves. Like Nael mentioned, it's really expensive, the capital required for AI. So, some of the questions that need to be answered would be, how long is it going to take to generate products for the mass market that people will start to generate revenue? Are customers willing to pay a premium for these products or not? Is AI technology going to lead to new products that are innovative, or are they going to be features on established products?

And if it's just features, what's the return going to be on those type of products? And then ultimately, the question that Nael's talked about, like what's the return on invested capital? And if the return's not that high, if it's hard to see, it'll probably slow down the evolution of AI and how much capital people are willing to put behind it. So, it's clearly very powerful, very interesting technology. It's unclear what the role is that it'll play, what kind of return it's going to generate for investors. And so, that's yet to be determined.

Chris Zand: Thanks, Greg. Very helpful. We're coming towards the end of our session now. Before turning to the Q&A portion, I'd like to ask the panel one final question. This is an election year, and the country is now just a little over three months away from going to the polls. Some clients have expressed concern about the lead-up to the election, which has obviously been quite tumultuous so far. And so, as a question for the panel, I'd like to ask how you all think the lead-up to the election may impact the market. Are there any adjustments to our portfolios that you're contemplating or considering in advance of the election?

John Osterweis: I'll start and then my partners can maybe give some more specifics. In general, we do not do a lot of portfolio adjusting for political reasons, and the reason for that is that the economy seems to have a life of its own independent of what goes on in Washington. Secondly, very specifically to what's going on right now, I would say, before Biden stepped down, it looked like it was a Trump victory.

Now that Biden has stepped down and Kamala is the presumptive nominee, I would say it's a 50/50 bet as to which party wins. And so, to make portfolio adjustments based on a 50/50 bet, it wouldn't make a lot of sense, frankly. I would say that if Trump gets elected and he does everything he's threatening to do, such as implement across-the-board tariffs and deport a very large part of our labor force, that would be inflationary.

But I think we would have to react to that at the time and not do it in an anticipatory manner. We're bottoms-up stock pickers. We're trying to find companies that can grow over the next five, 10, 15, 20 years, and obviously grow throughout whatever political regime happens to be of the moment.

Carl Kaufman: Let me add a little bit to that. I agree with John. The economic cycle and the political cycle do not sync up. Since England and France have already had their election, maybe we just sell everything and buy their markets. Who knows? No, just kidding. First, both parties appear to be committed to deficit spending, although in different ways. Clearly, Republicans prefer to cut taxes, whereas Democrats prefer to spend more on stimulus. Regardless, both the deficit and the debt are likely to increase further under either regime.

The fear has been that this would cause crowding out. I've been hearing about crowding out now for about 45 years. Hasn't happened yet, but it may this time. Who knows? Second, it does seem, as John mentioned, the big wild card is Trump's tariffs. And remember, the last time he imposed tariffs, there's two ways to overcome them. One is, the exporting economy or companies can lower their prices to make up for the tariffs, which is exactly what happened the last time. The Chinese manufacturers ate the tariffs, basically. So, their profitability was lower.

If you did the same thing today, given the state of China's economy, they don't have the wherewithal to do that. So, John is absolutely correct. It would be inflationary. It would be like a tax on consumers. So, we'll have to see what happens. But either way, policy could be inflationary, which is probably why the Fed has been taking its time on cutting rates, because it doesn't want to have to reverse course.

Chris Zand: Thank you, Carl. Thank you, John. Very helpful. We'll go ahead and start the Q&A portion of our call in a moment. Before that, John, any final comments before we do?

John Osterweis: No, not really. As I said, I think we're moderately constructive on the economy. We do not see an imminent recession. Obviously, a lot of what the market does will be highly dependent on earnings. And so, to the extent we can find companies with improving earnings or accelerating earnings and cash flows and selling at reasonable multiples, those are things we'll remain very interested in.

Chris Zand: Great, John. Thank you. All right. Let's go ahead and open up the floor to the audience now, and we'll start with a question that came through during our discussion here. Before we start, I just want to remind everyone that we are happy to meet with you, either virtually or in person, to discuss your portfolios, financial planning, and even review estate planning considerations.

So please reach out to us if any of those are of interest or you have any financial advice needs that happen to come up. The first question that we received is, "How much of a difference do you feel fiscal and monetary policy will evolve beyond 2024 based on the results of the upcoming election?"

Carl Kaufman: I can take that one. I don't think the election will really affect monetary policy. As we've said, the cycles are independent. I think if the Fed decides to start cutting close to the election, it probably means that they see greater weakness in the economy and want to help contain any slowdown before it's too late. That would be counter to what they've done for the last 100 years, but you never know. There could be a first time where they are preemptive rather than reactive. I'll leave it at that.

Chris Zand: Thank you, Carl. We'll move to the next question. This question is, "What do you think the chances are for the current estate tax exemptions to remain in place once the 2017 Tax Cuts and Jobs Act exemptions expire in 2025?" I'll take a crack at this one to start. Just in terms of reference, the question is referring to the lifetime gift exemption, which is the amount any individual can give during their life or leave at their passing free of any estate taxes.

Estate taxes are roughly 40% on the federal level. So, it's a significant amount. Currently, an individual can leave $13.6 million free of any tax, or gift it during their lifetime. And if nothing is done from a legislative standpoint, at the end of 2025, that amount will go down to $6 million. So, for a married couple, we're talking about a shift from a little over $27 million down to $12 million. It's a significant amount from a planning standpoint.

In talking with estate planning and tax professionals in our community, we've heard varying perspectives on where things will go. Historically, the lifetime gift exemption has been kept level or it's gone higher, but you don't want to plan on that and suddenly miss out on a significant giving opportunity or subject your estate to significant taxes, considering the tax rate is 40%.

At this point, our sense is it's a 50/50 toss-up, and our advice would be that you spend some time in the coming year with us from a financial planning standpoint and with your tax and estate planning team to discuss what your capacity would be for giving should this exemption go down, and give it a hard consideration. That's our best advice right now. And again, we encourage you to take us up on discussing that further should it be of interest to you. Okay. We've got one last question. "Can you provide an update on the global economy? It seems like the U.S. is doing better than a lot of other countries right now. Is that right?"

Carl Kaufman: That's pretty much right, Chris. Europe has always grown slower recently. China has really slowed down. They just cut rates. So, we are the shining beacon of the world. Despite that, rates are lower in most of the developed world than they are here, and they seem to be... I mean, Europe's already had one cut, and they're on hold for now.

So the question is, how much stimulus do these countries and we give to our economies? I'd like to think that given the robustness of our economy, that we can maintain our economic lead and continue to grow. I think there are plenty of opportunities investing here at home. It doesn't mean there aren't any wonderful companies overseas that happen to do a lot of business in the U.S. But overall, we are the envy of the world when it comes to an economic engine. John, if you have anything to add to that.

John Osterweis: I would just add as a background here that, as I think all of you know, China had a one-child policy. That has now become a real issue for them, because as a result of the one-child policy, they are not reproducing at a rate sufficient to maintain their population. And in fact, the projections are that China will lose... I can't remember the numbers exactly, but a third of their population by 2050 or half their population by 2080. I mean, they're enormous, enormous numbers.

And you have the same phenomenon going on in Europe where women are not producing the number of babies needed to maintain populations. And so, the United States is in an interesting position where our birth rates may be down, but we have net positive immigration. So, our population is probably still growing, where populations in a lot of countries are declining.

And one of the things we want to do over the next few months is really look at demographics and see what the long-term implications are, but they're not good for the companies that are losing population. And so, this is another reason why the U.S., relative to a lot of other economies, looks so good. And I'll just leave it at that unless one of my partners wants to add something more specific.

Nael Fakhry: I would just add one point. So, the population is, it's now projected to be as low as 7 or 800 million within the next 75 years in China-

John Osterweis: China. Yeah.

Nael Fakhry: ... which is kind of remarkable, from the 1.5 billion range today. But the reason it's so important, the population growth, is because as these countries industrialize and move to... They all inevitably move into consumption-led economies, just like our economy, to two-thirds, to 70% consumption-driven in terms of GDP. So, to the extent that you have population growth, that means more consumption, and that's what drives the economy.

So if you have your population getting cut in half, it's a massive headwind to a consumption-led economy. And obviously, China has industrialized and is shifting to a consumption-led economy. So that specifically is just a structural headwind. And John, as you pointed out, in Europe... This is why immigration is so important in the U.S., UK, Australia, I think New Zealand. They are really the four countries where immigration is structural. So that creates kind of a release valve. So even as populations mature and the birth rate drops, if you can bring in that immigration, it continually supports that key driver of the economy.

John Osterweis: We're going to be taking a harder look at this over the next few months, so stay tuned on this one.

Chris Zand: Great. That was our last question. So, I'd like to thank our panelists, John, Carl, Greg, Nael, for all their helpful insights, and thank all of you for joining us today. As always, let us know if you have any feedback or questions regarding today's discussion or your own portfolio. We'd love to hear from you. And with that, thank you, and enjoy the rest of your day.