Quarterly Webinar Replay

Chris Zand: Hello, and thank you all for joining us today for the Osterweis quarterly call, where we will discuss recent market activity and trends, our portfolio positioning, our outlook for 2025, and implications of the new Trump administration, which just got kicked off a little over a week ago. I'm Chris Zand and I'll be moderating today's panel discussion featuring Chief Investment Officers, John Osterweis, Carl Kaufman, Nael Fakhry, and Greg Hermanski. And with that, let's go ahead and get started. John, as always, I'd like to start the conversation with your perspective on 2024, which was the second year in a row that equity markets performed quite well.

John Osterweis: Well, good afternoon everybody and happy New Year. Obviously 2024 was a really strong year, particularly in the cap weighted S&P. S&P was up on a cap-weighted basis 25%, on an equal-weighted basis, however, it was up 13%. We can get into that a little later. Market was strong most of the year and a lot of good things happened that caused that. The economy was strong, inflation was abating, interest rates were coming down. Unemployment was still quite low, and of course corporate profits were up and consumer confidence was up, so a lot of good things. There was concern obviously about conflict in the Middle East, spilling over into a much broader regional conflict That did not happen. So there was really not much to keep the market down last year.

Chris Zand: Thanks, John. Very helpful. Could you talk a little bit about the fourth quarter, the rally lost a little bit of steam in late December after the final Fed meeting of the year. What did you make of that?

John Osterweis: The final Fed meeting put a little bit of a damper on the market in that, the Fed said inflation is still a bit sticky, hadn't come down to the 2% target that they want, and that they may have to keep rates higher for longer. However, I would point out that rates are not so high as to really impede the economy, and so the market, once it digested that disappointment about lower rates, resumed its upward path.

Chris Zand: Thanks John. Now I'd love to get your thoughts on what's becoming an extended bull market. Obviously it's been good for investors, but valuations are above historic levels and market leadership continues to be concentrated. How concerning is that for you and the team?

John Osterweis: Well, it is somewhat concerning in that, we've had very narrow leadership in the market. The Mag 7, as you know, is now 35% of the total market. The Mag 7 stocks were up about 48% last year. The rest of the market was up quite a bit less than that. So one of the things that concerns us is that, trees don't always grow to heaven. At some point there'll have to be a change in leadership, and we think that plays into our strength, because we haven't chased the Mag 7 just in order to keep up. But we've been investing more broadly in other very high-quality stocks that we think ultimately will prove to be great investments. Before I turn it over, I would say that the Mag 7 is somewhat highly valued, but obviously deservedly so. The companies in the Mag 7 grow faster than the overall market. They have about double the profit margins of the rest of the market. They have secular tailwinds behind them, so they are truly outstanding companies and deserve to sell at a premium.

But the question is always: How much of a premium? And will something go wrong like competition from China that could put a pin in the balloon. So, to be determined.

Chris Zand: Thanks John. Very helpful. Let's come back to interest rates and inflation briefly. How much of that do you think will be a factor in the market as we look out at 2025? As you just mentioned, December saw a slew of headlines throwing the entire inflation narrative on its head, which definitely rattled the market. So I'd be curious in terms of how much of a factor you think that'll be in this coming year.

John Osterweis: Well, I think it'll be a major factor in the sense that people are going to focus in on it. The surge in inflation that we just witnessed was largely due to catch-up problems coming out of Covid and supply chain disruptions and shortages, et cetera. That clearly is now pretty much behind us, but generally, it takes time for inflation to abate. The real debate going forward is, which of Trump's policies will be highly inflationary? Across the board tariffs will be, deporting half our labor force would be. So the market's going to worry about that, and you'll see relief and fear and as we go back and forth. Obviously if inflation should start to rise again, the Fed's going to have to raise interest rates and that would put downward pressure on the market. So a lot of variables, not a lot of certainty at this point.

Chris Zand: Thanks, John. One just question that came through the Mag 7 is a reference to the Magnificent 7, which were seven stocks that have dominated the S&P's returns over the last 12 to 24 months. Apple, Microsoft, Google, Tesla, Meta, Amazon, and Nvidia.

John Osterweis: Right.

Chris Zand: And just maybe a follow-on question, John, that also came through the Q&A as we're going here. Your thoughts on being aligned with the S&P cap-weighted versus equal weight index at this juncture?

John Osterweis: Well, what we know from history is that the cap-weighted index and the equal weight index tend to do about as well as each other over time. There are moments like the last couple of years where the cap-weighted index clearly outperformed, but if you believe in reversion to the mean, I would say the proper bet is to be leaning more towards the equal weight at this point.

Chris Zand: Great. Thanks, John. We have a question about Trump's tariff policy in the Q&A, but we have a segment focused on that a little later in our conversation, so we'll be sure to come back to that.

John Osterweis: Okay.

Chris Zand: Okay, great. Very helpful. Let's pivot now and check in with Carl about fixed income. Carl, good to have you with us. Now, investment grade bond markets behaved very differently than the equity markets in 2024, returning just 1.25% for the whole year. Can you talk us through why there was such a divergence between the two markets?

Carl Kaufman: Thank you, Chris, and happy New Year everyone. Yeah, 2024 was another tough year for investment grade bonds. The 5-year annualized return for the Bloomberg aggregate Index is negative 0.33%, so they've had a rough stretch. Fundamentally, the difference between the two markets last year was that, equity investors were clearly much more optimistic, and normally, higher rates are bad for stocks, but they seem to have overcome that. Investors largely overlooked the concerns that are due to the strength in the economy as it relates to interest rates. And confidence that a Trump win late in the year would be good for business in 2025 with deregulation, tax cuts, etc. Bond investors on the investment grade side were more focused on the threat of inflation and higher rates, and clearly when the Fed announced that they were going to be slowing down the cuts, that did not sit well with investment grade issuers who were maybe got a little ahead over their skis anticipating a series of cuts.

Remember that in investment grade bonds, interest rate risk is the primary risk or interest rate volatility, let's call it. Whereas in other parts of the bond market such as high yield, you know credit risk is higher because they tend to be a little lower quality or smaller companies. So if the economy's doing well, then you don't have to worry about defaults as much as if it's doing poorly. So in 2024, duration or interest rate risk was again the story, and as interest rates drifted up, they caused bond results to compress in the investment grade universe. But in the high yield universe where we are mostly focused, things are proceeding well.

Chris Zand: Thanks Carl. Very helpful and a good lead into my next question, which is that, over the last year our fixed income strategy did much better, up 8% compared to 1.25 for investment grade. Can you talk about how we managed those headwinds like rising rates and changing policy by the Fed?

Carl Kaufman: Sure. As everybody knows, we have a magic eight-ball in our office and we consult that regularly. Now, seriously, markets like these are exactly why we have always preferred a flexible approach. One of our key philosophical tenets is that we like to take what the market is giving us rather than to make bets on what we think the market will do in the future. So the current interest rate regime has been very favorable for short-term investing. For most of the year, the yield curve was inverted, meaning that rates at the short end of the curve are higher than at the long end. So we just take that gift and overweighted the short end of the curve, because the yields we were getting on that were not much less than yields at the long end of the curve, but with a lot less volatility and risk.

So this has allowed us to capture attractive returns on a large part of the portfolio, and that also keeps us very liquid when buying opportunities present themselves, because mostly in short-dated bonds that are always either maturing and turning over and creating new cash that we reinvest at the short end. And also high yield bond allocations tend to be less sensitive to movements and interest rates. So when you combine shorter maturities, higher coupons, we've sidestepped most of the problems that impacted the investment grade market.

Chris Zand: That's great, Carl, thank you. Very helpful. Let's go ahead and switch gears back to equities now and talk a bit about how we're positioned for 2025 given some of the headwinds that we've already discussed, including elevated valuations, market concentration, and higher interest rates. For that segment, Nael I'd like to turn to you and get your thoughts on how we're approaching portfolio construction given these considerations.

Nael Fakhry: Sure. I'd say, we're doing really what we've always done trying to play both offense and defense. And mechanically what we've done is, we have trimmed or exited companies with higher valuations. Meanwhile, we've added a few companies, new companies that have attractive valuations and we've also added to companies that we already own that have attractive valuations. We've also increased our defensive positioning by adding, as I just said, to some companies with attractive valuations within Health care and Utilities specifically. But we are maintaining our exposure to higher growth companies that within Technology, within Industrials, within Financials, because the economy as Carl and John touched on, is healthy overall.

So it's important, we are taking a flexible approach and trying to capture upside but also remaining defensive. And I think wrapping it all together, we continue to anchor the portfolio around quality growth companies. These are, you've heard us talk about this, but just as a reminder, the way we define quality growth companies is as companies that have a durable competitive advantage that enables significant and growing free cash flow first. Second, they can reinvest to drive future growth. And third, they have really good incentives, they have great governance, and ideally they have really good management teams.

Chris Zand: Thanks, Nael. Very helpful. Greg, maybe you could talk a little bit about some of the individual companies in the portfolio that are particularly well-suited for this environment.

Greg Hermanski: Sure. Good afternoon everybody. I'll give you two names that we think are positioned well for this year. In both cases, the stocks had tough years in 2024, but we think they're well-positioned to rebound in '24 and beyond. One stock that we like is Deere. We bought the stock last year as the stock had traded down from very weak farm income. Farm income was down around 30% last year, and this led to a reduction in the purchase of new farm equipment and also it led to a glut of use equipment. So to fight that, Deere had to reduce both prices and their production. And this significantly hurt their profitability as well as their stock price. Now we believe the large reduction in production that they did in '24 and they're continuing in '25, is going to help support the fundamentals as we go through 2025. And so we think longer term about Deere, it has a fantastic brand, it has strong competitive motes, a huge dealer network, which has multiples of their competitors, and it's been driving technology forward with their Precision Ag initiatives.

As a result of the selloff, we were able to buy the stock at a very attractive valuation with lots of bad news already priced into the stock. And so we see a significant opportunity for share appreciation as we look forward from here. The second company is Airbus. It's been in the portfolio for a while. We think Airbus is very well positioned for 2025. During '24, there were a number of supply chain issues that plagued the entire industry. So why are we optimistic? During 2024, the supply chain improved throughout the year, and so as they exited the year, things were looking much better. And as we go into '25, Airbus is in a position to start really ramping up its production and its profitability.

The second point is that the company is in an enviable position of having over six years of backlogs for its planes. In addition, it operates in a duopoly with Boeing, there's limited competition. The average age of aircraft has increased meaningfully since the start of Covid. So this all leads into a situation where you have a better supply situation, incredible amount of demand, and it sets up for very strong growth over the next few years.

Chris Zand: Thanks, Greg. Very helpful. I was wondering if you could also talk a little bit about DeepSeek. For those of you who might not be familiar, DeepSeek is a Chinese AI company that recently launched a new LLM or a large language model, which actually rattled the markets yesterday and left many investors questioning their assumptions around development in AI. Now we know it's the early innings for AI development and things will continue to evolve, but Greg, what are your initial thoughts on the impact for some of the companies we're invested in?

Greg Hermanski: Yeah, I think first, we need to start with recognizing that we have limited amount of information on DeepSeek's new LLM and what they did. But there is information out there and what we do know is that, it has a very competitive LLM that performs well with leading LLMs like ChatGPT. So it is very competitive. We also know that they've used new innovative methods to train their models, and it's allowed them to train the models more cheaply than comparable U.S. models, and it also enables them to run the models at a much lower cost. And those are two really important points as we look forward. I would also just say that first, there's been some controversy, but we do believe that their claims are reasonable and probably pretty accurate. And we also believe that innovation is really good over time. So as far as impacts in the near term, there's probably going to be a limited amount of impact.

We would expect the companies continue to invest and compute power from semiconductors. They need that to continue to compete in the space. Over time, however, there's a hope that the new methods that DeepSeek used will be integrated into all of the LLMs, including the ones in the U.S., and that should drive down the cost of creating and running models. So for us, a more efficient lower cost models, that would be good for our software names like Microsoft, Intuit, and Salesforce, which use the LLMs to power their business. So that could really help drive their businesses forward. The reduced cost to run AI likely will drive broader adoption, which would be good for our hyperscale investments where these things are hosted. So Google, Amazon, and again, Microsoft would be beneficiaries there.

And then, for semiconductors, it's really probably a mixed bag. New training methods may reduce the number of semiconductors that are needed to train LLMs. But the reduced running cost probably increases the total adoption of AI, which would likely end up increasing the demand in totality for semiconductors. So they very well may end up being winners. So as we continue to see further innovation, which we will likely see, things will probably continue to change, and we're going to monitor these things closely. It's an exciting time for the evolution of AI and technology overall, but those are our initial thoughts.

Chris Zand: Thanks Greg. Appreciate the perspective. All right, let's go ahead and change gears now and turn the conversation over to our subject focus on the new Trump administration. It's been eight days since the second Trump administration took over in Washington and a lot's already happened. John, I'd like to bring the conversation back to you and get your thoughts on how you think his agenda will impact the equity markets.

John Osterweis: It's a great subject and one that I know we're all thinking about. A few weeks ago I had the good fortune of having dinner with General Petraeus and we asked him about Trump and he said, "Basically you need to take Trump seriously, but not literally." And I had dinner with a friend of mine who teaches psychiatry at Harvard. He says, "The one thing you need to know about Trump is he's going to do what he says." So you take all that, Trump is going to raise tariffs, he's going to deport illegal immigrants. Those two things could be very inflationary if he does it in large scale, and I'll get back to that. On the other hand, he is definitely pro-growth. He's going to reduce government regulation, which actually has the opposite effect.

It's noninflationary, it reduces costs for businesses. He's going to reduce taxes, which is obviously going to spur the economy. So it's hard to make a definitive statement about what the impact of the Trump administration will be, because you just don't know. My guess is that there will be some increase in tariffs that will not have a particularly large inflationary impact. There will be certainly stepped-up deportations and tighter borders, which will have some impact on labor availability. But again, it's hard to know how much. I think some of the risk with the Trump administration will be what I call "tail risk." How big will the deficits get and what will that mean for total borrowing relative to GDP? And are we going to reach some outer limit there?

The other tail risk might be climate, where if we back off of trying to get off of fossil fuels, do we accelerate climate change? And what are the long-term impacts of that? So these are all unknowns. I think probably the environment will be a robust one. Business will do well, profits will be up, and at least for the early parts of the administration, if I had to guess, I would guess that the markets would respond favorably to all that.

Chris Zand: Thanks, John. Very helpful. Carl, what about for fixed income? Are you worried that Trump's policies and agenda could result in a significant increase of the national debt to such a level that maybe it could then affect rates as well?

Carl Kaufman: Well, as I've said before, markets generally do what they're going to do regardless of who is in office. However, he has certainly been pretty aggressive in his first week with the executive orders, but we don't expect his agenda to be so disruptive that it impacts borrowing costs extremely negatively. I mean, I think he wants lower rates, he wants a lot of things that sometimes don't go together. But I think generally being a real estate guy, he wants lower rates. So I think if he gets a sense that his policies are causing rates to shift upwards, he's probably going to tone them down. We've been running huge deficits for a long time and the higher rates go the more people like to buy Treasuries. And that's, I've always said that the economic cycle is going to do what it does.

People's behaviors don't really change as a function of what goes on in Washington DC. They might worry a little bit more, but they're still going to lead their lives and contribute to the economy. And clearly job stability and job comfort that you will have a job and wages play more into that than tariffs and other things. But we'll have to wait and see. But right now I don't see a huge disruption.

Chris Zand: Thank you, Carl. Very helpful. Let me open this question up. It's on the same subject area. I'll open this question up to the entire panel. This was from our audience. How will the economy be impacted if DOGE vastly cuts government workers? And DOGE I believe is a reference to the Department, (the office) of Government Efficiency.

John Osterweis: I'll take a stab at it. I mean, obviously if a large number of government workers are laid off, that could lead to a higher unemployment rate. On the other hand, if the government becomes more efficient and is not imposing regulation after regulation, that would be stimulative to businesses. So again, it is one of these questions where you cannot come up with a definitive answer as to what the impact will be.

Chris Zand: Great, thank you, John. Another question for the panel. We've touched on this, but maybe we could just circle back quickly. Are the current valuations in the market worrying to any of you?

Nael Fakhry: I can jump in with a little bit of context. John alluded to this earlier or actually said it explicitly, that the market right now is trading right around 22x and the long-term S&P multiple is 17, so that clearly is high. A few pieces of context though are important. I'd say one, the S&P, if you believe consensus estimates, which you should be suspicious of, but if you believe them our earnings are going to grow about 17% this year on a year-over-year basis, that compares with 7% as the long-term S&P earnings average. So the rate of growth of earnings this year is expected to be very high and even last year saw very high earnings growth. So from that perspective, it would seem like the multiple is justified. Returns on equity for the aggregate S&P are also much higher than they have been historically and have steadily gone up and there's not a ton of leverage in the system.

So all of that would be supportive. Having said that, the reality is that, things change and a lot of that shift has been because of the Magnificent 7, these seven companies. And so, to the extent that there's, we talked about DeepSeek or any number of things could change and one or more of these companies could be basically dethroned, right? A competitive threat could arise. Valuations could just come down as growth declines. And so what you could see, I think very possibly we could see is obviously a market correction or you could see some of these very high valuation stocks just correct, whereas the rest of the market broadens and you could see a lot of volatility under the surface with not a huge amount of reaction in the overall stock market as the market broadens and perhaps the equal weight returns come into line with the market cap weighted return.

So we're definitely, as we said, we're getting more defensive and we've taken action to become more defensive. But the economy is very healthy at the moment and continues to grow. Unemployment's low, inflation is abating, it's still elevated, but it's less severe than it was. And so with all that happening, you can see how the economy's going to grow, but you have to be real about valuations, and it can't expect that it's going to be supported at 22, 23x.

John Osterweis: I would just add.

John Osterweis: I was going to just ask a question here. Do we know the difference between the multiple on the Mag 7 and the other 493 stocks in the S&P?

Nael Fakhry: Yeah, so if you look at the Mag 7, they're trading, there's been a lot of volatility in the last few days, but it's actually still holds. They're trading at about 32x right now, which is very high. Now again, much higher growth, all of that higher returns, higher margins. The rest of the S&P is trading under 20x, trading about 19x. So now, overall the S&P, the rest of the S&P is actually supposed to grow somewhere in the low teens range, about 13%. So if you believe that, again, that's double the rate of growth of the historical S&P. So having a slightly elevated multiple on the rest of the S&P doesn't seem crazy. The question as you said, John, is how much of a premium should the Magnificent 7 really trade at is 33x or 32x justified? Maybe not. I mean, why couldn't they trade at 25x? It's not like they deserve a 33x multiple regardless. So we think there's more of a question around some of these really high multiple companies.

Greg Hermanski: I was just going to add that we do monitor valuation of our companies very closely, and we do also take action on them and look at the relative valuation. So last summer, we ended up selling a couple of the companies that we really, really like because they're high quality companies, but the valuations got stretched. One was Applied Materials, one was Synopsys. Synopsys was trading I think over 40x earnings, it's a fantastic company. But at a certain point we do look for companies to replace, and that's where a Deere and Airbus or Boeing or some of the other names that we really like come into play. And the other thing that we do is, we do tend to trim names as valuation extends. So there's some companies that we really like, but we're very aware of what the valuations are and what the comparable companies are, and we're looking to upgrade the portfolio at all times, not just for quality, but also on valuation metrics.

Chris Zand: Great perspective. Thank you all. Well, that concludes the primary area of our presentation. We do want to save some time for the Q&A. And before we turn to the Q&A, John, do you have anything you want to add?

John Osterweis: I think we've said it. This is a year where there'll be a lot of cross currents and probably some volatility. And as Nael said, there may be some churning where some stocks go down, other stocks go up. So it should be a fun year.

Chris Zand: So why don't we start with a question that came in beforehand, and I'm going to direct this question to Nael. Can you provide an update on the real estate market? Seems like prices are still high, and even though mortgage rates are also high, the activity may be picking up. Nael, what's your take on that?

Nael Fakhry: Sure. So I guess we should probably segment it into the housing market and then the commercial real estate market. So if you look, as you pointed out at a baseline, the 30-year mortgage is right around 7%, which is really high relative to the last several years, but it's actually very normal relative to the long sweep of history. And we think it'll take time for households to adjust, but there are indications that that's starting to happen, meaning adjust to these higher rates. And there's some secular tailwinds at play within the housing market. We're short about 3 to 4 million homes in this country, and that's because we've written about this recently. The population here continues to grow and actually, recently has grown at a pretty fast clip, especially relative to the rest of the world. Plus there was a very long period of underbuilding after the financial crisis.

And then you add in that homes today are over 40 years old. The median home is over 40 years old. That's very old. It's the oldest the housing stock's ever been. And then on top of that, these really tragic wildfires and other natural disasters that are happening more frequently because of climate change. That can create acute shortages in these major population centers. So all of that is to say that there's a housing shortage and it's becoming more acute. Meanwhile, wages have moved higher in recent years and actually kept pace with inflation for the average person. So we think one way that it could possibly adjust is people buy slightly smaller homes, they put more down and they just adjust their expectations to the current reality. And we've actually recently made some investments premised on a housing recovery that should really benefit these companies because there's been a lot of, obviously the market's been suspicious of these high rates, and we think that these big forces, these secular forces should overwhelm the near-term headwinds from mortgage rates.

And then just lastly, more broadly on commercial real estate, obviously that's a very broad set of markets and geographies. You're talking about industrial real estate, multifamily, know the retail office. And what we've seen, so it really depends on the type of real estate and the geography, but broadly, we've seen that values have definitely stabilized and because some of these property types, the values really actually got hurt pretty significantly in the last few years as rates went up. But there's not a lot of excess leverage in the real estate market today, especially compared to past cycles. And supply has actually really been reduced because rates went up, so you haven't seen a lot of speculative building recently in the last several years. And so as you have pretty stable demand with a healthy economy and dwindling supply, you've seen a stabilization and you're starting to see an increase in valuations and demand.

Chris Zand: Great. Nael, thank you. Here's another question I'll propose to the whole panel. Is the Phillips Curve dead the relationship between employment and inflation?

Carl Kaufman: I'll take that one. Or if that's for those who don't know what the Phillips Curve is, it was an economist named A.W.H. Phillips who developed it. And it charged the relationship or inverse relationship between unemployment rate and inflation. So the theory is that, when unemployment is low, in other words, the economy is operating at full capacity, inflation should be high. When unemployment is high, inflation should be low. In the last almost two decades, it hasn't worked out that way. Unemployment has been pretty low since the '08 Great Financial Crisis and inflation was very low, so people thought the Phillips Curve is dead, but economists having two hands will argue that. "No, it's just dormant. It may not be dead, it may be dormant. The question is: What is causal?

So if you have, for example, the reason it's not working now is that inflation is coming down, unemployment rate is still pretty low, because as companies are able to pass along prices, they make more money and they more people. So it doesn't work as well in some periods as others. It may work again, but I'm not sure what it's telling us. So I would say there are probably better indicators out there than the Phillips Curve to follow for monetary policy. Because it has not been the best for the last 15 or so years.

Chris Zand: Thank you. Carl. We are coming up on our last question so far that's been submitted. Following up on a question from last quarter, has movement in the markets, economy, politics, etc over the last quarter changed your thinking on alternative asset classes such as private equity, real estate, precious metals, commodities, crypto, etc?

John Osterweis: Let me start with that. The answer is no, it hasn't changed our thinking. We have gotten more active in alternatives, but on a highly curated basis. I think if you can find investments that may be illiquid because they're private, don't trade. You can find from time to time really spectacular investments. And to the extent we can, we will show them to you. But what's happened in the market isn't what's driving our thoughts on that. I'll just leave it at that.

Chris Zand: Great. Thank you John.

Chris Zand: That was our last question. So, at this point, I'd like to thank John, Carl, Greg, and Nael for all their helpful insights. And thank all of you for taking the time to join us today for our panel discussion. As always, please let us know if you have any feedback or questions about today's discussion or your own portfolio, and we'd love to hear from you or help with any financial planning needs or questions that you may have. Wishing you a great rest of your day, and thanks again for joining us.