John Osterweis doesn't adhere to labels. Although Morningstar classifies his 16-year-old Osterweis Fund as a mid-cap blend stock offering, the 67-year-old manager shifted aggressively into money market securities and short-term corporate bonds last year as the bear market descended.

At the same time, he unloaded some financial services stocks and other holdings that he felt would not survive an upheaval in the economy. The move helped moderate the fund's slide in 2008 and by the end of the year it was down 29.2%, compared with a 37% slide for the S&P 500 index. Having a large chunk of assets out of the stock market continued to help during the first quarter of 2009, when the fund lost only 2.31% and the S&P 500 lost 11.67%. But as stocks picked up steam in the spring and summer, the fund's performance began to lag.

Osterweis, who has taken similar defensive measures in past market swoons, acknowledges that making decisive moves out of stocks can lead to underperformance at the beginning of bull markets. But he makes no apologies for ignoring the "stay fully invested" tenet that most stock fund mangers adhere to. "If you're walking along the railroad tracks and a freight train is bearing down on you, it doesn't make sense to just keep on walking on the same path," he says. "But it does make sense to get out of the way."

The fact that the bulk of Osterweis Capital Management's business comes from managing institutional and private accounts may help explain why avoiding freight trains takes a front seat to beating benchmarks, says Morningstar analyst Dan Culloton. "Osterweis' background in private wealth management makes him just as concerned about not losing money as he is about making money," he notes. "It will look out of step from time to time, but it has lost money in fewer rolling one-, three- and five-year periods since its inception than the broad U.S. stocks market."

A former philosophy major at Maine's Bowdoin College who went on to graduate from Stanford with an MBA, Osterweis believes his academic training at both schools provided valuable discipline that has helped him pick stocks and navigate markets for over four decades. "Philosophy is couched in logical reasoning, and that ties into whether or not a company has a well-thought-out strategy," he says. "You'd be surprised at how many former philosophy majors manage money." That group includes Osterweis as well as two other key employees at Osterweis Capital Management, which he founded in 1983 after managing private equity accounts for over ten years.

Shifting Strategies
By early 2009, the fund had pared its stock holdings to about half of its assets. As the year has progressed and the economy has begun crawling out of a recession, much of that cash has moved back into stocks. While Osterweis' outlook has improved, he still has about 30% of the fund in a mix of short-term money market securities and investment-grade and high-yield corporate notes with expected durations of one year or less. The current allocation reflects his view that any turnaround will be a slow process marked by fits and starts. The U.S. economy, he believes, is likely to move toward a fragile and modest recovery this year or early in 2010.

But he also sees potential for an economic relapse. Housing, which has typically led previous recoveries, is unlikely to pull the country out of the recession in this cycle when excess inventory lingers and credit standards for new loans remain tight. Constrained by overleveraged balance sheets and the inability to withdraw equity from their homes, consumers have a limited ability to spend. Although he does not view inflation as an immediate threat, it could become a greater risk once the economy regains some upside momentum. All these uncertainties, he believes, could weigh on equity valuations.

"Instead of moving into a prolonged bull market, stocks will gyrate up and down, reflecting the starts and stops of an economic recovery," he says. "In this environment, there will be opportunities to take advantage of the up and down swings in the market." He anticipates that the fund's historically low turnover may rise slightly going forward if the market is stuck in a sideways pattern for several years and he trades some positions more frequently to realize profits.

Even if he were truly bullish, he says, he might still have 10% of his assets in fixed income to provide some ballast and help meet redemptions. While the corporate fixed-income investments he uses in the fund are riskier than money market securities, they offer more attractive mid- to high-single-digit yields. Many of those same issues can also be found in the firm's other mutual fund, the Osterweis Strategic Income Fund.

On the equity side, Osterweis is moving into different territory than longtime shareholders are probably used to. In the past, he focused the concentrated portfolio of around 40 names mainly on out-of-favor stocks with weak but improving balance sheets. Now, with his more cautious outlook, he is steering the equity portion of the fund toward steady workhorses-medium and large companies with low debt levels, the ability to gain market share even during times of economic stress and above-average dividend growth. He avoids those companies that depend heavily on bank financing, since these have been severely constrained by the credit crunch, which is likely to continue. He also remains wary of financials.