Typically, balanced or asset allocation fund managers maintain a fairly consistent 50/50 or 60/40 split between stocks and bonds, with the latter side of that ratio diversified into investment-grade, international, Treasurys and high-yield securities of varying maturities. Billed as a flexible allocation fund, the Osterweis Strategic Investment Fund can keep as much as 75%, and as little as 25%, on either side of the fence. The fund’s current 65/35 allocation reflects manager John Osterweis’s “reasonably constructive view” of the equity markets.

“If we were extremely bullish about the stock market, we would have a 75% position there,” says the 71-year-old Osterweis. “But after a long bull market, there aren’t a lot of drop-dead bargains or truly mispriced stocks.” Nonetheless, he’s still managing to find buying opportunities among stocks that have dropped on some disappointing news or are misunderstood by the investing public.

Another indicator of management sentiment is the fund’s fixed-income position, which consists almost entirely of short-term high-yield corporate securities and convertible bonds. These below-investment-grade notes and bonds tend to be more sensitive to stock market movements and less sensitive to changes in interest rates than Treasury securities or investment-grade securities. In explaining the position, Carl Kaufman, who manages the fixed-income side of the portfolio, observes that in the current environment he prefers taking calculated, well-researched credit risks to making what he considers more potentially harmful interest rate bets.

“When we invest in the bond market, we look at where the risks and opportunities are,” says Kaufman, 58. “With yields on Treasury and investment-grade securities so low, and the potential for rates to go up, we see more risk than opportunity in those areas of the market.”

Despite a long run-up in the high-yield sector, Kaufman observes that the bonds “aren’t super-rich,” and that much of the hot money has gravitated to the longer end of the yield curve. “At the shorter end, we’ve been able to layer in some very nice yielding paper on companies we have researched thoroughly.”

In a recent report, Morningstar analyst Kevin McDevitt noted that while rising equity markets have benefited the five-star fund’s large position in high-yield bonds, the aggressive stance “leaves little buffer since equities and high-yield bonds tend to move in tandem when things get tough.” But he also pointed out that in the past, “management has shown with its other charges that it can get defensive, as was the case with equity sibling Osterweis (OSTFX) in 2008. It may be worth waiting to see how that’s applied here over the course of a full market cycle.” So far, the fund has proved its mettle by delivering a 17.5% annualized return for the three years ending September 30, putting it ahead of 98% of its Morningstar peers.

Kaufman refutes the notion that the fund’s heavy stake in high-yield bonds is riskier than other corners of the fixed-income markets, and adds that while a slow-growth economy, low inflation and pressure from the Federal Reserve will keep the pace of any rate increases measured, even a relatively small blip could spell trouble for certain types of securities.

“If rates go up 100 basis points, 30-year Treasury bonds would go down 17 points. I would call that pretty risky. If I can pick up 200 to 300 basis points over Treasurys without taking on too much risk, why not do that?”

Keeping It Simple
Given the fund’s ability to adjust stock and bond strategies to fit shifting markets, John Osterweis views it “as a core holding or as an alternative to alternative investments.” Although no one portfolio will be sufficient for most people, he says, “this fund will do as well or better than a more widely diversified portfolio people build around multiple asset classes.”

That viewpoint comes from an observation that the diversification benefits of alternative investments, which run the gamut from emerging market securities to commodities, have waned dramatically over the last decade as alternatives moved from the investment margins to the mainstream.

Now that more investors are using them, they tend to trace the ebb and flow of the U.S. equity market rather than move in the opposite direction. He believes many institutional investors and financial advisors have become over-diversified in myriad mutual funds and other structured products that, over the long term, are unlikely to provide superior diversification benefits or better returns than a balanced portfolio of stocks and bonds.

“We believe that the pendulum is likely to swing back in favor of U.S. equities and a simpler approach to diversification,” he said in a July 2014 report to shareholders. “This makes sense as long as the factors behind the bull market which emerged from the 2008 ashes are still in place. We believe this is the case and that the bull market will continue a while longer.”

Whether or not that happens, the fund’s equity strategy will continue to focus on what Osterweis views as the under-loved, underappreciated securities of companies with a catalyst for change and strong free cash flow, which he considers a better gauge of muscle than more easily manipulated earnings numbers. Companies can be any size, although Osterweis says the fund has a mid-cap bias. Equity exposure is fairly spread out among sectors, with the largest weightings going to health care (18%), consumer discretionary (17%) and financials (13%).

Over the last few years, Osterweis has been focusing his portfolio of 30 or so stocks on companies that have the ability to grow earnings in an environment of slow economic growth. He considers Johnson & Johnson, which he cites as the “highest quality stock in the portfolio” a prime candidate for doing that. He started buying the stock a few years ago when the price dropped amid concerns about patent expirations and product recalls. At the time, the stock had a dividend yield of 3.5%, double the yield of 10-year U.S. Treasury securities. Since then, the company has accelerated sales and generated ample free cash flow, which management has used to make tactical and strategic acquisitions. The stock yields 2.7% and sells at 16 times earnings.

Another holding, cable television provider Charter Communications, became part of the portfolio last year after concerns about poor management and excessive debt brought the stock’s price down. Under new management, the company has ramped up free cash flow, which it plans to use for share repurchases and reducing debt. Osterweis, who says Charter is cheap compared with other cable TV providers, estimates that free cash flow will come in at about $7.50 per share in 2015 and believes it will more than double in the 2016-2017 period.

One of the highest income-generating stocks in the portfolio is real estate investment trust Digital Realty, which specializes in offsite corporate data and computing centers. Osterweis bought the stock in early 2014 when the price dropped over investor concerns about overbuilding in this sector of the market. At the time, it was yielding a juicy 8%. “The interesting thing about Digital is that it uses 10-year leases with built-in rent escalation clauses of 2% to 3% a year,” he says. “Eventually, all the dumb money entering this market will be absorbed. And instead of lowering its payout, as many investors feared, the company has raised it.”

On the fixed-income side, the short-term, high-yield bonds that populate that part of the portfolio must have some defensive characteristics that offset their below-investment-grade credit ratings. One of those characteristics is that, unlike long-term bonds, companies often have the cash waiting in the wings to pay off short-term debt that’s coming due soon. To Kaufman, “this means their actual credit risk is less than the company’s credit rating might imply.”

Examples of what he considers low-risk securities in the bond side of the portfolio include Rite Aid’s 9.25% coupon bonds maturing in 2020. The bonds, which have call protection until March 2016, have a yield-to-call of 5%. Kaufman cites it as “a company with $25 billion in revenue and lots of free cash flow that’s being used to bring down leverage.”

Another bond position, crafts purveyor Michaels Stores, has a coupon of 7.5% and matures in 2018. Although the bonds are currently callable at 102, Kaufman says the company is unlikely to redeem until August 2015, when the call price drops to 101. In the meantime, the fund reaps a yield of over 6% until August. And 8.75% coupon bonds of steel distributor and producer Edgen Murray maturing in 2020 are priced to yield 4% and can’t be called until November 2015. They also have an added layer of protection from Japanese conglomerate Sumitomo, which acquired Edgen Murray in 2013 and would likely step in if the company were to have trouble paying the debt.