Q:  What is the investment philosophy of your firm?

A: In our investment philosophy, flexibility is a key word. The firm was founded twenty years ago by John Osterweis with the belief that managing money requires maximum flexibility and should not be ruled by style boxes. On the equity side, we believe that growth and value represent a continuum, not separate asset classes. On the fixed income side, flexibility means not only investing in both investment grade and high-yield, but also the ability to be really aggressive on the duration profile when necessary.

Q:  How did you come up with this philosophy and why you consider it a better way to manage money?

A: Initially set as an equity shop that manages money for wealthy families, endowments, and non-profit organizations, the firm has always sought out-of-favor companies with a problem that can be fixed, such as a failed acquisition or a failed new product launch. Once the problem is fixed, you get back the cash flow plus the growth premium. The firm had been investing in fixed income in addition to the equity, because if you like the stock, you should like the high yield bonds as well. If there’s an improving story, the company should be getting upgrades.

But that wasn’t really a strategy so four years ago we decided to come up with a strategy that’s based on the idea of managing money with no restraints. We came up with several observations of the fixed income market that guided our philosophy. The first one was that most people don’t look for alpha in fixed income because they don’t want to take too much risk. They are either investment grade or high yield investors. There’s a clear line drawn in the middle, which most investors don’t cross, so they stay in their box.

The second observation was that there are two bond market cycles, not just one. The first one is the interest rate cycle, which most investors are familiar with because of its impact on investment grade bonds. Since risk of defaults is low in the investment grade world, interest rates represent the largest variable according to which prices are adjusted. When interest rates are going down and bond prices are going up, that’s great.

But what happens when interest rates go up because the economy is strengthening? Bond prices move down and the investment grade manager is limited to managing duration as his only defense. This is the second cycle, the credit cycle, when high yield managers enjoy equity-like returns. The interest rate cycle delivers its best returns when rates are falling and the economy is weakening. By definition, these two cycles can never happen at the same time; they’re always consecutive.

So we designed a strategy that enables us to switch between the two when appropriate. In that way we can participate in both cycles and eliminate the negative returns associated which each of those asset classes in the down part of their cycles.

The third thing we noticed was that the transition periods between the cycles can last as long as a couple of years. To manage those transition periods, we decided that instead of looking for the most attractive area in the bond market, we should be looking at the riskiest part to be avoided at any time to eliminate the areas of greatest risk. A perfect example is the period when interest rates were going down to 1%. At that point the risk of interest rates changing direction was very real. We found that the area of greatest risk was the long-term investment grade class because you wouldn’t want to have a 30-year Treasury when interest rates start going back up.

As you progress both in the investment grade and in the credit cycles, you find that duration becomes an increasing risk. Obviously, at 6% you want the longest dated portfolio that’s practical and as you get lower, you want to reduce duration. That strategy achieves two things. First, it limits the volatility of the portfolio, which is usually greater at the turning points. Second, it allows an easy transition into the next cycle, which requires a different set of investments. You don’t take a hit selling a short-dated bond portfolio, so this is a very elegant solution for managing the transition points.

Q:  How that philosophy translates into an investment strategy and process?

A: The first step of the process is deciding where we want to be. Depending on where we think interest rates and the economy are going, we’re either in high yield and convertibles, or in investment grade. Typically, we’re not going to be in investment grade and high yield at the same time.

The next step is looking at that market in terms of risk management. As we get further into the credit cycle, for example, we’d avoid the more leveraged companies, the riskier credits. We emphasize credit work during the credit cycle, which involves visiting companies and talking to a lot of managements because we believe that adds value. We don’t just sit here looking at quotes and talking to brokers.

Then we build the portfolio one bond at a time. We have a rather concentrated portfolio of 35 to 50 names. The idea is to make sure that every name can stand on its own and that we’re totally comfortable with its credit metrics and its management. We put the companies through our own hurdles, so we wouldn’t simply buy benchmark issues or depend on the rating agencies, who can be slow to react to fundamental changes. We try to buy what we think are the best risk/reward candidates regardless of the universe we’re looking at.

Q:  What’s your strategy for the transition stage that you mentioned?

A: We mostly use duration as a defense. We’ve found one sector that seems to be very stubborn in terms of negative returns and that’s oneto- three year non-investment grade bonds. This sector hasn’t had a down year in the last eight or nine years.

I have an explanation although I can’t give you any academic research to back it up. The majority of non-investment grade issues typically belong to companies with few pieces of debt and maybe a bank line. My feeling is that nothing gets you as focused as a potential bankruptcy. If you’re the manager of a company with one piece of debt outstanding coming due within two or three years, you’re incredibly focused on making sure you get that refinanced because the alternative is pretty severe. It may mean bankruptcy so it’s an incredibly focusing experience.

Also, when you get into short-term high yield, the volatility of the price is lower than in longer-dated bonds. If there’s a credit widening because of a weak economic period, the move is not that big on the shorter end as it is on the longer end.

Q:  What’s your approach to research? Can give us some examples of ideas that became part of your portfolio?

A: At the firm we have seven senior equity analysts who are all partners and we all look at credits in the same way. Because we play in the convertible market, we all look at the companies in the same way and we’re all very collegial and so we have this additional valuable resource and they have us as a resource. It’s really the whole team that scouts out new names. As a result of our fixed income work, we’ve added some names to the equity portfolio and vice versa.