Fund Focus: Osterweis Has a Key Metric That's Proven Its Worth

Michael Shari's Fund Focus
Michael Shari's Fund Focus

You could be forgiven for wondering why you should keep your money in a mutual fund in this not very merry month of May. After all, the European Union's debt crisis is spiraling, the U.S. is becoming the Unemployed States of America and a combination of jittery investors and computer programs that move faster than the firms that created them stand a decent chance of pushing the stock market over the edge at any given moment.

But it may not be as hard as you think to find a perfectly decent mutual fund at a time like this. Equity funds out there do have track records for outperforming the stock market -- and beating the vast majority of their peers -- over long-term periods like 10 or 15 years, through good times and bad. This small minority of funds isn't celebrated most of the time because they tend not to appear at the top of the charts when the market is on the way up. They're run by relatively quiet, nerdy types who spend a lot more time crunching numbers in their cubicles and figuring out how to shield their clients from the worst effects of the next storm than they spend promoting themselves.

Take the Osterweis Fund (OSTFX). With $1 billion in assets, this midcap equity fund grew 11.26% over the last 15 years, beating the Standard & Poor's 500 stock index by 7.14 percentage points. That was a better total return than 87% of comparable mutual funds, according to Morningstar, a fund-rating firm in Chicago.

Avoiding What's "Moving Straight Up"

Compared to its peers, the Osterweis Fund's best years were the worst ones for most of the mutual fund industry. In 2002, when the S&P 500 fell by 22.1%, Osterweis fell by only 11.67%, which was a better showing than 99% of its peers, according to Morningstar. In 2008, when the S&P 500 fell by 37%, the fund lost only 29.23%, which was better than 89% of its peers. As the market rallied in 2009, Osterweis beat the index by 4.66 percentage points. Since Jan. 1, it has been just about as flat as the index.

To put it simply, Osterweis tries hard not to lose money and, in the process, cushions the blow during a crash. It does this partly by selling stocks in sectors that become all too popular. "We stay away from anything that is moving straight up," Matthew Berler, a co-manager of Osterweis in San Francisco, told me over lunch in Midtown Manhattan this week. In the late 1990s, the fund stayed away from dot-coms and other darlings of the tech boom, which famously became the tech crash of the early 2000s. Later, the fund got out of financial stocks before they started to sink under the subprime mortgage implosion of 2007.

More important, the fund's portfolio managers use a highly disciplined method of finding stocks that tend to outperform the stock market over the long term. They seek out companies that don't need to use very much of their earnings to stay in business and therefore have a lot of so-called free cash left over to invest in future growth. To find these companies, they use a metric known as free cash yield, which is calculated by looking at earnings per share, subtracting maintenance capital, adding cash to reflect ways the company can generate more cash in the future, subtracting cash to account for inflation, and dividing the result by the company's stock price.

"Free cash yield is the single most important metric that there is," Berler says. "I don't know why most mutual funds don't use it as a core metric."

Staying in Orbit

Osterweis is indeed one of a small minority of mutual funds that uses free cash yield as a core metric. It has led Osterweis managers to surprisingly resilient stocks like Digital Globe (DGI), a satellite imagery company that earns about three-quarters of its revenue from the U.S. government. Adjusted for about $120 million in depreciation on its satellites currently in orbit, Digital Globe's free cash flow at $2.50 per share, which divided by its current share price of $25.40, comes to a free cash yield of about 10%, Berler estimates.

He compares the free cash yield on stocks to the yield on long-term Treasurys, which are the closest thing to a risk-free investment in the U.S. Of course, the yield on Digital Globe is a lot higher than a 10-year T-bill, despite the obvious risks inherent in launching a satellite into orbit and keeping it out of the path of space junk.

Yet Digital Globe has risen about 40% since Osterweis bought it for about $18 a share last summer. The stock had fallen sharply on fears that the launch of the company's third satellite could fail even though, as Berler points out, the odds of that are less than 2%, and the satellites are insured. He was also emboldened by the Obama administration's decision to outsource pieces of the space industry to the more cost-effective private sector.

Most mutual funds pick stocks based on various measures of earnings or book value. But free cash yield isn't exactly rocket science, and any portfolio manager who uses it as a yardstick will be in a position to compare the forward rate of return for any stock with that of any stock or bond. Osterweis is among the precious few that wields that power -- and it will no doubt come in handy in the months to come.