BRIEFING BOOK

Data Information Knowledge WISDOM

JOHN OSTERWEIS President, founder and CIO of Osterweis Capital Management.

Forbes Townhouse, New York, NY

About John Osterweis.........................................................................

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Debriefing Osterweis........……………................................................. 3

Forbes on Osterweis “The 2008 Mutual Fund Survey: Honor Roll,” 09/15/08.......... “Horse Sense,” 03/14/05..............................…........................

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The Osterweis Interview.................................................................... 14

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ABOUT JOHN OSTERWEIS Intelligent Investing with Steve Forbes

John Osterweis is president & chief investment officer of Osterweis Capital Management, which he founded in April of 1983. The firm boasted an impressive average annual return of 16.2%, 4.7 points above the S&P 500, from 1995-2005.i The Osterweis Fund has been named to the Forbes Honor Roll. Prior to his own management firm, Osterweis served as a Senior Analyst, concentrating on the forest products and papers for several brokerage firms based in the southwest, including J. Barth and E.F. Hutton & Company, Inc. He also served as Director of Research for two firms and managed private equity accounts for over ten years. In addition to his business career, Osterweis is active on several non-profits boards, including Vice Chairman of Mt. Zion Hospital and Medical Center and Trustee of Bowdoin College. In his spare time, Osterweis participates in an extreme sport called “Ride ‘N’ Tie,” where athletes participate in a cross-country relay, alternating between riding horses and running long distances ranging from four miles to 100 miles. Osterweis captains a three-person team with roving members; he and his horse, Rush Creek Jax, are often joined by Osterweis’s son, Max. Osterweis graduated cum laude from Bowdoin College with a bachelor’s degree in Philosophy and a M.B.A. in Finance from Stanford University. Born in San Diego, Osterweis has spent the majority of his career in San Francisco.

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DEBRIEFING OSTERWEIS Intelligent Investing with Steve Forbes

“When someone offers you an absurdly high price for something don't assume he

knows more than you do, just sell it to him.” --John Osterweis

By David Serchuk August 20, 2008 Let Osterweis be Osterweis and he’ll make you money. The fund manager who has been beating the markets for more than a decade talks about how a contrarian’s courage can deliver great returns. What is one misplaced assumption in business today? I think in money management, one thing quite displaced is the whole emergence of “style box investing.” I don't know if you remember Xeno's Paradoxes? Xeno was a Greek philosopher who proved an arrow fired at a target never reaches the target, because it goes halfway each time. Style boxes have the same fallacy. They take a continuing thing, and divide it into discontinuing elements. Stocks move all through the boxes. A firms starts as small cap growth firm, then it grows, becomes and mid cap growth stock, then it hits a wall, becomes a mid cap value stock, they hire new management and it becomes a mid cap growth stock again. Here is the problem: [Mutual fund analysis firm] Morningstar developed the boxes as description of what managers are doing. They never meant it to be a limitation on what managers could do. They're descriptive not prescriptive. When used prescriptively, a style box has a deleterious effect. If you are a large cap growth manager you have to own that box, whether it's under or over valued. In 2000 you would have to own outrageously overpriced big cap names, and you had to sit there as they went down the tubes. A flexible manger could buy mid cap value at that time and went through the downturn in great shape. Style boxes prevent managers from playing proper defense, and offense. To me it is one of the tragic misconceptions. Why do you focus on free cash flow instead of earnings? We think that free cash flow tends to be a better measurement of corporate profitability because it’s less open to manipulation than earnings are. I have this

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somewhat naïve view that cash earnings are more real, in the sense, than accounting profits, where a company is consuming cash. My childlike view of profits is that it is the money at the end of the day, and you can do whatever you want with it. Companies that generate the free cash have multiple opportunities to grow; they can invest the cash into R&D, they can de-leverage, and grow that way, they can buy back stock. They can leverage if need be to make an acquisition, because they can pay money back. Also from a shareholder's standpoint, companies that generate cash are takeover targets. It's always good to have multiple buyers for a stock. Free cash supports higher dividends. What are some out of favor stocks you are interested in? A lot of what we do is based on discontinuities, not continuities. As a growth buyer, we look for firms with great return on equity. Our view is that we look for a stock with a lot of problems, and a past history that does not look good, but we think has a strong probability of seeing improvement in fundamentals. An example? Diageo is certainly one. We got calls from clients after we bought the stock. Why are we buying this piece of garbage that hasn't done anything in ten years? Well Diageo is not depressed the way they were when we first bought it [in 2004]. We first bought it several years ago, when it looked like a hodgepodge. They brought in new management, cleaned up the company. And they generate a ton of cash. At the time we bought it there was a 4.5% dividend, and we thought there is no way this can fail to work. Another example was Toys “R” Us, people looked at us as if we were nuts. “Don't you know Wal-Mart, and Target is killing them?” they’d ask. We said, you probably haven't read annual report, half the business is in Toys International, and Babies “R” Us, which is growing 15-20%. Kids “R” Us is a disaster. But they have two incredibly good businesses, almost half the company. Do the math. The growth businesses keep growing. In a few years, the growth businesses will not be 45% of the company, but 65%. People said that's impossible, we said it's not impossible, it's a certainty. There was a discontinuity between what everyone thought was going on, and what was going on. It eventually got sold. Babies “R” Us -- 40% of all pregnant women shop there. How many retailers have 40% market share? For the average shopping experience, a pregnant woman and her mother spends three hours there. How many retailers are like that? None, it doesn't exist.

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That's the kind of discontinuity we look for. A more recent example would be Fiserv -- A software company that basically provides payment systems for banks. It's the operating backbone of banks. Obviously banking is a bit out of favor, but Fiserv is essential to the operation of banks. A software model; it spits out a lot of cash. Their stock is depressed. Not severely, but definitely depressed. What was the best financial lesson you've ever learned? When someone offers you an absurdly high price for something don't assume he knows more than you do, just sell it to him. He may know more, but that's not a given. I used to collect knives as a little boy. I had a beautiful Arabian knife, inlayed in gold and silver, bought it for $4, someone offered me $250 once, I had to make up my mind within one minute. I thought this guy is an adult, he knows more than I do. I didn't sell it to him for $250. When I liquidated the collection ten years later, I got $25 for it. There are countless examples in the stock market of stocks that get huge multiples and people are afraid to sell, because they think the stock will keep going forever. Nothing goes forever. One recent example could be Google. There could be lots of names. Think of the whole tech bubble. People were right that the Internet was going to be huge, but they had to pay a reasonable price for companies in the Internet, or they lost a lot of money. This is like when radio came out. RCA got a huge price in 1929, because people thought radio was a great growth industry. It took from 1929 to 1955 for RCA to get its price back. What is your bold prediction for the future? I think from an economic standpoint we will have a very sluggish economy for a while, because the typical business cycle can't play out. This is the typical economic cycle: The economy slows down, the Fed cuts rates, housing picks up and drives us out of recession. That can't happen this time, because of the overhang of housing. They are also tightening standards. Mortgage rates are up, and mortgage availability is also up. Housing will not recover until 2010. So 2009 will be a slow year in the economy. We have a global slowdown happening with our slowdown. My bold prediction is that we are going to slog through for a while, and it's not clear what kind of power the Fed has or the Administration has in fiscal policy to really stimulate the economy.

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We went into the recession with ridiculously high deficits, and more spending may not do it this time. A lot of very tricky crosscurrents, I would bet on a sluggish outlook for a while.

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FORBES ON OSTERWEIS Intelligent Investing with Steve Forbes

2008 Mutual Fund Survey The Honor Roll William Heuslein 09.15.08, 12:00 AM ET

Down-market standouts--and long-term investing stars.

Times like these drive home a fact that has formed the basis of our Honor Roll selection process since its 1973 debut: Capital preservation matters. As the saying goes, stock-picking genius is sometimes nothing more than leverage in a rising market. Far rarer are money managers who bull ahead in good times but also shrewdly navigate through bear markets without giving back their gains.

With our annual Honor Roll, FORBES strives to find the funds, and managers, who have proved they can grow--and preserve--assets across entire market cycles.

The 2008 Honor Roll class has a very familiar look, driving home the point that consistency of performance is a big part of our selection process. Six of the ten funds from last year's lineup make repeat appearances. Two funds return to the cast after an absence of several years: Columbia Value & Restructuring (formerly known as Excelsior Value & Restructuring) and Wasatch Core Growth. Two newcomers: Meridian Value and T. Rowe Price Small-Cap Value.

There were four dropouts. Value Line Emerging Opportunities, a 2007 rookie, just missed the cut by coming in eleventh in our ranking. The other three 2008 no-shows from last year's class didn't quite keep up with the competition during a tough year: Honor list veteran Third Avenue Value Fund, onetime member Perritt MicroCap Opportunities and the roughed-up Muhlenkamp Fund, which ended a seven-year stretch on the Honor Roll. Ronald Muhlenkamp owned a lot of Countrywide Financial and AIG.

Keeley Small Cap Value Fund tops our chart in 2008, pulling ahead of its fellow Honor Roll classmate out of Chicago, the Bruce Fund. Keeley was runner-up to Bruce the two previous years. John Keeley has a keen eye for restructuring plays and companies in transition and has done well recently with Walter Industries and Petrohawk Energy. Newer additions to his portfolio include Hill-Rom Holdings, which makes hospital beds, and pharmacy manager PharMerica.

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Robert Bruce and his son Jeffrey direct an eclectic portfolio that includes shares of ATP Oil & Gas, Arena Resources and Amerco, U.S. Treasury Strips and convertible bonds. In troubled times it's what they consider a solid defense.

Mairs & Power Growth shows up for the fourth year in a row. Its long-term record is even better. This quintessential Honor Roll fund, hailing from Minnesota, has been a class member in 10 of the past 12 years. Strong suits: midwestern stalwarts like Medtronic, 3M and General Mills.

What distinguishes the Honor Roll from many other rankings is its emphasis on consistency. To rank funds, we gauge how well, or poorly, they've fared over four market cycles. The starting point for this latest survey is June 30, 1994. (The previous starting point was Jan. 31, 1994; the current market downturn, dating from October 2007, shifts the beginning point forward.) The end point is July 31, 2008. Honor Roll funds must earn a B grade or better in down markets and a C or better in up markets. Capital preservation is key here. Eight of our ten funds score either an A or an A+ for their bear market showings.

Honor Roll managers must have at least six years on the job; this eliminates the risk that a ranking will mask coattailing on a predecessor's record. We also require that candidates have diversified portfolios. This shuts out from consideration the many specialized funds that can do outstandingly well for a stretch, only to give back a lot of their gains when a commodity or a sector turns against them. Among the exceptional sector funds stricken from the candidate list are CGM Realty and Vanguard Health Care. Funds must also currently be open to new investors. That eliminates T. Rowe Price Mid-Cap Growth and FPA Capital, which are former Honor Roll members.

We calculate hypothetical investment results in dollar terms after factoring in any sales commissions and taxes paid by an upper-income investor who put $10,000 to work on June 30, 1994. We factor in the tax on distributed capital gains but not on unrealized appreciation of fund shares. By the end of July investors would, at minimum, have nearly quintupled their money in any of these ten Honor Roll funds. The list-leading Keeley Small Cap Value Fund would have turned that $10,000 investment into $73,900. The same money in the Vanguard 500 Index Fund would have grown to only $33,022.

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Honor Roll Winners PERFORMANCE

UP DOWN

FUND/800 PHONE

YEARS ON HONOR ROLL*

MAXIMUM CUMULATIVE LOSS1

LEAD MANAGER

AVERAGE ANNUAL TOTAL RETURN2

HYPOTHETICAL INVESTMENT RESULTS3

MAXIMUM SALES CHARGE

EXPENSES PER $100

PORTFOLIO TURNOVER4

A A Keeley Small Cap Value / 533-5344

5 -24.8% John Keeley Jr

16.2% $73,900 4.50% $1.33 30%

A A+ Bruce / 872-7823

4 -25.8 Robert Bruce

16.4 67,357 no load 0.78 15

B A Meridian Value / 446-6662

-- -22.6 multiple managers

16.0 65,758 no load 1.08 75

A B

Columbia Value & Restructuring-A / 345-6611

-- -34.6 multiple managers

14.6 60,162 5.75 1.02 11

C A

Mairs & Power Growth / 304-7404

4 -20.1 William Frels

13.8 54,405 no load 0.68 4

C A Wasatch Core Growth / 551-1700

-- -38.4 multiple managers

14.2 51,422 no load 1.18 54

B A+

Stratton Small-Cap Value / 634-5726

4 -25.8 Gerald Van Horn

12.7 49,158 no load 0.87 19

B A+ Delafield / 221-3079

4 -29.7 multiple managers

13.3 47,964 no load 1.28 a 61

C A+

T Rowe Price Small-Cap Value / 638-5660

-- -27.9 Preston Athey

13.1 47,226 no load 0.81 14

B B Osterweis / 866-236-0050

5 -26.0 John Osterweis

12.7 46,015 no load 1.18 56

1 - Greatest loss sustained during any unbroken string of monthly losses since 6/30/94.

2 - Total return (average annual) for domestic funds; from 6/30/94 to 7/31/08 before deducting loads and taxes.

3 - Hypothetical value on 7/31/08 of $10,000 invested 6/30/94, after load and taxes. Assumptions: Capital gains and income distributions are taxed at the highest marginal rate in effect at the time. Loads applied at 7/31/08 rate.

4 - Lesser of security sales or purchases divided by average net assets.

a - Net of absorption by fund sponsor.

* - Consecutive

Sources: Forbes; Lipper; Morningstar; CCH

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On The Cover/Top Stories Horse Sense James M. Clash, 03.14.05

Using free cash flow to find good stocks, John Osterweis has quietly turned in a stellar record for his fund--16.2% average annual return over the last decade. It sure beats net income.

When not managing money, John Osterweis likes to ride his horse, Rush Creek Jax, across the rolling western landscape. But the competitive Osterweis wants more than merely to clip-clop along through nature. Osterweis, his steed and another human--often Osterweis' son Max--practice a peculiar sport called Ride 'N' Tie, a cross-country race where each person alternates running and riding. This forces Osterweis, the captain of the threesome, to strategize on who does what when in order to get all eight legs across the finish line first in a race against similar teams (34 miles in five hours would be good). Osterweis, 62, likes to joke that of the stocks in his portfolio, "some gallop, some trot." But the combination has given the Osterweis Fund an impressive average annual return of 16.2% over the last ten years. That is 4.7 points above the S&P 500. A $100,000 investment in Osterweis would have returned $152,000 more than a comparable stake in the index. His key metric when evaluating stocks is free cash flow. That quantity is cash flow from operations (the first sum on a company's flow-of-funds page) minus capital spending (which typically appears just below on that page). The owner of a private company wants free cash even more than he wants net income. Free cash gives him the leeway to plow capital into expansion, pay dividends, buy back stock or whittle down debt. For the shareowner of a public company, free cash has the additional virtue of being less subject to accounting trickery than good old net income. As the saying goes: Earnings are an opinion, cash is a fact. Performance of the $160 million Osterweis Fund has been equally good in up and down markets, getting a solid B grade from FORBES in both categories and winning the fund a spot on our Honor Roll (see Sept. 20, 2004). The fund boasts a commendable meshing of reasonable expenses (no sales load, $1.36 per $100 of assets in fees) and great risk-adjusted returns. Insightful financial analysis is this fund manager's strong suit. Osterweis, who runs his fund from San Francisco, earned an M.B.A. from Stanford in 1969, then spent 14 years as a sell-side analyst covering paper and forest products stocks at firms including J. Barth and E.F. Hutton. In 1983, with an investment of $30 million, he founded Osterweis Capital Management to run high net worth, endowment and foundation money. In 1993 he added the retail

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stock fund. Today Osterweis Capital manages $2.4 billion and has 37 employees. The fund is a fairly concentrated portfolio with only 30 stocks, and it doesn't turn over much--58% annually compared with the average stock fund's 117%. This minimizes the trading commissions and potential tax burdens to fund shareholders. Size is not a criterion: Companies in the portfolio range in market capitalization from United Online at $625 million to Vodafone at $180 billion. Like other value managers, Osterweis screens for the usual suspects when seeking out beaten-down nuggets: a price low in relation to earnings and/or book value. The prospect of accelerating growth once any problems, perceived or real, are corrected, is a factor: Regal Entertainment, an Osterweis holding and the largest operator of movie theaters in the U.S., came out of bankruptcy in 2002 and is selling at just 13 times free cash flow. The value-oriented Osterweis' portfolio averages 15 times trailing free cash flow versus 38 for the S&P 400. If an outfit is younger, Osterweis will attempt to segregate the capital spending into two parts, one for maintenance, the other for expansion. He subtracts only the maintenance cap-ex in his free cash flow calculation. UnitedGlobalcom, for example, had a total of $450 million in capital spending last year, but Osterweis counted only $160 million, the amount he estimates to be the maintenance part of it. Thus free cash flows for Laidlaw International, the old-line bus transportation company, and Vodafone, the youngish cellular company, are calculated differently. But their price/free cash multiples are the same: 13. "Vodafone shouldn't be penalized for putting a higher amount of free cash into the growth of its business than Laidlaw," reasons Osterweis. Osterweis now sees value emerging in media stocks--older companies that are big free-cash generators. In July Dex Media, the moneylosing publisher of yellow and white page directories for Qwest, the Baby Bell, was selling at just six times free cash flow. Reason: Popular thinking held that the Internet would render such publications obsolete. While Osterweis concedes that phone directories will be limited to a meager 1% to 2% annual revenue growth, he feels their intensely local focus should keep them useful for ages. Dex also is interesting to Osterweis because it is highly leveraged and is using its ample free cash flow, $500 million annually, to pay down debt: 8% in 2004, 9% projected this year and 11% in 2006. The balance sheet bolstering, he wagers, will prompt a jump in stock price. Thus far Osterweis has been right. He bought Dex at $19. Currently, at seven times free cash flow, it trades at $24 and occupies 3% of the portfolio. Radio stocks soared in the late 1990s as dot-coms boosted ad spending, at one

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time accounting for more than 20% of all radio revenue. When that torrent ebbed, radio stocks did, too. Now, amid an improving economy, Osterweis sees some bargains. Citadel Broadcasting and Westwood One, with price/free cash ratios of 15 and 21, are two companies he owns. By traditional price/earnings multiples they are overvalued. Not by Osterweis' cash metric. But the younger satellite radio stocks, which Osterweis admits will be strong in the future, aren't of interest yet. "There are too many expectations built into the prices of Sirius and XM Satellite," he says, "just too much uncertainty." He is more certain about Vodafone's prospects. He bought in at $19 in September 2003 for ten times free cash flow. Since, it has jumped to $26. Regardless, Osterweis still favors the world's largest wireless service provider; Vodafone occupies 2.3% of his fund. The company owns a 44.5% stake in Verizon Wireless, the biggest U.S. cell provider. Osterweis believes the American cell market will continue to grow and that Verizon will capture more of it. UnitedGlobalcom, another of the younger companies, is the dominant cable operator in Europe and Chile. It emerged from Chapter 11 in 2003 with a strong balance sheet and good growth prospects. Osterweis bought in at $7.50, not so much on free cash flow, which was nothing special at the time, as on the projected growth of that flow. He was right: Free cash surged 470% in 2004. Since he got in, UnitedGlobalcom stock is up one-third with a recent price of $10 and makes up 3.3% of Osterweis' portfolio. He has bought more based on his continuing free cash flow growth projections: a 120% increase this year, 65% in 2006 and 50% in 2007. While Osterweis' method works most of the time, it isn't foolproof. Last July, after Marsh & McLennan mutual fund unit Putnam Investments was fined for improper trading by New York Attorney General Eliot Spitzer, Osterweis got interested. Marsh, then down 55% from its price before the scandal, was trading at just 14 times free cash flow, and Osterweis thought Putnam's troubles were behind it. So he bought at $45. Then, a few months later, Spitzer went after Marsh's insurance business on a bigger charge--bid-rigging of contracts. Says Osterweis: "The cloud may permanently impair Marsh's core business, and we aren't interested in permanently impaired businesses." Osterweis jettisoned his shares at $38; today Marsh sells at $32. Similarly, the recent troubles of pharmaceutical giant Merck over the recall of arthritis drug Vioxx has kept Osterweis on the sidelines. He says the painkiller's safety problems are bad enough (it allegedly poses cardiac risks). But then there are the accusations that Merck knew about the drug's health risks and stayed mum about them.

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You can buy the Osterweis Fund direct or through Charles Schwab's fund supermarket, although you won't find it on Schwab's "Select" list. To get on that, a fund must fork over 40 cents per $100 of assets, and Osterweis won't jack up his expense ratio just for the listing. "You'll have to ask for my fund by my name," jokes Osterweis. He also runs another smallish ($57 million) retail fund, Osterweis Strategic Income, for investors interested in bonds.

Show Me Your Cash

These stocks may not be bargains on a P/E basis, but they are based on price/free cash flow, the metric John Osterweis uses.

Company Recent Price P/E

Price/Free Cash Flow

Citadel Broadcasting $14.00 50 15¹

Dex Media 23.82 NM 7¹

Laidlaw International 22.00 34 13¹

Toys "R" Us 22.07 32 9¹

UnitedGlobalcom 9.85 NM 23²,³

Vodafone 26.00 NM 13²

Westwood One 24.55 25 21¹

¹Based on operating cash flow less all capital expenditures. ²Based on operating cash flow less maintenance capital expenditures. ³2005 estimate. NM: Not meaningful. Sources: Osterweis Capital Management; Forbes.

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THE OSTERWEIS INTERVIEW Intelligent Investing with Steve Forbes

00:08 Steve: Corporate Reputations Hello, I’m Steve Forbes. It's a privilege and pleasure to introduce you to my guest, John Osterweis. John is the manager of the Osterweis Fund and a current member of the Forbes Honor Roll for mutual fund managers. John will discuss long-term investing in chaotic markets. My conversation with John Osterweis follows, but first … Corporate America has seen its image tarnished over the past several months. Reeling from the worst markets since the 1930s, its culture of risk and innovation has been pilloried from within and without. But we need to understand that while some companies have failed, entrepreneurial capitalism has not. True, many of the wounds suffered by corporate America were self-inflicted. Mortgage lending standards were trashed. Hundreds of billions of dollars of junk mortgages were made. These subprime loans were packaged and spread globally. Not all these loans went bad, but they were enough to cause the near collapse of the financial system. It's time for responsible firms and politicians to do what must be done to restore confidence. For markets to work efficiently again, there must be cuts in individual and business tax rates. There must also be regulatory changes such as getting rid of mark to market accounting. Then, banks will start lending again. Here in the U.S. the biggest source of capital is the mortgage market for startups. People expand their loans or take out new loans to start businesses. The vibrancy of our economy depends on these startups, and their innovations. Microsoft and Apple both started during the 1970s, another period of economic malaise. But you'd be hard pressed to find two firms that better represent the promise of capitalism. We can't expect corporate America’s reputation to be redeemed overnight. But if we make it easier for the next generation of risk-takers to get their chance, America’s economy will once again shine. And the big firms will shape up or ship out. In a moment, my conversation with John Osterweis… [02:12] Go Anywhere Fund STEVE FORBES: John, thank you for joining us. First of all, if you could explain your unusual investment philosophy. You're not constrained by size of

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companies. You call yourself a value investor. But you have a little different twist to it. Could you quickly explain how you approach this world? JOHN OSTERWEIS: Sure. We really look at the stock market as a single asset class. And so, we try not to be constrained by either size of company or the traditional value versus growth paradigm. What we try to do instead is identify specific companies that maybe trading is of value stocks because they're troubled. They've disappointed, or whatever, but where there is some kind of catalyst that will get the company back on track and actually growing again. And so, the trick for us is to try to find that inflection point between value and growth. And so, we were buying value cheap. And then hopefully, the company turns the corner, turns back into a growth stock, and then the value goes up, as well. STEVE FORBES: So, what do you look for in how to favor stocks? How do you know what is the inflection point? Do you have to see a year, two years, where there is growth in parts of the company? Or how do you know when to go into a stock like that so that it just doesn't mean low value forever? JOHN OSTERWEIS: No, which they can. There are a lot of different ways this can happen. One is a company could emerge from bankruptcy with new management, a cleaned-up balance sheet, and all of a sudden instead of being troubled, it's ready to go again. STEVE FORBES: For example? JOHN OSTERWEIS: We bought Regal Cinemas out of bankruptcy. Not out of bankruptcy, but as it emerged from bankruptcy. As you may recall, a few years ago, the movie theater chains all over expanded as they went from multiplex to megaplex. And about three quarters of the movie-theater chains in this country went bankrupt as a result. [Phillip] Anschutz got control of Regal in bankruptcy. As the company came out of bankruptcy, it had a decent balance sheet again and a very savvy management team. And we knew there would be no more over expansion. So, it became a very interesting stock for us. Another way you can get at it is what we call "inside-out growth," where a company may have a dominant business that does very poorly. But it may have a smaller business within the company that’s growing and doing very well. And at a certain point, the growing business becomes the dominant business. And if you can catch that inflection point, the results can be extraordinary. So, to give you an example, we bought Toys “R” Us a number of years ago. Everybody knew the toy business was in trouble. What they didn't see was that International Toys and Babies “R” Us were both growing 15 to 20 percent a year. And we felt we were within two or maybe three quarters of when those growth businesses would become the dominant businesses. And Wall Street was taken

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completely by surprise. Because all they had seen were the domestic toy business doing worse and worse every year. [05:54] King Cashflow STEVE FORBES: Now, what are the so-called metrics that you look for? It's obviously not earnings per share. You don't seem to have been caught up in EBITA. What's the key thing that you look for? JOHN OSTERWEIS: Well, the key metric is free cash flow. STEVE FORBES: Which you define as? JOHN OSTERWEIS: As earnings after tax, add-back depreciation, subtract out maintenance CAPEX. And then if we want to get really strict if we're looking at a very leveraged company, we also subtract out required debt service, principal repayment. Because one of the big traps in looking at just free cash flow, if you're dealing with a leveraged company, is that that free cash really isn't free. It must go to debt repayment. STEVE FORBES: Otherwise, you might do as the New York Times did with Mr. [Carlos] Slim. JOHN OSTERWEIS: Exactly, or worse. Or worse. STEVE FORBES: And do you also like to look at capital adequacy spending? How do you size that up if a company is doing right or doing too much or too little? JOHN OSTERWEIS: We look at it. And we judge it we try to figure out what maintenance CAPEX is, and then look at growth CAPEX on top of that. STEVE FORBES: And do you feel that free cash flow is better than earnings precisely because cash is cash and not numbers that are rather elastic? JOHN OSTERWEIS: Rather elastic and negotiable. [07:27] The Art of Holding STEVE FORBES: Now, when you hold the company, unlike some other investors, you just don't wait for a quick turn. Sometimes, you hold these things for awhile. How do you know how to hold onto these things? How long? JOHN OSTERWEIS: How long? Well, that's an art. If it's a company that's moved from being troubled to growing, it can be very difficult. Because you're holding it during the growth period. Obviously, valuation is going up. So, you're

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beginning to take on valuation risk. And it's an art to figure out when the valuation gets ahead of the growth prospects. And so, that's one thing we look at. Of course, if the fundamentals start to disappoint, we'll sell the stock. STEVE FORBES: So, how do you know? Can you give us a couple of examples of stocks where you felt, "Hey, the price is getting ahead of the turnaround in operations, or the growth in operations?" JOHN OSTERWEIS: One that we were very successful with was Forest Labs, which was a specialty pharma company. We bought the stock after the company had disappointed investors by inadvertently stuffing their distribution channels with product. When management realized what they had done, they immediately shut down their factory and said, "We won't ship anymore product until the distribution channels are cleared out." Wall Street panicked, sold the stock down, had all sorts of bad names to call management. We looked at them and said, "Look. These guys made an honest mistake. They caused something to happen. They now have put in the fix, which is to stop shipping product. All they sell are pills. When the inventories get down to the requisite level, they'll start the factory up. And the company will be off and running again." So, that was the base case. The upside came when they in-licensed a drug that competed with Prozac, and was a drug that in Europe, had up to 40 percent market share in some markets. We thought that drug might double the size of the company. It ended up probably quintupling the size of the company. So, there was a period of years where Forest Labs was the fastest-growing specialty pharma company at least in the United States. And the stock got up to a pretty hefty multiple. I recall it may have been about 40 times earnings. At that point, we said, "Hey, wait a minute. It's 40 times earnings. It's now a one-product company, essentially. We're out of here." [10:30] Roy Neuberger STEVE FORBES: Now, you knew Roy Neuberger? Or Neuberger-Berman? JOHN OSTERWEIS: Right. STEVE FORBES: And one of the things about Roy Neuberger was, he just loved to trade. What did you learn from that, both how he picked stocks and why he just would no, he didn't churn. He just loved to go in and out, in and out, in and out. JOHN OSTERWEIS: He loved to trade. He was an inveterate tape reader. And he was a great trader. But his instincts, I'm not a trader. I'm a long-term investor. But his instincts of buying really good, solid companies when they get

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hit, and selling them when they go up, if you use a slightly different time frame, is the same process we use. We're looking for good companies that are out of favor selling cheap when they move back up. We use a much longer time period. But it's the same discipline. STEVE FORBES: So, his approach was not dependent on patterns always repeating themselves? JOHN OSTERWEIS: In some cases, these would be patterns that would repeat over and over again. I once watched him double his money in free trades in a very sleepy company called Crown Zellerbach, which was probably the sleepiest of the Forest products companies. STEVE FORBES: So, he knew in a certain range of buy and then sell? JOHN OSTERWEIS: Exactly. STEVE FORBES: And then buy and sell? JOHN OSTERWEIS: Buy and sell. He would just go back and forth. [11:55] Sober Banks STEVE FORBES: Now, why do you think this economic cycle is different from anything any of us have seen in our lifetimes? You've seen a lot. JOHN OSTERWEIS: I've seen a lot. Nothing like this. And I think the fundamental difference this time is that there is a systemic deleveraging that's going on. If you think about what banks were 20 or 30 years ago, there were companies that had a reasonable amount of leverage, maybe ten times. They made loans, kept the loans on their books and made a spread income. If you think about what banks were over the last 20 years, they were companies that levered up probably 20 to one. They originated loans, packaged them, sold them as securities, off-loaded the risk onto somebody else, maybe kept a little bit of residual risk on their own balance sheet. That game is over. The banks are going back to a much more sober level of leverage. Same for the brokerage business, same for a lot of corporations. STEVE FORBES: And some of those firms, it's 30 to one. JOHN OSTERWEIS: Was 30 to one in the brokers. And the brokers are either now parts of banks or they have become bank-holding companies themselves. So, the days of 30-to-one leverage are finished. So, it would be just a sector issue if it were anybody other than the banks. The fact that it's the banks that are

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deleveraging means that we have a massive credit contraction that will be with us for some time. STEVE FORBES: By some time, how long? JOHN OSTERWEIS: Multiple years. STEVE FORBES: Multiple years? JOHN OSTERWEIS: I think its multiple years. Because the other problem is, they've got so many bad loans on their books that it's questionable as to whether the banks have any real equity left. There are people who have referred to these banks as the living dead. STEVE FORBES: Well, in Japan, they had the word called "zombie." JOHN OSTERWEIS: Zombie, yeah. [14:02] Advice For Obama STEVE FORBES: But with the banks now, is there anything that the new President can do to help out? Or is this just something we just have to live with until it gets over? JOHN OSTERWEIS: Well, I think the government clearly has to play a role in preserving the banking system, which means they either have to continue to put funds into the banks or they have to do the good-bank/bad-bank separation. Or they have to buy assets. And I think to just let this run its course without government intervention would be a disaster. STEVE FORBES: Which approach do you think would be the most fruitful? There's now talk of creating an equivalent of the old resolution trust corporation entity or entities that would take off the bad assets and isolate them, so the system can start to function again. JOHN OSTERWEIS: That may be the best course. Because one of the things that worries me is, we're early in the credit cycle. So, we've started to see the problems in subprime, Alt-A, the home residential mortgage business. You're just about to see the problems in commercial real estate. We've begun to see problems in credit-card loans and auto loans. But we haven't seen a wave of corporate defaults. So, I think there's a lot of credit pain left to go, which means that the banks are going to face continued write-downs for some time. STEVE FORBES: Now, just take commercial real estate. Unlike past cycles, we don't have a lot of empty buildings out there in most parts of the country, unlike

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houses. And so what's unique about this crisis? Is it the capitalization was all wrong, or what? Why are they in trouble now? JOHN OSTERWEIS: Well, I'm assuming that a number of retail chains and individual retail stores will go under. And that will leave mall developers high in dry, in many cases. And so, to the extent that they're over-leveraged or heavily leveraged, they're going to be in trouble. I don't know about office buildings. But I would suspect we're going to start to see significant increase in office vacancies as company after company downsizes. [16:40] Cautious Buys STEVE FORBES: Now, in an environment like this, you said you're not fully invested. How much are you in the market? Do you think even though the economy has, still, troubles ahead, the financial sector still has got to do a lot of shrinkage in terms of leverage, are stocks cheap? Have the markets already taken account of a lot of this? Or is this a time to still have a lot of cash on the side? JOHN OSTERWEIS: I think it's a time to be cautious. Because, I mean, the problems for the financials are obvious. But we clearly don't know what the bottom is for the financials. And it may be that by the time the government gets through supporting these companies, there's not much equity left for the current shareholder. So, the current shareholders could still be quite deluded. The other thing we haven't talked about is the consumer is going to de-leverage. Or said another way, the savings rate's going up, which means the spending rate is going down. And since the consumer is two-thirds of the economy, it seems to me that any predictions about what the economy is going to do are pretty much speculation at this point. STEVE FORBES: So, what will make you buy an issue in this market? There seems like everything's a bargain now. JOHN OSTERWEIS: I don't think everything's quite a bargain. I think there are some stocks that are clear bargains, where the earnings are relatively immune from the cyclical pressures. STEVE FORBES: Do you have a couple quick examples? JOHN OSTERWEIS: Yeah. We bought a utility about a month ago, couple months ago, where there was forced selling because of a couple of hedge funds that needed to liquidate. We were able to buy this utility at about point-six times book with a four and a half percent yield and a 35 percent payout. With that low payout, our assumption was that over the next few years, book would continue to grow. And at some point, a well run utility ought to sell at one times book. Now,

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if you do the math, it implied that this is a stock that could double. And meanwhile, you got paid a four and a half percent yield. STEVE FORBES: Which stock was that? JOHN OSTERWEIS: This is a company that's now called NV Energy, Nevada Utility. STEVE FORBES: Right, right. Despite Las Vegas. JOHN OSTERWEIS: Despite. Yeah and we said even if Las Vegas has a really tough time, this company's still going to be earning plenty of money. STEVE FORBES: Now, in terms of investing, you value investing. You say you are in short-term corporates. Can you explain the unique phenomenon there, that we probably have never seen before? Even at a time when treasuries are yielding virtually zero, you have almost the exact opposite on the corporate side. JOHN OSTERWEIS: Yes. What's happened in short-term corporates is fascinating. In the fourth quarter of last year, there were a lot of forced liquidations. And it is far cheaper to sell a six-month piece of paper or a three-month piece of paper or a one-year piece of paper by taking a couple point hit, than it is to try to sell ten and 20-year paper where you might have to take a ten-point hit. So, as a result of forced liquidations, we were seeing short-term corporate bonds, that is a year or less, trading at 10, 11, 12 percent. The extreme pressure's off. But they're still trading at 8, 9, in many cases. And our caveat is that the company must have cash on the balance sheet in order to pay us off. Because we don't want to take refinancing risk. So, if the cash is there, the company's cash flow positive, it's a short-term maturity. It's like stealing candy. [20:59] Sold Our Financials STEVE FORBES: Well, that leads to the question. What is the best financial lesson you've learned? JOHN OSTERWEIS: Well, probably the best financial lesson I learned was something you and I talked about, which is when somebody offers you a lot of money for something, it's probably a good idea to take it. The example we talked about was an Arabian knife I bought when I was a kid, golden-silver inlaid handles. I'd paid $4 for it and a famous art dealer came to our house one night. And I thought he might know the true value. He said he wasn't sure of the true value, but he would offer me $250 for this, at which point my parents blanched and I

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refused to accept the money. Because I thought he knew more than I did, and therefore he was going to get a bargain. When I ultimately sold the knife, I got $25 for it. STEVE FORBES: Well, that leads, in terms of what is true value, what made you leery of financials? As you know, a lot of so-called value investors, people who've had good long-term records a year or so ago, were looking at financials and saying, "Boy, they've been battered. They've been hit. There are bargains here." But you didn't. JOHN OSTERWEIS: No, we didn't. We basically sold all of our financials. And the reason was, we kept seeing either a change in political landscape, or we had no idea the depth of the troubles in these companies. And we said, "Since we can't know, we don't know what the risk is." And so, instead of saying this is cheap because it's 80 percent of book, we said, "We don't know what book is." And at the end of the day, nobody knew what book was. STEVE FORBES: So, looking at the world today, you're heavily in cash or short-term corporates. You don't see this thing turning around quickly. What do you think is the misplaced assumption today? What do you look out there and say, "Boy, people still don't get something?" JOHN OSTERWEIS: I think there's a tendency on the part of investors to think that nothing's changed. And set in a more technical term, there's this concept of mean reversion, or reversion to the mean. And the theory that stocks are cheap relative to book or relative to this or relative to that, they're going to go back to some mean valuation. I think what you don't know is what P/Es will be going forward. I mean, if you take the financials, they are no longer growth stocks. They were growth stocks for 20 years. But they're not growth stocks now. And what that means is, that the P/Es, or the price to book that you thought represented the mean, is wrong. You have to go back to a 50-year mean or a 60 or a 70-year mean. And people don't do that. STEVE FORBES: So, we're still stuck in the patterns of the last few decades? JOHN OSTERWEIS: Yeah. [24:28] A Long Recession STEVE FORBES: So, what is your bold prediction for the future? JOHN OSTERWEIS: My bold prediction is that this is going to be a very lengthy recession. It's not going to turn around soon. And the recovery is going to be relatively mild compared to normal recoveries. Because housing, at least for the

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time being, cannot be the engine that drives us out. It's hard to see what the engine that's going to drive us out of recession is. STEVE FORBES: So, you don't see a new, well not new, but innovations coming along, giant versions of iPods and the like that might gin up this economy? JOHN OSTERWEIS: That might do it. Something in alternative energy might do it. I mean, it's not bleak forever. But I would say near term, the risks are to the downside as opposed to missing some big upside. STEVE FORBES: And finally, we've chatted about this before. Winston Churchill liked to say that if you want to keep your brain agile, you should have a hobby that totally absorbs your attention-- that gets your mind off the problems at hand. He said the mind, the brain, is not like a switch that you can turn on or off. If you're churning something, you will continue to churn something in the mind. So, to refresh it, you've got to focus totally on something else. You have an unusual hobby. Churchill had a hobby. It was painting. You have an unusual one, and you're still alive. JOHN OSTERWEIS: I'm still alive. The hobby is an odd sport called Ride-n-Tie, which is an endurance race where each team consists of two runners and a horse. The runners alternate riding and running over pretty tough terrain for 25 to 35 miles. And that tends to focus the brain. STEVE FORBES: Oh, wow. And what does your insurer say? JOHN OSTERWEIS: I haven't asked him. STEVE FORBES: John, thank you very much. JOHN OSTERWEIS: Thank you, Steve. A pleasure.