Howard Marks

Investor Letters from Howard Marks

Below, I summarize my takeaways form the letters from Howard Marks. I like his letters because they’re detailed, full of passion, have a consistent clarity of thought, and most importantly, a clear ownership of biases. There’s a lot that I disagree with him, especially when his letters veer in to overall governance and general economics, but this hasn’t affected (or, so I think) my views on how valuable and effective his letters are. Some of the paragraphs in his letters show decades of experience in the thoughts behind them. And most importantly, for a novice like me, his letters are simple. Below, I summarize the letters that I have read. I have skipped the ones that are unrelated to investing (or, so I think) or the ones that didn’t contain any new lessons for me.

The Value of Predictions – 02/15/93

It’s hard to profit from forecasting because of the crescendo of negativism, low (and falling prices) and difficulty in predictions–all happening simultaneously, which makes it to hard to predict right. Not only that, you have to hold fast to an improbable non-consensus forecast while things likely move against you (assuming one is doing the right thing to begin with) to eventually profit from it. He makes another great point about top-down investing where someone assume A will happen, which means B for the economy, which in turn implies C for interest rates making sector D great for investment with E most likely to benefit. Now even if you are right 2/3rd of the times at every step, the eventually likelihood of stock E being the best company is only 13%.

Genius Isn’t Enough – 10/09/98

In almost a cryptic fashion (to me, must be obvious to him), Marks says that leverage should never be used to turn low spreads into wide ones, but only to take advantage of already-wide spreads.

Irrational Exuberance – 05/01/00

Discussing why stock market kept rising through five rate raises in 1999, Marks says that there are two reasons no one cared–(a) typically stocks dip where there’s competition from fixed income investments, and no one cared about rates going from 6.25% to 6.5% because people were expecting 20% from stocks, and (b) typically rising rates make it harder for people to buy homes/cars, and businesses to invest in capex etc, but if no one cared about the economy (because stocks always go up), it didn’t matter. All in all, rate rises work to slow down the stock market because in the end, people agree that it works.

Investment Miscellany – 11/16/00

Quoting Richard Bookstaber, Marks says that as good times keep going, market participants become more like each other, which means that the liquidity demanders hold pretty much the same assets to dispose when they eventually do need liquidity and at this point everything looks correlated.

There They Go Again – 05/06/05

In the mid-1980s institutional investors charged into real-estate but the tax reform in 1987 reduced demand for tax shelter purposes and economic slowdown of early 90s cooled demand further.

Capital Markets Line today is low and flat, which means that the prospective returns are among the lowest that we have seen and risk risk premia are the narrowest. Given this, what can one do? You can focus on specific niches and specific people, and hope not to “reach for return”.

It Is What It Is – 03/27/06
Marks says that a lot can be inferred simply by knowing what’s going on today (w/o predicting anything), and classifies the observations in 3 categories–economic cycle, market performance and most importantly, behavior of people around. Further in the letter, Marks lists the following items–economy, outlook, lenders, capital markets, terms, interest rates, spreads, investor fear-factor, willingness of asset-owners to hold, paucity (or otherwise) of sellers, popularity of markets, exclusivity of funds, recent performance, asset prices, prospective returns, whether aggressiveness and broad reach is in vogue (or, is it caution and selectivity).

Dare To Be Great – 09/07/06
The crowd is usually in broad agreement — and wrong — at the extremes.

The New Paradigm – 10/19/06
After 2002, when return expectations from equities cooled, people started looking at alternative investments. Per JPMorgan, this world amounts to $3T vs. bond and equity world of $60T, and thus people are under-estimating the amount of capital that can be put to work in alternative investments. In discussing buyout funds, Marks cited a study done by the FT that showed that the total unspent capital of the buyout funds stood at $297 bn, which if deployed could buy $1.5T of companies in the years ahead. In discussing CDOs, Marks cited Grant’s, who in turn, quotes Michael Lewitt of Harch Capital – “… having a credit market priced on a non-credit basis – meaning priced off quantitative and arbitrage bases, and not on credit fundamentals – is not a healthy thing.”

The Race to the Bottom – 02/14/07
Marks cites FT which pointed out that while in 2002, 1/10th of capital committed to PE funds were put to work within one year, in 2005, the corresponding portion was 30%. Marks says that the buyout funds raised 3x the capital that they raised in 2002, which implies that these funds deployed capital 9x as fast as before.

Everyone Knows – 04/26/07
Marks recalls the first time he met with Michael Milken. Marks recalls his first meeting with Milken whose logic was–(a) if you buy AA or AAA bonds, there’s only one way for them to go: down, but if you buy B-rated bonds and they survive, the surprises will be on the upside, (b) because investment process is prejudiced against HY bonds, their yields more than compensate for the risk, (c) the main goal is to weed out bonds that may default, and because some will anyway, diversification is critical.

Most of the return from a long-term bonds comes not from the promised interest payments or the principal, but the interest earned on the interest, and this fact reveals how variable returns from a fixed income security can be.

It’s All Good – 07/16/07
Market cycles such as credit cycles fluctuate much more than economic and business cycles, due largely to the volatile cycle in investor psychology.

Investors accept financial inventions only in bullish times. This is related to a willing suspension of disbelief which springs from the glee over how well things are going.

No Different This Time – Lessons of ’07 – 12/17/07
Mortgage broker makes a loan, which is sold to an investment bank, which packages it and sells it to a CDO originator, who finances this by raising debt from institutional investors and is facilitated by a placement agent or an investment bank. So, even if the original loan was priced reasonably in the beginning, what are the chances that the CDO debt was priced fairly in the end?

Now What? – 01/10/08
This is one the best accounts I have read of how the credit crisis spiralled. I have NOT summarized it below because it is important to read the letter in its entirety.

In 1990 and 2002, Oaktree earned net IRRs in 30s/40s without leverage, which shouldn’t happen in a normal market. Marks says that this happens because they were aided by people who were selling things far below net worth, and they did that because of a fire sale process.

Default in HY bonds had averaged 4.2% over 20+ years (as of ’08), and reached double-digits in ’90-91 and ’01-02. LBOs of 80s cratered in 90s, and providers of capital cut back their lending in the 90s, and thus, buyouts didn’t contribute to the ’02 debt crisis. Given the amount of HY debt issued recently, even a moderate rate of default will contribute to the perception of a credit meltdown, though potential defaults will be delayed because of issuer-friendly debt.

Whodunit – 02/20/08

There’s something fundamentally wrong with the process when there’s no party to a transaction who wants the appraisal to be conservative (regarding the pricing of homes).

On risk management, one has to trust the same person who made the investment. If you trust someone to assemble portfolios, they’re the ones who can best judge how things will behave in combination. Otherwise, people who know less about the underlying investments end up second guessing people who know more.

Doesn’t Make Sense – 07/31/08

Rating agencies are slow to adjust ratings, but when they do, they usually overshoot.

What Worries Me – 08/28/08

Marks talks about the shorthand that every $1 (/barrel) change in the price of oil means a transfer of $1T from the oil-consuming nations to oil-producing nation over the next 100 years.

Nobody Knows – 09/19/08

Marks says that no knows how the financial crisis will eventually pan out. Far more importantly, he adds that his conviction that this is true frees him from having to methodically assess strengths and weaknesses of the economies and institutions, and permits him to focus on strategic realities. He says that market is taking its lead from the yesterday’s markets, so it is unclear whether the market knows.

Volatility + Leverage = Dynamite – 02/17/08

This was an on outstanding letter, and led to this thought on my part–even though certain investors (including me) frown upon volatility as a measure of risk, it is actually a very important dimension of risk when leverage is employed. Now, back to the letter. Marks says that it can be wise to use leverage to take advantage of high offered return (/excessive risk premia), but it is unwise to use leverage to turn low offered return into high ones (as was done in ’03 – 07). He also adds that leverage achieved with secured capital isn’t nearly as risky as situations when one is subject to margin call, or can’t bar the door against capital withdrawals.

Touchstones – 11/10/09

Popularization of new investment vehicles is possible only in rising markets, with their suspension of skepticism, easy access to money, and dearth of trying moments.

A quote by an English economist Aurthur C. Pigou – “The error of optimism dies in a crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant.”

Tell Me I’m Wrong – 02/22/10

On inflation – Rising prices can lead to demand-pull inflation by convincing people to stock up on goods to avoid higher prices later. People also start to borrow to invest in assets like land etc. with the belief that irrespective of the interest rate used to finance the purchase, the asset’s price would rise at a faster rate (epitome of inflationary thinking).

Warning Flags – 05/12/10

After the .com crash, interest rates kept low by the Fed, combined with 3-year decline in stocks since Depression reduced interest in traditional investments. As a result, investors focused on alternative investment vehicles such as MBS, infrastructure, real estate and so on. This, combined with the idea that risk has been vanquished by (a) Greenspan put, (b) risk diversification due to financial engineering, and (c) wall of liquidity coming from China and oil producers, led people to take on a ton of risk.

Skepticism calls for pessimism when optimism is excessive, but it also calls for optimism when pessimism is excessive. This is hard to follow, which is why when after the financial crisis, bonds were offering highest yields in 25 years, there were few buyers.

Worst of loans are made in the best of times. Because default rate in good times is at multi-year lows (25-year lows in 2007), it is very difficult for a average supplier of capital to maintain a high level of risk aversion and prudence, especially when this means ceding business to someone else.

Cash moving into loan market represents a greater willingness to hold more illiquid assets (my note: at least, this applies to the banks if not the investors).

Hemlines – 09/10/10

The question to ask in 1990s was not “What has been the normal performance of stocks?” (ala Stocks for the Long Run) but rather “What has been the normal performance of stocks if purchased when the avg. P/E is 33?”

By 2003, investors expected 6-7% returns from the stock market vs. 10-11% before, and people started looking at alternatives (PE, real estate, MBS etc.) for the next solution. Now, with the panic gone, no one feels that (s)he owns too few stocks, which is weird, as stocks have recovered only half of their 2007-09 losses. (Marks goes on to say that stocks look cheap at this stage and provides various statistics).

Open and Shut – 12/01/10

Why do securities fluctuate so wildly when profits oscillate moderately and GDP moves very little? Yes, financial leverage and operating leverage play their part, but the big reason is the fluctuations in psychology and the influence of this on the availability of capital. Most raging bull markets are helped by increased and often imprudent willingness to provide capital, whereas most collapses are preceded by refusal to finance certain companies or sectors.

The pain of 2008 crisis was short-lived and beyond the usual warning flags (CCC-issues, dividend recaps, cov-like, PIKs etc.), the following have been observed:

• issuance of 100-year bonds
• Issuance of 50-year bonds callable in 5 years
• TIPS at -0.55% plus inflation
• “drive-by” deals that give investors little time to study credit-worthiness and covenants

While yields on HY debt are above average, leverage is moderate and equity P/Es are below average, inadequate yields on Treasurys are driving bond investors to take more risk, and thus, absolute yields are low across fixed income instruments.

How Quickly They Forgot – 05/25/11

Signs of carefree investing behavior in 2007:

• Record issuance of HY debt
• High %age of CCC debt
• Unquestioned dividend recaps
• PIKs
• Increasingly large buyouts, at higher multiples, of increasingly cyclical companies
• Shrinking STTs
• Incorporation in places like Luxembourg, which is an uncertain bankruptcy environment

30-year norm of HY debt: 350 – 550 bps of STT is typical, and can go as low as 300. HY debt is important to keep an eye on as the spreads help facilitate quantification of risk. (My note: some investors also keep an eye on Excess spread ex-default, which has averaged 200 bps over time, and in Sept. 2014, with defaults at a low level, the excess spread ex-default was 350 bps).

What’s Behind the Downturn – 09/07/11

Markets usually do a good job of coping with one problem at a time, but when there’s a confluence of negative events, the markets can lose their cool.

Similarly, markets can also become captivated with simple themes such as “internet will change the world”, “equities are good” and “who needs bonds?”.

What Can We Do For You? – 01/10/12

This is a great letter and should be read over and over again in entirety. Below are some pieces that make sense even without the entire context:

We can act not on basis of what the future holds, but simply on the basis of what’s going on in the marketplace, such as listed below. “We may never know where we are going but we’d better know where we are.”

• STT of HY bonds
• Spreads between B and CCC bonds
• Yields and spreads of converts
• Price of distressed senior loans–60 or 90?
• S&P P/E
• Covenants on deals
• Presence of investor ebullience
• Popular and over-subscribed investment vehicles

We may have a view but we will never lean on our views so much that for the results to be good, our views have to be right.

Assessing Performance Records — A Case Study – 02/15/12

This is a great letter and should be read over and over again in entirety. The one sentence that stuck with me is : “In order to survive and have a chance to produce long-term performance, investors have to live up to their constituents’ expectations in the short run.” A very important part of investing as an agent, that is seldom discussed.

Deja Vu All Over Again – 03/19/12

Stocks appear to be valued fairly because of the following factors:

• Stocks haven’t returned anything for the past 12 years
• 30-year return on stocks have been lower than bonds
• S&P is below its 2000 highs despite earnings doubling since
• P/E in low double digits
• Equity allocation has been cut substantially in favor of bonds and alternative investments

It’s All a Big Mistake – 06/20/12

Efficient markets effectively theorize that market prices are set by a pricing czar who is (a) tireless, (b) aware of all the facts, (c) proficient at analysis and (d) thoroughly rational. This is not true for most investors.

Often times, investing is taking advantage of others’ mistakes, or as Bob O’Leary, part of Oaktree’s distressed debt puts it, “Our business is often an examination of flawed underwriting assumptions”. Distressed-debt investing’s biggest advantage is that it embodies an anti-error business model. So, it’s not that distressed debt investors do not make mistakes, just that their likelihood of doing so is greatly reduced do to the nature of their investment activity (counter-cyclical). Cycles are big sources of error and pro-cyclical behavior is one the biggest destroyers of capital.

For active investing to work and for the excess returns to exist, market participants, and collectively the market, has to be making mistakes.

Ditto – 01/07/13

In economics, investments and capital markets, a cycle is not best viewed as a progression of standards positive/negative events but rather as a chain reaction.

There are certain limits on extremes of sales and margin cycles, but no checks exist on swings of investor psychology, and these swings contribute more to major market movements than anything else, and don’t expect this to change.

Here’s an example of how an upswing in risk develops:

• When economic growth is slow/markets are weak, people worry more about losing money and disregard the risk of missing opportunities. (My note: Capital Preservation is the order of the day)
• Economy shows some signs of life (My note: Asset Valuation metrics are used to justify a certain minimum value)
• Continued positive economy and better earnings eventually convinces people that real recovery is underway (My note: Earnings Valuation metrics are used).
• People feel smarter and richer and positive sentiment takes hold. People who have been watching from the sidelines begin to worry about missing opportunities and less about risk of losing money. (My note: Relative Valuation becomes the metric du jour).
• Risk aversion evaporates and investors begin behaving more aggressively. People find it hard to imagine how losses ever could occur. (My note: Risk premium gets crimped, now that justifications on earnings power are too stretched to support valuation)
• Financial institutions rush to provide leverage and financing.
• Leveraged investors report big gains.
• Market begins to look like a perpetual motion machine. Everyone concludes that things could only get better.
• Last skeptic capitulates and the last potential buyer buys.

Somewhere in there, a macro trading decision (“China will support the world economy” / “Fed will support the markets” etc.) emerges, and when most investors get behind the idea, they all eventually turn out to be wrong.

On Risks and Returns as of Jan ’13: investors are not thinking bullish but acting bullish. These people are buying not because they want to, but because they feel that they have to.

Leverage in private-equity deals: Per Thomson Reuters, since 2008, PE firm put 42% of equity in large buyouts, but in the past 6 months, the %age has fallen to 33% (vs. 31% in 2006 and 30% in 2007). Per LCD, Debt/EBITDA for the past 6 months for large transactions are now at 5.5x (vs. 5.4x in 2006 and 6.2x in 2007).

High Yield Bonds Today – 02/21/13

HY bonds have a shorter duration than IG bonds of the same maturity, amply because of the higher coupon, and thus are less effected by an increase in interest rate. Another way to think about deciding between HY and IG is to think of the default rate of the HY bonds that would lead to the same performance as the IG bonds. As of Feb-13, HY bonds would have needed 9% default per Oaktree team (vs. avg. of 1.4% over the previous 30 years, and not even one instance of 9% default) to return the same yield as IG bonds.

The Outlook for Equities – 03/13/13

On Equity Risk Premium(s) –  it can be defined in at least 4 four different ways:

1. The historical excess of equity returns over RFR
2. The minimum incremental return that was demanded to shift away from RFRs
3. The minimum incremental return that people are demanding today
4. The margin by which equity returns will exceed RFR

Only #1 can be measured and #4 is the only one that matters. Everything else is just a bridge between #1 and #2. People often think of ERP like how STT is thought of when people think of HY bonds, but they have nothing in common, because with stocks there’s no contractual cash flow. To get some idea we can compare the earnings yield (1/avg. P/E ratio of 1/16 = 6.25%) to the RFR (avg. of 3%) to get an avg. ERP of 3.25% (my note: not sure why we are comparing earnings to cash bond yield and not adjusting the earnings with a payout ratio to get the dividend payout ratio to get on a cash/cash basis, but I guess the exercise if pretty crooked anyway).

On U.S. profits – per Warren Buffett, when people forget that corporate profits are unlikely to grow 6%+, they tend to get into trouble.

On equity valuation as of March 2013 – Equity mutual funds are seeing only modest inflows, though outflows have stopped. Stocks aren’t highly valued. Many institutions’ equity allocation is below the 50-year average, and no one’s rushing to move them up. In other words, attitude towards equities is of disinterest and apathy and thus, stocks can still move up.

The Role of Confidence – 08/05/13

It usually takes years to build confidence so as to reach a dangerous zenith but only weeks or months for it to collapse ala how air goes in the balloon slowly but goes out much faster.

Dare To Be Great II – 04/08/14

Another one of the articles that needs to be re-read several times, but the overall takeaway is that before managing money, one needs to formulate an explicit investing creed (what one believes in and what one is willing to ignore), and how successful investing is necessarily contrarian.

Risk Revisited – 09/03/14

Oaktree is aiming for 10% return and is bearing the following types of risk to achieve the return: credit, illiquidity (which retail money has a harder time making into, and this, appears relatively attractive), concentration, and leverage risk (which can tunr into a funding risk). Some of the strategies that Oaktree is employing include (a) Enhanced Income (3x leverage on senior loans), (b) Strategic Credit, © mezz Finance, (d) European Private Debt and (e) Real Estate Debt. Finally, economic and company fundamentals in the U.S. are fine, and while asset prices are full, they’re not at bubble levels. But when the capital markets are not demanding and risk aversion is low, something eventually goes wrong. My note: there’s a lot of discussion about how to categorize risks, which I didn’t find useful, but may be useful to others.

Liquidity – 03/25/15

The basic tenet is that an asset vehicle (fund, CLO, whatever) cannot be more liquid than its underlying assets.

This implies that for an asset manager, you need to consider a couple of things:

• Buy assets that can be held for a long time, even if price discovery ceases to take place
• Investment vehicle structure (leverage, client/manager relationship, performance expectations) should permit the long-term investing suggested in the bullet above.

Trading should be thought of as cost of doing business, not a source of returns.

Risk Revisited Again – 06/08/15

Oldest “new strategy” is Enhanced Income where Oaktree has 3-to-1 leverage on a portfolio of senior loans, where they look for the following when borrowing:

1. borrowing is for a term exceeding the duration of the underlying investments
2. without the threat of margin calls in case of price declines (no stats given)

 

It’s Not Easy – 09/09/15

Investment risk resides most where it is least perceived.

Many people tend to confuse between fundamental risk and investment risk. What has to be remembered is the defining role of price, and investment risk is determined largely between price of an asset and its intrinsic value.

Investors can usually keep their heads in the face of one negative, but when they face more than one risk simultaneously, they often lose their cool. (A related thought I had while reading this point and certain points around this bullet is that while people imagine confidently averaging down in a given stock at the time of their purchase, they are unable to do when the time comes because often a number of stocks go down at the same time, making them think that something fundamental has changed in the world).

Often people sell in such times, and emotional behavior is cloaked in intelligent-sounding rationalizations such as “sell down to sleeping level”. The only two valid reasons to sell are (a) fundamentals have changed, and (b) price has risen enough.