On 24 May 2023, Howard Marks spoke by video to a room of MBA students at INSEAD’s Fontainebleau campus outside Paris. Marks is a pioneer of distressed debt investing as an asset class and in 1995, he founded Oaktree Capital Management, where he is now Co-Chairman of a firm with over 1,000 employees globally and more than US$170 billion assets under management. Marks has written two books and is best known for his client memos published since 1990 (free to subscribe). He was interviewed by Roi Lipovetzky and Andras Galambos, students at INSEAD. This is part 1, of a 2-part series.
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Marks starts with two lessons from his investing career that started in 1969, over 50 years ago.
“Number one, we pretty much only learn from our failures, we don't learn much from our successes. And number two, it's very desirable to learn the lessons early in your career when you have time to correct your mistakes and when you don't have too much money to lose.”
Price is more important than quality
He gives the example from his early days when all the big banks and investment banks believed the so-called Nifty 50 companies in America were the best and the fastest-growing, and so good that nothing could ever go wrong and there was no price for their stocks that was too high. But he saw massive losses by investors after 1969, so what went wrong?
“Well, guess what, the prices were too high, and these stocks sold between 60 and 90 times earnings and five years later they sold between 6 and 9 times earnings, which is an easy way to lose 90% of your money. So, this came as quite a shock to everybody who had thought that these things were bulletproof.”
He switched from equities to start a convertible bond fund, also investing in high-yield bonds. And here is the first lesson which challenges some standard investing conventions. He moved away from investing in what were supposed to be the best companies:
“Now, I'm investing in the worst public companies in America, and I'm making money steadily and safely. So, this was really formative for me. What does it teach you? It's not what you buy, it's what you pay, that investing success doesn't consist of buying good things, but buying things well ... But if you buy things for less than their intrinsic value, you're probably on your way to a good outcome.”
Investor psychology drives market prices
He then talks about the importance of understanding investor psychology.
“The economy goes along. In a good year, it's up 3%, in a bad year, it's up 1%. Corporate profits increase. Sometimes they're up 10%, sometimes they're up 5%. The stock market fluctuates wildly. The element behind the fluctuations is not changes in the fundamentals, but changes in investor psychology, which are just wild. So, you better understand what psychology is embedded in the price of the asset you're thinking about buying. If you buy something that's the subject of great optimism, and if that optimism is embedded in the price, which it invariably will be since the optimism is widespread, then it's going to be hard to get a bargain ... the most important stuff is about psychology and understanding where you are in the cycle.”
Winning by not losing
Marks describes a surprising discussion with a pension fund client with another important lesson about thriving by surviving, not aiming for the top:
“And in the 14 years, he was never above the 27th percentile or below the 47th percentile. Where do you think you are for the whole period? Well, you might say 37th percentile on average. The answer is, for this particular fund, 4th percentile. How can that be? The answer is that in investing, most people eventually shoot themselves in the foot ... you can succeed by being a little bit above average consistently and by avoiding disasters.”
Marks says that anyone who argues you need to take risks to be in the top 5% of fund managers, and that means sometimes being in the bottom 5%, is taking the wrong approach. Clients don’t want the bad results and don’t demand the top results.
Superior investors need to think differently
Marks does not support contrarian investing for the sake of it, because sometimes, the consensus is right. But at some point over time, to be above average, an investor must think differently. Average active investors can be replaced by an index. Readily-available information about the present cannot hold the secret to superior results because everybody has it. A good investor needs to know something that others don't, or have a variant in perception or interpreting or understanding information.
He gives the example of General Motors bringing out a new Mustang, and investors buying the stock because it will be popular. But everyone knows the car is coming, so what is the superior information? Is there too much optimism in the share price? Thinking must be more nuanced but not simply for the sake of being different.
The incredible 40-year tailwind
Most investors did not realise how wonderful the period of 1980 to 2020 was for investing with decades of falling (and then ultra low) rates boosting asset prices. Marks gives a fascinating example of his own borrowing:
“I had a loan outstanding from the bank in 1980 and they sent me a slip of paper saying the interest rate is 22.25%. 40 years later in 2020, I was able to borrow at 2.25%. This 2,000 basis point (20%) decline of interest rates over those 40 years had a profound effect on investors and investing. When interest rates come down, the discounted present value of future cash flows goes up, that is to say assets become more valuable. Business is strong. Relatively few people default or go bankrupt. Borrowing becomes cheaper so that leverage strategies become more profitable than one expected. All these good things happen in a declining interest rate environment.”
He concedes the low rates were bad for savers but the US Federal Reserve had a long history of bailing out the markets when required, and lower rates made it easier for company management and asset holders. It was a wonderful environment for buyouts and private equity because lower borrowing costs would often rescue bad transactions (in otherwise zombie companies). Never confuse brains with a bull market.
Equity returns from fixed interest
Times have changed since 2021. We now know that easy monetary policy from central banks produces inflation and central banks realise they can't be accommodative all the time and they can't engage in continuous stimulus.
Rates are not going back to where they were. Marks believes the Fed Funds rate is more likely to be between 2% and 4% in future, rather than zero and 2%, making it a better time to invest in credit for yield. For example, the S&P return over the last 100 years has averaged a little over 10%, but today, his funds achieve 8.5% from high-yield bonds, 9.5% from levered loans, and 11% to 13% for senior loans to the biggest buyouts. It is equity returns from fixed income, which are much more dependable than equity returns. It is a massive change in two years.
Macro forecasting and economists are a waste of time
Marks says he does not rely on forecasting because it is unknowable.
“In January of 2016, I was having dinner with Warren Buffett. And he says to me, for a piece of information to be desirable, it has to satisfy two criteria. It has to be important. It has to be knowable. The macro is very important. Seems to be the thing that moves the market most, but it's not knowable … You've got Buffett, you have Munger, you have Peter Lynch, you have Bill Miller, and you can go on down the list of successful investors. Now, give me a list of the macro investors who have been successful.”
“Where are the rich macro investors? And there are so few (under questioning, he conceded on Soros and Druckenmiller). And if you look at the performance of hedge funds, for example, which has been terrible in the last 20 years, there's a subsector called macro. And their results are even worse. Who knows more than others about the macro future? Virtually nobody.”
Marks calls it the ‘Illusion of Knowledge’ in one of his memos, placing little value on predictions.
“I've been talking about the uselessness of forecasting for a long time ... And the belief that you know is dangerous if the truth is that you don't know. And that's how you get into big trouble. So, I'm firmly against it. Oaktree, I hope I don't insult anybody in the audience, but Oaktree doesn't have an economist. We don't invite economists in to give their talk. And one of the tenets of our investment philosophy is that our investments are not based on macro forecasts.”
He prefers to focus on micro analysis to gain an advantage investing in companies, industries and securities and not trying to guess at what GDP will be next year. He references the US Fed and its hundreds of PhD economists, and the Fed can't even predict what the Fed is going to do.
“Now, if it's your behavior and you publish a prediction, obviously you have it within your power to make it come true. And the Fed's predictions of its own behavior don't come true. So, I would say, if they don't know what they're going to do, how the hell can any of you figure out what they're going to do?”
Which is why Firstlinks infrequently covers macro predictions and market forecasts. Not only do most other financial newsletters cover these macro guesses in detail, regularly correcting themselves with forecast updates, but the predictions are of little merit for long-term investing and portfolio construction. It’s good to hear Howard Marks confirm our content preferences.
Graham Hand is Editor-At-Large for Firstlinks. This is Part 1 of a selection of Howard Marks’ comments to INSEAD’s Fontainebleau students on 24 May 2023. Part 2 will be published next week. The full discussion is here. This article is general information only.