Lines In The Sand

=== PAGE 5 === The Race to the Bottom Everyone Knows It’s All Good It’s All Good . . . Really? Now It’s All Bad? No Different This Time – The Lessons of ‘072007 Now What? Whodunit The Tide Goes Out The Aviary Doesn’t Make Sense What Worries Me Nobody Knows Plan B The Limits to Negativism V olatility + Leverage = Dynamite2008 The Long View Will It Work? So Much That’s False and Nutty Touchstones2009 Tell Me I’m Wrong I’d Rather Be Wrong Warning Flags It’s Greek to Me Hemlines Open and Shut All That Glitters2010Table of Contents (continued) === PAGE 6 === On Regulation How Quickly They Forget Down to the Wire What's Behind the Downturn? It's All Very Taxing2011 What Can We Do For You? Assessing Performance Records A Case Study Déjà Vu All Over Again It's All A Big Mistake On Uncertain Ground A Fresh Start (Hopefully)2012 Ditto High Yield Bonds Today The Outlook For Equities The Role of Confidence The Race Is On2013 Getting Lucky Dare to Be Great II Risk Revisited The Lessons of Oil2014 Liquidity Risk Revisited Again It’s not Easy Inspiration from the World of Sports2015Table of Contents (continued) === PAGE 7 === Expert Opinion Lines in the Sand There They Go Again... Again Yet Again?2017 Latest Thinking Investing Without People The Seven Worst Words in the World2018 Political Reality Meets Economic Reality Growing the Pie This Time It's Different On the Other Hand Mysterious2019 You Bet! Nobody Knows II Latest Update Which Way Now? Calibrating Knowledge of the Future Uncertainty Uncertainty II Not Enough The Anatomy of a Rally Time for Thinking Coming into Focus2020On the Couch What Does the Market Know? Economic Reality Political Reality Implications of the Election Go Figure!2016Table of Contents (continued) === PAGE 8 === Selling Out The Pendulum in International Affairs Bull Market Rhymes Conversation at Panmure House I Beg to Differ The Illusion of Knowledge What Really Matters? Sea Change2022 Lessons from Silicon Valley Bank Taking the Temperature Fewer Losers, or More Winners? Further Thoughts on Sea Change2023 Easy Money The Indispensability of Risk The Impact of Debt The Folly of Certainty Mr. Market Miscalculates Shall We Repeal the Laws of Economics? Ruminating on Asset Allocation2024 On Bubble Watch Gimme Credit Nobody Knows (Yet Again) More on Repealing the Laws of Economics Calculus of Value A Look Under the Hood Cockroaches in the Coal Mine Is It a Bubble?2025Something of Value 2020 in Review Thinking About Macro The Winds of Change2021Table of Contents (continued) === PAGE 9 === Addendum to Third Quarter Client Letter From: Howard S. Marks Re: The Route to Performa nce We all seek investment performa nce which is above average, but how to achieve it remains a major question. My views on the subj ect have come increasingly into focus as the years have gone by, and two events in late September -- and especially their juxtaposition -- made it even clearer how (and how not) to best pursue those superior results. First, there was an article in the Wall Street Journal about a prom inent money management firm's lagging performance. Its equity results were 1,840 basis points behind the S&P 500 for the twelve months thr ough August, and as a result its five-year performance had fallen behind the S&P as well. The president of the firm explained that its bold over- and under-weightings weren' t wrong, just too early. Here is his explanation, with whic h I strongly disagree: If you want to be in the top 5% of money managers, you have to be willing to be in the bottom 5%, too. The above calls to mind a convertible mutual fund I discussed in m y second quarter 1988 letter to convertible clients. The fund held large amounts of common stock in the first eight months of 1987 and cash after that. As a result, its return was more than 1,600 basis points better than the average convertible fund for th e year, and 945 b.p. ahead of the second-place fund. In the next half year , its tactics were equally divergent ... but wrong this time, producing performance whic h was far enough behind to negate the majority of its 1987 achievement and pull its 18-month results well back into the pack. My observation at that time mirrored the f und manager quoted above, but from a negative viewpoint: . . . in order to strive for performance which is far different from the norm and better, you must do things which expose you to the possibility of being far different from the norm and worse. These cases illustr ate that bold steps taken in pursuit of great performance can just as easily be wrong as right. Even worse, a co mbination of far above-average and far below- average years can lead to a long-term r ecord which is characterized by volatility Uand U mediocrity. As an alternative, I would lik e to cite the approach of a m ajor mid-West pension plan whose director I spoke with last month. The return on the plan's equities over the last 1990 Oaktree Capital Management, L.P. All Rights Reserved === PAGE 10 === fourteen years, under the direction of this man and his predecessors, has been way ahead of the S&P 500. He shared with me what he considered the key: We have never had a year below the 47th percentile over that period or, until 1990, above the 27th percentile. As a result , we are in the fourth percentile for the fourteen year period as a whole. I feel strongly that attempting to achieve a superior long term record by stringing together a run of top-decile years is unlikely to succee d. Rather, striving to do a little better than average every year -- and through discipline to have highly superior relative results in bad times -- is: - less likely to produce extreme volatility, - less likely to produce huge losses which can't be recouped and, most importantly, - more likely to work (given the fact that all of us are only human). Simply put, what the pension fund's record tell s me is that, in equities, if you can avoid losers (and losing years), the winners will take care of themselves. I believe most strongly that this holds true in my group's oppor tunistic niches as well -- that the best foundation for above-average long term performance is an absence of disasters. It is for this reason that a quest for consistency a nd protection, not single- year greatness, is a common thread underlying all of our investment products: UIn convertibles U, we insist that our call on potential appreciation be accompanied by above average resi stance to declines. UIn high yield bonds U, we strive to raise our relati ve performance by avoiding credit losses, not by reaching for higher (but more uncertain) yields. UIn distressed company debt U, we buy only where we believe our cost price is fully covered by asset values. There will always be cases and years in wh ich, when all goes right, those who take on more risk will do better than we do. In the l ong run, however, I feel strongly that seeking relative performance which is just a little bit above average on a consistent basis -- with protection against poor absolute results in t ough times -- will prove more effective than "swinging for the fences." October 12, 1990 1990 Oaktree Capital Management, L.P. 2 All Rights Reserved === PAGE 11 === Memo to: Clients From: Howard Marks Trust Company of the West Re: First Quar ter Performance The mood sw ings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best desc ribes the location of the pendulum "on average," it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward an extreme itself that supplies the energy for the swing back. Investment markets m ake the same pendulum-like swing: - between euphoria and depression, - between celebrating pos itive developments and obsessing over negatives, and thus -between overpriced and underpriced. This oscillation is one of the most dependa ble features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at a "happy medium." In late 1990, the secu rities markets were at a negative extrem e as concerns about the economy and Iraq produced exaggerated risk aver sion and thus drastic under-valuation of all securities considered to be of less than "gilt-edge" quality. The subsequent first quarter swing toward more reasonable valuati ons imparted to our por tfolios some of the best quarterly perfor mance in our history. With investors worrying less about default ra tes and forced selli ng, our high yield bonds returned mo re than at any tim e since the second quarter of 1980. The rebirth of interest in smaller and second-tier stocks produced a quarterly return for our convertibles above any since the fourth quarter of 1982. Lastly, suspension of "end-of-the-world" thinking and an increased willingness to envision po ssible solutions caused our distressed-debt Special Credits portfolios to gain even more than either high yield bonds or convertibles. It would be wonderful to be able to successfully predict th e swings of the pendulum and always m ove in the appropriate direction, but this is certainly an unrealistic expectation. We consider it far more reasonable to try to (1) stay alert for occasions when a market has reached an extreme, (2) adjust our behavior slightly in response and, (3) most importantly, refuse to fall into line with the herd behavior which renders so many investors dead wrong at tops and bottoms. 1991 Oaktree Capital Management, L.P. All Rights Reserved === PAGE 12 === The first quarter's swing back from the negative extreme has been rapid and impressive. No one can say whether it came too soon or went too far, and we ar e cautious that these dramatic results may have been realized w ithout great improvement in the fundamental economy. However, we feel "fair" does a much better job of describing the prices which resulted than would "excessive." That is, th e pendulum is closer to the midpoint at this time than to an extreme. The bargains which were so readily availabl e in the fourth quar ter of 1990 are no longer there to the same extent, and we are not acting as if they were. And we certainly are not planning on a continuation of the first quarter's performance. Instead, from today's more reasonable prices, we consider our three areas to be poised for a continuation of their "normal" above-average ri sk-adjusted performance. April 11, 1991 1991 Oaktree Capital Management, L.P. 2 All Rights Reserved === PAGE 13 === Memo to: Clients From: Howard Marks Re: Microeconomics 101: Supply, Demand and Convertibles Two principal factors determine wheth er an i nvestment will be successful. The fir st is the intrinsic quality of the under lying entity bei ng invested in. In short, how good is the venture you are buyin g a piece of or lending money to? It's b etter to invest in a good company than a bad one, ceteris paribus, [Ceteris paribus is a favorite term of economists. It mean s “everything else b eing equal,” and yes, at a given p rice, it's smarter to invest in a better company than a worse one. Of course, “everything else” neve r is equal, and you're not lik ely to be asked to choose between two assets of obviously different quality at the same price.] The second factor determining wheth er something will be a good investment is price. Ceteris paribus, given two assets of similar quality , it's better to pay less than mo re. Lots of investors take the approach of searching out co mpanies with better products, managements, balance sheets and prospects. Many say they will only buy top quality assets. Our group does not have that luxury and, at any rate, pursuing museum qu ality assets would be antithetical to our philosophy. In conv ertibles, as in high yield bonds and certainly in distressed debt, our companies generally are not wi dely applau ded or atop the ratings heap. Instead, they fall within a br oad range in terms of quality. We are less concerned with the absolute quality o f our companies than with the price we pay for whatever it is we're getting. In short, we feel “everything is triple-A at the right price”. We have man y reasons for followi ng this approach , including the fact that relatively few people compete with us to do s o. But we feel buying any asset for less than it's worth virtually assures success. Identifyi ng top quality assets does not; the risk of overpaying for that quality still remains. What does all of this have to do with micro economics? Well microeconomics is the study of the price-setting p rocess, and much of price comes down to a matter of supply and demand. Ceteris paribus -- in this case, holding the level o f supply constant - - price will be higher if there is more demand and lower if there is less. And that's why buying when everyone else is can, in and of itself, doom an investment. Many real estate investmen ts made in the 1980s were ill-fated because excess demand from investors and too-easy credit induced builders to erect structures for whic h there are no tenants. Many of the later LBOs failed because excessive demand p ushed prices for companies to levels which were 1992 Oaktree Capital Management, L.P. All Rights Reserved === PAGE 14 === too high given their prospects. Conversely, buying what no one else will buy at any price almost assures eventual success, and that leads to a di scussion of the current level of demand for convertibles and its impact on their prices. I wrote this summer that convertibles tend to capture most of the upside performance of stocks while being significantly insulated from declines, and that such performance characteristics should be attractive given the high level of uncerta inty today. What I didn't mention -- and what I want to point out now -- is that one of the factors contributing to the availability of bargains among convertib les is the relatively low level of demand for them. Here in 1992, strong demand has supported stock prices. Important among the components of that demand is the heavy flow into mutual funds of cash fleeing from low- yielding short term investments. But flows into convertible funds have been low, as indicated by the following clipping from Ba rron's. The figures are worth reviewing. Convertible securities funds don't get much respect. They had a great 1991, when they rose 30%, matching the S&P 500, and so far this year, they're up 3.5%, while the S&P is down a fraction. This showing is impressive since convertibles, bond-equity hybrids, are usually a more conservative choice than stocks, trailing the S&P in bull markets and falling less than stocks in down markets. Yet investors, normally quick to snap up anything offering better yields than CDs and money-market funds are staying away. Assets of convertible funds stood at $2.36 billion on June 30, up just $100 million since the start of the year, and way below their peak of $5.3 billion just before the 1987 crash. Reaction was negative, and conve rtible mutual fund assets dropped to $3.2 billion at y ear-end 1989 and only $2.2 billion today, down 62% from the 1987 level. If strong inflows are, as I believe, a precursor of poor performance (and vice versa), then the outlook today should be excellent. Convertibles are getting no respect and attracti ng no inflows. That leaves bargains for those willing to act as contrarians. We hope you will consider convertibles an attractive way to hold an increased portion of your commitment to equities. October 8, 1992 Between 1977 and 1984, the number of convertible mutual funds was constant at seven, and at the en d of that period their total assets stood at the princely sum of $452 million. By the end of 1987 there were thirty funds with assets of $5.8 billion, for a thirteen-fold increase. It can clearly be seen in retrospect that the strong flow of capital into convertibles in 1985-87 “poisoned the well” and led to a loss of price discipline, to purchases of over-priced securities, and to poor performance. 1992 Oaktree Capital Management, L.P. 2 All Rights Reserved === PAGE 15 === Memo to: Clients From: Howard Marks, TCW Re: The Value of Predictions, or Where'd All This Rain Come From? Anyone who has been my client for long has heard from me on many occasions with negative comments about market forecasts. Now, I have decided to say at once all of the bad things I can think of about predictions. UThe Expected Value of a Forecast = Value of Correct Forecast x Probability of Being Correct The motivation for trying to guess the directi on of stocks or bonds is easy to understand. Observers have for years noted the wide pr ice s wings, calculated the value of a dollar invested at the bottoms and disinvested at th e tops and compared the result against the value of a dollar invested under a “buy-and-hold P” P strategy. The difference is always temptingly large. The problem, however, comes from the fact th at none of the forecaster' s attempts to capture the swings have any value unless his or her predictions are right. UBut It's Hard to be Right I agree with John Kenneth Galbraith. He said “We have two classes of forecasters: Tho se who don't know -- and those who don't know they don't know.” If it was easy to predict the future, it would be easier to attain excellent investment results -- then maybe everyone could have above-average performance. UBeing Right With Average Consistency Doesn't Help Let's face it: mo st of us have roughly the same ability to predict the future. And the trouble is that being right as often as the averag e forecaster won't produce superior results. Every investor wants results which are above average. In the institutional world, relative perf ormance is the Holy Grail. Even elsewhere, the objective is to be the first to see the future -- and take the appropriate route to profit. It obviously doesn't help in these pursuits to be right onl y as often as others are. 1993 Oaktree Capital Management, L.P. All Rights Reserved === PAGE 16 === UAn Average Forecast Doesn't Help Even If It's Correct Being "right" doesn' t lead to superior performanc e if the consensus forecast is also right. For example, if the consensus forecast for real GNP growth is 5%, then stock prices will come to reflect that expectation. If you then conclude that GNP will grow at 5% and your expectation of rapid growth motivates you to bu y stocks, the stocks you buy will be at prices which already anticipate such growth. If actual GNP growth at 5% is subsequently announced, stock prices probably will not jump -- because thei r reaction to 5% growth took place when the consensus forecast was arrived at . Instead, the best guess is that you will earn the normal risk-adjusted re turn for equities over your ho lding period. Bottom line: correct forecasts do not necessarily tran slate into superior investment results . UAbove-Average Profits Come From Correctly Forecasting Extreme Events At least twenty-five years ago, it was noted that stock price m ove ments were highly correlated with changes in earnings. So people concluded that accurate forecasts of earnings were the key to making money in stocks. It has since been realized, how ever, that it' s not earnings ch anges that cause stock price changes, but earnings changes which come as a surprise. Look in the newspaper. Some days, a company announces a doubling of earni ngs and its stock price jumps. Other earnings doublings don't even cause a ripple -- or they prompt a decline. The key question is not "What was the change?" but rather "Was it anticipated?" Was the change accurately predicted by the consensus and thus factored into the stock price? If so, the announcement should cause little reaction. If not, the announcem ent should cause the stoc k price to rise if the surprise is pleasant or fall if it is not. This raises an important Catch 22. Ever yone's forecasts are, on average, consensus forecasts. If your prediction is consen sus too, it won't produce above-average performance even if it’s right. Superior performance comes from U accurate non- consensus U forecasts. But because most forecasters aren't terrible, the actual results fall near the consensus most of the time -- and non-consensus forecasts are usually wrong. The payoff table in terms of performance looks like this: Forecast Consensus Non-Consensus Yes Average Above Average Accurate? No Average Below Average 1993 Oaktree Capital Management, L.P. 2 All Rights Reserved === PAGE 17 === The problem is that extraordinary perf ormance comes only from correct non- consensus forecasts, but U non-consensus forecasts are hard to make, hard to make correctly and hard to act on U. When interest rates stood at 8% in 1978, most people thought they'd stay there. The interest rate bears predicted 9%, and th e bulls predicted 7%. Most of the time, rates would have been in that range, and no one would have made much money. The big profits went to those who predicte d 15% long bond yields. But w here were those people? Extreme predictions are rarely right, but they're the ones that make you big money. UMost Forecasts are Extrapolations The fact is, most forecas ters predict a future quite like the recent past. One reason is that things generally continue as they have been ; major changes don't occur very often. Another is that most people don't do "zero-based" forecasting, but start with the current observation or normal range and then add or subtract a bit as they think is appropriate. Lastly, real "sea changes" are extremely difficult to foretell. That' s why some of the best-remembered foreca sts are the ones that extrapolated current conditions or trends but were wrong. Business Week may never live down "The Death of Equities" and "The Death of Bonds." At th e mid-1990 lows, the press suggested that no one would ever buy a high yield bond again. In 1989, nobody thought the Cowboys would ever win without Tom Landry, or that the Lakers or 49ers would ever lose. Six years ago, the growth of both coasts' economies was considered assured, and the Rustbelt's suffering was expected to continue forever. Only two years ago, George Bush was a shoe-in. And that brings m e to my s ubtitle: Where'd All This Rain Come From? The motivation for this memo came as I considered the extrao rdinary amount of preci pitation the West has experienced this year -- and newspaper articles of a couple of months ago. According to the articles, the rings on old tr ees suggested that fifty year droughts might be the norm and the five year drought to date just the beginning. No one predicted the dro ught before it began -- when such a forecast might have helped. But just as it may have been about to end, th e possibility of its l ong-term continuation was unveiled. 1993 Oaktree Capital Management, L.P. 3 All Rights Reserved === PAGE 18 === UForecasters are Usually Mo st Wrong at the Extremes It's at just such times --- such inflection points -- when accurate forecasts of change would be the most valuable but are the hardest to make. Take high yield bonds, for instance. In 1989 a nd 1990 they absorbed a continual beating as a series of negative developments came together . There was the recession, the failure of a number of the leveraged buyouts of the 1980s , enactment of excessively stringent regulation and the collapse of Drexel Burnha m, Columbia Savings and Executive Life. All of this was tied together -- and accentuat ed -- by lots of overl y negative publicity. Each development was another drip of "Chinese water tort ure." Each one put an end to some investor's ability to remain optimistic. And so each one eliminated a potential buyer, created a seller a nd moved prices lower. And after all, what is a market bottom? It's that moment when the last holder who will become a seller actually does so -- and thus the moment when prices hit levels that will prove to have been the lows. From that point on, with no one left to turn negative, a few pieces of good news or the arrival of a few buye rs with belief in values are enough to turn a market. So you can see that the crescendo of negativ ism, the lowest prices and the greatest difficulty in predicting a rise all occur simultaneously. No wonder it's hard to profit from forecasting. UExtreme Forecasts are Hard to Believe and Act On Let's say the average investor was appro ached in October 1990 by someone who had enough imagination and courage (because that's what was needed) to make a positive case for high yield bonds. Would the investor have believed and bought? Probably not. Potentially-profitable non-consensus forecas ts are very hard to believe and act on for the simple reason that they are so far from conventional wisdom . If a forecast was totally logical and easily accepted, then it would be the consensus forecast (and its profit potential would be much less). So if someone told you the U.S. auto makers' share of domestic market was going back to 100% in five years, that would be a forecast with enormous imp lications for profit. But could you possibly believe it? Could you act on it? The more a prediction of the future differs from the present, (1) the more likely it is to diverge from the consensus forecast, (2) the grea ter the profit would be if it's right, and (3) the harder it will be to believe and act on it. 1993 Oaktree Capital Management, L.P. 4 All Rights Reserved === PAGE 19 === UYou Have to Be Right About Timing Too Not only must a profitable forecast have the event or direction right, but it must be correct as too timing as well. Let's say you accepted the forecast that the Bi g Three would come to again own 100% of the U.S. market, and you bought the stocks in response. What if a year later their share was lower (and their stocks too)? Could you contin ue to hold out for the long term, or would your resolve weaken? What if their shares (and stocks) were unchange d five years later? Wouldn't you give up? And wouldn't that be just in time to see the prediction come true? In poker, "scared money never wins." In inves ting, it's hard to hold fast to an improbable, non-consensus forecast and do the right thing…es pecially if the cloc k is telling you the forecast is off base. As I was told years ago, "being too far ahead of your time is indistinguishable from being wrong." UIncorrect Forecasts Can Cost You Money As you know, we run our portfolios without refe rence to what we think the broad markets will do. An observer might think such behavior e xposes us unduly to the fluctuations of the markets, and that to protect our clients we should actively go in and out of the markets based on what we think will happen. But remember, that will work only if our for ecasts are right (and right more often than the consensus is right). I would argue that because forecasting is uncertain, it's safer not to try. For example, people hold equities because they find prospective long-term equity returns attractive. The average annua l return on equities from 1926 to 1987 was 9.44%. But if you had gone to cash and missed the best 50 of those 744 months, you would have missed all of the return. This tells me that attempts at market timing are a source of risk, not protection . It would be nice in anticipati on of subsequent performance to be able to vary the amount invested, but I think it's just too risky to try. UIt Costs Money to Make Forecasts As suggested above, the best thing might ju st be to settle for average long-term performance in markets that are hard to predict. Efficient marketeers think stock market forecas ts are about as good as coin tosses. If you're right half the time without bias , your forecasts won't help or hurt versus buy-and-hold. But 1993 Oaktree Capital Management, L.P. 5 All Rights Reserved === PAGE 20 === forecasts are implemented through transactions which cost money. If you're right half the time and spend money to try, your performance will fall further below buy-and- hold results the more trading you do. UFew People Revisit Their Forecasts We always read "I think the stock market's going to go up." We never read "I think the stock market's going to go up, (and 8 out of my last 30 predictions were right)" or "I think the stock market's going to go up (and by the way I said the same thing last year and was wrong)." Can you imagine deciding which baseball player s to hire without knowing their batting averages? When did you ever see a market forecaster's track record? UMost Forecasts Don't Allow for Alternative Outcomes I imagine that for most money managers, th e process goes like this: "I predict the economy will do A. If A happens, interest ra tes should do B. With interest rates of B, the stock market should do C. Under that environment, the best performing sector should be D, and stock E should rise the mo st." The portfolio expected to do best under that scenario is then assembled. But how likely is E anyway? Remember that E is conditioned on A, B, C and D. Being right two-thirds of time would be a great accomplishment in the world of forecasting. But if each of the five predic tions has a 67% chance of being right, then there is a 13% probability that all will be correct and th e portfolio will perform as expected. And what if some other scenario unfolds? How will the portfolio do? How do the forecaster/investors make allowances in th eir portfolios for the likelihood that their predictions will prove incorrect? ULastly, Ask Yourself "Why Me?" By this I mean "if someone has made a potentially valuable forecast with a high probability of being right, why is it being shared with you?" Think how profitable a correct market forecast could be. With very little capital, a good forecaster could make many times more in the futures market than in salary from an employer. Okay, let's say he likes to work for other people -- than why does his employer give his forecasts away rather than sell them? Maybe the thing to ask yourself is whether you would write out a check to buy the forecast you're considering acting on. 1993 Oaktree Capital Management, L.P. 6 All Rights Reserved === PAGE 21 === Groucho Marx said "I wouldn't join any cl ub that would have me as a member." Another formulation may be "I would neve r act on any forecast that someone would share with me." I'm not saying that no one has above-average forecasting ability. Rather, 'as one University of Chicago pr ofessor wrote in a paper years ago, such forecasters are more likely to be sunning themselves in Saint Tropez than going around entreating people to borrow their forecasts. * * * There is a bottom line for us on the subjec t of predictions regarding macro-scale events and widely-followed markets about which information is rather evenly disseminated (so-called efficient mark ets). In sum, we feel that: most forecasters have average ability consensus forecasts aren't helpful correct non-consensus forecasts are potential ly very profitable but are also hard to make consistently and hard to bring yourself to act on forecasts cost money to implement and can be a source of risk rather than return The implications for us are clear. We will continue to eschew portfolio management based on forecasts of market trends, about which we think neither we nor anyone else knows much. Instead, we will continue to try to "know the knowable" -- that is, to work in markets which are the subject of bias es, in which non-economic moti vations hold sway, and in which it is possible to obtain an advantage th rough hard work and superior insight. We will work to know everything we can about a small number of things…rather than a little bit about everything. Convertible securities, high yi eld bonds and distressed compa ny debt are all markets in which market inefficiencies gi ve rise to unusual opportunities in terms of return and risk. We will continue to exploit these opport unities in a manner which is risk-averse and non-reliant on macro-forecasts . February 15, 1993 . . . [predictions] ought to serve but for winter talks by the fireside. Sir Francis Bacon 1993 Oaktree Capital Management, L.P. 7 All Rights Reserved === PAGE 22 === URandom Thoughts on the Identificati on of Investme nt Opportunities Howard S. Marks -- January 24, 1994 1. No group or sector in the inves tment world enjoys as its birthright the promise of consiste nt high returns. There is no asset class that will do well simp ly because of what it is. An example of this is real estate. People said, "You should buy real estate because it' s a hedge against inflation," and "You should buy real estate because they're not making any more." But done at the wrong time, real estate investing didn't work. 2. What matters most is not w hat you in vest in, but when and at what price. There is no such thing as a good or bad i nvestment idea per se. For example, the selection of good com panies is certainly not enough to assure good results -- see Xerox, Avon, Merck and the rest of the "nifty fifty" in 1974. Any investment can be good or bad dependi ng on when it' s made and what price is paid. It's been said that "a ny bond can be triple-A at a price." There is no security that is so good that it can't be overpriced, or so bad that it can' t be underpriced. 3. The discipline which i s most important in investing is not accounting or economics, but psychology. The key is who likes the investment now and who doesn' t. Future prices changes will be determined by whether it comes to be liked by more people or fewer people in the future. Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity. At that point, all favorable facts and opinions are already factored into its price, and no new buyers are left to em erge. The safest and most potentially profitabl e thing is to buy some thing when no one likes it. Given time its popularity, and thus its price, can only go one way: up. Watch which asset cla sses they're hold ing conferences for and how many people are attending. Sold-out conferences are a danger sign. You want to participate in auctions where there are only one or two buyers, not hundreds or thousands. You want to buy things either before they 've been discovered or after there' s been a shake-out. 4. The bottom line is that it is best to act as a cont rarian. 1994 Oaktree Capital Management, L.P. All Rights Reserved === PAGE 23 === An investment that "eve ryone" knows to be undervalued is an oxym oron. If everyone knows it's undervalued, why have n't they bought it and driven up its price? And if they have bought, how can the price still be low? Yogi Berra said, "nobody goes to that rest aurant; it's too popular." The equally oxy-mo ronic investment versi on is "Everybody likes that security because it's so cheap." 5. Book the bet that no one else w ill. If everyone likes the favorite in a football game and wants to bet on it, the point spread will grow so wide that the team -- as good as it is -- is un likely to be able to cover the spread. Take the othe r side of the bet -- on the underdog. Likewise, if everyone is too scared of junk bonds to buy them , it will become possible for you to buy them at a yield spread which not only overcompensates for the actual credit risk, but se ts the stage for their being the best performing fixed income sector in the world. That was the case in late 1990. The bottom line is that one must try to be on the other side of the question from everyone else. If everyone likes it, sell; if no one likes it, buy. 6. As Warren Buffet said, “the less care with w hich others conduct their affairs, the more care with which you should conduct yours." When others are afraid, you needn't be; when oth ers are unafraid, you'd better be. It is usually said that the market runs on fear and greed. I feel at any given point in time it runs on fear Uor U greed. As 1991 began, everyone was petrified of high yield bonds. Only the very bestbonds could be issued, and thus buyers at that time didn't have to do any credit analys is -- the market did it for them. It s collective fear caused high standards to be imposed. But when investors are una fraid, they'll buy anything. Thus the intelligent investor's workload is much increased. 7. Gresham's Law says "bad money drives out good." When paper money appeared, gold disappeared. It w orks in investing too: bad investors drive out good. When undemanding investors appear, they'l l buy anything. Underwriting standards fall, and it gets hard for demanding investors to find opportunities offering the return and risk balance they re quire, so they're forced to the sidelines. Dema nding investors must be wil ling to be inactive at times. 1994 Oaktree Capital Management, L.P. 2 All Rights Reserved === PAGE 24 === Memo To: Clients From: Howard S. Marks, TCW Re: Risk in Tod ay's Markets The ability of the stock m arket to react so harshly on February 4 to a small, Fed- mandated rise in interest rates, pushing the Dow down 96 points, suggests a lack of preparedness for negative developments. This prompts me to write to you about certain risks I feel may be presen t in the markets today. There are plenty of bullish arguments to be ma de about the prospects for the economy and corporate profits, and pundits to make th em. While I will not devote space or time to them, I don't pretend they are nonexistent. And I won't deny the possibility that as an inherently cautious investor, I sometimes tend to overstate the negatives. What I want to do, however, is point out the degree to which I feel investors are behaving in a risk- tolerant manner today, and the implications for all of us. Two very powerful trends are at work, and have been for the last few years. The first is the decline in interest rates, which ha s carried rates to the lowest levels of the last thirty years and brought on great dissatisfaction with the returns available from low-risk fixed income investments. The second is the fabulous performance which was produced by virtually all investments in securities fr om 1991 to 1993. This was a period in which risk-taking was rewarded, and almost without exception very high returns went to those who took great risk. Put these two phenomena together and what do you have? I think the answer is an environm ent in which risk-taking is greatly encouraged. It is often said that the market runs on fear and greed, but I believe it usually runs on fear or greed; that is, at m ost points in time, one or the other predominates. Right now, because of the two trends cited above, gr eed is greatly elevated and, perhaps more importantly, fear is in short supply. Thus, -the money market investor, not content to earn 3% per year, (a negative return after taxes and inflation), turns to notes and bonds, -the bond investor, unhappy with returns at the shorter (read "l ow-risk") end of the curve, extends maturities, -the high grade bond inv estor drops down in quality, -the fixed income investor turns to equities, -the equity investor joins a hedge fund, 1994 Oaktree Capital Management, L.P. All Rights Reserved === PAGE 25 === - the domestic investor looks overseas, - the international investor emphasizes emerging markets, and - the traditional bond-and-stock investor s earches for "alternative investments" likely to repeat the success of the LBO and bankruptcy funds. And why shouldn't they? The "stick" is th e low prospective return offered in each investor's traditional bailiwick, and the "carrot" is the high returns earned recently in the riskier sectors. In brief, "why should I settle for 3% in T-bills when I can get double-digit returns in stocks?" There are numerous signs of infatuation with -- or non-questioning acceptance of -- the pursuit of high returns. The torr ential inflow of dollars to mu tual funds is one; I recently attended a conference at which a fund group re presentative said they were taking in $100 million a day, 90% of it for foreign funds. The rising level of margin debt is another. Books on investing are reaching the best-sellers list. The names of hedge fund managers are almost household words. And that brings me, for purposes of illustration, to the subject of hedge funds. When I first got to know the money management comm unity twenty years ago, only a handful of managers were good enough to command a share of the profits as compensation. Today, according to a recent article in Forbes, there are 800 hedge funds, and some people think being accepted by one of the big na mes is the chance of a lifetime. I think it's important to remember, though, the symmetrical nature of most investments: almost every sword is two-edged, and he w ho lives by a risky strategy may die by it. Investments which will make you a great deal of money when things go well but not lose you a lot when things go poorly are very rare, and their existence must presuppose extremely inefficient markets. With the average stock or bond returning 10-15% last year, how did some hedge funds make 70% or more? It was through bold and heavily- leveraged plays on macro-developments such as currency movements. What would have happened if the managers' calculations ha d proved wrong? The hedge fund manager I know with the best performance last year, up more than 100%, is said twice in his life to have lost 30% in one day! Do the hedge f und aficionados know how much risk they are taking? For how long are they tying up their money? How much do they know about the strategies being employed? As the Forb es article pointed out, the sum of the "information" most hedge fund investors rece ive is a quarterly paragraph reporting the rate of return. I am not complaining about the fact that th ere are hedge funds, or about their popularity. My point is simply that the level of risk bor ne by investors is being systematically raised, often unknowingly and at a time when many valuations are quite high. 1994 Oaktree Capital Management, L.P. 2 All Rights Reserved === PAGE 26 === Comparison against low interest rates makes low earnings yields and dividend yields seem tolerable. Likewise, low rates increas e the discounted present value of companies' future earnings as calculated by valuation m odels. For these reasons and others, many valuation indicators are at levels today wh ich have proved dangerous and unsustainable in the past. Just as today's low interest rates are pushing investors toward riskier securities all along the "food chain" describe d above, however, this sword can also cut the other way. Warren Buffet said, in one of my favorite adages, "The le ss prudence with which others conduct their affairs, the gr eater the prudence with which we should conduct our own affairs." Another adage I'm fond of is, "W hat the wise man does in the beginning, the fool does in the end." No course of investment action is either wise or foolish in and of itself. It all depends on the point in time at which it is undertaken, the price that is paid, and how others are conducting themselves at that moment. When everyone shrinks from a security because it's "too risky," the few who will buy it can do so with confidence, secure in the know ledge that the price has not been bid up, and in the likelihood that othe rs will eventually outgrow their fear and jump on the bandwagon. Today, many prices have been bid up, and the bandwagon is already crowded with wild-eyed investors. It is my view that, first, few of the trends being pursued are at their beginnings; money has been flowing to today's popular sectors for at least a year or tw o. Second, while some may argue that prices are not forbiddingly high, it's almost impossible to argue that they're very low (or that the easy money hasn't already been made). Third, it seems to me that investors are accepting higher le vels of risk throughout the system. Here's one illustration: Our cautious high yi eld investing saved clients a lot of money and heartache in 1989 and 1990. Because we apply in-depth, downside-conscious credit analysis to the high yield segment of the bond market, and define it narrowly, investors who were chastened by the last decline and don' t want to bear the full brunt of the next one have hired us repeatedly in the years since. Now, however, we detect increased interest in more "eclectic" managers w ho will buy cash-paying or non-cash-paying bonds, going concerns or bankruptcies, convertible or straight bonds, and U.S. or foreign debt. This is just one example, near to us, of the new acceptability of risk -- at what just might be the wrong time. Too-low interest rates and too- high prices may prove at some point to have set the stage for a correction. If so, many of the riskier tactics to which recent trends are pushing investors will increase the extent to which that correction is felt. What course of action, then, would we argue for? We do not preach risk-avoidance . In fact, the knowing accepta nce of risk for profit is at the core of much of what we do, and we feel there is an important role today for investing which is creative and adaptable. But we would take this opportunity to exhort you to review most critically the risk asso ciated with your curre nt and contemplated 1994 Oaktree Capital Management, L.P. 3 All Rights Reserved === PAGE 27 === investments, and not to be among those who unc ritically joined the trend toward risk. Whatever investment opportunities you decide on, we would encourage you to stress thorough appraisal of th e risks entailed and cautious implementation. What is it that distinguishes the investme nt opportunities we’d suggest you pursue today? Not just the offer of high retu rns, but of returns which are more than proportionate to the risk entailed . The reason we champion inefficient markets (such as the high yield bonds, convertibles and distress ed debt we're involved with) is that there exists by definition the potential, if expl oited correctly, for an uncommonly favorable ratio of return to risk. Exploitation of opportunities in inefficient markets; insistence on preserving capital; refusal to pursue maximum return at the cost of maximum risk; specialization rather than dabbling; heavy emphasis on care ful analysis; use of less-risky senior securities -- these themes have been the co rnerstones of our approach over the years. They remain highly relevant and should continue to be pursued by all of us, especially at this point in the cycle. February 17, 1994 1994 Oaktree Capital Management, L.P. 4 All Rights Reserved === PAGE 28 === Memo To: Clients From: Howard S. Marks, TCW Re: "Risk in Today' s Markets" Revisited Seven weeks ago, we put out a memorandum entitled "Risk in Today's Markets." Its essence was that the excellent returns earne d in risky strategies through 1993 had eroded the fear factor in many markets and, c oupled with the low yields available on conservative fixed income investments, had cau sed many investors to take "one giant step forward" on the risk curve. It also pointed out that just as declining rates had acted to raise prices and generate good returns, rate movements could cut the other way too. Lastly, it cautioned that when others are ac ting imprudently, driven by greed and without much fear, it is important that we raise Uour U level of prudence. Unfortunately, the even ts of the interveni ng seven weeks have shown these observations to be in order. It is the purpose of this follow-up memo to review the developments of the intervening time period, attempting to make sense out of what has happened and searching for lessons that can be drawn. It 's about understanding basics of investing which don't come and go. The current "correction" dates from Februa ry 4, when the Federal Reserve Bank raised short term interest rates a sm all amount in order to choke off inflationary thought and action. The air quickly came out of the bond ma rkets, and the declin e has been swift and deep. Although there were good days for a wh ile as well as bad, th e bond market never did recover its equilibrium once the rate rise had begun. The yield on the 30-year Treasury bond rose from 6.21% on January 28 to 7.40% on April 4, with its price falling 14%, from 100.41 to 86.22. The decline spread quickly to other asset classes, and many investors in riskier strategies suffered harsh consequences. Some observers protest that economic and industry funda mentals continue to be favorable. But those positive developments had come to be valued too highly, and the resulting correction of valuat ions has been painful. UIt's important to note the first lesson, then: successful investing has at least as much to do with what you pay for an asset as it does with what that asset's fundamentals are U. But why did the Fed's half-point bump up in shor t rates cause such devastation? First, of course, even a small step in terms of policy-related tightening implies there may be much more to come. More importantly though, th e move suddenly took a big bite out of investors' optimism and reawakened their f ear. Through January, investors acted as if nothing could go wrong. That first rate rise se rved to remind them that something could go wrong -- and had. Thus there has been a swing back from a euphoric extr