Weekly

=== PAGE 708 === With the panic now gone, stocks have recovered, but only about half their 2007-09 losses. The S&P 500 stands at a level that was first reached in 1998, meaning over the last twelve years, the average stockholder’s paltry return of less than a percent a year came entirely from dividends. People talk about the “lost decade in equities,” and still no one seems to feel he owns too few stocks. A Brief History of Bonds The recent history of bonds requires less telling. Bonds were the bedrock of investment portfolios in the first half of the last century . Along with Treasurys, utilities and corporates, business was brisk in railroad and street car bonds. Graham and Dodd’s classic, Security Analysis , devoted more than 200 pages to “fixed-value i nvestments” including preferred stock, of which next to nothing is heard today. The story of bonds in the last sixty years is the mirror opposite of what happened to stocks. First bonds wilted as stocks monopolized the spotlight in the 1950s and ’60s, and at the end of 1969, First National City Bank’s weekly summary of bo nd data died with the heading “The Last Issue” boxed in black. Bonds were decimated in the hi gh-interest-rate environment of the ’70s, and even though interest rates declined steadily duri ng the ’80s and ’90s, bonds didn’t have a prayer of standing up to equities’ dramatic gains. By the time the late 1990s rolled around, any investme nt in bonds rather than stocks felt like an anchor restraining performance. I chaired the investment committee of a charity and watched as a sister organization in another city – which had suffered for years with an 80:20 bond/stock mix – shifted its allocation to 0:100. I imagined a typical institutional investor saying the following: We have a little money in bonds . I can’t tell you why. It’s an historical accident. My predecessor created it, but his reasons are lost in the past. Now our fixed income allocation is under review for reduction. Even though interest in stocks remained low in the current decade, little money flowed to high grade bonds. The continued decline in bonds’ popularity was fed, among other things, by the decision on the part of the Greenspan Fed to keep interest rates low to stimulate the economy and combat exogenous shocks (like the Y2K scare). With Treasurys and high grade bonds yielding 3- 4%, they didn’t do much for institutional investors trying for 8%. As a result of a process I consider quite standard , bond allocations reached all-time lows at just the time they became needed. Other than cash and gold, Treasurys were the only asset that performed well in 2008. In fact, they benefited from a massive flight to quality. Corporate high grade and high yield bonds suffered along with everything else in 2008, but less than stocks, and they’ve enjoyed a comparable recovery. Thus bo nds have performed much better than stocks since the onset of the crisis in Ju ly 2007, as shown on the next page. 2010 Oaktree Capital Management, L.P. 4 All Rights Reserved === PAGE 709 === June 30 to June 30 2007-08 2008-09 2009-10 three years 10-year Treasury bond 12.6% 7.3% 8.3% 30.8% Barclay’s Govt/Credit 7.2 5.3 9.7 23.8 Citi High Yield Index -0.5 -4.2 24.7 18.8 S&P 500 -13.1 -26.2 14.4 -26.6 MS EAFE Index -22.5 -26.1 7.1 -38.7 MS Emerging Markets 2.6 -30.0 20.6 -13.4 Clearly, the recent performance edge of bonds over stocks has been dramatic. What’s Going On Today? Now, suddenly, investors seem to have awakened to bonds’ attractions. This after failing to do so in time for the crisis, when hold ing bonds would have been of great value. Is this just another case of investors driving while looking in the rearview mirror? And are they shifting from stocks to bonds at just the wrong time? The headlines are dramatic and the facts are clear. In just the last few weeks, we’ve seen newspaper stories like these: “Investors Fleeing Stocks with Cash Flow Lure JP Morgan” (Bloomberg, August 16), “Treasury Bears Cave as Bond Yields Keep Tumbling” ( The Wall Street Journal , August 16), and “Growing Concern over Bond Bubble” ( Financial Times , August 21). Bloomberg reported as follows: About $33 billion flowed out of funds owning U.S. shares this year . . . About $185 billion was sent to bond funds through July 31, the most on record, according to the Investment Company Institute. These statistics relate to mutual funds and their retail investors. While not necessarily the same for institutions, they are indicative of trends in investor psychology. In other words, the disaffection with stocks is continuing, and the withdrawn capital and much more is flowing to bonds. (It must be noted, however, as Tom Petruno of the Los Angeles Times pointed out on August 21, that gross inflows to equity mutual funds are s till very substantial – and larger than those into bond funds – although exceeded in this period by outflows.) The first question I want to tackle is “why these tr ends?” The answer with regard to stocks is simple. They were over-hyped in the 1990s; they disappointed in the 2000s; and investors are extrapolating the poor performance (even at lower pr ices) just like they previously extrapolated good performance (at higher prices). This tendency to expect trends to continue is typical of investor behavior, especially with regard to phe nomena that should instead be expected to regress toward the mean. In the late 1990s, when stocks were performi ng so well and universally expected to far exceed most investors’ return needs, no one saw a reason to hold fixed income instruments with their modest yields. Now stocks have p erformed poorly for a decade and expectations have been cut back. Equities are no longer considered the sure thing they were. The other day The New York Times ran an article entitled “In Striking Shift, Investors Flee Stock Market”: 2010 Oaktree Capital Management, L.P. 5 All Rights Reserved === PAGE 710 === Renewed economic uncertainty is testing American’s generation-long lo ve affair with the stock market. . . . Small investors are “losing their appetite for risk.” . . . “Like everyone else, I lost” during the recent market declines [an individual investor] said. I needed to have a more conservative allocation.” . . . Investors pulled $19.1 billion from domestic equity f unds in May, the largest outflow since the height of the financial crisis in October 2008. (August 22, 2010) Turning conservative after a crisis smacks of cl osing the barn door after the horse has left, but it’s a regular feature of investor psychology. Of course, there has to be a fundamental rationa le for investor behavior, and the current low opinion of stocks is based on the spreading belief that the recovery will be anemic and there could be a double dip. Also behind it may be the expectation that tax rates on dividends and long-term capital gains will rise relative to the rates on ordinary income. And why is so much capital flowing to bonds? The analogy to hemlines serves well in this regard. Take a long-established style, stir in changed circumstances, and add a significant swing in psychology. Bonds became passé over a long period of time, and stocks caught everyone’s attention. When these trends had gone as fa r as they could, and the error of the fashion extreme ultimately was exposed, bo nds came back into style. Bonds used to constitute the majority of portfol ios; then a 70:30 equity/bond mix became the norm; and then bonds went further out of style. And then, when bond allocations got as small as they could, the style mavens began to call for more, instead. Of course it helped that bonds outperformed during and after the crisis. So few people held bonds going into the crisis, a nd in such small amounts, that the attractions of bonds must seem like a sudden revelation: They’re senior in the capitalization to equities, of course, so they’re less subject to fundamental risk. Then there’s what I call the “power of the coupon.” In addition to redemption at maturity, mo st bonds provide an interest check every six months. Not only are these cash flows spendable a nd investable, but they also serve to stabilize bond prices, restraining volatility. Sounds like a gr eat deal. So why, people now wonder, did we hold so few? Take historically small allocations, add in newly discovered merits, and you get a buying trend and rising prices. The fundamental underpinnings for the buying trend in bonds are the converse of those compelling equity reductions: concern about eco nomic sluggishness, the chance for a double dip, and even the distant possibility of deflation. Under any of these circumstances, companies are likely to do poorly, so you’d rather own senio r securities (debt) with the promise of positive returns if held to maturity, rather than junior ones (equities), to which just about anything can happen. And if inflation is declining – taking interest ra tes with it – you’d rather secure a fixed rate of return with a bond than hold a totally variable instrument like a stock. With inflation at zero or negative, the thinking goes, locking in today’s in terest rates will prove to have been a godsend. Finally, if we get back into another crisis, w ouldn’t we rather hold bonds? Look how well they did during the last one. 2010 Oaktree Capital Management, L.P. 6 All Rights Reserved === PAGE 711 === At What Price? That question – at what price? – isn’t just the right question to ask about bonds versus stocks today. It’s the right question regarding every investment at every point in time. I try every chance I get to convince people that in investing, there’s no such thing as a good idea . . . or a bad idea. Anything can be a good idea at one price and time, and a bad one at another. Here’s how I’ve put it in the past: It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough. . . No asset class or investment has the birthright of a high return. It’s only attractive if it’s priced right. (“The Most Important Thing,” July 1, 2003) Investment success doesn't come primarily from "buying good things," but rather from "buying things well" (and the difference isn't just grammatical). (“The Realist’s Creed,” May 31, 2002) The thing to think about isn’t whether you’d rather have junior or senior securities in a recession, or fixed rate securities versus variable ones in deflation. The question is which securities are priced right for the future possib ilities: which ones are priced to give good returns if things work out as expected and not lose a lot if they don’t? You mustn’t fixate on a security’s intrinsic merits, but rather on how it’s priced relative to those merits. So, for example, it’s not enough to say “We want fixed rate securities in deflationary times.” You’ll be glad to be holding 2½% ten-year Tr easurys if deflation materializes, but how will you feel if it doesn’t? And what’s the probability of each outcome? If bonds are ideal for deflation and stocks w ill bear the brunt of the associated economic weakness, is that all that matters? Would you rather buy overpriced bonds than underpriced stocks? Is there an objective standard for overpriced and underpriced? And, for example, if the ten-year note will pay 2½% regardless of the envir onment, and stocks will return 15% if deflation is avoided and lose 10% if it’s not, doesn’t defl ation have to have a likelihood exceeding 50% for bonds to be preferred? (Check the math.) My point here is that simplistic blanket statemen ts are no help at all in making investment decisions. How have investors gotten killed in the past? By falling for statements like these: High-growth stocks are a good thing (1970). Bonds rated below triple-B aren’t appropriate for investment (1977). No one will ever buy equities again (1979). There can never be too many disc-drive manufacturers (1988). The Internet and optical fiber will change the world (1999). Home prices can only go up, and there can’t be a nationwide surge in mortgage defaults (2006). High yield bonds are unattractive given the risk of Armageddon (2008). Most of today’s positive articles about bonds are totally devoid of discussion of prices and probabilities. But it’s only by assessing those things that attractiveness can be determined. 2010 Oaktree Capital Management, L.P. 7 All Rights Reserved === PAGE 712 === What To Do Now? Ever since the financial crisis started in mi d-2007, I’ve been saying any recovery would be lackluster and investors shouldn’t be planning on prosperity. To me that called for investing in solid, stable, non-cyclical companies; avoiding levered companies and strategies; emphasizing risk-controlled strategies and ma nagers; and, perhaps foremost, holding more bonds and fewer stocks. These were general principles: my own bl anket statements, if you will. But now that stock prices have drifted lower a nd bond prices have continued to surge, I find I must reconsider the emphasis on bonds. How are bonds priced today? What returns can we expect? Let’s consider that 2½% ten-year note. With regard to Treasury securities, where it still seems safe to say there’s no credit risk, there are three possible states of nature. If we buy at a yield to maturity of 2½% and in terest rates don’t change, we’ll enjoy an annual return of 2½% per year for the next ten years. (With interest rates unchanged, there’ll be no change in price other than from accretion to par at maturity, and we’ll be able to reinvest the interest payments at the yields available at the time of purchase, an assumption implicit in the yield-to-maturity calculation.) If interest rates fall in response to economic wea kness or deflation, we’re likely to see interim appreciation. And if we sell at the appreciat ed prices, our holding-period return will exceed the yield to maturity at which we bought. Even if we just hold, our 2½% notes will be desirable museum pieces, as in, “Do you remember the good old days, when you could get2½% on Treasurys?” (In truth, though, how much lower can yields go from here?). Finally, if the economy, inflation and interest rates surprise on the upside relative to today’s low expectations, having locked in a yield of 2½% won’t turn out to have been a good thing.From 2½%, it’s clear that rates have much fu rther to go up than down. Any substantial increase in bond yields would bring meaningful interim price declines. It must be borne inmind that holders of the bonds of creditworthy issuers don’t have to worry about permanent capital losses (unless they’re frightened into selling when things are down). A bond that’smoney-good will outlive any negative interim fluctu ations, pay par at maturity and deliver the yield at which it was bought. So the real risk for people who invest in these bonds is that their returns turn out to be sub-par under the circumstances. If inflation turns out to be normal, investors in the 2½% note may end up with no more purchasing power down the roadthan they have today – that is, a real return of zero. Thus, if there are positive surprises in the environment, bond holders are likely to wish they had stocks instead. Portfolio construction is supposed to strike an appropriate balance between safety and certainty on one hand and aggressiveness and gains-seeking on the other. The key question is whether today’s bond buyers are leaning too heavily toward the former and forgetting too much about the latter. Are they too pessimistic and thus honoring uncertainty to excess? An article by Richard Thaler of the University of Chicago, in The New York Times of August 22, makes an important point. He wrote about CFOs, but I think it’s largely the same for investors: . . . the confidence limits [of their forecasts] widen after bear markets, mostly because estimates at the lower bound become more pessimistic. This puts a new light on the recent comment by Ben S. Bernanke . . . that the economic outlook was “unusually uncertain.” . . . Yes, things feel more uncertain after bad times, 2010 Oaktree Capital Management, L.P. 8 All Rights Reserved === PAGE 713 === but severe market downturns tend to occur after long bull markets when we are feeling least uncertain. In other words, investors become so accustome d to good times that bad times seem unsettling in comparison. That could explain excessive appetites for the safety of bonds and thus why, according to Deutsche Bank, “the top 10 low est-yielding U.S. corporate new issues in history have been sold in the last 14 months” (Bloomberg, August 16). And what about sellers of stocks? I’m no lo nger an “equity guy” by profession, and Oaktree manages far more bonds than stocks, so this isn’ t a commercial. But I feel investors may be overlooking some substantial merits on the part of stocks today (data from Bloomberg, August 16, except as noted): Having made their organizations lean and bene fited from declining floating-rate interest costs, cheaper labor or staff downsizing, companies are doing a good job of making money despite today’s lackluster economic environm ent. “Earnings for S&P 500 companies may rise 36% in 2010 and 16% in 2011, the largest two-year advance since 1994-5.” Rather than spend that money on expansion or acquisitions, most companies are piling it up. “The Federal Reserve reported in June th at nonfinancial companies were holding cash totaling more than $1.8 trillion, having built up th eir hoards at a rate unmatched in more than 50 years” ( LA Times , August 25). This pile of cash adds greatly to companies’ financial security and to the potential for dividend increases or stock buybacks in the future. Finally, those selling or shunning stocks today seem to be overlooking some very attractivevaluation parameters. oPrice/earnings ratios are lower than usual. “The S&P 500 trades at 14.4 times annualearnings, compared with an average of 16.5, according to data . . . that goes back to 1954.” Not giveaway levels, but 13% below the post-war average. oAnnual free cash flow for American companies excluding banks is running at 6.8%of their market value. This “cash flow yi eld” is roughly capable of being compared against the yield on bonds. Although (unlik e dividends or interest) the cash flow isn’t necessarily received by investors as it’s earned, it should contribute to stocks’value one way or another. The bottom line is that, as bond prices rise (reduc ing yields) and p/e ratios fall, the chances increase that stocks will outperform bonds. Thus the benefits high grade bond investors feel they’re gaining through what they’re buying can be undone by what they’re paying . I’ll say it another way: the attractiveness of one investment re lative to another doesn’t come from what it’s called or how it’s positioned in th e capital structure, but largely from how it’s priced relative to the other. I’m impressed today by the ability to assemble a por tfolio of iconic, high quality, large-cap U.S. growth stocks that will provide appreciation in a strong environment, a measure of protection in a weak environment, and a meaningful dividend yield regardless. To me, and given my standard view that we don’t know what the macro futu re holds, these stocks’ potential over a range of possible scenarios is more attractive than bonds which will do well in periods of economic weakness or deflation but poorly in strength or inflation. 2010 Oaktree Capital Management, L.P. 9 All Rights Reserved === PAGE 714 === Compared to stocks, I feel Treasurys and high grade bonds currently reflect all of the environmental factors in their favor and perhaps more and are priced rich relative to stocks. For them to do well from here, with yields so low, everything has to work out as the bond bulls hope. My friend, hedge fund manager Doug Kass, publish es a daily note to investors. (Given that I average a memo every couple of months, I find the very idea daunting.) I usually like what he writes, which is another way of saying we think a lot alike. Doug’s August 18 note carried a catchy headline, “Setting Up For the Trade of the Decade.” His nominee for that sobriquet: shorting the U.S. bond market. What about high yield bonds, one of Oaktree’s fl agship asset classes? They’re selling at yield spreads over Treasurys that are well above the hi storic norms, and their promised yields to maturity (before credit losses) should help instituti onal investors toward their return goals. On the other hand, it must be said that if interest rates rise, high yield bonds will see interim markdowns (albeit cushioned by their modest dur ations and the “gravitational pull” of price toward par at maturity). In all, given today’ s yield spreads, we believe high yield bonds will outperform high grade bonds in most foreseeable long-term environments. Leveraged loans may deserve consideration as well. The yields on these loans are low in the absolute, like other fixed income instruments, but relatively attractive at 5½-6%. The loans are senior-most in the capital structure, meaning they should provide some protection in a sluggish economy, and the fact that their interest rates float with LIBOR should insulate them against interest rate increases. Oaktree manages half a dozen large “multi-strate gy fixed income” accounts, in which we are responsible for allocating capital to our various marketable securities strategies. Recently, in recognition of the developments described above, we made a modest initial shift away from high yield bonds and into convertibles, with their sens itivity to equity market trends. Here’s what I wrote to our multi-strategy clients a month ago: Certainly by the onset of 2000, people believed too much in stocks and thought too little of bonds. Now, a decade later, th ese things are reversing. As we enjoy our portfolios’ performance, we should be alert for a day when bonds will have become too popular and stocks’ outcast stat us will have rendered them too cheap. We can pat ourselves on the back for being in the right asset classes today, but we shouldn’t fail to consider what th ese diverging performance trends can do to tomorrow’s returns. Since few investment trends continue forever, it’s usually smarter to expect ultimate regression to the mean rather than growth to the sky. No one should view the great popularity of bonds relative to stocks without reservation. September 10, 2010 2010 Oaktree Capital Management, L.P. 10 All Rights Reserved === PAGE 715 ===