Howard Marks, Co-Chairman of Oaktree Capital, cautions about the growing pressure for risky behavior and explains why it’s time to play defense.
Few investors are as highly respected as Howard Marks. But if you want to know from him what the stock market is going to do over the next few months, you’re going to be disappointed. The Co-Chairman of Oaktree Capital does not need to pretend that he knows the future. Instead, he points his focus on the things that are most important for a superior performance in the long-run: risk control and a good sense of market cycles.
«I feel most strongly that there is no place for aggressiveness in investing today», Mr. Marks states with regard to the current environment. Although he doesn’t spot signs of euphoria, he cautions that investors are forced to take significant risks when they’re hunting for yield. Against this backdrop, he thinks that it’s very challenging to achieve decent returns with a prudent investment strategy. How to get the odds on your side, the legendary value investor reveals in this interview with The Market.
Mr. Marks, risk assets are back in favor. In the United States, the stock market has staged a swift recovery from the December lows and has made a new all-time high. Are investors getting ahead of themselves?
I would not say so. I don’t see people swinging for the fences. In fact, optimism is restrained today. I don’t see people running around saying: «There is no risk, nothing can go wrong.» Investors do not have that attitude. Rather, I think that most people’s attitude is: «I have to take risk in order to make a decent return in a low return world. I know that the economic recovery is old, I know that the bull market is old, but I hope they keep going.» This reserved attitude is a positive.
Why do investors feel the need to make risky bets?
Today, many investors are what my late father-in-law used to call «handcuff volunteers». They are doing what they have to do, not what they want to do. In the US, the typical institutional investor, meaning a pension fund or an endowment, needs an annual return rate of 7 to 8% to make the math work. But in a low-return world this is very hard to achieve, and impossible without bearing significant risk. This means that people acknowledge that they have to move out on the risk curve. I see rather that than euphoria.
What does this mean from the perspective of an experienced value investor like you?
As an investor, you make the most money when you do things that other people aren’t willing to do, like taking risks others shun. Attractive investment opportunities arise when you spot some security or some part of the market being ignored and you come to the conclusion that it’s languishing cheap. But today, I don’t think anything is being ignored. Investors are willing to do almost everything.
Is this also true for the credit markets, one of Oaktree Capital’s core strengths?
Take new private credit funds for example. From 2008 to 2013 there were roughly 80 new credit funds of which 20 were first time funds. But in the last five years, there have been around 320 new credit funds of which more than 80 were first time funds, as I wrote in my September memo. To me, the ability of asset managers to raise first time funds is indicative of risk tolerance on the part of clients. Even though many of these asset managers never managed such an investment vehicle before, they’re offering to learn with the money of their clients. And if people run up and say «here, take my money, take my money», it tells you something about their attitude. There is a belief in markets and in managers and thus a willing to take risk. What comes to mind is what I consider the number one investment adage: «What the wise man does in the beginning, the fool does in the end.»
What about psychological aspects? The higher asset prices go, the more difficult it gets for most people to stay on the sideline.
The economic historian Charles Kindleberger said it best: «There is nothing worse for your mental wellbeing than to watch a friend get rich.» It’s a great saying because envy is one of the strongest forces in the world. People don’t buy a stock at $5 and they don’t buy it at $10, $15, $30 or $40. But when it gets to $50 they say: «Shoot, I can’t stand the pressure, I have to go in.» The point is, everybody wants to get rich. And everybody wants to find a way to get rich which doesn’t entail risk. So people are optimistic for the simple reason that they want to get rich.
Oftentimes that’s when things end up in tears. How can you stay prudent and avoid short-term temptations in order to earn superior returns in the long-run?
Investing is a funny thing because a lot of people think that the long-run is a series of short-runs. Yet, the long-run is a thing in itself: If you aim to pursue superior long-run performance then it doesn’t work to try to accomplish superior short-run performance every year. The things you might do to try to be in the top decile in a given year increase your risk of being in the bottom decile. But if you do just consistently well, with no trips to the bottom decile or even to the bottom half of the distribution, it will make you superior in the long-run. So trying to be superior in the long-run by foregoing maximization in the short-run is the most reliable course.
In others words: Just striving to do a little better than average every year is the key to coming out on top in the long-run?
It’s a philosophic thing. Trying too hard in the short-run exposes you to the risk of doing badly. Trying to find big winners on every trade exposes you to the risk of having losers. You accomplish more by having goals that are modest but more reasonable. Put differently, trying to be a big home run hitter induces the possibility of strike-outs — and strike-outs have a very bad effect on your long-term performance. That’s why the investment business is full of people who got famous for being right once in row.
Then again, keeping a clear head when things get really exciting is easier said than done.
The major volatility of the market is the result of fluctuations in psychology: Good news makes people excited and buy. Bad news makes them depressed and sell. But if you get excited when things go well and depressed when things go badly you’ll buy high and sell low, and you are unlikely to have superior results. By definition, your reaction has to be different from that of others.
How do you do that?
There are only two ways: You can be an unemotional person who’s in charge of his or her psyche, or you can be an emotional person who can keep it under control. Most of the great investors I know are unemotional people. They are intellectual and analytical, solid and not volatile. In the great crash of 1907 for instance, J.P. Morgan walked out on the floor of the New York Stock Exchange and said: «I buy». Another example is Warren Buffett’s $5 billion investment in Goldman Sachs during the financial crisis.
Oaktree, too, made some big and successful bets at the depths of the financial crisis. How do you remember these turbulent days?
As I recount in my recent book, in the fourth quarter of 2008 we invested more than half of a billion dollars a week on average for fifteen weeks in a row. I can’t say we were absolutely sure or we had no fear. We were uncertain and we did it with trepidation. But we did it anyway. So the essential question is: Do your feelings control you? Or do you control them?
Since the financial crisis, monetary policy has become more important than ever. Today, many investors rely on the central banks to always have their back. Is it even worth the effort to be cautious and prudent in this environment anymore?
I hear people saying: «Maybe the Federal Reserve can use the reduction of interest rates forever. Maybe the central banks can just use quantitative easing forever, continuously buy securities and pop liquidity into the economy. And, maybe we don’t ever have to have a slowdown again.» Simply put: «It’s different this time.» But how much money would you want to bet on that? Is it really possible that we will never have a recession again? I’m not sold on this because the riskiest thing in the world is to believe that there is no risk. When people sense that the risk of an economic slowdown has been eliminated, they will take steps to ensure that there is plenty of risk present, in particular by bidding up security prices too high. People create risk through their own behavior.
So what should your investment approach look like today?
First of all, the future is never fixed or knowable. That’s why Oaktree’s investment philosophy includes the principle that we don’t make investment decisions based on economic forecast. Anybody who’s involved in the investment business should banish words like «always», «never», «has to», «can’t» or «must» from her or his vocabulary. In our business there is no place for certainty. With that in mind, I like to quote Henry Kaufman, who was the chief economist at Salomon Brothers. He said that two kinds of people lose a lot of money: «Those who know nothing and those who know everything.» So, at best, the future is merely a probability distribution of future events. All you can do is get the odds on your side.
What are the odds in the spring of 2019?
It’s hard to answer. In investing there is a lot of «on one hand» and «on the other hand». Take the US economy for example. It’s is doing quite well – probably the best in the developed world. However, this is the second half of the tenth year of the recovery and there has never been one in the US that lasted more than ten years. However, this has also been the slowest recovery since World War II. And because it’s been slow there have not been excesses which require a great correction. Then again, the rest of the world seems to be slow and slowing. So the question is: How long can the US do well if the rest of the world does poorly?
What do you think personally?
Some people make the mistake of saying: «Well, there has never been a recovery of more than ten years, so this one has to stop soon.» This is silly. There is no «has to». There is no iron gate that comes down on the tenth anniversary which ends the economic progress. Here’s another way to look at it: It’s said that economic recoveries do not die of old age but usually of monetary contraction. Yet, monetary contraction usually takes place as a response to the economy overheating which this one is not doing. And the Fed has recently disavowed monetary contraction at this time. So, I don’t think there is going to be a recession this year and I doubt there will be one next year. And who knows about 2021? All you can say is the odds are against this recovery going on for many more years.
And what do you observe when you take the temperature of the financial markets?
As I said before, the element of euphoria is missing and that’s a positive. But I do think that people are behaving in pro-risk ways. Investors are heavily in leveraged credit, private credit and private equity. All of these are prosperity- and optimism-oriented strategies. What’s more, the bull market in stocks is more than ten years old. According to the P/E ratio on the S&P 500, equities are priced high but not extremely high, especially relative to other asset classes. So, the easiest thing to say on that subject is that I don’t think we are in any kind of bubble. I don’t think we are at risk of a crash.
So what should investors do, given that we’re likely in the later stage of the cycle?
It’s important to understand that the cycle oscillates around the midpoint, which is generally thought of as the secular trend, average or, as I say, fair value. It exerts something like a magnetic pull. So it’s relatively easy for prices to go from undervalued to fair. But then, it’s harder for things to go from fair to rich, and from rich to very rich. Simply put, the movement from cheap to fair is easy money and, in some sense, dependable. But the movement from fair to overpriced is not easy money and it’s not dependable. That’s because it depends on people making mistakes. Of course, people tend to make mistakes. That’s why it’s unwise to say «this bull market is going on for more than ten years and it can’t go any further». All we can say is that the easy money has been made.
What does this mean in terms of cycle positioning?
I feel most strongly that there is no place for aggressiveness in investing today. Yet, I also believe that the outlook is not so bad and the prices are not so high that we have to practice maximum defense and go to cash. So, for several years, Oaktree has been operating under the mantra «move forward, but with caution». We became cautious too early, but we still are. What that means is we are essentially fully invested in most of our funds and accounts, but we are using even more caution than usual.
How should investors calibrate their portfolio accordingly?
There are three ways to do it: Number one is go to cash. But that’s very extreme and easy to be wrong. Number two, you change your asset allocation: bonds rather than stocks, high grade bonds rather than low grade bonds, US rather international markets, developed world rather than emerging markets, large companies rather than small ones, and defensive companies rather than cyclical or growth companies. And then, the third way is to be defensive even within your existing asset allocation, just by shifting to safer approaches and safer managers within your asset classes. It’s challenging today to invest in a low-return, highly priced world. But I think a cautious approach can enable you to access returns even while behaving prudently.