Howard Marks spoke at Barclays Global Financial Services today. Below are his comments from a transcript obtained by ValueWalk.
Howard Marks: Thanks very much, Skip. Thank you for joining me this morning, everybody. And one of the most important jobs that I perform at Oaktree Capital Group LLC (NYSE:OAK) is to figure out the micro environment and the setting in which we all perform. We don’t consider ourselves market timers. We don’t raise in lower cash and our clients don’t expect us to do that, not doing so has always been an important part of our investment philosophy. But on the other hand, we think it’s very, very important to have a handle on the macro environment and to determine how aggressive or defensive to be and how much money to raise. I always say that – people ask me, what scares me, that’s the second question after what happens after you go under the buzz. And I will say, well, there are two things that scares me; one is raising too much money and the other is raising too little money. And it’s very hard to get that exactly right, but certainly to do that, we have to have a handle on the environment.
Howard Marks on macro forecasters
And before I go on with my remarks, let me just say that we also don’t consider ourselves macro forecasters and we don’t have an economist on staff and the things we do are not based on forecasts of the economy, but one of my sayings is that we may not know where we’re going, but we ought to know where we are. And so, a lot of what I talk about this morning will be about the current environment and what it implies for how we should behave.
I think that to put it simply, the world is much more uncertain than it used to be. This is the biggest change in last five years. Most people are aware of the uncertainties that exist in the environment, nevertheless many markets are raising and it’s important to know why.
When I say that the world is more uncertain, if you think back, I was reminded this morning that we’re within a week of the fifth anniversary of the Lehman filing, which is a good marker for all of us, but if you think back six years or seven years to the world as it existed at that time, how you would you describe it? Well, here is what I would say. I would say that people were 100%. People who would have been filling these seats in this room were 100% certain that they understood what made the world tick. What it would look like five years from then, and how anything could get fixed, if it went wrong. And I think the biggest single change in the world is nobody thinks those things anymore. Everybody realized that the world looks very different from what they would have said six years or seven years ago, what they would have said it would look like today. And clearly it’s been demonstrated the Fed etcetera cannot just push buttons and fix things. If you watch TV there is no easy button with regard to the economy. And I think that this change to the consciousness of uncertainty is a very big change.
Howard Marks: Central banks liquidity
But let’s talk about the current environment. What has been driving the markets for the last few years: Number one, of course, the central banks understood Bernanke as the scholar of depression, understood perhaps better than not any that it was the absence of liquidity, the withdrawing of liquidity that exacerbated the depression to the extent that it was bad.
And it’s us, the central banks to varying degrees created a lot of liquidity and particular of course reduced interest rates to zero. Now when we saw them reducing interest rates five years, six years ago what did we think? We said, aha, this is great because it will stimulate the economy and it will get – it will reduce the cost of doing business [ph] with current people to buy things, take on inventories, build plans et cetera, that’s great.
Number two, this is terrific because this will recapitalize the banks. And if you lend banks money at zero, which they can lend out at 5% it’s like you gave them $5 times the capital, and that’s great. What most people didn’t catch on, I must admit that I didn’t catch on to the current extent is that when you reduce the interest rates on treasury to zero you force people at the risk curve because it pulls down the whole risk curve, and so if you want to get the returns like you used to get before it happens, you must go further out the risk curve to make that money. And, that’s been the story over the last few years in the capital markets.
So, money was created, it had to go some place. The central banks lowered the return on treasuries and other safe investments and this caused people to look elsewhere for the risky markets they create. Before the crisis, you used to be able to get 6%, 7% on intermediate term treasury notes and now of course, you can’t even get that from high yield. So, you go to high yield or you go beyond, if you need 6% or 7%. You can’t stick around the treasuries.
Howard Marks: Low bond yields
Now, in addition to what the central banks did, there have been certain factors which reinforced these trends; number one, the returns on risky assets have been very good over the last few years, and so people are encouraged to do more of it; number two, the default experience among high yield bonds, for example, has been unusually low since 2010.
And when people – when defaults don’t occur, people tend to get sloppy and say well, I think we’re living in a low default world, I think we’re living in a safe world; and then number three, psychology becomes more positive as markets rise. So you take those factors together, good experience, low defaults and rising psychology and that’s why I say that even though people are not thinking bullish, they are concerned about the uncertainties, they are acting bullish, their behavior and not only they’re buying riskier securities, but they are buying them at lower returns and they are buying it with weaker features. The covenant is disappearing. It’s easy to do a dividend recap, a CCC issue or something like that in the high yield bond market. So, if you take it all together, what do you have, today, the price for pursuing safety appears very high in terms of opportunity cost, and the price for accepting risk appears very low, mainly because risky securities have been performing so well, and of course, this is the combination of factors that very much encourages risk taking, and that has been the story of the world in the last few years.
So the question is, for us to decide how to behave today? How to position our business, our portfolios? So, obviously, there are factors on both sides, and there are always are and that’s a healthy debate. And today, the fact is arguing for us to move forward and take action or and invest or the number one, the U.S. economy is recovering; number two, psychology is muted; number three, prices of most assets are moderate, stocks are selling at a fairly normal PE ratios, high yield bonds are selling at actually generous yield spreads related to treasuries, and finally, safety is priced too high to pursue, it’s with the exclusion of risk taking. If you say, I want safety today, I don’t want to worry about losing money, then you get a pittance in terms of return. So these factors argue for forward movement, but there are also factors that argue for the application of caution.
Number one, the level of uncertainty is very high in the world as I discussed. Number two, the economy is – can only be described as sluggish. We continue to see two steps forward, one step back, which I guess is better than other places where you see one step forward and one step back. There is the possibility of highly significant negative developments.
Howard Marks: Black swans
You know, what you might call black swans. I mean, there are things out there which have a low probability of happening, but could have substantial consequences. Examples would be some problem with the euro and the euro – and Europe don’t feel the me like they are out of the woods organizationally. Another would be hyper inflation brought on by too much money printing and other would be deflation and it Japan experience and I point those two out to just show you that the fact that people worry today about both inflation and deflation shows you what a confusing world we live in today. And then finally, the providers of capital are providing risk tolerant behavior and all four of those factors in my opinion add for – argue for restraint.
So I’ve devised over
the last five years and increasingly apply for myself three questions which help us put these matters into focus. Number one, do you expect prosperity or not? Now, I don’t know what any economist is predicting for GDP next year. I don’t care about quarters of a percent. The question is prosperity or not. If yes, then you would invest more in equities and in growth stocks and cyclicals and you would take on more risk and you would use more leverage, everything else being equal. And then if not, you would invest more in debt, more in value stocks, among your stocks and stable stocks and you would opt more for safety and you would use less leverage. So I think the decision as to whether or not we’re going to have prosperity is very important.
I – as I said I think the economy is doing okay. I think it will continue to do okay. I believe it’s going to be sluggish. I believe we’re not going to have what I would call prosperity, which is what people remember. I believe we’re not going to have a period when people – we get back to what people used to call the good old days. Now I may be wrong and I am first to admit, number one that I am very cautious usually and number two, that the surprises could be on the upside. I mean, things like how these starts could click and so forth, but I’m not – that’s not my central expectation.
Howard Marks: Risks to worry about
Question number two, which risk should you worry about? I think this is very important. People who are in the investment business really face two risks. The traditional one that everybody – the man on the street understands is the risk of losing money. But the second one is a little sneakier. It’s a risk of missing opportunities. And you can eliminate either one. If you say I don’t want to take any risk of losing money, so then you buy all treasuries. But if you say I don’t want to have any risk of missing opportunities, then you can’t buy any treasuries. So, the solutions are mutually exclusively. You can’t solve both. And you can – you have two choices, you can either fixate on one to the exclusion of the other or you can balance the two.
We know, of course, that we should balance the two, but we should – we can emphasize one over the other at a point in time should we want to. And this I think helps us – a lot of the time I think about what we should do by saying what’s the mistake you can make today. Is the mistake investing or is it not investing? Is it buying too much or buying too little? Is it buying too risky or is it buying too safe? And we try to figure out what the potential risk is today and then not make it and something about the way my mind is worried, why [ph] tells me that it’s easier to figure out the mistake and not make it than it is to figure out the right thing and do it, although one seems like it should be the converse of the other.
But which to worry about today? Well, that leads me to the third question, which is – which attributes should you favor? Let’s go back to the six months that followed the Lehman filing five years ago. You were in the fourth quarter of 2008 in the credit market to the first quarter of 2009 in the equity markets, what did you need to make money? You needed two ingredients and in deference to the women in audience, I’ll say you needed money in nerve. And if you had money in nerve you made a lot of money and you needed money that was unspent and you needed the nerve to spend it.
What didn’t you need? Caution, conservatism, risk control, selectivity, discipline, patience that kind of attribute. If you have those attributes they held you back. The people who had those things made less money over the last five years than the people who only had money in nerve, and that’s what you needed then. Now, does that mean that money in nerve is the formula for [indiscernible] in the investment business and the answer is no, because if you had money in nerve in the first half of 2007 then you bore the full brunt of the crisis, that’s when you needed caution and conservatism and those other attributes. So, again, another way of thinking about really the same question what do you need today, which set of attributes should you be bringing to your investment activities? And my answer frustratingly is, as to the second two questions is we are somewhere in between.
Now, it’d be nice to be able to always get up here and to say we are at a all-time high, we should sell or an all-time low we should buy, but the truth of the matter is if you think about the sine wave that represents the markets and psychology over the decades, you see how little of the time the markets are at the ultra cheap or the ultra expensive. And you can see that most of the time its somewhere in between and I think we’re in between now and given the fact that it’s so clear what to do with the highs and lows, which is not to say that everybody does it and given how much of the time we spend in between really a lot of our life consists of figuring out what to do in between. So, my own prescription for an uncertain world is that, number one, you should make sure your expectations are moderate. And when I put out a new edition of my book a little later on, my book has 20 chapters, each one says the most important thing is and then it has a different thing. In the second edition, I added another chapter, which says the most important thing is reasonable expectations. And today, we’re living in a low-return world and it’s very, very dangerous in a low-return world to have high expectations because it gets you into trouble.
Howard Marks: Corporate investments
Number two, emphasize corporate investments. I think that corporations are great because the corporation, a well-managed corporation with a great opportunity is adaptable and it can adapt to international competition or domestic competition. It can adapt to inflation or deflation, not perfectly, but better than most other potential forms of investment like governments.
You must commit to active decision making. You must realize that doing nothing is doing something. Doing nothing should require a conscious active decision not to stay with the portfolio you have and instead you should examine your portfolio and question, is this the right one? You should remember that the reasons for caution are not imaginary, what I call the improbable disaster is not impossible in this environment. So maybe you should leave something over for that possibility. And you should balance these many pros and cons and you should realize it’s not easy to balance them and you should realize that it’s not supposed to be easy. And Charlie Munger told me that at lunch, just before I published the book and that was the last thing I added to the book.
The first chapter says the most important thing is second-level thinking and it starts with a call from Charlie, who says none of this easy and anybody who thinks it’s easy is stupid. And this is not easy and anytime you think that you have a way to make money easy, you’re probably not conscious of the reality. So to wrap up, I believe that the outlook is not so propitious and assets are not so cheap as to call for aggressive investing, but by the same token conditions are not so bad and prices are not so high, but its time to be high – extremely risk averse. And if you agree with that assessment and you combine those two sentences then you get to my mantra, which has been Oaktree Capital Group LLC (NYSE:OAK)’s mantra for the last two plus years move forward, but with caution. So as we raise money we invest it, but I think we insist on investing it with caution.
And when people, well I put out a memo in February 2007, called The Race To Bottom describing what I thought was the conduct going on in the pre-crisis days. And what happens is when people are in heat to invest and today of course they have to invest to make the kind of returns they want. They often tend to drop their caution and that’s particularly the wrong time to do so. So that’s my macro formulation today and later on I’ll be glad to discuss it with you. But I just wanted to discuss why we think Oaktree Capital Group LLC (NYSE:OAK) is suited to handle this environment and we had this investment philosophy.
And as I was [indiscernible] this morning by David, number one says risk control is our number one job. We have voiced about risk control first, not making a lot of money, not beating the market, not being in the top quartile risk control. And once you’ve done that, then you can try to do those other things. But we try to set up our portfolio so that the surprises – so that we perform consistently, don’t provide disappointments and the surprises are on the upside. So from inception, for example we have 26-year, 27-year records in high-yield bonds and converts and with that performed by a 100 or 200 basis points a year steadily with less risk as indicated by highly superior Sharpe ratios. Our Sharpe ratios are about 50% higher than the Sharpe ratios on the benchmark showing that our risk adjusted returns are very high.
Closed-end funds
Our closed-end funds, distressed that, starting 25 years ago next month, distress for controlled real estate, the power opportunities and mezzanine finance have generated an aggregated IRR of just about 20% a year on a gross basis and that’s twice what the S&P has returned over that
period and every fund has a positive return. We’re very proud of the consistency of that record not at Oaktree Capital Group LLC (NYSE:OAK), not just the level of the returns, but the consistency with which they have been achieved. All 48 of our funds as I say have positive returns, the ones that were formed before last year where it’s really too soon to have meaningful results. All 19 of our distressed debt funds which were one of our flagship strategies have double digit gross returns ranging from just about 10 to 57, I think.
84% of our capital in closed-end funds has an IRR which is over the 8% hurdle required to get a carry and as I recall from high school 84 is a good mark at that time, all I was hoping for. And well, at the same time, we’ve distributed $40 billion to our clients in the last five years and have grown our AUM by 50%.
So I think we’ve proceeded cautiously and conservatively and got a lot done. I think that it’s very important that you understand from me my definition of our goal as a business is to deliver client satisfaction. And client satisfaction is not just high returns, it’s something more, it’s dependability. And Keefe, Bruyette puts out an annual survey of where would you like to put money and we’ve been number one among the alternative firms for the last few years. And I think it’s not just other people promise higher returns and even from time to time get them, but it’s the dependability and the fact that people know they can count on us.
So if you look, for example, I think we have delivered client satisfaction. In our open-end strategy, that’s U.S. high yield, European high yield, U.S. converts, international converts, busted converts, senior loans, we have about 129 full calendar years of history. So, that’s it – now we are getting up to statistical significance. Now it’s a real test. In 118 of those years, we had returns that I would call good returns.
Howard Marks: Good year for company
What’s a good return? Good year is a year in which we either have a high absolute return or beat the index or both. Why do I establish that as my criterion, because number one, the client will be happy and number two, you won’t get fired because there will always be somebody who did worse. There’ll always be somebody who either didn’t – who didn’t make a good return and didn’t beat the market. So, a good year is one in which we make a good return or beat the market or both. And 91% of our years have been good years by that standard. Taken the extreme example, we – our longest running strategy is U.S. high yield bonds. I started that at Citibank in 1978. In 1986, when we joined TCW, we had to restart our record, because you couldn’t just walk across the street and show them your returns. You had to be able to document them, which could do. So we have a 27-year record in high yield bonds. We’ve never had a bad year by that standard. And this is what clients want; they want stability, consistency, dependability, and they want to be able to sleep at night.
We also deliver a high level of service and reporting. We’ve had a very, very low incidence of portfolio manage turnover, and in the vast majority of the strategies that I named to you, every single person who has ever managed those portfolios is still at Oaktree Capital Group LLC (NYSE:OAK) today. And this is a record going back 35 years and very few organizations can say that, and of course, I think we have a very strong reputation for integrity and putting the client first.
These strong investment returns had driven fundraising success. Since January of 1, 2007, the period covering the crises and recovery, we’ve raised more than $81 billion of gross capital. We’ve raised almost $10 billion or more every year for the last six years, not including 2013, and we think we’re on pace to do so again this year. And this year, for the first time, we’re doing it without a distressed debt fund, an Opportunities Fund. Every year, prior to that in this record, we had an opps fund, that we were raising, and our opps fund stays great demand, and enable us to reach that standard.
But this year for the first time, we are not raising an opps fund. We haven’t invested last year’s fund yet, and yet, we think we’re on track to raise $10 billion again. 78% of our assets come from clients, who are in multiple strategies. So what happen as they go into one, they have a good experience in terms of dependability, consistently see a return and then they tend to go into more.
39% of our assets come from clients who are in four or more strategies. And our clients are in wonderful stripe of the investment population. We have 100 of the 300 largest global pension fund, 75 of the 100 largest U.S. global – U.S. pension funds, 38 of the states, 300 universities, colleges, endowments, foundations and 10 sovereign wealth fund. And we continue to innovate and develop step-out strategies to capitalize our new opportunities. You know, if you went back that magical five years that I keep talking about, high yield bonds paid 10% and in this stress, we are looking for 20% or more. And that was – everybody was satisfied with that menu. Today, high yield pays about 6%, in this stress we are looking for 15% or more and the clients want to be able to access something that will pay them 9%, 10% or 11%. And so we’ve put a lot of energy in the last year and a half into developing and delivering that for them and we’ve raised $4.3 billion in strategies that did not exist at the time of our April 2012 IPO.
So, the enhanced income fund, which uses moderate leverage on senior loans, we’re using leverage because now instead of six years ago, now you can get leverage were you can’t get a margin call because prices fall. We saw firsthand, the corners that can occur when you can get a margin call on price declines, this leverage does not permit that. Strategic credit is an offshoot from the distressed debt funds. It’s the things that are too risky for the high yield portfolio, but don’t satisfy the return criteria and of the distressed debt portfolios. So, where we think we can get 9%, 10%, 11%, 12% and we are raising money for that in nine-digit separate accounts, and we’ve raised several in the last year. Real estate debt, another area where we think we can get high-single, low-double digits and the non-A buildings in the non-prime cities, we think are a great place to earn very good returns in real estate debt.
Emerging market opportunities, we’ve started a new group to invest in distressed and distressed corporate debt in the emerging markets, and we did it because we attracted a great, great individual to lead that. Emerging market equity long-only, we’ve been managing a long, short fund for the last 15 years, but two years ago we went into long-only, and we’re compounding a good record there.
And then finally European dislocated debt, basically the direct lending opportunities that the European banks will not take fully. So, that’s what we’re doing at the present time. That’s – I’ve told you why I think positioning ourselves in these kind of tweener strategies is the place to be today as long as we execute with caution. Skip, is there any time for questions? A couple of questions. Yes, sir.
Q&A with Howard Marks
<Q>: [Question Inaudible]
<A – Howard S. Marks>: Thank you. Thank you.
<Q>: If you went back to 19 – I’m sorry, if you went back to the …
<A – Howard S. Marks>: Say the part about the excellent presentation.
<Q>: Quasi-excellent. Congratulations.
<A – Howard S. Marks>: Thank you.
<Q>: I hope to copy you and do better.
<A – Howard S. Marks>: Thank you.
<Q>: If one went back to 1970s when there was period of significant easy money, and we had a significant commodity and expansion in oil, food, obviously the support, the shocks of Vietnam, the OPEC formation and so forth. In this period of time – in this period of time where we’re having easy money and it’s all going into the capital markets for as you articulate well. Could this end in the same bad way that it ended in the 1970s when Volcker came in after Arthur Burns, Volcker basically decided that we had an unhealthy economy despite the fact that we had the markets rising and essentially squish the whole system down, could you have a change in fed policy where you have the same ending where even though all of us in this room want to believe stocks are attractive, we could have a different, obviously, something that’s easy money has taken away and, obviously, the economy, which is not necessarily very healthy, we have some of that recurrence of what happened in the late 1970s.
<A – Howard S. Marks>: Well, I just want to add two things to your question, which you omitted. Number one, you didn’t use the world inflation and inflation was the semi [ph] characteristic of that period. I have a note on the wall that I got from the bank. I had a loan outstanding at three quarters over something called prime, you may
recall prime.
<Q>: I do.
<A – Howard S. Marks>: And I got a note from the bank every time the rate changed and I have the one that says the rate on your loan is now 22% in the quarter. And that was all brought on by high inflation. That’s was Volcker came in, that’s what he squished by withdrawing money and that – and the other thing we – you should mention is, of course, that his doing so hurt the markets in the short-run but set the stage for the greatest bull mark in history. Now, I’m not necessarily making an analogy and anytime I get a question that starts with could, then I say yes, because in this world anything can happen. The main thing I would say is that inflation I find extremely mysterious. Nobody knows how it gets started and it was clearly demonstrated in the 1970s that once it gets started, nobody knows how to end it. Same for deflation as the Japanese have demonstrated and so…
<Q>: However, Howard, debt has become a much more significant factor?
<A – Howard S. Marks>: Debt is a very significant factor today. We’re living in a largely unlevered world then. So, the answer is yes. I mean lots of – there are so many uncertainties out about there – out there that’s really the underlying reason for my caution. And the removal, the tapering could be an elegize to Walker’s decision to withdraw liquidity. And there is every reason to believe that if the tapering occurs that the market – that the economy will grow less than it otherwise would have. I’d like to believe that if they time the withdrawal of the tapering right and if they do the tapering for the simple reasons, the economy is doing better than the economy will still do okay even without the stimulus. So – but I mean this little discussion that we’re having just illustrates how uncertain the world is and how important I think it is that we behave with caution. I put out – you mentioned the equities, I put out a memo in I think March called the Outlook for Equities, in which I listed something like five factors arguing strenuously that equities were attractive and seven factors or eight factors saying that they – just as strenuously that they were overpriced. So, nothing is obvious.
<Q>: Thank you.
<Q>: I have the mic over here.
<A – Howard S. Marks>: Yeah.
<Q>: Two questions; one, what’s your outlook on interest rates and how it is impacting your positioning and there is a hedge question too, as there is a headline in the journal today hedge fund fees cut back on fees. Do you have a view on that issues sustainability of fees and alternatives?
<A – Howard S. Marks>: Okay, well, number one, you obviously didn’t get the memo where I said I’m not a forecaster, but having said that I mean my personal expectation, Oaktree Capital Group LLC (NYSE:OAK) does not base it’s investment actions on macro forecast. Having said that, my personal view on interest rates is that they will probably raise although I don’t think dramatically because the economy is not that dynamic and there is not much inflation. So, those are the two factors that usually call for high rates and we don’t see either of those.
As for hedge fund phase, is anybody here work for hedge funds? Anyway, I wrote a memo on hedge funds 10 years ago, that was the only one. And I said there that I predicted the average hedge fund will grow 6% or 7% a year. It will return 6% or 7% a year, which are the coming years and then eventually people will get tired of paying two in 20 to get 6% or 7%. And I think they probably have made about 6% or 7% a year over the last decade, but nobody seems to have gotten tired of paying two or 20.
Although I haven’t read the journal story yet this morning and maybe they will tire of it. If you went back – I was – there is a guy name, Rick Rees, he was with Cumberland, which was a good hedge fund. I met him over the summer. I hadn’t seen him in 40 years and I said 50, but he corrected me. But if you went back 40 years or even 30 years, the number of people I knew who got 20% of the profits, you could count on one hand. And now thousands and thousands of people get 20% of the profit. And I believe that for a client to give a manager 20% of the profits, that is the safe to give a manager the return on a fifth of his capital, the manger should be exceptional.
And I think that there aren’t that many exceptional people. There aren’t 10,000 exceptional people in this industry. And so my answer to you on fees is that the exceptional will continue to deserve carry and presumably we’ll get it and the unexceptional will not.
