Howard Marks On What Investors Should Worry About

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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

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