A Conversation with Howard Marks: Mastering the Market Cycle

well Howard it's almost lunchtime you know by your standards here so one I want to thank you for coming and I want to talk for a moment about something that plays very an important element in cycles then you've spent a lot of time writing about it in before I get there one of the great challenges for all of us to contemplate today is this area of trying to understand finance and financial markets and many of you work on that area and I want to challenge each of you today because this is an area Howard and I we might touch on it have focused on together for more than four decades and that challenge is what do people think what is their view there's a quote in this book that Howard gives you from John Kenneth Galbraith talking about how little finance or access to capital or financial markets as you know it how little it plays as people talk about history and what occurred in history over the years and there it comes why don't you tell us about that to start having well first of all it's from a book called the brief history of financial euphoria which I read a very long time ago which I recommend to everyone it gives you a good feeling for sick ocala T for the behavior of the herd for the importance of contrarian ISM and and and and it is an honest book in the sense that it is brief and I enjoy that but the point is that in investing in particular one of the outstanding characteristics is shortness of memory and the point is we we know so much from history but if we disregard history we know so little if we disregard history then every time something happens anew we have to start from scratch figuring out what it means if we understand history we can put it in we can do what I call in the book pattern recognition and we can say oh yeah that that's like that I saw that 10 years ago in 30 years ago and and that's and and then here's what it comes from and here's what plays out and here's what it's going to result in but most people ignore history most booms and I you know I probably lived through about half a dozen real booms in my 50 years in the business are usually about something new and the Internet in 99 the nifty 50 Xerox and 69 whatever it might be subprime mortgage securities and the people who get excited about it who caught in to it who are intoxicated by the positives and willing to ignore the negatives if you if you say to them you know well that kind of that happened 20 and 40 years ago and it ended badly what they say is they use the four worst words in the world it's different this time the rules of the past don't apply the you know yes the average p/e ratio historically has been 16 but now it's 32 and that's okay because the Internet has changed the world and something like that and so it go back one slide though if you will and and what it says is that past experience to the extent that it is part of memory at all is dismissed as the primitive refuge of those who do not have the insight to appreciate the wonders of the present and you know they if you say to somebody in 99 who's buying an internet stock which has no profits and no sales and that you know at an astronomical price they said well you just don't get it you're an old fogey and the point is that the past is relevant and and now you can bring up that next slide Michael because that was a good one thank you and and most of the time it's not different now clearly some of the time it is different but not as often as people think let's talk for a moment about this slide by Reinhart in there was a book written this time it's different and it really related to sovereign debt and credit and so I'm at Berkeley and 65 studying credit and almost all sovereign debt is rated triple-a and it's considered the least risky debt of all and the head of the Federal Reserve Paul Volcker and the 70s is telling everyone that no country ever defaulted ever went bankrupt yet and has absolutely nothing to do with history and I think I want to just underline this point then Howard has made here when you step back in history ask yourself have you done the original research what is common wisdom you know as I listened to Paul Volcker in that period of time that chairman Volcker talking on the speech I remember most howard was one and around 80 or 81 that Poland is not International Harvester both Poland and International Harvester were trading in 31 cents on the dollar and his point was Poland as the country countries don't default I don't go bankrupt and of course International Harvester could go bankrupt well he was right but he was wrong International Harvester paid you off a hundred cents on the dollar never missed an interest payment and Poland reorganized its debt and the 30 so for every dollar of debt you got 30 cents of sleep he was right semantically he was just not right financially okay yeah and so I just want to stress the importance of research and Howard let's go back to the late 1960s early 1970s and when I went to Wall Street we had fixed commissions for stock and the highest compensated people in the financial system were those that were generally equity salesmen because when you bought a stock the charge was 1% if he bought a million dollars worth of stock anta paid ten thousand today that might be $3.75 if you can't negotiate a better deal and so they live during this period of time but when you went there here's a look if you want to just buy five shares of Berkshire Hathaway and Warren Buffett who's a good friend Howard and a good friend of mine if you want to buy a stock you can see what you would have paid then and what you put it pay now so being in that business it's been a tough business to be in once you went into an open market but the issue is if you step back in that point in time the fundamental issue was sales and if you look at the pyramid on Wall Street as Howard and I entered this period of time almost 50 years the power was in sales then it went to trading and if you were long and overnight you did a little research to try to figure out what is this thing and so what my focus was and Howard being one of the most representative individuals of this dramatic change that occurred was changing this pyramid let's start with research the fundamental part of investing his research have you done the data so if you've come here today have you checked off anything in the book what these little post-its that you might want to relate to and then we can go to trading can you actually buy it it might be an interesting idea but can you invest in the case of Howard buying a million dollars of something is not going to affect your portfolios or your clients so the question in trading is they're a big enough market for you to play Kappa and lastly now you're focused on buying and selling process but the inverting Howard take us back in your own career for a while and talk about why you chose to go to Wall Street how you ended up at Citibank when we met each other well you know I started off my dad was an accountant and I thought I'd be coming I took actually took hi counting in high school and liked it and I didn't admit that well I was in high school but so I went to Wharton and I figured I'd take it degree in accounting but then when I got there I started to study finance and I found that more interesting so I shifted over then I went to University of Chicago for a master's degree and that was in accounting and when I got out of there I still didn't know what I wanted to do and applied for six different jobs and six different aspects of finance but I had had a good summer at Citibank the year before I like the people I liked what I did so I went into Investment Research and it was nothing more wasn't a much more conscious decision than that and that was that was 1969 started off in equity research and then became director of research and the bank engaged in what was called nifty 50 investing it invested in the best and fastest growing companies in America without regard to price because if the official dictum was if it's good enough and fast growing enough it's worth any price which is kind of the opposite of what I think you believed Michael and if you bought the nifty 50 the day I got there in 68 and if you hold it diligently until 73 you lost almost all your money in the best companies in America and there's a lesson in that of course that that it's not what you buy it's what you pay for but then in 78 because that exercise with which I was associated was so unsuccessful it was time for me to find the new job I was lucky I didn't get canned and I switched to the bond department in order to manage money and then in August of 78 I got a call from the head of the bond department and he said there's some guy name's Milken or something out in California and he deals in these things called high-yield bonds and can you figure out what that means now you know we take it for granted today we all know what they mean and actually high-yield bonds are quite mainstream today but in those days they were an obscure corner that very few people know about they were called junk bonds and so I said about trying to study them I met with Mike in November of 78 and then came out here to California in to visit with him in January 79 for the first time and now I'm investing in the worst companies in America and I'm making money steadily and safely and as a really important lesson in that that in good investing is not a matter of buying good things but buying things well Howard I want to maybe paraphrase what you've said I'm not sure you're investing in the worst company in America what you're investing in well I use that as a figures many great companies that have the wrong capital structure okay and so once again as we focus on this I want to take us back to the beginning and what's focused for you your children your grandchildren in a recent poll in the United States of people under 30 they asked the people under 30 will you have a better life than your parent set and so maybe we could just you know pull up that slide here for a moment and have you reflect on what percent of people under 30 in America thought that they would have a better life than their parents at what date in the last few months okay so you've picked your we're not going to embarrass you here but if we look at the answer you'll see it's a very low percentage and if you go to Western Europe you'll see a very low percentage there is no country over 30 percent but as you travel the world if you're in China its 78% and in your Brazil in spite of everything that's occurred and Turkey is more than 50% higher than the United States as is India and other countries and if you go to Mexico today in that net numbers probably in the 80s and so the question is why do people feel that way how do they feel 90 percent are optimistic of the future in Mexico and so they have a much different view of the world and so one of the challenges for finance and we're going to talk about it today as we talk about these cycles is that why do you fifty percent of people under 30 think socialism might be a good idea they obviously haven't been studying what's occurred in Venezuela as you've destroyed an entire country the country with the most reserves and you say yourself well why do people feel this way well the average person in America what is its interaction with the financial system one a student loan and the burden of student loan that's now approaching one-and-a-half trillion that is confining them as they think about their life and second a mortgage whether they or their parents and during this period of time which we will talk about they almost lost their home or they lost their home so what is the financial system doing for them and this connection but let's go back to accounting Howard in many ways County as a language understanding a balance sheet reading those footnotes etc but you outline in the book a few things that you felt were fundamentally required to be an investor understand cycles accounting was one but while we talked about a few of those well I think I think everybody knows you have to understand the county you have to know finance you should know something about history but the most important thing which they don't teach you in business school psychology and if you if you go back and look at the past if you look at a graph of the economy for the last 50 years it kind of looks like this it's got an upward trend and very modest divergence from the trend sometimes the you know the trend is a 2 is a 2% trend line sometimes it's up 3 and sometimes one in extremes it's up 4 or down one or two very modest volatility if you look at company results companies have leveraged financial and and operating and their profits go like this if the if the economy is up 2% profits go up 10 if the economy is up 20% profits go up 30 and and and so forth and so the the and if the economy's down to then for a typical company maybe profits will be down 15 so the graph of profits is much more volatile than the graph of the economy and then if you look at a graph of the stock market it looks like this why what's the difference and the difference is psychology and you know Richard Fineman the great physicist said that physics would be much harder if electrons had feelings we walk in the room we turn on the light switch the lights go on every time we don't even wonder about it I wonder if they're going to go on this time but the the the that's because the electrons go in this pattern they never go there they never say no we're on strike they never forget to move they always do what they're supposed to do but but people have feelings and people rarely do what they're supposed to do and they often react in the extreme to the events that that develop and those extreme reactions caused this extreme volatility they overreact to things and sometimes they don't react at all and sometimes they don't react as they should so I think that if you want to it exists in the investment world and you want to in you can just buy and hold good things if if they wanted to take that approach but if you want to improve upon that I think it's very important to understand the ebb and flow of psychology and enact accordingly so let's look at that a different way I arrived around 1 o'clock last night from Ashland Oregon where they have a Shakespeare Festival and have for decades and you wonder why our people going to Shakespeare plays hundreds and hundreds of years later why is it relevant and if you step back and start thinking about what are these plays about it underlines what Howard is addressed so let's take a look it's you know some of these plays what is handling about what does Macbeth about what are these about well we see it in West Side Story but if we took a look at the place and talked about what is the emotion or what is someone addressing in that play Macbeth self-deception ambition indecision friendship love hate prejudice betrayal honor Duty all of these human emotions which exists today and one of the things how it writes about is what are some of the traits required to be an investor to take care to take advantage of cycles and one of them is aggressiveness and so we could go to Hamlin and talk about inaction inner struggle etc that he wrote about and how would I think one of the things that strikes me and I think anyone that's read your work over the decades has been that simplicity is the ultimate sophistication and you point that out you love to write and I think people love to read you because you express things that are often extreme we sophisticated and complex in ways that are easy thank you and congratulations on a great book again a lot of people always wish they would write a book how did you get yourself to say okay I'm going to stop and write a book good question well it all started with with my memos to clients which I started writing in 1990 I can't exactly remember why I started it's a long time ago I know I never said you know if I if I if I write them it'll do it'll get us more business or if I write them you know the people will subscribe I think I just had something that I wanted to say and I said it and the point is that I one of the main reasons that I write is that I enjoy it I'd rather write they're not and they you know the bill bill Graham of the of the Fillmore which was a rock club in 270 said it's only work if you'd rather be doing something else and I wouldn't and if you look at the memos and and you can go to online to oaktree capital calm and look at the memos and you see that there's almost always one coming out in September and one coming out in January which means I wrote it on summer vacation and Christmas vacation and and anyway so I started writing these memos and with one and ninety and one at 91 and maybe I didn't write one in 92 and in and for 10 years nobody responded I never had a response not only did nobody ever say it was good nobody ever said I got it and and of course these this was in the days of mail and so we would print them up and fold them and put them in an envelope and address them and send them out and nobody ever responded but then on the beginning of 2000 I first day I put out a memo called bubble calm about the tech stocks and it turned out to it had two virtues number one it was correct and number one it was correct soon which are both important and then then after 10 years as I say I became an overnight success but then well it wasn't ten years Howard it was thirty years yeah maybe okay and I think this is something I just want to stress when we talk about a frame of reference or understanding history if you watch the hundred meter dash in the Olympics that a person covers in less than 10 seconds you can wonder well it's a gold medal etc how long did you prepare that person might have prepared their entire life for those ten seconds and so Boheme prepared an understanding it wasn't the ten years and in fact probably the previous twenty even had more effect on you from that standpoint and I just want to relate to something that was really important Howard talked about many of you who might choose to be in the investment business today it was really this failure of the nifty 50 that created modern money management people gave their money into a trust department that large bank could manage your money and as Howard said they put you into this nifty 50 stocks you could just hold forever and the fact that you lost half your money adjusted for inflation half your money well if you lost half your money playing it safe what did you have to lose to go to the growth of the mutual fund industry or other small money managers that gave birth because of the failure of the traditional safe system from that standpoint and and so I just want to stress on this there there are very few accidents and Howard talks about luck and we'll get into it shortly but there's a very famous quote the harder I work the luckier I get and what is luck luck is when opportunity meets the prepared mind so I just want to come back to you were not an overnight that you prepared 30 years for that well anyway so they so the memos continued and then then we connected with Orrin Buffett on a transaction coming out of the Enron and we were you know we one of our main activities is to stress that investing in he had a position in one of the subsidiaries and we were we were a little bigger than him and so he gave us his proxy and he said you work it out and we produced a good result and so that's how we really got got close in the early 2000s and then I wrote a memo I think in which I made some reference to him and and I I sent it to him and I said I just want to make sure you saw it and he says yeah I saw it he says it was really good and he says in fact if you'll write a book I'll give you a blurb for the jacket I had always thought that when I retired I would turn the memos into a book but when you have that from Buffett then you have to get into gear and so that's really the immediate reason why I wrote it and I started in 2010 and it came out in 2011 was called the most important thing and and you know and I always told to Warren Buffett and on the front it says this is that rarity a useful book warren buffett and that those few words sold a lot of copies so howard let's step back and talk for a moment about the most important thing in that book you listed a number of important things but market cycles is the only book you've written from that list yes why market cycles well I think that so the book says the most important thing there are 21 chapters and each one says starts off by saying the most important thing is and that it's a different thing because in investing there is no one important thing there is maybe you might argue there's no you know what was it Lombardi's as winning is not the let's see how many people in the audience even know who the bard is it somebody anybody okay well we have at least a third he said winning is not everything it's the only thing and as I say in the book I'm not exactly sure what that means but I think that the two most important topics in investing are risk in cycles and they're connected because where you are in the cycle determines your for the for the intermediate-term now the reason I think risk is so important is because I think that the distinguishing mark between a great investor and a not great investor is not merely how good the return was but how much risk they took to get it if you you know you can take you can lever up an S&P now at nowadays with the derivatives or ets you can buy any in ETF that goes up or down four times as much as the SP or maybe eight times and if you if you buy that and you go into a very positive period in the market you'll have an astronomical return but it doesn't mean you're a great investor because they'll say look at that guy he went up eight times as much as the S&P well guess what if it had been a down period he would have gone down eight times as much as SP he had had no value who is not a good investor I think that an exceptional investor is someone who has a good return disproportionate to the risk born a good return with the risk under control so I think that I actually do think that risk is the most important thing and in the book there are 21 chapters and there are three on risk understanding risk recognizing risk and controlling risk but I also think that where we are in the cycle is enormous ly influential in terms of how much risk you'll bear and I'm not crazy about the title of this book I was encouraged to do that by my publisher because they thought if we said mastering the market cycle we'll sell more books because everybody will figure out that they'll get rich but I like the subtitle and the subtitle is getting the odds on your side we don't know what the future holds I am NOT a believer in forecasts in fact Michael started off by by with a quote from Galbraith my other favorite quote from Galbraith is that there are two kinds of forecasters the ones who don't know and the ones who don't know they don't know and and I believe that very strongly and I am firmly in the first camp I don't know what the future is going to bring and I don't think anybody does the future can only be thought of intelligently as a probability distribution what is the range of things that may happen which is the most likely which other ones are probable and which ones are unlikely and we describe a great quote from Elroy demson at the London Business School more risk means more things can happen there will happen that's the source of risk is that the future is uncertain and then and if the future could be predicted in theory there would be no risk so let's step back how in and try so we're really talking about risk adjusted returns and when Howard has said is can you achieve returns with little to no risk and that's quite different from someone that's taking a lot of risk and so as we think about the world we live in there's been enormous movement today from active management of assets to ETFs or passive management of assets but it's easy to understand what's occurred what's occurred here is the market has gone up so significantly and so if you're fully invested ie and an ETF by nature you're a hundred percent invested in whatever that asset category is versus a money manager who might be 50 percent invested sixty percent so in an up market it's very difficult to outperform person that's fully invested however in a down market which we really haven't seen in this growth of passive investment or ETF what is going to occur okay obviously you're gonna go down more because you're fully invested not necessarily hedged and you also run the risk of the issue of redemption so we really haven't so Howard and I are firm believers in fundamental analysis would you like to touch base at all on passive or short estimate versus fundamental investment and obviously your background in Wharton and Chicago we both live during a period and Demick life of this idea that the markets were perfect that no one could outperform the market our academic training people won Nobel prizes for it they even won Nobel prizes for telling you capital structure didn't matter etc so take us back to this debate Howard well I was a Wharton undergraduate and I learned the practical side of investing and then I went off to the University of Chicago for my Master's and I learned the theoretical side and the the finance theory the key theories had just been developed almost entirely at Chicago in 63 for that period was when they can't emerge and we learned things like Michael described one of the most important of which is called the efficient market hypothesis and what it says is that people the market consists of a whole bunch of people who are highly motivated to get rich they're all intelligent they're all numerous they're all hooked up by computer they're all trying very hard and their search for bargains has the effect of driving bargains out of existence that if they if there are any cheap stocks they find them they buy them they're buying raises the price of the stock to full value if there are any over pricings they sell them they that brings the price down to the point where that's their fair - so all prices are fair given for the risk involved QED you cannot outperform the market that's the official conclusion of the efficient market hypothesis and by the way they told us in Chicago empirically that the average mutual fund had not beaten the market but charged high fees clearly everybody collectively can't beat the market so on average they had an average all investors do average but after high fees all average on average do below average and you shouldn't be in a mutual fund which is actively managed and has high fees you should and they said back when I was a kid why not just buy one of every heart in the sbu suggesting were both still not cancer we're both still not kids and we're still both not kids but but they said why not just buy every stock in the SP no we didn't have a term for it but about five six years later the term index fund emerged and there started to be index funds and if the average active investor does worse than the market then it's better to be in an index fund which merely emulates the market index index investing got off to a very slow start in mid 70s Vanguard started the first serious index fund Jack Bogle and it still grew very slowly because you had to overcome the traditional resistance to turning things over to automatic processes and you know is it I wrote a memo if you want to read on this subject I wrote a memo in June entitled investing without people and I talked about the historic development of index funds and it quotes Ned Johnson of fidelity and he said no American is going to settle for being below average now that is really I have nothing against Ned but it's a great example of I think that that statement has no introspection or alternatively maybe it's the statement of a salesman because of course you would settle for average if everything else you could do would put you make you below average and and and for so many people so many people would have been better off if they had average anyway the point is that that the highly priced active management in broad swaths clearly not everyone did so much worse than low-cost passive investing that in the last 10 or 15 years the movement to index investing and other passive forms Mike mentioned ETS has Grint gained a lot of traction and now 37 or 40 percent of all equity mutual fund capital is run passively but but importantly the important thing I want to state before you jump in is that it's it's not that act that passive management is so good I believe this occurred because active management was so bad well also I think it occurred as you focus on cycles during a period where markets went up that's true interest rates went down so it's a period of time where you wanted to be fully invested and so we will see how it does during a period of time when markets go down where you're fully investor from that standpoint so how would I want to kind of go back in time to your career change going from stocks to bonds and so if I pulled up the six lessons of credit here for a moment just take a look at them and try to relate them a little bit to investing and cycles so credit is what counts not leverage and we could look at as we go through some of these cycles what occurred at the end of a 708 we had financial institutions leverage 60 70 80 to 1 that were rated triple-a we could look at loans to real estate and I would as we look at some of these cycles real estate played a large part in the latter part of the 80s and the problems of his belief that it only goes up interest rates you know Howard doesn't have a whole chapter on this but who can predict interest rates and very few people have ever successfully and as you look at home prices a Nobel Prize was issued for pointing out in a hundred and twenty years the price of a home went down 50 percent or went up 50 percent and this idea that you can leverage an asset 95 or 98 percent to one with that volatility and Howard writes about that and we'll come back in the book as we look at the others on that list here Howard I want to go kind of back to the end of that list of these six lessons of credit and one of them was on sovereign debt but anyone could have known that if you went back and took a look at that we could see that the very last one is debt underpins all markets and so understanding debt so in recent days here in 2008 and October 12 today we've had a lot of volatility and one of the reasons cited for that volatility was the increase in interest rates but let's get back to your point on risk Howard can we generate rates of return with less risk so if any of you play bridge or other types of games your knowledge of bidding and how people play allows you to improve your probability of success in the play of a hand and I remember Howard one of the things I mentioned to you back in 78 was when you invest in equities and you wrote about it later it's a popularity confidence if no one in the world agrees with you unless you're willing to buy the whole company you will not be successful and the exciting thing about investing in debt is if no one else in the world agrees with you but you are right you will generate significant rates of return talk about this movement as you think about risk relative and equity and debt markets or well you know trends in the investment business go in in in long periods and from roughly the 60s at least until 2000 stock stock investing equities became more and more popular and bonds got less and less respect I remember when I was in the investment research department at citibank and they had these all the young people followed Xerox and Coke and and and Polaroid and and they had these two old guys from Germany who sat in the corner and they would put out a statistical sheet on bonds every two weeks it was hard when you didn't have computers but I remember and I still have when they put one out and up in the upper right-hand corner in a box it says our last issue because everybody lost interest in bombs stocks where the great thing growth was the story and and you know everybody the pendulum swung toward fascination with growth everybody bought more stocks everybody you know and I imagined back in the in the late 90s the CIO of a pension fund saying it well you know we have a few bonds left my predecessor bought those I nobody can remember why but we're gonna get rid of those and so by the time 2000 rolled around and the puncturing of the tech bubble everybody was in stocks nobody was in bonds stocks went down for three years in a row for the first time since 1929 bonds did great but nobody had him so then everybody wakes up and they say to hell with that growth stuff we want income and safety and now the pendulum swings towards bonds and the truth about bonds which all the people forgot in the in the equity mania is as Michael says your return in stock investing comes certainly in the short run from swings in popularity you find a stock you think is worth 20 you buy it for 10 as he says if nobody comes to agree with you it sits at 10 for the rest of your life and you don't make any money the great thing about bonds which very few people understood is that in with bonds or debt your income does not your return doesn't come from the market it comes from the issuing company it is a contract with the issuer you give me money now I'm gonna give you X interest a year for the next X years and at the end of X years I'm going to give you your money back it's a contract and if they stay in business they have to honor that contract if they fail to honor the contract you get the company there's a slight exaggeration but but the point is that the returns on bonds are contractual and dependable and and that's very different and the expected return on stocks is higher than on bonds because they're riskier as it should be but the uncertainty with regard to stocks is enormous whereas the uncertainty involved in a contractual relationship with a creditworthy company is not enormous and and this is what people overlook now of course I believe that that you know bonds have picked up in attractiveness and popularity and especially loans which are senior in their companies and floating rate so you don't have interest rate risk and like any other investment there there's the risk of becoming over popular so let's take a look just for a moment at this period of time that Howard talks about as his transition from equity debt investing trying to reduce the risk and generating rates of return in a period of time that I often refer to as the most important period in modern financial history this period of the early 70s to the mid 70s and the particular year I would focus on his 1974 this is a year when the stock market went down 50% interest rates doubled and this was kind of the end of the financial structure as we knew it based on a banking system and one of the keys that potentially de-risk things is once your economy is no longer financed by a banking system but by tens of thousands of institutional investors you change energy prices at this time doubled and the stock market went down substantially and if you remember Howard it was one at the end of 79 but the one I remember particularly was the one at the end of 74 that no one would ever buy a stock again okay which Howard would tell you signals it's time to invest in the market the minute that was on the cover of Businessweek what was this result in 74 companies with the highest rates of return those growth companies were denied capital as the financial institutions had to focus on saving themselves yeah this therefore stopped job creation jobs were lost and as the financial institutions were weakened in so many ways if we go to the next slide these things occurred and lastly it created the modern financial markets and you now finance companies in the public and private markets because if you were the head of a business do you want your business dependent on the on the strength of the financial institution that's lending you money so they're in trouble you're in trouble and the Asian crisis in the 1990s started in Thailand where an entire economy was financed by five banks and when they were in trouble but is this this world that Howard has lived in during this period of time essentially the public and private markets have replaced the banks as the funder and banks shrunk by 50 percent adjusted for inflation in the 1980s but the country grew from that standpoint so Howard I'd like to to take a look at a lesson here that both you and I spoke about if we go back to say 73 before the bond market really broke down in interest rates to 76 and 2008 to 2011 if we could take a look at how common those periods of time are in a slide so take us back to 2008 2011 and this the slide that Howard's firm oak tree really took advantage of in this period of time to me I was on television telling everyone we've already been through this is just a repeat the challenge in life is how many people in financial markets in 2008 even remember the early to mid-1970s as Howard pointed out well it's it's interesting obviously if to have been in the investment business no.8 and to have the experience of 74 you had to be working by definition 34 years but the truth of the matter is that the investment business was terrible in the decade of the 70s you couldn't get a job in the 70s I know people classmates of mine from grad school who wanted to go into investment business but rather than get out in 69 when I did they got out and said they couldn't get a job in the investment is for their whole lives and they dug in in other fields but the point is you had to have your job in the 60s and that means bio 8 you had to be working more than 40 years how many people worked more than 40 years so by definition the pool of people with with the recognition of the past pattern is is very small and you know clearly we ran into very difficult problems the over investment on high leverage in the subprime products in o56 caused the you know the loss of some of the most important banks and and investment banks and people started talking about the end of the world and security prices melted down loan prices melted down and activity froze because everybody was uncertain will there be a tomorrow if I buy anything today will it will it be a market tomorrow will it have any value tomorrow and all the quiddity dried up and as I say people were talking about the end of the world and it was the most pronounced cycle that that that we've lived through but still there was really no reason I mean I I kept thinking about what Roosevelt said the only thing we have to fear is fear itself people were just afraid there weren't afraid of anything rational they were just afraid and what you had to do is you had to keep your wits and you know one of the hopes is that if you read history if you if you read the book if you understand cycles you will be able to reduce the emotional influences at that time and cut through them and and maybe we will just say keep your wits about you so we concluded in late Oh eight after the bankruptcy of Lehman Brothers put the markets into freefall that you know will the will the financial world end or not and what we said was that it's hard to predict the end of the financial world if you conclude that the financial world will and it's hard to have any idea what to do and most of the time the financial world doesn't end we also made a very simple calculation should we buy or not well if we invest and the financial world ends kind of doesn't matter but if we don't invest and the financial world doesn't end then we didn't do our job so by that you know here we are in an environment where really people had no idea what was coming next and we're talking about the end the world and I thought the analysis was rather simple that we had to buy so at oaktree we invested six hundred and fifty million dollars a week in the last fifteen weeks of of Oh 8 that's about 10 billion and that's really all you had to do it almost didn't matter what you did as long as you bought and it was a point in time in cycle and these points in time come along every once awhile where you don't need conservatism caution risk control discipline patience or selectivity you need money and the nerve to spend it and if you had money in earth to spend it in in late Oh eight in the credit market or early oh nine in the stock market you've made a ton of money and by playing that cycle so I think is a frame of reference it was 1974 and I was on this institutional investor panel with one of the leading professors in the world of finance and he pointed out that his z-scores if you remember those Howard were predicting that 700 out of the 2,000 or so largest companies in America we're going to go bankrupt I had pointed out if you studied the Depression in history that was not going to happen and then you made a hundred percent on your money in seventy five or six unleveraged just find it similar to the opportunities that Howard had identified in Oh 809 and I was on a panel with him in 77 and it was so interesting because he pointed out that his z-scores had predicted the four major bankruptcies that had occurred in the previous four years but had you not been at the previous session you would have not realized that he had predicted seven hundred to include four and I think that is the issue and Howard one of the other areas I think that might be interesting for you to touch on is that it's interesting when you think about what occurred in this Oh Wade session we all should have fully understood it because we had a dry run in 1985 86 87 88 when the price of housing went down when the price of oil went down and almost every single major financial institution in Texas did not survive all those triple a's and most of them in Louisiana or Arkansas and collar I don't have problems because the price of homes went down as much as 50% and so fully understanding what can happen when the price of residential real estate the United States more than any country should have fully understood this going into the last Oh 8 but the point I want to address Howard really is when we think of the ratings an S&P and rated more than 14 15,000 securities triple-a there are only three or so companies the United States that are triple-a by both yet when you look at a rating that rates something Triple C or single B you find that if the it might be a triple C at a hundred but it might be a Triple A at forty but the reigning remains the same and how do you take that into consideration however well you know if you if you take anything away from today I think that's the most important point as I said before it's not what you buy is what you pay and the great revolution I think of the period we're discussing here when the nifty 50 were the great companies and they and though they failed as investments and when the shall we say low rated companies in the high-yield bond world succeeded an investment the the great transition is from the belief that good is good and bad is bad to the belief that anything can be good at a price and it's an enormous sea change and it has dominated the last really 40 years and and I I want to say that Michael was really at the vanguard of that change and and it should not be underestimated when I went into the high-yield bond business 1978 you know I wanted to figure out what we're talking about here and in those days of course we didn't have anything computerized so if you wanted to study bonds you had to go to something called Moody's manual Moody's Manion was a book literally this thick with the thinnest paper in the world onionskin he had it had billions of pages in it and it had all the data on all the come that had bonds outstanding so you pull it down from the shelf and you find this one's ready to triple a single a single B triple C and I said well what does that mean so I went to the front where they defined the ratings and here's what it said about a single B bond which is most of what you originated most of what I bought single day fails to possess the characteristics of a desirable investment now if I took Jim Williams out to the street and if he if he needed a car and I had a car out there I wanted to sell and I showed it to him and I said Jim would you buy my car I'm Jim Williams is with us today he runs the Getty trust chief investment all there's a great job so that's why we're focused here on October 12 2018 on Jim Williams if I said to him would you buy my car hopefully there's a question he would ask before he says yes or no what is it what's the price Moody's was saying that be rated bonds are bad investments regardless of price and really the big realization of the last 10 40 years is that just about every asset can get cheap enough so that it's a good investment and most investments can get so expensive that they're a bad investment and the revolution of the high-yield bond industry was really to say see in the if you if if we had prevailing views from Moody's that a B rated bond is a bad investment then by definition a be rated bond could not be issued and in those days a bond rated below investment-grade which means below trip will be could not be issued wasn't proper the only way you got to have bonds rated below triple B is if they were issued as investment grade and then went bad we call those fallen angels the revolution that was effectuated in the high-yield bond industry primarily by mike some others and that has dominated the last 40 years appropriately is that if a risky company he doesn't like me to say that if a highly levered company issues bonds which have some risk due to the high leverage it's okay to buy them if they offer enough interest to compensate now that seems like such an obvious statement that for every bond of every riskiness there is an interest rate which is compensatory and an interest rate which is excessive and yet this is this was a thinking that was absent prior to 78 when everybody thought that the the route to success as an investor was to buy high-quality assets and by the way by amid any price and now we look back at that and think how stupid that was so it to take you back into hmm the firm I joined in the late 1960s was the leading research firm in the world Paul Miller who MA Oh Howard nose head of the vestment committee at Penn long before then Howard took over J Sheridan clay Anderson etc and they were the leading equity firm and I said to them what about debt and as Howard was saying and the 60s debt was really investment great or it was private and the insurance companies rated not investment great investment great because it was internal the way they looked at it so I went and took a look at the recommended list of stocks and 80% of them would have been non-investment great and so the understanding of this capital structure I would finish the story by telling you that the firm had the leading aerospace and airline analyst rated number one in the country and he was recommending TWA and I said to him you know herb it's interesting you're recommending TWA you know we're buying TWA for converts at twenty five cents on the dollar and he told me he didn't know they had convertibles outstanding so the focus on the capital structure was not something you really focused on you know from that standpoint and and I want to go if I could just for a moment to capital structure Howard and I think one of the things you've signaled in your firm is this issue that your firm is willing to take an investment where you're a first lien and impress the issue to a private equity firm or in the marketplace that if you don't want to pay me just hand me the keys then and many firms were quite surprised in the case of regal theaters for example KKR was the owner and in yourself and Phil and shoots company brought up the dad and I remember they told me that was shocked you called him and said well either give us our money at par okay your hand is the keys your choice and it took him quite a while to hand you the keys by the way can i interject here sure that that one of the reasons Donald Trump remained solvent is because the banks had loaned the money for his casinos they said we want our money he said I'm not going to give you the money but you can have the keys and they were so terrified take the keys that they said no no it's okay you can keep running now the true story so capital structure Howard you know I think both you and I feel it's very important in the 1970s this enormous volatility half the value a company could have was when you financed how you finance it and so we've come through a period of here of no covenants extremely low rates and so if you have no covenants it's hard to default unless you can you get at maturity from that standpoint talk to us about how you see capital structure and risk well I think that as mike says it's a much it was for a long time much ignored that for confer for a given company there can be a good company a capital structure a bad gun capital structure if you if you want to start a company and you need a hundred million dollars and you put in a hundred million dollars that's viable but it may be less than optimal because you could have maybe borrowed some of that money at three percent which would amp up the return on the other money on the on the equity on the other hand if you say I want to start a company I need a hundred million dollars you go to the bank and they give you ninety-nine if the value of the company declines by a few percent you're insolvent you've lost all your equity in that case the capital structure was wrong because the the business was too volatile to have a highly levered capital structure so of course one of the things that emerged in the 70s and people have made a science of ever since is getting the optimal capital structure for a company the higher the leverage the higher the return on equity when things go well the lower the leverage the higher the likely the more likely you are to get through tough times so you have to optimize on that and it's it's a serious pursuit now the the phd's will tell you that they could compute the optimal capital structure using an algorithm I think it's best a matter of judgment because among other things given the fact that the equity is what gets you through the tough times somebody has to make a judgement in my opinion how tough is tough how bad an environment do we have to prepare for what is the right capital structure for that so for myself minded my credit work at Berkley and then I focused my master's work on capital structure in the latter part of the 60s and I think we will look back at the current period if you're borrowing money and four and three quarters with no covenants for seven years is that an asset or is that a liability to the lender right yes did you read the latest memo yes I put out a memo two weeks ago entitled the seven worst words in the world now remember the four worst words in world were it's it's different this time the seven worst words in the world are too much money chasing too few deals and I believe that that's been descriptive of our environment the last few years and when there's too much money in the hands of providers of Finance and they are too eager to put that money to work bad things happen and interest rates get bit down and risk it up because the if you have no covenants then you have a defective instrument and a higher probability of losing money as a lender and I think that's what's happened and and but this is one of the many things in the world which is cyclical and I think we'll see a cycle in this - should we take some questions now we're gonna take some but I just want to comment if you want to look at 77 to 79 pages in the book you'll see Howard's comments on capital structure why don't we take a couple questions anyone want to ask a question this morning of Howard so Jim Williams chief investment officer of the Getty has asked us a question on covenants are our covenants cyclical the demand for covenants is cyclical and that and of course and that of course makes nobody's ago and why is the demand for sake of companies because number one the the more money that is in the hands of lenders and the more eager they are to put it out the less they have the ability to demand covenants because of the competition to lens and the other thing is that that there's a chapter in the book which talks about the cycle in attitudes towards risk and attitudes towards risk change volatile ii and and with great influence and when things are going well what do people say risk is my friend the more risk I take the more money I make and I'm out to optimize maximize risk and by the way I don't think anything to worry about so when people feel that way clearly they feel well I can dispense with covenants because I don't see anything to worry about and then when things go bad for a while what do they say I hate risk bearing risk is just another way to lose money I don't care if I ever make any money in the market again I just don't want to lose any more get me out at any price and when people are in this terrified mode and risk aversion sores then they demand risk premiums and they can get them because there aren't a lot of people competing to put money out the few people who will put money out can be demanding and get what they want in terms of covenants so I think it is very cyclical mostly stemming from the demand side I think this is a really important point than how it is made the value of a security might be more dependent on the covenants then the interest rate yeah and understanding that issue then in some cases it is the covenants they give you full recovery way Mike I think we for the for the people who who aren't credit pros I think we should say one word about what covenants are covenants are protective verbiage in a bond indenture debt contract which requires certain standards be met by the borrower so and there are two kinds there's incurrence and maintenance incurrence means you had to satisfy certain standards the day the debt is incurred and maintenance means you have to satisfy certain standards throughout the outstanding period of the loan and clearly the these you know the covenants don't protect the company from falling on bad times but if it falls on bad times and it violates a covenant a maintenance covenant then the creditors have the opportunity to become active and to make certain demands and to gain influence and and and so forth and so the presence of maintenance covenants limit the deterioration of a credit and in in profit at times people stop demanding maintenance covenants we get what's called covenant cuff light as we are now and that means that that the the operations of the company can deteriorate through the outstanding period of the debt and as long as they continue to pay the interest then the creditors have no influence and and what that means is that if there eventually is a bankruptcy there will be much less there to recover from and I would say today in late 2018 they're one of the riskiest areas does lie in triple being the lowest level of investment grade where there are no covenants and we've all seen through history with many private equity people in the room that you can use that debt without any covenants to become at the bottom of the pile and a redoing of the capital structure by the way I want to tell you a story I don't think I've told you but I was once speaking to a University of Chicago a Wharton credit conference and somebody asked the question what is the role of rating agencies and I said the role of the rating agencies is to be wrong because see when they put out a rating which is either too high or too low it gives us something to shoot against tonight I think today for the audience thinking about the ratings and credit and capital structure so uber is selling debt its first real public type debt it has valuations fifty sixty billion dollars and little to no debt the debt is rated Triple C about the lowest you can possibly be rated why you're not in bankruptcy so the perception of equity markets of enormous growth Tesla a company also worth 40 50 60 billion dollars has debt that trades at Triple C we work a company we read about today and October 18 that someone wants to buy the whole company for twenty billion dollars has one issue of debt outstanding rated Triple C so what is this dichotomy between companies worth 20 40 60 billion dollars with little to no debt and I think if we go back and listen and read this book of markets I'll you'll see that many industries have so much risk that even though you think they're valuable they might not be able to take on any debt from that standpoint let's take one or two more questions yes sir [Music] well I think the response to the financial crisis was terrific I think the financial crisis had the potential to really produce a depression and if you read Hank Paulson's book you know you'll see he was terrified and what I was telling people back to no aid you know there was a there was a news caster I made a bit may have been Walter Cronkite who once said if you're not confused you don't understand what's going on and I told people in oh eight if you're not afraid you don't understand what's going on I mean we were highly levered the banks were in freefall and and it looked like there was a vicious circle going on and I think that Paulson Bernanke and Geithner did great things aggressively and they worked so I know I would there's anybody who would second-guess anything they did as an idiot and and we are in the clear visa V the global financial crisis and clearly especially in this country you know the other countries did not take the actions that those that trio took and or as early or as aggressively and the other countries are not doing as well as we are and have not recovered to the same set so the the the direct effects of the global financial crisis are over and we're doing quite well we were we are in the tenth year of an economic recovery the tenth year of a bull market etc however the actions that we took to get out of the phonetic global finance crisis were extreme and the like like all those medicines they advertised on TV they have side effects and we're not now we have to go off the medicine and you you described it I think you described it as an experiment and if you conduct an experiment for the first time it's folly to say that you know how it's going to go there there there was never a stimulative exercise to the extent of the QE and the rate cuts had never had rates at zero before and so now that we're trying to reverse the influences and sell the bonds the securities that were brought through the quantitative easing and bring the interest rates back up in the direction of normal you can't say how it's gonna call the world's central banks that you have twenty two trillion dollars on their balance sheet now almost probably quadruple what they had in normal that they have to end that how's it going to go what's gonna be the fact can't tell you so and and most people you know over the last year or two I did I get a lot of questions and you usually you can tell what's going on in the world from the questions because usually at a point in time a lot of people ask the same question and one of the questions I've been getting for the last couple years is what could go wrong you know everything's going swimmingly but we know it's not going to go well forever what could bring it to a close and clearly an unspecified miscalculation by the Fed is one of those things we don't know enough to know what the error would be but we know that when you're doing something on precedent that there can be error I'd say you're allowed to do research so what is the research let's look at liquidity in the world so Howard said there is 22 trillion held by Federal Reserve banks in the world well there's 26 trillion in deposits by Chinese nationals there's 17 trillion yielding zero deposits by Japanese individuals Japanese financial institutions today have changed dramatically but so of the corporations and corporations in Japan are holding 6 trillion u.s. in cash a hundred and twenty percent of the GDP of the country individuals in America percentage of their assets in cash is double what it was in oh seven oh eight and so one of the challenges in the world is this enormous liquidity than Howard has spoken about today that's driven up acid values but we still have trillions of dollars invested at negative rates adjusted for inflation so we are not where we were in oh seven oh eight and lastly I asked each of you where would you hold your assets today and if you're a citizen of China for example what percent of your assets do you want in a different currency in a different country do you want 20% would you be willing to transfer five trillion in assets to US dollars today and so when you've seen the volatility of currencies one of the things that you as you reflect on US financial markets is who wants to get their money into the US dollar so I can get it in a couple ways I can just hold cash in the bank or I can buy a US government security that pays me more than zero and so we've heard today from Howard about liquidity in the world that has driven up asset prices but this liquidity exceeds the amount that central governments are holding in assets today and so that is one of the challenges let's take another question yes sir I haven't really spent much time on that I don't have a good answer maybe my does the Institute has a major effort on that Ariane no our Center for financial markets has been one of the leaders in creating those opportunities owns and if you're interested I'm sure you could go to the website and take a look at this this is really more related to rebuilding areas of the country you incentivising your attachment one more question you know I I get that question a lot and and and in particular have these tactics artificially raised to level the bar I don't think so I'm not an expert on this but you know you look at algorithmic for example these guys buy and sell massive amounts within a fraction so I don't see how constantly buying buy sell buy sell buy sell Pacific could buy us the market in either direction I just don't see it now the passive and out and index investing the key I also think that that does not in itself raise the level of the market but what it does is it ignites certain stocks as popular and certain stocks as unpopular let's take the extreme example all the money that's going to flow into the stock market in the next ten years he's going to flow into S&P index funds what that means is there would be enormous demand for the S&P stocks they would go to prices which are exaggeratedly high there'd be no demand for any other stocks they would fall to prices which are too low so clearly the effect is that when that's see when there's passive and an index investing the key is that nobody ever says should the money go into that stock and is today's price fair if it's in the index or in the passive recipe it goes in regardless of the merits of the company or the fairness of the price so clearly passive and index investing has the as the potential and probably has biased at the market it in terms of made some stocks higher than they should be in some stocks lower and you know if Amazon for example is held today by value ETFs and growth ETFs and high-quality ETFs and you know and large company ETFs as it is as a way to attract money when people change their mind and want to get out who's going to buy those stocks if if the buying was on autopilot elevating their prices who what buying is going to counter that so I want to separate your question into two parts just for the audience today one passive investment and Howard's really dwelled on here is not making any value decisions and but algorithm let's call it AI investing it's quite different you have people all over the world writing algorithms to try to predict what occurred in closing I want to discuss one area that I want to stress to each of you if you read this book you will learn about many market cycles how it goes into detail of what occurred in these cycles and particularly focused on this o eight cycle to today but looking back at other cycles when we talk about risk and trying to minimize risk you know there's many types of risk walking out your front door is arrest probability of driving in a car is a risk flying in an airplane is a risk that everyone is making a decision every day what is the risk and so one of the things I want to come back to is where Howard started and where this book is so important and that is understanding psychology you have psychologists standing from Chicago who won a Nobel Prize in Economics from trying to understand psychology and when you think about it we had a period of time and one of the other risk is regulation and understanding regulation because you can put regulation in place that puts any company out of business any industry out of business by changing the rules if you go back in to another point in history when the nobility in England could no longer compete with the mercantile class what did the nobility do they went to the king and said we need new rules that we're allowed to compete and you're not allowed to compete and Howard and I lived through a period in the latter part started in the mid 1980s which I call Neutron legislation it's ok to loan money against a building but you can't loan any money to a person that would occupy the building and remember there's only 4 or 500 investment grade companies in America out of millions and so legislation was introduced and Howard and I had an opportunity in Washington and 85 I think I was there six to visit to ban the ability to invest in non investment grade debt by pension funds by mutual funds by insurance companies etc and introduced banning the deductibility of interest so if you were non-investment grade you could not deduct interest if you were investment grade you could and it was basically put forth and these memories are indelibly imprinted in my mind and I think yourself Howard what shocked you and this is why I want to stress how what importance Howard plays and taking complicated things and making them sound that you can understand them because if we don't have the citizens of the United States understand the financial system and what it's created for us then you can rest assured in a democracy they will vote for another form of system as to what occurred in Venezuela a number of years ago and so Howard and I spent a year or so or two trying to educate people that most of the jobs in the country were created by non-investment grade and why do we want to ban access to capital to companies that are growing in today's world you would be saying you can't buy any over debt you can't buy any Tesla debt you can't buy weworks debt and so on we're talking about many come oast of your tech companies are not investment grade no matter what their market camp today Howard want what were your memories you've taken today where you know 35 years later almost from that period of time and how did this have a factor in your desire to write to try to explain these things well I look I'd like to like you I think that since we are a democracy we better have educated voters you know right now on the Hmong the Millennials there's most people think that socialism might be a great idea you know and it's easy it's easy to stand up and say you know we should have universal health care we should have the free education in college you know my my late stepmother used to think that everybody should get a vacation and a color TV and all these things go sound grade and would get a lot of voters but you have to understand the consequences yeah things have costs you know economics is really the the study of choices and you have to make choices do you spend you you can't do everything you want to spend your money here here or here and if you want to spend money where you going to get it from these are these are the these are all the topics that people have to be educated on if you put it in a question where do you think that that day college should be free or not most people would have no incentive to say no but at what cost with what consequences and and so I'm with you in terms of wanting an educated populace so in closing today I just want to show you a chart from this cycle Larry if you have that chart showing high yield performance late 80s to early 90s I'd like you to pull it up for a moment and here is a cycle where this legislative caused a dramatic change in the market place and once the country realized you're eliminating a hundred percent of all job creation it reversed in the next year let's lay 91 in here so you made forty percent in one year on your money this was not induced by a market cycle then Howard talks about but by a legislative cycle and I stress this that it's important in understanding that good government's important good management's important so in closing Howard we had a number of people come here today and one of the reasons they came here today was to get your signature on their books so at what price well I think if everybody lines up I'd be glad to do so okay great and I think we thank you and I don't think you fully realize the importance of your writing and trying to make complicated things and finance understandable to the general public so thank you thank you Mike [Applause]

Channel: Milken Institute

Views: 228,161

Rating: 4.7845273 out of 5

Keywords: Milken, Institute, howard marks, michael milken, mike milken, investing, stocks

Id: Xbs5e5pcVYI

Length: 89min 53sec (5393 seconds)

Published: Mon Jan 14 2019