Motley Fool Hidden Gems Investing - Howard Marks on China, Risk, and Interest Rates

Episode Date: January 29, 2023

If a key to personal happiness is low expectations, then a key to investing may be realistic expectations. Howard Marks is the co-founder and co-chairman of Oaktree Capital Management. Motley Fool Director of Small Cap Research Bill Mann caught up with Marks to discuss: - Why higher interest rates created a “Sea Change” for investors - China’s economic miracle, and its impact on inflation - Lessons from the era of easy money - What life insurance companies can teach investors about risk To read Howard Marks' latest memo, click here: https://www.oaktreecapital.com/insights/memo/sea-change   Host: Bill Mann Guest: Howard Marks Producer: Ricky Mulvey  Engineers: Rick Engdahl, Annie Franks Learn more about your ad choices. Visit megaphone.fm/adchoices

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And the answer is that even a bankrupt company has value. And by the way, in law, they call it the estate, like a dead person. The estate has value. And so when everybody's throwing the debt out as if it has no value, if you can buy it at a low price, maybe you can get a good return. I'm Chris Hill, and that's Howard Marks, co-founder and co-chairman of Oaktree Capital Management, a leader in alternative investments, including the biggest distress debt fund in the world. His memos are considered required reading by many investors, and his latest one describes

the widespread impacts of more normal interest rates. Bill Mann caught up with Howard Marks to talk about why he likes sectors that other people consider uninvestable, his views on inflation, as well as winners and losers from the era of easy money. You put out a letter and investing luminaries, you know, starting with Warren Buffett have said that when you put out a memo that he drops everything and reads it and I'm in the same boat. And you put out a memo in December, it was called Sea Change. And in Sea Change, you describe what you see in 53 years of investing, only the third, really, the dawn of the third era of investing. Now, obviously, in that period of time, we've seen lots of fads,

we've seen lots of trends. But in this case, we're talking about something that is a total transformation. And we have felt it too, but I wanted to take the opportunity to, you know, to ask you, you know, really in your own words to, you know, to talk about what it is that you see that's happening and why you think it's happening now. I think, Bill, that since the global financial crisis, which ended in 2009, we've been living in a world which was engineered to be an easy world. Some of the manifestations may not have been intentional. But the point is that the Fed had to save the country and the world from the global financial crisis. It did so by drastically lowering interest rates and increasing liquidity

through quantitative easing, the buying of bonds. And those two changes had many ramifications. And they made, I would say for just for a summary, they made the world an easy place. And it was an unusually, unnaturally easy place for the 13 years from the 09 through the end of 21. What do I mean? Well, first of all, of course, it was it was very easy to borrow money. and it was cheap to borrow money. And borrowers did not have to commit to extensive documentation or restrictions. What we call covenants tended to disappear. Now, the reason for this is largely because the reduction of interest rates reduced the returns on very safe instruments like cash,

at T-bills, high-grade bonds, to the point where people who, investors, especially institutions that need 6% or 7% or 8% a year, couldn't use those things. They had to move out the risk curve in order to get the kinds of returns they needed. And that made their capital readily available to riskier companies at low interest rates. um the accommodative monetary policy that i described uh supported the economy so we had the longest economic recovery in history it supported the the markets we had the longest bull market in history uh declining interest rates increase the value of all assets the theoretician uh says that the value of an asset is the discounted present value of all the future

cash flows. If you lower the rate at which you do the discounting, the present value of future cash flows goes up. So assets became more valuable. It was very difficult to default or go bankrupt in this accommodative environment. So the rate of defaults and bankruptcies was very low. In the prior crises I had managed money in, 1991, 01, 02, we had two years of double-digit defaults in the high-yield bond universe. In this case, we only had one, again, because of these accommodative policies. You could always go get more money. Exactly. Money was available. Yeah, a zombie company which consumed money, where the debt service requirements exceeded the cash flows, as you say, burnt money every quarter, but it was very easy for them to get more money.

So an easygoing environment. And, you know, the main point of the MMOC change is that, number one, obviously, you know, in 1980, I had a loan outstanding from a bank and I got a slip from the bank saying the rate on your loan is now 22 and a quarter. It seems like a lot. 40 years later, I was able to borrow at two and a quarter. Yeah. So I just think that interest rates don't have much further to go on the downside. so that phenomenon is largely over uh and i think that the uh for various reasons the fed is not going to go back to the ultra low interest rates of the last 13 years and i think that uh uh this is uh so we're back more to in my opinion a a more normal environment uh you know where

it's not easy to get finance. Some people can, some can't. It's not as cheap. There may be some covenants involved. It's not so easy to avoid default and bankruptcy. It's not so easy to avoid recession. It's just going to be a little more challenging time. Now, if people say, I want to go back to normal. Let's go back to normal, like 2015, 2016, 2017. That was not normal time we are in normal this is normal yeah this is the the new uh conditions that i describe are normal the conditions of the last 13 years were abnormal there was a brilliant chart and i should send it to you it was provided to me the bank of japan did it and it showed that the interest rates over the last 13 years worldwide were at 700 year lows yeah and probably longer than that

But they sort of ran out of the capacity to track from the beginning of recorded history in which interest was a formalized thing. We were at a 700-year low. And what's really interesting to me, so I got my start in investing in Japan, and it was the early 1990s. And so it was a very incredible time to be an investor. And Japan never did learn that lesson, or at least they have pushed it off, that the types of cleansing that you're talking about, bankruptcy is good. Bankruptcy, it hurts, and I think that it feels bad. But in some ways, our country works best because we are really good at rewarding well-invested capital and punishing poorly invested capital. And in the last 13 years, that accommodative environment made that something that was, you know, you could step through it.

You know, I said in one of my memos during the pandemic that fear of bankruptcy is to capitalism as fear of hell is to Catholicism. It's what keeps us on the straight and narrow. It's what makes us make prudent decisions. And if you're not afraid of bankruptcy or default because the conditions are so benign and you believe that there's always a put from the Fed in which they'll bail you and the economy out, then you don't have to be so prudent. So that's the downside. And that creates moral hazard and all those things. It also creates what I saw in Japan was a 30-year period in which capital just was not, you didn't get any kind of return because there was so much poorly allocated capital that was not allowed to be siphoned out of the system yes yeah uh so when we spoke in 2018

we were we we we were uh we were talking just after you had published your book and i describe your book mastering the market cycle as one of my old friends it immediately went into the pantheon of books for me, along with Ralph Wenger's Zebra and Lion Country, The Intelligent Investor, Peter Cundill's book. It is a fabulous book. Thank you. But there's something I wanted to read from here, because I think when we were talking about it in 2018, and when you were writing about it, on one hand, it felt like we might as well have been speaking in Albanian. So as risk attitudes swing from high to low, so do opportunities for profit or loss. When everything's going well and asset prices are soaring, investors tend to view

the future as rosy, risk as their friend, and profit as easily achieved. Everyone feels the same, meaning little risk aversion is incorporated in prices and thus they're precarious. We had another year and a half to two years after, once you wrote this book, and it occurred to me later on, seeing you, and it really occurred to me reading in SeaChange that this was a period of time in which Oak Tree Capital and your investment team pulled back, and you described it as being a really difficult time for your firm. And I wanted to ask, really, how did you stay on? How did you stay disciplined? What was it that you saw if you didn't see a date certain in which things would change? What were the characteristics that allowed you to remain

counter to what was happening in the market? Well, look, everything we do starts off with wanting to do the right thing for the client. And that means invest aggressively when there are excellent opportunities and cautiously when there aren't. And so, you know, from October of 2012 until February of 2020, the doorstep of the pandemic, I used to give a speech entitled Investing in a Low Return World. And for the credit investor, which is what we predominantly are, we were in a low return world. When the Fed set the risk-free rate on Fed funds at zero, all returns scale from that. So if you start here, they go like that. But if you start here, they go like that. Right. The curve is the same. It's just where it starts.

Right. Right. So we had a downward move and all assets offered prospectively low returns, just like your Japanese friends. Now, I wasn't around for the whole 700 years, but. But, you know. These were some of the lowest prospective returns in history and especially on credit, which is, as I say, what we do. So we had to acknowledge that. And in that speech in the low return world, I said, how do you pursue return in a low return world? And I said I listed six possibilities. One is that you invest as you always have and expected the returns you've always gotten. But that was there as a red herring, because that's really not true. If you do what you've always done, you have to expect much lower returns. So that was a fake number. So number two was do what you've always done and accept that the return will be lower than it used to be. Number three was reduce your risk because you think you're in precarious territory and accept that the return will be lower still.

Number four, go to cash because you think that the precarious conditions are going to produce a correction, which will enable you to make great investments at the bottom, sit there in cash. but you better be right and you better be right soon since cash yields zero in that environment. Number five was go the other way, take on a lot of incremental risk in pursuit of incremental return. And then number six was look for special what I call special niches and special people in that difficult environment where you can still get a better deal than than average. And that was it. So we basically, you know, we we calibrate our portfolio positions by manipulating our balance between aggressiveness and defensiveness. And in that environment, we went pretty defensive. Now, we couldn't go, you know, hide under the bed and accept the zero return. our clients give us money and they tell us what to invest in. Our job is to make the investments.

But we so we adopted a mantra called move forward, but with caution, invest, try to be fully invested, but do it cautiously. And we are an inherently cautious firm, I think. So when I say with caution, I mean more caution than usual. And so we were in a cautious mode in this period. We thought it would end, and we had no idea when. I mean, I guess there's two parts to this question. The first of which is how important having well-aligned shareholders were for you. Because obviously, as you said, you went defensive. You have investors who have given hundreds, billions of dollars to you to manage in a certain way.

But there could possibly be a prudence versus expectation disconnect. How important is having well-aligned shareholders to you and what you do? It's the key. You can't, I mean, if we're acting for them, we can't have a successful relationship if we're not in agreement on how we're going to behave. And, you know, the key in many forms of life, the key to happiness is low expectations. But I would say that the key with somebody like an investment manager is realistic expectations. Now, we have an investment philosophy.

We're proud of it. We send it out. We talk about it all the time. Tenant number one is risk control. We hold ourselves out as the risk-controlled alternative in our niches. And I can't imagine that there's a client out there who doesn't expect Oaktree to behave in a risk-controlled manner. So now when they see that such and such a market is up 50%, they may say, gee, I wish I wouldn't have hired Oaktree. I hear what they say that they do, but maybe I want to be exposed a little bit less to what they do.

But I don't think that any of them could say, you know, oh, Jesus, it came as quite a surprise to me that they acted in a risk-controlled manner. So an agreement on expectations and clear communications are really fundamental, in my opinion, to a successful relationship in this business. And I try to work hard on both. And I think we have both. And I think our clients come to us for our risk-controlled approach. Uh, and we have times when we do great and times when we do less great, uh, for that reason. Um, but, um, you know, the point is, uh, we moved forward. We, we stayed fully invested, but with great selectivity and an emphasis on, on caution and margin of safety. Uh, and we produced

respectable returns in that period, given the environment and, and all you can do as an investor is produce returns that are reasonable given the environment. But we raised small amounts of money. We stayed, our assets under management remained fairly stable for most of that period when a lot of the public peers among alternative investment managers were doubling and tripling. their assets. And, you know, as I say, I think our returns were certainly respectable, were certainly roughly in line with our benchmarks. Our closed-end funds produced respectable, non-penalty, absolute returns. They just weren't up to what we had done in previous environments. And by the way, I failed to say on your first question, when you asked

about the sea change. So the real import of this is that in that climate of the last 13 years, it was great to be an asset owner. It was great to be a borrower. It was not so great to be a lender or a saver. And what the government really does, and I put the Fed in that category, is my position is that the government doesn't add to GDP and the Fed doesn't make anything. All it does is engage in policy decisions. And what policy decisions do is they favor some groups over others. They direct assets and revenues towards some groups and away from others. So this behavior on the part of the Fed for at least the last 13 years, and maybe arguably since Greenspan came in 25 years ago, they penalized savers and lenders. And that made it a tough period.

But you asked before about Boorstin and knowledge and misunderstandings. So if it was a good period for owning assets and it was a good period for borrowing, what about somebody who owned assets using borrowed money. It's a double bonus, right? And that is private equity. So, you know, as I said in the memo, you study a company, you conclude that the company overall will return 10% a year. Then you find out that you can borrow the money at 8%. So you say, this is great. We can borrow at 8% and invest at 10%. So you do it. Then when the debt matures and you go to renew it, they say, OK, now it's going to cost you 5%. And you say, boy, I'm smart. And were you smart or were you the beneficiary of a downtrend in interest rates? Clearly, the latter. But it

feels like smart. And the people who did it get their pictures in the paper. That's the nature of our business. It's not necessarily the people who made the most best reasoned decisions. It's the people who did X, Y, Z and were favored by the gods. So if those were the factors that were rewarded in the certain environment, and if the environment is going to be quite different going forward, maybe different strategies will be rewarded in the coming environment and not necessarily a continuation of the same ones. There was a word that you didn't write in Sea Change, but to me, it was in the background. And the word is China. Because when you're talking about a 13-year period, I think you're generally talking about an interest rate environment.

But the 40-year period, you're talking about primarily the impacts of globalization. And for a 40-year period, we had the capacity and the endless desire to export inflationary, you know, inflation to China. Is that time over as well? Well, I would rephrase. I wouldn't say we exported inflation. I'd say we exported sourcing, which had the effect of fighting inflation. And I think there was a 25-year period there. Maybe it was, hold on, maybe it was something like 1990 to 2015, when consumer durables prices overall declined by 40%. And it didn't happen because the U.S. production got cheaper. It happened because we imported more and more and more from Asia. And when we're talking

about durables, we're talking about appliances and things of that nature, TVs. And raise your hand if you have an American-made TV. So the point is- It's a coffee table if you do. And by the way, this was this was the period that coincided with what I call China's economic miracle. I'm not going to put you on the spot, but do you know how much Chinese GDP is up in the last 42 years? It's something like. Oh, you mean aggregate? Now, how many how many what percentage or how many times has it doubled? Has it tripled? Oh, I think it's like I think it's like eight times a hundred times.

So I was really wrong, really wrong in 1978. You did put me on the spot by not putting you can cut that out. But but in 1978, as I recall, Chinese GDP was 177, 178 billion dollars. And most recently, it was 17.8 trillion. So that's 100 X. Yeah. And our business made China rich and allowed them to move people from the farms to the cities and into manufacturing, from agriculture and so forth. And but it's largely over. Ironically, there are a lot of people who want to do outsourcing who say now China's too expensive because the Chinese miracle raised the per capita income and the wage in China. and you can't get work done as cheaply over there anymore as you used to. Right, on a yield basis, it doesn't really work out anymore. Right, exactly. And then so you have people going to countries other than China, Vietnam or Bangladesh are examples. But then you have the fact that the pandemic demonstrated that we have to worry about sources of supply.

So there's a force going on now called de-globalization, which is a reversal of the sourcing abroad in some small ways, in some certain areas. But that will stop or undo the progress against inflation that globalization produced. So you can't have it both ways. Yeah. Yeah. It can't be both ways. And you're exactly right that it was a continuum. And if raising China's economic standards was a goal, and from the outset, from both sides, it was a goal. I mean, Richard Nixon looked at China and said, having a China in poverty is not helpful for anybody. So it was absolutely a policy goal, but they've done it. You are at the point now where China is no longer competing on price. Now, if inflation averaged, I'm not 100% sure on this datum, but if it averaged 2% a year in this country for the last 30 years,

And that benefited from the process I described in which durable prices went down by 40%. What would inflation have been if durable prices hadn't gone down by 40%? And if durable prices are not going to go down by 40% in the years ahead, what will inflation be? And so I think we may have a slightly higher normal rate of inflation than we did over this period. So you do agree with me that we exported inflation? I'm still stinging from the fact that my guess at the exponents were, you know, for how much China has grown was so far off.

But it does so, I mean, even if you know your stuff, exponential math or exponential factors are really, really hard to contemplate. And so what we're suggesting and what you're suggesting in C-Change is that a lot of the things that have not worked for 15 – that have not worked for the last 13 years maybe are about to. It's not yes, no, black, white. Of course. It's not by that. The things that were penalized in that period will be less penalized or may be benefited. Great example. High-yield bonds.

That's really where I started as a money manager in 78, and it's a big part of what we do here at Oak Tree. And about a year ago, they yielded four-something, and that was the low-return world. They were not useful to the institutional client trying to make six, seven, or eight. Who would invest in low-quality debt to make four-something? Well, today it yields about eight. That's a usable rate of return. So that's just a very simple example of what you're talking about, the availability of returns now that I would describe as helpful or ample. They're not the highest I've ever seen.

They're not – I wouldn't describe them as the most generous, but at least they're usable. Another example is one of the things we invest in here and are well-known for is distressed debt. Well, guess what? There wasn't much distress. Right. If you could just keep raising capital. Yes. Right. Yeah. So so, you know, the default rate in my first 30 years in that position, the default rate averaged around four percent a year in the last 13 years, average something more like two. So very little default, not much for default distressed debt funds to do. So we raised smallish funds, and they had moderate returns. Not our dream environment. Yeah. Yeah. It sounds to me, Howard, like you were describing a much better environment

than we've had in a long time for pensions, for pooled money, that they have struggled so much for the return for their current obligations, what are some of the other areas you think will benefit from the new world order? Well, it's basically everything on the lending side of the equation. That's one. So ranging from cash, which now has a few percent positive return through treasuries, through high grades, through high yield. Private lending now yields low double digits. It used to be mid to high single digits. Distressed debt funds should be able to make more money in a more target-rich environment. And then there is the one-off here and there. If you want to look at the things that have been hurt, an example is the emerging markets.

and you know uh the emerging markets face uh significant challenges uh they've incurred a lot of debt denominated in dollars and they don't have that much access to dollars uh but you know this this low return world the the the the hunt for return on investors part allowed made dollar capital available to the emerging markets through loans which was not has not normally been the case So they'll struggle with paying off those loans, but the securities are starting from a cheap place. Is it cheap enough? Are they going to go up? I'm not saying that, but there are two piles of securities or assets.

There's one pile that everybody knows about, feels they understand, feels good about, feels are seemly and prudent, and they're optimistic about. Then there's another pile of things that people don't know about, don't understand, don't feel good about, things they think are unseemly and they're pessimistic about. Which pile contains the bargains? It's the latter. Now, that's not to say I want to say very clearly for you, for your viewers and listeners, that's not to say that everything on the latter pile is a bargain. But that's but the bargains are in that pile. I've made a living for 50-odd years buying things on that pile, doing the things other people didn't want to do. So you get to China.

What's the word that people have been applying to China for the last year or so? Uninvestable. Yeah. I like to hear that. Okay. I like to hear that because I say, okay, nobody else is willing to do it. That means there's not much optimism in the prices. That means the prices may be low, may be too low.

Let's take a hard look. Yeah. that's that's how we think around here it was an argument that i was making about oil and gas companies two years ago when you were able to buy them at you know and they weren't profitable necessarily but you were buying them at 0.1 asset value that's yeah that that can work out okay it's probably been the best performing sector yeah yes been been quite satisfactory so uh we have about six minutes and I'm about to ask you a 55-minute question. So how do you go about in a distressed market making a business case? Because to me, there's a contrarian element, but in order to

be contrarian, you also, to be successfully contrarian, you also have to be right. I mean, it's contrarian to go stand right next to the fireworks when they're going off, but that's not. Well, you know, my first book, most important thing, there's a second edition, the illuminated edition. And in the second, the chapter on contrarianism, Joel Greenblatt, the great equity investor, says just because five other people refuse to stand in the path of an oncoming truck doesn't mean it's smart for you to do so. You know, contrarianism for its own sake is not a good idea. So but the answer is, you know, when we started this in 88, my partner, Bruce Karsh and I, Bruce had the idea. He said, you know, you've owned all these high-yield bonds, which went from par to 10 to 30. Why don't we just do the 10 to 30 part?

And so, you know, but people would say, how can you invest in the debt of a company that's bankrupt? And the answer is that even a bankrupt company has value. And by the way, in law, they call it the estate, like a dead person. The estate has value. And so when everybody's throwing the debt out as if it has no value, if you can buy it at a low price, maybe you can get a good return. Now, what's a low price? Okay. So what Bruce and I did is we spec'd out the job of the analyst to ask three questions. Number one, what will this estate be worth at the time that the bankruptcy restructuring is completed? Number two, how will that value be

divided up among the various claimants. Number three, how long will it take? So if you know that you're going to get a certain size pizza, you know how many pieces it's going to be cut into, and you know how long it's going to take, then you know how much pizza you're going to get and when. The only question is, how much do you have to pay for it? So you compare the terminal value with the current price, and you say it's a buy or it's not a buy. So this is not a buy and prey. This is the same studious analysis that you engage in with small caps and Motley Fool does with all the things it does, just in a different dimension. There's something that's very important about what you just said, because what you're describing in high yield and distressed

debt, I think if you were to throw it into a bucket, you would say is some of the highest risk components of, of, of, of the capital markets, but you're still dealing in is, is not maybes. Yeah. Right. And it's, it's, I'm so glad that you went through and describe that process because I think that the environment that we are moving into from my own perspective is it's going to be valuing is, is more than it has been. And is, is, is value, right? Not will be. Will be is growth. Is, is value. And we consider ourselves value investors like you. Yeah. Yeah. But you can be, I think a lot of people view value investing as being, you know, utilities or being, you know. Yeah. You know, I'm going to take one, use one of the remaining three minutes

to talk about risk bearing. And I was asked in 1981 by the Financial News Network, one of the first cable shows, how can you invest in high yield bonds when you know some of them are going to default? And I said to them, the most conservative companies in America are the life insurance companies. How can they insure people's lives when they know they're all going to die? I mean, this is what it's it. This is risk and return thinking. So I'm going to describe to you the prudent bearing of risk for profit. So the life insurance company knows everybody's going to die. It's not an unknown risk. It's a risk you can contemplate. Number two, it's a risk you can study. When I got my first life insurance policy, they actually sent a doctor to my house

to give me a physical. So you can assess the risk. Number three, it's risk you can diversify. And no insurance company insures just smokers or just skydivers or just people who live on san andreas vault you have a diversified portfolio by age sex occupation uh location etc and number four is risk you're well paid to take yeah so they charge you a premium which is more than adequate to pay for the fact that yeah you're going to die yeah and that's all that's all we have to do risk awareness risk assessment diversification pricing my job your job and hopefully the job of of those who are listening. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations

for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill, thanks for listening. We'll see you tomorrow. Thank you.