We Study Billionaires - The Investor’s Podcast Network - TIP378: Move Forward with Caution w/ Howard Marks

Starting point is 00:00:00 You're listening to TIP. On today's episode, we have an extremely special guest, and that is billionaire and investing legend, Howard Marks. Howard really needs no introduction, but I just have to say that if you have not read Howard's memos, you are missing a critical piece of your investing education. Howard has also written some of my favorite books, including mastering the market cycle and the most important thing. And speaking of cycles, we discussed them in depth in this episode, along with how much

Starting point is 00:00:27 investors should really focus on macro. Spoiler alert, very little. How to balance risk without the temptation to time the market? Howard's thoughts on Bitcoin, bonds and interest rates, evergreen wisdom around price and value. And be sure to stick around for the last question where Howard provides a portfolio he would leave to his grandchildren. There is so much wisdom in this episode. I know you're going to enjoy it as much as I did. So without further ado, here's my discussion with Howard Marks. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

Starting point is 00:01:16 Welcome to The Investors Podcast. I'm your host, Trey Lockerbie, and Man, oh, man, am I so excited to have with me today, Mr. Howard Marks. Howard, welcome back to the show. Thank you very much, Trey. Nice to be back. This is the first time you and I are getting a chance to chat, and I'm really looking forward to it, mainly because your last memo, I would call it a masterclass, honestly, on the macro environment.

Starting point is 00:01:41 And it actually is a great amalgamation of a lot of topics we've been covering on the show and laid out in a very concise way, almost the most digestible format I've found. You are a longtime friend and fan of Warren Buffett, and you even began your recent memo with a quote from him, which states, for a piece of information to be desirable, it has to satisfy two criteria. It has to be important, and it has to be knowable.

Starting point is 00:02:06 So this explains the context behind a core tenant of Oaktree, which states that Mac is not critical to investing because it's not knowable. But with that said, I'm wondering if the macro landscape has become so distinct and unique, read as wacky maybe, to previous cycles

Starting point is 00:02:23 that you felt so compelled to cover it Is that the reason? I think that I turn Buffett's quote around in the memo later on to say that just because something is not knowable, that doesn't mean it's not important. And so, look, I have an opinion on the future, always as do, you know, most of the people that I know as does everybody at Oak Tree. But what we say at Oak Tree is it's one thing to have an opinion, and it's something very different to believe you're right. So a pine away, but don't put too much confidence in it. In the last

Starting point is 00:03:00 six, seven years, I've been addicted to Mark Twain's statement that it ain't what you don't know that gets you into trouble. It's what you know for certain that just ain't true. If you know sentence that begins with, I don't know but, or I could be wrong, but, ever got anybody into trouble. The sentences that get people into trouble are, I'm sure that, or I'm confident that, or there's no doubt that. And what I'm talking here, Trey, is about a mindset. And when you're in an area, which is beset with uncertainty, variability, unpredictability, randomness, things like that, It just strikes to me as folly to be confident that you know the future. And I think it's one of the most important things in life, any walk of life, is to be realistic. And I think that realism in investing includes not being too confident about what you think you know. Well, let's talk about another Mark Twain quote, which is history doesn't repeat itself, but it does rhyme. And what I'm kind of curious to talk to you about, since you're such an expert on market cycles and

Starting point is 00:04:17 I've written one of my favorite books on market cycles, there's always this hesitation to buy into the hype of a bubble, perhaps, and say, this time is different. But what I'm really curious to know is, you know, in your letter you state that since 2008, we haven't been operating in a free market. And so is this time truly different? Well, I think this is a very different time. And in fact, the events of the last year and a half, vis-a-a-a-ha-a-ha-COVID, cyclical events occur for reasons that are endemic, internal to the market. And they usually have to do with excesses of optimism and then correction, which leads to excesses of pessimism and then correction. So people think they know that things are going to be very good, but then they incorporate too much optimism, which means that they buy too much, they use too much leverage, they drop down in quality too much, they bet more than they should, etc. And when everybody does that, prices go too far on the upside to the point where they become precarious, and then they correct. And then on the downside, people sell. short, retreat to the sidelines, swear they're never going to take risk again, and eventually

Starting point is 00:05:42 things go to excess on the downside. But because everybody has sworn off risk taking, they don't get back in. So what we're all in this business to do, those of us who are active investors, is buy low and sell high. But everything in our nature conspires to make us buy high and sell low. And so it is essential to combat those instincts. And this event of the last year and a half was not a cycle. It wasn't born. I mean, the decline was not born out of excessive optimism. And the recovery was not merely a bounce back from excessive pessimism.

Starting point is 00:06:25 This was like a meteor hitting the earth from outer space. The decline wasn't the result of ex-f optimism. It was it. this thing called a pandemic, the coronavirus. Then the recovery was not merely a bounce back from excess of pessimism. It was the result of the greatest economic rescue effort in history, which worked. So I think that there are relatively few lessons about cycles to be gained from the last year and a half. And I think that maybe the greatest lesson to be gained is that it's hard to estimate fully the things that are going to happen. And by the way, one of the things that's worth

Starting point is 00:07:08 noting is for those people who consider themselves forecasters, who among us understood on March 23rd that from that date on, the market would march up in a straight line to the point where it has now doubled from March 23rd, 2020 till today, August 21, the S&P 500 has doubled. Where are the people who thought that was the case. I certainly wouldn't be one of them. And, you know, most of us underparticipated in the rally. Now, that's a bit of an oxymoron because if we underparticipated, everybody underparticipated, then how did the rally take place? And that shows you the folly of generalizations. But the point is, this was not a normal cyclical event. It was something very different. I'm glad you bring that up, actually, because there's an old adage that you can't time the market,

Starting point is 00:08:00 And J.P. Morgan did this study back in 2015, and it basically showed that by missing the best days in the market, which were essentially the days when the trend capitulated, it resulted in a massive difference in return. So, for example, staying fully invested from 97 to 2016 resulted in an S&P return of 7.68%. Whereas by missing the 30 best days in the market that were usually after quick correction of sorts, your return would actually have been. negative 0.5%. So I know that Oakmark obviously has a tenant about not timing the market. So what I'm more curious about is how you balance positions based on the cycle versus simply just investing through all fluctuations.

Starting point is 00:08:45 I think the answer, Trey, lies in the fact that while we invest through just about all situations, there have been times that we turn quite, that doesn't mean we behave equally through all situations. And sometimes we become more aggressive and sometimes we become more defensive. And I think that's a good thing to do, although clearly it's not easy to do it right. And if we were to make the mistake that you just outlined and missed those 30 days, we would really have hurt our clients. One thing I want to say before I move on is that in a way, the thing you posed is what we used to call in high school a trick question. because those of us who are attentive to the market cycle, and let's say you're good at doing it,

Starting point is 00:09:32 would be less likely to be out of the market on those 30 days. What you're saying is, after the market gets killed, it usually bounces back. And if you miss that bounce day, you're in trouble. Well, number one, if you missed the bounce day, you might have also missed the killing day. So they may offset. But if you're a good timer and sensitive to excessive, and able to weed them out, chances are you would not have dropped out of the market at the low ab and missed the rally. Great point. You might have also missed the initial decline.

Starting point is 00:10:07 Well, exactly right. So to me, we hear those things all the time, if you would have missed the best day, the best 10 days, the best 30 days. It's like fun with numbers. Yes, if, but is it possible? I think the main import of your question is that the market does not. perform smoothly. And there are huge up days and also big down days. The up days, I think, tend to be bigger than the down days. But the function of the market setting the appropriate price for assets is not a smoothly operating one. And every once in a while, there's a big boom.

Starting point is 00:10:42 And we shouldn't be surprised when that's the case. I guess I'm asking mainly because, you know, we recently had Jeremy Grant them on. And he highlighted that, although a lot of people were calling this market a bubble for a long time, we've In his mind, we've only recently seen bubble activity, whereas before the pandemic hit, we were in this very slow growth. And as you highlighted, you know, the slowest growth since World War II. And so I'm just curious, I guess, if you're seeing similar bubble territory now in the recent market days, and if so, if it's reminding you of, you know, say, 2006, when you began, quote, unquote, planning for destruction when things weren't kind of operating, right? Are you seeing any similarities to that time? Well, there certainly are similarities, and they are the events that cause Jeremy and others to say bubble territory and to blow the whistle of caution.

Starting point is 00:11:36 I think this concept of aggressive versus defensive is very important. You know, I go on TV every once in a while, mostly after I just finish writing a memo. And they're constantly trying to get me to say, buy or sell in or out. And in the last four or five years, I've gotten away from that kind of talk. And now the way I say it is this. And by the way, short answers, especially in the investment business, are usually a mistake because the concepts are complex and not given to easy short answers. So rather than say by or sell, what I say is this. Every investor, especially everybody in your audience, should have, in my opinion, a view of what their normal risk posture should be. And let's say we're talking about individuals. Let's say we're talking about you. How should you set your normal risk posture? And in my opinion, the answer is you look at your age, your income, your current earnings, the relationship between your current income and your needs,

Starting point is 00:12:38 the amount of money that you have in the bank or in a portfolio, the number of dependents you have, the level of your aspirations, and in particular, you have to make a judgment about your ability to live with volatility, mostly intestinal. Do you have the ability to ride out the ups and downs? Or are you likely to panic at the low and sell out, which is the worst wealth killer in history? You think about all those things, you mesh them together. The way I say it is from zero to 60, Zero is all cash. 60 is maximum risk plunging into aggressive investments may be using leverage. Zero to 100.

Starting point is 00:13:26 Where should you be? You should probably be about 75 or 80. You know, one thing is when you're older, if you think about the market cyclically, ups and downs, the younger you are, the more you can count on the long-term trend. And you have the freedom to, if you have the intestinal strength, you have the freedom to ignore the short-term ups and downs. The older you get, the long-term trend becomes a bit academic, and the short-term trends might make a bigger difference, especially people who are, for example, retirees. Retiree, or someone who's about to retire, who has just about enough money to retire and live,

Starting point is 00:14:06 shouldn't be investing aggressively anymore because while the trend-line outlook for aggressive investments might be positive, they might come across some difficult periods in which their lives may be thrown into a tailspin. And, you know, one of my favorite sayings is never forget the man who was six feet tall, who drowned crossing the stream that was five feet deep on average. In our business, survival on average is irrelevant. You can't say, well, yes, he survived on average. You have to be able to survive on the bad days. And you have to survive all the time.

Starting point is 00:14:41 But the challenge, of course, comes on the bad days. And so anyway, the point is you come up with a number and you say, Trey, okay, I'm an 80. My next question is, will you change your risk posture from day to day or month to month, depending on what goes on in the market? Some people say, no, I'm not going to change. I'm in the position. I have a good portfolio. I'm going to leave it alone.

Starting point is 00:15:04 Some people say, yes, I'd like to change because when the market is too high, I'd like to cut back a little. and when the market is too low, I'd like to put more oomph into my portfolio. So if you are interested in changing your posture as appropriate, then question number three, what about today? Today, do you think you should be more aggressive than your normal or more defensive than your normal? And I think that that's a more useful way to think about this than buy-sell. And so in the years leading up to the pandemic, we never had a bubble warning. We never turned highly defensive. Our motto was move forward, but with caution, move forward, make investments. We were making investments every day. We were trying to be fully invested. But with caution,

Starting point is 00:15:52 since we're a firm that takes a cautious approach to our investments, with caution meant more caution than usual. And that's what we did. So we had a portfolio that was biased toward caution, for several years, it didn't help because it turned out that the period 09 through 19, for the most part, was a period when caution was your enemy and aggressiveness was more helpful. Quick question on more caution. When you say more caution, are you referring to more of a cash position or just smaller position sizes in general? How do you think about caution?

Starting point is 00:16:26 That's a great question. And most people throw that term around without asking that question. I think there are three ways to increase your caution. Number one, go to cash in whole or in part. Very difficult because number one, it's a two-decision action. You have to get out, but then you have to get in at a more propitious time or else it wasn't worth it. Charlie Munger says it's actually a three-decision process because you have to get out, you have to get in, and while you're out, you have to figure out what to do with the money. This is very difficult. And the other thing about, I try not to make decisions which are going to be a disaster if things don't break your way. I think one of the important

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Starting point is 00:21:31 When you were referring back to the idea of, you know, as you age, getting more defensive, the typical routine or playbook for that would just be, you know, adding more and more to more allocation towards bonds. But given today's environment with the yields being so low and you're guaranteed to lose money right now on a real basis, Is that really the best move as you're getting into your, you know, more defensive stage? So the first way is to raise cash. But that's a real big problem because if you go to cash today and the market doesn't

Starting point is 00:22:02 crap out for the next two years, let's say it goes up 12% a year. Two years from now, you're going to be behind the eight ball. You lost out on 24% of appreciation. You'll never make that back. So going to cash, problematic, we never do it. The second, change your asset allocation. So, for example, we all know which asset classes are supposed to be more defensive than others. Bonds are supposed to be more defensive than stocks.

Starting point is 00:22:27 Big stocks are more defensive than small stocks. Emerging markets are less defensive than developed markets. The U.S. is more defensive than Europe, et cetera. So you can move from aggressive assets into defensive assets. And the trouble with that is you have to really transform your portfolio. You have to do a lot of selling and a lot of buying. And if you're in funds, it's hard to get out and so forth. The third way of being defensive is the one I would suggest to most people.

Starting point is 00:22:56 First of all, remember, most people don't know when it's time to get in and out. So they shouldn't be doing aggressive things. What they should do, in my opinion, is at the margin, you make changes in your portfolio that biases in a certain direction. So let's say you want to be more defensive. So in every asset class, be it high yield bonds, stocks, high grade bonds, anything, there are ways to be defensive and ways to be aggressive within the asset class. So for example, you say, well, I have a 30% commitment to, let's say, high yield bonds.

Starting point is 00:23:31 There are high yield bond funds out there which make the most in the good times, but lose the most in the bad times. There are other high yield bond funds that lose the least in the bad times, but don't keep up in the good times. So you can switch managers within your high-yield bond commitment, switching from aggressive managers to defensive managers. And that's the one that I think most people should look at. It's just hard to get it right to justify major changes in your portfolio based on hunches,

Starting point is 00:24:03 which is what I think they are, hunches about the macro. I'd like to tie back to the question right before that about, So as you're thinking about entering a more defensive age for the retail investor, and it was most commonly going to bonds, I'm just wondering how you're thinking about bonds. Ray Dalio recently said he'd rather own Bitcoin than a bond, because you're guaranteed to lose on a real basis. How are you thinking about bonds today? No, I think that's right.

Starting point is 00:24:32 I think that, first of all, it's, in a way, it's easy to say no bonds. It's very tempting to say no bonds with yields where they are. But if you say no bonds, then, I mean, bonds are in absolute terms, they are the safe asset class. If you say, no, we're not going to have bonds, then how are you going to implement safety in your portfolio? So Ray is certainly right that today's bonds are very unattractive. But you may want to have, I would think of bonds today. Look, in this day, when the Fed funds rate is zero to a quarter percent and the U.S. Treasury pays less than the 10-year pays less than one and a half and so forth, I would think of bonds of that type, safe bonds, kind of like cash, a way to store money

Starting point is 00:25:17 safely from which you don't expect much. Nobody who invest in the bond market today is going to make much, but hopefully they'll make a little income and their position will be steady if interest rates don't go up much, which is an important caveat. But I sit on some nonprofit investment committees and have done over the years. Today, I'm pretty emphatic that there is no place in your portfolio for something like an endowment. There's no place in that portfolio for securities whose only merit is that they're not going to go up and down much. As you say, if you buy the 10-year treasury today, you guarantee yourself a return over 10 years of less than 1.5% which doesn't do much for anybody. Endowments typically need about 7% annual

Starting point is 00:26:07 return to accomplish their philanthropic mission. And if you put many 1% bonds in the portfolio, it's going to make it awful hard to get the 7. And if you do so, and you still want the 7, that means with the rest of the money, you're going to have to do things that are extremely aggressive and try to offset the money that's invested at 1% and that risk could bite you in the butt. So I think that certainly Ray is right. In most portfolios today, there's no place for safe bonds. I'm tempted to ask. I know you've been spending a lot of time with your son, Andrew, over the last year

Starting point is 00:26:43 through the pandemic and talking a lot about Bitcoin. Any thoughts on that working its way into a portfolio at a time like this? I came out very strongly against Bitcoin in 2017, which was the first time when it entered our consciousness. It probably had been around for seven or eight years before that, but that's the year that went from one to 20, and everybody started 1,000 to 20,000. that's the year that everybody started talking about. And I came out very negative because I said, there's nothing behind it. It doesn't produce any cash flow or any return intrinsically.

Starting point is 00:27:16 The only return you're going to get in Bitcoin is by selling it to somebody for a price higher than you paid. But you can't value it. You can't say what is the fair intrinsic value of a Bitcoin and it doesn't produce cash flow. I was extremely negative. I was extremely outspoken. And as you say, I spent a good deal of the pandemic living with Andrew and his family, and we had to hash out some of these things because he's on the other side. The first thing I was informed of by him is, and I accept this, is that at that time and even today, I don't know enough to have a strong opinion about it. Over the course of my life, I've been quite a skeptic. I've been successful in being skeptical of financial. innovations, but that doesn't mean that all financial innovations are not worth it. And so I think that my reaction was a knee-jerk reaction to something new. And now I prefer to say, I don't know enough about it

Starting point is 00:28:16 to have a strong opinion. Andrew says to me, and Andrew does own it, and obviously it's been a very good investment. And fortunately, he owns it for me because he manages money for our family. But he says to me, Dad, are you ready to admit that I was right? So I said, well, let's put it this way, I'm less emphatic that you were wrong. But, you know, I mean, Bitcoin's been around now for a dozen years, and if it's a flash in the pan, it's an awful long pan. Maybe it may be something there. And what I missed in 2017, looking for intrinsic value and cash flow production, I missed the supply demand case. The supply demand case is that the software limits the issuance of Bitcoin, or the creation of Bitcoin, to 21, I think 21.5 million, whereas the

Starting point is 00:29:01 Demand can grow for a long time. People who live in places where you can't get to a bank, where you don't trust the banks, where you don't trust the government, where you don't trust the currency, a lot of these people are going to maybe turn to cryptocurrency. The other thing is that there's a big argument that it's, they call it digital gold, that it has some of the qualities of gold in the sense of being inflation resistant and maybe crisis resistant, but relative to gold that has advantages, which is you don't have to pay to store it. It's not challenging to send it someplace, move it around, and you can spend it, which you can't do with gold. So those are the arguments in favor of Bitcoin. And certainly in 2017, I wasn't familiar with them.

Starting point is 00:29:46 And the people who bought Bitcoin, would say a year and a half or two years ago have made a lot of money now. We'll see. We're probably not finished learning all there is to learn about Bitcoin. We'll see in the future whether it turns out to be legit asset class and holds value. As the years go by, it gets harder to say, you know, there's nothing to it. I ask because after reading your latest memo, and while you do say you don't understand enough of maybe about the technology, you certainly understand, I mean, you lay out the perfect case for Bitcoin, in my opinion, on your letter from the macro sense. And one of the other points I wanted to talk about that you've referred to recently stems

Starting point is 00:30:27 back to the cost of capital. And I'm wondering how you think through that, given that manipulated maybe too strong a word, but that certainly seems to be the case. And I'm wondering how you think about the discount rates today and what you're using in comparison to the interest rates I hand. Great question. Not an easy one. But I did say in the latest memo that we haven't had a free market in money for at least 12 years. And what I mean by that is that I'm sure that everybody who's an investor has to believe in the free market system. We probably don't have many socialists or communists investing in our stock market. But if you believe in the free market, a lot of your belief is that in a free market, assets flow to what we call their highest and best use. And so

Starting point is 00:31:16 the free market does a very good job of allocating resources. Nobody's going to work in job B if they can make much more money in job A. And the reason they can make more money in job A is because job A is working on a better product which faces more demand, more people want it. So there should be a product A company is more valuable. Workers will go to work there. So the resources migrate to their best use. And normally, the free market does a good job of incorporating considerations of risk and

Starting point is 00:31:50 return. When you're operating the free market, a lot of people say, well, on the one hand, I'd like to make a lot of money by doing XYZ, but on the other hand, I might lose money by doing XYZ. So I'm going to only put it in a moderate amount, or I'm not going to do it, or I'm going to hedge it, or something like that. So that's how the free market kind of incorporates intelligence. We don't have a free market in money. The interest rate on certainly short-term funds, or ever since the global financial crisis of 09 has been set by the government. And most people would argue that today's interest rate is lower than it should be. And because we have a lower interest rate than might be appropriate, what does it mean?

Starting point is 00:32:32 It means that borrowers are subsidized, lenders are penalized. People who want to use leverage is encouraged. Savings is discourage. Savers, pensioners are penalized at the expense. of borrowers and risk takers. So the, look, the Fed's job is to manipulate the economy. And those manipulations have a, let's say a price because they take money away from where it would naturally end up. And they put it someplace where it naturally wouldn't end up, but they make it happen. So you asked how we think about rates. An asset value is in academic terms, but it turns out

Starting point is 00:33:15 that it often works in the real world. It's the discounted present value of the future cash flow. And if you're a savant and if you can see the future, or if you're an analyst trying to do a good job, you lay out the cash flows from that investment year by year for the next X years as far as you think you can see. And maybe you have a probability distribution, maybe you have a central point and a range of high and low, but you lay out the future. And then you discount those cash flows back to the present to come up with the present value. What does it mean to discount? Well, if the interest rate today is 7%, and you're going to get money in 10 years, then that money is worth half today what it will be in 10 years. So you come up with a present

Starting point is 00:34:03 figure for what the future cash flows are worth. And the lower the rate at which you discount, the higher the present value of those cash flows. So, So the level of the interest rate you use in your analysis figures importantly in setting the price. But the answer is today, and so today you could use a discount rate of 3%. And if you find something that's going to pay off in 10 years and you discount it back to the present at 3% and you buy it, you think you're doing a good thing. But maybe that means you make 3% a year, which isn't a very good return. So you have to discount at an interest rate, which is an attractive rate of return to you.

Starting point is 00:34:43 You can't succumb to using today's interest rates. One of the things I said in the memo is that most assets appear to me to be fairly priced today, given the low level of interest rate. So, you know, I just went through the way interest rates affect valuations. And today, we have the lowest interest rates in history. That would simplistically argue for the highest asset valuations in history. But if you buy it, the highest asset valuations in history, there's a lot of lots of ways things can go wrong in the future, like interest rates go up. People demand higher

Starting point is 00:35:18 returns. That means that tomorrow's values are not worth as much today. That means prices go down. One of the reasons the market has done so very well over the last 17 months is that by taking the Fed funds rate to essentially zero, the Fed has, well, people say, well, I don't want zero. high yield bonds look great at four. When the Fed funds rate was three, nobody thought high yield bonds were great at four percent yields. They said, no, I want nine. But today, with the Fed funds rate at zero, they say, oh, that's, that four percent looks pretty attractive. All judgments in investing our relative judgments. Sid Coddell, who was the editor of Graham and Dodd and Cottle, Graham and Dodd is the Bible of, it's called Security Analysis, their book, it's the Bible of our profession, although a little,

Starting point is 00:36:06 a little antiquated. Sid Cottle was the editor of the later editions, like the one I read in college. And Sid was a consultant to me at Citibank, and he said back around the early 70s, investment is the discipline of relative selection. All the decisions we make as investors are relative decisions. I think that based on return and based on the ratio of return to risk, I think this is better than that. So we buy this and we don't buy that or we buy this and we sell that. That's the way we make our decisions. Today, we're making relative decisions between two different assets, perhaps, relative to interest rates. And we have to understand that if interest rate change, everything else changes. And so the biggest mistake you could make today would be to discount at an ultra-low

Starting point is 00:36:52 discount rate because rates are low today. That's a good way to get into trouble. In some way, you have to try to insist on a good absolute return. You have to insist on what we call margin of safety. That's what permits you to do okay if things go against you. But it's hard in a low interest rate environment. We're living in what I call a low return world. And it's hard to make, for all the reasons I've been discussing, it's very hard to make a good return in a low return world. An endowment that needs seven, most endowments, pension funds, insurance, et cetera, with fixed obligations, have concluded that they can't make the return they need in the stock and bond markets. So they move to what are called alternative investments, which means private equity,

Starting point is 00:37:39 hedge funds, stress debt, real estate, all that kind of stuff. But that they go there to try to get the returns they can't get safely in stocks and bonds, but that introduces other risks, illiquidity, leverage, manage your risk, you know, you back the wrong horse. So the point is there is no safe and dependable way to get a high return in a low return world. Think about it. There can't be. I mean, one of the most important things that every investor has to learn is that at some point in time, they may have to say, no, that's too good to be true. And if I say to you, Trey, I have found a way to make a high return with certainty today. You have to say, no, Howard, that's too good to be true because the world would not permit that to exist. If somebody comes into your office, Trey, and says, you know, I've been managing money for 30 years. I've never had a down month. I've made 11% a year. I've never had a down. I've never had a down. down money. Your job is to say, that's too good to be true Mr. Madoff. And the reason Madoff got away with it for so long and hurt so many people so badly is that when people think they're making money, they never say, but does it make sense that it's so easy to make money safely?

Starting point is 00:38:53 And it can't be. So I think that reasonable expectations are one of the most important things for any of us investors. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform. So whether you're prepping for a SOC 2 or running an enterprise GRC program, VANTA keeps you secure and keeps your deals moving. Instead of chasing spreadsheets and screenshots, Vanta gives you continuous automation across more than 35 security and privacy frameworks. Companies like Ramp and

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Starting point is 00:42:12 and expenses. This and other information can be found in the income funds prospectus at fundrise.com slash income. This is a paid advertisement. All right. Back to the show. Well, I'm glad you brought up security analysis because it touches on the point of how important price is. And while you're saying that prices are appropriate relative to interest rates today, one of my favorite Buffett quotes is, price is what you pay, value is what you get. I'm curious on a couple of things around price and value. One is, well, let's just start with what is your earliest memory that taught you the importance of price. And then I want to kind of lead into maybe

Starting point is 00:42:52 where we go from there. Malcolm Gladwell wrote that great book, Outliers, who talked about the importance of what he calls demographic luck, what you and I might call right time, right place. And I was lucky in a perverse way because I started my career in the investment management business in 1969 at Citibank as a security analyst. And in those days, the banks did most of the investing. There were no boutiques. There were very few firms like Oak Tree or the firms that are on everybody's lips today. It was the banks. And most of the banks, what we call the money center banks, that's the banks in New York and Chicago and Boston and places like that. Most of the money center banks invested in what were called the nifty 50. And these were the 50 best and fastest

Starting point is 00:43:43 growing companies in America, companies that were considered so good that nothing could ever go wrong. And because they were so good and nothing could ever go wrong, that meant there was no price too high. And if you look in the index of my recent book, Mastering the Market Cycle, under no price too high, you'll find, see there are lots of citations. Because that's, we talked before about a bubble. That's one of the greatest indications of a bubble. If investors can think of an asset class and say, oh, you know what, for that, there's no price too high. That's a bubble because by definition it's irrational. For everything, there's a low price, a fair price, and a price too high. Anyway, so the banks invested in the 50-50. That certainly included Citibank. We were one of the great leaders.

Starting point is 00:44:25 That meant IBM, Xerox, Kodak, Polaroid, Merck, Lilly, Hewlett-Packard, Texas Instruments, Perkinelmer, Avon, Coca-Cola, and on like that. Great, great, great companies. And if you would have invested in those companies, did they ask out of work in September of 69, and held them for five years, diligently, you would have lost almost all your money, investing in the best companies in America. Why? Because people ignored price. And so they didn't get enough value, use warrants terminology. And the answer is that price matters a great deal. And the shorter your time horizon is, the more it matters. The shorter your time horizon is, the more important it is that you're not overpay. So anyway, the nifty 50 were selling at PE ratios. Today, the average, the average

Starting point is 00:45:14 average PE ratios in the low 20s, PE ratios between 60 and 90 in those days. And for the most part, those PE ratios have never been seen. And then five years later, the PE ratios were between eight and nine. And that's a good way to lose 90% of money, which most people did. So that taught me an important lesson. And I concluded at the time, it's not what you buy. It's what you pay for. That really matters. Then I was very fortunate. The break of my life came in 1978 when I was assigned to the bond department. I wanted to get into money management. My reign as director of research at Citibank, involved as it was with the Nifty 50 was not so successful. So they said, I said, I want a management. They said, okay, we'll put you into bond department, start a convertible bond fund,

Starting point is 00:45:57 which I found very interesting. It was a backwater that nobody else was looking at. And then in August of 78, I got the call that changed my life from the head of the bond department. He said, there's some guy out in California named Milken or something, and he deals in something called high-yield bonds? Can you figure out what that means? Because a client had come in and they said, we want to hire a bond fund. So now I'm investing in the worst public companies in America and I'm making money safely and steadily, whereas investing in the best companies in America had been really dangerous. So then I concluded that good investing is not a matter of buying good things, but buying things well. And if you don't know the difference, then you shouldn't be

Starting point is 00:46:42 doing much investing. So that brush with the nifty 50 taught me the importance of paying a fair price. The real lesson is that there are no assets which are so good that they can't become overpriced and dangerous. And there are few assets which are so bad, which that at the right price they can't be bargained. You know, one of the things that Oatree has done for the last 33 years with great success is investing in the debt of bankrupt or likely to be bankrupt companies. We call it distressed debt investing. And you might say, but Howard, how can you invest in the debt of bankrupt companies? You know you're not going to get repaid. And the answer is that a, if you buy the debt of a bankrupt company or soon to be bankrupt company, it embodies, it gives you a

Starting point is 00:47:36 claim on the value of the company as a creditor, if you buy a sheep enough, that maybe you're paying a price for that claim, which is so low that it's going to have a great return. And that's what we try to do. So I think that price is extremely important. And as I said, in bubbles, basically what it means is they ignore price. And that's a terrible thing to do. A big difference between the late 60s and now, it seems, is the IP involved. Because I'm seeing similarities now, especially with the Fang stocks and companies that are leading the S&P 500, that I start to worry about those who are big time indexers. And I'm wondering if you see similar risk, these companies seemingly have no top because

Starting point is 00:48:24 it seems almost impossible to put a price on their IP. So do you look at, you know, the fact that the S&P 500 is market weighted as a potential risk to a lot of retail investors? Great question. Very relevant question. In every market cycle, we get to the point where people say, you know what, this thing, whatever it is, whether it's the nifty 50, 50 years ago, or internet 20 years ago, or tulip bulbs, several hundred years ago. They get to the point where they say, well, this is, this is now, it's risen to the point where it's a sure thing. This can't, can't lose. Why not? Well, for example, you look at the tech or the fangs. They're in the S&P heavily.

Starting point is 00:49:10 Every time a dollar flows into, say, an S&P index fund or even an active manager who kind of secretly closet indexes, money is going to flow into these names, predominantly, because they are so heavily weighted in the index fund. in the index, which means that money has to keep flowing in, which means that they have to keep doing better, which means that they'll never falter, which means that they're a sure thing. Well, there are no sure things, and there's nothing that can't falter. My dad used to tell the story about the guy who was the habitual gambler, and every week he would go to the track and lose all his money. So one day, he heard about a race with only one horse. So he went out to the track, and he put all his money down, and halfway around the track,

Starting point is 00:49:52 the horse jumped over the fence and ran away. The point is, there are no sure things. And if you, this goes back to the Mark Twain, if you find something that you think is a sure thing, and you bet disproportionately on it because it's a certainty, and it turns out not to be a certainty, that's how you lose a lot of money. And so you can construct this account for the fangs that I just described about how the money has to keep flowing into them, and it's kind of self-perpetuating. And when I was little, we used to talk about perpetual motion machines, which is a machine that can run forever with no fuel because it generates its own energy. They've never come up with one yet. It was a cartoonist named Rube Goldberg, who used to design

Starting point is 00:50:34 those, and we used to talk about Rube Goldberg devices. But the truth is, there is no perpetual motion machine. There's nothing that goes on forever. And the way to lose a lot of money is to buy something on the presumption that it is a perpetual motion machine and then have a reawakening. I think that the, and you know, by the way, the magic is off some of the fangs this year. They're not necessarily having great year. Stock markets, S&Ps up 18%. Many of them are underperforming. And Andrew would say that one year doesn't matter.

Starting point is 00:51:04 But the thing is that I believe that if the market goes like this and you have some asset, be it, let's say it's a fang and it keeps going like this, if one asset outperforms the others long enough. You have to flip it over. The flip over outperform, what you find underneath is becoming more expensive. That's what outperformance is. So if asset A outperforms B, which is to say appreciates more than B, long enough disproportionate to the merits, eventually it will become overpriced. And if it's overpriced, it is then likely to run into some hiccups. And a correction. So I just don't think that one asset can outperform all the others forever. And investors who hear that siren song of permanent outperformance are in trouble if they succumb.

Starting point is 00:52:01 I want to touch on corporate debt as you did earlier because it seems like that game is shifting a little bit as well. The Fed now holds nearly $14 billion in corporate bonds themselves. How does the Fed's recent involvement into these markets affect Oak Tree's investing playbook? The most important thing about that, Trey, is what it did in the recent past. We were expecting something, you know, a massive recession, something approaching a global depression if the central banks hadn't come to the rescue. And in the first half of 2020, we raised the largest fund in history for, distressed debt investing, $15 billion. Previous record was our 08 fund, which was $11 billion.

Starting point is 00:52:50 And we were, we started to invest that money and so forth. And in March and April, there were great, great bargains to be had. Then the Fed came in, cutting interest rates, giving out grants and loans, and starting to buy some corporate debt, which they had never done before. The Fed had never bought corporate debt before. And the main effect of that was that it precluded the kind of of meltdown that we had expected to occur and that we had expected to take advantage of. But that's in the past. And there were lots of companies that would not have gotten through the pandemic in one piece, but they got through because the Fed kept loading them up with money, making more

Starting point is 00:53:34 money available to them, and buying their bonds. Anyway, we are value investors. I don't know if the Fed's going to keep buying. And by the way, the $14 billion they bought is something, but it's not a huge amount of money in bond market terms. And I assume they're probably done buying corporate bonds now. It's a very radical thing for the Fed to do, and they've probably done all they want to do for a while. But, you know, we kind of, you said that one of the tenets of Oak Tree's investment philosophy is we don't let market macro forecasts influence our investment decision. We don't say, well, let's say, should we buy that bond?

Starting point is 00:54:09 Will the Fed be buying that bond on Thursday or not, you know, that kind of thing? Or will they be cutting interest rates or raising it? We look at an asset. We say we think we can get a return of X percent under normal circumstances. And we think that X percent is a good return given the level of risk in that company. And so we make that decision kind of on an internal basis, the company, the risks, and the possible return without making guesses about what's going to happen. in the environment. It's just too hard to get that environment part right.

Starting point is 00:54:45 All right. Well, I want to be mindful of your time, but I do have one seemingly unfair question left, which I'm borrowing from Tony Robbins' book Money Master the Game, where he essentially asked Ray Dalio if he could package together a portfolio for his grandkids that they couldn't touch for, say, 30 years. What allocations would kind of make up a portfolio like that? I'm just posing the same question to you because I'm just incredibly curious. This is what I want to say to your listeners, Trey. The most important thing is to start an investment program while you're young, continue it as you grow and don't screw it up.

Starting point is 00:55:21 That's my most important recommendation. How do you screw it up? You tamper with it too much. And of course, as I mentioned some time ago, the biggest screw up you can do is to sell out at the bottom. And so most people are not really suited for getting in and out of the market. And I said that I think that that's how you're going to practice defense. It's very problematic. If you look at the stock market, the stock market has returned about 10% a year for the last 90 years.

Starting point is 00:55:52 And if you can make 10% a year and if you can avoid paying any taxes, so don't sell, your money will double every seven years. money compounds at 10% a year, it doubles in seven years. So let's say your grandchildren are five. They're going to live to 75. We've got a 70 year program ahead of them. That means if you can do 10% a year and not pay taxes, both of which are heroic assumptions, that it's going to double 10 times. So you put in a dollar today. The kid is five. Two, four, eight, 16, 32, 64, 128, 28, 28, 256, 512, 1,024. A dollar, the positive when the kid is five, will be $1,000, 70 years from now.

Starting point is 00:56:43 Just don't screw that up. Don't get in the way of the compounding machine. You know, I think it was Mark Twain. Maybe Albert Einstein said, the greatest invention in history is compound interest. Just get out of the way. Don't screw it up. So I think that, and by the way, my grandchildren should probably be at about, about 95 or 100 on my risk return dial from zero to 100. Why? Because they have their whole lives

Starting point is 00:57:10 ahead of them and their parents and their grandpa is probably going to backstop them anyway. So they should invest early, probably all in the stock market. You don't have to get fancy with other things. And so that what, and by the way, that means index funds, really, an S&P index fund, a Russell 2000 index funds. You know, you want to get maybe an emerging market fund. You might want to have some exposure to the emerging markets to smaller companies, certainly to China, which is probably going to before those grandchildren become adults, China will be the biggest economy in the world. So you want to have exposure to China and perhaps the other emerging markets. So I think my advice is a variety of equity index funds,

Starting point is 00:57:57 which complement and round out each other and then leave it a long. You know, when automation began to make great inroads into employment, as they did in the arts and especially the teens, they used to talk about the factory of the future. In the factory of the future, there's one man and one dog. The dog's job is to keep the man from touching the machinery. And the man's job is to feed the dog. It's the same with the grandchildren. My job is to create a portfolio for them and keep them from putting their hands on it. I think that that is a formula which is sure to work in the long run. And anything you do in the short run to try to outthink the market is probably going to reduce your likelihood of achieving your long run goals. Well, I love the simplicity in that. And you mentioned Einstein. So there's another quote attributed to him that everything should be made as simple as possible

Starting point is 00:58:52 but not simpler. But simple doesn't always equal easy. And what you're highlighting there is how hard that can be to the temptations are sometimes too great. So I think it's very wise and really great advice. Howard, this has been an incredible honor. I cannot thank you enough for coming on the show and providing all this wisdom for our audience. It's a huge amount of value you've shared with us and you've been very generous with your time. Thank you for your interest in my ideas and thank you for sharing them with your listeners. I hope they're helping.

Starting point is 00:59:22 I hope we can do it again sometime soon. Absolutely. All right, everybody. That's all we had for you this week. As I mentioned at the top of the show, be sure to go to oak treecapital.com to find Howard's three memos. I can't believe these things are free. The wisdom is incredible. Also definitely go check out Howard's books. And if you enjoyed the episode, let me know on Twitter at Trey Lockerbie. And for all things, TIP, simply Google TIP or the Investor's podcast and find all the resources we have for you there. And with that, we'll see you again next time. Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by the Investors Podcast Network

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We Study Billionaires - The Investor’s Podcast Network - TIP378: Move Forward with Caution w/ Howard Marks

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