Christoph Gisiger conducted the following interview with Howard Marks (Trades, Portfolio) in last week of February 2014. Christoph is from Finanz und Wirtschaft, a Swiss paper. Howard Marks (Trades, Portfolio) is chairman of Oaktree Capital, author of “The Most Important Thing”, countless memos and a guru in the field of value investing.
Mr. Marks, next week Wall Street will celebrate the fifth anniversary of the end of the equity bear market. What are your thoughts when you’re looking back to the dark days of the financial crisis?
Because people play an important role in determining the course of the financial markets, stock prices move like a manic-depressive. Of course, there were some severe fundamental problems in the years 2008 and 2009: The economy was bad, capital markets were closed, and Lehman Brothers and other financials firms went bankrupt. But most people exaggerated that into a belief that the world was ending. In line with that, asset prices were ridiculously low. Therefore, five years ago the key to making money was to have money to spend and the nerve to spend it. In other words: To do the exact opposite of what most people were doing erroneously at that time.
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And what’s your take on the stock market today, half a decade later?
Around the beginning 0f 2012 it was clear that a lot of recovery from the crisis had taken place. The economy, investor psychology and the price of credit investments had recovered, and pro risk behavior had started to return to the markets. Because of that, our mantra at Oaktree Capital for the last few years has been: «move forward, but with caution». Although a lot has changed since then I think it’s still appropriate to keep the same mantra. Today, things are not cheap anymore. Rather I would describe the price of most assets as being on the high side of fair. We’re not in the low of the crisis like five years ago. But similarly, I don’t think we’re in a bubble.
This week, the S&P 500 printed a new intraday all-time high. What indicators are you looking at to feel the pulse of the market?
The easy thing to look at is the P/E ratio on the S&P 500. The post war norm is about 16 and the lowest point I’ve ever seen was in the late seventies when it got down to 7. At the beginning of 2012 it was around 11 which was very cheap too. During the financial crisis stock prices went down and then they came back up somewhat. At the same time, company profits moved ahead sharply, which reduced the ratio of price to earnings. So equities were extremely cheap, as I wrote in March 2012 in one of my memos called «Déjà Vu All Over Again». But we’re not there anymore.
So where do we stand now?
Let’s think about a pendulum: It swings from too rich to too cheap, but it never swings halfway and stops. And it never swings halfway and goes back to where it came from. As stocks do better, more people jump on board. From 1960 to the late nineties everybody thought that owning stocks was the way to get rich with no risk. Stocks, which had always gone up 10% a year on average, went up 20% on average in the nineties. Then, from 2000 to 2012 with the burst of the dot-com bubble and later the financial crisis, people fell out of love with stocks, causing them to get too cheap. Now people are in the process of falling in love again. And every year that stocks do well wins a few more converts until eventually the last person jumps on board. And that’s the top of the upswing. But I don’t think that craze is back now. That’s a reason for optimism, because that means more affection can develop.
What are the risks investors should be aware of as this bull market goes on?
If I ask you what’s the risk in investing, you would answer the risk of losing money. But there actually are two risks in investing: One is to lose money and the other is to miss opportunity. You can eliminate either one, but you can’t eliminate both at the same time. So the question is how you’re going to position yourself versus these two risks: straight down the middle, more aggressive or more defensive. I think of it like a comedy movie where a guy is considering some activity. On his right shoulder is sitting an angel in a white robe. He says: «No, don’t do it! It’s not prudent, it’s not a good idea, it’s not proper and you’ll get in trouble». On the other shoulder is the devil in a red robe with his pitchfork. He whispers: «Do it, you’ll get rich». In the end, the devil usually wins. Caution, maturity and doing the right thing are old-fashioned ideas. And when they do battle against the desire to get rich, other than in panic times the desire to get rich usually wins. That’s why bubbles are created and frauds like Bernie Madoff get money.
How do you avoid getting trapped by the devil?
I’ve been in this business for over forty-five years now, so I’ve had a lot of experience. In addition, I am not a very emotional person. In fact, almost all the great investors I know are unemotional. If you’re emotional then you’ll buy at the top when everybody is euphoric and prices are high. Also, you’ll sell at the bottom when everybody is depressed and prices are low. You’ll be like everybody else and you will always do the wrong thing at the extremes. Therefore, unemotionalism is one of the most important criteria for being a successful investor. And if you can’t be unemotional you should not invest your own money, period. Most great investors practice something called contrarianism. It consists of doing the right thing at the extremes which is the contrary of what everybody else is doing. So unemtionalism is one of the basic requirements for contrarianism.
For what warning flags should investors watch out now?
There are two main things to watch: valuation and behavior. A great thing about investing is that you have historic valuation standards. You should be aware of them, but you shouldn’t be a slave to them. You can compare the current P/E ratio to historic standards and see that the current P/E ratio is about fair relative to history. So valuations are moderate to a little expensive in most areas. Looking at investor behavior, you can ask yourself: Is everybody at the club, on the train or in the office talking about stocks? Is everybody having fun and making easy money? Is everybody saying «even though the market has doubled, I’m going to put more money in»? Is every deal sold out? Is every fund sold out? In other words: Is the party rolling? And if that’s the case, then you should be very cautious. It’s like Warren Buffett (Trades, Portfolio) says in one of my favorite quotes: "The less prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own affairs".
How about the super easy monetary policy? With interest rates at almost zero percent and large-scale bond buying programs like QE3, the Federal Reserve and other central banks are encouraging such a risk-seeking behavior.
The availability of cheap money in too-large quantities is behind many of the excesses in the financial markets. If you look around, what do these places have in common: the southwest of the United States, China, Ireland and Spain? Too much building! In all of these jurisdictions the overbuilding occurred because money was too easy. There’s no question that the easy money policy of the Fed has dangerous aspects. On the other hand, the action of the central banks in reducing interest rates during the crisis was absolutely necessary. If they hadn’t done it we would have gotten into even bigger trouble. But that doesn’t mean that there aren’t some negative consequences. Every governmental action has consequences. Even if the main policy is correct there are side effects, like with medicine.
What are those side effects?
One of the negative consequences is that money is has been cheap. In short, we don’t have a free market in money. The barrower has been subsidized and the investor or saver has been penalized. If you’re a company with a big loan outstanding your interest cost has gone down. On the other hand, if you’re a pensioner living on your savings, your income has shrunk. The other important threat is that because central banks pushed interest rates so low, people moved out the risk curve to get the returns they needed. People used to get 6 or 7% from U.S. Treasuries. Now they have to move to riskier investments like high yield bonds to get the same return.
A field where Oaktree Capital has great expertise is credit investing. How hard is it to still find attractive investments in the credit space?
For bargain hunters like us it’s a challenging time. We like it better in the crisis, when everybody thinks the sky is falling and everybody is willing to sell things for a fraction of what we think they’re worth. Today, there is no panic and no worry. Everybody can refinance. There is little distress. The default rate on high yield bonds has been very low for the last four years. So it is slow going for us. But we’re harvesting. The assets we own have become very valuable because we bought them in a time of worry and now we can sell them at highly appreciated prices. And although it’s not easy there are still certain areas where we are investing: For example real estate, Europe and shipping.
And what’s your outlook for the bond market?
I remember very well one loan that I had in the early eighties when the interest rate reached more than 22%. So over the last thirty three years, bond investing has been very successful with interest rates declining. But this can’t go on much further because interest rates are down to almost zero percent now. The one thing I am pretty sure of is that interest rates can’t go below zero. It’s not impossible to have negative interest rates, by the way, but it’s unlikely. The other point is that the conditions of the markets always change and we don’t always know how they’re going to change. Most people agree that there is a very high chance that the Fed will continue to taper its bond purchases. But we don’t know what the effect will be. In other words: Everybody thinks tapering will make interest rates rise. But maybe interest rates already have risen in anticipation of the tapering, so that the event of the tapering itself will not cause a rise. One thing you can never be sure of in the investment world is «if A, then B». Processes and linkages are not always predictable,
Even if the Fed is scaling down QE3 gradually it will continue with a very easy monetary policy. And since central banks around the globe keep on printing cheap money, many investors are fascinated by gold. What are your thoughts on the archaic metal?
At the end of 2010 I put out a memo about gold called «All That Glitters». My conclusion was that there is no intelligent way to invest in gold. Here’s what I mean: A professional tries to invest by looking at a company and figuring out how much money it makes and how much money it is going to make in the future. Then he figures out what this company is worth and compares the current price to that value. But you can’t figure out what gold is worth. It doesn’t really have much practical use and it doesn’t produce income. You might say: Gold is a good buy because it’s a store of value, it protects against inflation, and it gives comfort in times of panic. So you argue that’s a good reason to buy gold today at $1300. But the trouble is that all those things were also truth when it was at $1900, and the person who bought it there has lost a third of his money. Therefore, you can’t invest intelligently in gold. There is no way to translate those virtues into a dollar figure. By the way: If you take the word «gold» and you take away the letter «l» then you have god. And it’s the same analysis: Either you believe in it or you don’t.
That leads us to an essential philosophical question. What’s the role of luck in investing?
Luck is extremely important. Skill, hard work and perseverance are all very important. But you need luck, too. Sure, you can maximize your chances of success by doing good analysis and making good decisions. But that doesn’t mean they’re going to work all the time, since the world is not an orderly place and randomness plays an important part. One of the first things I learned at university is that you can’t tell from the outcome whether a decision was a good investment decision or a bad investment decision because of the role of random and luck.
So how can we even tell who’s really a good investor and who’s not?
I always like to point out that nobody does their own dental work, or their medical work, or their own legal work. Therefore, in investing, like in any other field, you should hire a skilled professional because it’s not easy. Let me correct that: it’s easy if you want to do average. You can buy an index fund or a portfolio of average mutual funds and you get average results. But success in investing for me is not to be average; it’s to be above average. That’s the part that is hard. Investing is a mental activity in which you have to double think at what I call the second level, since your job is to out-think the others and most things are counterintuitive. That’s not true in a physical activity like bridge building or tennis, for example, in which you don’t have that level of psychological and emotional complexity.
But then again, to win a grand slam tennis tournament like Wimbledon it’s also not enough to be average.
First of all, unlike in investing, there’s not that much luck in tennis. A pro like Roger Federer knows exactly where the ball is going to go when he moves his shoulder, his elbow, his hip and his legs in a certain way. But in investing that’s not true. Outcomes aren’t fully predictable or dependable. And there’s more: When Federer plays he tries to hit winners. If he does not hit a winner and gives an easy return, Nadal will stuff it down his throat. But when you and I play together, I don’t have to try to hit winners. I can beat you by not hitting losers. I’m just going to keep the ball in play. I put it every time back knowing that if I can do it twenty times you’re finally going to hit the ball into the net or off the court. So I don’t have to hit a winner. I only have to avoid hitting a loser. And that’s our motto at Oaktree Capital, too. We want to make a large number of competent investments and have none of them to blow up. And if we avoid the losers, the winners take care of themselves.
Is that also true for your personal investment portfolio?
I am a conservative investor. My ownership of Oaktree Capital and the income I derive from Oaktree’s success and my investments in Oaktree funds is very substantial. So I’ve never felt the need to press up my risk exposure. I am not one of these people who feel that every dollar has to be fully employed at maximum return every minute. I derive a lot of comfort from having liquidity and a dependable portfolio. Before the crisis, I used Treasuries for virtually all my money that was not invested in Oaktree. That allowed me to get a return of around 6% with total safety. Today, if I want to invest in Treasuries with one to five year maturities I only get 1%. That’s not enough because after taxes and inflation I lose money. So the answer is that I have increased my active investments. I’m still not maximally aggressive. By necessity, like everybody else in the world, I’ve moved out the risk curve – but in my case with caution.
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"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain