This is part three of my notes from Howard Marks' (Trades, Portfolio) new book "Mastering The Market Cycle: Getting the Odds on Your Side."Â
I’ll share some thoughts on my favorite story from the book. In Chapter 8, "The Cycle in Attitudes Toward Risk," Marks told the story of how excessive risk aversion caused a pension fund client to subject investments with enough margin of safety to unreasonable scrutiny and endless negative assumptions.
The background of the story went like this: A few weeks after the Lehman bankruptcy, Marks' firm Oaktree formed a levered fund but with less leverage than others. Oaktree used four times leverage versus the more conventional eight and would get a margin call only when the average market price of the loans in the portfolio got down to 88, which they thought was unlikely since prior to the crisis, senior loans rarely traded below 96.
However, after Lehman’s bankruptcy, loan prices fell to uncharted areas and Oaktree had to raise additional equity to get the leverage from 4-to-1 to 2-to-1. And Oaktree’s clients agreed to put more equity in the funds. At the new level, Oaktree wouldn’t be getting a margin call unless the loans fell to 65.
And amazingly, the unimaginable happened: The loans fell to near 70 and Oaktree then needed to get the leverage down to 1-to-1 and eliminate the risk of a margin call.
Here is how Marks recalled the conversation with a pension fund client:
"Now I was offering the fund’s investors a chance to pay to retain the fund’s loans at yields to maturity that were well into double digits, and levered returns on the overall fund in the 20s (before fees and potential losses due to defaults). Of course, if a pre-existing investor failed to put up his pro rata share of the additional equity and allowed someone else to do so instead, that would be tantamount to selling off part of his interest in the fund’s portfolio at those yields.
And yet, the combination of non-stop price declines, portfolio liquidations and a total absence of buyers made it challenging for some fund investors to take the step again adding capital. Some were fatigued from having to deal with the issues popping up everything in the portfolios. Some viewed this chance not as rescuing their investments, but as possibly “throwing good money after bad.” Some didn’t’ have liquid funds on hand. And some just didn’t have the willingness to defend additional investment to their bosses. At bottoms, it can be extremely hard to take actions that require conviction and staunches. And that led to the event I’m going to describe.
I went to a pension fund that was an investor in the fund, to make the case for an additional equity investment. The yields I laid out were attractive, they admitted, but they were worried about the possibility of loan defaults. The conversation like this:
Pension fund: What about the potential that defaults will render the investment unsuccessful?
HM: Well, our average default rate over the past 26 years in high yield bonds – which are junior in the capital structure to loans like the fund holds – has been about 1% a year (and bear in mind that there are recoveries in the case of default, meaning our credit losses have been less than a percent per year). Thus defaults at our historic rate would do little to diminish the fund’s promised return in the 20s.
Pension fund: But what if it’s worse than that?
HM: The worst five-year period we’ve ever had showed defaults averaging 3% per year; obviously nota problem relative to the yields we are talking about.
Pension fund: But what if it’s worse than that?
HM: The average default rate in the high yield bond universe –without assuming any ability to avoid defaults through skillful credit selection – has been 4.2% a year. Resulting credit losses of 2-3% clearly wouldn’t do much to jeopardize the results on this investment.
Pension fund: But what if it’s worse than that?
HM: The worst five years in history of the universe averaged 7.3% - still not a problem.
Pension fund: But what if it’s worse than that?
HM: The worst one-year default rate in high yield bond history was 12.8%. That still leaves plenty of return here.
Pension fund: But what if it’s worse than that?
HM: One and a half times the worst year in history would be 19%, and we would still make a little money given the portfolio yields in the 20s. And for such a minimal return to be the result, defaults of that order of magnitude would have to happen every year – not just once.
Pension fund: But what if it’s worse than that?
At this point I asked, “Do you have any equities?” And I told him if they did – and really believed the doomsday scenarios toward which they had been pushing me – they’d better leave the room and immediately sell them all.
My point is that, in a negative environment, excessive risk aversion can cause people to subject investments to unreasonable scrutiny and endless negative assumptions. During panics, people spend 100% of their time making sure there can be no losses… at just the time they should be worrying instead about missing out on great opportunities."
This story is absolutely fascinating to me in a few ways.
First of all, Oaktree was able to raise more capital during that turbulent time when fear and panic was widespread. This says a lot about Oaktree’s reputation and its client base. Without a primary focus on risk control and the right clientele, it would have been near impossible to do the right thing at the moment.
Second, we can see how Marks was so logical and clear in his thinking during the downturn and how he did his worst-case analysis. The client asked six times, “What if it’s worse than that?” And each time Marks offered a clear and logical answer, with solid data points. He basically laid down the “six levels” of high-yield bond worst-case analysis:
- Oaktree’s average default rate over the past 26 years in high yield bonds.
- Oaktree’s worst five years default rates.
- The average default rate of the high-yield bond universe.
- The average default rate over the past 26 years in high yield bonds.
- The worst one-year default rate in high yield bond history.
- One and a half times the worst one-year default rate in high yield bond history.
Of course the worst- case analysis for a fixed-income portfolio is different from an equity portfolio. Many equity value investors use the historical analysis to guide their worst-case analysis, which can be a good starting point but may also lead to sub-optimal results if they fail to consider what has changed.
Third, it blew my mind that as experienced and specialized as Oaktree’s team is, they still underestimated the worst case by a large margin – they thought the worst case was 96 but it ended up being near 70. But what’s impressive is how they reacted to the changing environment and turned the crisis into a great opportunity to make outsized returns. Again, without a track record of risk control and the right client base, it would be unimaginable.
I’ll end with a quote from Marks:
“The rational investor is diligent, skeptical and appropriately risk-averse at all times, but also on the lookout for opportunities for potential return that more than compensate for the risk.”
Read more here:Â
Book Review: 'Mastering the Market Cycle: Getting the Odds on Your Side' by Howard Marks, Part 1Â
Book Review: 'Mastering The Market Cycle: Getting the Odds on Your Side' by Howard Marks, Part 2Â
