The Most Important Thing Illuminated

by Howard Marks

  So in most things, you can’t prepare for the worst case. It should suffice to be prepared for once-in-a-generation events. But a generation isn’t forever, and there will be times when that standard is exceeded. What do you do about that? I’ve mused in the past about how much one should devote to preparing for the unlikely disaster. Among other things, the events of 2007–2008 prove there’s no easy answer.

  “VOLATILITY+LEVERAGE=DYNAMITE,” DECEMBER 17, 2008

  Especially in view of the vagaries presented previously in this chapter, I want to make clear the important distinction between risk control and risk avoidance. Risk control is the best route to loss avoidance. Risk avoidance, on the other hand, is likely to lead to return avoidance as well. Once in a while I hear someone talk about Oaktree’s desire to avoid investment risk and I take great issue.

  Clearly, Oaktree doesn’t run from risk. We welcome it at the right time, in the right instances, and at the right price.

  PAUL JOHNSON: Marks is clear in his distinction. Risk control is not risk avoidance, and the “right price” is the operative part of his statement.

  We could easily avoid all risk, and so could you. But we’d be assured of avoiding returns above the risk-free rate as well. Will Rogers said, “You’ve got to go out on a limb sometimes because that’s where the fruit is.” None of us is in this business to make4 percent.

  So even though the first tenet in Oaktree’s investment philosophy stresses “the importance of risk control,” this has nothing to do with risk avoidance.

  It’s by bearing risk when we’re well paid to do so—and especially by taking risks toward which others are averse in the extreme—that we strive to add value for our clients. When formulated that way, it’s obvious how big a part risk plays in our process.

  Rick Funston of Deloitte & Touche said in the article that prompted this memo (“When Corporate Risk Becomes Personal,” Corporate Board Member, 2005 Special Supplement), “You need comfort that the … risks and exposures are understood, appropriately managed, and made more transparent for everyone. … This is not risk aversion; it is risk intelligence.” That’s what Oaktree strives for every day.

  “RISK,” JANUARY 19, 2006

  The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners. Skillful risk control is the mark of the superior investor.

  JOEL GREENBLATT: The math behind the compounding of negative returns helps ensure this outcome (e.g., a 40 percent loss in one year requires a return of 67 percent to fully recover).

  8

  The Most Important Thing Is … Being Attentive to Cycles

  I think it’s essential to remember that just about everything is cyclical. There’s little I’m certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero. And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future.

  The more time I spend in the world of investing, the more I appreciate the underlying cyclicality of things. In November 2001 I devoted an entire memo to the subject. I titled it “You Can’t Predict. You Can Prepare,” borrowing the advertising tagline of MassMutual Life Insurance Company because I agree wholeheartedly with their theme: we never know what lies ahead, but we can prepare for the possibilities and reduce their sting.

  In investing, as in life, there are very few sure things. Values can evaporate, estimates can be wrong, circumstances can change and “sure things” can fail. However, there are two concepts we can hold to with confidence:

  • Rule number one: most things will prove to be cyclical.

  • Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.

  Very few things move in a straight line. There’s progress and then there’s deterioration. Things go well for a while and then poorly. Progress may be swift and then slow down. Deterioration may creep up gradually and then turn climactic. But the underlying principle is that things will wax and wane, grow and decline. The same is true for economies, markets and companies: they rise and fall.

  The basic reason for the cyclicality in our world is the involvement of humans. Mechanical things can go in a straight line. Time moves ahead continuously. So can a machine when it’s adequately powered. But processes in fields like history and economics involve people, and when people are involved, the results are variable and cyclical. The main reason for this, I think, is that people are emotional and inconsistent, not steady and clinical.

  Objective factors do play a large part in cycles, of course—factors such as quantitative relationships, world events, environmental changes, technological developments and corporate decisions. But it’s the application of psychology to these things that causes investors to overreact or underreact, and thus determines the amplitude of the cyclical fluctuations.

  When people feel good about the way things are going and optimistic about the future, their behavior is strongly impacted. They spend more and save less. They borrow to increase their enjoyment or their profit potential, even though doing so makes their financial position more precarious (of course, concepts like precariousness are forgotten in optimistic times). And they become willing to pay more for current value or a piece of the future.

  All of these things are capable of reversing in a second; one of my favorite cartoons features a TV commentator saying, “Everything that was good for the market yesterday is no good for it today.” The extremes of cycles result largely from people’s emotions and foibles, nonobjectivity and inconsistency.

  Cycles are self-correcting, and their reversal is not necessarily dependent on exogenous events. They reverse (rather than going on forever) because trends create the reasons for their own reversal. Thus, I like to say success carries within itself the seeds of failure, and failure the seeds of success.

  “YOU CAN’T PREDICT. YOU CAN PREPARE,” NOVEMBER 20, 2001

  The credit cycle deserves a very special mention for its inevitability, extreme volatility and ability to create opportunities for investors attuned to it. Of all the cycles, it’s my favorite.

  The longer I’m involved in investing, the more impressed I am by the power of the credit cycle. It takes only a small fluctuation in the economy to produce a large fluctuation in the availability of credit, with great impact on asset prices and back on the economy itself.

  The process is simple:

  • The economy moves into a period of prosperity.

  • Providers of capital thrive, increasing their capital base.

  • Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk.

  • Risk averseness disappears.

  • Financial institutions move to expand their businesses—that is, to provide more capital.

  • They compete for market share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction and easing covenants.

  At the extreme, providers of capital finance borrowers and projects that aren’t worthy of being financed. As The Economist said earlier this year, “the worst loans are made at the best of times.”

  PAUL JOHNSON: This insight is hard to fully comprehend until one has been hurt by not following its sage advice! Although students nod their heads in agreement when the topic is discussed in class, they are the investors and bankers that will undoubtedly repeat this mistake in the future.

  This leads to capital destruction—that is, to investment of capital in projects where the cost of capital exceeds the return on capital, and eventually to cases where there is no return of capital.

  When this point is reached, the up-leg described above—the rising part of the cycle—is reversed.


  • Losses cause lenders to become discouraged and shy away.

  • Risk averseness rises, and along with it, interest rates, credit restrictions and covenant requirements.

  • Less capital is made available—and at the trough of the cycle, only to the most qualified of borrowers, if anyone.

  • Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies.

  • This process contributes to and reinforces the economic contraction.

  Of course, at the extreme the process is ready to be reversed again. Because the competition to make loans or investments is low, high returns can be demanded along with high creditworthiness.

  CHRISTOPHER DAVIS: Again, you get higher return and lower risk.

  Contrarians who commit capital at this point have a shot at high returns, and those tempting potential returns begin to draw in capital. In this way, a recovery begins to be fueled.

  I stated earlier that cycles are self-correcting. The credit cycle corrects itself through the processes described above, and it represents one of the factors driving the fluctuations of the economic cycle. Prosperity brings expanded lending, which leads to unwise lending, which produces large losses, which makes lenders stop lending, which ends prosperity, and on and on.

  … Look around the next time there’s a crisis; you’ll probably find a lender. Overpermissive providers of capital frequently aid and abet financial bubbles. There have been numerous recent examples where loose credit contributed to booms that were followed by famous collapses: real estate in 1989–1992; emerging markets in 1994–1998; Long-Term Capital Management in 1998; the movie exhibition industry in 1999–2000; venture capital funds and telecommunications companies in 2000–2001. In each case, lenders and investors provided too much cheap money and the result was overexpansion and dramatic losses. In Field of Dreams, Kevin Costner was told, “If you build it, they will come.” In the financial world, if you offer cheap money, they will borrow, buy and build—often without discipline, and with very negative consequences.

  “YOU CAN’T PREDICT. YOU CAN PREPARE,” NOVEMBER 20, 2001

  PAUL JOHNSON: I continue to be impressed, throughout the book, with how decade-old memos read as fresh as recently written ones. This memo is a prime example. Marks’s use of his old memos is particularly effective in showing that history repeats or, at least, that man has a tendency to repeat history.

  Please note that this memo, written almost ten years ago, perfectly describes the process through which the 2007–2008 financial crisis arose. It wasn’t predictive ability that enabled me to write it—just familiarity with a never-ending underlying cycle.

  JOEL GREENBLATT: Understanding that cycles are eventually self-correcting is one way to maintain some optimism when bargain hunting after large market drops.

  Cycles will never stop occurring. If there were such a thing as a completely efficient market, and if people really made decisions in a calculating and unemotional manner, perhaps cycles (or at least their extremes) would be banished. But that’ll never be the case.

  Economies will wax and wane as consumers spend more or less, responding emotionally to economic factors or exogenous events, geopolitical or naturally occurring. Companies will anticipate a rosy future during the up cycle and thus overexpand facilities and inventories; these will become burdensome when the economy turns down. Providers of capital will be too generous when the economy’s doing well, abetting overexpansion with cheap money, and then they’ll pull the reins too tight when things cease to look as good.

  SETH KLARMAN: Indeed, this is an essential virtue of capitalism. Oversupply of a good leads to a price decline and lower profits. Suppliers of that good stop expanding and contract if they can. A market-based system will respond in ways a centrally planned economy cannot, leading to more optimal use of society’s resources.

  Investors will overvalue companies when they’re doing well and undervalue them when things get difficult.

  And yet, every decade or so, people decide cyclicality is over. They think either the good times will roll on without end or the negative trends can’t be arrested. At such times they talk about “virtuous cycles” or “vicious cycles”—self-feeding developments that will go on forever in one direction or the other.

  Case in point: On November 15, 1996, The Wall Street Journal reported on a growing consensus: “From boardrooms to living rooms and from government offices to trading floors, a new consensus is emerging: The big, bad business cycle has been tamed.” Does anyone remember a steady, non-cyclical economic environment in the years since then? What would explain the emerging crisis of 1998, the recession of 2002, and the financial crisis—and worst recession since World War II—of 2008?

  This belief that cyclicality has been ended exemplifies a way of thinking based on the dangerous premise that “this time it’s different.” These four words should strike fear—and perhaps suggest an opportunity for profit—for anyone who understands the past and knows it repeats. Thus, it’s essential that you be able to recognize this form of error when it arises.

  One of my favorite books is a little volume titled Oh Yeah?, a 1932 compilation of pre-Depression wisdom from businessmen and political leaders. It seems that even then, pundits were predicting a cycle-free economy:

  • There will be no interruption of our present prosperity. (Myron E. Forbes, President, Pierce Arrow Motor Car Co., January 1, 1928)

  • I cannot help but raise a dissenting voice to the statements that … prosperity in this country must necessarily diminish and recede in the future. (E.H.H. Simmons, President, New York Stock Exchange, January 12, 1928)

  • We are only at the beginning of a period that will go down in history as the golden age. (Irving T. Bush, President, Bush Terminal Co., November 15, 1928)

  • The fundamental business of the country … is on a sound and prosperous basis. (President Herbert Hoover, October 25, 1929)

  Every once in a while, an up- or down-leg goes on for a long time and/or to a great extreme and people start to say “this time it’s different.” They cite the changes in geopolitics, institutions, technology or behavior that have rendered the “old rules” obsolete. They make investment decisions that extrapolate the recent trend. And then it turns out that the old rules do still apply, and the cycle resumes. In the end, trees don’t grow to the sky, and few things go to zero. Rather, most phenomena turn out to be cyclical.

  “YOU CAN’T PREDICT. YOU CAN PREPARE,” NOVEMBER 20, 2001

  We conclude that most of the time, the future will look a lot like the past, with both up cycles and down cycles. There is a right time to argue that things will be better, and that’s when the market is on its backside and everyone else is selling things at giveaway prices. It’s dangerous when the market’s at record levels to reach for a positive rationalization that has never held true in the past. But it’s been done before, and it’ll be done again.

  “WILL IT BE DIFFERENT THIS TIME?” NOVEMBER 25, 1996

  Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do. People often act as if companies that are doing well will do well forever, and investments that are outperforming will outperform forever, and vice versa. Instead, it’s the opposite that’s more likely to be true.

  HOWARD MARKS: The riskiest things: When things are going well, extrapolation introduces great risk. Whether it’s company profitability, capital availability, price gains, or market liquidity, things that inevitably are bound to regress toward the mean are often counted on to improve forever.

  The first time rookie investors see this phenomenon occur, it’s understandable that they might accept that something that’s never happened before—the cessation of cycles—could happen. But the second time or the third time, those investors, now experienced, should realize it’s never going to happen, and turn that realization to their advantage.

  The next time you’re approached with a deal predicated on c
ycles having ceased to occur, remember that invariably that’s a losing bet.

  9

  The Most Important Thing Is … Awareness of the Pendulum

  When things are going well and prices are high, investors rush to buy, forgetting all prudence. Then, when there’s chaos all around and assets are on the bargain counter, they lose all willingness to bear risk and rush to sell. And it will ever be so.

  The second investor memo I ever wrote, back in 1991, was devoted almost entirely to a subject that I have come to think about more and more over the years: the pendulum-like oscillation of investor attitudes and behavior.

  PAUL JOHNSON: Chapter 9 is essentially an extension of the three earlier chapters on risk and offers additional insight into how to analyze the current risk temperature in the markets.

  The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward an extreme itself that supplies the energy for the swing back.

  Investment markets follow a pendulum-like swing: