On 24 May 2023, Howard Marks spoke by video to MBA students at INSEAD’s Fontainebleau campus outside Paris. Marks is a pioneer of distressed debt investing as an asset class and in 1995, he founded Oaktree Capital Management, where he is now Co-Chairman of a firm with over 1,000 employees globally and more than US$170 billion assets under management. Marks has written two books and is best known for his client memos published since 1990 (free to subscribe). He was interviewed by Roi Lipovetzky and Andras Galambos, students at INSEAD. We published Part 1 last week.
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In Part 1, Marks said he avoids macro forecasts because they are unknowable and therefore offer no market edge. He concentrates more on the micro risks he can understand if something with a company goes wrong, such as a product going out of favor, too much competition or management mistakes. But he then made an admission that although he believes macro forecasting is “terrible”, every micro forecast requires a macro forecast. To predict company earnings, for example, he needs to know GDP in a future year or whether the economy be “booming or cratering”.
Making neutral forecasts
How does Marks reconcile this micro/macro view? He relies on what he calls “neutral forecasts”, that next year will be like most years or this year, in a neutral extrapolation. He says if everybody thinks GDP will rise by 2%, there is no money to be made by forecasting 2%. Only at 4% or 0% can a forecaster act and make money. But he doesn’t know which is correct, so he ignores both.
“Most of the time, forecasts of a deviation from trend, forecasts of the end of extrapolation, are usually wrong. So, in order to make money from a macro forecast, you have to have a forecast which is non-consensus, which is hard because most of the evidence is reflected in the view of the consensus, and you have to be right, which is hard because the future is hard to predict. You put those two conditional things together and you figure out that macro forecasts have no value.”
He says the things fund managers do are simple, but it's hard to do them in a superior manner that creates added value.
Taking the temperature of the market
Before Marks engages in a new activity or investment, he takes the temperature of the market to gauge the psychology. It can be pessimistic or optimistic and overdone in one direction or another. Nobody can predict psychology. He cites the market reaction during the pandemic on 23 March 2020, after the S&P500 was down a third in the previous month. When the Fed made some announcements, the market started going up, but most people thought the optimism was wrong. Then it went straight up from there, but it was unpredictable. Investors thought that what the Fed was doing would be insufficient, but the market rose anyway.
Marks believes that even when people say they know what the market is going to do, they never know when, because knowing when is a matter of knowing when psychology will turn. He says that whenever he hears a statement which starts with the word when, he rejects it.
Know your balance between aggressive and defensive
Marks was asked about the ideal investor behavior in an overvalued market, such as when prices are higher than intrinsic values. He says it’s about finding the right personal balance:
“Each investor should have a notion for what is the right balance of aggressiveness and defensiveness for them. It's a personal thing, it's subjective, and it varies from one person to another and from one institution to another. So let's say, you have a sense for that. Now the question is, today, should you be at your normal balance, or should you be emphasising offense or defense relative to your norm, whatever your norm is. The S&P was at 4,800 and now it's at 4,200 but last year it was at 3,500. It's kind of in the middle ground. The P/E ratio is a little high, but it's not ridiculously high. The outlook calls for a recession, but nobody says it's going to be a profound recession. We're seeing inflation, super-high deficits and debts of the U.S. and other countries, plus the geopolitical uncertainty in Ukraine and in China and so forth. So, I would be a little balanced toward defensiveness today rather than aggressiveness. And you'd have to be creative to sketch out a very optimistic future for the next year. But don't listen to me because I'm incapable of it.”
The future is always unclear
It’s welcome to hear Marks say he does not rely on forecasting and his opinion has little merit, despite the fact that he is one of the leading global names in investing. People still want to know about his forecasts even when he tells them they are a waste of time. The investment industry is desperate for sage guesses to remove some future doubt, but the amount of time the financial media, advisers and investors spend on this pontificating does not match its dubious value. Marks expands:
“I don't know what's going to happen. The future is unusually murky, unusually uncertain. Well, I believe that there are two kinds of times. There's the time when the future is clear. And there's the time when the future is murky. The main difference is that when people think the future is clear, they're probably wrong. The future is always uncertain. And the belief that it's not tends to get people into trouble because they become sanguine at a time when they should not be.”
The biggest mistakes companies make
Marks is the world’s leading investor in distressed debt, and he sees companies at their worst, where they have made mistakes. Oaktree steps in with capital, often to rescue the business when other lenders disappear. But shareholders and the company pay a high price as Oaktree controls a chunk of equity in the form of convertible debt, rather than simply lending money. When the company’s fortunes improve, Oaktree becomes a major shareholder and enjoys the upside, not only a fixed income return. He says:
“Companies that get into trouble either can't imagine a negative-enough scenario or overestimate their ability to succeed in a negative scenario. One of my favorite sayings is never forget the person who was six feet tall who drowned crossing the stream that was five feet deep on average. The idea of surviving on average is a ridiculous idea. Like a skydiver, on average, who is successful 98% of the time. It's not a good idea. You have to be successful all the time, which means you have to survive all the time, which means you have to survive in the worst of times. And so, when companies over-lever, it's because they overestimate their ability to persist in a negative environment. And then, the negative environment comes along, and they melt down.”
Marks has invested through many different markets, including when Leveraged Buy-Outs (LBOs) were completed with 96% debt and 4% equity. Leverage magnifies successes but it also magnifies failures, and equity carries a company through the tough times. Often, the deals with too-little equity fail. He says management might allow for revenues to fall 10% but not 20%, and then rather than profits falling 60%, they go down 100%.
But he also supports the right level of leverage, not the least. In his student days, 20 American companies were rated AAA, and while it gave them bulletproof balance sheets, their returns on equity were compromised. They realised that a rating of AA or A was high enough and still gave a low cost of capital. But the major mistakes come from too much debt.
Graham Hand is Editor-At-Large for Firstlinks. This is Part 2 of a selection of Howard Marks’ comments to INSEAD’s Fontainebleau students on 24 May 2023. The full discussion is here. This article is general information only.