Billionaire value investor Howard Marks of Oaktree Capital Management said people like to ask him what inning it is — and they’re not talking about baseball. In 2008, the question meant they wanted to know how close it was to the end of the financial crisis. These days, as the stock market reaches lofty levels, they want to know how close it is the end of the bull market.
“I’ve been saying, ‘we’re in the eighth inning’ — for a little while,” said Marks, a highly respected Wall Street investor who foresaw the mortgage crisis and dot-com bubble, at the recent Wharton investor series bearing his name. “I realized about a year ago that there’s one problem with that locution, which is this isn’t baseball and we don’t know how long the game is going to go.” In investing, the game could go to nine innings or even longer.
On January 26, the Dow Jones Industrial Average hit an all-time high of 26,616.71 — after zooming up by nearly 5,000 points in just one year. The S&P 500 and Nasdaq Composite also hit historic highs this year. Although the three indices have since come down from those peaks, stocks still are far from cheap compared to their historical averages. Meanwhile, the robust U.S. economy, with the unemployment rate at a low 4.1%, provides the optimistic backdrop that might keep stocks aloft for a while.
“The current economic recovery is the third longest in history, and if it goes on another year, it will be the longest in history — there’s nothing to say it can’t [keep rising],” said Marks, founder and co-chairman of Oaktree, the largest investor in distressed assets in the world. “There are no laws of nature or physics at work here. So there’s nothing to say it can’t go on another year, another two years, another three years. Anything’s possible.”
But in his trademark cautionary style, Marks also pointed out that no economic recovery has lasted more than 120 months, or 10 years. The U.S. recovery is in its ninth year. While there is no apparent reason why the recovery couldn’t hit a new record, Marks said it might be one of those historical limits that could stick, like human longevity. “Just about everybody dies by 114. We get more and more people living past 100. But still, almost nobody lives past 114. We don’t know why, but that’s the rule.”
“Over the previous decade that I lived through, we had lots of minor boomlets and then corrections. Don’t automatically think bubble-crash.”
When the market does fall, Marks said, don’t automatically expect a crash either. Recent investors might expect big swings in the market since their experience of major downturns had been the dot-com bust and subprime mortgage crisis. But they should look even further back in history. “Over the previous decade that I lived through, we had lots of minor boomlets and then corrections. Don’t automatically think bubble-crash.”
Marks said the hallmark of a bubble is the presence of “bubble-thinking,” where investors take a grain of truth and run away with the concept. In the late 1990s “the grain of truth was that the internet will change the world,” he said. “People took that grain of truth and they expanded it to mean that … if you invested in an internet or e-commerce company, you’ll probably make a fortune because the internet is going to change the world. And as a consequence, it didn’t matter what price you paid.”
The internet did change the world, but about nine out of 10 companies in the sector also ended up “valueless,” Marks said. Failed dot-com firms include such former household names as eToys, Pets.com and Webvan. “When you reach the point where people have separated value and price considerations from platitudes, and things have slipped their moorings and gone off into infinity — that’s a bubble. So if you hear people say price doesn’t matter, no price is too high, then I think you’re in bubble land.”
Bubble thinking surfaces periodically in history. Marks recalled that when he took a summer job in Citibank’s investment research department in 1968, investors were crazy for the “Nifty Fifty” — 50 large-cap, blue-chip growth stocks in America that included IBM, Xerox and Coca-Cola. He said they were selling for “astronomical” prices of 80 to 90 times earnings. That compares with the average price-to-earnings (P/E) ratio for the S&P 500 in the post-war period of about 16 times earnings.
But despite the high prices, many investors loved owning the stocks. The rationale was, “if it was a little too high, so what? It was growing so fast it will just grow into the price,” said Marks. But it turned out that investors who bought these stocks in 1968 and held them for five years would have lost 97% of their investment. The lesson? “Price does matter,” he said.
Today, investors are enamored with the so-called FAANG stocks: Facebook, Apple, Amazon, Netflix and Google. They sport P/E ratios of 30, 18, 234, 246 and 58, respectively, based on trailing 12-month earnings. In one of his famous memos to clients, Marks said he was not calling for investors to sell or buy these stocks. Rather, he said the anointing of a group of “super-stocks” is a sign of the state of the market. “You can’t have a group treated like the FAANGs have been treated in a cautious, pessimistic, sober market.” That means it’s not a market with good bargains.
Value Never Goes Out of Style
So what if bargain stocks are hard to find? It does matter if investors want to consistently make a profit. “There’s only one intelligent form of investing, and that’s to figure out what something is worth and trying to buy it for less,” Marks said. “Distressed debt [borrowings of companies in trouble, which is Oaktree’s specialty] is not different in that regard.”
Fellow billionaire value investor Warren Buffett once told Marks that he likes to buy companies when they’re “weeds, not flowers.” Oaktree also believes in this dictum of investing in troubled assets and selling them for a profit once they recover. But shouldn’t investors wait for the price drop to stabilize before jumping in so they won’t be, in Wall Street parlance, catching a falling knife? “The trouble is that once that happens, then the price would have rebounded,” Marks said. “We want to buy at a time of upset and while the knife is still falling. I think the refusal to catch a falling knife is a rationalization for inaction.”
“There’s only one intelligent form of investing, and that’s to figure out what something is worth and trying to buy it for less.”
However, ‘falling knife’ investments with turnaround potential can be scarce in this long-running bull market. “We’re in hiatus now and it’s no fun. We’re not happy when we can’t buy bargains,” Marks said. With not many good deals around, Oaktree has kept its portfolio to $100 billion under management for four years now. “We don’t think it’s the right climate for us to increase.”
But once the market cycle turns, Oaktree is ready to pounce. “Cycles are one of the most important things in the world,” said Marks, who is writing a book on the subject. It’s important to recognize them as they happen and determine “where we stand in them and what that implies for the future.” The reasons behind cycles, as well as their timing, duration, speed, level of violence and amplitude, differ. As such, people who depend too much on cycles coming at set times “tend to get in trouble because they either anticipate too much or they miss things.”
But cycles do occur with regularity throughout history even if one can’t pinpoint exactly when they will come. “Most things in life are cyclical,” Marks said. In the markets, one can sense the bullish tide turning “when there’s too much money, when there’s too little risk aversion, when there’s too little fear, too much eagerness, etc. — that’s how you get excesses to the upside that have to be corrected to the downside.”
Oaktree sees the signs and waits patiently for bargains. In the last 30 years, this disciplined strategy has paid off, with an average internal rate of return of 17% a year — without taking on debt. That compares with an annual return of around 10% in the S&P 500 over the same period. Marks noted that without the bargain-buying opportunities during the 1990, 1991, 2001, 2002 and 2008 downturns, the return would have been much less.
But all this waiting for bargains also brings up a key management challenge. “How do you keep an organization going when its business goes out of favor for 80% of the time? 60% of the time?” Marks said. “The answer is first, you have to hire people who are long-term oriented, who don’t need instantaneous gratification. … You need maturity. We have to hire grownups.”
Marks said Oaktree also created a culture that encourages long-term thinking. “There are years … when we don’t make much money. Nobody takes a cut in pay. Nobody who does a good job has ever had a cut in pay,” he said. “And we don’t pay people just on how much money they made us that year. So we try to set up a physical and financial environment in which we can hold out for those periods — and I think that goes a long way.”
Downside of Passive Investing
There’s another trend that has buffeted Oaktree and other active investment managers: the shift to passive investing. In active management, money managers pick investments to analyze before making strategic bets on them. In passive management, money is invested in index funds — or funds that automatically buy all the securities in an index — as well as exchange traded funds (a security that tracks an index) and the like. Why are many investors fleeing active? “The main reason is because the active managers who charge high fees didn’t earn them,” Marks said. “Most active managers had not done as well as the index.”
“When there’s too much money, when there’s too little risk aversion, when there’s too little fear, too much eagerness, etc. — that’s how you get excesses to the upside that have to be corrected to the downside.”
Hedge funds, in particular, have lost their sheen in investors’ eyes. Marks said he wrote a memo in 2004 predicting that the average hedge fund would make 5% to 6% a year. Ten years later, Barron’s told him that it was writing an article about that memo because the average hedge fund return over the past decade was 5.2%. “The bloom is off the rose with regard to the hedge fund industry,” Marks said. “Eventually, people will get tired of paying 2% plus 20% of the profits to make 5% or 6%.”
But passive investing has its drawbacks, too. Marks said one Oaktree client called him to say that the organization’s new treasurer wants to put all their investments into index funds. “I said, ask him how he feels about having all his money invested in funds where no one is thinking about which stock should be included, or what they are worth or how they should be weighted. That’s a very extreme thing.”
The “supreme irony” of the shift to passive is that the actions of active managers do determine the weightings of the stocks listed in an index in the first place, Marks said. “There’s a trend [toward] passive investment on the premise that the active investors don’t really know what they’re talking about. And yet the [modus operandi] of the passive investor is to emulate the decisions made by the active investors who they think are idiots. It doesn’t make any sense. That’s what passive is doing today and we have to wonder about the wisdom of passive investing.”
Future Returns Harder to Get
At the Wharton fireside chat, Marks reflected on a successful investment career that spanned a half century. One critical thing he learned was that unlike in marriage, “not being very emotional is very useful in the investing world. … You make the really big money in this world by unhooking from the market when it gets up [high], when everybody’s happy and nobody could think of anything that could ever go wrong and everybody thinks that trees could grow to the sky.” That’s the time to sell. When the market collapses and everyone’s pessimistic, it’s time to buy.
Marks also had a front seat to the birth of the high yield, or junk, bond market. “Back in 1978, I got the call that changed my life.” His boss at the time called him to say there was a guy named “Milken or something out in California and he deals in something called high yield bonds and can you figure out what that means?” Junk bonds were debt of troubled companies and Michael Milken is credited for creating this trillion-dollar securities market.
Back then, there was scant information about junk bonds. About 90% of investment organizations also had a rule against buying a bond rated below ‘A’ or triple ‘B,’ Marks said. Indeed, credit rating agency Moody’s defined a ‘B’ rated bond as one that “fails to possess the characteristics of a desirable investment,” he said. “In other words, it’s a bad idea.” Another wrinkle was that 40 years ago, investors found it “unseemly” to buy the bonds of troubled firms even if they could make money, Marks said.
Today, high yield bonds are a commonplace investment where performance data is readily available. “There’s no more ignorance to trade off of,” Marks said. “And there’s no more scruples … anybody will do anything to make a buck.” With everyone angling to get the best returns in anything, good deals will be tougher to come by. “It’s hard and maybe the big money has been made in high yield bonds, and certainly in hedge funds and maybe in private equity,” he said. “The world has become more intelligent and [to do well] you have to work harder than I did.”