Notes from “How Quickly they Forget” – Howard Marks

Howard Marks from Oaktree Capital occasionally puts out a letter to his investors.  Marks, and his fund, are very value oriented.  Here are several notes from his latest letter:

  • Rather than balancing greed against fear, euphoria against depression, and risk tolerance against risk aversion, investors tend to swing wildly between these extremes.
  • Past patterns will recur.  Speculators who ignore these patterns will tend to lose money rather than gain from them.
  • Reasons investors fail to remember the past:
  • Demographics – new investors enter the market who’ve never experienced long-term stock cycles (and don’t bother to study them).
  • The human mind tends to suppress bad memories.
  • The human mind doesn’t do a good job with fighting greed.
  • A quote from Charlie Munger: “Nothing is easier than self-deceit.  For what each man wishes, that he also believes it to be true.”
  • We must look at other investors’ sentiment when assessing the current value of assets.  During panics, many investors are reluctant to lend, driving up interest rates.  This provides good opportunities for return.  If investors are very willing to lend at low rates, it could signal trouble ahead.
  • Leading up to 2007, many overly risky behaviors were taking place.  The issuance of non-investment grade debt was at record levels.  Companies were borrowing money to pay out higher dividends.  Leverage was being used increasingly for company buyouts.  The yield spread between high-yield bonds and treasuries sank to record lows.  (Why invest in anything other than treasuries if the yields are similar?)
  • Marks now goes on to say that he feels 2011 is beginning to feel much like 2005.  (Note, however, that the bubble didn’t burst until 2007.  Is Marks again a little too early?)
  • The portion of buyouts that is done with equity or debt fluctuates depending on the sentiment of the market.  After the fallout of the financial crisis, 38% was the average amount of equity that went into a buyout.  This year, its already back down to 30%, and quickly approaching the 2005-2009 average of 25%.  Companies are already willing to use more debt down to make a buyout.
  • Here is an 8 year timeline of the YTM/spread vs treasuries on high-yielding bonds:
  • Normal – Dec 2003 – 8.2%/443bp
  • Bubble Peak – June 2007 – 7.6%/242bp
  • Panic Trough – Dec 2008 – 19.6%/1,773bp
  • Recovered – March 2010 – 9.0%/666bp
  • Now – April 2011 – 7.5%/492bp
  • (While we might not be in “bubble territory” yet, I’d keep an eye on the spread – as it approaches 3%, that could be where the market begins to turn.)
  • While there are some areas of the market that are seemingly overvalued – high-tech stocks, social network sites, emerging markets every now and then, and possibly gold and commodities, most investors are moving toward low-risk portfolios.
  • Stocks aren’t cheap, yet stocks aren’t “bubbly.”
  • Right now, investors are being pushed toward more risky assets due to the weakness of returns in safer investments.
  • Many pension and investment funds are still trying to achieve the coveted 8% return YOY.  This handcuffs them to risky assets.
  • As others are willing to indulge in more risk, the savvy investor should be even more prudent when assessing risk.
  • While many seasoned investors assumed that the detriment of the 2008 crisis would be lasting, the huge amounts of government intervention immediately revived investors’ appetite for risk.
  • The huge fed rate cuts meant that anyone holding cash or low-yield bonds were going to get smoked by the market.  Investors and fund managers were (are) literally forced into taking on risk.  Much of the bond market has been removed as an investment vehicle, leaving equities and other non-traditional types of risky investments.  As more money flows into fewer types of asset classes, bubbles can form.
  • The attractive buying time during the financial crisis lasted only 15 weeks.  A short-lived crisis may mean a quickly-forgotten crisis.
  • During the early innings of the recovery, as a result of no demand for treasuries in favor of corporate debt, companies were able to quickly roll over the high-interest debt to lower yielding debt.  The default rate fell from 10.8% in 2009 to 1.1% in 2010.  This was the greatest one-year decline in history.  As a result, bond prices went up (yields went down) and people who were invested made money.  But this has led to a rush to “join the party,” and people are convinced that the situation is improved.
  • As more and more investments become lower-yielding, many investors will reach for return – go out even further on the risk curve.  This is likely the most flawed approach, unless extreme diligence is conducted.
  • Will we return to the days of the 1980s and 90s when economic growth was strong and eager to spend?  No.  During those days, initially clean consumer balance sheets led way for leverage via credit cards.  During the mid 2000s, the consumer then levered up through their home equity, which at the time was growing.  Now, the average consumer is already levered up on credit (or can’t get credit because they’ve already defaulted), and home equity has evaporated.  The growth of the 1980s and 90s is long gone (at least for 5-10 years.)
  • Other investors’ seemingly risky behavior says its time to begin getting conservative.
  • Uncertain macro issues existing today: a weak US recovery, the US deficit and the political process in general, the fallout due to inevitable deleveraging and austerity, the debt levels of many eurozone nations, the possibility of high inflation, and the uncertain outlook of of USD and the euro.
  • Because of the multitude of potential negative issues, and the fact that stocks are fair- to over-priced, the assumption that stocks will greatly appreciate from here because everything will “work out fine” seems a little foolhardy.
  • At the conclusion of the shareholder letter, Marks suggests going back to one of his previous letters from the mid-2000s for a better picture of past events.  I’ll be recording those notes soon.
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About dwkmusings

Student in Georgetown University's McDonough School of Business MBA Program
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