Fireside Chat with Howard Marks of Oaktree Capital Management

No, I was some people plan ahead and some don't, and I was in the latter category. I was very young when I went to college. I was 17 for my whole freshman year. But interestingly, I grew up in New York. I went to the public schools and one of my buddies at some point in time said they're giving you a course in accounting and we should take it. And I took it and I just really liked it and so I figured I'd become an accountant. I applied to Wharton. My guidance counselor told me I wouldn't get in, but I did get in to study accounting. Then when I ran into finance, I switched to finance as my major. Then after that I took an MBA at University of Chicago where I did major in accounting. And then when I was coming to the end, you know, I didn't know what I wanted to do. So I applied for six different jobs in six different fields. And in the end I took the job at Citibank in investment research. I had had a summer job there the previous year and I liked it and I went back. It wasn't a brilliant decision. It was just a path of least resistance and the familiar avenue. And you started off as an equity research analyst following office equipment and then conglomerates, which was a group that by the way I came out here on my first business trip which was in January of 1970 and fell in love with California and wanted to live out here and it took me 10 years to find a way because the investment community in LA was really tiny.

You know, my first break came, well, my first break was probably when I got into Wharton, but then there was an oil embargo in 1973 and they asked me to start up research in oil and gas because the banks were investors in the growth stocks and all the other coverage had to be readjusted. And so I had to start coverage in oil and gas and then in the basic industries of paper, chemicals, steel, and forest products. And then I was associated with the investment in the growth stocks. It was called the Nifty 50. It was a total disaster. And so when that failed, I was relegated to the bond department which was the equivalent of Siberia. But interestingly, when I at 29 I became the bank's director of research for equities and I had 75 employees, a $5 million budget which was a lot of money then and I was on the five most senior investment committees. Then I got sent to the bond department. I had no employees, no budget, no committees. And I was ecstatic because all I had to do was follow 40 securities and know more about them than anybody else. And so it's really important. Everybody wants, we used to kid at the bank in those days, everybody wanted BMR, broad managerial responsibility. It's not for everybody and you know you shouldn't aspire to something just because it's a common aspiration. But when I got the chance to just study a few securities and outperform other people, I found it much more interesting and rewarding. And then three months later, I got a call from the head of the bond department who said, 'There's a guy in California called Milken or something and he deals in something called high yield bonds. Do you think you can figure out what that means?' Because a client had asked for a high yield bond portfolio. I said, 'I think I can.' And of course, that was '78. That was the beginning of that world. If you've read Malcolm Gladwell's Outliers, you know that it's great to be the first. And I was. And the fund I started at Citibank in '78 was the first high yield bond fund from a mainstream financial institution and that's the root from which all of Oaktree has grown. So I wouldn't describe my process as intentional or focused. I kind of drifted along but got lucky.

Sure. Well, one of the important sayings in life is that experience is what you got when you didn't get what you wanted. And if you think about it, if you bought the Nifty 50 stocks the day I got to work in September of '69 and if you held them loyally and faithfully and diligently, within five years, you lost 95% of your money. And it turned out that it had been a bubble and many of the companies were overestimated and all of them were overpriced. And so that was very informative. It's very desirable to learn your lessons early and also preferable to learn your lessons when there's not a lot of money at stake, which I did. And so now on the other hand, in many ways that scarring experience made me too conservative. And you know, I've been risk averse all my life. And given the, if you think about it, from 1980 when the inflation was solved essentially to date, generally speaking the more optimistic you were the more money you made. So that was the downside of that. But what it taught me, what I came out of that experience saying is that it's not what you buy, it's what you pay. And good investing is not just a function of buying good things, but of buying things well. And the difference is not just grammatical. And so you know, when I had the chance to go into high yield bonds rather than an asset class that was beloved and on the pedestal of popularity and overpriced, I got to go into an asset class that almost everybody else said I wouldn't touch that with a 10-foot pole. And when you hear that you say, oh maybe I can get that at a bargain price. There is no such thing as a bargain-priced asset that everybody loves, it's an oxymoron. But if they say I hate it, and you know, people, but in '78, you know, it's almost 50 years ago, people would say, 'Well young man, I'm sure you could make money doing that but it wouldn't be right.' Okay, let's go, sounds good to me. So that was my process and I got some lucky opportunities.

Well, that's what you call a softball. So when I was getting out of Wharton, when I went into Wharton, I had no plans to get a graduate degree. And I thought a Wharton degree would be sufficient, but by the end of the four years, we had a little something going on called the Vietnam War. And if you came out of school, you were a good candidate, and I got my 1A classification, which I was not eager to seize on. So, but at that time, if you stayed in school, you were deferred from the draft. So I said I'll get an MBA and so I couldn't go to Wharton because that would be repetitive. Harvard and Stanford turned me down and I went to University of Chicago. Now, the Wharton education that I had, this was pre-theory. I don't know what they're teaching here now, but this was before the theory of investment had been developed at Chicago in the early 60s. But when I went to Wharton in the early 60s, it hadn't been developed. So my education was pragmatic and qualitative. Then I got to Chicago where the theory had been developed and implemented and my education was quantitative and theoretical. Either one of which would probably be a disaster but the combination of the two was very, very helpful. And you know, I took a, the final exam in my favorite investment course consisted of one question. How do you reconcile the theory you've learned here with what you're going to do in the real world? And I've spent the last 56 years working on that question. And so, just a question about volatility. So at Chicago, the main thesis was that the main way you can enhance your returns is by accepting more risk. And even people in the investment business subscribe to that. And at the end of the process to see if you did a good job you would compute something called the Sharpe ratio which is basically the ratio of your return to the risk. Well we know what the return was. You were up 14% last year or nine or 17 or whatever it was, but what's the risk? What number do you use for risk? And they said, well, we'll use volatility. The fluctuation of the value. The great thing about volatility is you can look at history and know what the volatility of an asset was. You can use that number to extrapolate into the future volatility. You can incorporate it in calculations to figure out what has the highest risk-adjusted return. There's only one weakness. It's not risk. So, it's a number which serves as a proxy for something, but it is not an accurate proxy because, believe it me, investors don't care about volatility. I've never heard anybody say, 'Oh, you know, I don't think I'm going to invest in that because it could be volatile.' They say I'm not going to invest because I could lose money. That's risk. Risk in my opinion, and my view has evolved, risk is the probability of a negative outcome, of an undesirable outcome. It is not the volatility of the stream. And Buffett said, 'I would rather have a lumpy 15 than a smooth 12.' And if you can survive long enough to enjoy the long-term benefit of the lumpy 15, it beats the hell out of the smooth 12. But you have to survive. And so volatility is relevant for some people, but volatility is not risk. And if I had that interview and somebody said the volatility is this, I would have to educate them.

This was a graphic presentation that I virtually saw every day at University of Chicago for two years. And of course what you know, the line slopes up and to the right, that means positive correlation. You have return on the vertical axis and risk on the horizontal axis and you go from left to right on the horizontal axis, that is to say you take on more risk, the line goes up and you get more return. Positive correlation. Now, and this is what I was taught at Chicago and if you say to most people even today, even the people who haven't read the book, what does that mean, that relationship? Ignore the squiggles for now. Just focus on the diagonal line. They would say, 'Well, what it means is the riskier assets have higher returns.' And you'll get that nine times out of ten, right? Nothing could be more incorrect if you think about it. If a risky asset can be counted on to have a high return, then it's not risky. So, it can't be true. It's just incorrect on its face. What the relationship means is that an asset that appears to be risky has to appear to offer a high return or else nobody will buy it. That makes perfect sense. If I come in here with my Oaktree sales kit and I say we have a Treasury bill fund that will give you a return of six or we have a venture capital fund where we're going to invest in AI startups and if we choose the right ones we think we can make you six. Which will you take? You'll take the Treasury bill fund. You'll say, 'Why would I possibly take the risk associated with doing startups if it doesn't offer a premium return?' That's the most intelligent thing you can say. It has to appear to offer a high return. But it doesn't have to deliver. That's where the risk lies. And so what I did in a memo in '06 called 'Risk' is I took these little bell-shaped probability distributions and I turned them on their side and I superimposed them on the line. So now as you go from left to right on the horizontal axis and you increase the risk, what happens in the old graph? The return went up, the expected return. Now the expected return goes up but the range of possible outcomes becomes wider and the bad outcomes become worse. That's risk. Risk is the unpredictability and the possibility of a wider range of outcomes and the fact that some of them can be more negative. That's risk. And so when we select our investments, we have a trade-off to make. You can have an investment you expect to have a low return dependably, confidently, maybe even contractually. Or you can have an investment with a high expected return, upside beyond that but the chance of falling short and even losing money. That's the fundamental choice. Do you want certainty or do you want the possibility of a high return? You can't get both. There's no such thing as the certainty of a high return. And so this chart captures all of that and I use pictures a lot because I do think that it's true what they say, a picture is better than a thousand words.

Sure. Who in the audience can tell me what was the most important event in the financial and investment world in the last 50 years? Pardon me. Low interest rates. You're cheating. Who said that? Most people say Lehman Brothers, global financial crisis, tech bubble meltdown, Black Monday in '87. But I believe that it was the decline in interest rates. And so I wrote this memo that Jeff's referring to called 'Sea Change' in December of '22. By the way, I'm going to refer to memos. They're all available at the Oaktree website, oaktreecapital.com, under the heading of Insights, and the price is right because they're free. And you can sign up for, you can read all the old ones. I've been writing them for 35 years. We just passed 35. And you can read the old ones or you can sign up for a subscription to the new ones. And as I say, they're free. So, where was I going? Interest rates. So I wrote this memo called 'Sea Change' in December of '22 and I said that in 1980 I had a personal loan outstanding from the bank and I got a slip of paper in the mail and it said the interest rate on your loan is now 22 and a quarter. And 40 years later in 2020, I was able to borrow at two and a quarter fixed for 15 years. So in other words, a decline of 20 percentage points or what we call in the business 2,000 basis points over 40 years. And this had a profound impact on the financial and investment world. How? Number one, when interest rates go down, investments become more valuable. And what? Well, what do I mean? Well, let's say you own a bond of mine. I've promised to pay you, I've borrowed money from you. I promise to pay you money back at the end with 8% interest. That's worth, let's say, 100 cents on the dollar. But if the prevailing interest rate goes from 8 to 6, a bond that promises eight is better than contemporary interest rates. It's worth more than 100 cents on the dollar and it'll go to 110. So, my partner Sheldon Stone, who's been my partner since '83, my longest surviving partner, goes around doing this all day. Rates down, price up, rates up, price down. That's the way it works. And it works in all of the investment world because whatever the potential return is on an investment, it looks better when interest rates are lower, it looks relatively more attractive. And when interest rates are higher and you can get 14% on bonds, you turn up your nose and so the price goes down. So declining interest rates are extremely beneficial for asset ownership and of course they're beneficial for people who borrow money because the cost of borrowing goes down. So what happens if your strategy is borrowing money to buy assets? You get a double bonanza when interest rates go down. The value of what you own goes up and the cost of financing it goes down and it turns into a real bonanza. And I compared it in the memo to going out to the airport and getting on the moving walkway. And you know, you get on the walkway and you walk at your normal pace and you make great progress over the ground. Then you say, 'Boy, I'm fit.' But maybe it wasn't all you. And it's the same with levered strategies. When interest rates go down, the levered investor makes a lot of money, but maybe it wasn't all her.

Well, it would not be rational. All right. Thank you. So you can go out and buy something and if it goes up, you'll make some money. Or you can go out and borrow some money and buy five of them and if they go up, you'll make five times as much money. If it goes up, well, declining interest rates make it go up and the cost of paying the money, well, the better example, so you're sitting there and you find a company, if you buy that company you think you can make 10% a year if you own it and you talk to your investment banker and they say, 'Well, we can get money for you at 8%.' You say, 'Oh, I can borrow at 8 and invest at 10, let's go.' So you go out and do it but then interest rates go down and rather than make 10, you make 12. Right. And rather than pay eight, you pay six and you say, 'I'm Bernard Baruch,' you know. And so you have to, you know, we used to have a saying, 'Don't ever confuse brains with a bull market.' And when you're lucky, when you happen upon a salutary environment, never think it was all you. And most people credit themselves with all their successes and blame others for their failures. But private equity, which is buying companies using borrowed money, was enormously successful. It's not a coincidence. It was created in the early '80s at the beginning of this period that I mentioned to you. And it shouldn't come as a surprise that it prospered. And in fact, and also of course this was, since 1980 for the most part, this was a great period in the economy, great period to be a corporation in America. And if you could have lost money buying an American company using borrowed money in a period of declining interest rates, there's got to be something wrong with you.

You know, Jeff, it is on my radar. It's very worrisome. It's not something I can do anything about and it will affect everybody universally pretty much the same. So, it's not like if you say, 'Well, let me think. You know, the Fed's going to lose its independence and the interest rate is going to be 3% next year.' Not much I can do about that. And by the way, if they cut the long rate, which is what Trump wants, the short rate, the long rate may even go up because people get more worried about the long-term future of America. But there are these things in the environment that we have to live with, and that's one of them. But I think it's a very negative thing. I think that you know, the interest rate is to the business community kind of like oxygen is to living organisms and it's the environment we live in. It's a necessary condition of doing business is interest rates. And a lot of what we do is calibrated off of interest rates. And we know that if the economy is languishing, if you cut interest rates, you stimulate business and it picks up because it's cheaper to build factories and cheaper to buy cars and everything gets more vibrant. And if the economy is overheated and prices are going up too much and inflation is a worry, you raise interest rates and that cools it off for the inverse reason. And this is the legitimate role of the Fed. And you know, but in my own view, I prefer a Fed chair who is not an activist, who is not an interventionist, and who leaves these things alone. Who says, you know, if the economy is producing jobs, which is a big part of the Fed job, it doesn't need stimulus. And if it's not overheating and inflation isn't rising, we don't need restriction. Just leave it alone. Don't mess with it. And I think Powell is more in that category than some of the recent predecessors. Alan Greenspan, who took over in the mid-'90s, was something between an activist and a cheerleader. And he injected liquidity every time he could think of any reason why liquidity might be needed. And you might remember Y2K, which was something that people were afraid of when we turned from the 20th century to the 21st and the clocks changed. They were afraid that the computer mechanisms wouldn't know what year it is. They would think that it went back to 1900 and so Greenspan injected liquidity to make sure that that wouldn't have a bad effect. Anyway, so I'd like a non-interventionist Fed. But I would say in general politicians want lower interest rates because the lower the rate, the more the economy is stimulated. The better the economy is, the better it looks to the voters. And the other thing is we have this enormous $38 trillion debt. The lower the interest rate is, the easier it is to service. So, no elected official wants higher interest rates, but sometimes you need them to fight inflation. And so, that's why we have an independent Fed to do the right thing with interest rates rather than pander to the voters by cutting rates. You might say, 'Well, Howard, why not cut rates? You know, you said it makes it easier to service the national debt and it stimulates the economy. Why not?' And the answer is number one, it stimulates inflation, which is bad for most people. Most people in America spend every penny they make to live. And if the cost of goods go up and their wages don't go up, then they can't live as well. So that's one reason. And then the other reason is because when interest rates are artificially low, people make dumb decisions in the business world. And just think about this. You say to somebody, 'Would you buy this bond that's a 4% bond?' No, I would never buy a bond that pays 4%. It's ridiculous. It's a low rate of return. The company is too risky. It doesn't deserve to be able to borrow money at 4%. It's absurd. I'll lend you the money at 2%. I'll take all I can get. And so when interest rates are low, people engage in unwise decisions. And I wrote a memo in January of '23, I think, or no, '24, entitled 'Easy Money.' And perpetually easy money is not a good thing. The Fed should not be in a perpetually stimulative position or a perpetually restricted position. And most of the time, they should let the interest rate, who should determine interest rates? The Fed, the president, Congress? No. The borrower and the lender. You say, 'I want to borrow money to build a building.' The lender says, 'I'll give you money at 8%.' You say, 'That's ridiculous. I'll pay seven.' That's a naturally occurring interest rate. And there's such a thing as natural interest rates and that's where

That's where the rate should be and not where most of the time, not where somebody in Washington wants it to be.

By the way, let me just add one thing. I imagine here at Pepperdine, you teach, especially to business students, you teach the benefits of the capitalist system.

And we believe, I went to Chicago, Milton Friedman was the shining light there. And he was the most outspoken defender of capitalism and the free markets. And we all concluded, and I'm sure it's true, that the free market is the best allocator of resources. That includes money. The free market sets the interest rate and money goes to the right purposes. And if we mess with it and control the interest rate artificially too high or too low, it warps that. So I would say hands off as much as possible.

Well, I wrote that memo in February of '07. And at the very end of '04, I started to turn cautious too early for the simple reason that I saw dumb deals getting done. And I talk about easy money. So, you know, I would go into my partner Bruce Karsh on a daily basis with a page from the Wall Street Journal. I said, 'Look at this piece of crap that got issued yesterday.' And if the market is being run by people who are diligent and prudent and cautious, this deal could not be done. So that means we have imprudence in the marketplace. And Buffett says the less prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own affairs. When other people are carefree and unworried, it warps the market. We should be terrified. It's only when people are terrified that we should turn aggressive, and that's a rule that we follow. And so I thought that the market was not... By the way, this line, remind me why does it slope up and to the right? Or remind yourselves. Why does it slope up to the right? Two words: risk aversion. We don't want to lose money. We don't like uncertainty. We prefer safety. So we are averse to incremental risk and demand compensation if we're going to take it. Risk aversion. And so when investors are behaving in a suitably risk-averse manner, the market is safe and sane. When they forget to be suitably risk-averse, the market becomes insane and unsafe. And that's what we thought was going on. So that was '05, '06. And at the beginning of '07, I wrote this memo that Jeff cited called 'The Race to the Bottom.' And what I said in there is that the market for investments, the market for the opportunity to make loans, let's say somebody wants to build a building, Pepperdine wants to build a building. They go to five banks and they say, 'We'd like to borrow money.' It's an auction that takes place. Who gets the opportunity to lend the money to Pepperdine? Who wins? The bank that will accept the lowest rate of interest and the least safety. So, when you go out and you're a lender and you're looking for loans and somebody says, 'Well, I need money.' And you say, 'Well, you're not that great a risk. I need 8% interest and a full set of documents.' And somebody else says, 'I'll take 7%. I don't need that many documents.' And then somebody else who's the boss has been beating up because they haven't been making enough loans and they've been losing market share. Somebody else says, 'I'll take 6%. I don't need any documents.' So who gets to make the loan? The person who will accept the least return and the most risk. And when the marketplace is heated and people are behaving imprudently and when people have money that they have to put out and they're too eager to put it out, the person who wins the auction is actually the loser because they make an imprudent investment. And if the economy and the market stay good, maybe they get out of it. But if they are tested by hostile conditions, the flaw in the investment is exposed and they lose money. And that's why Buffett says it all comes down to Buffett. He says it's only when the tide goes out that we find out who's swimming naked. It's when conditions in the business world turn adverse that we find out who made bad loans and bad investments.

In the section on risk, I say that risk and loss are not the same. Risk is the possibility of loss. So the example I used, because I wrote it in 2011 when I was in Los Angeles, I said, 'You may have a house and it may have a construction flaw, but you don't find out until there's an earthquake.' So risk is the potential for loss. The loss occurs when the tide goes out.

The tide went out. We saw who was swimming without clothes.

Oaktree as a whole invested $650 million a week on average for 15 weeks, or $10 billion in a quarter. And but see, the lead-up was that because we were worried in '05 and '06, we sold a lot of assets, we liquidated a lot of funds. If we raised funds, we raised only small funds, we increased our selectivity. And then on the first day of '07, for our opportunities funds, which you might say distress debt funds, we ran out to raise a new fund, first day of '07. And the biggest fund in history was $2.5 billion, that was our '01 fund for four and a half. So we went out to raise $3 billion, and within a month we had orders for $8 billion. And we said we can't do anything with $8 billion. So we'll take $3.5 billion. We'll close that fund. That was fund seven. But we said, if you still want to invest, we'll take your additional interest in a standby fund and we'll collect commitments and we'll just put it on the shelf. And if the stuff hits the fan, we'll invest it. If it doesn't hit the fan, that'll just be our next fund. And so by the time we were done marketing fund 7B, it was $11 billion in an area where the biggest fund in history was $2.5 billion. And it was closed in March of '08. And then you had the bankruptcy of Bear Stearns, Merrill Lynch, Lehman Brothers, AIG, Wachovia Bank, Washington Mutual. And I'm just reading now the galley of Lloyd Blankfein's memoir, former CEO of Goldman Sachs, and I just finished last night reading the section on the global financial crisis. And believe me, we were on shaky ground. And we all knew that Morgan Stanley was next. And Morgan Stanley was like this. And even Lloyd says that Goldman Sachs, which was in a essentially strong position, when confidence is withdrawn from the whole financial sector, anything can happen. Um, and so, but you know, nobody wanted to buy anything. Everybody was selling everything. The prices were collapsing down every day. And so we took the $11 billion off the shelf and started to invest it. And Bruce Karsh, my partner, you know, he's very brave and I supported him. And in that fund, he invested an average of $450 million a week. And that's all you had to do. By the way, you didn't have to be selective, patient, disciplined, perspicacious, any of those things. All you had to do was have money and the willingness to spend it. And, you know, when the market is cascading down and nobody else will buy and you're the only buyer, which we essentially were, great things happen.