The IPO Frenzy Has Begun — ft. Howard Marks

You have to accept the likelihood that what you're doing is closer to speculating. And I don't say that word pejoratively than analytical investing. There's a spectrum which goes from what I'll call analytical investing in prosaic understandable companies to speculative investing in futuristic companies that can't be described at all. You should calibrate your activities based on where you are on that spectrum. That's the whole thing. And it's very hard to do. This is the hardest thing I think I've ever seen in the investment world because of this enormous degree of uncertainty.

There's no question about the fact to use Alan Greenspan's saying from about 30 years ago that we have exuberance. That's the only thing we know for sure. He pioneered the phrase irrational exuberance. The question is, is today's exuberance irrational? Number one, I don't think anybody can definitively say so. And the reason I say that is that I don't think I've ever heard anybody tell me exactly what AI will be able to do or when or for whom or how much profit it'll produce and for whom. There's an arms race going on between what you described as some of the greatest companies on the planet. I would describe what we call the hyperscalers as mostly the greatest companies I've ever seen. And they're engaged in an arms race. Can only one win? Is it winner take all? Can several win? Nobody can tell me these things. So I don't think there's an analytical or what we call a value-based way to decide whether or not to participate in these IPOs and if so at what price wherein the AI, as far as I think virtually all of us are concerned, is a concept we can't define its parameters. And it's a great concept. It's likely to be the most powerful force any of us have ever seen. But that's all we know. And a decision to participate or not participate and what price to participate at is really what my South African friends call a thumbsuck. You can't put numbers on a pad and figure out what these things are worth, which is what value investors like me historically have done.

It does feel like that. We have a technological innovation. I've seen several. I've read about many more over the last 150 years. This may be the greatest. This may be the most powerful. It's also in many ways the least specifiable. The technological innovations I'm talking about, let's just for a starting point let's say the railroads back in the 1860s, and then radio in the 1920s, the automobile, computers in the 1950s and 60s, internet in 2000. It may be revisionist history but I think we had a much better view of what all of those could do. They didn't have this unimaginable, unlimitable upside that AI has or the, in my opinion, degree of uncertainty. We knew that the railroad would carry goods and people from coast to coast. We knew that radio would carry messages. We may not have known exactly how they would produce profits or how they would become television, but anyway, all the things I mentioned were accompanied by what we call bubbles. People got excited about developments which were unprecedented. They threw vast amounts of money about building the infrastructure for it. There was a winner take all race. There was excitement. There was exuberance. The capital flowed in like water. In every case, too much capital flowed in. I think it's fair to say too much infrastructure was built and prices were paid that were too high and a lot of the people who provided the capital for these bubbles lost their money. I think it's fair to say that those comments have been true in every case that I enumerated. So I wrote in a memo recently this year and I think it's true that if this technological innovation with its exuberance doesn't produce a money-losing bubble, it'll be the first. And now it could happen. You can't rule these things out. And maybe this is a good time for me to introduce the rejoinder of the optimist. What do they say? This time it's different. Okay, that was true about the railroads. It was true about radio. It was true about computers and the internet. But this time it's different. And this time we have a development of incalculable, unlimitable value. So this time it's really true that there's no price too high. That's what they say.

But the problem with that ad is they always say that this time it's different is never different. And they've said it in each of those bubbles that I mentioned. I think so nobody including me should say definitively that this is a bubble, that the people who invest in these early stages of AI will lose their money, that the people who invest in the companies you named will pay prices that they'll never see again, but you must be alert to the possibility. The way people get into trouble is by not being alert to the possibility.

My favorite fortune cookie says that the cautious hold them or write great poetry. So investing in these companies today could be a huge error, but it could be great poetry and the people who resist because it could be an error could miss out on the greatest thing in history. And that's what makes these decisions so hard. The people who invest today in traditional industries in transportation, in distribution, in retailing, in real estate, they don't have for the most part the risk of committing grievous error, but they also don't have access to the possibly best thing in history. So you just have when you sit here with something that's so young and where the future is so unestimable, you just have to deal with it as a concept or not deal.

In dealing with the future, the way most people deal with the future is by coming up with a forecast. I argue strenuously that if you want to deal with the future, you need two things, not one. You need a forecast and you need a judgment regarding the probability that your forecast is right. So you can make a forecast about the future of AI. You can make a forecast which is optimistic. But I just think if you say this is my judgment about the future of AI, and by the way, I'm highly confident that I'm right, I think you're probably making a big mistake. I've never met anybody who thinks they can tell me what this world is going to look like five or 10 years from now. And so why should any young person you described who's laying the foundation for his investment portfolio, why should he conclude that he's probably right when all these other people are? We know it could be great. I bet it's probably going to be great. I said in my last memo that in terms of its basic capabilities, my guess is that it's more likely to be underestimated today than overestimated today. But what we're talking about is how much capital should it receive and what is a piece of a company that engages in this activity worth? And the value investor, the old-fashioned investor like me and my fellow travelers, what we do is we figure out what a company's like, we look at what it makes today and what potential earning power it's building. We try to figure out what its earnings will be in five or 10 years. We put a what we think is a reasonable valuation on those earnings largely related to the earnings potential in the subsequent decades and then we look at the price today and we try to figure out whether today's price is fair relative to that earnings power. And I don't think I've ever seen an industry or companies where that is less feasible. If somebody will tell me what they think Anthropic's net earnings will be in 2036, I'll bet them that they're not within 50% of the truth. Of course, we'd have to wait 10 years to find out. But if I'm right, how then you make an investment in Anthropic stock in the IPO, you have to accept the likelihood that what you're doing is closer to speculating, and I don't say that word pejoratively, than analytical investing. And there's a spectrum which goes from what I'll call analytical investing in prosaic understandable companies to speculative investing in futuristic companies that can't be described at all. And you should calibrate your activities based on where you are on that spectrum. That's the whole thing. And it's very hard to do. This is the hardest thing I think I've ever seen in the investment world because of this enormous degree of uncertainty.

Well, maybe a robot can come into your house and with a camera and assess your situation and make the needed repairs. Then I said, "Sure. Why can't somebody build a robot that can give you a good massage?" And so the world has become a much more uncertain place. The probabilities that can be assigned to the future are much broader today than ever. I think that's an important change. When I was a kid, the world didn't change. A comic book was always a dime. New technologies didn't come along that often. We were pretty confident that the world would look the same 10 years later and for the most part it did. But today I think you have to accept that much more change is possible. So the investor has to recognize that he or she is living in and dealing in a much less predictable world.

I still think there is a more predictable part of the economy. It'll probably be a while before the energy business gets disrupted to the point where we use something in lieu of oil and gas. That's probably largely true of the food industry, probably the timber industry and the home building industry, transportation. It's probably going to be a while before we walk into a station, become dematerialized, and show up in another city. Retail has been disrupted but it looks like we're maybe at a baseline level of in-person shopping that's not going to go further. I don't know. But so you can identify areas, metals and mining, paper, chemicals. I guess I would say for the most part that things that have less intellectual content are less likely to be disrupted by AI, which is basically an intellectual problem solver and productivity tool. So I think we can make a list of things that we think are less likely to be disrupted by AI. We just shouldn't be too cocksure about it. But that's what we do for a living, Scott. We're still investing. We're investing according to the same investment philosophy and in many of the same industries. But we have to constantly renew our thinking. The worst, it seems that the most laughable thing to do today would be to say you know I found some companies in industries that'll never change.

We start with the traditional indicators of valuation like the PE ratio whether it's the Shiller CAPE ratio or the traditional S&P PE ratio. And those things showed the market to be, I used the expression a year ago, lofty but not naughty. The non-Shiller PE ratio is about 23 or so today. The 80-year average is 16. So we're roughly 50% higher today. But in 2000, I think it was 32. When I started in this business as a young man in 1969 in the research department at Citibank, the bank and most of the banks invested in what were called the Nifty Fifty. Those were the 50 largest growth companies in America. And they were considered one-decision stocks. You bought them and you never sold them. And they were priced at 80, 90, 100 times earnings. And then in 1973 and 74, they went down 80, 90% and many of them never recovered. So the lesson is that even the best companies can be overpriced. And that's what we have to be careful about today. The question is not whether AI is going to be great. The question is whether the prices being paid for AI-related stocks today are justified by the future cash flows that those companies will generate. And that's a very difficult question to answer. But the traditional valuation metrics suggest that the market is expensive, but not necessarily in bubble territory. However, the concentration of the market in a few large tech stocks is reminiscent of the Nifty Fifty era and the dot-com era. And that's a warning sign. So we have to be cautious. We have to be aware that the market is priced for perfection and any disappointment could lead to a significant correction. But we also have to recognize that we could be in the early stages of a technological revolution that could transform the economy and create enormous value. So it's a very difficult environment to navigate. But we do it by focusing on the fundamentals, by being disciplined, and by not getting caught up in the hype. We look for companies that have strong competitive advantages, that are generating real cash flows, and that are trading at reasonable valuations. And we avoid companies that are priced for perfection and that have no margin of safety. That's the value investing approach. And it's served us well for over 50 years. So we'll continue to follow it.

Called the Nifty Fifty, which were considered to be the best and fastest growing companies in America. Xerox, IBM, Kodak, Polaroid, Mercy, Texas Instruments, Hulu, Packard, Coca-Cola, Avon, etc. And most of those stocks were selling at PE ratios between 60 and 90.

So to look at the Mag 7, take out Tesla, they're selling at PE ratios in the 30s. Doesn't sound so expensive to me. But that's just PE. But you can't just depend on PE. That's too simplistic. The companies are different. Their capital intensiveness is lower, their marginal profitability is higher since the product is an intellectual product rather than a piece of metal. It doesn't cost much to make the next one. So their incremental profitability is much higher. And another thing is we've never ever seen companies growing at the rates of today. You know, and I don't know the specifics, so I don't want to go there, but you hear about companies that are growing 50% a month or 100% a year or whatever it might be. You've never seen that before. And you look at AI and the progress that it has made in the last four years. Three years ago, you talk about moats, you talk about impregnability. Three years ago, most people thought software was a great industry to invest in because everybody who used computers, which was everybody, needed software. And if you had a software system that served your company and industry, it would be expensive to change. And for the most part, it was hard to figure out a reason to change. So that's a pretty good moat. More recently, people are wondering whether the whole software industry is going to go out of business because nobody writes software anymore. AI writes its own software for itself. People have to tell it what to write, but it can write it without any help. So now in that world, there's something called SaaS, software as a service, and around February 1st we had something called the SaaS apocalypse, where the great AI companies announced some coding models and everybody said that's it, the whole software industry has gone out of business. Now that's probably an exaggeration. But it's very hard to figure out these things. By the way, I want to come back to something that you asked me a long time ago and I never answered, and I don't want to leave it unanswered. How do you invest in this given all these uncertainties that I'm talking about? And you know what history has shown is that one of the greatest mistakes you can make is being not optimistic enough. And another mistake you can make is to say the future is unclear, so I can't invest. Those two things don't necessarily go together. The future is always unclear. Maybe it's more unclear than ever, but that's not a reason not to invest. You just have to invest carefully, knowingly. You have to be aware of the risks you're taking. So how to invest in AI? Like anything else, there's a spectrum. At one end of the spectrum we have ultra high possible returns with great uncertainty, and at the other end of the spectrum maybe we have somewhat lower possible returns with less uncertainty. Now all of this is more uncertain than ever, but that spectrum still exists, and so you can choose a point on that spectrum. Let me give you a couple examples. You can invest in what we call the hyperscalers: Amazon, Google, Meta, Microsoft for example. They have established businesses with moats, enormous operating cash flow. They want to get into AI. They maybe feel that they have to compete vigorously in this winner-take-all battle. But with established businesses and cash flow and some diversity of business, these are as I said before without naming names some of the greatest companies I've ever seen. So you would think that investing in them would be maybe the low-risk way to invest in AI, but if AI booms and takes off and octuples in the next three years, since they have other businesses holding back their growth rate, they're not going to be the maximum profit winners. Then you have established companies. As you said before, we don't know their profitability, their finances, and maybe they're one-product companies in the sense that they're all AI. So maybe it's harder to specify their future. But Anthropic and OpenAI for example, Nvidia, have a very high probability I think, not being an expert, a high probability of still being successful 5 or 10 years from now. They may not be the number one they are today, but they're unlikely I think to be obsoleted. So they're depending on the price you pay and its fairness, they may be riskier than the hyperscalers, but they're not make it or break it. They're already up and running. And then you have startups where you don't know where they may not have revenues. They may have revenues but no profits. You may not even know what the product will be, but if you can get in at something called ground level and they turn into a big winner, you can make an incalculable amount of money. And I described this in a recent memo as a lottery ticket. And so at the riskiest end of the spectrum, you have lottery behavior. If you think about the lottery, most people who buy lottery tickets lose all their money. A few people become incredibly rich. So that's probably the profile of performance at the riskiest end of the spectrum. You can pick where to play on the spectrum. You can mix positions on the spectrum. And then you can decide how much of your total portfolio should be in these companies on the spectrum.

In the heat of the moment, in the exuberance, people say things like profits don't matter. What matters is in the future. We used to value stocks on earnings. Then when we started investing in companies with no earnings, we talked about investing on the basis of sales, ratio of sales. Then when we talked about companies that had no sales, people back in 1999-2000 said, well, what's how much per eyeball? How much per click? And people put values on internet stocks based on how many people were going to their site even though they were going there free. But I believe ultimately it always comes down to value. Ultimately at some time in the future, profitability will matter. If you find a company that's a great tech leader today, and it looks like it has an unlimited technological franchise and great expertise, and if you tell me that 20 years from now it still won't be making money, my guess is that the price paid today by an exuberant investor will produce disappointment. When exuberance is replaced by sobriety, people say, of course profits matter. We invest in companies which we think will make money, and their profits will make money for us. So it's silly to disregard completely the possibility of profits. By the way, Warren Buffett said in connection with the internet in I think 2000, he said there's no doubt about the fact that the internet will add to efficiency, but that's not the same as adding to profitability. And that's relevant today also. AI is going to change the world. I have no doubt about that. Who will it make money for? If all the hyperscalers plus the anthropics and openais of the world and Tesla and some of the startups all engage in battle and compete against each other at enormous costs, how profitable will they be? Who will make the money? And if AI is primarily a labor-saving device, which I think might be an accurate description, who gets the benefit of the labor savings? Maybe the customer. The shipping company or the retail company or the warehouse company benefits from a price war among AI providers such that the user adds to his or her profits, but the purveyor of AI services doesn't do that great. These things can't be specified.

How long do you have?

First of all, I'm pretty sure I predate you. When I attended the University of Chicago in 1968, the professor pointed out that the average mutual fund did worse than the S&P before fees and then charged a high fee. So he says, why don't they just buy one share of each stock in the S&P? There were no index funds, no concept of indexation, but it came along and today the majority of mutual fund equity capital is managed by indexation or passive investment. That's one reason why a lot of people have disappeared. The consumer was not well-informed and paid a high fee for a defective product, which is not a great business model. On the other hand, in the last let's say 40 years, there have been all these innovations. We lived 40 plus years in a period of declining interest rates which made a lot of things very successful, and a lot of people cashed in and built very profitable businesses investing in what are called alternative investments: private equity, private credit and things like that. And they found an environment which was perfect for them. And especially since March of 2009, which was the low point of the global financial crisis, things have been rosy for over 17 years. And so a lot of people have made a lot of money. This tends to get sorted out in the bad times. In the good times, the great investors do great, the bad investors do good. In the bad times, it gets sorted out. There may be rougher times ahead for some of these new things in the investment business and some of it may get sorted out. By the way, closest to home for Oaktree, in the last 15 years, they developed a business called private credit, which is really just a broader term for what we call direct lending, which is private loans for midsize buyouts. I'm informed on good authority that this didn't exist in 2010 and it's $1.7 trillion today, and I'm told that there are roughly 700 direct lending managers. And so the availability of that $1.7 trillion put a lot of people into business and made a lot of people extremely successful along with a very favorable economy and with low or generally declining interest rates which are salutary. So this has been an ideal environment and we have 700 managers making money in this industry today. What will it look like 5 or 10 years from now? We'll find out. But I'm told that of the 700, roughly 3% were in business before the global financial crisis. So we don't know how many of them have what it takes to deal with a harsh environment. Making money in a salutary environment proves almost nothing. To make money in a salutary investment environment, you can do it on the basis of good judgment and hard work and skill, or you can do it on aggressiveness and getting lucky. It doesn't get sorted in the good times. As Buffett says, it's only when the tide goes out that we find out who's been swimming naked. So this period that you describe, and particularly the period 2009 to date, this has been salad days. And nobody should look at those 17 years and say, oh, that was a long period, so that's probably normal. This was the greatest period imaginable for the investment industry and especially for the alternative investment industry, and one day I think the tide will go out and one day some of this will be sorted.

I think it's overblown. These were managers who collected money from clients and gave loans for midsize buyouts. Some of them will be unsuccessful but probably not a large percentage. This activity has been around in different guises since 1978 or 1977. I was lucky to be asked to start Citibank's high yield bond activity in 1978, and we've been making loans to companies of moderate creditworthiness and doing well for 48 years. People who don't do it as well will not have great results. But most of the loans will pay, and the people who are throwing up their hands are probably exaggerating the difficulty and extrapolating the fears in software, which are probably overblown. Having said that, retail investors or individual investors bought these products, and these are private loans. There's no market for them. You can't get out of them at the drop of a hat. And so most of the unease concerning what you call private credit, what I call direct lending, is around the fact that people have said, okay, I'm not that happy. I'd like to get my money back. And if you went into a non-traded BDC, which is what we call these things you're talking about, the people said you can only let out 5% of the investors per quarter. And other people said, what do you mean? I put money in, I can't get it out. Well, that was always the terms. If you read the prospectus, which very few people do, it was there. None of this is a surprise, but people do things in the good times when they're feeling no pain, sometimes without adequate care or research or prudence, and they tend to regret them in the bad times. Some of that is going on, but I don't think there was a misrepresentation. People should not be surprised that they can't get all their money out every quarter. And one of the most powerful forces in the investment business is disillusionment. People went from being unworried to thinking that the ship is sinking, and that's very painful. The unworried feeling was mistaken, and now the feeling that the ship is hopelessly sinking is also probably mistaken.

I've enjoyed a great career and I don't consider it over. Investing is a fascinating field. Just think about this podcast and think about the number of times I said, I don't know. Or something's unpredictable or inestimable or incalculable. So what we do every day is we peel an onion, and we deal with uncertainty, and we make judgments. We make the best judgments we can in an uncertain world. In his book Fooled by Randomness, Nassim Taleb made a comparison between investing and dentistry. He said if you go to dental school and you learn how to fill a cavity and you fill the cavity that way every time, you'll be successful every time. That's not true of investing. So if you're the kind of person who wants to be successful every time, don't become an investor, become a dentist or an engineer or something where you have physical rules in play that are reliable. There are no physical rules in investing that will make you successful all the time. Warren Buffett, the most successful investor of all time, attributes his success to 12 investments over the last 60-70 years. He didn't have that many abject failures, but many of his investments were only moderately successful. He did 12 great ones. So do you like dealing with uncertainty and ambiguity? Can you live with a batting average which is far from a thousand? The only thing I would emphasize is that investing has been an enormously profitable industry for those of us participating in it in the last 50 years. You shouldn't become an investor just because it's a high paid industry. But if you meet the description I just laid out, I think it's a great thing to do. It's exciting. It's intellectually challenging. You never reach a point where you say, well, I got this figured out. And I find that to be a wonderful attribute.

Thank you, fellas, for your great questions. It's been a pleasure.