Howard Marks Presentation To UCLA Student Investment Fund

The Inoculated Investor http://inoculatedinvestor.blogspot.
com/
Howard Marks Presentation to UCLA Anderson Student Investment Fund
Capturing Efficiencies in Distressed Debt
• Introduction
o No investments are good or bad intrinsically
 It all depends on the timing and the price
o Fashion fads come and go
 In 2010, the fad was safety
 What Marks does to determine the quality of the investment is to project himself
into the future
• What kind of scenario would have to play out for the return to make
sense?
o In terms of buying Swedish gov’t bonds at .9% yield, depression

and deflation are the only outcomes that would make the
decision prudent
• Investing successfully surrounds buying assets for less than they are
worth
o Distressed debt
 What is distressed debt?
• Debt for which the markets do not believe the bonds will pay principle
and interest
 Generally, distressed debt investors want a creditor claim on the company
 Restructuring is the event that comes about after a default
• Trigger (such as restructurings) are important in investing
o 3 questions that Oaktree asks itself in determining whether to make an investment
 What is the pie worth?
 How will it be split up among claimants?
 How long will it take?
• If you can get all of these right you can determine the IRR with certainty
The Inoculated Investor http://inoculatedinvestor.blogspot.com/
• You might want to buy a piece of each of the different classes of debt to
hedge the uncertainty of how the pie is going to be split up
o Sub debt for example has nuisance value and its holders can
often extract more than they should when the pie is being
divided
 Oaktree has bought the sub debt even when it believed

the chances of making money were not great in order to
hedge against weird outcomes of the pie splitting
o Determinants of supply and demand of bonds
 Lowering of credit standards
• These are the logs that provide fuel for the fire
• There is a correlation between the level of issuance of HY bonds and the

subsequent likelihood of default
 Onset of economic weakness
• Put a match to the logs and ignites the crisis
• General cycle dynamics
o Build Up
 Start off with a hospitable environment
 Risk taking is profitable
 Credit standards decline as risk aversion declines
 Issuance balloons
 Quality of issuance declines
o Potential factors that can combine to trigger a crisis
 Recession
 Credit crunch
 War
o Consequences
 Prices fall
 Holders engage in panicked selling
 Supply overwhelms demand
 Price collapse gains momentum
 Losses snowball
 High prospective returns become available
o Subsequent Events
 Economy recovers
 Defaults spike
 Capital markets reopen
 Psychology improves
 Prices snap back
 Super high returns are realized
o Cycle continues
 Default rate recedes
 Supply of mainstream debt recedes
 Capital for investment swells
 Investment opportunities and prospective returns contract
 Investors lower their sights and pursue special niches
• First distressed debt cycle Marks lived through was 1980-1993
o People were averse to these bonds in 1980 and1981
 The entire universe of high yield (HY) bonds was very small in that time with
yearly issuance of only about $1B
 Pension funds and endowments did not buy these
 Moody’s said B rated bonds were bad ideas in general
• This statement was “crap”
o They ignored price completely

o How could HY bonds be bad investments at every price?
 People’s prejudice and bias creates opportunities for Oaktree
• Market efficiency theory is inaccurate
• Securities become mispriced and people who figure that out can make
money
• At very least smart investors can know enough to refuse to fall in line
with the herd mentality
• What is inefficiency?
o Very simple: a mistake
 Smart investors take advantage of such mistakes
 Perception of HY began to change in the mid-1980s
• Issuance went from $1B a year to $7B
• Psychology is very cyclical
o In 1981, low issuance and low defaults were due to high credit
standards
 People saw low defaults and thought that HY bonds

were fine in general
• But this was self-selecting because people only

bought high quality HY bonds then
o When you see issuance increase, it is not because issuers want to

issue more debt necessarily
 It has to do with Wall Street demand
• It is not driven by supply from companies
o Supply is elastic
o What is hidden is that when there an increase in quantity, it is

usually accompanied by a willingness to buy lower quality bonds
 Leads to increased willingness to buy, decreased risk

aversion, and decreased skepticism
o What went wrong in this particular cycle?

 Exogenous and endogenous events
• Collapse of LBOs
• Iraq War
• Milken goes to jail and Drexel gets shut down
 Prices fell => panicked selling => losses snowball, => high prospective returns
become available because debt can be bought cheap
• Low issuance starts again
 Recovery begins then prices come back up and super high returns are realized
• But then then cycle begins again
 What about what is going on now?
• Egypt: The situation is cataclysmic
• No one know what the impact of the Egypt situation will be on the world
and on the US
o But the stock market continues to go up
o When one thing happens the market can retain its equanimity
 But when a bunch of things go wrong, the market is

prone to a crash—contagion effect
• 1990-2002 Cycle
o A number of events caused another downturn and started the cycle over again
o Lesson: It is never over
 The cycle always begins again
• Marks even uses the same slides—just adds new data
 Oaktree’s business is like a basketball game with an infinite # of quarters
• If you have a good year and you come back again Jan. 2nd with a clean
slate
o Marks doesn’t believe in macro forecasts
 We know rather little about the future

o The people who are great investors are the ones who understand the cyclical nature of
things
 Henry Kauffman from Salomon: There are two types of people who lose money:
those who know nothing and those who know everything
 Amos Tversky: It is frightening to realize that you don’t know something but it is
even more scary to realized that the world is run by people who think that they do
• Current environment in high yield
o People are now saying that what happened in 2008 was sunspot
 In 2008 you could buy HY bonds with a yield of 22% and now the yield is more
like 7%
 People are going back into high yield bonds
• Standards are lower and of course issuance is up
• Soon to be released book: The Most Important Thing
o Pre order the book: http://www.amazon.com/Most-Important-Thing-Thoughtful-

Publishing/dp/0231153686/ref=sr_1_1?ie=UTF8&qid=1297973638&sr=8-1
 Comes out in May (according to Amazon)
o Galbraith was one of his main influences
 Shortness of memory is one of the amazing thing about financial markets. But
why?
• Either people die off or retire
• People’s memory tells them to not do something because it is clearly too

good to be true but that restraint is often overtaken by greed
o You want that free lunch
o You want to make big returns when others are
o Willing suspension of disbelief overcomes memory and

prudence
 This is why the cycle is the same over and over
• Memos from Marks that address this topic:

“You can’t predict but you can prepare” and
“Happy Medium”
• Available on Oaktree’s website:

http://www.oaktreecapital.com/memo.aspx
o Combination of micro knowledge about companies and markets is important
 But you also have to understand cycles
o We never know where we are going but we sure as hell should

know where we are now
• What is debt?
o General rule: debt is never repaid
 Countries, consumers and companies never pay off their debts: they just can’t
• Think of California, for example
 If on the day the bonds mature the credit window is closed then you are bankrupt
 If the window is open then people allow you to take on more debt
• It all depends on psychology and where the pendulum is
o The pendulum swings between optimistic to pessimistic; from

willing to lend to unwilling to lend; from greedy to fearful
 This is what happens to cause things to go crazy and

leads to pendulum to swing away from the middle
o On average the pendulum is in the middle but it spends very little

time there in reality
• Have to think about whether or not the average means anything
o Momentum towards one extreme actually causes the swing to the

other direction
o Example: Average returns for stocks is about 10%
 How many years has the return been between 10% and
12%?
• Not enough to rely on the average: the average

deviates from the norm
• The never ending credit cycle: 2003-2010 and the current recovery
o Risk averse investors limit quantities and demand high quality

o High quality issuance produces good results
o Good results cause investors to become complacent and risk-tolerant
o Risk tolerance opens investors to increased issuance and reduced quality
o Lower quality issuance eventually is tested by economic difficulty and failures
o High defaults have a chilling effect, making investors risk averse once more
o The cycle then repeats
o Where are we now? We are in between bullets three and four
 You can do things in the credit markets that you couldn’t do two years ago
• The Buffet quote most often used by Marks seems to apply now:
o “The less prudence with which others conduct their affairs, the
greater the prudence with which we should conduct our own
affairs”
 People are becoming aggressive (not back to 2006-07 levels) but they are getting
back to 2008 levels
 People are getting complacent
o What is Oaktree doing?
 Goal: understand where they are in the cycle and act accordingly
 Process: raise money, buy things cheap, sell them when they are rich
• These are the things Oaktree has to do to be successful
o But, all three cannot be done at the same time
 People aren’t that stupid: either everything is rich or

everything is cheap
 In Q4 2008 they knew where they were
• Raised $11B in March 2008
o Between September 15th, 2008 and the end of the year they
deployed most of that money
o If you missed that window you basically missed the entire

opportunity
 Oaktree was buying senior debt on great companies with

yields in the 30’s and prices in the 50s and 60s
o Now they are scraping to find deals that safely produce 13-15%
 Could get higher returns if they take on risk
• But that is not their game
• Wisdom from Marks
o 3 stages of a bull market
 Stage 1: Few intelligent people see improvement
• Q4 2008
o AIG, Lehman, WAMU gone
 World was going to end and a few people bought

bargains then
 Stage 2: Most people accept that improvement has occurred
 Stage 3: Every idiot thinks that things will get better forever
• Current view in the markets: the world ending was just a head fake
o People are worried about being left behind
o The greatest adage of investing:
 What the wise man does in the beginning, the fool does in the end
o Oaktree Mantra
 If you can avoid the losers, the winners will take care of themselves
o There are old investors and there are bold investors
 But there are basically no old and bold investors
o The 4 most important things according to Marks (also the title of his new book)
 A solidly based, strongly held estimate of intrinsic value
 The relationship between price and value
 Being mindful of cycles (and where we stand within them)

 Contrarian behavior
• Each of these is a chapter in the book
Q&A
• Question #1: Would he elaborate on his views on gold?
o Gold has worked for 2000 years because people put store of value in it
 That will probably continue
 People like gold in times of uncertainty
• When you have inflation or collapse of the value of currencies then

sentiment turns toward gold
o What could prick the bubble is increased confidence
 Usually leads to a decline in interest in gold
• People no longer feel as though they would rather hold gold than Euros,
dollars, etc.
o Gold looks like it is becoming more expensive
 But actually the dollar is getting cheaper
 It is not true in Australia that gold is appreciating
• Gold appreciation may be most indicative of a loss of respect for the

dollar
o The trouble with inflation is that governments inflate their currencies to get through
crises
 Classic example of hyperinflation is Weimar Germany
• Have to ask yourself: will the gov’t debase the currency by printing more
money?
o There is nothing intelligent to be said about the value of gold because it cannot be valued
 No way to determine intrinsic value
 No estimate of what a buyer should play because of the lack of cash flow
• Only worth what people will pay for it

• Question #2: I asked Marks what he thought of the actions of financial institutions in the US
before and during the crisis. Were the actions fraudulent or due to stupidity?
o Marks does not think that there was much fraud
 There was much more stupidity
 Creating securities that can be bet against was not necessarily fraud
 Most people are stupid around money
 But, there always is some fraud
• Most people can’t walk by a pile of money without picking some of it up
• Greed overcomes logic
o Most people were not smart enough to know the folly of their
ways
o CLOs
 Rating agencies issued 16,000-17,000 AAA ratings on subprime securities
• Meanwhile there are only 4 AAA corporate ratings in the US
 I-banks tried to get the highest rating they could
• They did not intend to defraud
• Young MBAs without ethical and moral standards or training thought

this was a game and tried to get the highest possible rating
o Knew they could sell more, the higher rating
o Chuck Prince quote: “As long as the music is playing, you've got to get up and dance.
We're still dancing.''
 Prince knew that the when the liquidity went, things were going to go badly
• He never got credit for that
 If he had made the statement in 2005 that he was going to stop dancing then he
would have lost his job
 March 2007 note: “Race to the Bottom” addresses this topic
• For real products the best way to gain share is not to lower the price but
to increase the quality
• Commodities are goods in which there is no differentiation is quality
o Only way to sell more is to cut your price
• For the financial community to lend out more, it had to cut its prices
o Banks lower their interest rates to lend more
 They can’t make their products better
o People stopped being skeptical, risk averse
 If other people are making those loans then there is a

race to the bottom
o If you win an auction all that it means is that you paid more than
anyone else was willing to pay
 In certain times in the cycle you don’t want to win

auctions
• But in the fall of 2008 it would have been OK to

win an auction
o But not right now or in 2007
o Second greatest adage of investing:
 Being too far ahead of your time is indistinguishable from being wrong
 Jeremy Grantham of GMO became negative on tech stocks in 1995-96 and he

went into cash
• As a result from being early, he lost half of his business
 It is hard in this business to do the right thing
• But it is almost impossible to do the right thing at the right time
o The only way to never look wrong is to do what everyone else is

doing
o To be good in this business you have to be comfortable with

being wrong for a period of time

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The Inoculated Investor http://inoculatedinvestor.blogspot.

Howard Marks Presentation to UCLA Anderson Student Investment Fund

Capturing Efficiencies in Distressed Debt

o No investments are good or bad intrinsically

 It all depends on the timing and the price

o Fashion fads come and go

 In 2010, the fad was safety

o In terms of buying Swedish gov’t bonds at .9% yield, depression

 What is distressed debt?

 Generally, distressed debt investors want a creditor claim on the company

 Restructuring is the event that comes about after a default

• Trigger (such as restructurings) are important in investing

o 3 questions that Oaktree asks itself in determining whether to make an investment

 What is the pie worth?

 How will it be split up among claimants?

 How long will it take?

 Oaktree has bought the sub debt even when it believed

o Determinants of supply and demand of bonds

 Lowering of credit standards

• There is a correlation between the level of issuance of HY bonds and the

 Onset of economic weakness

• Put a match to the logs and ignites the crisis

• General cycle dynamics

 Start off with a hospitable environment

 Risk taking is profitable

 Credit standards decline as risk aversion declines

 Quality of issuance declines

o Potential factors that can combine to trigger a crisis

 Holders engage in panicked selling

 Supply overwhelms demand

 Price collapse gains momentum

 High prospective returns become available

 Capital markets reopen

 Prices snap back

 Super high returns are realized

 Default rate recedes

 Supply of mainstream debt recedes

 Capital for investment swells

 Investment opportunities and prospective returns contract

 Investors lower their sights and pursue special niches

• First distressed debt cycle Marks lived through was 1980-1993

o People were averse to these bonds in 1980 and1981

 Pension funds and endowments did not buy these

 Moody’s said B rated bonds were bad ideas in general

• This statement was “crap”

o They ignored price completely

o How could HY bonds be bad investments at every price?

 People’s prejudice and bias creates opportunities for Oaktree

• Market efficiency theory is inaccurate

o Very simple: a mistake

 Smart investors take advantage of such mistakes

 Perception of HY began to change in the mid-1980s

• Issuance went from $1B a year to $7B

• Psychology is very cyclical

 People saw low defaults and thought that HY bonds

• But this was self-selecting because people only

o When you see issuance increase, it is not because issuers want to

 It has to do with Wall Street demand

• It is not driven by supply from companies

o What is hidden is that when there an increase in quantity, it is

 Leads to increased willingness to buy, decreased risk

o What went wrong in this particular cycle?

 Exogenous and endogenous events