Howard Marks, Oaktree Capital — 2023-09-12
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Memos from Howard Marks 2023-09-12T07:00:00.0000000Z" pubdate title="Time posted: >9/12/2023 7:00:00 AM (UTC)">Sep 12, 2023
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My memos got their start in October 1990, inspired by an interesting juxtaposition between two events. One was a dinner in Minneapolis with David VanBenschoten, who was the head of the General Mills pension fund. Dave told me that, in his 14 years in the job, the fund's equity return had never ranked above the 27 th percentile of the pension fund universe or below the 47 th percentile. And where did those solidly second-quartile annual returns place the fund for the 14 years overall? Fourth percentile! I was wowed. It turns out that most investors aiming for top-decile performance eventually shoot themselves in the foot, but Dave never did.
Around the same time, a prominent value investing firm reported terrible results, causing its president to issue an easy rationalization: "If you want to be in the top 5% of money managers, you have to be willing to be in the bottom 5%, too." My reaction was immediate: "My clients don't care whether I'm in the top 5% in any single year, and they (and I) have absolutely no interest in me ever being in the bottom 5%."
These two events had a strong influence on me and helped define my – and what five years later became Oaktree's – investment philosophy, which emphasizes risk control and consistency above all. Here's how I put it 33 years ago in that first memo, titled The Route to Performance :
I feel strongly that attempting to achieve a superior long-term record by stringing together a run of top-decile years is unlikely to succeed. Rather, striving to do a little better than average every year – and through discipline to have highly superior relative results in bad times – is:
less likely to produce extreme volatility,
less likely to produce huge losses which can't be recouped and, most importantly,
more likely to work (given the fact that all of us are only human).
Simply put, what [General Mills's] record tells me is that, in equities, if you can avoid losers (and losing years), the winners will take care of themselves. I believe most strongly that this holds true in my group's opportunistic niches as well – that the best foundation for above-average long-term performance is an absence of disasters.
As you can see, my dinner with Dave was a seminal event; his approach was clearly the one for me. (Incidentally, I want to share that after decades of not having been in touch, Dave was among the many kind people who wrote in recent months to encourage me vis-à-vis my health issue. This is a great example of the many personal dividends my career has paid.)
Putting It in Brief
That first memo, and the bit cited above, include a phrase you've likely heard from Oaktree: If we avoid the losers, the winners will take care of themselves. My partners and I considered this phrase so fitting that we adopted it as our motto when Oaktree was formed in 1995. Our reasoning was simple: If we invest in a diversified portfolio of bonds and are able to avoid the ones that default, some of the non-defaulters we buy will benefit from positive events, such as upgrades and takeovers. That is, the winners will materialize without our having explicitly sought them out.
We thought that phrase was innovative. But in 2005, while working with Seth Klarman to update the 1940 edition of Benjamin Graham and David Dodd's Security Analysis – the "bible of value investing" – I read something that indicated we were late by about 50 years. In the section Seth asked me to edit, I came across Graham and Dodd's description of "fixed-value" (or fixed-income) investing as "a negative art." What did they mean?
At first, I found their observation cynical, but then I realized what they were saying. Let's assume there are one hundred 8% bonds outstanding. Let's further assume that ninety will pay interest and principal as promised and ten will default. Since they're all 8% bonds, all the ones that pay will deliver the same 8% return – it doesn't matter which ones you bought. The only thing that matters is whether you bought any of the ten that defaulted. In other words, bond investors improve their performance not through what they buy, but through what they exclude – not by finding winners, but by avoiding losers. There it is: a negative art.
One more anecdote concerning the origin of the phrase: I've always been interested in old books. A few years ago, while walking through a Las Vegas convention center on the way to meet with a client, I came upon a rare book fair. I stopped at the booth of a book dealer I know, and my eye immediately fell on a book he had for sale: How to Trade in Stocks, by Jesse Livermore. Here's the quote the dealer had highlighted: "Winners take care of themselves; losers never do." You may be tempted to believe Livermore borrowed my idea . . . until you realize that, like Graham and Dodd, he published these lines in 1940. So much for my innovation.
At the time I adopted that saying, my partners and I were primarily high yield bond investors. And since non-convertible bonds have little upside potential beyond their promised yield to maturity, it truly was the case that our main job was to avoid the non-payers, with the assumption that some subset of the payers would likely give us exposure to positive developments that occurred. It was an appropriate way to sum up our approach as bond investors.
But fortunately, I joined up with Bruce Karsh in 1987, and in 1988 we organized our first distressed debt fund. Now we were investing in bonds that had defaulted or seemed likely to do so. We thought we might be able to buy them at bargain prices because of the cloud they were under, giving us the possibility of capital appreciation. Bruce has since become well known for his investing acumen, and, certainly, his returns since 1988 can't be attributed to the mere avoidance of losses. When you aspire to returns well above those available on bonds, it's not enough to avoid losers; you actually have to find (or create) winners from time to time. The returns generated by Bruce and his group show that they've done so.
Oaktree now has a number of what I call "aspirational strategies," meaning they need winners. So why do we still use the above phrase as our motto, and why is "the primacy of risk control" still the first tenet of our investment philosophy? The answer is we want the concept of risk control to always be top of mind for our investment professionals. When they review a security, we want them to ask not only "How much money can I make if things go well?" but also "What will happen if events don't go as planned? How much could I lose if things get bad? And how bad would things have to get?"
Risk control is still number one at Oaktree. Seventy-plus years ago, UCLA football coach Henry Russell "Red" Sanders said, "Winning isn't everything, it's the only thing." (The saying is also attributed to Vince Lombardi, legendary football coach of the Green Bay Packers.) While I haven't figured out exactly what that phrase means, I'm firmly convinced that for Oaktree, risk control isn't everything; it is the only thing.
Not Risk Avoidance
Understanding the distinction between risk control and risk avoidance is truly essential for investors. Risk avoidance basically consists of not doing anything where the outcome is uncertain and could be negative. And yet, at its heart, investing consists of bearing uncertaint