Howard Marks, Oaktree Capital — 2024-05-08
-
Japanese
-
Korean
-
Simplified Chinese
-
Traditional Chinese
Memos from Howard Marks 2024-05-08T07:00:00.0000000Z" pubdate title="Time posted: >5/8/2024 7:00:00 AM (UTC)">May 8, 2024
- PDF (English)
- PDF (Translations)
- Listen to Memo
- Archived Memos
Subscribe
My partner Bruce Karsh recently supplied me with a newspaper article about chess that inspired me to write a brief memo called
The Indispensability of Risk
. The response to the memo was favorable, hopefully because people found the content valuable, but quite possibly because it was only three pages long versus the usual ten to twelve. Thus encouraged, I'm following up with another short memo.
One of my more interesting sources for readings on practical philosophy – including investment philosophy – is the blog from the Collaborative Fund to which Morgan Housel, a fund partner, is a regular contributor. As I read Housel's musings, I often find myself saying, "that's right in line with what I think." And at other times, I say, as I hope others say after reading my memos, "I never thought of it that way."
I found Housel's April 30 article, entitled "How I Think About Debt," particularly interesting. The subject is the impact of debt on longevity, and it really boils down to a discussion of risk, one of my favorite topics.
Housel starts by discussing the 140 businesses in Japan that are still operating more than 500 years after they were founded and the few that are purportedly more than 1,000 years old.
It's astounding to think what these businesses have endured – dozens of wars, emperors, catastrophic earthquakes, tsunamis, depressions, on and on, endlessly. And yet they keep selling, generation after generation.
These ultra-durable businesses are called "shinise," and studies of them show they tend to share a common characteristic: they hold tons of cash, and no debt. That's part of how they endure centuries of constant calamities.
Clearly, all else being equal, people and companies that are indebted are more likely to run into trouble than those that aren't. And it goes without saying that a home or car that hasn't been used as collateral for a loan can't be foreclosed on or repossessed. It's the presence of debt that creates the possibility of default, foreclosure, and bankruptcy.
Does that mean debt is a bad thing and should be avoided? Absolutely not. Rather, it's a matter of whether the amount of debt is appropriate relative to (a) the size of the overall enterprise and (b) the potential for fluctuations in the enterprise's profitability and asset value.
Housel frames the issue by introducing the idea of potential volatility over one's lifetime: "Not just market volatility, but . . . world and life volatility: recessions, wars, divorces, illness, moves, floods, changes of heart, etc." With no debt, he postulates, we're likely to survive all but the most infrequent, most volatile events. But in a succession of illustrations, Housel shows that as the level of one's indebtedness increases, the range of volatility one can withstand narrows, until at a very high level of debt, only the tamest of environments are survivable. As Housel puts it, " as debt increases, you narrow the range of outcomes you can endure in life. "
Housel's approach to thinking about debt – and especially his illustrations – reminded me of my December 2008 memo,
Volatility + Leverage = Dynamite
. (Unless otherwise indicated, this memo is the source of the quotations that follow; in all cases, emphasis is in the original.) In that memo, I used a series of simple graphics to show that the lower a company's debt load is, the greater the decline in fortune it could survive. And I made the following observation about the root cause of the Global Financial Crisis, which was in full force at the time of the memo:
. . . the amount of borrowed money – leverage – that it's prudent to use is purely a function of the riskiness and volatility of the assets it's used to purchase. The more stable the assets, the more leverage it's safe to use. Riskier assets, less leverage. It's that simple.
One of the main reasons for the problem today at financial institutions is that they underestimated the risk inherent in assets such as home mortgages and, as a result, bought too much mortgage-backed paper with too much borrowed money.
Portfolios, Leverage, and Volatility
The reason for taking on debt – i.e., using what investors call "leverage" – is simple: to increase so-called capital efficiency. Debt capital is usually cheap relative to the expected returns that motivate equity investments and thus relative to the imputed cost of equity capital. Thus, it's efficient to use it in lieu of equity. In casinos, I've heard the pit boss say, "The more you bet, the more you win when you win." Likewise, for a given amount of equity capital, (a) the more debt capital you use, the more assets you can own and (b) the more assets you own, the greater your profits will be . . . when things go well.
But few people talk about the downside. The pit boss never says, ". . . and the more you lose when you lose." Likewise, when your assets decline in value, the more leverage you've employed, the more equity loss you'll suffer.
The magnification of gains and losses stemming from leverage is typically symmetrical: a given amount of leverage amplifies gains and losses similarly. But levered portfolios face a downside risk to which there isn't a corresponding upside: the risk of ruin. The most important adage regarding leverage reminds us to "never forget the six-foot-tall person who drowned crossing the stream that was five feet deep on average." To survive, you have to get through the low points, and the more leverage you carry (everything else being equal), the less likely you are to do so.
. . . it's important to recognize the role of volatility. Even if losses aren't permanent, a downward fluctuation can bring risk of ruin if a portfolio is highly leveraged and (a) the lenders can cut off credit, (b) investors can be frightened into withdrawing their equity, or (c) the violation of regulatory or contractual standards can trigger forced selling.
Obviously, the greatest leverage-related losses occur when the potential for downward fluctuations has been underestimated for a meaningful period of time and thus the use of leverage has become excessive. Generally speaking, "normal levels of volatility" – those seen on a regular basis and documented through historical statistics – are used in investors' calculations and reflected in the amounts of leverage they employ. It's the isolated "tail events" that saddle levered investors with the greatest losses:
The problem is that extreme volatility and loss surface only infrequently. And as time passes without that happening, it appears more and more likely that it'll never happen – that assumptions regarding risk were too conservative. Thus, it becomes tempting to relax rules and increase leverage. And often this is done just before the risk finally rears its head. As Nassim Nicholas Taleb wrote in Fooled by Randomness :
Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet, under a numbing false sense of security . . . Second, unlike a well-defined precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality. . . . One is thus capab