A Conversation with Howard Marks: Mastering the Market Cycle

Well, Howard, it's almost lunchtime, by your standards here, I want to thank you for coming and I want to talk for a moment about something that plays a very important element in

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s and then you've spent a lot of time writing about it. Before we get there, one of the big challenges that we all need to contemplate today is this area of ​​trying to understand finance and financial

market

s and many of you work in that area and I want to challenge each of you today because this is an area Howard and I could touch on the topic that we've focused on together for over four decades and that challenge is what people think, what their point of view is.

There's a quote in this book that Howard gives you from John Kenneth Galbraith talking about little funding or access. to the capital or financial

market

s as you know it, which plays little since people talk about history and what happened in history over the years and here it comes, why don't you tell us about it to start have it? Well, first of all, it's from a book. called the brief history of financial euphoria which I read a long time ago and which I recommend to everyone. It gives you a good feel for the sick ocala T for the behavior of the pack for the importance of the opposite ISM and and and it's an honest book in the sense that it's short and I enjoy it, but the point is that by investing in particular one of the outstanding characteristics is the lack of memory and the point is that we know a lot about history, but if we ignore history we know very little.

If we ignore the story then every time something happens again we have to start from scratch figuring out what it means if we understand the story we can include it we can do what I call in the book pattern recognition and we can say oh yeah that's like I saw that 10 years ago in 30 years ago and and that is and and then this is what is coming and this is what is developing and this is what will result, but most people ignore the history, most of the booms and I , you know, I've probably survived about half a dozen real booms in my 50 years in business they usually have to do with something new and the Internet in '99, the nifty, '50, Xerox and '69, whatever, titles of subprime mortgages and the people who get excited about it, who got caught up in it, who.

They are intoxicated by the positive and willing to ignore the negative if you tell them that you know well those types of things that happened 20 and 40 years ago and ended badly what they say is that they use the four worst words in the world, it is different This time the rules of the past do not apply. You know, yeah, the average P/E ratio historically has been 16, but now it's 32 and that's okay because the Internet has changed the world and something, so let's go back a slide. although if you will and what it says is that past experience, to the extent that it is part of memory, is discarded as the primitive refuge of those who do not have the vision to appreciate the wonders of the present and you know that if you you tell someone in '99 who is buying internet stocks that have no profits or sales and you know at an astronomical price they told you well you just don't understand it, you're a nebulous old man and the point is that the past is relevant and now can you show the next slide Michael because it was good, thank you and most of the time it's no different now clearly sometimes it's different, but not as often as people think, let's talk for a moment.

On this Reinhart slide there was a book written this time, it's different and it really relates to sovereign debt and credit, so I'm at Berkeley and I'm 65 years old studying credit and almost all sovereign debt is rated triple a and considered the least risky debt of all and the head of the Federal Reserve Paul Volcker and the 70s is telling everyone that no country has ever defaulted has ever gone bankrupt yet and it has absolutely nothing to do with history and I think I want just underline this point, then Howard has said Here, when you go back in history, ask yourself: have you done the original research?

What is common wisdom? You know, when I heard Paul Volcker in that period of time when President Volcker was speaking in the speech. I remember Howard was one year old and about 80 or 81. that Poland is not International Harvester, both Poland and International Harvester were trading at 31 cents on the dollar and his point was that Poland, as a country, countries do not default, I am not going to bankruptcy and of course International Harvester could go bankrupt, well he was right. but he was wrong. International Harvester paid you a hundred cents on the dollar, never stopped paying interest, and Poland reorganized its debt and the 30, so that for every dollar of debt you had 30 cents of sleep.

I was right semantically, I just wasn't doing well financially. Well, yeah, I just want to emphasize the importance of research and, Howard, let's go back to the late 1960s and early 1970s and when I went to Wall Street we had fixed commissions on stocks and the highest-paid people in the financial system were those that were generally stock sellers because when you bought a stock the charge was 1% if you bought a million dollars worth of stock and paid ten thousand today that could be $3.75 if you can't negotiate a better deal and for that's what they live during this period of time. but when you went there, here's a look, if you just want to buy five shares of Berkshire Hathaway and Warren Buffett, who is a good friend of Howard's and a good friend of mine, if you want to buy one share, you can see what you would have paid on that moment and what you pay now, so being in that business has been difficult once you entered an open market, but the problem is if you go back to that moment, the fundamental problem was sales and if you look at the pyramid on Wall Street When Howard and I came into this almost 50 year time period, the power was in sales, then it shifted to trading and if you stayed long and overnight you did some research to try to figure out what this is and what My approach was and Howard was one of the most representative individuals of this dramatic change that occurred, he was changing this pyramid, let's start with the research, the fundamental part of reversing your research, have you done the data?

So if you've come here today, have you scored? anything in the book, these little post-its that you might want to identify with and then we can go negotiate. Can you really buy it? It may be an interesting idea, but can you invest in Howard's case by buying a million dollars worth of something? it will not affect your wallets or your clients, so the point in trading is that there is a big enough market for you to play Kappa and lastly, you are now focused on the buying and selling process, but Howard reversed takes us back to his own business. career for a while and talk about why you chose to go to Wall Street how you ended up at Citibank when we met well you know I started my dad was an accountant and I thought he would come I actually took hi counting in high school and I liked it and I didn't admit it Well, I was in high school, but I went to Wharton and I thought about getting a degree in accounting, but then when I got there I started studying finance and I found it more interesting, so I changed and went to the University of Chicago for get a master's degree in accounting and when I left there I still didn't know what I wanted to do and I applied for six different jobs and six different aspects of finance, but I had had a good summer at Citibank the year before.

I like people. I liked what I did, so I went into Investment Research and it was nothing more. It wasn't much more of a conscious decision than that and that was it. It was in 1969 that he started in equity research and then became director of research and the bank engaged in what was called ingenious 50 investing: it invested in the best and fastest companies in the United States without regard to price, because if the official maxim was if it's good enough and it grows fast enough, it's worth any price, which is the complete opposite of what I think you believed Michael and if you bought the nifty 50 the day I got there at 68 and if you keep it diligently until 73 you will lose almost all your money in the best companies in America and there is a lesson in that, of course, that it is not what you buy but what you pay, but then in 78, because That exercise I was associated with was so successful, it was time for me to find the new job that I was lucky they didn't fire me and I moved to the bond department to manage the money and then in August of '78 I got a call from the head of the bond department and told me there was a guy named Milken or something like that in California. and he deals in these things called high yield bonds and can you understand what that means?

Now you know that today we take it for granted, we all know what they mean and in fact high yield bonds are quite common today but in those days they were a dark corner that very few people know about they were called junk bonds and by That's what I said I was trying to study them. I met with Mike in November of '78 and then came here to California to visit him in January of '79 for the first time. and now I'm investing in the worst companies in America and I'm making money steadily and safely and as a really important lesson that good investing is not a matter of buying good things but of buying good things, Howard, maybe I want do it.

Paraphrase what he has said. I'm not sure he's investing in the worst company in America. What he is investing in. I use it as a figure. Many great companies that have the wrong capital structure, okay, and so on again. focus on this, I want to take us back to the beginning and what focused on you, your children, your grandchildren, in a recent survey in the United States of people under 30, they asked people under 30 if they would have a better life than that of his parents. So maybe we could just show that slide here for a moment and have you think about what percentage of people under 30 in America thought they would have a better life than their parents, on what date in the last few months, okay?

You have chosen, we are not going to embarrass you here, but if we look at the answer you will see that it is a very low percentage and if you go to Western Europe you will see a very low percentage: there is no country over 30 years old. percent but as you travel the world if you are in China it is 78% and in Brazil despite everything that has happened and Turkey it is more than 50% higher than the United States as well as India and other countries and if you go to Mexico today, the net numbers are probably in the 80s, so the question is why do people feel that way, how do they feel? 90 percent are optimistic about the future in Mexico and therefore have a very different vision of the world and therefore one of the challenges. for finance and we're going to talk about it today as we talk about these

cycle

s is why do fifty percent of people under 30 think socialism might be a good idea?

Obviously they have not been studying what happened in Venezuela like you. I have destroyed an entire country, the country with the most reservations, and you yourself say well, why do people feel this way? The average person in America what their interaction is with the financial system, a student loan, and the student loan burden that is now approaching. -a billion and a half that is confining them while they think about their life and second a mortgage, either themselves or their parents, and during this period of time that we will talk about they almost lose their home or lost their home, so what is it? the financial system does it for them and this connection, but let's go back to Howard's accounting in many ways.

County as a language, understanding a balance sheet, reading those footnotes, etc., but you describe in the book some things that you felt were fundamentally necessary to being an investor. understanding cycle accounting was one, but as we talk about some of them, I think everyone knows that you have to understand the county, you have to know finance, you have to know something about history, but the most important thing is that they don't teach you. in business school psychology and if you go back and look at the past, if you look at a graph of the economy for the last 50 years, it looks like this: it has an upward trend and a very modest divergence from the trend, sometimes the you know that the trend is a 2 is a 2% trend line sometimes it goes up 3 and sometimes one at the extremes it is up 4 or down one or two very modest volatility if you look at the results of the company, the companies have leveraged themselves financially and operationally and your profits go like this if the economy goes up 2% profits go up 10 if the economy goes up 20% profits go up 30 and so on and so on and so on and if the economy goes down until then for a typical company maybe profits are down 15 so the earnings graph is much more volatile than the economy graph and then if you look at a stock market graph it looks like this why what's the difference?

And the difference is psychology and you already know Richard Fineman, the great physicist. He said that physics would be much more difficult if electrons had sensations We walk in the room We turn on thelight switch the lights come on every time we don't even wonder about it I wonder if they'll come on this time but the That's because the electrons follow this pattern, they never go there, they never say no, we're on strike, never They forget to move, they always do what they're supposed to do, but people have feelings and rarely do what they're supposed to. they're supposed to do and they often overreact to events that unfold and those extreme reactions caused this extreme volatility, they overreact to things and sometimes they don't react at all and sometimes they don't react like they should so I think if you want , it exists in the investment world and you want to get in, you can just buy and hold good things if you wanted to take that approach, but if you want to improve that, I think.

It's very important to understand the ebb and flow of psychology and act accordingly, so Let's look at it another way. I arrived last night around 1 o'clock from Ashland Oregon where they have a Shakespeare Festival and have done so for decades and you wonder why our people go to Shakespeare plays hundreds and hundreds of years later, why is it relevant ? What does Macbeth say what these are about? Well, we see it in West Side Story, but if we took a look at the place and talked about what the emotion is or what someone is going for in that play, Macbeth, self-deception, ambition, indecision, friendship, love, hate, prejudice. betrayal honor Duty all these human emotions that exist today and one of the things that is written about is what are some of the traits necessary for an investor to be careful to take advantage of the cycles and one of them is aggressiveness, so we could Go to Hamlin and talk about inaction, infighting, etc., what he wrote and how he would think.

One of the things that stands out to me and I think anyone who has read your work over the decades has been that simplicity is the ultimate sophistication and you point that out. you love to write and I think people love to read you because you express things that are often extreme, sophisticated and complex in easy ways, thank you and congratulations again for a great book, many people would always wish to write a book like Did you manage to say good Am I going to stop and write a book? Good question, well it all started with my notes to clients that I started writing in 1990.

I don't remember exactly why I started, it was a long time ago. I know I never said, you know, if I write to them, it will help, it will give us more business or if I write to them, you know, people will subscribe. I think I had something I wanted to say and I said. and the point is that one of the main reasons I write is because I enjoy it. I'd rather write that they're not and you know, Bill Graham from the Fillmore, which was a rock club on 270, said it only works if you'd rather do something else and I wouldn't do it and if you look at the memos and you can go online to oaktree capital calm and look at the memos and you'll see that there's almost always one that comes out in September and one that comes out in January, which means I wrote it over summer vacation and Christmas vacation and anyway I started writing these memos and with one ninety-one in 91 and maybe I didn't write one in 92 and in and For 10 years no one responded, I never had a response, not only did no one say it was good, no one said I received it and of course this was in the mail days, so we printed them, folded them and put them up. on an envelope, I addressed them and sent them and no one responded, but then in early 2000, on the first day I published a memo called calm bubble on technology stocks and it turned out that it had two virtues, number one was correct. and number one was right early, which is important and then after 10 years, like I say, I became an overnight success, but hey, it wasn't ten years, Howard, it was thirty years, yeah , maybe that's okay and I think this is something that I just want to emphasize that when we talk about a frame of reference or understanding of history, if you look at the hundred meter dash in the Olympics that a person runs in less than 10 seconds, you can ask yourself: well, it's a gold medal, etc., how long did you prepare that person?

They have prepared their entire lives for those ten seconds and so Boheme prepared an understanding that it wasn't the ten years and in fact probably the previous twenty even had more of an effect on you from that point of view and I just want to relate to something that was really important. . Howard talked about many of you who might choose to be in the investment business today. It was really this failure of the ingenious 50 that created modern money management. People gave their money to a trust department so a big bank could manage their money and, like Howard said, put you in these nifty 50 Stocks You Could Hold Forever and the fact that you lost half your money adjusted for inflation , half your money well, if you lost half your money playing it safe, what did you have to lose to go to the growth of the mutual fund industry or other small money managers that were born due to the failure of the security system traditional from that point of view, and so I just want to emphasize that there are very few accidents and Howard talks about luck and we'll get into it briefly, but there's a very famous quote, the harder I work, the luckier I get and what is luck, luck?

It's when opportunity meets a prepared mind, so I just want to come back to you, it wasn't overnight that you prepared for 30 years for that. So the memos continued and then we connected with Orrin Buffett about a transaction that came out of Enron and we knew that one of our main activities is to emphasize that investing in him had a position in one of the subsidiaries and we were a little bit bigger than him and so he gave us his power and said figure it out and we got a good result and that's how we really got closer in the early 2000s and then I wrote a memo, I think in which I made some reference to it and I sent it to him and I told him I just want to make sure you saw it and he says yeah I saw it and he says it was really good and he says actually if you write a book I'll give them a blurb for the jacket.

I always thought that when I retired I would turn the memos into a book, but when you have that from Buffett then you have to get to work and that's really the immediate reason why I wrote it and started it in 2010 and it came out in 2011 it was called Lo most importantly and you know, I always said that to Warren Buffett and on the front it says "This is that rarity, a useful book by Warren Buffett and those few words." I sold a lot of copies, so Howard, let's take a step back and talk for a moment about the most important thing about that book.

He listed a number of important things, but Market Cycles is the only book he has written on that list. Yes, why are market cycles good? Think that then the book says the most important thing, there are 21 chapters and each one says it starts by saying what the most important thing is and that it is a different thing because in investing there is not one important thing, perhaps you could argue that there is not. Do you know what the Lombardi thing was? Winning isn't seeing how many people in the audience know who the bard is. He is someone.

Well, we have at least a third. He said that winning is not everything, it is the only thing and as I say. In the book I'm not exactly sure what that means, but I think the two most important topics in investing are risk in cycles and they are connected because where you are in the cycle determines your for the medium term. The reason I think risk is so important is because I think the distinguishing mark between a great investor and a not-so-great one is not simply how good the return was, but how much risk they took on to get it.

If you know you can take it on, you can do it. Take advantage of an S&P today with derivatives or ets, you can buy any in ETF that goes up or down four times more than the SP or maybe eight times and if you buy that, you will enter a very positive period in the market you will have a return astronomical, but that doesn't mean you're a great investor because they'll say, look at that guy, he's up eight times as much as the S&P, guess what if it had been a bearish period. He would have dropped eight times more than SP.

It wouldn't have been worth it. He is not a good investor. I believe that an exceptional investor is someone who has good returns disproportionate to risk. Good profitability is born with risk under control. I think I actually think risk is the most important thing and in the book there are 21 chapters and there are three on risk, understanding risk, recognizing risk and controlling risk, but I also think that where we are in the cycle It influences greatly in terms of how much risk you will take and I'm not crazy about the title of this book. My editor encouraged me to do it because they thought that if we claimed to master the market cycle we would sell more books because everyone would realize I know they will get rich, but I like the subtitle and the subtitle puts the odds on your side, we don't know what it holds the future, I DO NOT believe in forecasts, in fact, Michael started with a quote from Galbraith.

My other favorite Galbraith quote is that there are two types of forecasters: those who don't know and those who don't know, don't know, and I firmly believe that and I'm firmly in the first camp. I don't know what the future holds and I don't think anyone does. The future can only be intelligently considered as a probability distribution. What is the range of things that can happen? Which is the most likely? Which others are likely? and which ones are unlikely and we described a great quote from Elroy Demson at the London Business School more risk means more things can happen, will happen, that's the source of risk is that the future is uncertain and so what if the future could be predicted in In theory, there would be no risk, so let's go back and try, so we're really talking about risk-adjusted returns and when Howard said, can you achieve returns with little to no risk?

And that's quite different from someone who is taking a lot of risk and so when we think about the world that we live in, today there has been a huge movement from active asset management to ETFs or passive asset management, but it's easy to understand what happened, what happened here, is that the market has gone up so significantly, and if you are fully invested, I mean, and it's an ETF by nature, you're 100 percent invested in any asset category, compared to a money manager who might be 50 percent invested and sixty percent invested, so in a rising market it's very difficult to outperform a person who is fully invested.

However, in a bear market that we haven't really seen in this growth of passive investing or ETF, what's going to happen is okay, obviously, you're going to fall more because you're fully invested, not necessarily hedged and you also run the risk. Howard Risk and I strongly believe in fundamental analysis. Would you like to touch on some basis on passive or short estimates versus fundamental investments and obviously your experience at Wharton and Chicago? We both lived for a period. and Demick, the life of this idea that markets were perfect, that no one could beat the market, our academic training, people won Nobel Prizes for it, they even won Nobel Prizes for telling you that capital structure didn't matter, etc. , so take us back to this debate, Howard.

Well, I was a student at Wharton and I learned the practical side of investing and then I went to the University of Chicago to do my master's degree and I learned the theoretical side and financial theory. The key theories had just been developed almost entirely in Chicago in 63 for that period was when they can't emerge and we learned things like Michael described one of the most important of which is called the efficient market hypothesis and what it says is that people, the market is made up of a lot of people who are highly motivated to get rich everyone is intelligent everyone is numerous everyone is connected by computer everyone is trying very hard and their search for bargains has the effect of making the bargains that do disappear. there are cheap stocks they find them, they buy them, they are buying they increase the price of the shares to their full value if there are overprices, they sell them, that reduces the price to the point where it is fair, so all prices are fair given because of the risk involved QED can't beat the market, that's the official conclusion of the efficient market hypothesis, and by the way, we were told empirically in Chicago that the average mutual fund hadn't beaten the market, but it charged high fees, clearly All together they cannot win. the market, so on average they were average, all investors are average, but after the high fees, everyone on average is underperforming and you shouldn't be in a mutual fund that is actively managed and has high rates, I should do it and they told me when I was a child, why not buy one of each heart in the ssu suggesting that neither of us were still cancer, neither of us are still children and we are not children yet, but they said Why not buy all the SP shares, right?

I didn't have a term for it, but about five and six years later the term index fund emerged and index funds began to exist and if the active investorThe average does worse than the market so it is better to be in an index fund that simply emulates the market index investing had a very slow start in the mid-1970s. Vanguard founded the first serious index fund, Jack Bogle, and still So it grew very slowly because we had to overcome the traditional resistance to moving things to automatic processes, and you know, that's how it is. I wrote a memo if you want to read about this topic I wrote a memo in June called investing without people and I talked about the historical development of index funds and I quote Ned Johnson from fidelity and he said that no American is going to settle for being below average now. , that's really I have nothing against Ned, but it's a great example of I think that statement lacks introspection or, alternatively, maybe it's a salesman's statement because of course you'd settle for average if everything What you could do would allow you to make yourself below average and for so many people, many people would have been better off if they had been average anyway.

The point is that high-priced active management across broad sectors clearly didn't work for everyone. much worse than low-cost passive investing than in the last 10 or 15 years the movement towards index investing and other passive forms Mike mentioned that ETS has gained a lot for Grint. traction and now 37 or 40 percent of all equity mutual fund capital is managed passively, but the most important thing I want to say before we get into it is that it is not that act that makes passive management so good. I think this happened because active management Management was very bad, well I also think it happened when you focus on cycles during a period when markets went up, that's true, interest rates went down, so it's a period of time where you wanted to be fully invested and we'll see how it works during a period of time where the markets go down where you are fully invested from that point of view, so how would you want to go back in time to your change career, moving from stocks to bonds, what if I took out the six credit lessons here? just take a look at them for a moment and try to relate them a little bit to investing and cycles, so that it's credit that counts, not leverage, and we might see, as we go through some of these cycles, what occurred at the end of a 708.

If financial institutions had triple A rated 60 70 80 to 1 leverage, we could look at real estate lending and looking at some of these cycles, real estate played a big role in the late part of the 80s and the problems. of his belief that it only raises interest rates, you know, Howard doesn't have a whole chapter on this, but who can predict interest rates? And very few people have ever done it and if you look at home prices, a Nobel Prize was awarded for pointing out in one hundred and twenty years, the price of a home went down 50 percent or went up 50 percent and this idea that you can leverage an asset 95 or 98 percent against one with that volatility and Howard writes about that and we'll come back in the book as we look at the others on that list here Howard, I want to go back to the end of that list of these six credit lessons and one of them was about sovereign debt, but anyone could have known that if they went back and we took a look and we could see that the last one is that debt underpins all markets and therefore we understand debt in recent years. days here in 2008 and today October 12th we have had a lot of volatility and one of the reasons cited for that volatility was the increase in interest rates, but let's go back to your point about risk.

Howard, can we generate rates of return with less risk? So if any of you play bridge or other types of games, your knowledge of the offerings and how people play will allow you to improve. your probability of success in the one-handed game and I remember Howard, one of the things I mentioned to you back in '78 was when you invest in stocks and you wrote about it later, it's a confidence of popularity if no one in the world agrees I agree with you. Unless you are willing to buy the entire company, you will not be successful and the exciting thing about investing in debt is that if no one else in the world agrees with you, but you are right, you will generate significant rates of return.

Talk about this movement as you think about relative risk and the stock and debt markets, or do you know that trends in the investment business appear over long periods and from approximately the 1960s to at least the year 2000, investment Stocks became more and more popular and bonds got less and less respect. I remember when I was in the investment research department at Citibank and they had these, all the young people followed Xerox, Coca-Cola and Polaroid and they had these two old guys from Germany who would sit in the corner and publish a statistical report. sheet about bonds every two weeks was difficult when there were no computers, but I remember and still have when they put one in the upper right corner in a box that says our last issue because everyone lost interest in bombing stocks where the best thing was growth and, now You know, everyone, the pendulum swung towards the fascination with growth, everyone bought more stocks, everyone, you know, and I imagined in the late '90s the CIO of a pension fund saying it right, you know? we have some bonds left, my predecessor bought them, no one can remember why, but we are getting rid of them, so when the year 2000 came and the tech bubble burst, everyone was in stocks, no one was in bonds, stocks fell .

For three years in a row, for the first time since 1929, bonds did very well, but no one had it, then everyone wakes up and says to hell with all this growth stuff, we want income and security, and now the pendulum swings toward the bonds and the truth about bonds. What all the people forgot in the stock mania is, as Michael says, that the return on investing in stocks certainly occurs in the short term due to changes in popularity. You find a stock that you think is worth 20 and you buy it for 10, as he says, if no one comes.

To agree with you, it stays at 10 for the rest of your life and you don't make any money. The good thing about bonds, which very few people understood, is that with bonds or debt your income does not come from your income. the market comes from the issuing company it is a contract with the issuer you give me money now I will give you X interest per year for the next X years and at the end of X years I will give you your money back it is a contract and if they stay in business they have to live up to that contract, if they don't live up to the contract you get the company, that's a slight exaggeration, but the point is that bond returns are contractual and reliable, and that's very different and The expected return on stocks is higher than on bonds because they are riskier as they should be, but the uncertainty with respect to stocks is enormous, whereas the uncertainty involved in a contractual relationship with a solvent company is not enormous and this is what people overlook now of course I think bonds have gained appeal and popularity and especially loans that are senior in their companies and floating rate so there is no interest rate risk and as any other investment, there is a risk of becoming very popular, so let's take a look for a moment at this period of time that Howard talks about as his transition from equity debt investing, trying to reduce risk and generating rates of performance in a time period that I often refer to as the The most important period in modern financial history, this period from the early 70s to the mid 70s and the particular year that I would focus on is 1974, This is a year where the stock market fell 50%, interest rates doubled and this was kind of the end of the financial structure as we knew it based on a banking system and one of the keys that potentially eliminate The risk is that once your economy is no longer financed by a banking system but by tens of thousands of institutional investors, it will change energy prices right now. it doubled and the stock market went down substantially and if you remember Howard it was one in late '79, but the one I especially remember was the one in late '74 where no one would ever buy a stock again.

Well, what would Howard say to you? notes that it's time to invest in the market at the time it was on the cover of Businessweek what this result was in 74 companies with the highest rates of return, those growing companies were denied capital as financial institutions had They have to focus on saving themselves. Yes, therefore, this stopped. job creation jobs were lost and as financial institutions weakened in many ways, if we move to the next slide, these things happened and finally modern financial markets were created and companies are now financed in the public and private markets Because if you were the head of a company, would you want your business to depend on the strength of the financial institution that is lending you money?

So they're in trouble, you're in trouble, and the Asian crisis of the 1990s started in Thailand, where an entire economy was funded. for five banks and when they were in trouble, but is this the world Howard has lived in during this period of time? Basically, public and private markets have replaced banks as financiers and the banks shrank by an inflation-adjusted 50 percent in the 1980s, but the country grew from that standpoint, so, Howard, I I would like to take a look at a lesson that you and I talked about if we go back to say 73 before the bond market really crashed interest rates to 76 and 2008 to 2011 if we could take a look at how common they are those time periods on one slide, so take us back to 2008 2011 and this is the slide that Howard's firm oak really took advantage of in this time period for me, he was on TV telling it.

All of us who have already been through this are just a repeat of the challenge in life: how many people in the financial markets in 2008 even remember the early and mid-1970s, as Howard rightly pointed out, it's interesting, obviously, to have been in the investment business. no.8 and to have the experience of 74 you had to be working by definition for 34 years but the truth of the matter is that the investment business was terrible in the 70s you couldn't get a job in the 70s, I know. people, grad school classmates of mine who wanted to go into the investment business, but instead of getting out in '69, when I did, they came out and said they couldn't get a job in investing for life and they went into it. to other fields, but the point is that you had to have your job in the 60s and that means bio 8, you had to work more than 40 years, how many people worked more than 40 years, so by definition the group of people with recognition of the past The pattern is very small and you clearly know that we run into very difficult problems.

Overinvestment in high leverage in subprime products in 056 caused the loss of some of the largest banks and investment banks and people started talking about the end of the world and stock prices melted. of loans melted and activity froze because everyone was unsure if there will be a tomorrow if I buy something today there will be a market tomorrow it will have some value tomorrow and all the quiddity dried up and like I say people were talking about the end of the world and it was the steepest cycle we've ever been through, but still there was really no reason, I mean, I kept thinking about what Roosevelt said, the only thing we have to do. fear is fear itself people were just afraid they weren't afraid of anything rational they were just afraid and what you had to do is keep your wits about you and you know one of the hopes is that if you read history if you Read the book, if you understand the cycles, you will be able to reduce the emotional influences at that time and eliminate them, and maybe we will just tell you to keep your wits about you, so we conclude at the end of Oh, eight after the bankruptcy of Lehman Brothers. markets in free fall, you know whether the financial world will end or not and what we said was that it is difficult to predict the end of the financial world if you conclude that the financial world will end and it is difficult to have any idea what to do and most of the time the financial world doesn't end we also did a very simple calculation if we buy or not well if we invest and the financial world ends it doesn't matter but if we don't invest and the financial world doesn't end then we didn't do our job so you know here we are in an environment where people really had no idea what was coming next and we're talking about the end of the world and I thought the analysis was pretty simple. that we had to buy, so at Oaktree we invested six hundred and fifty million dollars a week in the last fifteen weeks of Oh 8, that's about 10 billion and that'sreally all you had to do, it almost didn't matter what you did, as long as you bought and it was a moment in the cycle and these moments appear from time to time when you don't need conservatism caution risk control discipline patience or selectivity you need money and the courage to spend it and if you had money on earth to spend it at the late eight o'clock in the credit market or early nine o'clock in the stock market, you've made a lot of money and by playing that cycle, I think is a frame of reference, it was 1974 and I was on this panel of institutional investors with one of the leading professors in the world of finance and he pointed out that his z scores, if you remember those, Howard predicted that 700 of the roughly 2,000 largest companies of the United States would go bankrupt.

He had pointed out that if you studied the Depression in history that wasn't going to happen and then made one hundred percent of your money in seventy-five or six with no leverage, you would just find it similar to the opportunities that Howard had identified in Oh 809 and I I was on a panel with him at 77 and it was very interesting because he pointed out that his z-scores had predicted the top four bankruptcies that had occurred in the previous four years, but if you hadn't been at the previous session you wouldn't have realized that. he had predicted seven hundred to include four and I think that's the problem and Howard, one of the other areas that I think might be interesting for you to mention is it's interesting when you think about what happened in this session of Oh Wade, We All Should I totally understood it because we had a trial in 1985 86 87 88 when the house price went down when the oil price went down and almost every major financial institution in Texas didn't survive all those triples and most of them were in Louisiana or Arkansas and necklace, I have no problems because the price of housing fell by up to 50% and therefore I completely understand what can happen when the price of residential real estate, the United States, more than any other country, should have understood this completely.

Getting into the last Oh 8, but the point I really want to address Howard is when we think about S&P ratings and we rate over 14 15,000 stocks.triple-a there are only about three companies in the United States that are triple-a by both , but when you look at a rating that rates something Triple C or simple B, you discover that yes it could be a triple C with a hundred, but it can be a Triple A at forty but the reign is still the same and how do you take that into consideration, for very well that you know if you take anything away from today, I think that is the most important point, as I said before, it is not what you buy, it is what you pay and the great revolution.

I think about the period we're discussing here when the Nifty 50 were the big companies and, although they failed as investments, and when the, let's say, low-rated companies on high-yield bonds. The world succeeded in an investment, the great transition is from the belief that good is good and bad is bad to the belief that anything can be good at a price and it is a huge sea change that has dominated the last few 40 years and I mean Michael was really at the forefront of that change and it should not be underestimated when I got into the high yield bond business in 1978, you know, I wanted to find out what we're talking about here and in those days of course .

We didn't have anything computerized, so if you wanted to study bonds you had to go to something called the Moody manual. Moody's Manion was a book literally this thick with the thinnest paper in the world, onion skin it had, it was billions of pages and it had all the data on all the countries that had bonds outstanding, so you take it off the shelf and you find this one ready to triple a single a single B triple C and I said well, what does that mean? So I went to the front where they defined the ratings and this is what it said about a single B bond, which is most of what you originated, most of what I bought in a single day does not have the characteristics of a desirable investment now, if I took Jim Williams out on the street and if he did need a car and I had a car that I wanted to sell and I showed it to him and said, Jim, would you buy my car?

I'm Jim Williams, he's with us today, he runs the chief investment officer of the Getty trust, all there is great work, that's why we focus here on October 12, 2018 on Jim Williams, if I told him would you buy my car, hopefully there would be a question you would ask before you say yes or no, what is it, what is the price? Moody's was saying that. Rated bonds are bad investments regardless of price and really the big realization of the last 10 to 40 years is that almost any asset can become cheap enough to be a good investment and most investments can become so expensive that They are a bad investment. and the revolution of the high yield bond industry was really to say "look if we had Moody's prevailing view that a B rated bond is a bad investment then by definition a B rated bond couldn't be issued." and in those days, you couldn't issue a bond rated below investment grade, meaning it will be below ride grade, it was not appropriate, the only way to have bonds rated below triple B is If they were issued at investment grade and then went bankrupt, we call them fallen angels.

The revolution that was effected in the high yield bond industry primarily by Mike and others and that has appropriately dominated the last 40 years is that if it is one. risky company, you don't like me to tell you that if a highly leveraged company issues bonds that have some risk due to high leverage, it is okay to buy them if they offer enough interest to compensate now that seems like such an obvious statement that for every bond of every risk There is an interest rate that is compensatory and an interest rate that is excessive and yet this was a thought that was absent before '78, when everyone thought that the path to success as an investor was to buy high quality assets. and, by the way, at any price, and now we look back and think. how stupid it was, then, to take you back to hmm, the firm I joined in the late 1960s was the world's leading research firm Paul Miller, who MA Oh Howard was the head of the clothing committee of Penn long before Howard took over from J Sheridan.

Clay Anderson, etc., and they were the leading equity firm and I told them what about debt and like Howard was saying, was the debt of the '60s really a big investment or was it private and the insurance companies rated it as no? a great investment, a great investment because it was internal. The way they looked at it, I went and took a look at the recommended list of stocks and 80% of them would not have been great for investing, so understanding this capital structure. I would end the story by telling them that the company had the top airline and aerospace analyst ranked number one in the country and he was recommending TWA and I said, you know, weed, it's interesting, you're recommending TWA, you know we're buying TWA for converts to twenty-five cents on the dollar and he told me that he didn't know that they had convertibles outstanding, so the focus on capital structure was not something that you really focused on, you know from that point of view, and I want to go, if I could , for a moment, to the capital structure.

Howard and I think one of the things that you have pointed out at your company is that your company is willing to make an investment where you are the first lien and present the issue to a private equity company or the market, which if you don't want to To pay me just give me the keys and many firms were quite surprised in the case of Regal cinemas for example KKR was the owner and in you and Phil and the shoots company mentioned the father and I remember them telling me that he was surprised when you called . him and said: well, give us our money at par, okay, your hand is the keys, you choose and, by the way, it took him a long time to give you the keys.

Can I interject here, sure that one of the reasons Donald Trump remained solvent is because the banks had lent him the money for his casinos they said we want our money he said I'm not going to give you the money but you can keep the keys and they were so terrified take the keys that they said no, no, it's okay. I can go on and tell the real story now, so capital structure, Howard, you know? I think that both you and I feel that this enormous volatility is very important in the 1970s, half of the value that a company could have was when it was financed, how it was financed, and that's how we got there. through a period here with no covenants, extremely low rates, so if you don't have covenants, it's hard to default unless you can get to maturity from that standpoint, talk to us about how you view the capital structure and the risk.

I think that, as Mike says, for a long time it was ignored that to give a certain company there can be a good company, a capital structure, a bad capital structure, if you want to start a company and you need a hundred million dollars and put a hundred million dollars, that's viable, but it may not be optimal because maybe you could have borrowed some of that money at three percent, which would increase the other money's return on equity, on the other hand, if you say I want to start a company. I need a hundred million dollars.

You go to the bank and they give you ninety-nine. If the value of the company decreases by a small percentage, you are insolvent. You have lost all your capital. In that case, the capital structure was wrong because the business was too volatile to have a highly leveraged capital structure, so of course one of the things that came out in the '70s that people have made a science of Since then it is to obtain the optimal capital structure for a company the higher the company is. the higher the leverage will be the return on equity when things are going well the lower will be the leverage the higher will be the probability of getting through tough times, so you have to optimize that and it's a serious pursuit now, the doctors will tell you. who could calculate the optimal capital structure using an algorithm.

I think it's better a judgment call because, among other things, since capital is what gets you through tough times, in my opinion, someone has to judge how hard the tough thing is. How bad of an environment do we have to prepare for what's the right capital structure for that? So for my part, I did my credit work at Berkley and then I focused my master's work on capital structure in the late '60s and I think we'll see Going back to the current period, if you're borrowing money and four and three-quarters without clauses for seven years, is it an asset or is it a liability for the lender, right?

Yeah, did you read the last memo? Yes, I posted a memo two weeks ago. recently titled the seven worst words in the world now remember the four worst words in the world where it's different this time the seven worst words in the world is too much money chasing too few deals and I think that has been descriptive of our environment the last In a few years and when there is too much money in the hands of the finance providers and they are too eager to put that money to work, bad things happen and interest rates go down and they take risks because if you don't have covenants, then you have a defective instrument and a higher probability of losing money as a lender and I think that's what happened, but this is one of the many things in the world that is cyclical and I think we will see a cycle in this, should we take some actions? questions now we are going to answer some, but I just want to comment.

If you want to look at 77 to 79 pages into the book, you'll see Howard's comments on capital structure. Why don't we answer a couple of questions? This morning's question to Howard, so Jim Williams, chief investment officer at the Getty, asked us a question about agreements: Are our agreements cyclical? of the companies because, first of all, the more money there is in the hands of the lenders and the more eager they are to get it, the less ability they have to demand agreements because of the competition for lenses and the other thing is that there is a chapter of the book that talks about the cycle in attitudes towards risk and attitudes towards risk change volatile ii and and with great influence and when things are going well what do people say?

Risk is my friend the more risk I take the more money I make and My goal is to optimize, maximize risk and by the way I don't think there's anything to worry about so when people feel that way they clearly feel good. I can do without the conventions because I don't see anything to worry about and then when things go bad for a while, what do they say? I hate taking risks. Taking risks is just another way to lose money. I don't care if I ever make money in the market again. I just don't want to lose anymore.

Take me out at any price and when people are terrified and have sores due to risk aversion, then they demand risk premiums and they can get them because there are not many people competing to get money, the fewPeople who will put up money can be picky and get what they want in terms of covenants, so I think it's very cyclical and is mainly due to the demand side. I think this is a really important point beyond how it is made, the value of a security could depend more on the covenants than the interest rate. Yes, and understanding that problem, then in some cases it is the agreements that give you a form of full recovery, Mike.

I think we are for people who are not credit professionals. I think we should say a word about what conventions are. Covenants are protective talk. in a bond deed debt contract that requires the borrower to meet certain standards, so there are two types: Incurrence and maintenance, Incurrence means that you had to satisfy certain standards on the day the debt is incurred, and Maintenance means that it must meet certain standards throughout the outstanding period of the loan and clearly these, you know, the covenants do not protect the company from falling on bad times, but if it falls on bad times and violates a covenant, a maintenance agreement, then the Creditors have the opportunity to become active and make certain demands and gain influence and so on, so the presence of maintenance agreements limits the deterioration of a credit and in profits, sometimes people stop demanding maintenance agreements, we get what is called covenant light as we are now and that means that the operations of the company can deteriorate during the outstanding period of the debt and as long as they continue to pay the interest, the creditors have no influence and what that means is that if there is ultimately a bankruptcy there will be a lot There is less to recover from and I would say that today, at the end of 2018, they are one of the riskiest areas.

It's three times the lowest level of investment grade where there are no covenants and we've all seen it throughout history with a lot of private equity people. in the room that you can use that debt without any agreement to be at the bottom of the pile and a redo of the capital structure by the way. I want to tell you a story that I don't think I've told you, but I was Once, speaking at a Wharton credit conference at the University of Chicago, someone asked what the role of rating agencies is and I said the role of rating agencies. rating is being wrong because you have to see when they issue a rating that is too high or too low, it gives us something to shoot against tonight.

I think today, for the audience, you think about ratings, credit and capital structure, so Uber is selling debt, its first real public type debt, it has fifty sixty billion dollar valuations and little to no debt. has the Triple C rating, about the lowest rating that can be given to it, why is it not bankrupt, so the stock markets perception of enormous growth Tesla, a company that is also worth 40, 50, 60 billion dollars, has debt that is listed on Triple C, we work in a company that read about today and on October 18 that someone wants to buy the entire company for twenty billion dollars has an issuance of the outstanding debt has a Triple C rating So what is this dichotomy between companies worth $20, $40, or $60 billion with little or no debt?

I think if we go back and listen and read this book about markets, we'll see that many industries have so many There's a lot of risk that even though you think they're valuable, they may not be able to borrow from that standpoint, let's answer one or two more questions. . Yes sir. Well, I think the response to the financial crisis was excellent. I think the financial crisis had the potential to really produce a depression and if you read Hank Paulson's book you know you'll see that he was terrified and what he was telling people was of no use, you know there was a newscaster that I did a little bit may have been Walter Cronkite, who once said that if you're not confused you don't understand what's happening and I told people in the eighth grade, if you're not afraid, you don't understand what's happening.

I mean, we were very leveraged, the banks were in free fall and it seemed like there was a vicious cycle and I think Paulson Bernanke and Geithner did great things aggressively and they worked, so I know there would be someone who would question anything they did like an idiot and we are in the clear visa V, the global financial crisis and clearly, especially in this country, you know that the other countries did not take the measures that those three took or as early or as aggressively and the other countries are not doing as well as us and have not recovered to the same level, so the direct effects of the global financial crisis are over and we are doing quite well, we are in the tenth year of economic recovery, the tenth year of a bull market, etc., However, the actions we took to get out of the phonetic global financial crisis were extreme and similar, like all those medications that they advertise on television, they have side effects and now we don't have to stop the medication and you described it, I think so. described it as an experiment and if you do an experiment for the first time it's crazy to say you know how it's going to go there, there was never a stimulus exercise to the extent of QE and rate cuts had never had rates at zero before and Now that we are trying to reverse the influences and sell the bonds, the securities that were obtained through quantitative easing and bring interest rates back to normal, there is no telling what the world will be called.

Central banks that have $22 trillion on their balance sheets now probably quadruple what they had under normal conditions. They have to finish. How is it going to go? What will be the fact? I can not tell you. Over the last year or two, I've gotten a lot of questions and you can usually tell what's going on in the world from the questions because usually at any given time a lot of people are asking the same question and one of the questions they we've been getting for the last two years is what could go wrong, you know everything is going swimmingly, but we know it won't go well forever, which could bring it to an end and clearly an unspecified miscalculation on the part of the Federal Reserve is one of those things that I don't know enough to know what the mistake would be, but we know that when you do something based on precedent there can be a mistake.

I would say you can do research, so what is the research? Let's look at the liquidity in the world, Howard said there is 22 trillion in the hands of the Federal Reserve banks in the world. Well, there are 26 billion in deposits from Chinese citizens. There are 17 trillion zero-yielding deposits held by Japanese individuals. Japanese financial institutions today have changed dramatically, but so have corporations and corporations in Japan own 6 trillion US dollars. in cash one hundred and twenty percent of the country's GDP Individuals in the United States the percentage of their assets in cash is double what it was in oh seven oh eight and that is why one of the challenges in the world is this enormous liquidity of the that Howard has spoken. today that has driven up acid values, but we still have trillions of dollars invested at negative inflation-adjusted rates, so we are not where we were in seven or eight and lastly, I asked each of you where you would keep your assets today and if you are a citizen of China, for example, what percentage of your assets do you want in a different currency in a different country?

Do you want 20%? Would you be willing to transfer five trillion assets into US dollars today? And when you've seen the volatility of the currencies One of the things that you think about in the US financial markets is who wants to convert their money into US dollars so they can get it in two ways: can I just have cash in the bank or can I buy a US dollar. government security that pays me more than zero and that is why we heard Howard today talk about the liquidity in the world that has driven up asset prices, but this liquidity exceeds the amount that central governments have in assets today and that is one of the challenges. let's take another question yes sir I really haven't spent much time on that I don't have a good answer maybe the Institute has a great effort on that Ariane no our Financial Markets Center has been one of the leaders in creating those opportunities are their own and yes If you are interested, I am sure you can go to the website and take a look at this.

In reality, it is more related to the reconstruction of areas of the country. Encourage their attachment. One more question. Know. I get that question. many and in particular have these tactics artificially elevated to level the bar. I don't believe it. I'm not an expert on this, but you know, if you look at algorithmics, for example, these guys buy and sell massive amounts at a fraction, so I don't see how to constantly buy, buy, sell, buy, sell, buy, sell, Pacific the market could buy us in any direction. I just don't see it now, passive, outside and index investing is the key.

I also think that in itself does not increase the level of the market, but what it does is turn certain stocks as popular and certain stocks as unpopular, let's take the extreme example, all the money that will flow into the stock market in the next ten years , it will flow into the S&P index funds, which means there would be enormous demand for S&P stocks, they would go to outrageously high prices, there would be no demand for other stocks, they would fall to too low prices, so clearly the effect is that when that will be seen, when there is passive investment and an index, the key is that nobody ever says if the money should go to that stock and if today's price is fair if it is in the index or in the passive recipe in which goes, regardless of the merits of the company or the equity of the The price is so clearly passive and index investing has the potential and probably has been biased in the market in terms of causing some stocks to rise higher than they should be and some stocks go down and you know if Amazon, for example, is held today by value and growth ETFs.

High quality ETFs and ETFs, and you know, big company ETFs as a way to attract money when people change their minds and want to know who is going to buy those stocks, if the buying were on autopilot, driving up their prices, who and what. buying is going to counteract that, so I want to separate your question into two parts just for today's audience: a passive investment and Howard really stopped here on not making any value decisions, but the algorithm, let's call it AI investing, is quite different, you have people. all over the world writing algorithms to try to predict what happened at closing.

I want to discuss an area that I want to emphasize to each of you. If you read this book, you will learn about many market cycles and how it details what happened in these cycles and I particularly focused on this eighth cycle until today, but looking back at other cycles, when we talk about risk and try to minimize the risk, you know there are many types of risk, walking out the door of your house is an arrest, the probability of driving a car is a The risk of flying on an airplane is a risk and everyone makes a decision every day about what the risk is and so one of the things I want to go back to is where Howard started and where this book is so important is understanding the psychology that you have.

Chicago psychologists who won the Nobel Prize in Economics for trying to understand psychology and if you think about it, we had a period of time and one of the other risks is regulation and understanding regulation because you can implement regulations that put any company in out of business any industry out of business by changing the rules if we go back to another point in history when the nobility in England could no longer compete with the merchant class what did the nobility do? They went to the king and said we need new There are rules that allow us to compete and you're not allowed to compete, and Howard and I lived through a period in the latter part that started in the mid-1980s that I call neutron legislation. .

It's okay to lend money against a building, but you can. I didn't lend money to a person who was going to occupy the building and remember there are only 4 or 500 investment grade companies in the United States out of millions, so legislation was introduced and Howard and I had an opportunity in Washington and I think I was there six to visit to prohibit the ability to invest in non-investment grade debt by pension funds, mutual funds, insurance companies, etc. and introduced the prohibition on interest deductibility, so if you were not investment grade you couldn't deduct interest, if you were investment grade you could and basically it was introduced and these memories are indelibly etched in my mind and I think Howard was what surprised you and that's why I want to emphasize the importance that Howard plays and taking complicated things and making them look like you can understand them because if we don't make the citizens of the United States understand the financial system and whathas created for us, then you can be sure that in a democracy they will vote for another form of system like what happened in Venezuela several years ago and so on.

Howard and I spent a year or two trying to educate people that most of the jobs in the country were created without investment grade and why we want to prohibit access to capital for companies that are growing in today's world. saying you can't buy any excess debt, you can't buy any Tesla debt, you can't buy Weworks debt, etc., we're talking about a lot of your tech companies not being investment grade, no matter what their current market is. . Howard, what were your memories that you've taken today, where you know 35 years later, almost from that period of time and how did that influence your desire to write to try to explain these things well?

Look, I wish I liked them. I think since we are a democracy, it is better that we have educated the voters. You know, right now, among the Hmong, the Millennials, most people think that socialism could be a great idea, you know? And it's easy, it's easy to stand up and say, "You know we should." have universal health care, we should have free college education, you know, my late stepmother used to think that everyone should have vacations and a color television and all these things would work well and attract a lot of voters, but you have to understand it. the consequences, yes, things have costs, you know, economics is really the study of options and you have to make decisions.

Do you spend? You can't do everything you want, spend your money here, here or here, and if you want to spend the money where. you'll get it from these are these are all the topics that people should be educated about if you put it in a question where do you think college should be free that day or not? most people would have no incentive to Say No, but at what cost and with what consequences, so I'm with you in terms of wanting an educated population, so to close today I just want to show you a graph of this cycle, Larry , if you have that graph showing high performance performance later.

From the '80s to the early '90s. I'd like you to stop it for a moment and here's a cycle where this legislation caused a dramatic change in the market and once the country realized it was eliminating the hundred percent of all job creation, was reversed. in the next year, let's put 91 here, then you made forty percent in one year on your money, this was not induced by a market cycle that Howard talks about, but by a legislative cycle and I emphasize that it is important to understand that the good governance is important. Good management is important, so to close Howard we had several people come here today and one of the reasons they came today was to get your signature on their books, so at what price?

Well, I guess if everyone lines up, I'd love to do it. do it, okay, great and I think we appreciate it and I don't think you fully realize the importance of writing and trying to make complicated things and finances understandable to the general public, so thank you, thank you Mike.