[00:03:05] Shawn O’Malley: In the original 1990 memo, Marks goes on to reference his experience working at a mutual fund in 1987, where the fund massively outperformed its peers by investing heavily in stocks and then narrowly avoiding the 20 percent Black Monday crash of 1987 by proactively going into cash at a time when others weren’t.

[00:03:23] Shawn O’Malley: Going their own way had paid off in 1987, but completely backfired six months into 1988 negating all of the outperformance from the year before. Marks’ conclusion was the opposite of the portfolio manager mentioned a minute ago who thought that to be a top investor, you have to be willing to tolerate terrible years of underperformance.

[00:03:42] Shawn O’Malley: Mark says, quote, in order to strive for performance, which is far different from the norm and better, you must do things which expose you to the possibility of being far different from the norm and worse. So, bold decisions for the sake of great performance can just as easily be devastatingly wrong. On top of that, you may find yourself having above average and below average years that average out to produce mediocre returns while experiencing stomach churning volatility along the way.

[00:04:09] Shawn O’Malley: A pension fund director named David Van Benshoten is most responsible for influencing Marks’ thinking on this. He found that even though his pension fund never finished in the top decile of returns in a given year, consistently ranking in the top half of return distributions earned them top decile returns over longer periods.

[00:04:28] Shawn O’Malley: Van Benshoten told Marks that they never had a year below the 47th percentile for returns over a 14 year period, or until 1990, above the 27th percentile. Yet those steady, modestly above average returns place the fund in the fourth percentile for the 14 year period as a whole. Marks concludes this short memo by stating that he, quote, feels strongly that attempting to achieve a superior long term record by stringing together a run of top decile years is unlikely to succeed.

[00:04:58] Shawn O’Malley: Rather, striving to do a little better than average every year 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. My takeaway is that when investing in stocks, if you can avoid losers and losing years, the winners will take care of themselves.

[00:05:21] Shawn O’Malley: Swinging for the fences is by no means the most viable strategy for long term success in investing. So that’s Marks’ first memo to investors, which tens of thousands of investors worldwide, if not more, now eagerly read when they’re published every few months. Last September, 33 years later, Marks revisited his first memo and built on it in a memo titled fewer losers or more winners.

[00:05:46] Shawn O’Malley: He explains that in the years since his first memo was published, the phrase, if we avoid the losers, the winners will take care of themselves became something of a motto for Oak Tree. He also came to calling investing a negative art while working with Seth Klarman to update the 1940 edition of Benjamin Graham and David Dodd’s book, Security Analysis, which is known as the Bible of value investing.

[00:06:08] Shawn O’Malley: In it, Graham and Dodd coined the term negative art when referring to investing in bonds. To understand why they call it a negative ART, consider a set of 100 bonds paying 8 percent interest rates. If 90 of them pay back all of their interest and principal while 10 default, what matters from an investor’s perspective is simply avoiding the ones at default since the remaining will all pay the same 8 percent return.

[00:06:31] Shawn O’Malley: For bond investors in particular, they improve their performance not necessarily by what they buy, but by what they exclude. In that example, it’s less about finding winners and more about avoiding losers, hence the term negative art. As we learned from the 1990 memo though, the concept of investing being a negative art is relevant to stock investors as well.

[00:06:52] Shawn O’Malley: In the early 20th century, the iconic stock trader Jesse Livermore conveyed the same idea in his book, How to Trade Stocks, saying, quote, winners take care of themselves, losers never do. Yet in stock investing, it’s not quite as simple as just avoiding the losers. As Marks puts it, quote, when you aspire to returns well above those available on bonds, it’s not enough to avoid losers.

[00:07:14] Shawn O’Malley: You actually have to find or create winners from time to time. He calls strategies relying on finding winners, aspirational strategies and oak tree has evolved to include more aspirational strategies than it used to. That begs the question of why avoiding losers has remained oak trees motto as Marks’ thinking has evolved and the firm has come to rely more on picking winners.

[00:07:36] Shawn O’Malley: As Marks puts it, they want risk control to always be top of mind. When reviewing a potential investment, whether it be a stock, high yield bond, or convertible bond, they want to not only ask, how much can I make if things go well, but also, what will happen if things don’t go as planned? How much could be lost if things go badly?

[00:07:55] Shawn O’Malley: At Oaktree, risk control isn’t everything. It’s the only thing. From here on in the memo, Marks takes great care to communicate that risk control isn’t the same as risk avoidance. Risk avoidance entails not doing anything uncertain where there’s a possibly negative outcome, which limits returns because investing requires investors to embrace uncertainty and the pursuit of more attractive returns and what’s paid by government bonds, which are considered to be the lowest risk form of investment.

[00:08:22] Shawn O’Malley: So risk avoidance really becomes return avoidance by hiding from uncertainty. Risk control, on the other hand, is declining to take risks that exceed your threshold for uncertainty and where you wouldn’t be rewarded well enough to justify taking on that extra uncertainty. Marks calls this approach the intelligent bearing of risk for profit.

[00:08:42] Shawn O’Malley: To flashback in time for some context, Mark started managing money in 1978, running portfolios that invested in convertible bonds, which have the potential to convert into shares of stocks and high yield bonds, which primarily lend money to companies deemed to be risky borrowers by credit rating agencies.

[00:08:59] Shawn O’Malley: When asked by a reporter how he can invest in these high yield bonds when knowing that some of the issuers are going to default, he responded by asking how life insurance companies can insure people’s lives when they know they’re all going to die eventually. In a nutshell, that’s how Marks thinks about intelligent risk bearing.

[00:09:16] Shawn O’Malley: It’s like life insurance companies that can still earn a profit by using actuarial tables to model out the timeline for expected payouts versus the premiums they can charge today and the interest they can earn in the meantime. To intelligently bear risk as an investor, the risks at hand have to be ones that you’re aware of, capable of analyzing, diversifiable, and that pay a sufficient reward for assuming.

[00:09:40] Shawn O’Malley: There will inevitably be losing investments across a lifetime, but the question is really rather how many losers there will be and how bad they are relative to your winners. Marks goes on to discuss how the great Warren Buffett is widely seen as having only 12 excellent winning investments across his career.

[00:09:58] Shawn O’Malley: And Charlie Munger has said that the vast majority of his wealth came from not 12, but just 4 winning investments. Their combined success boils down to having a lot of investments that did decently. A relatively small number of big winners that they invested in heavily for decades and relatively few big losers.

[00:10:15] Shawn O’Malley: Trying to avoid having any losers isn’t a useful goal, since the only way to do that is to not take any risk, which means not earning returns above the risk free rate offered on savings accounts and government bonds. To quote Marks, there’s such a thing as the risk of taking too little risk. Most people understand this intellectually, but human nature makes it hard for many to accept the idea that the willingness to live with some losses is an essential ingredient in investment success.

[00:10:43] Shawn O’Malley: Just look at tennis players to make the point. You cannot win a tennis by not taking any risk. Setting out to not make any service faults would be an unproductive goal. To ensure that you do not make any faults, your serves would have to be so weak and cautious that your opponent could easily crush them back.

[00:11:00] Shawn O’Malley: To an extent, you must serve aggressively to win. That means identifying and betting on the companies that will become the market’s biggest winners. Over Marks’ four decade career, there have been a handful of times when a few big winner stocks came to disproportionately represent the market’s gains.

[00:11:16] Shawn O’Malley: Most recently, we’ve seen that with the so called Magnificent Seven of Apple, Microsoft, Google’s parent company, Alphabet, Nvidia, Tesla, and Facebook’s parent company, Meta. Just seven companies now represent over one third of the market cap weighted S& P 500 index as they’ve compounded returns at incredible rates in recent years to keep increasing their weighting in the index.

[00:11:39] Shawn O’Malley: Something similar happened in 2017 with some of the same companies that went by the acronym FANG, which included Facebook, Amazon, Apple, Netflix, and Google. So top heaviness and markets isn’t completely new and other famous examples date back to the nifty 50 of the 1960s, which was a craze that swept up shares in companies like IBM, Kodak, and Xerox.

[00:12:00] Shawn O’Malley: When the market becomes this concentrated and a few names, you’re destined to underperform index benchmarks like the S and P 500. If you don’t have at least as much exposure to stocks like the magnificent seven in your portfolio. The problem is that when good investors do find themselves with a chunk of their portfolio devoted to companies that become big winners, can they hold on to them all along the way?

[00:12:20] Shawn O’Malley: Imagine that you’d owned a good bit of Apple 20 years ago at the split adjusted price of 37 cents per share. Today, you’d be up over 600 times your original investment, with the stock trading around 230. Because most investors subscribe to the idea of taking money off the table after big gains, you’d almost certainly have sold shares along the way and not realized the full potential return available to you.

[00:12:43] Shawn O’Malley: Meanwhile, Apple’s weight and stock market indexes has only increased, making it harder for you to continue outperforming the market as Apple helped propel the S& P 500 higher and gain a greater share of it while you cashed out. That is, in brief, why it’s so hard to beat the markets over a lifetime, and why the accomplishments of Charlie and Warren are all the more impressive.

[00:13:03] Shawn O’Malley: To recap, the performance of stock indexes is often dominated by a few big names. The gains for these market leaders can seem outrageous, driving investors to reduce their stakes for the sake of diversification. Yet, as you own fewer of the winners, and their representation in indexes grows, the You’ll find it nearly impossible to keep up with the market averages.

[00:13:22] Shawn O’Malley: For investors to beat the market, they must find the right balance that aligns with their own skills between owning fewer losers and finding more winners. Some will be better at the more winners part, and others will be better at the fewer losers part. But some combination of both is necessary for true risk adjusted outperformance.

[00:13:41] Shawn O’Malley: So there it is, Marks’ thoughts on what it takes to beat the market as expressed first in 1990 and in 2023. That covers the most important parts of this memo. And now I want to step back in time again to hear Marks recounting another fascinating period in markets, the 2008 financial crisis. Marks’ late 2008 memo is called Nobody Knows, and he begins by saying that the memo’s title is no joke.

[00:14:06] Shawn O’Malley: Nobody knows the real significance of the recent events in the financial world, or what the future holds. Everyone has opinions, but opinions are not knowledge. As John Kenneth Galbraith is quoted as saying, there are two kinds of forecasters. Those who don’t know, and those who don’t know they don’t know.

[00:14:24] Shawn O’Malley: As Marks put it at the time, accesses have been committed at financial institutions that we’ve never seen before in terms of their scale and breadth, and many new financial inventions are in place that never existed before, so clearly no one can know how things will pan out. Two words are synonymous with this era. Boom and bust.

[00:14:44] Shawn O’Malley: They capture it all. If you have a boom, you’ll eventually have a bust. And the further the boom goes, the worse that bust will probably be. Without a boom, there’s no need for a bust either. Leading up to the financial crisis between 2003 and 2007, U. S. economy had no great boom, which actually helped hold things together in light of the turmoil.

[00:15:04] Shawn O’Malley: The boom came, however, in the financial sector, specifically at the banks and other lenders, but that doesn’t include the stock market. Transcribed He says that for all the pain stock investors felt throughout that year in 2008, it pales in comparison to the apocalyptic thinking that had gripped the banking system.

[00:15:19] Shawn O’Malley: Marks blames the decades long bubble in the financial sector on a range of factors, beginning with it becoming the employer of obvious choice for the best and brightest, contributing to greed and risk taking, which drove out fear and skepticism and carried institutions and asset prices to unsustainable levels.

[00:15:37] Shawn O’Malley: Other factors contributing to the financial sector bubble forming and popping in 2008 include reduced interest rates to stimulate the economy, resulting in dissatisfaction with returns on low risk investments that pushed investors to chase riskier and riskier investments to earn higher returns. This underpinned a broad scale willingness to try new forms of financial engineering like derivatives, which carry massive leverage.

[00:15:59] Shawn O’Malley: As financial institutions chased higher returns and leverage, a system of disintermediation arose that sliced and diced risky investments so much that many genuinely believed all the risk had been engineered away. From there, too much trust in and reliance on rating agencies to assess the risk throughout the financial system further enabled risk takers to justify their decisions.

[00:16:22] Shawn O’Malley: And then, blame falls on the unquestioning acceptance of financial platitudes that justify these risks. Like, the idea that houses and condos are always good investments that appreciate in value, that a nationwide decline in home prices is unimaginable, and that it’s okay to grossly borrow money if you’re sufficiently hedged on paper.

[00:16:42] Shawn O’Malley: If you were planning on watching the movie The Big Short, I think I just saved you about two hours. Obviously, I’m kidding, but this is a pretty solid breakdown of what went on, and Marks was able to appreciate in real time what was driving the crisis. In simpler terms, Marks sums up the crisis as a shortage of adult supervision and common sense.

[00:17:02] Shawn O’Malley: He says, quote, so now we find financial institutions that endangered themselves by using extensive short term borrowings or deposits to make investments that turned out to be enormously risky when an unlikely disaster, a nationwide decline in home prices occurred. A few structural changes helped risk build up until it bubbled over.

[00:17:20] Shawn O’Malley: He primarily cites the repealing of the 1933 Glass Steagall Act, allowing commercial banks and investment banks to combine, which was originally enacted in response to the great crash of 1929. While the phrase too big to fail became popular in justifying the never ending expansion of America’s largest financial institutions, he says they also became too big to manage and, worse, too big to understand and disentangle.

[00:17:44] Shawn O’Malley: Yet, despite the financial world imploding at the time of writing, Marks says this, quote, Heroes aren’t people who are unafraid, but rather those who act bravely despite their fears. Investors mustn’t let emotion control their actions. The market is, in many cases, taking its lead from the market. Price declines cause fear, and thus further price declines.

[00:18:05] Shawn O’Malley: As one such example of this, Marks discusses how surges in the price of credit default swaps can ripple across markets. Credit default swaps are like insurance against debt defaults. If you owned credit default swaps on JP Morgan, you’d pay recurring premiums to whoever is providing you that insurance.

[00:18:23] Shawn O’Malley: And if JP Morgan were to default, you’d collect a large payout protecting you from that. But credit default swaps can be traded in the open market, and if for whatever reason, a firm’s credit default swaps increase in price, that implied creditors were anxious about the company. That could trigger a selloff in the company’s stock and in its bonds, which could frighten away customers or push depositors to withdraw funds, spurring an actual crisis for the business.

[00:18:49] Shawn O’Malley: Yet the market for credit default swaps is a thin one, and Marks highlights the massive room for manipulation at the time as a single large purchaser of default insurance could spark a spiral that wiped out billions of dollars’ worth of stock and bonds. He advised investors at the time to apply skepticism to the bad news they saw.

[00:19:07] Shawn O’Malley: He told them to question whether the market signals of panic were actually valid, and if instead, they offered the buying opportunity of a lifetime. In hindsight, he was quite right. It more than paid to be a contrarian. Marks goes on to make an argument akin to Pascal’s wager, which is the idea that one ought to believe in God because while it doesn’t hurt to do so, not believing would result in eternal punishment.

[00:19:33] Shawn O’Malley: I’d say the following is the investment equivalent of Pascal’s Wager. Marks argues, quote, Will the financial system melt down, or is this merely the greatest down cycle we’ve ever seen? My answer is simple. We have no choice but to assume that this is not the end, but just another cycle to take advantage of.

[00:19:50] Shawn O’Malley: I must admit it, I say that primarily because it is the only viable position. In other words, if the financial system is collapsing. Then everyone’s wealth will be wiped out anyways, so all we can do is act as if things will carry on. In a total collapse, it really wouldn’t matter what you did because the value of everything is going to zero, but if everyone thinks there’s a collapse while you continue as if there isn’t and snap up assets at deeply discounted prices, assuming there’s another side to come out on, you will come out a winner.

[00:20:20] Shawn O’Malley: Short of stacking up gold coins and canned food and living in a bunker, there was nothing that could really be done to protect oneself from the type of financial crisis that was being feared at this time. Yet, if you sold all your stocks and other assets, fearing such a crisis that never came, you’d be disastrously poorer for doing so.

[00:20:39] Shawn O’Malley: As Marks states so concisely, most of the time, the end of the world doesn’t happen. We will invest on the assumption that it will go on. That companies will make money, that they’ll have value, and that buying claims on them at low prices will work in the long run. What alternative is there? He then goes on to outline his simple framework for a recovery.

[00:21:00] Shawn O’Malley: First, a few forward looking people begin to believe things will get better as prices reach a point where they simply can’t go any lower, and then positive momentum picks up as most investors recognize improvement underway. And then lastly, the recovery overheats as everyone becomes sure that things are fine and will get better forever.

[00:21:19] Shawn O’Malley: Quote, everyone was happy to buy 36 months ago when the horizon was cloudless and asset prices were sky high. Now, with heretofore unimaginable risks on the table and priced in, it’s appropriate to sniff around for bargains, the babies that are being thrown out with the bathwater. That was Marks’ late 2008 memo, right in the midst of the worst financial crisis in modern history and I’d love to read through it again just to see what it was like for a professional working in the industry at the time.

[00:21:48] Shawn O’Malley: I really find the logic and clarity during a crisis inspiring. This was actually not the first time, though, that Marks’ market predictions and wisdom seemed incredibly prescient. Including this moment in 2008, there are at least five memos that Marks highlighted in 2023 as having stood out for their accuracy in identifying key turning points in markets.

[00:22:09] Shawn O’Malley: He also jokes that while each of these forecasts in his career were right, he had the benefit of only making five major market bets over the course of a 50 year career, so he waited for the most extreme moments of market dysfunction. His 2023 memo, Taking the Temperature, walks through these moments. One of them was his 2008 call for investors to get aggressive about looking for bargains, as we already discussed, so I’ll go through the other four.

[00:22:35] Shawn O’Malley: The rest of his successful five market calls came in the early 2000s against the backdrop of a massive run up in tech, media, and telecom stocks. He writes that he had recently read Edward Chancellor’s book, Devil Takes the Hindmost, which helped him realize how the dot com bubble of the late 90s was so similar to past historical bubbles.

[00:22:55] Shawn O’Malley: The masses were lured by the promise of easy trading profits, as some quit their jobs to go full time trading the market. Even if most of these companies, supposedly on the cutting edge of technology, were money losers. His memo, Bubble. com, outlines how investors were euphorically bidding up prices for companies that not only had no profits, but in some cases, no revenue.

[00:23:17] Shawn O’Malley: He wrote, quote, in short, I find the evidence of an overheated speculative market in technology, internet, and telecommunications stocks overwhelming, as are the similarities to past manias. To say they have benefited from a boom of colossal proportions and should be examined very skeptically is something I feel I owe you.

[00:23:34] Shawn O’Malley: In hindsight, marks adds that he thinks this bubble burst for the simple reason that prices had become unsustainably high. The s and p 500 index would go on to fall 46% from its 2000 high to the low in 2002. Wow. The more tech heavy NASDAQ index declined by 80%. The incident painfully instilled the true meaning of the word bubble into the minds of a whole new generation of investors.

[00:23:57] Shawn O’Malley: From 2004 through 2007, Marks’ memos made several more calls in the aftermath of the dot com bubble and in the lead up to the 2008 financial crisis. In his 2004 memo, Risk and Return Today, Marks expressed that he still thought a more slow motion train wreck was forming, with the Federal Reserve still maintaining 1 percent and accommodative monetary policy four years after the bubble in internet stocks peaked.

[00:24:24] Shawn O’Malley: With low interest rates, making it difficult to earn meaningful returns without taking on riskier investments, that’s exactly what many did. They sought less certain investments for the sake of higher returns, since treasury bond yields were so meager. This point is built around the more fundamental idea that investors dislike risk and prefer safety, where risk is the uncertainty around whether they will actually earn the return, they expect to.

[00:24:49] Shawn O’Malley: The proof behind this point is that if the U. S. government finances itself by selling 30 year bonds that paid 5 percent interest rates, no one would turn around and instead buy 30 year bonds paying 5 percent from a startup company. Because the U. S. government has the ability to tax the world’s largest economy, while also being able to print money to pay bills issued in its own currency, it’s seen as the gold standard for borrowers.

[00:25:12] Shawn O’Malley: It’s very unlikely that America won’t be able to pay its bills, so buying bonds from the US government where it promises to pay you back in the future isn’t considered particularly risky. Obviously, the same can’t be said for a startup or any company, really. As Marks makes the point in his 2004 memo on risk and return, for investors to take on risk, they must be induced to.

[00:25:34] Shawn O’Malley: Normally, this happens when an investment’s potential return is sufficiently attractive to justify the added risk. If that same startup company offered bonds paying 12 percent yields, investors might reconsider. As we’ve already mentioned though, an inability to earn meaningful returns on low risk investments can also induce investors to take on more risk.

[00:25:54] Shawn O’Malley: This sort of risk bearing is more out of necessity than because investors want to. Thank you. To make the point, consider that you manage a state pension fund for teachers and other governmental employees. Now, imagine that the pension is modestly underfunded, such that for to be able to pay future retirees, it must invest more aggressively today and earn at least a 7 percent return per year on average.

[00:26:16] Shawn O’Malley: When the Fed sets higher interest rates and you can earn 5 or 6 percent on government bonds, you can hit your target return without too much extra risk. At 1 or 2 percent risk free interest rates, all of a sudden you have to make up a lot of ground to get to your 7 percent target return that’s required to keep the pension fund operating smoothly.

[00:26:35] Shawn O’Malley: You start looking at bonds from more financially shaky companies that pay higher rates. Maybe you look at highly leveraged real estate projects, tech stocks, private equity, whatever it takes. So in 2004, investors were falling over themselves to get away from low risk, low return investments, which was setting the groundwork for a new bubble to form near the end of the memo.

[00:26:57] Shawn O’Malley: He writes, quote, there are times for aggressiveness. I think this is a time for caution. The problem is that even when the returns available in markets do not justify the risks as was broadly the case during this time, investors are often too stubborn, proud, or impatient to wait for circumstances to change.

[00:27:15] Shawn O’Malley: As Marks writes, no one wants to throw in the towel with regard to investment returns. No one likes to admit that their intelligence and hard work won’t be enough to get them to their target. But at times when the markets are offering paltry, absolute returns and inadequate compensation for bearing risk, it’s the only thing to do.

[00:27:33] Shawn O’Malley: And his 2005 memo, there they go again. Marks details how in the pursuit of meaningful returns, many were relying on the fallacy that home prices only go up. There was a lot of optimism surrounding new financial products tied to real estate that created an illusion of safety, prompting many to believe the foremost dangerous words in finance.

[00:27:53] Shawn O’Malley: This time, it’s different. That statement is almost always followed by a brazen disregard for learning the lessons of past economic cycles. He cites a few classic illustrations of the types of flawed thinking that grips markets as bubbles form. In aggregate, it’s a combination of beliefs ranging from thinking that a given type of investment is guaranteed to continue delivering high returns.

[00:28:15] Shawn O’Malley: To falling for surface level stories that ignore how markets really work, like believing no price is too high for a good enough growth company. The most recurring and harmful of these bubble mindsets is the projection of future returns based on the past. I see this all the time, personally. Friends ask me what mutual funds they should invest in for their 401k, and they say, oh, look, this one has done better over the past decade, so I want to invest in it.

[00:28:41] Shawn O’Malley: Marks writes in response to this, instead of being encouraged by months or years of price appreciation, investors should be forewarned. That’s because of financial gravity. Nothing can rise forever, and if a stock or asset class like emerging markets have been outperforming for a decade, the odds are stacked against it that that trend will continue.

[00:29:02] Shawn O’Malley: In response to the real estate deals going on at this time in 2005 that embrace these elements of classic bubble thinking, Marks and his co-founder at Oaktree would say to each other, quote, if deals like this can get done, there’s something wrong with the market. As they still do, people at the time justified real estate investments by calling them a good inflation hedge or saying that they aren’t making any more of it.

[00:29:24] Shawn O’Malley: While that’s true, Marks retorts that there’s a lot of land left to develop, and something is only an inflation hedge if it’s bought at a fair price to begin with. On top of this, the real economic value of homes was declining at the same time prices were surging. Home prices rose 16. 4 percent from 2003 to 2004, yet the average rent payment was flat.

[00:29:46] Shawn O’Malley: From an investment perspective, a home’s economic value stems from the rent you expect to collect while owning it. If homes are worth more and more, but the actual cash flows from rent they can generate are not growing, then Then clearly there’s an unsustainable disconnect. The question Marks tries to wrap his head around is why people were willing to pay these higher valuations for houses.

[00:30:08] Shawn O’Malley: Similar to investing in internet stocks during the dot com bubble, there was a belief that buying homes as an investment couldn’t go wrong. At the same time, there was a lot of FOMO from seeing others get rich off of piling into real estate. No one wanted to regret not having bought into real estate, and these decisions were rationalized by arguments that suggested a shortage of land combined with demand for property from baby boomers and foreigners would prolong the good times indefinitely.

[00:30:34] Shawn O’Malley: In response to all this, Oaktree went defensive. They sold off large amounts of assets, liquidated large funds, and significantly raised the bar for what investments they would consider. By July 2007, Marks was still warning investors that risks on the horizon were now much closer than before. And his memo, it’s all good.

[00:30:54] Shawn O’Malley: Eight months after he wrote that memo, the investment bank Bear Stearns melted down thanks to its investments in subprime mortgages, and a rapid succession of bankruptcies and bailouts began after that. The S& P 500 would fall 53 percent from its 2007 peak to its low in February 2009. While the rest of the world panicked over what to do about these real estate woes, Oaktree held on with zero exposure to subprime mortgages or mortgage backed securities.

[00:31:22] Shawn O’Malley: That decision wasn’t made because Marks and his team were subject matter experts on real estate though. In fact, he writes in hindsight in 2023 that much of these troubled assets were being traded in a relatively remote corner of the investment world, and what helped Oaktree was their ability to quote, take the temperature of the market and recognize things fell off.

[00:31:43] Shawn O’Malley: His 2007 memo shows that philosophy in real time. Marks wrote then that, one thing I believe in most strongly is the inevitability of cycles. I always say that while we can’t know where we’re going, we ought to know where we are. He makes the point that markets are like a pendulum, swinging between extremes.

[00:32:01] Shawn O’Malley: Although the middle is technically the average, they spend very little time in this average midpoint. Depending on where we are in a cycle, the market swings toward one extreme or the other. That is, between extreme greed and optimism or extreme fear and pessimism. These swings occur because a majority of market participants psyches join together in the same direction as a herd.

[00:32:23] Shawn O’Malley: Marks adds that quote, no matter how favorable and steady fundamentals may be, the markets will always be subject to substantial cyclical fluctuation. The reason is simple. Even ideal conditions can become overrated and therefore overpriced, so don’t fall into the trap of thinking that good fundamentals equal positive market outlook.

[00:32:43] Shawn O’Malley: In the same way that moviegoers suspend disbelief in the name of having fun and enjoying a film, investors caught up in bubbles suspend disbelief by implicitly accepting that the good times will go on forever or that they will see the bad times coming before others and know when to get out. In the 90s, no one could fathom a reason why online retailers and new internet enabled companies wouldn’t work out, similar to how many today can only see a version of reality where the hype around AI not only comes true, but that its effects are overwhelmingly positive and not negative.

[00:33:17] Shawn O’Malley: I think the following passage from Marks was quite prescient in mid-2007. It seems the value of outstanding credit default swaps, insurance against defaults among corporate debt instruments, exceeds the value of the instruments insured. How will this work if a wave of defaults occur? How well are the provisions of these insurance contracts documented?

[00:33:38] Shawn O’Malley: How readily will the writers of the insurance pay up? What will be the effect if the conditions are chaotic? Certainly didn’t know exactly how things would unfold, but he knew the setup was getting dangerous and we’d soon learned the cost of these new financial innovations. This overlaps a lot with what we’ve already talked about and Marks’ other letters from the 2004 to 2008 period here, but the evolution in his thinking is really fascinating to read.

[00:34:05] Shawn O’Malley: Whereas in 2004, he was sort of abstractly musing on how bad things were starting to happen and would continue to happen with interest rates so low. By 2007, he was case by case pointing fingers at the biggest vulnerabilities brewing beneath the surface that many didn’t understand until years after the 2008 crisis.

[00:34:24] Shawn O’Malley: During this time in 2007 and 2008, Oaktree organized an 11 billion dollar reserve fund to purchase highly distressed debt, which are typically bonds from companies that have either already defaulted, are in bankruptcy protection, or are facing immediate bankruptcy. Marks made the decision, as we’ve discussed, that if the financial world melted down, then it didn’t matter what they did.

[00:34:45] Shawn O’Malley: But if it didn’t, not acting would have meant they weren’t doing their job. So after Lehman went under, Oaktree began investing 400 million a week from September 2008 through year end for a total of 6 billion in a single quarter. I just want to emphasize how uncommon this was. Almost no one else was doing this as markets cratered and warnings about the complete destruction of the financial system gripped mainstream media.

[00:35:10] Shawn O’Malley: It was almost unimaginable to have any shred of optimism about the future, let alone to plow billions of dollars into distressed assets. As Marks framed things in his 2008 memo, The Limits to Negativism, he asserts that skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive, but it also calls for optimism when pessimism is excessive.

[00:35:35] Shawn O’Malley: In the third stage of a bear market, everyone agrees things can only get worse. The risk in that, in terms of opportunity costs or foregone profits, is equally clear. There’s no doubt in my mind that the bear market reached the third stage last week. That doesn’t mean it can’t decline further, or that a bull market’s about to start, but it does mean the negatives are on the table, optimism is thoroughly lacking, and the greater long term risk probably lies in not investing.

[00:36:03] Shawn O’Malley: So Mark’s made the market calls in his career that he’s most proud of in 2000, 2004 through 2007, 2012, and 2020. Let’s jump ahead to 2012 and see what happened then. With the global financial crisis and the rear view mirror and s and p 500 returns, essentially flat for over a decade from 2000 to 2011, poor performance had led investors to lose interest in stocks.

[00:36:29] Shawn O’Malley: But lows and optimism actually meant things probably couldn’t get any worse. This is second order thinking rather than looking around and thinking, wow, markets are in rough shape and most people are feeling negatively about investing. So I should feel negatively too. A sophisticated investor recognizes that this negativity will not last forever and is actually making financial assets relatively cheap.

[00:36:50] Shawn O’Malley: In the 2012 memo deja vu all over again, he talks about an article he read in 1979 and business week titled the death of equities, which declared that high inflation had killed the enthusiasm for owning stocks among millions of investors. The conclusion the article reached was precisely wrong though.

[00:37:08] Shawn O’Malley: It argued that the death of stock investing was a near permanent condition that wouldn’t reverse anytime soon. But from there on for the next 21 years. Stock indexes delivered an average annual return of 17. 9 percent that would have 32x’d every dollar invested in 1979. Sentiment falling so low that Businessweek could confidently proclaim the death of stock investing was exactly the moment to be getting bullish on stocks.

[00:37:35] Shawn O’Malley: Mark says that 2012 was similar. After the great financial crisis, investors were depressed and four years later, enough time had passed that it was just the right time to be turning bullish again. From 2012 through 2021, the market returned 16. 5 percent a year and has continued to hit new highs into 2024.

[00:37:54] Shawn O’Malley: Once again, excessively negative sentiment resulted in major gains. And that brings us to Marks’ next and final defining market prediction we’ll cover from March 2020. In a memo titled Nobody Knows Too, inspired by his original Nobody Knows memo from 2008, Marks gave his perspective on markets amid the COVID induced pandemic.

[00:38:17] Shawn O’Malley: He told clients that just because the course of a pandemic was unknowable, that doesn’t mean no action should be taken. In a weekly memo at the time, he added that quote, the bottom is the day before the recovery begins. Thus, it’s absolutely impossible to know when the bottom has ever been reached. Even though there’s no way to say the bottom is at hand, the conditions that make bargains available certainly are materializing.

[00:38:41] Shawn O’Malley: No one can argue that you should spend all your money today, but equally, no one can argue that you shouldn’t spend any. Compared with his previous market calls that relied on history and logical analysis, Mark’s recommendation here is more of an acknowledgement of ignorance. All that was known for sure was that a pandemic was underway and the U.

[00:38:59] Shawn O’Malley: S. stock market was down one third. Although the fundamentals of companies couldn’t be assessed because no one knew what would happen to the economy, he did know that an incredible amount of selling had already transpired and logically, as people have sold, the less they have left to sell, which leaves them with cash to use when their outlook becomes less pessimistic.

[00:39:17] Shawn O’Malley: That was enough to know that bargains are being offered, even without rigorous analysis. Sometimes, he writes, it’s really as simple as that. When most investors knee jerk reaction is to sell or hide on the sidelines, a contrarian decision to buy may be more than justified. The trick is to keep your head when others are losing theirs.

[00:39:37] Shawn O’Malley: So, in reflecting on these 5 moments of decisive market bets, Marks writes in his 2023 memo taking the temperature that this is not meant to be self-congratulatory. Instead, we all go through life hoping to learn from our experiences, and on occasion, it’s helpful to look back at the key moments to see what patterns emerge.

[00:39:56] Shawn O’Malley: Once or twice a decade, markets go so high or low that the probability of being contrarian and right becomes compellingly high, but there were only a handful of these moments in Marks’ career. There are 5 market calls that he had conviction in and is proud of, not 50. More market calls creates more noise at times when the odds are less clear that make it more likely you’ll be wrong.

[00:40:18] Shawn O’Malley: The takeaway then is to avoid making macro calls too often and certainly don’t try and make a living doing so. When markets hit extremes, our performance comes from both being able to understand the fundamentals like going through company’s financial statements and understanding their valuations and also being able to read the temperature of the market.

[00:40:36] Shawn O’Malley: There is often a flawed notion among value investors that they can solely focus on evaluating companies from the bottom up and that nothing else matters. But at least according to Howard Marks, that isn’t true. Any bottoms up analysis relies on making estimates about the future, and estimates about the future are predicated on the macro environment.

[00:40:54] Shawn O’Malley: If you think a company can keep compounding sales at 10 percent a year, that gets pretty hard to justify with a recession on the horizon. So, to some limited extent at least, investors have to have an awareness of the macro environment and the temperature of markets. To do that, Marks encourages us to be students of history, to recognize the types of patterns and cycles that underpin peaks and bottoms.

[00:41:16] Shawn O’Malley: He also says to watch for moments when most people are so optimistic that they think things can only get better or the converse, and that what happens in markets and economies is ultimately not some mechanical process, but the result of swings and human emotion. Investors who stand out can resist emotionality, avoiding the crowd rather than joining in and can recognize illogical propositions like stocks haven’t fallen so far that no one should be interested in them.

[00:41:43] Shawn O’Malley: His book, Mastering the Market Cycle, is an excellent read and provides tangible insights on how Marks has come to understand what drives cycles, how they evolve, and how to know at what point in the cycle we’re in. The one thing he says they never do at Oak Tree is predict that the macro environment will be distinctly better than normal.

[00:42:01] Shawn O’Malley: It’s their goal to build portfolios that surprise to the upside and relying on optimistic assumptions is rarely part of that process. Their assumptions are much more often neutral. By necessity, Oaktree models with assumptions, but they’re seldom boldly idiosyncratic or optimistic. Marks ends the memo with an intriguing question.

[00:42:21] Shawn O’Malley: Would you rather buy at what turns out to be a market top, or sell at the bottom? He says the answer is actually easy. He’d much rather buy at the top. That’s because with markets, the next top is usually higher than the next, so you’ll eventually come out ahead, but when you sell out at the bottom, you make that downward fluctuation permanent.

[00:42:39] Shawn O’Malley: There is no redemption to be had. This is why he calls selling at the bottom the cardinal sin of investing. That’s all I have for you today. We’ve been through a ton of Marks’ writings, and I’ve attached links to all of the memos mentioned today in the show notes if you want to read them yourself, as well as links to the books that Marks mentions.

[00:42:57] Shawn O’Malley: Howard Marks is one of my favorite investors to learn from, and his memos across his career provide an incredible opportunity to see what things were like at different points in financial history through the eyes of a great investor who lived through it all.

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