HOWARD MARKS

Howard Marks is one of my heroes in the investment management business.  He is the leader of Oaktree Capital, a firm based in Los Angeles that manages some $100 billion for large institutional investors.  It is largely a “credit” related firm with its roots in high yield corporate bonds, distressed debt, real estate, and convertible securities.  We worked together in the late 1970s and 80s at what was then Citicorp Investment Management, Inc.  I am sure that he made a bigger impression on me than I did on him. 

Howard was the research director at Citi when I first joined the firm.  But, he soon became bored with that and started a high yield corporate bond business there just as institutional investor started adding that as part of their portfolios.  After taking his talents to a couple of other firms, he started Oaktree some 20 years ago.

Why is he my hero?  Other than the fact that he has made a gazillion dollars, it is because he understands how risk and return are related.  Everything starts with US Treasury bonds, and you must get paid sufficiently to take on the extra risk you are assuming in other things such as credit risk, liquidity risk, etc.  Or, you shouldn’t do it!  He gets it!

Howard sent his clients his midyear memo last week.  I would have just asked him if I could send it to readers of this letter, but it is 23 pages long!  I have a rule- no more than 2 pages.  Here are the important points of his letter:

• Asset prices are high across the board.  Almost nothing can be bought below intrinsic value.  In general, the best that we can do is look for things that are less overpriced than others.  Therefore, prospective returns are just about the lowest they have ever been.

• Investors are readily accepting significant risk as the price of chasing yield.

• Yields on high yield bonds, distressed debt, etc. are not sufficient relative to the risks in these markets.

• Complacency rules.  Valuations are being ignored and excused under the pretext that things are justifiable today relative to other things.  Unfortunately, you can’t eat relative performance.

Howard points out several specific things in today’s marketplace that underscores his message.

• Some of the highest equity valuations in history.

• Complacency at an all-time high.

• The elevation of a “can’t lose” group of stocks. (Facebook, Amazon, Netflix, Google).

• The movement of more than a Trillion dollars into passive, value-agnostic investing.

• The lowest yields in history on low-rated bonds and loans, and emerging market debt.

• The most fundraising in history for private equity, especially technology. 

• The Bitcoin phenomenon.

Howard Marks is a very smart guy.  He is paid to be a worrier.  He is probably purposefully early in bringing this message.  And, he is probably warning his clients that they can expect to have a period of underperformance if he is wrong.  But he is going to take some risk off the table.  But, as I look at the three things we always come back to – Sentiment, Money, and Valuation, I am getting a little worried too.

Sentiment is way “overbought.”  Investor Intelligence reports a dangerous level of over 60% Bulls.  Few investors left to buy.

Monetary factors are changing.  Short term interest rates are rising.  The Federal Reserve is planning to reverse its bond buying program in September allowing bonds on their balance sheet to mature without replacing them.  This is a major change toward tighter money. 

Valuation is high for everything, including stocks. The S&P 500 is already above my yearend forecast of 2450.

I think it is time to reevaluate the risk in your portfolio.  For my part, in the last week, I have reduced the risk in my own portfolio to a “moderate” position, from “aggressive.”  I think the opportunity cost of missing the returns on stocks and low rated bonds for the next 12 months is not great relative to the risk.

 A note from WSC and WAMI . . .

Robert C Davis is a Chartered Financial Analyst and is affiliated with Woodlands Asset Management, Inc. as a consultant.  Founding partner of Davis Hamilton Jackson and Associates, a Houston based investment advisory firm; Bob is now retired and living in Caney Creek, Texas.  He now lends his expertise and knowledge of the markets to our company and customers.  We hope you find it interesting and insightful.