1 Memo to: Oaktree Clients Howard Marks From: Re: It’s All a Big Mistake Mistakes are a frequent topic of discussion in our world. It’s not unusual to see investors in poor performance. But rarely do we hear about mistakes as criticized for errors that resulted I’m writing now to point out that an indispensible component of the investment process. out. In short, in order for one side of a mistakes are all that superior investing is ab L.P. e other side has to have been a big mistake. transaction to turn out to be a major success, th cker, or an unskilled there’s a “fish” (a su There’s an old saying in poker that player who’s likely to lose) in every game, and if you’ve played fo r an hour without having figured out who the fish rt of, it’s likely that transaction you’re pa is, then it’s you. Likewise, in every investment someone’s making a mistake. The key to success is to no t have it be you. Usually a buyer buys an asset because he thinks it ’s worth more than the price he’s paying. But s its value. It’s pretty safe thinks the price he’s getting exceed the seller sells the asset because he to be true, thanks to eaking, that doesn’t have to say one of them has to be wrong. Strictly sp MANAGEMENT, But in general, meframe and investors’ circumstances. differences in things like tax status, ti win/win transactions are much less common than . When the dust has win/lose transactions RESERVED. seller are unlikely to be equally happy. settled after most trades, the buyer and stakes. First, it serves as a focus on the topic of investing mi I consider it highly desirable to resent, and thus of the importance of mistake reminder that the potential for error is ever-p CAPITAL of every transaction is wrong, we have to ponder minimization as a key goal. Second, if one side RIGHTS it causes us to consider how to minimize the why we should think it’s not us. Third, then, probability of being the one making the mistake. ALL Investment Theory on Mistakes lligent, objective and efforts of motivated, inte According to the efficient market hypothesis, the © OAKTREE rational investors combine to cause assets to be priced at their intrinsic value. Thus there are no mistakes: no undervalued bargains for superi or investors to recognize and buy, and no over- Since all assets are priced fairly, once bought at valuations for inferior investors to fall for. fair prices they should be expected to pro duce fair risk-adjusted returns, nothing more and nothing less. That’s the source of the hypoth esis’s best-known dictum: you can’t beat the market. truth is that while all I’ve often discussed this definition of market effici ency and its error. The investing), (a) far from all investors are motivated to make money (otherwise, they wouldn’t be it seems almost none are consistently objective and rational. of them are intelligent and (b) All Rights Reserved. CONFIDENTIAL © Oaktree Capital Mana gement, L.P.
2 Rather, investors swing wildly from optimistic to pessimistic – and from over-confident to prices can lose all c terrified – and as a result asset onnection with intrinsic value. In addition, investors often fail to unearth all of the relevant information, analyze it systematically, and step These are some of the elements that give rise to what forward to adopt unpopular positions. s’ highfalutin word for “mistakes.” are called “inefficiencies,” academic I absolutely believe that markets can be effici ent – in the sense of “quick to incorporate information” – but certainly they aren’t sure to incorporate it correctly . Underpricings and However, the shortcomings descri overpricings arise all the time. bed in the paragraph just above are often far from “right,” it’s render those mispricings hard to pr ofit from. While market prices ors to detect instances when the consensus has done a faulty job nearly impossible for most invest of pricing assets, and to act on th right when it says the market ose errors. Thus theory is quite L.P. e vast majority of investors. can’t be beat . . . certainly by th ced that (a) pricing mistakes investing only if they’re convin People should engage in active rs they hire – are capable of ering and (b) they – or the manage occur in the market they’re consid identifying those mistakes and taking advantage of them. Unless both of those things are true, any time, effort, transaction costs and manageme nt fees expended on active management will be Active management has to be s wasted. een as the search for mistakes. Behavioral Sources of Investment Error MANAGEMENT, sell at fair prices, and thus there’s no ry asserts that assets As described above, investment theo RESERVED. such thing as superior risk-adjusted performance. tells us that superior But real-world data performance does exist, albeit far from universa possible to buy things lly. Some people find it on. But doing so requires the cooperation of people for less than they’re worth, at least on occasi ey’re worth. What makes them do that? Why do who’re willing to sell things for less than th CAPITAL mistakes occur? The new field of behavioral finance is all about l ooking into error stemming RIGHTS from emotion, psychology and cognitive limitations. (2) aware of all the facts, (3) If market prices were set by a “p ricing czar” who was (1) tireless, ALL proficient at analysis and (4) thoroughly rational and unemotional, assets could always be priced ation – never too low or too high. In the absence of that czar, right based on the available inform if a market were populated by investors fitting that description, it, t oo, could price assets perfectly. © OAKTREE That’s what the efficient marketer s theorize, but it’s just not the cas e. Very few investors satisfy icularly at number four – being all four of the requirements listed above. And when they fail, part e same direction at the same time. That’s the rational and unemotional – it seems they all err in th reason for the herd behavior that’s behind bubbles and crashes, the biggest of all investment mistakes. According to the efficient market hypothesis, pe ople study assets, assess th eir value and thereby ange in that value, value and the outlook for ch decide whether to buy or sell. Given its current Market participants engage prospective return and risk level. each asset’s current price implies a 2 All Rights Reserved. CONFIDENTIAL © Oaktree Capital Mana gement, L.P.
3 in a continuous, instantaneous au are updated. The goal is to ction through which market prices set prices such that the relati return and risk – that is, its onship between each asset’s potential prospective risk-adjusted return – is fa l other assets. ir relative to al Inefficiencies – mispricings – are instances when one asset offers a higher risk-adjusted return ght appear to offer a equally risky, but A mi than another. For example, A and B might seem higher return than B. In that case, A is too cheap, and people will sell B (lowering its price, sing its price, lowering its nd reducing its risk) and buy A (rai raising its potential return a s of the two are in line. That risk) until the risk-adjusted return potential return and increasing its condition is called “equilibrium.” e opportunities for extraordinary functioning market to eliminat It’s one of the jobs of a L.P. rpriced assets and buy underpriced assets. ipants want to sell ove profitability. Thus market partic They just don’t do so consistently. Most investment error can be distilled to the fa ilure to buy the things that are cheap (or to buy enough of them) and to sell the things that are de ar. Why do people fail in that way? Here are just a few reasons: Bias or closed-mindedness – In theory, investors will shift their capital to anything that’s cheap, correcting pricing mistakes. But in 1978, most investors wouldn’t buy B-rated bonds – at any price – because doing so was considered speculative and imprudent. In MANAGEMENT, y price – because they were 1999, most investors refused to buy value stocks – also at an deemed to lack the world-changing potential of technology stocks. Prejudices like these RESERVED. prevent valuation disparities from being closed. l out of high-priced assets and into – In theory, investors will move capita Capital rigidity cheap ones. But sometimes, investors are condemned to buy in a market even though CAPITAL venture capital, there there are no bargains or to sell even at giveaw ay prices. In 2000, in RIGHTS was “too much money chasing too few deals.” In 2008, CLOs receiving margin calls had like these create mispricings. s at bankruptcy prices. Rigidities no choice but to sell loan ALL ts when they get too rich in a – In theory, investors will sell asse Psychological excesses bubble or buy assets when they get cheap enough in a crash. But in practice, investors fail to sell, for example, because of an aren’t all that cold-blooded. They can unwarranted excess of optimism over skepticism, or an excess of greed over fear. © OAKTREE Psychological forces like greed, fear, envy and hubris permit mispricings to go uncorrected . . . or become more so. Herd behavior or sell an asset if its – In theory, market participants are willing to buy price gets out of line. But sometimes there are more buyers for something than sellers (or st investors’ inability to vice versa), regardless of price. This occurs because of mo diverge from the pack, especially when the beha vior of the pack is being rewarded in the short run. 3 All Rights Reserved. CONFIDENTIAL © Oaktree Capital Mana gement, L.P.
4 The foregoing goes a long way to support Yogi Berra ’s observation that “I n theory there is no difference between theory and practice. In practice there is.” Theory assumes investors are clinical, impact of these forces. Theory has no answer for the unemotional and objective, and always willing to substitute a cheap asset for a dear one. In practice, there are numerous reasons why one asset can be priced wrong – in the absolute or relative to others – and stay that way for months or years. Those are mistakes, and superior investment records belong to investors who take advantage of them consistently. A Case In Point L.P. Bruce Karsh and his distressed debt team have averaged returns of roughly 23% per year before fees and 18% after fees for more than 23 years w capital. All eighteen ithout any use of borrowed of their funds have been pr s have been quite scarce. I consider ofitable, and money-losing year d to be able to make that this record nothing short of aber rant. You’re simply not suppose kind of return for that long, and esp ecially without the use of leverage. Investing skill aside, what made it possible? at can’t be it; there’s nothing in a name. Is it because it’s called “distressed debt”? Th Is it because distressed debt is an undiscovered market niche? That can’t be it either; MANAGEMENT, and under-appreciated when we raised our distressed debt may have been little-known stitutional investors w ho haven’t heard of first fund in 1988. But there can’t be many in RESERVED. inly the secret’s out. distressed debt by now; certa ure into the sordid world of default and Can it be because people are unwilling to vent bankruptcy? That might have been the case in the 1980s, but today most investors will CAPITAL do anything to make a buck. RIGHTS So, then, why? I think it’s largely a matter of mistakes. ALL At our London client conference in April, I listened as Bob O’L eary, a co-portfolio manager of “Our business is often an our distressed debt funds, described his group’s work as follows: examination of flawed underwriting assumptions.” In other words, it’s their raison d’être to © OAKTREE profit from the mistakes of others. diate inspiration for this memo. The active Hearing Bob put it that way gave me the imme investor only achieves above averag e performance to the extent that he can identify and act on mistakes others make. The opportunities invested in by our distressed debt funds are a glaring example. What’s the process th rough which the mistakes arise? The analysis performed by a company’s management, or the due diligence performed by a prospective acquirer, understates the stre sses to which a business will be subjected 4 All Rights Reserved. CONFIDENTIAL © Oaktree Capital Mana gement, L.P.
5 to withstand them. Using Bob’s terminology, they employ and/or overstates its ability overly optimistic underwriting assumptions, particularly in good times. As a result, debt is piled on th at turns out to be more than the company can service when things turn down. Just as companies and acquirers are often t oo optimistic in good times, debt holders tend to become too pessimistic in bad times. As a result, they become willing to sell the debt of financially distressed companies at prices that overstate the nega tives and thus are too returns with less-than-commensurate risk. low, giving us the potential for superior stressed debt investing. All three of these are foundational elements for success in di L.P. The first two contribute to the creation If no one rn situations. of high-potential-retu underestimated risk and thus overloaded capital structures with debt, there wouldn’t be many defaults and bankruptcies. We call these lending decisions “the unwise extension of credit” or, alternatively, “stacking wood for the bonfire.” gative developments and scary prospects, And if no one panicked in response to ne and thus sold out too cheaply, there would be no reason to expect higher risk- anything else. debt than from adjusted returns from distressed MANAGEMENT, Many of the biggest mistakes made in the busin ess and investment worlds have to do with into eternity, whereas the truth is that trends cycles. People extrapolate uptrends and downtrends RESERVED. an go well or poorly forever, most things regress to the mean. The usually correct: rather th longer a trend has gone on – making it appear more permanent – the more likely it usually is that the time for it to reverse is near. And the longer an uptrend goes on, the more optimistic, risk- ople become . . . just as they should be turning more cautious. tolerant and aggressive most pe CAPITAL RIGHTS So, for example, when the economy is thriving and profits are rising, people conclude that tions should be undertaken, and more debt can company operations should be expanded, acquisi be borne. That same bullishness causes providers of debt to bestow larger amounts of money on ALL rates and with looser covenants. Thus cycles are big weaker borrowers, at lower interest is one of the biggest destroyers of capital. sources of error, and pro-cyclical behavior © OAKTREE The point here is that one of distressed debt in vesting’s great advantages is that it embodies an anti-error business model . Distressed debt investors . . . well and investors are ere everything’s going . . . almost never invest in companies wh enthralled; there’s no such thing as a financ ially distressed company that everyone loves; . . . by definition rarely invest before th e emergence of significant problems, hopefully ses are left in the bag; meaning fewer negative surpri 5 All Rights Reserved. CONFIDENTIAL © Oaktree Capital Mana gement, L.P.
6 icant discounts, often from forced or highly . . . are in business to buy debt at signif motivated sellers. “Distressed debt at par” is an oxym oron and, at least in theory, distressed debt investors are ba as prices fall . . . not the rgain hunters whose ardor rises reverse like so many other investors. st that their likelihood of vestors can’t make mistakes; ju It’s not that distressed debt in r investment activity. Anything that decreases doing so is reduced by the very nature of thei involuntary safety mechanism – works to his an investor’s chance of erring – even an advantage. Distressed debt is, by definition, an area where: L.P. borrowers and lenders have made grave mistakes, es have come to light, and at least some of those mistak attend a downturn often make debt holders the stress, unpleasantness and uncertainty that sell out at the wrong time and price. In other words, it’s an area where negativism and error are crystallized, maximized and magnified. And nothing is more likely to make an asset too cheap than excessively negative psychology. ople have wised up such that When we’re out raising a new fund, investors often ask whether pe MANAGEMENT, the answer has been no, and in fact there’s no they’ll no longer make these mistakes. Thus far e. The proof? The all up the learning curv reason to believe there’s been any progress at RESERVED. -07 and flowered in the crisis of 2008 were distressed debt opportunities that built up in 2005 red, and certainly the most plentiful. some of the best we’ve ever encounte CAPITAL One Classic Mistake RIGHTS Investing consists of just one I want to take this occasion to touch on a favorite thought of mine. profit in the future. Thus there’s no getting away thing: choosing which assets to hold in order to ALL from the need to make decisions concerning the future. two things: (a) an opinio In deciding which future to prepare for, you need n about what’s likely © OAKTREE to happen and (b) a view on the probability that your opinion is right. Everyone knows about the former, but I think relatively fe w think about the latter. “Of course they do,” you might say. “If they In short, most people believe in their opinions. nions, they wouldn’t hold them.” Everyone’s And that’s the point. didn’t have faith in their opi entitled to his or her opinion. But one of our favorite sayings around Oaktree states that “it’s one thing to have an opinion, and someth ing very different to act as if it’s right.” ons because we believe them. (We rarely hear anyone say Clearly, our opinions are our opini But just as clearly, we believe (or should “Here’s what I think, and I’m probably wrong.”) being right about the rs. The probability of believe) more in some of our opinions than othe 6 All Rights Reserved. CONFIDENTIAL © Oaktree Capital Mana gement, L.P.
7 weather tomorrow in California, a B-rated bond issuer paying its debts, and Greece being part of in each case. Few people would take issue with the European Union in three years is different that. If that’s true, the reliance we place on each prediction – and the action we take in that reliance – Yet, as I see it, most people who believe in forecasting come up with their should vary. opinions and then act on them with equal am ounts of confidence. This is one of the greatest sources of investment error. ng. It’s also okay to say you have a view on It’s perfectly okay to say you don’t know somethi sure you’re right. In that case you’re likely to moderate what might happen but you’re not so t to be wrong. As Mark Twain put it, “It ain’t your actions and emerge intact even if you turn ou L.P. what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” e 1999 graduating class Or as Treasury Secretary Robert Rubin told th of the University of ce between certainty and likelihood can make all Pennsylvania, “. . . understanding the differen the difference.” Forecasting error is much less likely to prove fatal in the absence of excess conviction. I’ve mentioned before the frequency with which I icularly apt quote just feel I come across a part when I need it for a memo in the making. Thus I’ll close this section with one on the present xclusivo Listserv” of May 29: subject from Yaser Anwar’s “E MANAGEMENT, . . . while every one well knows himself to be fallible, few . . . admit the feel very certain, supposition that any opinion, of which they may be one of the RESERVED. knowledge themselves to be liable. (John examples of the error to which they ac Stuart Mill, “On Liberty,” 1859) In other words, nearly everyone accepts that his or her opinion might be wrong . . . just not this CAPITAL time. RIGHTS A Big Mistake in the News ALL A vast amount of ink and airtime is being devoted to the subject of JP Morgan’s loss of multiple risk. People – and especi ally politicians – have billions of dollars in its effort to hedge credit seized on the loss to prove that Jamie Dimon is n’t perfect and bank regul ation is inadequate. © OAKTREE Clearly, JP Morgan made a mistake – or more than one. Jamie Dimon has described the hedge “a terrible, egregious mistake.” How could that be the case – as “poorly designed,” “sloppy” and loss – in a field as inherently defensive as and how could the result be such an enormous hedging? The answer’s simple: as Charlie Mung er once said to me about investing, “It’s not supposed to be easy. Anyone who finds it easy is stupi d.” The truth is, it’s hard to get it all right of hedging as it is of investing. all the time, and that’s just as true ll something to lessen the impact if your Hedging sounds easy: you own something, so you se ere are lots of ways to be wrong. investment performs badly. But th 7 All Rights Reserved. CONFIDENTIAL © Oaktree Capital Mana gement, L.P.
8 Hedging with the wrong thing but don’t want to suffer the . Let’s say you own some A full impact if its price declines. Why not just sell short an equal amount of A to hedge? ly shorting A is the same as not owning The answer is that owning A and simultaneous anything. The long and short positions exactly offset each other, meaning you can’t make (or lose) any money. That’s not hedging, that’s negating. inate them. So you hedge by selling short You want to dampen fluctuations, not elim something you think will move in sympathy with A, but not exactly. The hope is that by doing it very well, you can eliminate more of the risk of loss than you do of the potential for gain. That’s the meaning of a “positive arbitrage.” L.P. Buying Ford stock and simultaneously shorting Ford accomplishes nothing. So perhaps you buy Ford and short General Motors, which you think will perform less well, going up less than Ford or down more. But by transact ing in two different assets, you by definition is is called “basis risk.” In introduce the possibility of an unfavorable divergence. Th short, it’s the risk that the behavior of the two assets relative to each other will differ from down, giving you a loss, but rather than go what you expected. For example, Ford goes down in sympathy (which would give you an offsetting gain on the short position), a favorable development at GM makes it go up, compounding your loss as the hedge goes against you. MANAGEMENT, You hold 1,000 Ford shares, and you think that – given Hedging in the wrong amount. short 500 GM shares to hedge your risk. their likely relative performance – you should RESERVED. opposite directions, their relative movements But it turns out that while they move in dged too much (and thus you lose more on aren’t what you expected. Thus you either he ition) or you hedged too little (so the the hedge than you make on the underlying pos There’s no sure way to choose the right protection you sought doesn’t materialize). CAPITAL “hedge ratio.” RIGHTS The two sides of the position may work as you expect, but not when you Time risk. the short run, meaning the loss on one side of expect. Thus the hedge may fail to work in ALL her, in which case you’ll look flat-out the hedge may occur before the gain on the ot wrong for a while. And if you’re requir ed (by regulation, margin call, capital at point, the result could be quite negative. withdrawals, etc.) to close out the position at th © OAKTREE might want to adjust or remove Insufficient liquidity. If conditions or goals change, you your hedge. But market developments in term s of liquidity might make it impossible to alter one or both sides of the position. In other words, hedging consists of an attempt to cede some potential gain in exchange for a greater reduction in potential lo ss. It’s a very reasonable co urse of action. But it doesn’t necessarily have to work. olate past relationships In attempting to set up effective hedges, there’s little choice but to extrap between things. If they could be counted on to persist unchanged, there’d be little risk of being 8 All Rights Reserved. CONFIDENTIAL © Oaktree Capital Mana gement, L.P.
9 to hedge, or whether the two sides of the wrong about which asset to hedge with, how much eryone else in the investment world, would-be hedge will move simultaneously. But, just like ev ’t be counted on to hold in the nships that held in the past can hedgers must understand that relatio future. The New York Times And let’s remember, as wrote on May 26, “Yes, Morgan lost big – but, as Mitt Romney has pointed out, someone else won.” That’s the bottom line on all investing. There’s generally a right side and a wrong side to every investment. Which will you be on? * * * L.P. largely from putting at least as Risk control isn’t an action so much as it is a mindset. It stems much emphasis on avoiding mistakes as on doing great things. g – requires an understanding of the fact that Risk control – and consistent success in investin for the picking; others must create them for us by making high returns don’t just come along tter job if we force ourselves to understand the mistakes. And looked at that way, we’ll do a be mistake we think is being made, and why. rrors to which others tical and psychological e Risk control requires that we avoid the analy MANAGEMENT, succumb. RESERVED. In particular, risk control requires that we temp nions with acceptance of er our belief in our opi our fallibility. In the end, superior investing is all about mistakes . . . and about being the person who CAPITAL . profits from them, not the one who commits them RIGHTS June 20, 2012 ALL © OAKTREE 9 All Rights Reserved. gement, L.P. © Oaktree Capital Mana CONFIDENTIAL
10 Legal Information and Disclosures This memorandum expresses the views of the author as of the date indicated and such views are subject to change without notice. Oaktree has no duty or obligation to update the information contained herein. Further, Oaktree makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Mo reover, wherever there is the potentia l for profit there is also the possibility of loss. This memorandum is being made av ailable for educational purposes only and should not be used for any not be construed as an es not constitute and should other purpose. The information contained herein do solicitation to buy any securities or related financial offering of advisory services or an offer to sell or ation contained herein concerning economic trends and instruments in any jurisdiction. Certain inform performance is based on or derived from information pr ovided by independent third-party sources. Oaktree L.P. Capital Management, L.P. (“Oaktree”) believes that the sources from which such information has been e accuracy of such information and has not obtained are reliable; however, it cannot guarantee th such information or the assumptions on which such independently verified the accuracy or completeness of information is based. herein, may not be copied, reproduced, republished, This memorandum, including the information contained or posted in whole or in part, in any form without the prior written consent of Oaktree. MANAGEMENT, RESERVED. CAPITAL RIGHTS ALL © OAKTREE CONFIDENTIAL © Oaktree Capital Mana gement, L.P. All Rights Reserved.
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