Howard Marks (Trades, Portfolio) is a legendary investor and the founder of Oaktree Capital. He is an incredibly wise and thoughtful investor whose perspective has been widely praised by the likes of Warren Buffett (Trades, Portfolio). In an April 2023 interview for the Real Estate Luminaries series, Marks revealed his thoughts on interest rates, the economy and how to navigate the uncertain climate. Here are my notes on the interview, supplemented with my own commentary on the topcis at hand; let’s dive in.
The power of serendipity
Marks graduated with an MBA in Accounting and Marketing at the University of Chicago in 1969 at 23 years old. He says he didn’t know what specific job he wanted to do, but he knew he “wanted to go into finance," so he applied for “six jobs in six different areas," including investment banking, investment management, corporate accounting, etc.
There was one role that seemed more “glamourous” than the others, so if he got offers for all six, he aimed to take that one. However, in a funny turn of events, Marks got offers from all the jobs except the one he wanted! 30 years later, Marks ended up getting in touch will the main interviewer after an incredibly successful career. He told him that he didn’t get the job, as the firm owner actually contacted the wrong guy, who turned out to be Marks' roommate.
According to Marks, if it wasn’t for that stroke of "bad luck," he would have spent the next 40 years at Lehman Brothers and had nothing to show for it. Lehman Brothers collapsed in 2008 and sparked the global Financial Crisis. The moral of this story is that life is filled with serendipity, and often opportunities we don’t get come with a silver lining.
Uncertain times
The prevailing rhetoric these days is that we are in “uncertain times." However, Marks believes there are only two types of times. The first is a time when we know what will happen “in the coming 10 years." The second is where we don’t what will happen. The main difference is in the first scenario, "you're wrong." In other words, the future is always unknown, it's just sometimes we assume it's less unknown than other times.
Marks quotes his October 2022 memo titled "The Illusion of knowledge," saying, “The enemy of knowledge is not ignorance, but the illusion of knowledge." If investors believe a certain investment strategy, asset class or stock is a sure thing, that is often when it can be most dangerous.
Interest rate changes
Back in the 1980’s, Marks took out a personal loan that had a whopping 22.25% interest rate. 40 years later he was able to borrow funds at just “2.25% fixed for 15 years." We have had decades of declining interest rates, which has lowered the cost of funds and capital for businesses and individuals.
Given investing is often a game of alternatives, a low interest rate environment meant bank savings accounts and treasury bills weren’t much benefit to an investor. Therefore capital flowed into the stock market, venture capital and cheap mortgages (which has caused real estate inflation).
Marks believes it was “inexplicable” for the U.S. Federal Reserve to keep rates at close to zero for “seven years” after the Financial Crisis. The Fed managed to “maintain” these low rates as the economy didn’t experience inflation until 2021.
Those individuals who joined the industry in the “last 15 years” believe we are in a “high interest rate environment” today. But Marks believes we are actually in a “normal interest rate” environment.
This is one of the tenets of the “Sea Change” Marks referred to in his past memo. It is the change from a low-interest rate environment to a slightly higher rate environment.
How to invest in this environment
Marks is not a fan of making forecasts, but says he believes we will see a “moderate recession." A core part of Oaktree Capital’s investment philosophy is to not “predicate” its investments on “macro forecasts."
Oaktree tends to make “neutral assumptions” which in this case means “rates stay where they are." This is an interesting take, as the Fed initially only raised interest rates to bring inflation under control. U.S. inflation has fallen from its 9.1% high in June 2022 to just 5.3% by March 2023. This is still above the Fed's 2% target. But personally, I would assume if/when inflation falls below this level, interest rates would then be ratcheted down.
Marks believes it's best to be prudent and consider this as a bonus, as opposed to basing your core investment thesis on this happening. The low-interest rate environment was “great” for “people who owned assets." It was “great for people who borrowed money." In addition, it was a “double Bonanza” for people who “bought assets with borrowed money."
This environment encouraged risk-taking, and we saw this manifest in a boom in meme stocks, unprofitable and unproven tech stock and other speculative assets. “Never confuse a bull market with brains," said Marks of this situation.
Oaktree’s core philosophy is value investing, which has a goal to “buy things for less than they are worth." The challenge is it requires the cooperation of someone who is “willing to sell an asset for less than it's worth." This tends to happen during the “bad times” as there are more “motivated sellers.”
Interestingly, a value strategy actually underperformed a growth strategy in the decade up until 2021. However, in a new environment of high-interest rates and lower valuations, the environment is more suited to “bargain hunters."
In a high-interest rate environment, the “discount rate” will be higher, which should subsequently devalue each asset. The goal is to be aware of this new environment and how it may impact your investments.
One of Oaktree’s “greatest businesses” is investing in distressed debt, which is perfectly suited for a recessionary environment. One of its funds has a “22-year record” with a “gross return 22% per year, unlevered."
This is “predicated” on the fact that even good assets can get over-levered, which decreases their probability of getting through a rough patch.
Investor psychology
A strategy Marks likes to use when investing is “taking the temperature of the market." For example, during the good times, when people feel cash rich and are celebrating, that is often when assets become overvalued.
During the bad times, there is often an emotion of desperation and people trying to keep what they have. Investor psychology tends to fluctuate between “flawless and hopeless."
Earnings have a tendency to fluctuate more than GDP at a macro level, while stock prices fluctuate to an even greater degree. This difference can be accounted for by investor psychology and leverage.
An example Marks gives is the “Nifty 50” during the 1970’s. These were considered to be the greatest companies in America and thus “no price was too high." Of course this didn’t last, and many of these stocks eventually crashed.
Therefore, a great investment is not just about buying great companies, but buying them at an undervalued price. For a “low-quality asset,” it will likely become a great investment if purchased at a very low price.
The question you should ask is, “Is the prospective return sufficient to compensate for the risk?” Ultimately this comes down to “superior subjective judgment," according to Marks.
Lessons from Silicon Valley Bank
Marks released a memo in mid-April 2023 which discusses lessons from Silicon Valley Bank. In his recent interview, Marks says he believes this is “not going to be as bad” as the Financial Crisis of 2008. This is due to a few reasons, the first being that the bank was “concentrated in a single sector and region," mainly the tech/health startups in Northern California. He believes this is “not as thoroughly taken up” as the “subprime mortgages” of 2008.
Real estate market forecasts
There is approximately $4.5 trillion of mortgage capital in the U.S., which is going to “refinance” at the new higher interest rates. Therefore, to maintain the current loan to values (LTV) at these higher interest rates would require an extra $500 billion to $600 billion in additional “equity capital."
This could have a knock-on effect on the economy with far-reaching implications. REIT prices declined by 25% in 2022, and bid-ask spread widened. In a liquid stock market, “prices collapse,” but in private markets such as real estate, transactions slow down or “crater."
Marks believes usually a few sellers “have to sell” for a variety of reasons and that is when prices of “private assets decline." However, often investors who run private portfolios don’t “mark down” their portfolios as much as they should.
Final thoughts
Howard Marks (Trades, Portfolio) is an incredible investor who has outperformed the stock market over the decades, while also providing incredible wisdom to investors. He believes we are experiencing a “Sea Change” in the economic environment. However, if one can keep a solid value investing strategy and take advantage of the fluctuations in investor psychology, it should result in great returns long term.
