Howard Marks (Trades, Portfolio) is a billionaire investor, arguably one of the greatest of all time. As one of the co-founders of Oaktree Capital, he has racked up an incredible return of 22% per year for his distressed debt fund alone over a 35-year period.
In a 2023 interview, Marks sat down with the dean of accounting at the University of Chicago to discuss the founding story of Oaktree Capital and his strategies for investment success. In this discussion, I have summarized the lengthy interview, providing direct quotes in parts and extra context for clarity. Let’s dive in.
Education
The investor said he originally planned to study accounting, but ended up majoring in finance. Interestingly, Marks took Japanese literature as his minor at the University of Pennsylvania.
Further, a real driver of him deciding to go to business school was the Vietnam War, as he was at the age where a draft was likely and he knew there was an “above zero” probability of not coming back in 1967.
The importance of luck in success
The guru acknowledged that luck has played a part in his and most people's major success. He referenced Microsoft (MSFT, Financial) founder Bill Gates (Trades, Portfolio). He said if he went to high school 10 years earlier, the computer system would have been dated with simple “batch processing.” Instead, Gates got access to an early computer (teletype machine) that was directly connected to a mainframe computer at a nearby computer company called Computer Center Corp. (CCC).
In a similar vein, Marks noted he was also “incredibly lucky” in his investing education as Wharton taught him the “qualitative” side and the University of Chicago taught him the “quantitative” side, of which that educational institute was a pioneer in this area.
As such, Marks' skill came in the “synthesis” of both qualitative and quantitative.
However, he said he also had a “stroke of bad luck” which turned into good luck with regard to his first job. He was rejected for a job at Lehman Brothers by accident as the recruiter ended up calling the wrong guy, as Marks found out years later.
Lehman Brothers subsequently went bankrupt during the financial crisis of 2008 and Marks could have easily ended up with nothing.
“Man plans and God laughs,” he added.
Lessons from the Nifty 50 bubble
In 1969, Marks took a summer job at Citibank (C, Financial), which was known as a “money center bank” at the time. These banks were heavily involved with investing and were focused on the “Nifty 50,” the so-called 50 best companies in the U.S.
According to him, they were “so good, it was felt nothing bad could ever happen.” It was also assumed that there was “no price too high.”
These stocks included Coca-Cola (KO, Financial), Proctor & Gamble (PG, Financial), IBM (IBM, Financial), Xerox (XRX, Financial), Kodak (KODK, Financial), Polaroid and many more. Although some of these companies have continued onto success, many others, such as Kodak and Polaroid, were disrupted. But the real killer for investors was the valuation was too high even for some of the greatest companies.
Marks recalled that if you invested into them in 1969, when he joined and held them firmly for five years, you “lost almost all your money” because the price-earnings ratio corrected from “80 to 8.”
The junk bond king
In early 1978, Marks said he was sent to the bond department, which he called “Siberia” in those days, and was told to start a “convertible bond fund.” This was technically a step down for him since he would now be classed as just a portfolio manager. Previously, he was given a prestigious title as head of research, a $5 million budget and a team of 75 people. For most people, this would be distressing, but Marks said he was “ecstatic.”
This was because in the head of research job, he had to know “two sentences” on 400 companies, the “epitome of superficial.” However, in this new job, Marks only had to know more than anyone else on 20 companies.
Marks started managing $15 million and a few months later had a call from a guy named Michael Milken, who wished to discuss “high-yield bonds. Milken was later named the “Junk Bond King” after major success.
Prior to the late 1970s, there was no such thing as issuing a bond with a non-investment-grade rating. Marks said all bonds had to be “triple A, double A, single A or triple BBB” or you couldn’t issue it. By definition, a “highly levered company couldn’t issue bonds.”
The innovation was that bonds could be issued from these companies with high debt, as long as the return compensated for that.
This led Marks to an epiphany that he still lives by today: “Investing is not a matter of buying good things, but buying things well.”
In other words, you can buy a great company, but if the price is too high, it may be a poor investment. This is also true if you invest in a poor company, but it is cheap enough it may be a good investment.
The birth of Oaktree Capital
Marks had built up a strong track record of over 10 years, with high-yield bonds firmly “beating the market.”
The next innovation came from a guy Marks had hired named Bruce Karsh. He the idea to start a “distressed debt fund.” This was a “radical idea” to buy the debt of companies that were close to bankruptcy.
However, Marks realized this was not so different from buying the bonds of poor companies. As often, a bond would fall very low in price and would require the fund to go on the credit committee to restructure the debt before selling the bond at a higher price.
So Marks and Karsh launched their first distressed debt fund in 1988. This was also the start of the leveraged buyout and private equity industry.
This meant small companies could raise capital to acquire larger ones, which was previously unheard of. However, by the 1990s many of these leveraged buyouts went bankrupt because the companies could not survive the high debt servicing requirements during the recession at the time.
This was a perfect storm for Marks, whose fund managed to achieve an incredible 45% gross return, with no leverage.
During that time, the company Marks worked for, TCW, would take “half of the incentive fees,” which was millions of dollars. In addition, many of the firms ran strategies he “didn’t believe in” and he disliked having to endorse them.
These factors combined spurred Marks to start to Oaktree Capital in 1995 with five other members of the group he had recruited. Shortly after starting the fund, another 27 people quit TCW and went to join Marks at Oaktree.
Internet bubble and crash tailwind
In 1999, the internet bubble popped, which, according to Marks, resulted in the “first three-year decline” of the S&P 500 since 1939.
He recalled people “lost faith” in the stock market. In addition, the Federal Reserve lowered interest rates to stimulate the economy. Therefore, investors did not have many places to turn who wanted yield, apart from alternative investments, which Oaktree specialized in and thus saw tremendous success.
Being a contrarian
In the mind of Marks, the definition of value investing is “buying things for less than they are worth.”
The challenge is it requires “assistance” from somebody else who is willing to sell things for less than they are worth.
Therefore, Oaktree tends to deploy capital best during crises when “asset holders get scared.”
Out of Oaktree’s 35-year record, just six years, which were the years of market crashes, pulled up the average return of the fund substantially to 22% per year gross.
To help with being a contrarian, Marks uses a concept called “second-level thinking.” This helps him to think “different from the herd,” but also “deeper” and “better.” Another skill is the ability to be “unemotional” when making investment decisions.
How to make great investment decisions
Investing success all comes down to “insight,” which Marks said you either “have it or you don’t.”
Another strategy he employs is to view the future and decision-making as a “probability distribution.” This can involve the best case, worst case and average case.
Then one must calculate if the “expected return compensates for the risk which lurks in the left-hand tail.”
With regard to understanding the stock market, its important to remember share prices are determined by people who have feelings. As such, Marks said it is psychology which determines the prices in the short term.
In the guru's famous memos, he effectively tests the market for psychological cues and looks for “extremeness.” For example, in 2005 and 2006, he detected “optimism” and a “lack of fear.” This was an indication to Marks that asset prices were overvalued.
Another example would be late 2020, which also had similar exuberance due to the stimulus and thus, would have been a good time to sell growth stocks at the highs. Investors deemed that period to be “flawless” after being “hopeless” just a few months before.
Conversely, when risk aversion has become “excessive,” he noted that is an indication that prices may be too low and it is now time to buy.
Final thoughts
Marks is an incredible investor and truly insightful when it comes to his investment style. The ability for investors to think at a “second level” and avoid the herd is challenging, but it can lead to tremendous success in the long term. He is an inspiration to us all and his lessons are invaluable, so it is no wonder Warren Buffett (Trades, Portfolio) reads his memos.
