Talks at Google

Transcription

MALE SPEAKER: Hello, everyone. Welcome to today's talk. We have a very, very special guest today. And I couldn't be more pleased. In thinking about an introduction for him, I quickly realized there's nothing that's going to beat his own words. So I'm going to share a couple of snippets from his writings over the years. And as I do so, think about what would be your guess when he wrote them. So here's one. The bottom line is that many of the investors setting the prices in today's markets don't care about valuation. I get no sense, at all, that the analysts and portfolio managers backing the large cap growth stocks and internet high flyers can imagine prices at which they would be mere holds or, heaven forbid, sells. When do you think this was written? AUDIENCE: [INAUDIBLE]. MALE SPEAKER: This was '99. So yeah, there's something to say about the timeliness of what our guest writes. And here's one more. This is from the last 10 years. In the end, buyers took out the biggest mortgage possible given their incomes and prevailing interest rates. Such mortgages would land them in the houses of their dreams and would leave them there as long as conditions did not deteriorate, which they invariably do. Anyway you slice it, standards for mortgage loans have dropped in recent years and risk has increased. Logic based? Perhaps. Cycle induced and exacerbated? I'd say so. Certainly, mortgage lending was made riskier. We'll see in a few years whether that was intelligent risk taking or excessive competitive order. When was this? AUDIENCE: [INAUDIBLE]. MALE SPEAKER: This was 2007. And we are a few years from there. And we've seen what happened. So I'm sure all of you want to know what's on our guests mind today. And we are so fortunate that he's here with us in person. So without any further ado, ladies and gentlemen, please join me in welcoming the one and only Howard Marks. [APPLAUSE] HOWARD MARKS: Well that's quite an induction and [INAUDIBLE] puts a lot of pressure on me that I have to be right. So it's hard. But I'm really excited to be here. I want to thank [INAUDIBLE] for setting up this event. And he's worked very hard to make it go well for you and for me. And I hope it'll be fun for all of us. And because I get the impression here at Google that fun is important. Right? AUDIENCE: Absolutely. HOWARD MARKS: So there aren't too many things in life that are worth doing if they can't be fun. As you know, I wrote a book in 2011 called the most important thing. And the reason it has that title is because I would find myself in my client's office. And I would say the most important thing in investing is controlling risk. And then five minutes later, I would say the most important thing is to buy at a low price. And five minutes later, I would say the most important thing is to act as a contrarian. So back in 2003, I believe, I wrote a memo called The Most Important Thing. I listed 19 things. Each of which was the most important thing. And then I used that. I couldn't think of a better format for my book. So I used the same format in 2011. Interestingly, some of the things are different. That goes to show you that one's thinking should still be alive and should still evolve. And I know that [INAUDIBLE] and some of the other fellows went to see Charlie Munger speak in Los Angeles this week at age 91. And I'm sure he's still evolving and getting younger. So I'm going to try to do the same. Now I should tell you, and I don't know if you know this, but I write memos to the clients. And I'll refer to a lot of memos in this session, probably. And they're all available on oaktreecapital.com website. And the price is right. They're all free. And I've been sending them out now 25 years. I started in 1990. And I got a letter from a guy named Warren Buffet in 2009 or '10. And he said, if you'll write a book, I'll give you a quote for the jacket. So I had been planning on writing a book when I retired from work. But Buffet's promise caused me to accelerate my time frame. And what the book is is-- who here has read it? OK, about half. So what the book is, it's a recitation of my investment philosophy. And as it says in the forward to the philosophy, which I took the forward-- I don't know about you, I never read the forwards books. But I took the forward to mine very seriously. And what it says in there-- it's not designed to tell you how to make money. And it's not designed to tell you how easy investment is or to try to make it easy. And in fact, my highest gold is probably to make it clear how hard it is. Investing is very difficult because it's, kind of, counter intuitive. And it, kind of, turns back on itself all the time. And there are no formulas that work. So what I tried to do in the book is teach people how to think. Now the thoughts they should hold change from time to time. But how to think, I think, is valid in the long term. And it's my invest philosophy. And I wasn't born with an investment philosophy. You'll hear from a lot of people, if you're interested in investing, he'll say, well, I started reading prospectuses at age eight, and I didn't. Or you know, at 13, I invested my bar mitzvah money, which I didn't do. But in fact, when I was getting out of graduate school-- age 23 in 1969 so I know you can all do the math-- I didn't know what I wanted to do. I had studied finance at Wharton and accounting at Chicago. And I knew I wanted to do something in finance. But I wasn't very specific. So I interviewed in five or six different fields. Large consulting firms, small consulting firm, accounting firm, corporate treasury, investment management, investment banking, six, so I ended up in the investment business. Why? Because I had a summer job in '68 at city in the investment research department and I liked it. I had fun, right. That's a good reason. So I went there. And by the way, interestingly, there was nothing magical about working in the investment business at that time. It paid the same as all the rest. All six jobs that I was offered had the same pay. Between 12.5 and 14 a year, not a month. And there were no famous investors at the time. Investing was not a household word. There were no investment TV shows. So I just did it because I liked it. I liked the people. And I thought that the investing was intellectually interesting. So I didn't have a philosophy then when I started. And I had some things I had learned in school. But I think that your philosophy-- your philosophy-- as opposed to somebody if you studied Descartes or Locke or somebody like that, you learn his philosophy. You might learn a philosophy by studying a religion. But that's not your philosophy. Your philosophy will come from the combination of what you have been taught by your teachers and parents and your experiences and what your experiences tell you about the things you were taught and how they have to be modified. So I developed my philosophy. It might seem like I started writing the memos a long time ago-- 25 years-- but I had been working already over two decades, at that time. So I think that the integration of real life into philosophy is essential. Now I prepared a few slides for today. And basically, the slides are here to illustrate where philosophy came from. Talk to you about some of the foundations and roots. So I call it origins and inspirations. And I hope you'll find it interesting. So first of all, not in order chronologically but, hopefully, in order to try to make something intelligible. Fooled by Randomness, by Nassim Nicholas Taleb. Now who here has read that? All right, more people than have read my book. And I think it's very important. I think it's an excellent book with very, very important ideas. Now don't tell Nassim I said this, but I tell all the people I speak to that it is either the most important badly written book or the worst written very important book that you'll ever read. I think it's not very clear. And I think it's not-- well, maybe there's no attempt to make it clear. But I think a lot of the ideas are very important and even profound, in my opinion. So among other things, and the basic theme is that in investing there's a lot of randomness. And if you look at investing as a field without randomness where everything is determinative, you'll get confused because you will not draw the proper inferences from what you see. For example, just a brief example, you see somebody and they report a great return for the year. The scientist who thinks that the investment world runs like the world of physics might think, well, great return, that means the guy's a great investor. But in truth, it might be somebody who took a crazy shot and got lucky. Why? Because there's a lot of randomness in the world. When I went to Wharton in 1963, the first book I remember learning was called Decision Making Under Uncertainty, by C. Jackson Greyson who became, as I recall, America's first energy czar. And I learned a couple important things from that book. Number one, that you can't tell from an outcome whether a decision was good or bad. It's very important. Most people don't understand this. Totally counter intuitive. But the truth is, in the real world where there's randomness at work-- I mean, if you build a bridge and it falls down, then you must assume that the engineer made a mistake that it was a bad decision to build the bridge that way. But in the real world of where there's randomness, good decisions fail to work all the time. Bad decisions work all the time. The investment business is full of people who are, quote, right for the wrong reason. Made a bad decision, it didn't work out the way they thought, but they got lucky. And they were bailed out by events. So this is very important. And this is the basic theme of "Fooled By Randomness," Taleb's first book. Since then, he has written the black swan, which became more famous, but I don't think is as good a book. And he's written a book called anti fragile. And that one didn't get famous. But I think that this book is something everybody should read it if you have an interest in numbers, investing, and how the world works. So as I say, the book is all about the role played by luck. And basically, even if you know what's most likely, many other things can happen instead. This is very, very important. We talked earlier at lunch about what's the most important lesson you can draw. Well, of course, I'll never say most important to anything. But one very important lesson for you to learn is that you should not act as if the things that should happen are the things that will happen. Again, in the world of the physical sciences, you could probably bet that that's true. And the electrical engineer knows that if he turns on a light switch over here, the light will go on there every time because it's subject to physics. Not in the world of investing. So for every possible phenomenon, There is a range of things that can happen. There may be one where it's possible to discern which one is the most likely. And if we draw a probability distribution, that may be the highest point on the distribution. The most likely single outcome but that doesn't mean it's going to happen. And the reason we don't have many probability distributions that look like this but rather that look like this is because a range of things can happen. And it's very, very important to notice that, number one, there are lots of things that can happen. So you have to allow for them. And number two, the thing that is most likely to happen is far from sure to happen. So that's very key. There's a professor at the London Business School who put it so simply. He said risk means more things can happen than will happen. And again, this is profound in my opinion. In the economic world, people generally make decisions based on something called expected value, which is to say that you multiply every possible outcome. First of all, of course, you don't think in terms of a single outcome. You think in terms of a range of outcomes. So you take every-- if you could iterate over so many-- you take every possible outcome, you multiply it by the likelihood that it'll happen, you sum the results, and then you get something called the expected value from that course of action. And you choose your course of action based on the highest expected value. And that sounds like a totally rational thing. But what if the course of action that you're considering has some outcomes that you absolutely can't withstand? Then you may not do it. You may not do the highest expected value course of action because it has some you can't live with, you know. Who here is willing to be the skydiver who was right 98% of the time? You know, for example. So you may elect to do bike riding on the Google campus rather than skydiving, even though skydiving is more exhilarating 98% of the time. Anyway, so the point is as I lived my life from learning about [INAUDIBLE] learning about Taleb, from learning from my own experience, I realized that should does not equal will. Lots of things that should happen fail to happen. And even if they don't fail to happen, they fail to happen on schedule. So the thing that the economist or the financier thinks should happen this year may happen in three years. And you got to live three years to see it happen. One of my favorite sayings is never forget the six foot tall man who drowned crossing the stream that was five feet deep on average. We can't live by the averages. We can't say, well, I'm happy to survive on average. We got to survive on the bad days. And if you're a decision maker, you have to survive long enough for the correctness of your decision to become evidence. And you can't count on it happening right away. I always remind people overpriced is not the same as going down tomorrow. And if you bear that simple truth in mind, I think it helps. So Taleb and the role of lock luck, very important. Then John Kenneth Galbraith. John Kenneth Galbraith, for those of you who are not familiar with ancient history, was an American economist. Died around '05, I think, maybe a little after and at the age of about 98 and he was one of my favorites. He was a little on the left side. He was somewhere between free enterprise and socialism. But he was what we call a liberal in the days when it was OK to say that word. But he was very, very smart. And he was not famous as an economist. But he played a lot of roles in government. And he was a diplomat. But he wrote some very good books. And one of them is called A Short History Of Financial Euphoria. And I like thin books. And his is thin. Especially the ones he wrote in the last decade or two of his life were very thin. So I enjoyed those. But the short history is very good, and I'll recommend that to you. And one of the things he says is we have two classes of forecasters. The ones who don't know and the ones who don't know they don't know. Now I don't believe in forecasts, macro forecasts. People who forecast interest rates, performance of economies, and performance of stock markets. And I don't think that my efforts to be a superior investor and most other people's are aided by macro forecasts. So am I saying that the forecaster is never right? No, I'm not saying that. The forecasters are often right. Last year, GDP grew 2%. Many forecasters forecast that GDP will grow this year at 2%. That's called extrapolation. And usually, in economics, extrapolation works. Usually, the future looks like the recent past. So usually, the people who forecast a continuation of the current are right. The only problem is they don't make any money. Because let's take the economy-- most people forecast two something for this year. A growth rate of two something is cooked into the prices of securities today. If the growth rate turns out to be two something, everybody who forecasted that would be right. But security prices will not change much because that two something growth was anticipated and discounted a year or two ago. So all those people who are right won't make any money. So that's correct. So extrapolation works all the time. Forecasts that are extrapolations work all the time, but they don't make any money. Logically, am I saying that forecasts never make any money? No. The forecasts that make money are the forecasts of radical change. If everybody's predicting 2.4% growth for this year and if I predict minus 2 and it turns out to be minus 2 or I predict six and it turns out to be six, I'll make a lot of money. So forecasts which are not extrapolations-- forecasts which are radically different from the recent past-- are potentially very valuable if they're correct. Of course, they do not have any value if they're incorrect. And if they're incorrect, they'll cost you a lot of money. If everybody else thinks it's going to be 2.4 and you predict six and it turns out at 2.4, you're probably going to have taken the wrong investments and lost a lot of money. So deviant forecasts, which turn out to be right, are potentially very valuable but it's very hard to make them. It's very hard to make them correctly. It's very hard to make the correctly consistently. And somebody at lunch mentioned an early memo I wrote called the value of forecasts. And in one, there was the value of forecast and then there was the value of forecasts two, I think, right. And in one of those, I reviewed the history, the recent history, of the Wall Street Journal poll. Every six months, the Wall Street Journal publishes the results of a poll of economists on GDP growths, CPI, the value of $1, price of oil, whatever it might be, a bunch of phenomena. They do it consistently. And they ask ask, like, 30 people consistently over time. So it shows, basically, that most of the time when people get it right it's because they predicted extrapolation and nothing changed. Once in awhile, something changes radically. And invariably, somebody predicted it. But the problem is, if you look at that person's other forecasts over the years, you see that that person always made radical forecasts and never was right any other time. So of course, if you're getting your information from a forecaster, the fact that he was right once doesn't tell you anything. The views of that forecaster would not be of any value to you unless he was right consistently. And nobody's right consistently in making deviant forecasts. So the bottom line for me is their forecasting is not valuable. And that's something that my experience has told me. So we don't know what's going to happen and randomness will play a big role in what happens. And randomness is, by definition, unpredictable. Number three, The Losers Game, by Charlie Ellis. This is very interesting. Anybody here know the name of the company TRW? A few people. TRW used to be a big conglomerate. And now it's known primarily for credit scores. And there was a guy named Si Ramo. He was the R. It was Thompson, Ramo, Wooldridge. And he was the R in TRW and very smart. And Si Ramo wrote a book. And it was about winning at tennis. Who here plays tennis? OK, this is good because as I go around the world now, very few people play tennis anymore. But what Ramo said is that there are two kinds of winning tennis players. If you look at Pete Sampras, or Nadal, or Djokovic, how do they win? The winning champion tennis player wins by hitting winning shots. Hits shots that the opponent can't return. They're either so well placed, or so strategic, or so fast and hard that the opponent can't return them. And if Nadal hits a shot, which is not a potential winner, then his opponent can probably put it away because it doesn't have enough difficulty on the ball. So the championship tennis player wins by hitting winners. You play tennis, right? How do you win? Do you win? AUDIENCE: Sometimes. HOWARD MARKS: How do you win? AUDIENCE: If I win, it's by not hitting it out. HOWARD MARKS: That's right. The amateur tennis player like him and me, we win not by hitting winners but by avoiding hitting losers. And we believe that if we can just push it back 20 times and just get it over the net 20 times, our opponent can only do it 19. We believe that we'll out-steady him, outlast him, and eventually he'll hit it into the net or off the court. We'll win the point. But we'll win the point without having hit a winner. So there are obviously two styles of tennis. So the same is true for investing. So Charlie Ellis wrote an article called The Losers Game. And he said he thought that investing-- so championship tennis is a winners game. It's won by winners. He thought amateur tennis is a losers game. It's won by the people who avoid being losers. Charlie thinks or thought that investing is a losers game. So the best way to win at investing is by not hitting losers. Now I believe also that it's a losers game. Not as much as Charlie believes and not for the same reason. Charlie believes that investing is a losers game because the market is efficient and securities are priced right. I believe there are inefficiencies. I just think it's hard to consistently take advantage of them. And you have to be an exceptional person to take advantage of them on a consistent basis. And the reason that the pro can go for winners is because he is so well schooled and practiced and steady and talented that he knows that if he does this with his foot and this with this hip and this with his elbow and this with his wrist that the ball will go where he wants. He doesn't worry about miscues, wind, sun in his eyes, or distraction. He's so well schooled. In fact, in scoring tennis matches, they keep track of something called unforced errors. And the reason they keep track of them is because there are so few. The pro doesn't make a lot of unforced errors. We make unforced errors all the time. So in order to survive, we have to avoid them. So the point is, if you're going to be an investor, you have to decide am I good enough to go for winners, or should I emphasize the avoidance of losers in my approach? So I say here that the difficulty of getting it right is what makes defensive investing so important because it's just for us in investing, especially because there's randomness, if we do the right thing with our foot and hip and arm and elbow, we're not going to get a winner every time. And then the fourth origin that I wanted to talk about today was my meeting with Mike Milken in November 1978. So in '78, I got a call from my boss at Citibank. And he said, there's some guy in California named Mike Milken, and he deals with something called high yield bonds. Can you figure out what that means because one of our clients had asked for a high yield bond portfolio. And in that day, nobody knew about it. It was unknown. So I met with Mike in November of 1978. He came to see me at Citi in New York. He was looking for clients. He was just starting off in the high yield bond industry. And there was a great meeting. And he explained to me that if you buy AAA bonds, there's only one way to go. AAA bonds are bonds that everybody thinks a great. There companies are making a lot of money. They have prudent balance sheets. The outlook is good. Everything's perfect. So if everything's perfect, that means it can't get better. And if it can't get better, that means it can only get worse. It doesn't have to get worse. But if there is a change, it's going to be for the worse. And if you've bought a bond on the assumption that it's perfect and it gets worse, then you lose money. So that's important. On the other hand, he said, if you buy single-B bonds and they survive, there's only one way for them to go, which is upgrade. Now that's not exactly true because they can default and go bankrupt. But the ones that survive will go up, will be upgraded, and the surprises are likely to be on the upside. So this is very important. Again, this is about trying to hit winners and avoid losers. And if you're buying bonds that most people don't think much of, it's hard to have a big loser because such low expectations are incorporated. Now let me digress for a minute because this is really important. How do you make money as an investor? The people who don't know think the way you do it is by buying good assets, a good building, stock in a good company, or something like that. That is not the secret for success. The secret for success in investing is buying things for less than they're worth. So if you buy a high quality asset-- and I say in the book, there's a guy on the radio. When I lived in LA, I listened to NPR on the way work. And there was a guy and I heard him say it. He said, well, if you go into a store and you like the product, buy the stock. He couldn't be more wrong because what determines the success of an investor is not what he buys but what he pays for it. And if you buy a high quality asset but you overpay for it, you're in big trouble. You can buy a very low quality asset. But if you pay less than it's worth, chances are you're going to make money. So the book says-- chapter three says-- the most important thing is value. Figuring out what the value of an asset is. But chapter four says the most important thing is the relationship between price and value. So let's assume that you're able to figure out the value. If you pay more than that, you're in trouble. If you get it for less, the wind is at your back. So it was very, very important then to be in an area where the surprises were likely to be on the upside. And if you buy the bonds of B rated companies which there are such low expectations, maybe it's easy for there to be a favorable surprise. Now how can I prove to you that the expectations were low? The answer is that if you look in the Moody's guide to bonds in those years, what was the definition of a B rated bond? Quote, fails to possess the characteristics of a desirable investment. In other words, it's a bad investment. Now, I drove here from the airport in my car. And if I take you outside to look at my car and I offer it to you for sale because I don't need that car anymore. When I'm done here, I'm not coming back. If I say to you, would you like to buy my car, what is the one question you must ask me before saying yes or no? Price. You get an A. You get an A. So in other words, it's a good buy at a certain price. It's a bad buy at another price. Moody is now saying that B rated bonds are a bad by without any reference to price. So in other words, there's no price at which a company that has some credit risk is worth investing in. And by the way, before I turned to high yield bonds and '78, I was part of the banks machinery to buy the stocks of America's best companies. And I explained to [INAUDIBLE] if you bought the bonds of Hewlett Packard, Perkin Elmer, Texas Instruments, Merk Lilly Xerox, IBM, Kodak, Polaroid, AIG, Coca Cola, and Procter & Gamble, and if you bought them all in '68 and you held them until '73, you lost 90% of your money. Why? Because they were overpriced. The average stock since the postwar has traded at 16 times its next year's earnings. These were trading at 80 and 90 times. Why? Because they were so good. Everybody says these are great companies. Nothing can go wrong. So it doesn't matter what price you pay. And if you pay 80 or 90 times, that's fine. So here we are, in my experience-- again, experience as a teacher-- you invest in the best companies in America, you lose a lot of money. Then you go to the high yield bond business, you invest in the worst companies in America, you make most money. So it's an instructive lesson if you have your eyes open and you learn from experience, which I did. But the key words were and they survive. Right? This little trap there because you have to catch those three words. If you buy single-B bonds that don't survive, then you're in big trouble. But obviously, it's tautologically true that if a company about which the expectations are low survive, it'll probably, at minimum, it'll pay off at maturity. And maybe in the meantime it'll be upgraded or taken over if they survive. So what that convinced me when I was starting the high-yield bond business and this conversation came at a great point in time is that my analyst should spend all their time trying to weed out the ones that don't survive. Not finding the ones that will have favorable events but just excluding the ones that have unfavorably events. And that's what we did. Now I'll tell you an interesting story. Around '05 or '06, the bible of investing is a book called Security Analysis written by Graham and Dodd. And they wrote the first edition 1934. But Ben Graham was Warren Buffett's teacher at Columbia and, in many ways, the father of value investing. And he and David Dodd wrote this book in '34. And they updated it in '40 and then several times after. And the '40 edition is considered to be a great edition. So in '05 McGraw Hill, which owned the book, said they want to update the book. And they turned it over to Seth Klarman who's a great debt investor in Boston at Baupost and a professor-- I can't remember his name right now. What? AUDIENCE: [INAUDIBLE] Greenwald. HOWARD MARKS: [INAUDIBLE]. That's right. Bruce Greenwald at Columbia. So you should be up here. I'll sit down. And they turned it over to Seth and Bruce to bring out this revision. And they, in turn, asked people to revise the sections. And they asked me to revise a section on debt. So that meant I had to go and read the 1940 edition in order to update it. And I came across something fascinating. And it was and it verified what I had always thought. It said that bond investing is a negative art. What does that mean? What it means is, I don't know how many of you know how bonds work, but a bond is a promise to pay. You give me $100, and I promise to give you 5% interest every year, and then give your money back in 20 years. Fixed income it's called because all the events are fixed. The contract is fixed. The return is fixed, assuming the promise is kept. So all 5% bonds that pay will pay 5%. None will pay six. None will pay four. All the ones that pay will pay 5%. What does that mean? It means of the ones that pay, it doesn't matter which ones you buy. I'm going to like this one. I like that one a lot. That pays five. And I like that one. That pays five. It doesn't make any difference. You're not going to be a hero by choosing among the bonds that pay. The only thing that matters is to exclude the ones that don't pay. So if there are 100 bonds, 90 will pay. They'll all pay the same thing. It doesn't matter which of the 90 you choose. The only thing that matters is excluding the 10 that don't pay. Negative art. The greatness of your performance comes not from what you buy but from what you exclude. So I thought that was very useful. I should have that up here, too. But anyway, Milken was my fourth input. So Taleb says that the future consists of a range of possibilities with the outcome significantly influenced by randomness. And Galbraith says the forecasting is futile. And Ellis says that if the game isn't controllable, it's better to work to avoid losers than to try for winners. And Milken says that holding survivors and avoiding defaults is the key in bond investing. So if you put them all together, that's how you get the philosophy that's in the book. These were my origins. So when we started Oak Tree April 10 of 1995 almost exactly 20 years ago, we wrote down our investment philosophy. And here it is. We published it. We were a bunch of guys who had been working together for most of the previous 10 years at a different employer. And we left there as a group. And we started Oak Tree. So for a philosophy, I believe in writing things down. And like learning at the [INAUDIBLE] says today right them down, right. So we wrote down our philosophy. We published it. We never changed a word since. And the clients like knowing what our roadmap is. So these were the six tenets of the investment philosophy. So the first one says that the most important thing is risk control. And we tell the clients we think that for excellence in investing, the most important thing is not making a lot of money. It's not beating the market. It's not being in the top quartile. The most important thing is controlling risk. That's our job. That's what we'll do for you. And the clients come to us who want to invest in our asset classes with the risks under control. There are other people who put less emphasis on controlling risk. And they have better results in the good times and worst results in the bad times. Our clients want what we give them. Number two, we have an emphasis on consistency. So we say we don't try for the moon at the danger of crashing, you know. The first memo that I wrote in 1990-- I'm sure you remember that, [INAUDIBLE]-- talked about a guy who was head of an asset manager that had a terrible year. And he said, well, it's very simple. If you want to be in the top five percent of money managers, you have to be willing to be in the bottom. I have no interest in being in the bottom 5%. And I don't care about being in the top 5%. I want to be above the middle on a consistent basis over the long term. And there's a funny bit of math. This will confound the-- what did you call yourself-- data scientists? This will confound the data scientists in the room. So in that first memo, I contrasted the comments from that money manager with a comment from one of my clients who told me right about the same time there was the juxtaposition that caused me to write that first memo. He told me that for the previous 14 years, his pension fund had never been above the 27th percentile or below the 47th percentile. So it was solidly in the second quartile every year for 14 years. So let's see. 27. 47. The average of that is 37, right? What percentile do you think that fund was in for the whole 14 years? AUDIENCE: [INAUDIBLE]. HOWARD MARKS: Four. Four. And if you think about it, it's really almost mysterious. Why the fourth? Not the 37th. And the answer is that when people blow up, they really blow up. So we said we want consistency. We want to be a little bit above the middle all the time. Maybe we'll pop up to the top in the years when the markets are terrible and our risk control is rewarded. But we think that over a long period of time we'll be very respectable that way. And our clients will have an absence of bad experiences, which I think, for them, is very important. So then macro-forecasting is not critical to investing. We do not make our decisions based on macro-forecasts, as I explained to you. We all have opinions. We-- our official dictum is that it is OK to have an opinion. You just shouldn't act as if it's right. And I think this is very important. You know, Mark Twain said, "it's not what you don't know that gets you into trouble. It's what you know for certain that just ain't true." So we try to avoid holding strongly to those macro opinions. And finally, we don't do a lot of market timing, which is very, very hard to do. We do long term investing in assets that we think are underpriced. So that's the Oak Tree philosophy. You could see how the origins and inspirations that I went through fit into that. And in fact, it's all distilled in our model, which says that if we avoid the losers, the winners take care of themselves. And if we can make a large number of investors and just weed out the problems, then we'll have-- just think of the bell shaped curve. We'll have a lot to do OK and an occasional one, which is exceptional if we can weed these out. So a lot of money managers go into the clients and say we will get you in the top quartile into the great right hand tail. I think it's hard to do on a consistent basis. And if you aim for the right hand tail and you miss, you end up in the left hand tail. What we say is we'll just lop off the left hand tail. And if we can do that successfully, and we pretty much have, then what will you have? OK, good, very good, great, terrific, but no terrible, the average will be very good. And that's basically what we've had. So lastly, I'll just leave you with what I consider my three greatest adages. Not mine but the ones I've encountered over my career and that have been the most helpful. And they're all used in the book. First of all, what the wise man does in the beginning, the fool does in the end. In every trend in investing, it eventually becomes overdone. If you find an asset which is cheap and buy it, that's great. If everybody else figures it out that it's cheap, then it will go up. Then people see that it's rising. And more people jump on the band wagon and it goes up, up, up. And the last person to buy it is a fool. And the first person to buy it is a wise man. It's the same asset. Just at different prices. And as people say, first the innovator, then the imitator, then the idiot. So that's another way to look at this adage. Number two, never forget the six foot tall man who drowned crossing the stream that was five feet deep on average. Kind of like that skydiver who's right 98% of the time. It's not sufficient, depending on how you want to live your life, to survive on average. We have to survive on the bad days. So we have to be able to survive the low spots in the stream. Your portfolio has to be set up to survive on the bad days so you won't be shaken out of your investments. And then finally, being too far ahead of your time is indistinguishable from being wrong. And yet, that's a great challenge because, as I said before, the things that are supposed to happen will not necessarily happen. And they absolutely will not happen on time. So you have to be able to live until the wisdom of your decisions is proved, if at all. So all of these things, I think, say something about modesty and humility of belief rather than cock sureness, which I think is the greatest risk. So with that, [INAUDIBLE], I'll stop talking. And we have a little time left. And I'd love to take your questions. That's what I'm here for. MALE SPEAKER: Thank you, Howard. This was fascinating. So we are open for questions. Please raise your hand, and I'll bring the mic to you. AUDIENCE: The thing you said about what the wise man does in the beginning the fool does in the end, you can come up from a single stock. You can think about your whole philosophy that way. So you've been focusing here on avoiding losers. And maybe humans are, kind of, generally focused on trying to find winners. Maybe that's what we'll always do wrong. But if everybody in the world is trying to avoid losers, maybe the wise investor now shoots for the winners, do you know what I mean? Sort of self-balancing. HOWARD MARKS: Sure. Well, number one, I don't think that we have to worry about everybody becoming to prudent or to wise because we're talking about human nature. Charlie Munger-- the boys went to see Charlie Munger this week. One of the great quotes that Charlie gave me was from the philosopher Demosthenes, who said for that which a man wishes that he will believe. What do most people want more anything else? They want to get rich. Very few people think that the secret to their happiness comes from prudence and caution. Most people think it comes from that stroke of genius, which will put them on easy street. But you're absolutely right. And there are times when most people behave in a prudent and cautious manner. When is it? It's in a crash when security prices are down here. Right? That's the time to turn aggressive and buy. So Buffett says the less prudence with which others conduct their affairs the greater the prudence with which we must conduct our own affairs. And there are times when we should turn aggressive. And that's when everything's being given away. AUDIENCE: So you said hat you did not make any macro forecasts, right? But actually the macros can affect companies in other ways. Like if you have an interest rate of, like, 30%. I mean, 99% of the companies will be gone or something like that. So how do you even make an investment? HOWARD MARKS: OK. So now I know I'm not coming back to Google anymore because the people are too intelligent because this is one of the great traps. I say that we don't invest on the basis of macro forecast. But you have to have an economic framework in mind when you predict the fortunes of individual companies. And what I would say is what we try to do is it's one thing to say that oil is at 50 and we're going to invest in this company because it will do fine if oil's at 50, survive if it goes to 30, and thrive if it goes to 70. But it's another thing to say oil is 50, I think it's going 110, I'm going to invest in this company, which is going to be great if it goes to 110 but bankrupt if it stays at 50. So the question is, how radical are your forecasts? And we try to anticipate a future that looks pretty much like the norm and make allowance for the thing that things other than the norm can happen. And I can't really be much more concrete than that. By the way, all this stuff is judgment. You know, there are no rules. There are no algorithms. There are no formulas that always work. None of this is any good unless the person making the decision has superior judgment. And the first chapter of the book says the most important thing is second level thinking. Most people think on the first level. To be a superior investor, you must think on the second level. You have to think different from everybody else. But in being different, you have to be better. So the first level thinker is naive. He says, this is a great company, let's buy the stock. The second level thinker says it's a great company, but it's not as great as everybody thinks it is. We better sell the stock. That's the difference between being an average person and a person with superior insight. By the way, most people are not above average. Yes, sir. AUDIENCE: Do you think diversified index funds adequately protect the amateur investor from losers? HOWARD MARKS: Well this is a great question. The role of the index fund. A lot of people say, I'm going to take a low risk approach. I'm going to invest in an index fund. And they are confused. What an index fund does is it guarantees you performance in line with the index. So the point is because of the operation of what's called the efficient market, not many people can beat the market. It's true. Most mutual funds do not beat the market. Most mutual fund investors would be better off just to be in an index fund. And in fact, most active investment schemes impose fees that they don't earn. And that is one of the major reasons that most active investment schemes perform below average. So the index fund, which is called passive investing, yes it reduce, eliminates, the likelihood that you fail to keep up with the index. It also, of course, eliminates the possibility that you outperformed the index. So you trade away the two sides of the probability distribution for surety that you get index results. But it doesn't eliminate the risk of the investment. It eliminates the risk of deviating from the index. What you have to keep in mind is that the index fund investor loses money every time the index goes down. Why? Because there's no value added to keep it above. And by the way, index investing is a fine thing for the average amateur investor because the average amateur investor, number one, can't beat the market and, number two, can't find anybody or hire anybody who can beat the market. But the only thing is he shouldn't think that it's a risk-less trade. You eliminate what we call benchmark risk. But you retain the risk of the underlying asset. AUDIENCE: So you've been through one or two of these business cycles, I guess. HOWARD MARKS: Yes. AUDIENCE: And with availability of information and with a number of books being written about this subject about value, and proper investing, and how many managers don't beat the market, do you think the average investor is doing anything different than they were 20 years ago? HOWARD MARKS: Well, look, I think there's a minor movement toward indexation. It's not groundswell. There's still lots of money in actively managed mutual funds where there's 2% a year of fees and costs or one and a half. But I think there's more in indexation every year. And that's probably appropriate. But I'll just turn i around. I'll leave you with a question. Why can't people beat the market? Because the market's pretty efficient. And market prices most things right. And most people can't find and identify and act on the times when the market prices things wrong. That's why most people can't beat the market. That's what I learned at University of Chicago. And I think it's pretty true. So the reason for the inability to beat the market is the markets efficiency. The markets efficiency comes from the concerted efforts of thousands of investors who are trying to find the bargains. What happens when they stop trying? So when the interest in active investment declines because people give up on it and turn to passive investing and all the analysts quick studying the companies, then prices resume their deviation from intrinsic value. Then it becomes possible to beat the market again. So it's really paradoxical and, I would say, counter-intuitive. But I don't think we are close to that day. But in theory, there comes a day when so little attention is being paid to active investing that active investing starts working again. Yes, sir. AUDIENCE: Thanks, Howard, for coming for the talk. To talk about the difference in value and the price, the other dimension is time. So how do you estimate the time taking to [INAUDIBLE] to close? HOWARD MARKS: You never do. You never know. See, what he's saying-- again, it's a very good question. And what we want to do is we want to find things where the intrinsic value is here and the price is here. So his question is, how do we estimate the time that it's going to take for the gap to close? And the answer is there's no way to say. On occasion, there are what we call catalysts. And one catalyst would be the pending maturity of a bond. If a bond is going to mature in 2012 and it's selling at 60 because most people think it's going to go bankrupt but we think it's going to pay off at maturity, then the existence of the maturity date is going to force the convergence of price to value. Another catalyst today is all these activist investors. They find the company. It's selling. They think the interesting value is here. It's selling here because the management is sub par and they're not doing the right strategy. So they go in. They foment trouble. They try to get a board seat. They try to force the management to do the right thing to course, to cause, the price to converge with the value. So there are a few catalyst in the world. But generally speaking, you buy a stock. You hope-- you would think it's worth here. The price is here. You hope it'll convert. But there's no way to estimate the time. And that's the reason why being too far ahead of your time is [INAUDIBLE] from being wrong because it can take a long time. AUDIENCE: Would you always look for presence of catalyst when you find a gap? HOWARD MARKS: There aren't enough. I mean, it happens. Most of what we do is in the fixed income world. And there are more catalysts in the fixed income world than in the equity world. You find a stock. How many stocks you think the activist investors go after a year? 10? 20? 50? 100? No more. There are thousands of stocks. So most stocks are never going to get catalyzed. AUDIENCE: Curious if you could tell us what it was like when you were out raising money for Oak Tree in the early days. I would imagine that today some clients are skeptical. But I would imagine that it was-- was it a lot different for you back then? HOWARD MARKS: Well by the time we started Oak Tree, it wasn't that hard because we had a reputation. But when I started raising money for our strategies-- 1978 junk bonds-- 90% of investment organizations like Google had a rule, a concrete rule, against any bond investing below A or below investment grade, which is BBB. And of course, Moody said it's an imprudent investment. So that was very, very hard to overcome. But what you have to do is you have to find a few people. You see, you have to find a few people. You have to go say to them you should do this because nobody else is. Because nobody else is doing it, it's languishing cheap. You make no money doing the things that everybody wants to do. You make money by doing the things that nobody wants to do who then turn out to have value. And if you say that message to 100 investors in the beginning, maybe 10 jump on board. After it works for a while, then the rest come on, like the screen says. But hopefully, not too extreme. But the point is it was very hard in the beginning. And in certain foreign countries, it was even harder because in certain foreign countries where the thinking is a little more narrow than American thinking I always thought that if I go into somebody's office and I say you should do this because nobody else is they'd call the man in the white coat to take me away. They don't understand. You know, I think that Americans semi intuitively understand the value of contrarianism and of being a maverick. But in many countries, they just don't get it. So that's an example, high yield. But then we started Oak Tree in-- oh, no, no. That was at Citi. In '85, I switched from Citi to Trust Company of the West, TCW. And in '88, we brought out the first distress debt fund. Now we're not investing in companies that have a risk of default. We're investing in bonds that are either in default or sure to be. And people would say, well, how can you possibly make money investing in the bonds of bankrupt companies? And we had to explain to them that if a creditor of a company doesn't get paid the interest in principle as promised, they have a claim against the value of the company. And they exert that claim in a process called bankruptcy. And in bankruptcy, to oversimplify and over generalize, the old owners are wiped out. And the old creditors become the new owners. And if you bought an ownership stake through the debt for--what-- for less than it's worth, then you make money. And we've made about 23% a year for 28 years investing in distressed debt before fees without any leverage. So that's pretty astronomical. Why? Because from time to time in distress debt you get to buy things for less than they're worth. And in fact because other people are fleeing from the bankruptcy, maybe you get them to buy them for a lot less than they're worth. So it's very challenging. But you can't convince everybody. But if you can explain the merits and tell the story clearly, and concisely, and persuasively then you get some clients. And then, if you get good results, then you get more clients. AUDIENCE: Thank you, Howard, for your talk. One question. Buffet, in '99, said that if he was running very small amounts of money he would be able to find lots of bargains and beat the market by 50% and he would use the word guaranteed. I presume he meant that there are a lot of inefficiencies in the small capitalization stocks. One thing that kind of surprises me is if someone, an analyst, willing to work hard on his own, not in an institution, the word of distress debt investing is kind of shut out, even for the value investor. [INAUDIBLE] with a lot of technicalities and it seems like the big institution has a lot of advantage there. Are there such inefficiencies that are kind of shut out to the institutions but the small investor willing to work hard can find inefficiencies in the debt world? HOWARD MARKS: Well I think that the small guy can even be active in distressed debt. He can't get enough bonds to get a seat at the creditors committee table or have a voice. But he can still find superior values. You know, so what I was saying in answer to your question is that if you get some accounts and you have good performance, you'll get more accounts. So that goes a little further because what I really say is that if you have good performance, you'll get more money. And eventually, if you let that process become unchecked, if you get more money, you'll have bad performance. And this is one of the conundrums in our business. So you have to halt that. But the truth of the matter is that the little guy has an advantage as long as he's willing to stay small. Many people are not because in the short run, the more money you manage when you get fees, it's a great lure to take on more money. But you have to stop it at a point before it starts running your performance. Now, for the data scientists among us, I always like to point out that if I worked at Firestone Tires and I developed a new tire, and I wanted to know how far it would go, I would put it on a car and run it until it blew up, right. That's called destructive testing. But as an investor with clients and a fiduciary responsibility, I don't have the luxury of doing destructive testing. So I can't add more. People always say to me, well, what's the limit on how much money you can invest well? And I can't find out by running into the wall. I have to stop this side of the wall. One of the interesting lessons is that if you stop this side of the wall then you never find out where the wall really is. But that's what we have to do. So you have to stop. And I believe that the person who has a big brain, and a little money, and a lot of time, and exceptional insight can find great bargains. But that's a pretty daunting list. And I don't think that Buffett's guarantee necessarily extents to everybody in this room. AUDIENCE: Do you see any unhealthy trends in valuation in the market today the same way [INAUDIBLE] was valued in the past? HOWARD MARKS: Yes, I do because the menu extends. What we call the capital market line extends from what's called the risk free rate. The risk free rate is the rate, generally speaking, on the 30 day treasury bill. And of course, if you can get 3% on the risk free rate, then in order to tie up your money for five years in a five year treasury you want four. And to get it 10 years, you want five. And if you can get 10 years on a government security of 5%, then in order to go into a corporate security, which has some credit risk, you would demand six. And to go into a high yield bond, you demand 12 and so forth. So there's a kind of a process called equilibration, which makes things line up in terms of relative risk and return but always pegged from the risk free rate. Today, the risk free rate is zero. So everything that I just named, this capital market line, has had a parallel downward shift. So before the crisis, [INAUDIBLE] mentioned about the fact that I turned bearish. All my money was in was in treasuries. All the money that I had outside of Oak Tree was in treasuries. And I was getting 6 1/2% for one, two, three, four, five, six year maturities. I was getting income and safety. Today, you have a choice. Income or safety because the things today that are highly safe pay no income. You know, and if you go to Fidelity-- conduct an experiment. Go to Fidelity or Vanguard or a big mutual fund firm and go online and look at their menu of offerings and what is the current net yield after fees and expenses. And you'll see that for money market and short term treasuries, and maybe intermediate treasury, the yield is zero. So just think. The guy is watching the Super Bowl in his undershirt. He gets a statement from Fidelity. He opens it up, and it says the yield on your fund is now zero. He grabs the phone. He calls the 800 number. He says get me out of that fund that yields zero, and put me in the one that yields six. And he becomes a high yield bond investor. He has no idea why. He doesn't know what a high yield bond is. He doesn't understand what the dangers are. He doesn't understand how to pick a high yield bond manager. But he's seduced by that 6% versus zero. And all around the investment world today, people are chasing return. They don't like the low returns that are available on safe instruments. They're going for the gusto. They're going for riskier instruments. And they're doing it mindlessly. And I promised you I'd mention some memos. I forgot to do that. But if you go back, I wrote one in March of '07 called The Race To The Bottom. And I talked about the fact that when people are, number one, eager to invest and, number two, not sufficiently risk conscious they do risky things. And when people do risky things, the market becomes a risky place. And that's why Buffett says, the less prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own affairs. And that is going on now to some extent because people can't get a good return from safe instruments. They're going into the risky ones, and they're bidding. You know, so there's a race to the bottom. It's like an auction. Now if you want to buy a painting at Sotheby's, there's an auction, and the painting goes to the person who pays the highest price. But in the investment world, it's a reverse auction. Well sometimes you pay highest price, but sometimes you bid in lowest return. So there's a bond that's going to be issued by a company. I say I demand 7% interest. And this fellow says, no, I'll take six. And that guy says, I'll take five. I say I want protective covenants to make sure that the company can't do things that ruins its own credit worthiness. He says I'll do it with less covenants. And that guy says, I'll do it with no covenants. What happens? The bond is issued at 5% with no covenants. And that's the race to the bottom. And anybody who participates in that bond probably could be making a mistake. And that's going on now. Not to the same terrible extent that it was in '06 and '07. But you got to be careful today. Oak Tree's model for the last 3 and 1/2 years has been move forward but with caution. Caution has to be a very important component of everybody's actions today. Well thank you very much for being with me. And I hope you enjoyed it. And when I think of more stuff, I'll come back. MALE SPEAKER: Thank you so much. [APPLAUSE]