A Conversation with Howard Marks and Mike Milken

Investing lessons are derived from historical cycles:

• Investors are repeatedly victimized by failing to recognize that economic, business, and market trends are cyclical rather than linear.
• A common error involves extrapolating current trends indefinitely, assuming prices will either grow to the sky or crash to zero, leading to buying at peaks and selling at bottoms.
• The 1973-1974 "Nifty Fifty" crash serves as a primary example: despite being the "best and fastest-growing" companies, these stocks lost 90% of their value between 1969 and 1973 due to valuations reaching 80-90 times earnings.
• This event proved that asset quality does not guarantee safety; even high-quality assets can be fatal if purchased at excessive prices.

Specific historical market anomalies and their causes:

• Arab Oil Embargo: Investors erroneously concluded oil had infinite value after the embargo, leading to overvaluation of oil assets and massive long-term losses for those buying at the peak.
• Black Monday (1987): The market lost 20% in a single day due to "portfolio insurance" strategies that created a feedback loop when brokers could not execute sells, disproving the notion of a risk-free immunization strategy.
• Tech Bubble: Similar to the Nifty Fifty, investors ignored prices believing in permanent growth; a 1969 Merrill Lynch report predicted the computer industry would grow 100-fold, yet 29 of the 30 recommended companies failed to survive or remained in the industry 15 years later.
• 2007-2008 Crisis: The primary cause was a cultural shift where "risk was believed to have been banished" by liquidity, the Federal Reserve, and securitization, leading to a cessation of due diligence and risk aversion.

Risk perception and behavior:

• Risk is not synonymous with low quality; a low-quality asset becomes safe if the price is sufficiently low (e.g., buying B-rated bonds at 25 cents on the dollar).
• The most dangerous risk is the belief that no risk exists, which leads to complacency, higher prices, and eventual busts.
• Rating agencies are described as having a role to be wrong, illustrated by the existence of only four AAA-rated corporations historically versus 16,000 AAA-rated mortgage obligations during the 2007 boom.
• True risk management involves recognizing that risk is perverse; assets perceived as risky by the herd are often the safest investments due to depressed prices.

The role of knowledge, uncertainty, and luck:

• Investors should admit they "don't know" the future macro-economy (Fed policy, global growth rates) as these are largely unknowable.
• Success in investing relies on focusing on "knowable" factors: specific company fundamentals, industry dynamics, and security analysis where skill yields results.
• Outcomes are heavily influenced by luck and randomness (as argued by Nassim Taleb), meaning a single successful year does not prove skill; consistency over hundreds of decisions is required to distinguish skill from chance.
• Hard work is essential to position oneself to be "lucky," such as understanding demographics where outcomes are statistically predictable.

Bonds, reinvestment rates, and fixed income:

• The total return on long-term bonds is driven more by the reinvestment rate of coupons than by the initial coupon rate or price appreciation to par.
• Rising interest rates, while depressing interim bond prices, are ultimately beneficial because they allow for reinvestment of coupons at higher yields.
• The 1970s crisis for life insurance companies (e.g., Equitable Life) resulted from locking in low annuity guarantees that could not be reinvested at required rates when interest rates collapsed.
• High-yield bonds are not inherently fatal if bought at yields (e.g., 5%) where the probability of default is low; survival guarantees the return, with upside potential if the bond is upgraded.

Organizational culture and human capital at Oaktree:

• The firm's creed emphasizes standing for values other than profit or assets under management, specifically focusing on team harmony over individual performance.
• Compensation is tied to team and firm-wide profitability rather than individual "eat what you kill" models to encourage collaboration.
• The ownership structure is designed to expand over time, with the firm growing from 5 owners to 170 employee-owners to ensure alignment with long-term viability.
• Succession is not viewed as finding a clone but as finding individuals who can perpetuate the company's core values of putting clients first and prioritizing quality over quantity.

Forward-looking statements and current market views:

• Investors should be terrified when others are optimistic and cannot imagine losing money, and aggressive when others are terrified of the future.
• The speaker argues that one can position a portfolio for superior returns by assessing the current "temperature" of the market and market participant behavior without predicting specific macro events.
• The speaker advises against "ratings maximization" games where the focus is on achieving high ratings regardless of underlying asset quality, as seen in the pre-2008 mortgage-backed securities market.
• Succession in leadership is viable if the successor focuses on maintaining the firm's culture of excellence and client service rather than replicating the predecessor's specific actions.