A Conversation with Howard Marks and Mike Milken (updated)

Historical Market Lessons and Cyclical Behavior

• Failure to heed history is the primary cause of investor victimization, as people consistently extrapolate current trends indefinitely, ignoring the cyclical nature of economies, business life cycles, and markets.
• Investors suffer biggest errors by buying when prices are high and selling when low, driven by excitement during rallies and depression during declines, rather than the contrarian approach required for success.
• The 1973–1974 Nifty Fifty crash serves as a definitive lesson that asset quality and safety have little to do with investment risk.
  • Investors purchased the "best" 50 companies (e.g., IBM, Kodak, Xerox) regardless of price, believing growth would justify valuation.
  • These stocks traded at 80–90 times earnings in 1969, falling to 8–9 times earnings by 1973.
  • This resulted in a 90% loss of value in the "safest" assets, shattering the trust in large bank trust departments and fueling the growth of the private money management and mutual fund industries.
• The 1987 Black Monday crash demonstrated there is no "sure thing" in investing.
  • The market fell 26% in a single day due to portfolio insurance strategies that triggered automatic selling when prices dropped, causing a liquidity freeze where brokers could not answer phones.
  • The event highlighted the impossibility of predicting market movements and the failure of "immunization" strategies.
• The Tech Bubble (late 1990s) mirrored the Nifty Fifty dynamic despite the sector's eventual success in transforming the world.
  • Investors ignored valuations believing technology would change the world, yet lost all their money in the process.
  • A 1960s Merrill Lynch report predicted a 100-fold increase in the computer industry; while correct on the trend, 29 of the 30 companies they selected were no longer in business or the computer industry within 15 years.

Bond Investing and Reinvestment Risk

• Reinvestment rate is the critical variable in long-term bond returns, often more so than the coupon rate or initial yield to maturity.
  • Long-term bonds derive the majority of their return from "interest on interest" rather than the principal coupon.
  • When interest rates rise, the interim market price of bonds falls, but the ability to reinvest coupons at higher rates creates a long-term advantage.
  • The illusion of "yield to maturity" assumes reinvestment at the exact stated rate, which rarely occurs; high rate volatility makes this calculation illusory.
• The 1974 interest rate spike caused the collapse of insurers like Equitable Life.
  • Insurers had issued annuities guaranteeing high returns, but subsequent rate drops made it impossible to reinvest capital at those levels.
  • This demonstrated that credit quality alone does not guarantee safety if the reinvestment environment turns adverse.
• High-yield bonds (junk bonds) carry limited downside if bought at attractive yields.
  • Buying at a yield of 5% with a 5% probability of failure means the investor is unlikely to go broke, as survivors yield returns that cover the losses of defaulters.
  • Even if high-yield bonds underperform, the mistake is rarely fatal compared to the catastrophic losses from perceived "safe" assets.

The 2007–2008 Financial Crisis and Risk Perception

• The 2008 crisis was driven by "Too Much Trust, Too Little Worry," where market participants believed risk had been eliminated through securitization, tranching, and abundant global liquidity.
  • Investors assumed the Federal Reserve and global reserves could solve any problem, leading to a cessation of risk aversion.
  • The crisis proved that when risk aversion disappears, due diligence is abandoned, covenants are ignored, and prices detach from reality.
• Bull markets progress through three stages:
  • Stage 1: A few bright people realize opportunities.
  • Stage 2: The majority recognize the improvement.
  • Stage 3: Everyone believes improvements will last forever (the danger zone, reached in 2007).
• Risk is defined by perversity; the belief that there is no risk is the ultimate risk.
  • Ratings agencies were wrong in 2008, creating 16,000 Triple-A rated mortgage obligations despite only a handful of truly safe corporate entities existing.
  • Low-quality assets become safe investments when bought at deep discounts (e.g., 25 cents on the dollar), proving that price determines safety more than credit rating.
  • High-quality assets (like IBM or "safe" bonds) become the riskiest when purchased at inflated prices.

Uncertainty, Luck, and Skill

• Investors should not attempt to predict macro variables (e.g., Fed policy, geopolitical outcomes) because they are unknowable, even if they influence short-term market movements.
  • Success comes from focusing on the "knowable": specific companies, industries, and securities where skill and hard work yield an edge.
  • Past reliance on regression analysis often fails because the future is not a linear projection of the past (e.g., Singer Sewing Machine bonds traded at 35 cents due to social changes like the emancipation of women).
• Outcomes are heavily influenced by luck and randomness.
  • Success requires aggressiveness, timing, and skill; high aggressiveness at the right time can compensate for a lack of skill.
  • Short-term results are often luck-driven; long-term performance is required to distinguish skill from random probability.
  • Hard work puts an investor in a position to be "lucky," but one must work on the right things (knowable areas) rather than futile predictions (e.g., coin tosses).
• Demographics represent one of the few "knowable" trends, allowing investors to anticipate future population shifts and economic shifts with reasonable certainty.

Organizational Culture and Succession

• Oaktree Capital Group built its culture on specific pillars:
  • A defined "creed" to guide behavior and expectations.
  • A harmonious, team-oriented environment where individuals are incentivized on the firm's performance rather than individual "eating what they kill" models.
  • Broad ownership structure, growing from 5 founders to 170+ employees to align interests.
• The firm prioritizes values over immediate profit maximization.
  • Employees are selected for a constructive attitude and a desire for win-win solutions, particularly in restructuring distressed assets with flawed capital structures.
  • The firm rejects "ratings maximization" games, focusing instead on creating viable, long-term capital structures for companies.
• Succession planning focuses on perpetuating values, not finding a clone.
  • Successors do not need to replicate the founder's specific skills (e.g., writing memos) but must uphold the culture of excellence and client prioritization.
  • Quality and culture are the enduring assets of a firm; "good is good enough" is an acceptable outcome if it maintains stability.