Howard Marks, chairman of Oaktree Capital Management, and Mike Milken, one-time junk bond king turned philanthropist, go back a long way. Both men attended Wharton Business School in the late 1960s, and have played important roles in shaping today’s debt market as it is today. So when the latter interviewed the former at the annual Milken Institute Global Conference in Beverly Hills in May, it was a standing-room-only affair.
The main topic of discussion was ‘The Most Important Thing’, Marks's book about investing – and in particular, lessons from history that investors have failed to heed. Take the Nifty Fifty, for example.
“I’m not sure everyone in the room remembers the Nifty Fifty; we might be showing that we’re over 30,” Milken joked.
“Yes, well you have to go back,” says Marks. “When you and I got out of graduate school in 1969, [most of] the leading banks emphasised something called Nifty Fifty investing, which meant you took the fifty best companies in America – Xerox, IBM, Kodak, Polaroid, Merck, Lilly, Texas Instruments, Hewlett Packard, Avon, Coca-Cola, etc – and you bought their stocks regardless of price because they were the best and they were the fastest-growing. The little hitch was that when I joined Citibank in 1969, they were trading at 80 to 90 times earnings; and by 1973 they were trading at eight to nine times earnings. Which meant that you lost 90 percent of your money in the best companies in America.”
That was a painful lesson, probably one of Marks’ greatest learning experiences, he says. “Experience is what you got when you didn’t get what you wanted …. But what it taught me is that risk and safety have nothing, or little, to do with asset quality.”
Black Monday in 1987 was also instructive, said Marks. “Now, you think of the market being down 3 percent and how panicked people get. Try losing 26 percent of your money in one day. And there was not even an obvious candidate for what caused it.” The trouble was, he said, that investors had persuaded themselves they could protect their downside risk by buying insurance and selling when prices started to fall – “except the brokers wouldn’t answer the phone”.
The lesson there, he continued, was that nothing is for certain. “My dad used to tell the story about the inveterate gambler who always lost the rent money at the track and finally heard about a race with one horse,” says Marks. “So he went out and bet all his money – and halfway around the track the horse jumped over the fence and ran away. It’s not a very sophisticated joke, but the point is that there is no sure thing. There are certainly no sure things in investing, and when you hear about a sure thing the best thing to do is run the other way.”
A bit like today's high-yield bond market, asked Milken?
Marks isn't sure it’s quite so dramatic. “If you buy high-yield bonds today, at their paltry yield of 5 percent, and they survive, you will make 5 percent. Nobody ever went broke making 5 percent.” There might even be some unexpected upside, he adds. “You know, most people are terrified of rising interest rates because it depresses the price of a bond temporarily. But if the credit is good, it still goes back to par when you get paid off – and in the meantime the coupons are reinvested at a higher rate than you anticipated, so it’s really not bad news.”
Understanding and controlling risk – and the mistakes investors typically make in doing so – is a topic that comes up repeatedly in Marks’ book.
The number one error, begins Marks, is that most people still equate safety with high quality assets – a theory that episodes like the Nifty Fifty have disproved.
Similarly, the assumption that lower quality assets are riskier can be turned on its head. “When I got started in high-yield bonds back in 1978, Moody’s defined a single-B bond as follows: ‘fails to possess the characteristics of a desirable investment’.” But is there not a price at which they become a good investment? “What about at 75 cents on the dollar; what about at 50; what about at 25?”
That’s the type of ‘herd’ error one can take advantage of, he says; most people believe that as something is rising in price, it’s less risky. “I think that when something rises in price, it becomes more risky. I think that the things that everybody thinks are risky are safe, because their aversion to it forces down the price to the point where it is safe and potentially lucrative.”
The riskiest thing in the world, Marks concluded, is the belief that there is no risk.
“Risk is perverse – that’s the important thing. Like in 2007, the belief that there was no risk is what made the world risky. And in late 2008, after Lehman Brothers melted down, the belief that there was no potential future is what created a great potential future.”