Founder of Oaktree Capital: It's better to buy well than to buy cheap.

This article is a compilation from Smart Investors. Last year, Howard Marks was invited to participate in the "Distinguished Speaker Series" at the University of Chicago, where he had a very interesting and exciting exchange with the host, Dean Madhav Rajan. Hello everyone. I am Dean Madhav Rajan, the George Pratt Shultz Professor of Accounting. It's fantastic to see so many guests on this special day. As you know, we are celebrating the 125th anniversary of the University of Chicago, and the "Distinguished Speaker Series" is a great tradition of the Chicago Booth School of Business. We invite industry leaders, community leaders, and government officials to speak here, sharing their insights and experiences, and allowing you to engage with their speeches. For the 125th anniversary celebration, we have invited a group of top elites to give a series of speeches, including one of our most famous alumni, the co-founder and co-chairman of Oaktree Capital, Howard Marks. Let me give a brief introduction. Howard founded Oaktree Capital in 1995, where he is mainly responsible for the company's investment strategy, investment philosophy, and ensuring that the company adheres to these fundamental investment strategies and philosophies. He is also a master of communication. Many of you may have read his very famous memos, where he explains his products and strategies through memos. Now, he also shares his own experiences and macro thinking related to investments and Oaktree Capital decisions through memos. Before founding Oaktree Capital, Howard worked at TCW Group leading distressed debt investments, high-yield bonds, and convertible bonds. Prior to that, he worked at Citigroup for 16 years, leaving as Vice President and Senior Investment Manager for convertible and high-yield bonds. Today, we are very excited to have Howard here. He graduated from the University of Pennsylvania with a degree in finance and later pursued an MBA at the University of Chicago. Let's give a warm welcome to Howard. I will start by asking Howard some questions, but you can also submit your questions, which I will receive on my iPad and then relay them. Source: Internet 01 Majoring in Finance and Minoring in Japanese Literature at UPenn Rajan: Let's start with your academic background. You went to the Wharton School at the University of Pennsylvania for your undergraduate studies. What was your major? Howard: I initially wanted to major in accounting, but ended up majoring in finance. Rajan: Did you take other courses at UPenn as well? Howard: At that time, UPenn had two enlightening requirements. You had to spend a semester studying a foreign literature course, and you also had to minor in a non-business course. So, some people would cheat by minoring in e-commerce, statistics, or maybe political science as their non-business course. But I chose to study Japanese literature for my foreign literature course. I can't remember the exact reason why I chose this course, but I was deeply attracted to it later on, so I made it my minor. I scored 15 points in my Japanese literature course. After Rajan, what brought you to Chicago, and what differences did you feel here? Howard: To be completely honest with friends, the direct reason that prompted me to pursue postgraduate studies was the Vietnam War. During those days in 1967, the war was at its peak, and if you left college, you were likely to be drafted. My rating was 1A, which meant "get ready to go," but I didn't want to. You know, if you really went, there was no guarantee you'd come back. So, I never hesitated about pursuing postgraduate studies. Interestingly, I did hesitate about whether to go to law school or business school. You read all these articles about hedge fund managers, saying they invested their bar mitzvah money at the age of 13, right? That's not my story; I didn't really know what I wanted to do. I chose business school because it was a 2-year program, while law school was a 3-year program. Rajan: Can you talk about studying in Chicago? How is it different from Pennsylvania? Howard: Yes, of course. I think the Chicago School that we are familiar with developed between 1962 and 1964 (Note: the "Efficient Market Hypothesis" is a representative work of the Chicago School at that time), and I came here in 1967. In January 2014, I wrote a memo titled "Good Luck" because I felt very lucky throughout my life. In that article, I listed more than a dozen examples of my own good luck, one of which was coming to the University of Chicago at that time. In Malcolm Gladwell's book "Outliers," he extensively discusses the luck of demographics: the right timing, the right place. Bill Gates went to high school at the right time. If he had gone to high school 10 years earlier, the school would have had a batch processing computer system that only processed programming calculations through punched cards, just like when I was studying here, you could only do one calculation a day, and if you wanted to debug a program, you would spend your entire life on it, in such an environment, he couldn't have succeeded; and if he had gone to high school 10 years later, everyone would have had enough knowledge about computer software. So he happened to be at the right time for distributed processing (corresponding to "batch processing") to be useful to him (while in high school), and because his father was well-known in Washington, he could sit in the Washington University computer lab all day and do 100 calculations a day. That's good luck. I am also very lucky. I was among the first 1, 2, 3 batches of students to graduate from the University of Chicago, which is a huge advantage compared to those who did not have this kind of luck. (Answering your next question) What was education like at that time? At that time, education at the University of Chicago was 100% theoretical and quantitative, while Wharton was 100% qualitative and practical. Neither side alone was good enough; they really should have been combined. The academic community took a long time to combine these two. My favorite course at the University of Chicago was James Laurie's Securities Investment course. I still remember the final exam question, "How do you apply what you have learned in this course to the real world?" It was an inspiring and practical question that made you think. When it comes to James Laurie, he founded the Center for Research in Security Prices (CRSP) at the University of Chicago, which had a profound impact on the institution. However, his course was once ridiculed. It was called "Laurie's Storytelling Hour" because he would invite a real-world practitioner every week to tell stories that connected to their practical experience. The theoretical scholars mocked him. At that time, Eugene Fama (2013 Nobel laureate in economics) would say before each class, "I have never spent a day in the real world, and I never will." This mindset was a symbol of honor in 1960s Chicago. But I believe the school has now successfully integrated theory and practice. Yes, we have tried. Let's go back to your personal career. When you graduated from the University of Chicago, did you know what you wanted to do? No, I didn't. I wasn't the type to plan out my life. I was very young at the time, only 22 when facing the job market. What could I possibly know? You know, a young man's brain is still developing until around 26 or 27, and I'm sure mine was like that. I applied for jobs in six different fields related to finance, with no preference for any of the six. However, I don't know if you've heard this anecdote of mine. One of the jobs was slightly more prestigious and eye-catching compared to the others. I thought if they offered me the job, I would definitely choose to work there. But I didn't get that offer. Thirty years later, the recruiter from that company did something good for the school, so I wrote him a letter. I asked if he remembered me, that I had applied for a job with them back then, didn't get it, and congratulated him on the good deeds he did for the school. It was still the era of letter-writing, so I typed out the letter on a typewriter, dropped it in the mailbox, and it was a couple of months before I received a reply. The reply said, "Yes, I remember you, I have been following your career. If you want to know why you weren't hired, give me a call." So I stopped writing letters and picked up the phone to call him. After some small talk, I asked, "So, why didn't I get that job?" He said, "Because we hired the wrong person." I replied, "Oh, you're too kind to say that about me." He clarified, "No, that's not what I mean. What I mean is, the recruiters all voted to hire you, but the partner who was supposed to call you accidentally dialed the wrong number due to a morning hangover." In fact, he gave this job to my roommate. This is a true story. I had never told this story until one day when my roommate gave a graduation speech at Columbia University and shared this story. So I thought, I could also share this story. However, in the previous memo about good luck, I mentioned that if it weren't for a bit of bad luck at that time, I might have stayed at Lehman Brothers for 40 years and ended up with nothing. Because if you were a partner at Lehman Brothers, when Lehman collapsed, your shares would be worthless. So this is what people often say, "Man proposes, God disposes." Source: Internet The essence of investment lies not in buying well, but in buying wisely. Rajan, at what point did you decide to venture into high-yield bonds, the investment field where you made your mark? Howard, in 1968, I got a summer job in equity research at Citibank. After graduating from the University of Chicago in 1969, I continued with this job. At that time, banks like First Chicago Bank, Citibank, and JPMorgan Chase were referred to as "money center banks" (banks that catered to corporate clients, governments, and other banks, rather than individual depositors and consumers), which was their basic classification. In short, money center banks were the main investors at that time, as there were no BlackRock, Blackstone, and other large investment institutions. These banks closely followed the "Nifty Fifty" stocks, which were considered the 50 highest-quality and fastest-growing American companies. The Nifty Fifty stocks were believed to have two outstanding factors that set them apart from other companies: They were so outstanding that nothing bad would ever happen to them; They were so outstanding that their stock prices would never be too high. Therefore, regardless of how high the price was, the quality of the company could justify it, but this justification was not rigorous - "they are simply the best." On my first day of work on September 29, 1969, if you had bought these stocks from my first day of work and held them firmly for 5 years, you would have lost almost all your money, with a loss of over 90%, mainly because the average P/E ratio of the Nifty Fifty dropped from 80 times to 8 times. This was a great way to lose 90%. So, this was the market background of my early work, and this was the philosophy of Citibank's research department, not my fault. Anyway, in 1978, Citibank changed its Chief Investment Officer, who wanted to replace all senior positions with his own people. So he asked me, "What do you want to do next?" This was a polite way of saying that I could not continue in my original position (head of the stock research department). I replied, "I can do anything, just not spend the rest of my life choosing between Merck and Lilly" (the probability of anyone making the right choice is not more than 50%). This is what I learned from the University of Chicago, not so long ago. He said to me, "I hope you go to the bond department." The bond department at that time was as obscure as Siberia, "and I hope you establish a convertible bond fund." This was in early 1978, and I made the change in May 1978. Interestingly, when I was appointed head of the stock research department at the age of 29, I had 75 employees working for me, managing a budget of $5 million, which was a lot of money at the time, and I was also one of the five most senior members of the bank's investment committee. After becoming the manager of the convertible bond fund, no one reported to me, there was no budget, and I was no longer a member of the investment committee. Can I say I was as happy as a pig in mud? Rajan: Haha, of course. Howard: It truly enchanted me. As the head of the research department, my job was to understand 400 companies in two sentences, only in a superficial and summary way; whereas in this job, I had to understand these 20 companies better than anyone else. This brought me great rewards. I think this is a profound truth, some people are more suitable for senior, bureaucratic positions, while others are not, and it's best to know in advance what kind of position you want. Anyway, I went to work in the bond department, and I remember the initial management amount was $15 million, which was the funds allocated to me for the convertible bond fund. A few months later, I received a phone call that changed my career, the head of the bond department called me and said, "There's a guy named Milken in California doing something called 'high-yield bonds,' can you figure out what that is?" Clients were asking for high-yield bond funds, so I entered this field. Once again, Malcolm Gladwell (mentioned in the book "Outliers" "demographic luck" appeared), that year was the year high-yield bonds were created, 1977, 1978 (Howard said: luck allowed him to enter the bond department at the same time as high-yield bond investments). Before that, companies without credit ratings could not issue bonds, so bond-issuing companies had to have AAA, AA, A, or BBB bond ratings, otherwise they could not issue bonds. According to the previous definition, companies with high financial leverage could not issue bonds. The significant push by Milken and these people was that even lower-quality companies could issue bonds, as long as the agreed-upon return could compensate for the additional risk of asset quality. So, we no longer had to invest only in good quality companies, nor avoid investing in poor quality companies; but instead, we could invest in all companies, as long as the potential investment return was reasonable. In my words at the time: the essence of investment is not in buying good, but in buying well. If you don't know the difference between the two, you're in trouble. It's not what you buy, but the price you pay that determines whether an investment will be successful. Buying something at a high price can be very unsuccessful, while buying it at a cheap enough price can be very successful. That's the essence of high-yield bond investing. These may be the bonds of the lowest quality companies in America, they are definitely the lowest quality among listed companies. However, if their interest rates are reasonable, you carefully select them, hold them, and diversify your investment portfolio, you can make money steadily and safely. Therefore, the significant change in the concept of bond investment has greatly benefited me. Source: Internet 05 Five people left TCW Group and established Oaktree Capital Rajan, what made you decide to establish Oaktree Capital? Howard, you've jumped ahead 17 years, but that's okay... We were very successful, with good investment results, and we created an excellent track record. Interestingly, after managing money for 10 years, I wrote to Eugene Fama about our success in high-yield bonds. He said, "Send me your track record." So, I sent it to him, and our annualized return over 10 years outperformed the index by 200 basis points. He replied, "The track record is too short." For academics, the first reaction is usually that there is not enough data. Well, another 10 years passed, and I sent him our track record again, which may have been even better relative to the benchmark. He then replied, "Because you consistently and significantly outperform the index, you are 'clearly taking on hidden risks'." Because, theoretically, the main determinant of your returns is the systematic risk you take on. If your returns are higher than expected, theoretically, you are clearly taking on some hidden risks. So, I gave up trying to convince him after that. I have a good track record, and our reputation among clients is also very good. In 1987, I hired a person named Bruce Karsh to work for me. He was previously a lawyer, highly recommended to me, and had only been in investment for a few years; but he wanted to establish a distressed debt fund. If buying bonds from low credit-rated companies is considered unwise, buying bonds from bankrupt companies is considered aggressive. However, the fact is, if you are involved in high-yield bond investments, every once in a while you will encounter a situation: you buy a bond at face value of 100 dollars when it is newly issued, it keeps depreciating, and when the company goes bankrupt, the trading value of this bond is only 10 dollars, then through negotiations with the creditors' committee during the restructuring process, you eventually get a value of 30 dollars. So, not long after, we had a good idea in just 10 years: why not skip the process from 100 dollars to 10 dollars and only participate in the process from 10 dollars to 30 dollars? And that is the essence of distressed debt investment. In 1988, Bruce and I established our first distressed debt fund, which was a great success. He is a great fund manager and achieved great results. 1985 was the year when private equity investments and leveraged buyouts truly took off, as Michael Milken (the American financier mentioned earlier who promoted the rise of high-yield bond investments) made it possible for small businesses to acquire large companies through leveraged financing. Previously, when low credit-rated companies could not issue bonds, only large companies could acquire small companies. However, if you could get 95% to 96% of the acquisition funds through borrowing, even small businesses or individuals could acquire large companies. This was a significant change in the American financial world. Around 1985 was the year when leveraged buyouts truly took off. However, by 1990 and 1991, most of the iconic leveraged buyouts from the 1980s had gone bankrupt. The reason being, if you only have 4-5% in equity, you can't weather the market downturn. Our economy faced a recession, and when their businesses were struggling, they were all crushed by debt obligations. In 1990, the IRR of the distressed debt fund we established and managed by Bruce was 45% annually. You know what IRR is, it's a widely used but flawed model for measuring the rate of return on funds with maturity dates. At that time, our IRR was 45%, and we didn't use any leverage! That was a remarkable achievement. The reason for leaving TCW and founding Oaktree Capital. First, such outstanding performance added a new shine to our careers. Second, in our industry, including PE, VC, or managing such a large sum of money in other ways to achieve high returns, you would receive a 20% profit share as a bonus. This is known as a performance fee or incentive rate. For our former employer, TCW Group, the challenge was how to distribute this performance fee. If you raised $100 million, the management fee was $500,000, our agreement was that we would receive about half of the management fee or slightly more; but if you turned that $100 million into $200 million, earning a profit of $100 million, the company would get a $20 million performance fee, how should this $20 million be divided? We believed that TCW raised funds, provided financial services, and office space, so it was only natural for them to receive a management fee, but what contribution justified them receiving an incentive fee? However, they set a 50/50 performance fee sharing standard, which was a major reason that prompted us to leave. Another reason was that TCW Group, like Citibank, operated 50 different strategies in 50 different ways; on the other hand, from a financial and qualitative perspective, as my position in the group continued to rise, I became an advocate for strategies that I did not agree with, which made me uncomfortable. For example, TCW Group had people specialized in predicting interest rate trends, which I deeply doubted; facing such strategies made me very uncomfortable. For instance, we always invested conservatively, believing that the best way to achieve a long-term track record was to embrace many good years and miss some bad years; but there were people there who fiddled with the fan every day, which also made me uncomfortable. So, this was another reason we left. The five of us left TCW Group together and established Oaktree Capital in April 1995. Later, we were told that what we did was illegal because we reassembled the previous team to compete with our former employer. We informed TCW Group 30 days in advance, and when we officially started our business, another 27 people left TCW and joined us. So essentially, we had the complete team from TCW. But, I must say, we were fortunate. Once again, I mention luck. In the year 2000, the technology stock bubble burst. As I just mentioned, you could lose 90% on the Nasdaq 50 stocks and 99% on most technology stocks. The S&P index fell continuously in 2000, 2001, and 2002, marking the first three-year decline since 1939. People basically lost confidence in the stock market, leading to a continuous outflow of funds. At the same time, the Federal Reserve initiated a rate-cutting cycle to stimulate and rescue the economy. This resulted in a stock market without interest and a bond market with very low returns. Therefore, institutional investors concluded that they needed to enter a new field. To this end, they coined the term "alternative investments." Alternative investments are the field that Oaktree Capital engages in. We had already entered this field before the term was invented, just like KKR Group, Blackstone Group, Apollo Global, Carlyle Group, and others. In other words, a large amount of money is now flowing into the alternative investment field because people believe they cannot achieve the expected returns in the stock and bond markets. In this context, our positioning has benefited us greatly. So, this is another example where you can only attribute this to good luck. 06 Identifying Undervalued Assets is the True Definition of Value Investing Audience: Oaktree Capital's strategy is to identify undervalued assets and go against the trend to achieve above-average returns. How do you determine that you are right while the majority is wrong? What methods do you use to avoid consensus bias? Howard: Firstly, identifying undervalued assets is the true definition of value investing. You want to buy at a price lower than their value. Buying at the same price as the value won't make anyone happy, and buying at a price higher than the value is definitely not a good idea. Therefore, the essence of value investing is buying at a price lower than its value. Next, I must point out that this sounds like a reasonable pursuit and life goal, but the difficulty lies in needing the seller to be willing to sell at a price lower than its value, which is not a good idea from that perspective because sellers usually don't want buyers to take advantage. The solution is that our funds perform exceptionally well when asset owners panic and sell assets in times of crisis. I just mentioned that our funds did well in 1990 and 1991, and then we had to wait 10 years until the funds' performance in 2001 and 2002 was even better than in 1990-1991. This was followed by the international financial crisis seven years later, and finally, the COVID-19 pandemic. We have a 35-year track record in distressed debt investments, with a pre-fee annual return of 22% and a post-fee return of 16%. Our returns in non-crisis years are mediocre, but the funds we established and invested in during crisis years, which only account for 6 out of the 35 years, significantly boosted the return rate to around 22%. When it comes to this issue: How do you think you are buying things at a price lower than their value? And how do you ensure that your decision is not based on cognitive bias? You will learn a lot in investing, but many things we discuss today may be things I cannot teach you how to do, because there is no fixed method. John Kenneth Galbraith, an American economist, once said: You cannot learn to invest; if there were a method to teach you how to invest, the workload would be very heavy, and all intelligent people would become wealthy. This Monday, I went to West Point Military Academy and had a conversation with students interested in finance. They asked me when to sell? When to take profit? When to stop loss? I couldn't answer. All the ways to profit that you learn, all the investment methods you learn here, they are just frameworks of knowledge. They tell you what to do, but no one can tell you how to do it. You can try to make yourself more sensitive and make your thinking about things better or worse than the general public. I created the concept of "second-level thinking," which means thinking in a different, deeper, and hopefully more astute way than the general public; if you just change the way you think but it is a worse method, you will encounter problems. So the meaning of second-level thinking is to think in a different but better way. In my first book, "The Most Important Thing About Investing," there are 20 chapters, and each chapter describes one most important thing, but each of the 20 chapters talks about different things. Because in investing, there is not just one most important thing, there are many very important things. But the most important thing mentioned in the first chapter is "second-level thinking." I say this, but I am constantly asked "Can second-level thinking be learned"? My answer is: I don't know, but I am very cautious about it, just like they say in basketball "height cannot be changed through training," no coach in the world can make a player taller. This is a fact, there are some prerequisites to becoming a successful investor. One of the prerequisites is to become a second-level thinker, and the other is the ability to not be swayed by emotions. Can you teach these things? My answer is I don't know. I can explain to you why these prerequisites are very important, but I don't know if I can make you learn them. Ultimately, it all depends on your insight, do you have insight? And I don't know if people without insight can learn it later. I think many things in this regard have an artistic component. The entire investment industry is based on predicting the future. But I don't believe in macro predictions, I think the economy, markets, currencies, commodities, and interest rates are unpredictable, I admit that a very small number of people become wealthy relying on macro predictions. However, we all have to think about the future, we all rely on the future to operate investments. My favorite insight comes from former General Electric executive Ian Wilson, who said, "No matter how sophisticated the theories of this world are, they cannot help you avoid this fact: everything you know is about the past, and all your decisions are about the future." We must prepare for the future. I believe we should approach the future in a way that considers "probability distribution." The question is, whose probability distribution chart predicting future events is the most accurate? And who can best identify whether the market's mainstream expectations provide enough risk compensation for tail risks based on this probability distribution chart? This is about judgment, but as I just mentioned, I can explain why this is important, but I'm not sure if I can impart insight. The best example is on Friday, September 15, 2008, after the market closed, Lehman Brothers announced bankruptcy. All major announcements were made after the market closed, so we were all off work and these announcements could not affect trading. People had enough time to think about the impact of these announcements and then trade based on this new information on the next trading day. When I walked into the company on September 18, our arsenal was stocked with the large fund we raised: $10 billion (actually $10.9 billion) in capital for investing in distressed debt, dry powder. Should we invest this money? The market concern at that time was: the global financial system was on the brink of collapse, and all financial institutions would disappear. That was the market sentiment at the time, so how do you deal with it? You should analyze whether this view is correct. Wait a minute! How do you analyze whether the financial system will collapse? The answer is, there is no such thing as analyzing the future. We analyze based on the data we have, make inferences based on previous empirical methods, and draw conclusions. By the way, I learned this method from an epidemiologist at Harvard University. He used this method to describe the trend of the epidemic in the first week of the COVID-19 outbreak. Of course, he meant that we had no historical data on the epidemic, no historical experience for analogy, all of which were nonsense, and he was proven right. Anyway, what I mean is, you can't analyze whether the world's financial system will collapse. In fact, many such events ultimately depend on people's confidence. However, you have confidence to invest; my feeling is that no matter how educated you are, not everyone with good intelligence can maintain confidence in investing. Source: Internet 07 No Predictions, No Belief in Predictions Audience: You wrote that you sold a lot of assets in 2005 and 2006. What factors led you to do this? What logic was your decision based on? What were the results? Howard: The Financial Times has a column called "FT Lunch with the FT" every Saturday, where the author invites someone to have lunch and then reports on the conversation. I really like this column because they invite a variety of people to lunch, not just financial professionals like me. Last autumn, they invited me, and I took them to my favorite Italian restaurant, and we talked about some investment matters. The author asked me: Can you select some memos in advance and send them to me so I can have a general idea of the conversation? Therefore, I reviewed the memos since 2020 and selected four articles that I believe were written at pivotal moments in the market to send to him. Because I personally selected them, these four articles have all been validated afterwards. They share a common trait: firstly, they do not contain any predictions because I do not believe in forecasting. When we founded Oaktree Capital in 1995, because our team had worked together for 9 years, my partners and I sat down to discuss and write down what we believed in, our investment philosophy. I believe having an investment philosophy is crucial, in fact, I would call it a creed or belief: what do you believe in/not believe in? What will you do/what will you not do? Many of these beliefs were acquired through my studies at this university. We have 6 beliefs, the fifth one being: our investment decisions are not based on macro forecasts. Because no one's macro forecast can be good enough to be used for investments. Therefore, the memos do not contain macro forecasts, and they usually do not include specific analysis of individual stocks or sectors; most of the content in the memos is about investor behavior. Before the forum started, I also discussed with Professor Minnis (Accounting Professor at Chicago Booth School of Business): in fact, the overall performance of the economy is an upward, relatively smooth line, implying the long-term growth rate of the economy and some minor fluctuations. The average annual growth rate of the economy is 2%, some years it's 3%, some years it's 1%, some years it may reach 4%, and some years it's -2%; but obviously, the range of economic growth fluctuations is relatively moderate. So, looking at this curve over an appropriate time span, the fluctuations are small. Then, if you plot corporate earnings on a chart, the fluctuations in corporate earnings are much larger than those in the overall economy, even though the direction of corporate earnings is determined by the economy (consistent with the direction of the economy). Why are their fluctuations larger? The answer lies in the leverage that companies use. They use financial leverage, which means that the fluctuations in returns left to shareholders after paying debt costs can be significant. They use operating leverage because many of their costs are fixed, if sales double, profits may double; but if sales drop by half, profits could disappear entirely. Therefore, companies use leverage, making the fluctuations in profits greater than the fluctuations in revenue. Finally, if you plot stock prices on a chart, they fluctuate wildly up and down, and the volatility of stock prices is what investors truly focus on in the short term. When you buy stocks, you are truly purchasing a portion of the company's profits. Since stock prices are determined by corporate profits, why do stock price fluctuations not align with profit levels? Why are stock price fluctuations greater than profit fluctuations? The answer is as the great physicist Richard Feynman said: if electrons had emotions, physics would be much more difficult. Markets, any market, are made up of people, and humans have emotions. When they are excited, they push the price of obtaining the level of corporate profits to very high levels; when they are discouraged, they price it very low. People naively believe that stock prices are determined by events and fundamentals of a company. You see on TV, news anchors say: "The stock market went up by 200 points today because, for example, Tesla announced good news; or the stock market dropped by 200 points today because inflation seems out of control." But the right answer is: the stock market went up by 200 points today because people became more optimistic today; the stock market dropped by 200 points today because people are more discouraged today. Could it be that people's psychology plays a decisive role? So, in my deep contemplation, I focus a lot on what kind of investor psychology and behavior led to today's market? And, what should be our appropriate response to this? In 2005 and 2006, I observed excessive optimism, excessive eagerness, excessive demand, investors' insufficient risk aversion, and insufficient concern; all of which hinted that asset pricing might be too high. That's how it goes. So, I wrote a memo... and people came to talk to me about investor behavior, saying they have seen some unfounded behaviors in past crises, implying caution is needed now. It was around 2005-07, and in 2008, Lehman Brothers went bankrupt, triggering the global financial crisis, the worst financial crisis began. I also recorded a podcast yesterday, talking about this issue. Based on the trends in the economy and corporate profits, people think stock prices should move in a certain way, but because investors are emotional, stock prices do not always follow the expected path. Therefore, if you can measure and grasp emotions well, then you can feel the heat and cold of this market. I wrote a book called "Mastering Market Cycles," and I also consulted some ideas from my son, who is a very smart investor. Once I said to him, "Andrew, I predict the market will rise, I believe my judgment is correct." He said to me, "Yes, Dad, that's because you have made 5 predictions in the past 50 years." In those few times, the market either rose very high or fell very badly, but this time, in my view, the reasons for optimism are overwhelming, and the probability of success is very high. But if I tried 50 times, 500 times, or 5000 times in 50 years, I couldn't have such a high success rate. The most important thing I learned during this period is risk aversion, which is fundamental. Risk aversion leads people to demand higher returns and higher return potential in high-risk investments, which is indeed reasonable. Think about it carefully, it is risk aversion that keeps the market safe and rational at all times. If we are in an environment where risk aversion is insufficient, you will find that asset prices are generally too high. But sometimes, like after the bankruptcy of Lehman Brothers in 2008, when risk aversion is excessive, prices are very low, that's when you become a buyer. Before deciding whether to invest in an asset, let's first analyze whether the financial system will collapse. My answer is that there is no such thing. So how did I make this decision? It's hard to predict doomsday because it has never happened, and you don't have a very good decision-making system, so it's hard to say your judgment is correct. Similarly, it's hard to know what to do, how to live. Would you stroll around with gold bars? When you need to buy something, would you chip off some to give to the seller? It's tough. Because most of the time, the world is running normally, so it's hard for us to accept the idea that "the end of the world is coming." To put it another way, even if we were to invest, it wouldn't matter even if the world melted, because nothing would survive well. But if we don't invest today, and the world doesn't melt, it means we haven't done our job properly. So for me, it's a very easy decision. Bruce invested in the fund I just mentioned, averaging $450 million per week over the next 15 weeks, about $7 billion in a quarter. This just proves that the world is not melting. In the year you were born or even earlier, Jane Fonda starred in a movie called "The China Syndrome," about a runaway nuclear reactor that people feared would spread to the entire earth. Indeed, you have no evidence to prove that this won't happen. But fortunately, through the bankruptcy of Lehman Brothers, people actively seized the downturn, but from now on, you can't make these decisions based on provable assumptions. But sometimes, you have to make judgments. 08 The Average is Not the Norm, Far From It Audience: Your career, including learning and investing, revolves around cycles. What kind of cycle do you think we are in now? Howard: I have studied many cycles and have been personally involved in many cases, benefiting greatly. Theoretically, the past three years have not been cyclical... everything has a trend line. The average annual return of the S&P 500 over the past century is 10%, but interestingly, very few years have returns between 8% and 12%. It's usually 20%, 0%, 30%, or -10%. The average is not the norm, far from it. Of course, the long-term growth of the S&P is based on the long-term growth of corporate profits, so why are there hardly any years with a 10% increase? The answer is that 10% is just a trend line. In some years, people get very excited, and corporate management says, "I think the next year will be a prosperous one. We will actively participate, gain more market share, build another factory, hire 1000 workers, increase production, so when demand picks up, we can make a lot of money." So they all go and build factories. Unfortunately, in the era when everyone is building factories, hiring workers, and building inventory, our annual returns exceed 10% each year. The problem is that the anticipated "prosperous year" that everyone thought would come did not arrive, so now they are very disappointed. We have a 10% trend line, although there will be downward adjustments, we always maintain a positive attitude, and now we are experiencing a correction in the long-term trend. When it comes to the best way to think about psychology, imagine a pendulum placed in the middle. A statistics professor at the University of Chicago will tell you that the average position of the swinging pendulum is in the middle, but it spends very little time there. The pendulum swings between fear and greed, optimism and pessimism, trust and doubt, risk aversion, and risk tolerance. However, it stays briefly in what my mother calls the "happy medium." The pendulum tends to swing towards the extremes or the opposite side. So, when you push the pendulum to one side and give it a slight nudge, you get a cycle. When the upward movement exceeds the trend line, it will pull back towards the trend line. After crossing below the trend line, following a period of pessimism, people will say, "No! It shouldn't be that bad!" Then the market will pull back towards the trend line, cross above it, and rebound to new highs. Therefore, I believe that cycles are a process of excess and correction. However, the past three years have not been a result of excess and correction because we encountered an exogenous event - the COVID-19 pandemic, which was like a meteor hitting the Earth, unrelated to the cycle. This is the first time in world history that humans voluntarily halted the economy to combat a pandemic unrelated to the cycle. Then the Federal Reserve intervened with stimulus monetary policies to rescue the economy, also unrelated to the cycle. But these stimulus monetary policies have led to inflation. Now, the Federal Reserve is raising interest rates to curb inflation, and we are returning to a normal cyclical trajectory. Most of the impacts we have experienced in the past three years have been exogenous, not endogenous. If you want to understand investment psychology, it's simple. In the real world, things fluctuate between very good and not so hot, but investors often see it as swinging from perfection to extreme disappointment. Investors are used to being indecisive, experiencing intense and excessive psychological fluctuations. In March 2020, when the pandemic raged, everyone thought the world was in despair. But in 2021, the Federal Reserve's rescue efforts were very successful, and many people thought they did a great job, believing that the Fed would keep the economy thriving by maintaining low interest rates in the long term. I can only say that this is too optimistic. Last year was a tough year, and most assets struggled. "60% stocks and 40% bonds" is a hypothetical investment portfolio, but some people do manage their funds this way. It may seem old-fashioned, but it can serve as a benchmark. The biggest question is, can you improve this model through active investing? Last year was the worst year in history because both stocks and bonds performed poorly simultaneously, which is rare in history. Investor psychology was shattered, no longer seeing things as perfect. Ironically, after I gave a brief speech about the "happy medium," I felt that we were no longer perfect, and the pendulum was swinging towards despair. It has been like this for the past six months; we have crossed the midpoint and are swinging towards despair, but not too much. So, I believe that people's psychology is currently moderate, stock and bond prices are moderate, relatively reasonable, and we are not in an extreme situation. At the moment, I can't think of any particularly wise actions to take. 09 AI or Machine Learning in Investment: Perhaps Beating Most Investors in the Future Audience: How do you view the impact of artificial intelligence and machine learning on investment strategies? Will they erode excess returns? Howard: I don't intend to elaborate too much on this issue. All the memos I have written can be found on the Oaktree Capital's official website, and they are all free to read... In 2014, I wrote a memo called "Unmanned Investing." When I arrived here, the professor said that the average return of mutual funds was even worse than the S&P 500, especially after deducting fees. So why not buy one share of each stock in the S&P 500 index? At that time, there were no index funds, no indexing. In 1974, John Bogle founded the first commercial index fund at Vanguard. Now we have mutual funds, and I believe that most equity capital is managed through indexing or other passive computational methods. It's not that passive investing is good and active investing is bad. In the field of mutual funds, trading stocks incurs high fees, even if this action does not add value. However, regardless, we now have a large amount of passive investment, and a large sum of money waiting for us to operate, using the algorithmic model mentioned earlier, but this advantage is minimal. Small, temporary, inefficient, but I prefer to call it "mistakes." If the market temporarily makes a small mistake, such as one asset's price being much higher than another, although this high price won't last long, the operation may just make a small profit. But if you are doing this with high leverage and trading very actively... For example, the Renaissance Fund has achieved outstanding performance by taking advantage of these temporary market errors. There is a hedge fund called Long-Term Capital Management, founded by a group of very smart Nobel laureates around 1977. Most of them did what I just mentioned, used leverage very well, and they described what they did as "picking up coins worldwide." But in the fall of 1998, they went bankrupt. They didn't realize that they were picking up coins in front of a steamroller, and ultimately, based on divergent facts, everything will converge. They went through a period of divergence, and they used more leverage than they could bear, so the lenders brought them down. In short, we have indexing and passive investing, we have algorithms, and the final stop of this train is AI and machine learning. We have done some basic programming, and I understand that computers can basically only do addition, subtraction, comparison, and memory, that's it. A computer can process a large amount of data without making mistakes, and at a very fast speed, which is already superior to most people. This is why active investing is not very effective, so I think that AI or machine learning in investment may be able to outperform most investors in the future. But I hope it won't outperform the most outstanding investors, because all the knowledge we have is about the past, and computers are the same. Machine learning is when you give all the economic data, corporate data, and price data from the past X years to a computer, and it will quickly process everything to identify key factors for success. That's my interpretation. During the first three months of the pandemic, I was with my son Andrew, and his words caught my attention, "Ready-made quantitative information cannot be the answer to wealth." This is because, according to the Efficient Market Hypothesis, everyone knows this information. Sixty or seventy years ago, Buffett could buy a company worth $1 now for 50 cents because not many people knew this information. But now, everyone knows it. When I started as an analyst, every company had a position called an analyst liaison, specifically dealing with Wall Street analysts. I was at Citibank at the time, which was a well-known institution. They would leave the next year's budget on the table and go to the restroom, so some people knew the budget information, and some didn't. However, this is illegal now. The SEC has enacted laws to prevent this from happening. The SEC's goal is to ensure that everyone has the same information simultaneously, preventing information from becoming a key advantage. The Efficient Market Hypothesis believes that there are thousands of smart, math-savvy, highly motivated individuals in the market. So, an excellent investor (by the way, becoming an excellent investor is not the goal) can only outperform the index or passive investment benchmarks to stand out and justify charging high fees. Therefore, if you want to be an excellent investor, the ready-made quantitative information is not enough. You either rely on intuition or qualitative factors, such as the management's ability, the quality of new product lines, or the ability to judge the future in the absence of analysis. Audience: So, can computers do these things? Howard: I don't think so. In my memo "Unmanned Investment," I wrote, "Can a computer sit down and discuss five business plans from Steve Kaplan's course at the same time? Can it identify which one is Amazon? Can it pick out Steve Jobs from five CEOs?" I don't think so. Therefore, I believe there is still room for individual decision-making. After all, very few people can figure out which one is Amazon, and very few can understand who Steve Jobs is. Therefore, those excellent investors can bring value and make a living from it. Source: Internet Because customers trust us, we can raise funds Audience: You did well in raising and investing funds during the crisis. How did you do it? How did you handle it at other times? And how did you convince your LPs? Howard: Firstly, you are right, raising funds for closed-end funds is really difficult. So, today, I am planning for the fund that will start marketing next year and making judgments on investment opportunities for the next 1-4 years. From a behavioral perspective, when people become overly optimistic and start issuing a large number of loans, these loans are likely to turn into bad debts, which will bring us rare opportunities. All of this is based on empirical results. In this aspect, we have done very well. The reason I say this is that if you look at the records of the funds we manage, out of 34 funds over 26 years, the largest fund has always performed the best. This is a record that I am very proud of. However, it is somewhat counterintuitive now because people usually believe that smaller funds may perform better due to their greater adaptability and flexibility. But currently, the largest funds are indeed performing the best. This is because we raised the largest amount of funds when we predicted the greatest opportunities. For example, in 2001, we raised the best-performing fund in the history of our group, with a total annual return rate of 58%. So how did we do it? In the summer of 2002, we experienced the Enron scandal and the disclosure of scandals involving multiple companies, greatly undermining people's confidence in the business world and financial statements. Arthur Andersen went bankrupt because they were Enron's auditors. Subsequently, many telecommunications companies borrowed too much money and aggressively produced fiber optics when they were not needed, leading to an oversupply of fiber optics. The bonds of these losers depreciated, so we bought into these companies with returns ranging from around 20% to 70%. Confidence was restored shortly after, and a year later, the returns all reached double digits. I remember that fund rose by 90% that year. If that's the case, how big should the next fund be? The increase in the previous fund represents the opportunity for a decrease in the next fund, so the next fund should be smaller. For most people on Wall Street now, if they raise a fund, I think the size of that fund might be $1.5 billion, with a 90% increase in a year, how big will the next fund be? $10 billion? Why? Because it can be like that. There is a joke that goes like this, why can a dog do what a dog does? Because it can. We will not raise funds beyond our capabilities. If we have a very successful fund, it means that our future opportunities will diminish, and the next fund will be smaller. How did we raise funds? I think it's because our clients trust us, they believe we are telling the truth. We don't always say it's a great time to invest now, it's a great time to implement our strategy, so clients trust us. If we say the time is right now, they will entrust us with their money to manage, which is great. The investment philosophy of Oaktree is that we do not time the market. We won't say if an asset will be cheaper in 6 months, we will wait, but rather if it's already cheap now, we will invest today, and buy more as it falls. We believe we can always get more money, which gives us a high degree of freedom. It is not a scarce resource for us, and this is also the reason why our funds have been so successful. But first, we need to determine an appropriate scale based on the environment. We need to be mature enough to resist temptation. If we raise more money than we should, we need to stop.