The ideas that run through the book are best captured by an observation attributed to Mark Twain: “History doesn’t repeat itself, but it does rhyme.” While the details of market cycles (such as their timing, amplitude and speed of fluctuations) differ from one to the next, as do their particular causes and effects, there are certain themes that prove relevant in cycle after cycle. The following paragraph from the book serves to illustrate:
The themes that provide warning signals in every boom/bust are the general ones: that excessive optimism is a dangerous thing; that risk aversion is an essential ingredient for the market to be safe; and that overly generous capital markets ultimately lead to unwise financing, and thus to danger for participants.
An important ingredient in investment success consists of recognizing when the elements mentioned above make for unwise behavior on the part of market participants, elevated asset prices and high risk, and when the opposite is true. We should cut our risk when trends in these things render the market precarious, and we should turn more aggressive when the reverse is true.
One of the memos I’m happiest about having written is The Race to the Bottom from February 2007. It started with my view that investment markets are an auction house where the item that’s up for sale goes to the person who bids the most (that is, who’s willing to accept the least for his or her money). In investing, the opportunity to buy an asset or make a loan goes to the person who’s willing to pay the highest price, and that means accepting the lowest expected return and shouldering the most risk.
Thus the idea for this memo came from the seven worst words in the investment world: “too much money chasing too few deals.”
In 2005-06, Oaktree adopted a highly defensive posture. We sold lots of assets; liquidated larger distressed debt funds and replaced them with smaller ones; avoided the high yield bonds of the most highly levered LBOs; and generally raised our standards for the investments we would make. Importantly, whereas the size of our distressed debt funds historically had ranged up to $2 billion or so, in early 2007 we announced the formation of a fund to be held in reserve until a special buying opportunity materialized. Its committed capital eventually reached nearly $11 billion.
What caused us to turn so negative on the environment? The economy was doing quite well. Stocks weren’t particularly overpriced. And I can assure you we had no idea that sub-prime mortgages and sub-prime mortgage backed securities would go bad in huge numbers, bringing on the Global Financial Crisis. Rather, the reason was simple: with the Fed having cut interest rates in order to prevent problems, investors were too eager to deploy capital in risky but hopefully higher-returning assets. Thus almost every day we saw deals being done that we felt wouldn’t be doable in a market marked by appropriate levels of caution, discipline, skepticism and risk aversion. As Warren Buffett says, “the less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” Thus the imprudent deals that were getting done in 2005-06 were reason enough for us to increase our caution.
What are the elements that have created the current investment environment? In my view, they’re these:
In the current financial environment, the number “ten” has taken on particular significance:
What are the implications of these events? I think they’re these:
For the reasons described above, I feel the requirements have been fulfilled for a frothy market as set forth in the citation from my new book on this memo’s first page.
Do you disagree with these conclusions? If so, you might not care to read further. But these are my conclusions, and they’re the reason for this memo at this time.
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In memos and presentations over the last 14 months, I’ve made reference to some specific aspects of the investment environment. These have included:
I didn’t cite these things to criticize them or to blow the whistle on something amiss. Rather I did so because phenomena like these tell me the market is being driven by:
In short, attributes like these don’t make for a positive climate for returns and safety. Assuming you have the requisite capital and nerve, the big and relatively easy money in investing is made when prices are low, pessimism is widespread and investors are fleeing from risk. The above factors tell me this is not such a time.
In the years immediately following the Crisis, the banks – which remained traumatized and in many cases were marked by low capital ratios – were reluctant to do much lending. Thus a few bright credit investors began to organize funds to engage in “direct lending” or “private lending.” With the banks hamstrung by regulations and limited capital, non-bank entities could be selective in choosing their borrowers and could insist on high interest rates, low leverage ratios and strong asset protection.
Not all investors participated in the early days of 2010-11. But many more got with the program in later years, after private lending had caught on and more managers had organized direct-lending funds to accommodate them. As the Wall Street Journal wrote on August 13:
The influx of money has led to intense competition for borrowers. On bigger loans, that has driven rates closer to banks’ and led to a loosening of credit terms. For smaller loans, “I don’t think it could become any more borrower friendly than it is today,” said Kent Brown, who advises mid-sized companies on debt at investment bank Capstone Headwaters.
The market is poised to grow as behemoths and smaller outfits angle for more action. . . . Overall, firms completed fundraising on 322 funds dedicated to this type of lending between 2013 and 2017, with 71 from firms that had never raised one before, according to data-provider Preqin. That compares with 85 funds, including 19 first-timers, in the previous five years. (Emphasis added)
And what about the quality of the loans being made? The Journal goes on:
Companies often turn to direct lenders because they don’t meet banks’ criteria. A borrower may have a one-time blip in its cash flows, have a lot of debt or operate in an out-of-favor sector. . . .
Direct loans are typically floating-rate, meaning they earn more in a rising-rate environment. But borrowers accustomed to low rates may be unprepared for a jump in interest costs on what is often a big pile of debt. That risk, combined with the increasingly lenient terms and the relative inexperience of some direct lenders, could become a bigger issue in a downturn.
Observations like these tempt me to apply what I consider the #1 investment adage: “What the wise man does in the beginning, the fool does in the end.” It seems obvious that direct lending is taking place today in a more competitive environment. More people are lending more money today, and they’re likely to compete for opportunities to lend by lowering their standards and easing their terms. That makes this form of lending less attractive than it used to be, all else being equal.
Has direct lending reached the point at which it’s wrong to do? Nothing in the investment world is a good idea or a bad idea per se. It all depends on when it’s being done, and at what price and terms, and whether the person doing it has enough skill to take advantage of the mistakes of others, or so little skill that he or she is the one committing the mistakes.
At the present time, the managers raising and investing large funds are showing the most growth. But in the eventual economic correction, they may be shown to have pursued asset growth and management fees over the ability to be selective regarding the credits they backed.
Lending standards and credit skills are seldom tested in positive times like we’ve been enjoying. That’s what Warren Buffett had in mind when he said, “It’s only when the tide goes out that you learn who has been swimming naked.” Skillful, disciplined, careful lenders are likely to get through the next recession and credit crunch. Less-skilled managers may not.
Unfortunately, there is no single reliable gauge that one can look to for an indication of whether market participants’ behavior at a point in time is prudent or imprudent. All we can do is assemble anecdotal evidence and try to draw the correct inferences from it. Here are a few observations regarding the current environment (all relating to the U.S. unless stated otherwise):
Debt levels:
Quality of debt:
Other observations:
Moving on from the general to the specific, I’ve asked Oaktree’s investment professionals, as I did at the time of The Race to the Bottom, for their nominees for imprudent deals they’ve seen. Here’s the evidence they provided of a heated capital market and a strong appetite for risk, with their commentary in quotes in a few cases. (Since my son Andrew often reminds me of Warren Buffett’s admonition, “praise by name, criticize by category,” I won’t identify the companies involved.)
Of particular note, David Rosenberg, Oaktree’s co-portfolio manager for U.S. high yield bonds, provides an example of post-Crisis restraints being loosened. The government’s Leverage Lending Guidelines, “introduced in 2013 to curb excessive risk-taking, capped leverage at 6x – subject to certain conditions – and contributed to less aggressive dealmaking [sic] among regulated banks. . . .” Now the head of the Office of the Comptroller of the Currency has indicated, “it’s up to the banks to decide what level of risk they are comfortable with in leveraged lending. . . .” Here’s what the OCC head said on the subject: “What we are telling banks is you have capital and expected loss models and so if you are reserving sufficient capital against expected losses, then you should be able to make that decision.” (The quotes above are from Debtwire.) And here’s my response: how did that work out last time?
David goes on: “Not surprisingly, bankers have told me they are now testing the waters with 7.5x levered LBOs. A banker recently told me that for the first time since 2007, he has been in a credit review and heard the credit deputy rationalize approving a risky deal because it is a small part of a larger portfolio so they can afford for it to go wrong, and if they pass on the deal they will lose market share to their competitors.” That sounds an awful lot like “if the music’s playing, you’ve gotta dance.” I repeat: how’d that work out last time?
The bottom-line question is simple: does the sum of the above evidence suggest today’s market participants are guarded or optimistic? Skeptical or accepting of easy solutions? Insisting on safety or afraid of missing out? Prudent or imprudent? Risk-averse or risk-tolerant? To me, the answer in each case favors the latter, meaning the implications are clear.
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Before closing, I want to share my view that equities are priced high but (other than a few specific groups, such as technology and social media) not extremely high – especially relative to other asset classes – and are unlikely to be the principal source of trouble for the financial markets. I find the position of equities today similar to that in 2005-06, from which they played little or no role in precipitating the Crisis. (Of course, that didn’t exempt equity investors from pain; they were hit nevertheless with declines of more than 50%.)
Instead of equities, the main building blocks for the Crisis of 2007-08 were sub-prime mortgage backed securities, other structured and levered investment products fashioned from debt, and derivatives, all examples of financial engineering. In other words, not securities and debt instruments themselves, but the uses to which they were put.
This time around, it’s mainly public and private debt that’s the subject of highly increased popularity, the hunt by investors for return without commensurate risk, and the aggressive behavior described above. Thus it appears to be debt instruments that will be found at ground zero when things next go wrong. As often, Grant’s Interest Rate Observer puts it well:
Naturally, the lowest interest rates in 3,000 years have made their mark on the way people lend and borrow. Corporate credit, as [Wells Fargo Securities analyst David] Preston observes, is “lower-rated and higher-levered. This is true of investment-grade corporate debt. This is true in the loan market. This is true in private credit.”
So corporate debt is a soft spot, perhaps thesoft spot of the cycle. It is vulnerable not in spite of, but because of, resurgent prosperity. The greater the prosperity (and the lower the interest rates), the weaker the vigilance. It’s the vigilance deficit that crystalizes the errors that lead to a crisis of confidence.
Conditions overall aren’t nearly as bad as they were in 2007, when banks were levered 32-to-1; highly levered investment products were being invented (and swallowed) daily; and financial institutions were investing heavily in investment vehicles built out of sub-prime mortgages totally lacking in substance. Thus I’m not describing a credit bubble or predicting a resulting crash. But I do think this is the kind of environment – marked by too much money chasing too few deals – in which investors should emphasize caution over aggressiveness.
On the other hand – and in investing there’s always another hand – there is little reason to think today’s risky behavior will result in defaults and losses until we see serious economic weakness. And there’s certainly no reason to think weakness will arrive anytime soon. The economy, growing but relatively free of excesses, feels right now like it could go on a good bit longer.
But on the third hand, the possible effects of economic overstimulation, increasing inflation, contractionary monetary policy, rising interest rates, rising corporate debt service burdens, soaring government deficits and escalating trade disputes do create uncertainty. And so it goes.
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Being alert for the ability of others to issue flimsy securities and execute fly-by-night schemes is a big part of what I call “taking the temperature of the market.” By also incorporating awareness of historically high valuations and euphoric investor attitudes, taking the temperature can give us a sense for whether a market is elevated in its cycle and it’s time for increased defensiveness.
This process can give you a sense that the stage is being set for losses, although certainly not when or to what extent a downturn will occur. Remember that The Race to the Bottom, which in retrospect seems to have been correct and timely, was written in February 2007, whereas the real pain of the Global Financial Crisis didn’t set in until September 2008. Thus there were 19 months when, according to the old saying, “being too far ahead of one’s time was indistinguishable from being wrong.” In investing we may have a sense for what’s going to happen, but we never know when. Thus the best we can do is turn cautious when the situation becomes precarious. We never know for sure when – or even whether – “precarious” is going to turn into “collapse.”
To close, I’m going to recycle two of the final paragraphs of The Race to the Bottom. Doing so permits me to provide an excellent example of history’s tendency to rhyme:
Today’s financial market conditions are easily summed up: There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, as the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures. . . .
This memo can be recapped simply: there’s a race to the bottom going on, reflecting a widespread reduction in the level of prudence on the part of investors and capital providers. No one can prove at this point that those who participate will be punished, or that their long-run performance won’t exceed that of the naysayers. But that is the usual pattern.
It’s now eleven years later, but I can’t improve on that.
I’m absolutely not saying people shouldn’t invest today, or shouldn’t invest in debt. Oaktree’s mantra recently has been, and continues to be, “move forward, but with caution.” The outlook is not so bad, and asset prices are not so high, that one should be in cash or near-cash. The penalty in terms of likely opportunity cost is just too great to justify being out of the markets.
But for me, the import of all the above is that investors should favor strategies, managers and approaches that emphasize limiting losses in declines above ensuring full participation in gains. You simply can’t have it both ways.
Just about everything in the investment world can be done either aggressively or defensively. In my view, market conditions make this a time for caution.
September 26, 2018
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