I am a huge fan of Howard Marks, founder of Oaktree Capital. He’s been penning memos over the last three decades and they are always a great read.
His latest memo is titled “There They Go Again… Again” — a memo heeding caution for investors. It’s probably worth mentioning that he’s much more US-centric which explains his viewpoint.
Reading through it, I could not help but think about the recent boom and bust in the oil and gas sector in Singapore. There are still plenty of lessons to learn from the entire cycle – and its worth reflecting on so investors can be better prepared for the next crisis.
“Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of good business conditions. The purchasers view the good current earnings as equivalent to “earning power” and assume that prosperity is equivalent to safety.” – Benjamin Graham
Extracts from the memo
Investors have grown so confident about the seemingly interminable corporate- debt rally that many are dismissing the likelihood of large swaths of risky companies going bankrupt. After all, these covenants usually don’t matter until there’s a problem.
It’s a standard cycle: cautious investing produces good performance in a salutary environment . . . which leads to a reduction of caution . . . which leads to bad performance when the environment turns less favorable. This is part of the race to the bottom I wrote about in 2008.
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The Seeds for a Boom
- A benign environment – good results lull investors into complacency, as they get used to having their positive expectations rewarded. Gains in the recent past encourage the heated pursuit of further gains in the future (rather than suggest that past gains might have borrowed from future gains).
- A grain of truth – the story supporting a boom isn’t created out of whole cloth; it generally coalesces around something real. The seed usually isn’t imaginary, just eventually overblown.
- Early success – the gains enjoyed by the “wise man in the beginning” – the first to seize upon the grain of truth – tends to attract “the fool in the end” who jumps in too late.
- More money than ideas – when capital is in oversupply, it is inevitable that risk aversion dries up, gullibility expands, and investment standards are relaxed.
- Willing suspension of disbelief – the quest for gain overcomes prudence and deference to history. Everyone concludes “this time it’s different.” No story is too good to be true.
- Rejection of valuation norms – all we hear is, “the asset is so great: there’s no price too high.” Buying into a fad regardless of price is the absolute hallmark of a bubble.
- The pursuit of the new – old timers fare worst in a boom, with the gains going disproportionately to those who are untrammeled by knowledge of the past and thus able to buy into an entirely new future.
- The virtuous circle – no one can see any end to the potential of the underlying truth or how high it can push the prices of related assets. It’s broadly accepted that trees can grow to the sky: “It can only go up. Nothing can stop it.” Certainly no one can picture things taking a turn for the worse.
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I’ll use an example to illustrate the acceptance being accorded low-grade credit instruments. In early May, Netflix issued €1.3 billion of Eurobonds, the lowest-cost debt it ever issued. The interest rate was 3.625%, the covenants were few, and the rating was single-B. Netflix’s GAAP earnings run about $200 million per quarter, but according to Grant’s Interest Rate Observer, in the year that ended March 31, Netflix burned through $1.8 billion of free cash flow. It’s an exciting company, but as Grant’s reminded its readers, bondholders can’t participate in gains, just losses. Given this asymmetrical proposition, any bond issue should be characterized by solidity and a meaningful promised return, not the sex appeal of its issuer.
Should you take these risks to make less than 4% per year? In Oaktree’s view, this isn’t a solid debt investment; it’s an equity-linked digital content investment totally lacking in upside potential, and it’s not for us. The fact that deals like this can get done easily should tell you something about today’s market climate.
Additional reading
Netflix is carrying $20 billion in debt. Can it keep borrowing its way to success?
“That’s a lot of capital up front, and then you get a payout over many years,” Chief Executive Reed Hastings said in a recent investor call. “The irony is the faster that we grow and the faster we grow the owned originals, the more drawn on free cash flow that we’ll be.”
As a result, Netflix said it expects “to be free-cash-flow negative for many years,” meaning it will continue bleeding cash for the foreseeable future.
