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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
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.
The Seeds for a Boom
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.
“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.