Oil Shock 1973

literally. Three factors contributed to investors’ fascination with these stocks. First, the U.S. economy grew strongly in the post-World War II period. Second, these companies benefitted from their involvement with areas of innovation such as computers, drugs, and consumer products. And third, they represented the first wave of “growth stocks,” a new investment style that separately became a fad in itself. The Nifty Fifty were the object of the first big bubble in roughly 40 years, and since there hadn’t been one for so long, investors had forgotten what a bubble looks like. As a result of the popularity that was conferred on them, if you bought these stocks on the day I started work and held them tenaciously for five years, you lost well over 90% of your money . . . in the best companies in America. What happened? The Nifty Fifty had been put on a pedestal, and investors get hurt when something falls from it. The stock market as a whole declined by about half in 1973-74. And it turned out these stocks had been selling at prices that actually were too high; in many cases, their price/earnings ratios fell from the range of 60 to 90 to the range of 6 to 9 (that’s the easy way to lose 90%). Further, bad things actually did happen to several of the companies in fundamental terms. My early brush with a genuine bubble caused me to formulate some guiding principles that carried me through the next 50-odd years: It’s not what you buy, it’s what you pay that counts.

You might say, “making plus-or-minus-2% wouldn’t be the worst thing in the world,” and that’s certainly true if stocks were to sit still for the next ten years as the companies’ earnings rose, bringing the multiples back to earth. But another possibility is that the multiple correction is compressed into a year or two, implying a big decline in stock prices such as we saw in 1973-74 and 2000-02. The result in that case wouldn’t be benign. The above are the things to worry about. Here are the counterarguments: • the p/e ratio on the S&P 500 is high but not insane, • the Magnificent Seven are incredible companies, so their high p/e ratios could be warranted, • I don’t hear people saying, “there’s no price too high;” and • the markets, while high-priced and perhaps frothy, don’t seem nutty to me. * * * As I said at the start of this memo, I’m not an equity investor, and I’m certainly no expert on technology. Thus, I can’t speak authoritatively about whether we’re in a bubble. I just want to lay out the facts as I see them and suggest how you might think about them . . . just as I did 25 years ago. I hope you’ll keep reading for the next 25!2025

But if the government puts its thumb on the scale in favor of one party or the other, it distorts the workings of the free market and keeps it from functioning efficiently on behalf of society overall. More on this later. There are forms of seller behavior that are clearly wrong. These include collusion, price fixing, and predatory pricing designed to drive competitors out of the market. But laws prohibiting these behaviors are already on the books. Additional laws designed to prohibit and punish price increases that someone views as unfair, excessive or exorbitant – as opposed to being the result of improper conduct – are sure to prove difficult to enforce and counter-productive. Would a Law Against Price Gouging Work? Just as history is full of failed command economies, it also shows the ineffectiveness of attempts to regulate prices. In 1974, when the OPEC oil embargo set off inflation that made life difficult for millions, the U.S. government countered by distributing “WIN” buttons, standing for Whip Inflation Now. I still have mine, but neither it nor the voluntary consumer actions that were supposed to follow were enough to keep inflation from reaching 13.5% in 1980. The buttons were derided, with some skeptics wearing them upside down, according to Wikipedia. “Worn that way, ‘NIM’ stood for ‘No Immediate Miracles,’ ‘Nonstop Inflation Merry-go-round,’ or ‘Need Immediate Money.’ ’’ © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

For a long time, the pessimism appeared to be correct, with production falling to five million BOEPD by 2007. Meanwhile, the U.S. government created a Strategic Petroleum Reserve (“SPR”) in 1975 to alleviate – though not come close to eliminating – this erosion of American self-sufficiency. And then – Hallelujah! – shale economics became feasible in 2011, and our energy dependency ended. Now, U.S. production is more than 13 million BOEPD, and OPEC no longer has the upper hand. Occidental itself has annual U.S. oil production that each year comes close to matching the entire inventory of the SPR. Our country would be very – very – nervous today if domestic production had remained at five million BOEPD, and it found itself hugely dependent on non-U.S. sources. At that level, the SPR would have been emptied within months if foreign oil became unavailable. Under Vicki Hollub’s leadership, Occidental is doing the right things for both its country and its owners. No one knows what oil prices will do over the next month, year, or decade. But Vicki does know how to separate oil from rock, and that’s an uncommon talent, valuable to her shareholders and to her country. * * * * * * * * * * * * Additionally, Berkshire continues to hold its passive and long-term interest in five very large Japanese companies, each of which operates in a highly-diversified manner somewhat similar to the way Berkshire itself is run.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: I Beg to Differ _______________________________________________________________________________ I’ve written many times about having joined the investment industry in 1969, when the “Nifty Fifty” stocks were in full flower. My first employer, First National City Bank, as well as many of the other “money-center banks” (the leading investment managers of the day), were enthralled with these companies, with their powerful business models and flawless prospects. Sentiment surrounding their stocks was uniformly positive, and portfolio managers found great safety in numbers. For example, a common refrain at the time was “you can’t be fired for buying IBM,” the era’s quintessential growth company. I’ve also written extensively about the fate of these stocks. In 1973-74, the OPEC oil embargo and the resultant recession took the S&P 500 Index down a total of 47%. And many of the Nifty Fifty, for which it had been thought that “no price was too high,” did far worse, falling from peak p/e ratios of 60-90 to trough multiples in the single digits. Thus, their devotees lost almost all of their money in the stocks of companies that “everyone knew” were great. This was my first chance to see what can happen to assets that are on what I call “the pedestal of popularity.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: However, the most important aspect of this change didn’t relate to high yield bonds, or to private equity, but rather to the adoption of a new investor mentality. Now risk wasn’t necessarily avoided, but rather considered relative to return and hopefully borne intelligently. This new risk/return mindset was critical in the development of many new types of investment, such as distressed debt, mortgage backed securities, structured credit, and private lending. It’s no exaggeration to say today’s investment world bears almost no resemblance to that of 50 years ago. Young people joining the industry today would likely be shocked to learn that, back then, investors didn’t think in risk/return terms. Now that’s all we do. Ergo, a sea change. At roughly the same time, big changes were underway in the macroeconomic world. I think it all started with the OPEC oil embargo of 1973-74, which caused the price of a barrel of oil to jump from roughly $24 to almost $65 in less than a year. This spike raised the cost of many goods and ignited rapid inflation. Because the U.S. private sector in the 1970s was much more unionized than it is now and many collective bargaining agreements contained automatic cost-of-living adjustments, rising inflation triggered wage increases, which exacerbated inflation and led to yet more wage increases.

” Looking at the above, it’s important to note the degree to which people (and thus markets) seem to think long-term phenomena can change in the short run. It’s common knowledge that the coronavirus is still gaining ground in the U.S. and elsewhere; the economy is destined for a serious recession; leveraged entities have to worry about their sources of loans and liquidity; and the price of oil is among the very lowest since the 1973 OPEC embargo. But the prices of financial assets have moved down as well: appropriately, too much or too little? In other words, we have to consider the outlook and the appropriateness of value, in the context of unprecedented uncertainty and the total absence of guidance from analogies to the past. There’s no doubt about the ability of the government’s and the Fed’s massive cash injections to make things better in the short run, and certainly the market has treated them as sure winners. But I think it’s important to take time out for a serious discussion of possible scenarios. Are this past week’s remedies certain to work? Are the prior week’s negatives really erased? Which will win in the short and intermediate term: the disease, economic ramifications or Fed/Treasury actions? To try to think about these things in a responsible way, I’ve decided to try cataloging the optimistic and pessimistic elements. © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: What does the U.S. see today? • one of the greatest pandemics to reach us since the Spanish Flu of 102 years ago, • the greatest economic contraction since the Great Depression, which ended 80 years ago, • the greatest oil-price decline in the OPEC era (and, probably, ever), and • the greatest central bank/government intervention of all time. The future for all these things is clearly unknowable. We have no reason to think we know how they’ll operate in the period ahead, how they’ll interact with each other, and what the consequences will be for everything else. In short, it’s my view that if you’re experiencing something that has never been seen before, you simply can’t say you know how it’ll turn out. In my last two memos, I stressed my conviction that there’s no “informed” way to choose between the positive and negative scenarios we face today, and that most people decide in a way that reflects their biases.

The systemic importance of the banks necessitated their bailouts (the resentment of which contributed greatly to today’s populism). This time, leveraged securitizations are less pervasive in the financial system, and their risk capital wasn’t supplied by banks (thanks to the Volcker Rule), but mostly by non-bank lenders and funds. Thus I feel government bailouts are unlikely to be made available to them. (As an aside, it’s not that the people who structured these leveraged entities erred. They merely failed to include an episode like the current one among the scenarios they modeled. How could they? If every business decision had to be made in contemplation of a pandemic, few deals would take place.) • Finally, in addition to the disease and its economic repercussions, we have one more important element: oil. Due to a confluence of reduced consumption and a price war between Saudi Arabia and Russia, the price of oil has fallen from $61 per barrel at year-end to $19 today. The price of oil was only slightly lower immediately before the OPEC embargo in 1973, and in the 47 years since then it has only been lower on two brief occasions. While many consumers, companies and countries benefit from lower oil prices, there are serious repercussions for others: o Big losses for oil-producing companies and countries.

2T $ in PE dry powder, low gas prices and 0% interest rates pour fuel onto on the economy. The roaring 20’s mean the 2020's now. Bear case: Unemployment goes to 20%+. Everything does NOT go back to normal before at least a year or two, and in the meantime, there is a huge demand shock. The effects of the lockdown on businesses as well as the oil shock create depression-like conditions. In the Global Financial Crisis, I worried about a downward cascade of financial news, and about the implications for the economy of serial bankruptcies among financial institutions. But everyday life was unchanged from what it had been, and there was no obvious threat to life and limb. Today the range of negative outcomes seems much wider, as described above. Social isolation, disease and death, economic contraction, enormous reliance on government action, and uncertainty about the long-term effects are all with us, and the main questions surround how far they will go. Nevertheless, the market prices of assets have responded to the events and outlook (in a very micro sense, I feel last week’s bounce reflected too much optimism, but that’s me). I would say assets were priced fairly on Friday for the optimistic case but didn’t give enough scope for the possibility of worsening news. Thus my reaction to all the above is to expect asset prices to decline. You may or may not feel there’s still time to increase defensiveness ahead of potentially negative developments.

Even since the fairly high valuations that were in place when stocks took off (again) early in 1995, the basic ratio of market price to book value has risen from 4 to 6.5 times; the price-earnings ratio has risen from 15 to 20 times; dividend yields (yes, I’m old fashioned enough to believe that dividends still matter) have fallen from 2.7% to 1.6%. (And only at the 1929 peak, the 1973 peak and the 1987 peak did dividend yields ever get as low as 2.7%.)

1. Faith in the Financial Markets I’m confident that few, if any, of you in this sophisticated audience have any doubt that we have moved into a new era for the financial markets. I expect that it will be an era in which the returns of stocks and bonds alike will be substantially lower than the unprecedented double-digit returns we’ve experienced in the past, indeed—unless you’ve put in more than two decades in this wonderful business—the very past that comprises your entire first-hand experience in the markets. And you need three decades to have known first-hand what the 50% market crash in 1973-74 was like. (This one’s now at 40%). Suffice it to say that it was almost exactly twenty-years ago—on August 18, 1982, in the aftermath of a nine-year bear market—that interest rates turned downward and stock prices leaped upward. The T-bill rate, 11% when August began, promptly tumbled to 8%. The Standard & Poor’s 500 Stock Composite Index leaped from 103 to 113 during that single week, and to 120 by month’s end, in the blink of an eye, a gain of 17%. We were on the way. In the great boom, which culminated with a great bubble in March 2000, the Index was to rise to 1527. By then, the annual return on stocks had reached a level unprecedented in any comparable period in history—just short of 20% per year. And the bond market, which earned a return of more than 10% annually over this long period, also performed far better than ever before.

and contentious start arose one of the most important and powerful investment ideas of the age, an age whose anniversary we celebrate at this Sixth Annual Superbowl of Indexing. Two Schools of Indexing—Quantitative and Pragmatic I think it’s fair to say that there were two principal schools of index development. I’ll call one the Quantitative School—the masters of mathematics led by Harry Markowitz, William F. Sharpe, and the Wells Fargo Financial Analysis Department, who reached their conclusions after doing complex equations and conducting exhaustive research on the financial markets. Princeton’s Burton Malkiel also deserves a share of the credit. In 1973, in the first edition of his persuasive and ever-popular A Random Walk Down Wall Street, he endorsed the efficient market hypothesis and called for a no-load, low-fee mutual fund that simply buys the market and does no trading. In essence, the Modern Portfolio Theory developed by the Quantitative School proved that a fully-diversified, unmanaged equity portfolio was the surest route to investment success. While the Quantitative School developed its profound theories, what I’ll call the Pragmatic School simply looked at the evidence. Dr. Paul A.

Yet those who serve nominally as trustees, but relieved, by clever legal devices, from the obligation to protect whose who interests they purport to represent . . . consider only last the interests of those whose funds they command, suggest how far we have ignored the necessary implications of that principle.”1 In this industry, then as now, small groups “control the resources of great numbers of investors,” and it is fund managers who must accept the lion’s share of the responsibilities for the baneful trends I will discuss today. But fund directors—“those who serve nominally as 1 I last used that quotation in my “State of the Firm” address to the officers of Wellington Management Company in 1971, more than three years before I founded Vanguard. I was reflecting on the harm the fund industry inflicted on investors during the “Go-Go Era” of the 1960s, the precursor of the devastating 50% market crash of 1973-74.

Business Week described “a free-form financial corporation offering a complete line of financial services—worldwide. . . that may shake the entire industry.” The fledgling Institutional Investor magazine ran a cover story entitled “The Whiz Kids Take Over at Wellington.” We started off with a bang, and by the time 1967 was over, Ivest Fund was to have the best five- year record in the fund industry. But this was the “Go-Go Era” on Wall Street, which, as it turned out, was on the verge of collapse. What is more, the new investment group proved a painful disappointment. My determination to move quickly, my naiveté, and my eagerness to ignore the clear lessons of history had led me into a serious lapse of judgment. My error had resulted in failure—but just maybe reflected the attributes of a budding entrepreneur. In a sense, of course, life is often fair. I made a big error and I paid a high price. With the bust of the Go-Go Era in 1968, and then the terrible 1973-1974 bear market (down 50% from high to low; yes, it could happen again), the bloom was off the rose.had

If the words about efficiency, honesty, and economical operation strike you as a design for a firm called Vanguard, and if the idea that funds can’t beat the market seems to lay the groundwork for the index fund, so be it. But those things are probably what any young college student, idealistically seeking to build a new and better world, would have written. Whatever the case, the thesis led me directly into a career in this industry, for it was read by Walter L. Morgan, long-time member of the Union League, fellow Princetonian, legendary fund pioneer, and founder in 1928 of Wellington Fund. When I graduated in 1951, Mr. Morgan hired me. With few hardy souls having come into the beleaguered investment field during the 1930s and 1940s, my ascent was rapid. This fine gentleman groomed me, challenged me, trusted me, and liked me—we were friends for nearly half a century until his death at age 100 four years ago—and by 1965, at age 35, I was running his company. Mr. Morgan told me “to do whatever it takes” to prepare Wellington for the future. Headstrong, self-confident, and immature, I took a radical step, merging Wellington Management Company with a Boston investment firm. But I relinquished too much of Wellington’s voting control for my own good. While at first the merger was an extraordinary success, the end of the speculative boom of the “go-go” 1960s and the onset of the great 1973-74 bear market brought tough times.

Headstrong, impulsive, and naïve, I found a merger partner—in Boston, of all places— that I hoped would do exactly that. Alas, despite the glitter, I found no diamonds there. The merger worked beautifully for about five years, but the investment managers who were my new partners let our fund shareholders down, the stock market dropped 50%, and the assets we managed plunged from $3 billion in early 1973 to $1.3 billion in late 1974. Not surprisingly, the new partners had a falling out. But my adversaries had more votes at the Company than I did, and it was they who fired me from what I had considered “my” company. What’s more, they intended to move all of Wellington to Boston. I wasn’t about to let that happen. I not only loved Philadelphia, my adopted city that had been so good to me, but by 1974 I had established my roots here, finding unimaginable diamonds, first, in my beloved wife Eve, who was born and grew up here, and then in six wonderful children. We intended to say where we were, and I had a plan to do just that. For when the door slammed, a window opened, and the acres of diamonds I had begun to discover in 1951 were to remain in Philadelphia. Pulling off this trick was not easy. But I was able to parlay a slight difference in the governance structure of the Wellington funds, owned by their own shareholders, and Wellington Management Company, owned largely by my former partners, into a new career—and with it more diamonds than I ever could have imagined.

integrated, Russia comes to have a solid foundation, and, down the road, China becomes the world’s largest economy. In all, “a radically optimistic meme.”2 In hindsight, the only meme that seemed to take hold was the contagious idea that only the sky was the limit for the prices of the “New Era” stocks, and investors better jump on the band wagon…before it was too late. There were, to be sure, some respected investors and investment professionals, made wary by their knowledge of the nature of stock market returns and hardened by their experience in previous bear markets, who spoke out with passion and eloquence, calling the market overpriced. But the prophets were few in number, for the most recent prolonged bear market had come a full generation earlier, in 1973-74, when, the NYSE Index tumbled 50%, and the NASDAQ plummeted 60%. Alas, these warnings went unheeded. As Dickens might have said of the stock market last March, “it was the age of not enough wisdom, it was the age of too much foolishness.” Recognizing the Bubble While I’m hardly, in Dickens’ words, one of the profession’s “noisiest authorities,” just over a year ago, right at the market peak, I did prepare a speech on “Risk Control in an Era of Greed.” I pointed out that, “when reward is at its pinnacle, risk is near at hand.

Today, we have a new mutual fund industry, one that is distinctly different from its staid, largely conservative ancestor—in variety, in concept, in investor participation, in service quality, and in pricing. But the question is: Do we better serve investors? A New Industry Emerges Surely there are more fund choices. The number of mutual funds has exploded, providing investors with an enormous variety of fund objectives, strategies, and managers. Just 20 years ago, the old industry was composed of fewer than 300 equity funds—the embattled survivors of the great 1973-1974 bear market, licking their wounds. The new industry comprises a bewildering total of some 7,300 funds—not only 4,000 equity funds, but 2,200 bond funds and 1,100 money market funds as well.as

Virtually that entire margin was then lost during the next five years, leaving small caps about at par with large caps for nearly the full half-century. The small cap reputation was made during the 1973-1983 decade. Then, seemingly inevitably, RTM struck again for the fifth cycle. Just as the proverb warns us, it was darkest for the large caps before the dawn, and since then the sun has shone brightly upon them. On balance for the full period, the compound annual return on small cap stocks was +12.7% compared with +11.0% for large cap stocks. This difference, to be sure, resulted in a terminal value for small cap stocks that was three times that of large cap stocks. But, given the dominance of small caps in this single decade, I’m not sure I’d rely on it.stock

Second, it has provided just what it promised: performance excellence. On average, the surviving funds delivered an annual return of 12.6% compared to 13.2% for our 500 Index Fund. If we reduce the average fund return by 1.5% to account for the estimated survivor bias, the value of the average fund’s return would drop to 0.1 1000 10000 1933 1941 1949 1957 1965 1973 1981 1989 1997 S&P 500 CRSP Growth of $1, CRSP and S&P 500: 1926 - 2000 Avg. Ann. Return 11.0% 10.6% Correlation 0.98

domination in 1973-1983—but one of seven decades in the period—large caps were actually superior. Annual returns: large cap +11.1%, small cap +10.4%. In any event, the relationship between large caps and small stocks, if not entirely dominated by RTM, is permeated with the force of market gravity. We don’t have an historical chronicle of comparable length to those I’ve used for my first examples of RTM. So, for the evidence in U.S. versus international stocks, I can rely only on data for the past 38 years. Here, as shown in Exhibit VII, we again see profound evidence for my thesis. Here, I’ll compare the returns of the Standard and Poor’s 500 Stock Index and the Morgan Stanley Capital International Europe, Australasia, and Far East (“EAFE”) Index. While there were frequent swings to and fro, our ratio of cumulative value slightly favored the EAFE Index for the first 24 years through 1984. The compound returns were EAFE +9.7%; S&P +8.4%. Then EAFE exploded, outpacing the U.S. by fully two times during the brief 1984-1988 cycle. Since then, the U.S. has fully repaid the compliment, more than redressing that flash of EAFE brilliance during the subsequent nine years. For the full period, the compound returns on U.S. stocks and international stocks were identical at +11.5%. The relative value of each initial $1.00 invested by the investor who stayed in the U.S. was worth precisely the same for the internationalist.

Pillar 7. The Powerful Magnetism of the Mean In the world of investing, the mean is a powerful magnet that pulls financial market returns toward it, causing returns to deteriorate after they exceed historical norms by substantial margins and to improve after they fall short. Reversion to the mean is a manifestation of the immutable law of averages that prevails, sooner or later, in the financial jungle. In the boom-and-bust bubble we have just witnessed in the NASDAQ Index, we have a wonderful example of reversion to the mean (RTM). After closely tracking the NYSE Index of all listed stocks from the mid-1970s through the end of 1997, the unlisted stocks in the NASDAQ Index took off in 1998, rising 230% (!) though the first quarter of 2000, eleven times the 20% gain in the NYSE Index. Then, reversion to the mean promptly wreaked its havoc, and with a vengeance. Since then, the NASDAQ has tumbled 67%, compared to a loss of but 7% for the NYSE Index. At the high last March, a dollar invested in NASDAQ Index in 1972 had soared to $1.80 for each dollar in the NYSE Index. But it has now fallen to just 58 cents. RTM strikes again, and, I’m confident, not for the last time. $0 $10 $20 $30 $40 $50 $60 $70 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2000 NYSE Nasdaq 7. The Powerful Magnetism of the Mean $58.42 $32.33 $32.60 $18.99 Growth of $1

Consider the past 40 years: Dividend yield plus earnings growth came to a total of 11.2% per year. The actual return of the stock market came to an identical 11.2%. 0.1 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 Investment Return vs. Market Return: 1961 - 2001 Investment Return 11.2%/year Market Return 11.2%/year

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: logic was clear and convincing, per the following citation from Wikipedia (with apologies to Richard Masson, my conscience regarding sources, for relying on it): In 1973, Burton Malkiel wrote A Random Walk Down Wall Street, which presented academic findings for the lay public. It was becoming well known in the lay financial press that most mutual funds were not beating the market indices. Malkiel wrote: What we need is a no-load, minimum management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages and does no trading from security to security in an attempt to catch the winners. Whenever below-average performance on the part of any mutual fund is noticed, fund spokesmen are quick to point out “You can’t buy the averages.” It’s time the public could. . . . there is no greater service [the New York Stock Exchange] could provide than to sponsor such a fund and run it on a nonprofit basis. . . . Such a fund is much needed, and if the New York Stock Exchange (which, incidentally has considered such a fund) is unwilling to do it, I hope some other institution will. (Emphasis added) The first index fund appeared around that time. Again according to Wikipedia, the registration statement for the Qualidex Fund, designed to track the Dow Jones Industrial Average, became effective in 1972. I have no reason to believe it attracted many investors.

To be fair, there have been plenty of big falls in both the market and Berkshire Hathaway’s stock in the intervening 50 odd years since 1965. Berkshire’s shares fell by over 50% in 1973–75 and 2008–09, and by nearly 50% in 1998–2000, plus a mere 37% in 1987. The point about this is not simply that getting the timing of markets right is impossible it is also that in even attempting to do so you might have missed out on investing in Warren Buffett’s Berkshire Hathaway, the results of which far outweigh any market timing gains. So where are we now?date:

Assets of U.S. mutual funds have also soared, from $500 billion in 1985 to $16 trillion currently. (Exhibit 2) But the composition of fund assets has fluctuated widely—in 1970, an equity fund business— 87% equity funds, 8% in balanced funds, only 5% bond funds. (Exhibit 3) Then came the 1973-4 stock market crash. It almost killed the equity fund business. Equity fund assets dropped from $56 billion to $29 billion—a near-50% plunge. Bond funds helped to cushion the blow, and then, miraculously—and not a moment too soon— money market funds were created, bailing out the fund industry. By 1981, money market funds accounted

Pension funds that fail to take into account lower future returns are courting not merely disappointment, but disaster. Pension plans—public and private alike—are now facing a $1.5 trillion deficit, assuming future returns of 7 ½% per year. In an environment of 4% gross returns on stocks, 3% gross returns on bonds, and even (generously!) 8% gross returns on alternative investments. 7 ½% looks impossible, especially when investment costs are taken into account. Even a 5% net return after costs for pension funds looks like a stretch. Here, the word “crisis” seems appropriate. Challenges to Traditional Indexing The index revolution, like all revolutions—is not without its flaws. The most recent flaw is the focus on the concept of “Smart Beta”—replacing market-cap-weighted portfolios by portfolios weighted by so-called “fundamental” factors: dividends, earnings, book values, assets, etc. As a concept, Smart Beta is not a terrible idea . . . nor is it a world-changing one. But it suffers from the assumption that past data, heavily mined, will identify factors that will provide sustainable performance leadership. Mark me as from Missouri on that one. It ignores the principle of reversion to the mean (RTM) in stock returns, market returns, and mutual fund returns. That’s a huge mistake. Once again (remember the “Go-Go” fund craze of 1965-1968 and the “Nifty Fifty” craze of 1970- 1973?)

era—equity funds laced with speculative issues, “story stocks,” and phony accounting. (Shares were bought from corporate insiders by funds at discounts of some 50% from market value, then quickly marked up to market value, creating an immediate, if illusory, 100% return.) In that short-lived era when these speculative “aggressive growth” mutual funds were in the industry’s driver’s seat, both stupidly (from an investment standpoint) and brilliantly (from a marketing standpoint), I merged Wellington Management with Boston’s tiny Thorndike, Doran, Paine, and Lewis, adding a hot “Go-Go” fund to our menu. (Ivest Fund, meteor-like, lit-up the skies for a few years, and then burned out and crashed, its ashes finally deposited in the dustbin of history in 1980.) My new partners at Ivest hated bonds. When I proposed forming a bond fund in 1970, one of them quickly put the kibosh on the idea: “Don’t you realize that bonds are yesterday? Stocks are tomorrow.” But I finally persuaded my colleagues to form an income fund, 60% bonds and 40% dividend-paying stocks. (Today, the assets of Vanguard Wellesley Income Fund total $54 billion.) Then times changed (a little!) and we formed our first “pure” bond fund in July 1973—now Vanguard Long- Term Investment Grade Bond Fund—the first step in our gradual rise to dominance in the bond fund sector of our industry.

For the last 53 years, the company has built value by reinvesting its earnings and letting compound interest work its magic. Year by year, we have moved forward. Yet Berkshire shares have suffered four truly major dips. Here are the gory details: Period High Low Percentage Decrease March 1973-January 1975 93 38 (59.1%) 10/2/87-10/27/87 4,250 2,675 (37.1%) 6/19/98-3/10/2000 80,900 41,300 (48.9%) 9/19/08-3/5/09 147,000 72,400 (50.7%) This table offers the strongest argument I can muster against ever using borrowed money to own stocks. There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: In 1977, responding to the difficult energy outlook brought on by the Arab Oil Embargo, President Jimmy Carter created the position of Secretary of Energy and chose James Schlesinger as America’s first “energy czar.” Previously Schlesinger had served as Chairman of the Atomic Energy Commission, Director of Central Intelligence, and Secretary of Defense, and in his early days he taught economics at the University of Virginia. I was tickled by a story – undoubtedly apocryphal – about his days in academia that made the rounds when Schlesinger was in his new energy post. As the story went, Schlesinger was such a convincing evangelist for capitalism that two students in his economics class decided to go into business after graduation. Their plan was to borrow money from a bank, buy a truck, and use it to pick up firewood purchased in the Virginia countryside, which they would then sell to the grandees in Georgetown. Schlesinger wholeheartedly endorsed their entrepreneurial leanings, and they proceeded with great enthusiasm. From the start of their venture, the former students could barely keep up with the demand. Thus it came as quite a shock when their banker called to tell them the balance in their account had reached zero and the truck was about to be repossessed.

Here are some excerpts from an article about the recent market action: Oil prices fell sharply to a seven-year low, rattling stock markets at the end of a choppy week. . . . The price of Brent crude, the global energy benchmark, was down 5.6% to $37.49 . . . after Opec at its meeting a week ago failed to agree output cuts, leaving prices at the mercy of a global glut. “Lower oil prices are here to stay.” The CBOE Oil Vix is holding above the 54 level . . . as investors pay up to protect themselves [against], or speculate upon, further sharp moves in crude. That all sounds very serious. But is it? Does it make any sense? What’s the real significance of declining oil prices? The bottom line for me is that, if you aren’t an oil company or a net oil-producing country, low oil prices aren’t necessarily a bad thing. For net oil importers like the U.S., Europe, Japan and China, the drop we’ve seen in the price of oil is analogous to a multi-hundred-billion-dollar tax cut, adding to consumers’ disposable income. It can also increase an importer nation’s cost-competitiveness. The U.S. is both a producer of oil and an importer. That means the macro economy will enjoy the benefit of cost reduction and income enhancement, but domestic oil companies and those who provide them with products and services will gain less from production than had been expected, and some state and local governments will be hard-hit.

And that’s hard to find. Questioner: For most of the oil market’s history, there’s been some entity imposing production controls. But today Saudi Arabia has acted more as a . . . oil producer than controlling OPEC production. Would you suspect that this will result in negatives affecting the economics for all those involved in oil production? Charlie Munger: You know I would not have predicted that oil would be distressed in price. In fact, if you’d forced me to bet, I would have bet that what has happened wouldn’t have happened. I think it is generally true that with these commodities you can get periods of extreme high prices like we had and extreme low prices, like we have now . . . So I think that commodities can do strange things, both up and down in terms of price. And of course they have macroeconomic consequences, huge consequences. If you’re in Australia, having these commodities go way down is terrible. If you’re the tar sands area of Canada, having oil prices go down the way they have now, I don’t know even know how economic it is to produce tar sands oil at $30 a barrel. My guess is that it’s not very attractive. And it may not work at all for many people. So you’re in a weird period. But I think it’s the nature of the human condition that with free markets and stuff like iron ore and oil you’re going to have weird periods of high prices and weird periods of low prices. I’ve never been able to predict accurately, or make money predicting accurately, those swings.

merger brought us into the pension fund management business, which I thought would be a natural extension of the talents of our new management team’s mutual fund activities. So, I honored my fiduciary duty to the owners of Wellington Management Company—Mr. Morgan and its public shareholders. The firm had “gone public” in 1960, joining the parade of fund managers who poured through the gates opened by the ISI case. But I also believed that I had honored my separate and distinct fiduciary duty to the shareholders of Wellington Fund, for I expected that our new managers would apply their investment talents to enhancing the fund’s faltering returns . . . Wrong! Wrong! Wrong! Looking back, the merger was an abject failure—perhaps the worst merger ever, although AOL/Time Warner sets a high standard indeed. Though the “new era” finally ended, in this case, as 1973 began. Then, Wellington Fund had reached the most aggressive allocation to equities in its near-half-century history (82%, often of marginal investment quality). Its returns tumbled, and its reputation plummeted. Every one of our equity and balanced funds—including several new ones— failed its shareholders. And Wellington Management’s stock would trade at $6 per share, down 90% from its 1968 high of near $60. And, having given up too much stock to our new partners in the merger (who were largely responsible for our dismal performance) they fired me. My promising career had ended.

© Oaktree Capital Management, L.P. All Rights Reserved increasing (as new sources came on stream). Equally, everyone knows that lower demand and higher supply imply lower prices. Yet it seems few people recognized the ability of these changes to alter the price of oil. A good part of this probably resulted from belief in the ability of OPEC (meaning largely the Saudis) to support prices by limiting production. A price that’s kept aloft by the operation of a cartel is, by definition, higher than it would be based on supply and demand alone. Maybe the thing that matters is how far the cartelized price is from the free-market price; the bigger the gap, the shorter the period for which the cartel will be able to maintain control. Initially a cartel or a few of its members may be willing to bear pain to support the price by limiting production even while others produce full-out. But there may come a time when the pain becomes unacceptable and the price supporters quit. The key lesson here may be that cartels and other anti-market mechanisms can’t hold forever. As Herb Stein said, “If something cannot go on forever, it will stop.” Maybe we’ve just proved that this extends to the effectiveness of cartels.  Anyway, on the base of 93 million barrels a day of world oil use, some softness in consumption combined with an increase in production to cut the price by more than 40% in just a few months.

What this proves – about most things – is that to Dornbusch’s quote above we should append the words “. . . and they go much further than you thought they could.” The extent of the price decline seems much greater than the changes in supply and demand would call for. Perhaps to understand it you have to factor in (a) Saudi Arabia’s ceasing to balance supply and demand in the oil market by cutting production, after having done so for many years, and (b) a large contribution to the decline on the part of psychology. (In the “conspiracy theory” department, consider the rumor that Saudi Arabia is allowing or abetting the price drop in order to either punish Iran, Iraq and ISIL; put the U.S. shale oil industry out of business; or discipline the more profligate members of OPEC . . . take your pick.) The price of oil thus may have gone from too high (supported by OPEC and by Saudi Arabia in particular) to too low (depressed by negative psychology). It seems to me with regard to the latter that the price fell too far for some market participants to maintain their equanimity. I often imagine participants’ internal dialogues. At $110, I picture them saying, “I’ll buy like mad if it ever gets to $100.” Because of the way investor psychology works, at $90 they may say, “If it falls to $70, I’ll give serious thought to buying.” But at $60 the tendency is to say, “It’s a falling knife and there’s no way to know where it’ll stop; I wouldn’t touch it at any price.

The two main ones are fundamental risk (relating to how a company or asset performs in the real world) and valuation risk (relating to how the market prices that performance). For years investors, fiduciaries and rule-makers acted on the belief that it’s safe to buy high-quality assets and risky to buy low-quality assets. But between 1968 and 1973, many investors in the “Nifty Fifty” (the stocks of the fifty fastest-growing and best companies in America) lost 80-90% of their money. Attitudes have evolved since then, and today there’s less of an assumption that high quality prevents fundamental risk, and much less preoccupation with quality for its own sake. On the other hand, investors are more sensitive to the pivotal role played by price. At bottom, the riskiest thing is overpaying for an asset (regardless of its quality), and the best way to reduce risk is by paying a price that’s irrationally low (ditto). A low price provides a “margin of safety,” and that’s what risk-controlled investing is all about. Valuation risk should be easily combatted, since it’s largely within the investor’s control. All you have to do is refuse to buy if the price is too high given the fundamentals. “Who wouldn’t do that?” you might ask. Just think about the people who bought into the tech bubble. Fundamental risk and valuation risk bear on the risk of losing money in an individual security or asset, but that’s far from the whole story.

Since corporate directors have a fiduciary responsibility to stockholders but not to bondholders, some think they can (and perhaps should) do anything that’s not explicitly prohibited to transfer value from bondholders to stockholders. Bondholders need covenants to shield them from this kind of pro- active plundering, but at times like today it can be hard to obtain strong protective covenants. There are many ways for an investment to be unsuccessful. The two main ones are fundamental risk (relating to how a company or asset performs in the real world) and valuation risk (relating to how the market prices that performance). For years investors, fiduciaries and rule-makers acted on the belief that it’s safe to buy high-quality assets and risky to buy low-quality assets. But between 1968 and 1973, many investors in the “Nifty Fifty” (the stocks of the fifty fastest-growing and best companies in America) lost 80-90% of their money. Attitudes have evolved since then, and today there’s less of an assumption that high quality prevents fundamental risk, and much less preoccupation with quality for its own sake. On the other hand, investors are more sensitive to the pivotal role played by price. At bottom, the riskiest thing is overpaying for an asset (regardless of its quality), and the best way to reduce risk is by paying a price that’s irrationally low (ditto). A low price provides a “margin of safety,” and that’s what risk-controlled investing is all about.

During the 1975-1985 era, following the devastating 50 percent stock market crash of 1973-1974, the prime focus of the industry shifted from stock funds to money market and bond funds. To carve out a competitive niche—with the realization that the “costs matter” principle applies in all asset categories— we established the first municipal bond mutual funds holding portfolios with strictly defined-maturities. Our long-term, intermediate-term, and short-term offerings (unique, but hardly the triumph of amazing brilliance!) quickly changed the structure of the entire bond fund sector. A new framework for bond management had emerged. August 1977. Innovation # 4. One of the crushing failures that preceded Vanguard’s formation was the abject failure of Wellington Fund. New managers had turned this classic conservative balanced fund, founded by Walter L. Morgan, Princeton Class of 1925, into a type of aggressive stock fund. In the1974 market crash— which was wholly predictable—Wellington flamed out, its hard-earned reputation shattered. By 1978, with the substantial demands of implementing those first four innovations behind us, it was time to turn to the task of restoring Wellington Fund to its earlier eminence. Not only returning it to its traditional balanced portfolio (65/35 stocks/bonds), but giving it a new focus—a focus on a specific and clear dividend objective.

Mutual Fund Asset Growth 1951-2012 $2.5 $6.4 T $0.7 0.5 T $1.0 3.5 T $3.7 2.6 T 1,000 10,000 1951 1960 1970 1980 1990 2000 2012 Equity Balanced Bond Money Market $13.0 T $ billions 5. During the 1950s, assets of bond funds seemed stuck at around $500 million, with little growth during the next two decades. But, following the 1973-1974 bear market, bond funds began to assert themselves. As the financial markets changed, so did investors’ needs; income became a high priority. After that unpleasantness in the stock market, bond fund assets grew nicely, reaching $250 billion in 1987, actually exceeding the $175 billion total for equity funds. Bond funds then retreated to a less significant role during the 1990s. But today, following years of generous interest rates that were to tumble in recent years, bond fund assets have risen to $3.5 trillion, 25 percent of industry assets. As the dominance of equity funds waned, money market funds—the fund industry’s great innovation of the mid-1970s—bailed out the industry’s shrinking asset base. Exhibit 6. They quickly replaced stock funds as the prime driver. By 1981, money fund assets of $186 billion represented fully 77 percent(!) of industry assets. While that share has declined to 20 percent today, it is still a formidable business, with $2.6 trillion of assets. But given today’s pathetic yields and the possibility of a new business model for money funds (which will actually reflect their floating net asset values), it won’t be easy.

seven months earlier—filed with the State of Delaware the Declaration of Trust for a new mutual fund that promised not to engage in the practice of active management. Originally named “First Index Investment Trust,” it was the world’s first index mutual fund. Its birth was, curiously, the product of a divorce. (Now there’s a paradox!) In 1966, as head of the long-established Wellington Management Company, I bet the firm’s future on a Boston firm—Thorndike, Doran, Paine, and Lewis—run by four aggressive equity managers operating a hot “Go-Go” fund named Ivest, managing a growing pension business, and having investment talent that, I believed, could more effectively manage the portfolio of our faltering Wellington Fund. Yes, I was young and foolish, and (even worse!) I was wrong. But for a time, the merged firm prospered, yet only until the “Go-Go” era came to its inevitable end. As 1973 began, the stock market began its terrible 50 percent crash, even worse for Ivest Fund, which never did recover. (It no longer exists.) Worse, Wellington Fund performance was also a disaster—the worst performing of all balanced funds in 1967-1977. Our new business model faltered, and then failed. In the merger, I had ceded substantial voting power to the new managers, and it was they who fired me as the leader of Wellington Management. On January 24, 1974, I was replaced by their leader, Robert W. Doran. I leave it to wiser heads than mine to explain the perverse logic involved in that outcome.

Otherwise, we have not entered into any derivative contracts for some years, and our existing positions continue to run off. The contracts that have expired have delivered large profits as well as several billion dollars of medium- term float. Though there are no guarantees, we expect a similar result from those remaining on our books. Some Thoughts About Investing Investment is most intelligent when it is most businesslike. — The Intelligent Investor by Benjamin Graham It is fitting to have a Ben Graham quote open this discussion because I owe so much of what I know about investing to him. I will talk more about Ben a bit later, and I will even sooner talk about common stocks. But let me first tell you about two small non-stock investments that I made long ago. Though neither changed my net worth by much, they are instructive. This tale begins in Nebraska. From 1973 to 1981, the Midwest experienced an explosion in farm prices, caused by a widespread belief that runaway inflation was coming and fueled by the lending policies of small rural banks. Then the bubble burst, bringing price declines of 50% or more that devastated both leveraged farmers and their lenders. Five times as many Iowa and Nebraska banks failed in that bubble’s aftermath than in our recent Great Recession. In 1986, I purchased a 400-acre farm, located 50 miles north of Omaha, from the FDIC. It cost me $280,000, considerably less than what a failed bank had lent against the farm a few years earlier.

Without a Sunday paper, the News was destined to lose out to its morning competitor, which had a fat and entrenched Sunday product. We therefore began to print a Sunday edition late in 1977. And then all hell broke loose. Our competitor sued us, and District Judge Charles Brieant, Jr. authored a harsh ruling that crippled the introduction of our paper. His ruling was later reversed – after 17 long months – in a 3-0 sharp rebuke by the Second Circuit Court of Appeals. While the appeal was pending, we lost circulation, hemorrhaged money and stood in constant danger of going out of business. Enter Stan Lipsey, a friend of mine from the 1960s, who, with his wife, had sold Berkshire a small Omaha weekly. I found Stan to be an extraordinary newspaperman, knowledgeable about every aspect of circulation, production, sales and editorial. (He was a key person in gaining that small weekly a Pulitzer Prize in 1973.) So when I was in big trouble at the News, I asked Stan to leave his comfortable way of life in Omaha to take over in Buffalo. He never hesitated. Along with Murray Light, our editor, Stan persevered through four years of very dark days until the News won the competitive struggle in 1982. Ever since, despite a difficult Buffalo economy, the performance of the News has been exceptional. As both a friend and as a manager, Stan is simply the best.

Strange Bedfellows “Shared values” is one of the things I credit for Oaktree’s success over the years. All of Oaktree’s senior managers are conservative, cautious people; we all agree that risk control and consistency hold the keys to long-term investment success; and we all put clients’ account performance ahead of our company’s profit. Shared values make it easy to run an organization and particularly easy to reach agreement on policies and tactics. Now imagine what it would be like to run an enterprise where (a) some of the constituents believed much more in thrift, discipline and transparency than others and (b) there was no mechanism for making sure everyone played according to the agreed-upon rules. Welcome to Europe. In the 1950s Belgium, France, Italy, Luxembourg, the Netherlands and West Germany came together to form the European Coal and Steel Community, European Atomic Energy Community and European Economic Community, which in 1967 combined as the European Community. Denmark, Ireland and the U.K. joined in 1973, and Greece, Spain and Portugal joined in the 1980s. Membership has since expanded to 27 nations, and the name “European Union” (E.U.) was adopted in 1993. In 1999, eleven nations (since expanded to 16) agreed to form the euro zone and replace their individual currencies with the euro. Europe seemed to have accomplished the daunting task of pulling together its nations and adopting a single currency.

Ballyhoo took over from logic – excitement from value-consciousness – and these growth stocks’ prices reached 80 and 90 times earnings. The nifty-fifty stocks were tested – and found wanting – when the tide went out in the 1970s. Prosperity shifted to recession. The Arab oil embargo, a period of strong cost-push, and self- reinforcing cost-of-living adjustments created hyperinflation to which few people saw a chance for an end. Those growth stock p/e ratios went from 80 or 90 to 8 or 9. And stocks, Wall Street and the general economy went through a truly dreary decade, culminating in a BusinessWeek cover story entitled “The Death of Equities,” in August 1979. For evidence of the cyclicality of attitudes toward stocks, consider its final paragraph: Today, the old attitude of buying stocks as a cornerstone for one’s life savings and retirement has simply disappeared. Says a young U.S. executive: “Have you been to an American stockholders meeting lately? They’re all old fogies. The stock market is just not where the action is.” In the investment world, lows in sentiment usually coincide with lows in price, and the late Seventies were no exception. Because of the dreadful environment, you could buy an existing company in the stock market for less than it would cost to start one. I was fortunate to become a portfolio manager in mid-1978, and thus to benefit from the subsequent recovery of investor psychology from its nadir.

For years, things like the superiority of American products blunted foreign competition. One of the results was that the American worker enjoyed the highest wages and standard of living in the world. But now China, Korea and other nations have eclipsed much of our manufacturing advantage, allowing them to produce goods that are not just cheaper but at times better. It stands to reason that today, goods produced with high-priced inputs will not compete successfully. In order for U.S. goods to be competitive, our costs will have to come down, and with them our relative standard of living. Why should any country’s workers be able to command a higher standard of living if the goods they produce aren’t demonstrably superior? These trends have already taken effect in “legacy industries” like airlines and autos. For example, one of the main goals of the auto bankruptcies was to limit retirees’ lifetime benefits. I think we’ll continue to see declining relative costs in the U.S., to the betterment of our competitiveness but the detriment of our workers. Inflation, Exchange Rates and Interest Rates The macro question I get most often concerns the outlook for inflation. And as someone who lived through stagflation in the 1970s and paid interest at 22-¾%, I think it’s very much worth considering. The hyperinflation of the ’70s was sparked by the Oil Embargo of 1973.in

© Oaktree Capital Management, L.P. All Rights Reserved  In the mid-1960s, growth investing was invented, along with the belief that if you bought the stocks of the “nifty-fifty” fastest-growing companies, you didn’t have to worry about paying the right price.  The first of the investment boutiques was created in 1969, as I recall, when highly respected portfolio managers from a number of traditional firms joined together to form Jennison Associates. For the first time, institutional investing was sexy.  We started to hear more about investment personalities. There were the “Oscars” (Schafer and Tang) and the “Freds” (Carr, Mates and Alger) – big personalities with big performance, often working outside the institutional mainstream.  In the early 1970s, modern portfolio theory began to seep from the University of Chicago to Wall Street. With it came indexation, risk-adjusted returns, efficient frontiers and risk/return optimization.  Around 1973, put and call options escaped from obscurity and began to trade on exchanges like the Chicago Board Options Exchange.  Given options’ widely varying time frames, strike prices and underlying stocks, a tool for valuing them was required, and the Black-Scholes model filled the bill.  A small number of leveraged buyouts took place starting in the mid-1970s, but they attracted little attention.  1977-79 saw the birth of the high yield bond market. Up to that time, bonds rated below investment grade couldn’t be issued.

© Oaktree Capital Management, L.P. All Rights Reserved I recite these successes not for the purpose of self-congratulation, but to point out that while I was highly aware of the short-term cycle, I – like almost everyone else, it seems – failed to fully appreciate the big-picture peril implied by the level to which the cycle had risen. In short, I thought 2003-07 was like the other cycles I’ve lived through, just more so. I missed the fact that it was different not only in degree, but also in kind. This episode is different because over the preceding decades, the accretion of progressively higher highs and higher lows – in a large number of phenomena – brought us to a macro-high that hadn’t been witnessed for many years and held great danger . . . as we’re seeing. Forty years have passed since I first served as a summer trainee in First National City Bank’s Investment Research Department. My experience in seeing investors punished in 1969-70, 1973-74, 1977, 1981, 1987, 1990, 1994 and 2000-02 is what enabled me to detect the excesses of 2003-07. But since I didn’t live through the Great Depression or work through the full run-up to the painful 1970s, I didn’t have the perspective needed to understand where those relatively short cycles of boom/bust/recovery were taking us.

© Oaktree Capital Management, L.P. All Rights Reserved From time to time we saw better economies and worse – slowdown and prosperity, recession and recovery. Markets, too, rose and fell. These fluctuations were attributable to normal economic cycles and to exogenous developments (such as the oil embargo in 1973 and the emerging market crisis in 1998). The S&P 500 had a few down years in the period from 1975 to 1999, but none in which it lost more than 7.5%. On the upside, however, 16 of those 25 years showed returns above 15%, and seven times the annual gain exceeded 30%. Despite the ups and downs, investors profited overall, investing became a national pursuit, and America’s richest man got that way by buying common stocks and whole companies. A serious general uptrend was underway, reaching its zenith in 2007. The Rest of the Elephant There’s an old story about a group of blind men walking down the road in India who come upon an elephant. Each one touches a different part of the elephant – the trunk, the leg, the tail or the ear – and comes up with a different explanation of what he’d encountered – a tree, a reed, a palm leaf – based on the small part to which he was exposed. We are those blind men. Even if we have a good understanding of the events we witness, we don’t easily gain the overall view needed to put them together. Up to the time we see the whole in action, our knowledge is limited to the parts we’ve touched.

Until the 1950s, equities always provided higher current yields . . . for the simple reason that they had to. People invested primarily for yield, and riskier securities – stocks – would attract buyers only if they promised higher yields than bonds. This changed in the second half of the 20th century:  Common stock investing was popularized; I believe Charlie Merrill of Merrill Lynch deserves a lot of the credit for this.  Prior to some pioneering computer work at the University of Chicago in the 1960s, the historic returns on stocks had never been scientifically quantified. Then the Center for Research in Security Prices came up with the 9.2% compound annual return that fired many investors’ appetites.  The concept of growth-stock investing was popularized in the 1960s; I remember reading a broker’s brochure about companies with exciting earnings growth. This led to the “nifty-fifty” investing craze, in which investors (and especially bank trust departments) bought the stocks of fast-growing companies regardless of valuation. The equity boom burst in the 1970s.1973-74,

© Oaktree Capital Management, L.P. All Rights Reserved and considerably larger losses in nifty-fifty stocks. The stock market stayed in the doldrums for years, brokers drove cabs (literally), and Business Week ended a dismal decade with its downbeat cover story on stocks. In fact, the economy, markets and attitudes turned so negative for so long in the 1970s that rather than a downward cycle around the long-term upward trend, one might say the decade marked a downturn in the long-term trend (clearly there’s no standard for these things). Regardless of what you call it, the decline was so big that it took almost eleven years for the Dow Jones Industrials to get back to the high it reached at the beginning of 1973. But in 1982, stocks returned to what would be a 25-year bull market, and there arose an even greater cult of equities. Wharton Professor Jeremy Siegel wrote Stocks for the Long Run, showing there’d never been a long period in which stocks hadn’t outperformed cash, bonds and inflation. Everyone concluded stocks were the asset class of choice and the ideal investment. “65/35” was the usual stock/bond balance in institutional portfolios, but eventually stocks became more heavily weighted, as strong performance in the 1980s and ’90s further fired peoples’ ardor and as stocks’ long-term return was upgraded to 11%.

incentives for both performance and efficiency, but without the ability to capitalize earnings through public sale.” Within three years, a situation developed in which I was put in a position in which I would not only talk the talk about mutualization, but would walk the walk.15 Even before the 1973-74 bear market began, the investment returns of the Wellington funds had begun to deteriorate (both on an absolute and on a relative basis) and the large cash inflows they had enjoyed had turned to huge cash outflows. Assets of our flagship, the conservative Wellington Fund, had tumbled from $2 billion in 1965 to less than $1 billion, on the way to a low of $480 million. Wellington Management Company’s earnings plummeted, and its stock price followed suit. This concatenation of dire events was enough to destroy the happy partnership formed by an unfortunate merger I implemented in 1966, and I got the axe as Wellington Management Company’s CEO on January 23, 1974. But—here’s the catch—I remained as chairman of the mutual funds, with their largely separate (and largely independent) board of directors. Shortly before the firing, seeing the handwriting on the wall, I submitted a proposal to the mutual fund board of directors under which the Wellington Group of mutual funds would acquire Wellington Management Company and its business assets. The company would become a wholly-owned subsidiary of the funds and serve as investment adviser and distributor on an ‘at-cost’ basis.

© Oaktree Capital Management, L.P. All Rights Reserved In the “Information Age,” the lack of a college degree or computer literacy is a much greater handicap than it used to be. With non-information jobs increasingly moving overseas, what jobs will our less-educated citizens occupy? You might say education holds the answer, but (a) our public education system is in decline, and (b) how, especially given these jobs’ greater productivity, can there be enough tech-based jobs to keep our entire population gainfully employed? The Energy Problem When I began to drive in 1964, oil was $4 a barrel and gasoline was 29 cents a gallon. Then, in 1973, OPEC put an embargo on oil exports. We saw lines around the block at gas stations, and we were permitted to fill up just every other day. The price of oil jumped to $35 by 1980 or so, and then it subsided. It spent the period from 1986 to 2001 between $10 and $30 before going on to hit $92 in 2007 and $148 earlier this year. The bottom line, however, is that from about 1880 until a few years ago, we were in an environment of cheap energy. For over a hundred years, the price of oil didn’t rise, meaning it got dramatically cheaper in inflation-adjusted terms. This encouraged exactly the behavior one would expect: rapidly growing oil consumption, lagging increases in supply, little attention to the development of alternative energy sources, insufficient investment in mass transit, and weak efforts at conservation.

© Oaktree Capital Management, L.P. All Rights Reserved The ‘70s saw a 37% decline in the S&P 500 in 1973-74; huge losses in the “nifty-fifty” growth stocks; the Arab oil embargo in 1973; inflation in the high teens; short-term interest rates in the 20s; and an infamous Business Week cover story, “The Death of Equities.” Stagflation ruled, and there seemed to be no way out of the wage-price spiral. People wore buttons promoting President Ford’s WIN program (“Whip Inflation Now”), but neither the buttons nor the program did any good. New York stockbrokers were driving cabs, and it was extremely difficult to find employment in the investment industry. That means that in order to be part of the investment industry in the ‘70s, you pretty much had to have your job by 1969. And that in turn means you had to be at least 21 by 1969 . . . and sixty or older today. There aren’t many of us still working. I can tell you, no one was talking about a “V” in the 1970s. We experienced financial malaise lasting almost a decade. The best we felt we could hope for was a “saucer- shaped” recovery, a far different story. As I said in “The Tide Goes Out” in March, economies aren’t hard-wired, and no one knows in advance how things will go. Further, some of the ingredients this time never have been seen before. When taken together, I see problems that may not go away any time soon and the possibility of a sluggish period lasting more than months or quarters.

But under the rather broad umbrella provided by the title of my remarks this afternoon, “Marketing Mutual Fund Shares in the 1980’s,” I can give you some insights into both our decision-making process and our marketing strategy. Such a title, of course, gets me safely through the shoals and reefs of 1977-79—and if you had the conversations I have had with perhaps 50 individual broker/dealers—chief executives, mutual fund managers, registered representatives—in the past three weeks, you would surely see why that would be “a consummation devoutly to be wished.” (I should say that they were all tough conversations, but totally fair and honest.) But, in a different way, such a speech title also has the considerable advantage of providing a long-term perspective regarding the future of an industry—and an excellent, efficient, capable, accomplishing industry this one is—that has been beleaguered beyond belief over the past ten years. In that span, the stock market has gone “nowhere” on balance. The Dow Jones Average was “about to break 1,000”—it did not—in January, 1966, and you know where it is today. We have suffered two stock market debacles (1970 and 1973-74).

Innovation in the “Go-Go Era,” circa 1965-1968, saw the proliferation of scores of new “aggressive growth” funds, focusing on stock prices rather than business values; buying “concept” stocks and trading them with rapidity; and often holding “letter stocks” bought from corporate principals at discounted prices, only to immediately mark-up those prices to market value, illicitly inflating fund performance. Of course such an approach was destined to fail. But with the heady returns these funds reported, investors poured billions of dollars into them before it did so. While fund managers prospered, fund investors were ill-served. When the “Go-Go” era, well, “Went-Went,” it was quickly replaced by the “Favorite Fifty” Era, where the idea was to hold established growth stocks which (if one could ignore the certain decay that high growth rates inevitably experience) would provide permanent performance success. But of course by the time that eager fund investors had jumped on that bandwagon, the ride was over. The stock market crashed by 50 percent in 1973-74. While investors were once again impoverished, managers were once again enriched. In the aftermath of the crash, with equity funds in net redemption, the industry came up with still more innovations. They included “Government-Plus Funds,” which provided unrealistically high payouts by claiming that premiums on covered call options were “earnings.

*Impact of change in price-earnings ratio Sources of Long-Term Stock Market Returns— Dividend Yields and Earnings Growth, 1900 - 2006 1. 4.5% 4.5% 5.0% 1.7% 0.1% 0.1% 0% 2% 4% 6% 8% 10% 12% Nominal Real Speculative Return* Earnings Growth Dividends Total: 9.6% Total: 6.3% Investment Return $1,225,321 $33,094,516 $1,000 $10,000 $100,000 $1,000,000 $10,000,000 $100,000,000 1929 1933 1937 1941 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 The Importance of Dividends Value of Initial Investment of $10,000 in S&P 500, 1926 - 2007 With Reinvested Dividends Price Only 2. But while dividend income has accounted for nearly 50 percent of the long-term nominal annual return on stocks and 75 percent of the real annual return, even these figures dramatically understate the cumulative role played by dividends. Consider this: An investment of $10,000 in the S&P 500 Index3 at its 1926 inception, (Chart 2) with all dividends reinvested, would by the end of September 2007, have grown to $33,100,000 (10.4 percent compounded). If dividends had not been reinvested, the value of that investment would have been $1,200,000 (6.1 percent compounded)—an amazing gap of $32 million. Over the past 81 years, then, reinvested dividend income accounted for approximately 95 percent of the compound long-term return earned by the companies in the S&P 500. These stunning figures would seem to demand that mutual funds highlight the importance of dividend income.

The Becker Securities survey, for example, shows that the equity securities managed for pension funds by banks had a compound rate of total return over the past decade of 3.7% (net off estimated expenses); by insurance companies, the figure was 3.6%; by private investment counselors, the figure was 3.3%. One the same basis, the average annual return of common stock mutual funds was 5.4%—or something like half again as good! We at Vanguard will be presenting, in the coming months, a much more comprehensive analysis of mutual fund performance vs. the results of other institutional managers. For the summary figures above can only hint at the magnitude and consistency of mutual fund superiority. The common stock mutual funds also, for example, beat each of the other institutional management groups in the 1973-74 bear market, and beat each one again in the 1975-76 bull market. And the balanced mutual funds—how long has it been since anyone mentioned that group—have shown the same degree of superiority (perhaps to an even greater degree) over the total pension fund returns provided by the banks, and the insurance companies, and the private counseling firms. In each case, I should note, the results were achieved with a surprisingly similar balance between stocks and bonds (about a 70/30 ratio).

Young and headstrong, with self-confidence that belied my lack of wisdom and experience (I was then but 35 years of age), I put together a merger with a high flying group of four “whiz kids” who had achieved an extraordinary record of investment performance over the preceding six years. (Such an approach— believing that past fund performance has the power to predict future performance—is, of course, antithetical to everything I believe today. It was a great—but expensive—lesson!) Together, we five whiz kids whizzed high for a few years. And then, of course, we whizzed low. The speculative fever in the stock market during the “Go-Go Era” of the mid-1960s “went-went.” Just like the “new economy” bubble of the late 1990s, it burst, and was followed by a 50% market decline in 1973-1974. The once happy band of partners had a falling out, and in January 1974 I was deposed as the head of what I had considered my company. I was heartbroken. What’s in a Name?

narrow market sectors and individual foreign countries. (There are also some ETFs that claim to beat the market; I’ll leave to wiser heads to wonder about the validity of such claims, and how on earth they can call themselves index funds.) As mutual fund managers have become primarily mutual fund marketers. ETFs are enriching the coffers of financial entrepreneurs, fund management companies, and stockbrokers; it remains to be seen whether they’ll enrich the investors who trade them. But Some Innovation Has Served Investors To be sure, not all mutual fund innovation has ill-served fund investors. Indeed, among the greatest innovations is our industry’s history was the money market fund. The first one gingerly began in 1971. But—simply by giving investors the true money market rate (less costs), rather than the regulation- limited rates offered on bank savings accounts—assets had burgeoned to $58 billion by 1979, reaching $237 billion at the peak in 1981, and accounting for fully 80 percent of mutual fund assets! It was money funds that gave the industry breathing room after the 1973-74 bear market until stocks began their powerful and sustained recovery after the 1987 market crash. Money fund assets total $2.8 trillion today, accounting for about 24 percent of industry assets. They remain a major factor in the financial markets and a remarkable service to investors. Yes, money funds have also created huge profits for fund managers.

0% 20% 40% 60% 80% 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 Share of Corporate Equities Held by Institutions Source: Federal Reserve 6. I’ve written a book about these issues,8 and I express my conclusion bluntly. Using words remarkably close to those of Minsky, I describe how capitalism has changed for the worse. In a half- century we’ve moved from an ownership society where individual shareholders owned 92 percent of all stocks and financial institutions owned only 8 percent (Chart 6) to an agency society in which institutional shareholders now own 74 percent of all stocks. But we haven’t changed the rules. These mutual fund and pension fund managers have largely ignored the interests of their principals—fund shareholders and pension beneficiaries. To restore balance to the system, we need a new fiduciary society in which the interests of these 100 million principals—the last-line investors of America—come first. The Rise of the Financial Economy I’ve taken you on this long trip through risk and uncertainty, not only because I find these ideas both important and intellectually stimulating, but because they set the stage for my discussion of the concerns I hold today regarding our financial system and our society. I recognize that some of these ideas are complex, so let’s summarize the ground we’ve covered so far: 1. Black Swans—extreme and unexpected outcomes—are part of investing, and can’t be predicted in advance. 2.

When the dollar falls, it both makes our products cheaper for foreigners to buy and their products more expensive for U.S. citizens. That’s why a falling currency is supposed to cure a trade deficit. Indeed, the U.S. deficit has undoubtedly been tempered by the large drop in the dollar. But ponder this: In 2002 when the Euro averaged 94.6¢, our trade deficit with Germany (the fifth largest of our trading partners) was $36 billion, whereas in 2007, with the Euro averaging $1.37, our deficit with Germany was up to $45 billion. Similarly, the Canadian dollar averaged 64¢ in 2002 and 93¢ in 2007. Yet our trade deficit with Canada rose as well, from $50 billion in 2002 to $64 billion in 2007. So far, at least, a plunging dollar has not done much to bring our trade activity into balance. There’s been much talk recently of sovereign wealth funds and how they are buying large pieces of American businesses. This is our doing, not some nefarious plot by foreign governments. Our trade equation guarantees massive foreign investment in the U.S. When we force-feed $2 billion daily to the rest of the world, they must invest in something here. Why should we complain when they choose stocks over bonds? Our country’s weakening currency is not the fault of OPEC, China, etc. Other developed countries rely on imported oil and compete against Chinese imports just as we do. In developing a sensible trade policy, the U.S. should not single out countries to punish or industries to protect.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Returns, Absolute Returns and Risk U What’s In a Name? My memos often touch on the subject of investors’ foibles, one of the worst of which consists of their tendency to pay too much attention to labels (and too little to substance).  Enthusiasm for “growth stock investing” carried investors to the ridiculous conclusion that for the stocks of the fastest-growing companies, no price is too high. That was just before the “nifty-fifty” stocks of America’s best companies lost up to 90% of their value in 1973-74.  “Portfolio insurance” assured investors they could participate fully in stock market gains with protection against declines if they would simply commit to automatically enter sell orders pursuant to an algorithm. But in the crash of October 1987, investors found themselves unable to make those sales, and the ineffectiveness of the “insurance” (combined with the outsized positions it had encouraged) cost them dearly. And at any rate, portfolio insurance, like any mechanical risk-limiting device, should have been expected to limit long-term return as well as risk. After all, there rarely is a free lunch.  “Market neutral” funds were supposed to be insensitive to market fluctuations, but the so- described Granite Fund of mortgage-backed securities melted down in just a few weeks when it turned out not to be insulated from the rapid rise of interest rates in 1994.

declines of 20 percent or more). The current bear market is the worst of the bunch—off by almost 55 percent, even worse than 1973-74 and 2000-2001, when the drops reached 50 percent. What’s more, this decline is the first that I can recall in which the distress in the financial economy has so profoundly impacted the real economy of goods and services, harming a large mass of our citizenry, even those who had no meaningful participation in the boom that led to the bust, but who are now paying the penalty for the market’s excesses. It is not Wall Street, but the ordinary citizens of the United States who will foot the bill for the gross financial excesses of the recent era. “The government,” as always, has no money of its own. So it is paying the financial sector with our money. We may pay for part of this bailout with higher taxes; but given our flawed political system, the cost is more likely to be extracted from future generations with dollars that buy less. Inflation is just another form of taxation, albeit one that is sharply regressive. What we are witnessing is the verification of “the financial instability hypothesis” put forth by the economist Hyman P. Minsky (1919-1996). In 1992, Minsky warned that, “capitalist economies exhibit . . . debt deflations that . . . spin out of control (as) the economic system’s reactions to the movement of the economy amplify the movement.” Sad to say, Minsky adds, “. . .

118% 19% 48% 111% 74% 16 % 41% 79% 0% 20% 40% 60% 80% 100% 120% 140% 1946 1949 1952 1955 1958 1961 1964 1967 1 970 1973 1976 1979 19 82 1985 1988 1991 1994 1997 2000 2003 2006 Equity Fund Portfolio Turnover 3. But it is not mutual fund managers alone who are engaging in this inevitably counterproductive trading behavior for investors as a group. They are reflecting a trend toward speculation that has been growing since the mid-1960s. Total turnover of U.S. publicly-traded equities was also less than 20 percent through the mid-1960s. Even by the mid-1990s, it rarely exceeded 50 percent. But in 2007, stock turnover exceeded 215 percent per year. (Chart 4) That number soars to 280 percent if we include the breath-taking level of trading in exchange traded funds (ETFs). Clearly, the nature and character of our equity markets have changed. We are in a new era, one that is importantly defined by this orgy of speculation, by far the highest in history. When our market participants are largely investors, focused on the economics of business, the underlying power of our corporations to earn a solid return on the capital invested by their owners is what drives the stock market, and volatility is low.

© Oaktree Capital Management, L.P. All Rights Reserved The $195 million dollar profit translates into a 30.7% return on the $640 million of capital employed in the fund on average during the eight months. And that 30.7% return on average capital employed annualizes to 49.4%. Finally, the annualized IRR for the eight months – the proper measure, according to the experts – was 61.4%. So here are the returns for the fund: Time-weighted return -0.5% On average capital 30.7 On average capital (annualized) 49.4 Internal rate of return 61.4 Was the fund a marginal loser or a booming success? You pay your money and you take your pick, as my mother used to say. But clearly, there’s just one conclusion to be drawn with absolute certainty: no one figure is capable of rendering a precise picture of fund performance, particularly as relates to short periods of time. UShort-Term Success Because IRRs are annualized returns, the results for part-year investments can be highly misleading. I feel it is always undesirable to annualize returns on part-year investments, but doing so is an unavoidable aspect of calculating their IRRs. For me, it was the onset of option trading that first highlighted the folly of annualizing short-term results. Back around 1973, exchange-traded options came into existence (whereas prior to that time, options were an obscure corner of the investment world, traded over the counter among “put-and-call brokers”).

Everyone knows there’s too much money looking for a home in buyouts, venture capital, distressed debt, hedge funds, real estate, and on and on. But that isn’t keeping more from flowing there. I love that terrific Yogi-ism: No one goes there anymore; it’s too crowded. But the corollary is appropriate for the alternative investing world of today: Because it’s so crowded, everyone wants to go there. Buyouts represent a great case in point today. It’s a simple business (execution aside). You buy a company with a little equity and a lot of debt. If you buy it right, if you can make it a better company, and if you run into an environment characterized by a strong economy, freely available capital and rising asset prices, you’ll be able to sell it for more than you paid for it, pay off the debt and enjoy a leveraged return. The theory is clear, but (like everything else in the investment world) it doesn’t always work. It worked very well from its inception around 1973 to roughly 1985, a period in which it was cheaper to buy a company through the stock market than start it and no one had ever heard of Henry Kravis. Then LBOs became enormously popular in the late 1980s, and companies were bought at ever-higher prices and ever-higher leverage ratios. Many of those went bankrupt in 1990 (causing a boom for distressed debt investors, but that’s another story). That’s what we call a full cycle.

Thus it's tempting to think that the moderation of expectations may have stemmed from the corrosive emotional effect of recent losses on investor psyches, not from new data or objective analysis.  In fact, it's comforting to note a hopeful analogy. In August 1979, after a harsh correction in 1973-74 followed by several sluggish years, the cover of Business Week proclaimed "The Death of Equities" . . . just prior to the ignition of the historic bull market that lasted through 1999. As in that case, with attitudes toward equities beaten down so universally, the contrarian position today might be to bet heavily on them. Sentiment toward equities can hardly get worse and, unimaginable as it seems, it just could get better. At the same time, there are negatives to be dealt with:  Even though stock prices have come down substantially, the average P/E ratio remains high – in the upper teens or low twenties, depending on whom you ask. In the last major cycle, which bottomed in the 1970s, P/E ratios reached levels like today's at the UhighU and fell to single digits when prices hit bottom. By that standard, today's valuations suggest a high, not a low.  One reason today's P/E ratios are high in the absolute is that interest rates are so low. Low interest rates justify a high valuation of future cash flows.what

© Oaktree Capital Management, L.P. All Rights Reserved The impact of a decline must be gauged in light of its starting point. Stocks ended up cheap after the S&P's 1973-74 decline of 48%, but that's because the average P/E ratio started in the high teens and ended in single digits. Thus this correction's 45% decline doesn't necessarily have equal import, given that it started and ended with an average P/E ratio above 20! Of course, a case continues to be made that stock valuations are attractive (or, more typically, "are not unattractive") because of the low level of interest rates. Low rates raise the discounted present value of a given stream of future cash flows, and they reduce the competition that stocks face from bonds. As I see it, much of the case for the fairness of valuations today rests on the view that low prospective returns on stocks are reasonable given the low prospective returns on fixed income instruments. Maybe this makes stocks cheap at today's P/E ratios, but I don't consider it much of a positive. Further, in order for interest rates to continue to render stocks attractive, they must stay low. But low rates presuppose low levels of economic growth, demand for capital, and inflation. Are these the arguments on which to build a bullish case? There's also a strong counter-argument regarding economic recovery.

© Oaktree Capital Management, L.P. All Rights Reserved paraphrase Warren Buffett, when people forget that corporate profits grow at 8 or 9% per year, they tend to get into trouble. It's never clear what base period makes for a relevant comparison, but between 1930 and 1990, annual returns from stocks averaged about 10% year. Periods when they did better were followed by periods when they did worse. The better periods were usually caused by the expansion of p/e ratios, but valuations tended to return from the stratosphere, and in the long run, returns roughly paralleled profit growth. There always will be bull markets and bear markets. The bull markets will be welcomed warmly and unskeptically, because people will be making money. These markets will be propelled to great heights, usually by the rationalization that "it's different this time"; that productivity, technology, globalization, lower taxation – something – has permanently elevated the prospective return from stocks. The bear markets will come as a shock to the unsuspecting, demonstrating that, most of the time, the world doesn't change that much. For example, when you look at Siegel's 200-year straight-line stock market graph, no hiccup is visible in 1973-74. Try telling that to the average equity investor, who lost half his money. The bottom line is that risk of fluctuation always is present. Thus stocks are risky unless your time frame truly allows you to live through the downs while awaiting the ups.

They will be propelled to great heights, usually by the rationalization that "it's different this time; productivity, technology, globalization, lower taxation – something – has permanently elevated the prospective return from stocks." The bear markets will come as a shock to the unsuspecting, demonstrating that, most of the time, the world doesn't change that much. For example, when you look at Siegel's 200-year straight-line stock market graph, no hiccup is visible in 1973-74. Try telling that to the equity investors who lost half their money. The bottom line is that risk of fluctuation is always present. Thus stocks are risky unless your time frame truly allows you to live through the downs while awaiting the ups. Lord Keynes said "markets can remain irrational longer than you can remain solvent," and being forced to sell at the bottom – by your emotions, your client or your need for money – can turn temporary volatility (the theoretical definition of risk) into very real permanent loss. Your time frame does a lot to determine what fluctuations you can survive. UActive managementU – In order to get more out of the ups and try to lessen the pain of the downs, most people turn to active management via market timing, group rotation, industry emphasis and stock selection. But it's just not that easy. The American Way – earnestly applying elbow grease – doesn't often payoff.

They still are, and yet their stocks are now down 53%, 68% and 83%, respectively, from their highs. People too easily forget that in determining the outcome of an investment, what you buy is no more important than the price you pay for it. As Oaktree consistently demonstrates, we'd much rather buy a so-so asset cheap than a great asset dear. The stocks of great companies often sell at prices that assume their greatness can be perpetuated, and usually it cannot. While in business school in the 1960s, I read a brochure from Merrill Lynch introducing a novel concept called growth stock investing. Many of the stocks it profiled went on to be pillars of the Nifty-Fifty by the time I joined the First National City Bank in 1969. It was the party line that if the company you invest in is good enough and growing fast enough, there's no such thing as too high a price. Along with lots of companies that are still considered great, the Nifty-Fifty included such average companies of today as Avon, Kodak and Polaroid. Starting from their 1973 highs, we estimate these stocks' respective annual returns at .4%, (.4%) and (10.4%)! "Great company today" doesn't mean "great company tomorrow," and it UcertainlyU doesn't mean "great investment." On February 7, 2001, the Wall Street Journal carried "Unsafe Harbors: Folks Who Like To Buy A Stock and Forget It Face Rude Awakening."

The laws of business are being enforced, meaning that money-losing companies can't attract additional capital. Scores of firms have closed, and tens of thousands of employees have lost their jobs. In perhaps the height of indignity, the Internet has been turned against its own, as dot-coms have been formed to chronicle the collapse of dot-coms. Log on to dotcomfailures.com for a list of more than eighty. UTech/media/telecom stocks brought low U– Of course, the stocks that soared in 1999 tanked in 2000. The 86% gain of the NASDAQ Composite in 1999 was the greatest in history for any major average. Its 39% loss in 2000 was the greatest in its history and, in terms of major averages, trailed only the 1931 drops in the Dow and S&P. Throughout my 30-plus years in the investment business, I have seen one localized boom after another. Each time, the end was marked by a Wall Street Journal table cataloging once-hot stocks that had fallen more than 90% from their highs. Conglomerates (late 1960s), computer software and services (1969-70), the Nifty-Fifty (1973-4), oil stocks (early '80s) and biotech (early '90s) – they've all been there, and I felt certain that TMT stocks would join them sooner or later. The only difference is that in 2000, the top ten losers on the NASDAQ all declined more than 99%! The 14 stocks mentioned a year ago in "bubble.com" provide a pretty good sample; they're down 82% on average from their year-end 1999 prices and 87% from their highs in 2000.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients and Friends From: Howard Marks Re: Who Knew? For years, I've railed against people who claim they know what the future holds. And yet, in my last memo on September 3, 1997, I may actually have made a correct prediction, as follows: What could cause a market decline? A drop in investor confidence -- perhaps the commodity that's most freely available today -- would likely be the key, but the reason is hard to foresee…. The next surprise might be geopolitical (oil embargo, war in Korea), economic (tight money, slowing profit growth) or internal to the market (competition from bonds at higher interest rates, discovery of a fraud), but it's most likely to be something that no one has anticipated -- including us. Just the next month, the "Asian meltdown" came into full bloom, with profound ramifications for stock and bond markets all around the world. What this shows is that it's easy to be right about the future . . . if you restrict your predictions to two: (1) something significant is bound to happen eventually, and (2) we never know what it'll be. * * * Speaking of what we can know, I was in a client's office in December, cautioning that I thought we would never reside for long in the investment nirvana of the new paradigm where inflation, interest rates, economic growth, expanding profits and rising stock prices stay properly aligned.

© Oaktree Capital Management, L.P. All Rights Reserved In “Are You an Investor or a Speculator” (September 3, 1997), we wrote: What could cause a market decline? A drop in investor confidence -- perhaps the commodity that's most freely available today -- would likely be the key, but the reason is hard to foresee. “We're not expecting any surprises,” people say, and that has become our new favorite oxymoron. Surprises are never expected -- by definition -- and yet they're what move the market….The next surprise could be geo-political (oil embargo, war in Korea), economic (tight money, slowing profit growth), or internal to the market (competition from bonds at higher interest rates, discovery of a fraud), but it's most likely to be something that no one has anticipated -- including us. When I was a kid, my dad used to joke about the habitual gambler who finally heard about a race with only one horse in it. He bet the rent money on it, but he lost when the horse jumped over the fence and ran away. There is no sure thing, only better and worse bets, and anyone who invests without expecting something to go wrong is playing the most dangerous game around. 5) “Never confuse brains with a bull market.” When the 1990s began, the economy and the stock market were at very low levels. As a result, success came easily, risk-bearing paid off and the highest returns often went to those who took the most risk. They and their strategies were accepted as the best.

easy money has been made, and the improvement in these parameters is bound to subside. Anyone who thinks equity returns over the next fifteen years will look anything like the last fifteen is certainly bucking the odds. It is still important to look for what's relatively cheap. For example, the fact that big stocks have recently been beating small stocks by the widest margins in history means small stocks are likely to have their day in relative terms. This was shown in August, when the Dow was down 7% and small stocks rose. The possibility of a market decline certainly exists, and while "everyone" says a 5%, 10% or 15% dip would just be a buying opportunity, we wonder how investors would feel about a rerun of the 1973-74 experience, in which stocks declined an average of 2% a month for 24 months. At 8,200, we heard people say a 25% decline would only take the market back to the level of a year earlier -- implying that it wouldn't hurt. We doubt many investors who've never seen even a 10% "correction" would come through such a period with their equanimity unscathed. What could cause a market decline? A drop in investor confidence -- perhaps the commodity that's most freely available today -- would likely be the key, but the reason is hard to foresee. "We're not expecting any surprises," people say, and that has become our new favorite oxymoron. Surprises are never expected -- by definition -- and yet they're what move the market.

(If they were expected, their effects would already be priced into the market, rendering a price reaction unnecessary.) The next surprise might be geo-political (oil embargo, war in Korea), economic (tight money, slowing profit growth) or internal to the market (competition from bonds at higher interest rates, discovery of a fraud), but it's most likely to be something that no one has anticipated - - including us. What does all of this tell us? That we must return yet again to what may be the greatest Warren Buffet quote: The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs. Prudence is in short supply today, along with skepticism and disbelief. Thus we must be disciplined and selective in our investing today, and postpone our greatest enthusiasm for the bargains which are likely to be found in the months and years ahead. Here at Oaktree, we continue to recommend that clients think about downside as well as upside and adopt protective strategies: In convertibles, we continue to emphasize securities that are likely to fall much less than their underlying stocks and that are convertible into stocks that haven't soared, and we continue to take profits aggressively as prices increase (aren't we supposed to like things less, not more, as their prices rise?) Our high yield bond portfolios continue to hold only the obligations of creditworthy U.S. and Canadian companies and emphasize cash-paying securities.

© Oaktree Capital Management, L.P. All Rights Reserved * * * In the interest of full disclosure, I want to mention here that I've been contemplating the possibility that my views on these matters are too cautious and short-sighted. My conclusion is that I am a product of my experience. Many of us were raised by parents whose views were heavily influenced by living through the Depression. Likewise, I was baptized under fire during my first five years in the investment industry, when the shares of the best companies in America -- the "nifty-fifty" -- dropped 70% to 90% in the early 1970s and then the entire market lost roughly half its value in 1973-74. You have to be more than forty-five years old to have been in the business during that last real bear market in 1973-74. I've heard it said that today "everyone over forty is terrified by the market, but most of the people running money are under forty." There's a lot of truth to this, and it's interesting to note that relatively few of today's investment professionals are in their mid-to- late forties, a scarcity caused by the tough times in the industry in the 1970s and the resultant lack of hiring. Maybe I spend too much of my time worrying about the next bear market; I've been conditioned to do that. And maybe I'm wrong. But Oaktree's clients needn't worry that we'll manage their portfolios based on the assumption that a correction is imminent.

For owners of a business - and that's the way we think of shareholders - the academics' definition of risk is far off the mark, so much so that it produces absurdities. For example, under beta-based theory, a stock that has dropped very sharply compared to the market - as had Washington Post when we bought it in 1973 - becomes "riskier" at the lower price than it was at the higher price. Would that description have then made any sense to someone who was offered the entire company at a vastly-reduced price?

Naturally, I was delighted to attend Mrs. B's birthday party. After all, she's promised to attend my 100th. Katharine Graham retired last year as the chairman of The Washington Post Company, having relinquished the CEO title three years ago. In 1973, we purchased our stock in her company for about $10 million. Our holding now garners $7 million a year in dividends and is worth over $400 million. At the time of our purchase, we knew that the economic prospects of the company were good. But equally important, Charlie and I concluded that Kay would prove to be an outstanding manager and would treat all shareholders honorably. That latter consideration was particularly important because The Washington Post Company has two classes of stock, a structure that we've seen some managers abuse.

1967 ......... profit $17.3 less than zero 5.50% 1968 ......... profit 19.9 less than zero 5.90% 1969 ......... profit 23.4 less than zero 6.79% 1970 ......... $0.37 32.4 1.14% 6.25% 1971 ......... profit 52.5 less than zero 5.81% 1972 ......... profit 69.5 less than zero 5.82% 1973 ......... profit 73.3 less than zero 7.27% 1974 ......... 7.36 79.1 9.30% 8.13% 1975 ......... 11.35 87.6 12.96% 8.03% 1976 ......... profit 102.6 less than zero 7.30% 1977 ......... profit 139.0 less than zero 7.97% 1978 ......... profit 190.4 less than zero 8.93% 1979 ......... profit 227.3 less than zero 10.08% 1980 ......... profit 237.0 less than zero 11.94% 1981 ......... profit 228.4 less than zero 13.61% 1982 ......... 21.56 220.6 9.77% 10.64% 1983 ......... 33.87 231.3 14.64% 11.84% 1984 ......... 48.06 253.2 18.98% 11.58% 1985 ......... 44.23 390.2 11.34% 9.34% 1986 ......... 55.84 797.5 7.00% 7.60% 1987 ......... 55.43 1,266.7 4.38% 8.95% 1988 ......... 11.08 1,497.7 0.74% 9.00% 1989 ......... 24.40 1,541.3 1.58% 7.97% 1990 ......... 26.65 1,637.3 1.63% 8.24% The float figures are derived from the total of loss reserves, loss adjustment expense reserves and unearned premium reserves minus agents' balances, prepaid acquisition costs and deferred charges applicable to assumed reinsurance. At some insurers other items should enter into the calculation, but in our case these are unimportant and have been ignored. During 1990 we held about $1.

The disadvantages of owning marketable securities are sometimes offset by a huge advantage: Occasionally the stock market offers us the chance to buy non-controlling pieces of extraordinary businesses at truly ridiculous prices - dramatically below those commanded in negotiated transactions that transfer control. For example, we purchased our Washington Post stock in 1973 at $5.63 per share, and per-share operating earnings in 1987 after taxes were $10.30. Similarly, Our GEICO stock was purchased in 1976, 1979 and 1980 at an average of $6.67 per share, and after-tax operating earnings per share last year were $9.01. In cases such as these, Mr. Market has proven to be a mighty good friend.

We bought all of our WPC holdings in mid-1973 at a price of not more than one-fourth of the then per-share business value of the enterprise. Calculating the price/value ratio required no unusual insights. Most security analysts, media brokers, and media executives would have estimated WPC's intrinsic business value at $400 to $500 million just as we did. And its $100 million stock market valuation was published daily for all to see. Our advantage, rather, was attitude: we had learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values.

Through 1973 and 1974, WPC continued to do fine as a business, and intrinsic value grew. Nevertheless, by yearend 1974 our WPC holding showed a loss of about 25%, with market value at $8 million against our cost of $10.6 million. What we had thought ridiculously cheap a year earlier had become a good bit cheaper as the market, in its infinite wisdom, marked WPC stock down to well below 20 cents on the dollar of intrinsic value.

We hold all of the WPC shares we bought in 1973, except for those sold back to the company in 1985's proportionate redemption. Proceeds from the redemption plus yearend market value of our holdings total $221 million. If we had invested our $10.6 million in any of a half-dozen media companies that were investment favorites in mid-1973, the value of our holdings at yearend would have been in the area of $40 - $60 million. Our gain would have far exceeded the gain in the general market, an outcome reflecting the exceptional economics of the media business. The extra $160 million or so we gained through ownership of WPC came, in very large part, from the superior nature of the managerial decisions made by Kay as compared to those made by managers of most media companies. Her stunning business success has in large part gone unreported but among Berkshire shareholders it should not go unappreciated.

The conventional wisdom is that 1983 or 1984 will see the worst of underwriting experience and then, as in the past, the 'cycle' will move, significantly and steadily, toward better results. We disagree because of a pronounced change in the competitive environment, hard to see for many years but now quite visible. To understand the change, we need to look at some major factors that affect levels of corporate profitability generally. Businesses in industries with both substantial over-capacity and a 'commodity' product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc.) are prime candidates for profit troubles. These may be escaped, true, if prices or costs are administered in some manner and thereby insulated at least partially from normal market forces. This administration can be carried out (a) legally through government intervention (until recently, this category included pricing for truckers and deposit costs for financial institutions), (b) illegally through collusion, or (c) 'extra- legally' through OPEC-style foreign cartelization (with tag-along benefits for domestic non-cartel operators).

We continue to have serious problems in the Homestate operation. Floyd Taylor in Kansas has done an outstanding job but our underwriting record elsewhere is considerably below average. Our poorest performer has been Insurance Company of Iowa, at which large losses have been sustained annually since its founding in 1973. Late in the fall we abandoned underwriting in that state, and have merged the company into Cornhusker Casualty. There is potential in the homestate concept, but much work needs to be done in order to realize it.

Rather, this almost 600% increase has been achieved through large gains in National Indemnity's traditional liability areas plus the starting of new companies (Cornhusker Casualty Company in 1970, Lakeland Fire and Casualty Company in 1971, Texas United Insurance Company in 1972, The Insurance Company of Iowa in 1973, and Kansas Fire and Casualty Company in late 1977), the purchase for cash of other insurance companies (Home and Automobile Insurance Company in 1971, Kerkling Reinsurance Corporation, now named Central Fire and Casualty Company, in 1976, and Cypress Insurance Company at yearend 1977), and finally through the marketing of additional products, most significantly reinsurance, within the National Indemnity Company corporate structure.

In aggregate, the insurance business has worked out very well. But it hasn't been a one-way street. Some major mistakes have been made during the decade, both in products and personnel. We experienced significant problems from (1) a surety operation initiated in 1969, (2) the 1973 expansion of Home and Automobile's urban auto marketing into the Miami, Florida area, (3) a still unresolved aviation 'fronting' arrangement, and (4) our Worker's Compensation operation in California, which we believe retains an interesting potential upon completion of a reorganization now in progress. It is comforting to be in a business where some mistakes can be made and yet a quite satisfactory overall performance can be achieved. In a sense, this is the opposite case from our textile business where even very good management probably can average only modest results. One of the lessons your management has learned - and, unfortunately, sometimes re-learned - is the importance of being in businesses where tailwinds prevail rather than headwinds.

SELECTED BIBLIOGRAPHY Books Graham, Benjamin, and Dodd, David L. Security Analysis. New York: McGraw-Hill Book Co. First edition, 1934; Second edition, 1940; Third edition, 1951; Fourth edition (with Sidney Cottle and Charles Tatham), 1962. Graham, Benjamin, and McGolrick, Charles. The Interpretation of Financial Statements. New York: Harper & Row, Inc. First edition, 1937; Second edition, 1955. Graham, Benjamin. Storage and Stability, A Modem Ever-Normal Granary, New York: McGraw-Hill Book Co. 1937. Graham, Benjamin. World Commodities and JVorld Currency. New York: McGraw-Hill Book Co. 1944. Graham, Benjamin. The Intelligent Investor. New York: Harper & Row, Inc. First edition, 1949; Second edition, 1954; Third edition, 1959; Fourth edition, 1973. Benedetti, Mario. The Truce. Translated by Benjamin Graham from the Spanish. New York: Harper & Row, Inc. 1967. Harmon, Elmer Meredity. Commodity Reserve Currency, the Graham-Goudriaan Proposal for Stab£lizing Income of Primary Produe£ng Countr£es. Columbia University Press. 1959. Selected Articles by Benjamin Graham "Is American Business Worth More Dead Than Alive?" Forbes, June 1, 1932;June 13, 1932;July 1, 1932. "Stock Dividends," Barron's, August 3 and August 10, 1953. "The Renaissance of Value," The Financial Analysts Research Foundation, 1974. Articles by Benjamin Graham in the Financial Analysts Journal "Should Security Analysts Have a Professional Rating? The Affirmative Case," January 1945.

The present optimism is going to be overdone, and the next pessimism will be overdone, and you are back on the Ferris Wheel-whatever you want to call it--Seesaw, Merry-Go-Round. You will be back on that. Right now, stocks as a whole are not overvalued, in my opinion. But nobody seems concerned with what are the possibilities that 1970 and 1973-1974 will be duplicated in the next five years. Apparently, nobody has given any thought to that question. But that such experiences will be duplicated in the next five years or so, you can bet your Dow] ones Average on that. HB: This has been a most pleasant and stimulative visit. We will look forward to receiving in Charlottesville your memoirs manuscript. Thank you so much, Mr. Graham!