Howard Marks on Cash Reserves

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: exactly what that phrase means, I’m firmly convinced that for Oaktree, risk control isn’t everything; it is the only thing. Not Risk Avoidance Understanding the distinction between risk control and risk avoidance is truly essential for investors. Risk avoidance basically consists of not doing anything where the outcome is uncertain and could be negative. And yet, at its heart, investing consists of bearing uncertainty in the pursuit of attractive returns. For this reason, risk avoidance usually equates to return avoidance. You can avoid risk by buying Treasury bills or putting your money into government-insured deposits, but there’s a reason why the returns on these are generally the lowest available in the investment world. Why should you be well paid for parting with your money for a while if you’re sure to get it back? Risk control, on the other hand, consists of declining to take risks that (a) exceed the quantum of risk you want to live with and/or (b) you wouldn’t be well rewarded for bearing. I’ve written in the past about what I call “the intelligent bearing of risk for profit.” Here’s the backstory: I got my start managing money in 1978, when Citi asked me to run portfolios of convertibles and high yield bonds.

© Oaktree Capital Management, L.P. All Rights Reserved. dependence on the rest of the world. It has yet to be determined whether China’s landing will be soft or hard. And if China lands hard – in part because of weak demand from the rest of the world – will its weakness feed back, further weakening those nations from which China buys raw materials and finished goods? The world’s economy is complex, interrelated and interdependent. China is a major example of this and, at this moment, a contributor to worldwide uncertainty. So what do we find? Economic fragility throughout the world, I think, as well as a number of factors capable of exacerbating the situation in the short run or keeping it weak in the long. I can’t remember a time when no jurisdiction was considered completely safe for investment, but that seems to be the case today. When people enthuse about the U.S., it’s usually only in relative terms: “the best house on a bad block.” At the University of Chicago in the 1960s, I was taught that U.S. Treasury bills paid the “risk- free rate of return.” Nowadays most investors have trouble thinking of anything as riskless. When I talk to investors, most of them snicker uncomfortably about the proposition of even U.S. Treasurys being entirely safe. Is There No Good News? Isn’t there anything on the positive side of the ledger, capable of balancing against the weak fundamental picture described above and making investment attractive? A few things deserve mention, I think.

but severe market downturns tend to occur after long bull markets when we are feeling least uncertain. In other words, investors become so accustomed to good times that bad times seem unsettling in comparison. That could explain excessive appetites for the safety of bonds and thus why, according to Deutsche Bank, “the top 10 lowest-yielding U.S. corporate new issues in history have been sold in the last 14 months” (Bloomberg, August 16). And what about sellers of stocks? I’m no longer an “equity guy” by profession, and Oaktree manages far more bonds than stocks, so this isn’t a commercial. But I feel investors may be overlooking some substantial merits on the part of stocks today (data from Bloomberg, August 16, except as noted):  Having made their organizations lean and benefited from declining floating-rate interest costs, cheaper labor or staff downsizing, companies are doing a good job of making money despite today’s lackluster economic environment. “Earnings for S&P 500 companies may rise 36% in 2010 and 16% in 2011, the largest two-year advance since 1994-5.”  Rather than spend that money on expansion or acquisitions, most companies are piling it up. “The Federal Reserve reported in June that nonfinancial companies were holding cash totaling more than $1.8 trillion, having built up their hoards at a rate unmatched in more than 50 years” (LA Times, August 25).

© Oaktree Capital Management, L.P. All Rights Reserved risky. Thus, we must be induced to make riskier investments by the offer of higher prospective returns. We could accept the risk-free rate available on Treasury bills, but most of us choose instead to strive for more by taking on incremental risk. When you boil it all down, it’s the investor’s job to intelligently bear risk for profit. Doing it well is what separates the pros from the rest. What does it mean to intelligently bear risk for profit? I’ll provide an example. In the early 1980s, a reporter asked me, “How can you invest in high yield bonds when you know some of the issuers will go bankrupt?” Somehow, the perfect answer came to me in a flash: “The most conservative companies in America are the life insurance companies. How can they insure people’s lives when they know they’re UallU going to die?” Both activities involve conscious risk bearing. Both can be done intelligently (or not). The ability to profit from them consistently depends on the approach employed and whether it’s done skillfully. For companies selling life insurance, I said, the keys to survival and profitability are the following:  It’s risk they’re aware of. They know everyone’s going to die. Thus they factor this reality into their approach.  It’s risk they can analyze. That’s why they have doctors assess applicants’ health.  It’s risk they can diversify.

Certain that his forecasts are right and his portfolio is properly positioned, the “I know” investor wants to let his profits ride. The “I don’t know” investor is painfully aware of how much he doesn’t know; how much of his performance is beyond his control; that good fortune may have contributed to his results to date; and that events can easily turn against him. Thus he’s happy taking profits and banking some of his gains. If appreciation occurs beyond his expectations, it makes him stop and think . . . and maybe sell, not just celebrate. The “we” investor is comfortable holding cash when he can’t find attractive investments. At the present time, a number of the investors I most respect are holding or returning significant amounts of cash, or closing their funds. The confident “them” investor is pained by cash – he thinks he always should be able to find something worth buying. And he tends to be more relative-return oriented, and thus worried that an index or competitor might beat him if he isn’t fully invested. I see an extreme dichotomy in the fact that the “us” investor worries about losing money, while the other worries about underperforming. (I can’t claim to be 100% the former, because I – and most of Oaktree’s clients – think that in the long run, the best manager is the one who beats the others. That’s something that’s hard to argue with. But my desire for relative performance doesn’t make me comfortable with losses.)

© Oaktree Capital Management, L.P. All Rights Reserved On the other hand, these don’t:  Iraq refuses to admit inspection teams.  People start traveling again; airlines and hotels prove rewarding investments.  Technology and telecom equipment orders improve.  Post-Enron populism sweeps the U.S.; Democrats take control of both houses of Congress. Byron’s list shows us that (a) it is possible to predict some coming surprises, but (b) it isn’t possible to do so with high reliability. Thus it’s not clear that betting on his list of potential surprises – or any such list – would be profitable. UHere’s A Non-Consensus Forecast for You If you’re looking for an idiosyncratic, non-consensus forecast to make some money on, see Robert Prechter. As the February issue of “Bloomberg Markets” magazine stated: Forget about the Dow Jones Industrial Average returning to 11,000. Try Depression-era levels of less than 1,000. And don’t flock to bonds for safety: Municipalities will default and corporate bonds will be wracked by downgrades. Even the U.S. government’s credit status may sink low enough to make Treasury bills shaky. You’ve heard of extreme sports; Prechter’s recent record probably represents the norm for an extreme forecaster. He joined the pantheon of famous forecasters by being right the obligatory once in a row (but in a big way): he predicted a crash two weeks before October 19, 1987 made him right. Then, according to Bloomberg, “he missed the almost decade-long bull market.