Howard Marks on Contrarianism

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: the late 1960s, I was taught at the University of Chicago Graduate School of Business that the right price for an asset is the discounted present value of its future cash flows or earnings. You might object: What about all the other things listed above, such as a company’s plant and equipment, intellectual property, and management, and even its reputation? Don’t they have value? The value of all of these things is derived from their ability to contribute to the company’s earning power, and thus it’s captured in the earnings calculation. The key part of a security analyst’s job consists of arriving at earnings projections. Then those projections have to be converted into a fair price. At the University of Chicago, the discounting process was purely mathematical: you divide the earnings for each year in the future by (1+r) n, where r is the appropriate discount rate and n is the number of years out into the future the earnings are, and then you total up the yearly results. But in the real world, price is set by a different discounting process, which consists mostly of people applying their subjective opinions and attitudes about what the asset and its earning power are worth. So that’s what an asset’s price is: the consensus view of investors regarding its underlying fundamental value.

Thus, tax revenues coming in have fallen relative to benefit payments going out, and they are insufficient to pay benefits. The difference is made up by drawing from the Trust Funds. The math is simple: there are x dollars in the Trust Funds, and they earn interest at Treasury rates. By projecting growth in the number of workers and retirees, benefit payments and life expectancies, you can estimate with some confidence the year when, in the absence of corrective action, the Trust Funds will be exhausted. That year is 2035. At that point, either (a) benefit payments will have to be cut so that they equal tax receipts (and it’s estimated that receipts will be sufficient to pay only 79% of the promised benefits) or (b) the shortfall will have to be paid from the general U.S. government budget, further adding to the deficit. Nothing in this paragraph is conjecture. There are many options for solving this problem. They include the following: • raise the Social Security tax rate • increase the amount of earnings on which Social Security tax is paid (the current cap is $176,100) • raise the retirement age • shrink retirement benefits • reduce the cost-of-living adjustment • apply a means-based test, phasing out benefits as a retiree’s income rises The problem is that all the above would be wildly unpopular with voters. It’s assumedly for that reason that the two political parties have one thing they agree on: “hands off Social Security.

The response to my Sea Change memo was considerable, and a fair share of it was critical. Critics pointed out that I have sounded cautious before — too early, by their measure — and that the business of forecasting regime shifts is a low-batting-average endeavor. I concede both points. The decision to publish the memo was not a forecast that the world would end but a reminder that the assumptions embedded in prices had changed in ways that warranted re-examination. What struck me in the pushback was how often it rested on the belief that the prior regime was the natural state of things. A skeptic might reasonably ask why anyone should believe a particular market configuration — one that prevailed for roughly forty years out of several centuries of financial history — is the default to which we will inevitably return. The contrarian posture here is not to predict doom but to resist the gravitational pull of recent experience. If the regime has in fact changed, the burden of proof should fall on those who argue for reversion to the prior mean, not on those who argue for adaptation. That is the inversion Sea Change proposed and that this follow-up defends. The longer central banks remain constrained by inflation fighting, the more reasonable the adaptation hypothesis becomes.

I want to be clear that taking a sea-change view does not mean refusing to invest. It means calibrating the price you pay for the risk you assume to the new reality rather than the old one. When risk premia were historically thin, demanding more is a defensive posture, not an offensive one. The opportunity cost of holding cash has risen as rates have moved higher, but the opportunity cost of locking capital into illiquid commitments at thin spreads has fallen, because those spreads no longer compensate for the regime change. The hardest part of contrarian investing is not the act of going against the crowd — it is the patience required to wait for the crowd to come around. In the meantime, periods of repricing typically produce dispersion. Some assets turn out to have been mispriced conservatively; others reveal that the assumptions behind them were heroic. Distinguishing between the two is where value is created. The investor who expects a return to 2021 conditions may under-prepare for what is actually coming. The investor who expects a continued regime shift may end up positioned better but also needs to remain humble about timing. I do not know when the cycle resolves; I do know that the regime assumptions in prices look different from the regime assumptions I grew up with.

Superior investing requires being different from the consensus. That statement is so widely accepted as to have become a cliché, but the practice of it remains rare. The reason it is rare is that being different is uncomfortable — being different means being wrong some of the time, and being wrong in front of an audience that has the comfort of consensus is a special form of professional pain. Second-level thinking is the discipline of asking what the consensus believes and whether the consensus is right. The first-level thinker asks whether a company is good; the second-level thinker asks whether the consensus's view of the company's goodness is correct. The first-level thinker asks whether the news is good or bad; the second-level thinker asks whether the news is better or worse than what is already in the price. The two thinkers arrive at very different decisions from the same facts. The difficulty is that second-level thinking cannot be reduced to a formula. It requires judgment, context, and a willingness to disagree with people who are smarter than you in some respects. The case for being different is not that you are smarter than the consensus; it is that the consensus has under-weighted a consideration that you have weighed more carefully. The disagreement is about emphasis, not about information.

The question I am asked most often by readers of my memos is when to sell. The honest answer is that selling is harder than buying, and that the rules for selling are less well-defined than the rules for buying. The temptation to equate activity with adding value is strong, but the evidence that activity adds value is thin. Most investors sell for the wrong reasons. They sell because a position has gone up and they want to lock in the gain; they sell because a position has gone down and they want to stop the pain; they sell because they have found something else they prefer. Only the third of these is a sound reason, and even it requires that the alternative be meaningfully better, not marginally different. The case for holding is structurally underrated. When you own something you understand at a price you find attractive, the burden of proof should be on the case for change, not the case for stasis. Transaction costs, taxes, and the friction of redeployment all work against the active seller. The investor who turns over the portfolio constantly pays these costs without necessarily earning the returns that justify them.

Patience as an investment virtue is widely praised and rarely practiced. The reason it is rarely practiced is that patience requires accepting underperformance for periods that feel like eternities. The institutional investor who is patient through a multi-quarter period of underperformance faces career risk; the individual investor who is patient through a multi-year period of underperformance faces self-doubt. Both impulses push toward action when inaction would serve better. The contrarian case for patience is that the dislocations which produce the best returns are typically resolved over years, not weeks. The investor who buys a distressed credit at sixty cents on the dollar may wait two or three years for the restructuring to play out. During that period the position will appear to do nothing, and the temptation to sell into a slightly better bid will be constant. The investor who sells captures a small mark-to-market gain; the investor who holds captures the recovery. What I have observed across cycles is that the patient investor's outperformance comes in lumps. There are long stretches of little or no apparent progress, followed by short stretches in which the prior patience is vindicated all at once. The return stream is not smooth; the conviction that the work will pay off is what carries the investor through the dry stretches.

Contrarianism is widely misunderstood as simply doing the opposite of what the crowd is doing. That is a recipe for buying everything that is going down and selling everything that is going up, which is a way to lose money consistently. Real contrarianism is the discipline of identifying when the crowd has moved too far in one direction and acting on that view with conviction. The pendulum metaphor I have used throughout my career is meant to capture this. Market psychology swings between greed and fear, between risk tolerance and risk aversion, between optimism and pessimism. The pendulum rarely spends time at the midpoint; it tends to swing to one extreme, then to the other. The contrarian acts at the extremes — when the pendulum is at one end and the next move is back toward the middle, not further out. What makes this hard is that the pendulum can stay at the extreme for longer than the contrarian's patience or capital allows. The investor who is right about the extreme being an extreme but wrong about the timing can be carried out before the vindication arrives. The discipline required is to size positions so that the journey to vindication does not break the portfolio, and to maintain the conviction through the period when the market is still moving against the thesis.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Having made the case, I went on to distinguish second-level thinkers from those who operate at the first level: First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in “The outlook for the company is favorable, meaning the stock will go up.” Second-level thinking is deep, complex, and convoluted. The second-level thinker takes a great many things into account: • What is the range of likely future outcomes? • What outcome do I think will occur? • What’s the probability I’m right? • What does the consensus think? • How does my expectation differ from the consensus? • How does the current price for the asset comport with the consensus view of the future, and with mine? • Is the consensus psychology that’s incorporated in the price too bullish or bearish? • What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right? The difference in workload between first-level and second-level thinking is clearly massive, and the number of people capable of the latter is tiny compared to the number capable of the former. First-level thinkers look for simple formulas and easy answers. Second-level thinkers know that success in investing is the antithesis of simple.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: was much lower, almost unrecognizable when compared to today. Investment management wasn’t a hot field in which many people aspired to spend their careers. It was instead a cottage industry, with a small number of outfits practicing quite traditional activities. Second, information was extremely hard to come by and process. There were no computers, spreadsheets or databases. Before researching a stock, you first had to find it in either the back of the newspaper (if it was a mainstream issue) or large books put together by firms like Moody’s and Value Line (if it was more thinly traded). Then you had to either send a request to the company for the annual report or go to the library hoping to find a copy of the report or a broader publication that included the company’s financial statements. And third, with the industry so small, nascent and unpopular, the investment thought process wasn’t something broadly developed or disseminated. The key analytical frameworks were not yet codified, and folks like Graham and Buffett had a huge edge simply because they knew how to process the data they found. In short, there were few people searching; the search process was quite difficult; and few people knew how to turn the data they did find into profitable investment conclusions. In this environment, bargains could literally be hiding in plain sight for anyone with the willingness to look and the capacity to analyze.

In working on my new book, I divided the things an investor can do to achieve above average performance into two general categories: • selection: trying to hold more of the things that will do better and less of the things that will do worse, and • cycle adjustment: trying to have more risk exposure when markets rise and less when they fall. Accepting that “there is no better or worse time” simply means giving up on the latter. Whereas Buffett tells us to “be fearful when others are greedy and greedy when others are fearful” – and he’s got a pretty good track record – this commentator seems to be saying we should be equally greedy (and equally fearful) all the time. © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: return. You want to take risk when others are fleeing from it, not when they’re competing with you to do so. Do you see any differences between then and now? Is there any need to redo this description? Not for me; I think “ditto” will suffice. I’ll simply go on to borrow the conclusion from “The Race to the Bottom” (February 2007): Today’s financial market conditions are easily summed up: There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, as the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures. The current cycle isn’t unusual in its form, only its extent. There’s little mystery about the ultimate outcome, in my opinion, but at this point in the cycle it’s the optimists who look best. The Seeds for a Boom My son Andrew worked extensively with me in preparing this memo. We particularly enjoyed making a list of the elements that typically form the foundation for a bull market, boom or bubble. We concluded that some or all of the following are necessary conditions. A few will give us a bull market.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: To pull this part of the memo together, I can’t overstate my appreciation for the way Thomas Friedman described the UK’s situation in The New York Times on June 29: A major European power, a long-time defender of liberal democracy, pluralism and free markets, falls under the sway of a few cynical politicians who see a chance to exploit public fears of immigration to advance their careers. They create a stark, binary choice on an incredibly complex issue, of which few people understand the full scope – stay or quit the E.U. These politicians assume that the dog will never catch the car and they will have the best of both worlds – opposing something unpopular but not having to deal with the implications of the public actually voting to get rid of it. But they so dumb down the debate with lies, fear-mongering and misdirection, and with only a simple majority required to win, that the leave-the-E.U. crowd carries the day by a small margin. The dog catches the car. And, of course, it has no idea what to do with this car. There is no plan. There is just barking. The Voting Booth Now let’s think about the nature of elections. In The Intelligent Investor, Ben Graham described the stock market as a weighing machine in the long run but a voting machine in the short run.

© Oaktree Capital Management, L.P. All Rights Reserved Second-level thinking is deep, complex and convoluted. The second-level thinker takes many things into account:  What is the range of likely future outcomes?  Which outcome do I think will occur?  What’s the probability I’m right?  What does the consensus think?  How does my expectation differ from the consensus?  How does the current price for the asset comport with the consensus view of the future, and with mine?  Is the consensus psychology that’s incorporated in the price too bullish or bearish?  What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right? The bottom line is that first-level thinkers see what’s on the surface, react to it simplistically, and buy or sell on the basis of their reactions. They don’t understand their setting as a marketplace where asset prices reflect and depend on the expectations of the participants. They ignore the part that others play in how prices change. And they fail to understand the implications of all this for the route to success. For example, when I lived in Los Angeles, a stockbroker often spoke on the radio station I listened to while driving to work. His advice was simple: “If there’s a company whose product you like, buy the stock.” That’s first-level thinking. How seductively easy.

(Please note that the above discussion is entirely on the subject of short-term investing, and I go through it only to provide a graphic illustration of the difference between first-level and second- level thinking. Oaktree and I aren’t focused on short-term results, and the thinking we apply to long-run considerations is quite different. We think much less about what others will make popular in the short run; instead, we rely on the eventual functioning of the weighing machine. The highest priority – by far – should be an objective evaluation of fundamentals. Market participants can get so caught up in predicting other participants’ behavior that they ignore value and fail to buy bargains out of fear that the assets in question will remain unpopular or become more so. This creates great opportunities for those investors whose willingness to think independently and endure the short-term pain that comes with temporary unpopularity enables them to purchase attractive investments from the bargain counter.) What Keynes’s hypothetical contest shows most clearly is that the route to success in the competitive arena may not be what it seems at first glance. When the goal is to lift the greatest weight, achieve the lowest score on the golf course, get the highest grade on a math test or finish a crossword puzzle in the shortest time, the competition is against oneself and the objective challenge at hand.

 Won’t voters demand isolationism in the richer nations and relief from the pain of austerity in the poorer nations? Won’t elected leaders offering anything else be ousted?  Will the highly restrictive regulations and labor laws be eased so as to enable Europe to compete on an equal footing with the rest of the world?  Longer term, will the nations of Europe give a central body the control over economies and financial institutions required for an effective economic union?  Will UK voters vote in the coming referendum to stay in the European Union or leave?  Will the EU remain intact? Is a political union in which actions require unanimous support practical? Can governance and coordination be improved? Regarding Leadership:  Are there leaders – anywhere in the world – of the caliber we need to see us through these uncertain times?  Can officials who seek re-election first and foremost rise to the occasion and make the tough decisions needed to apply unpopular solutions to problems, rather than palliative Band-Aids?  Will the successors to Geithner and Bernanke prove up to the task of continuing the recovery while weaning the economy from ultra-low interest rates?  Is it conceivable that America’s elected leaders will create an environment in which uncertainty over taxation, regulation and healthcare costs no longer discourages businesses from investing in plant and personnel? © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved. supporting at yields near all-time lows, meaning prices near all-time highs. But I don’t find them scary (unless their duration is long), since – if the issuers prove to be money-good – they’ll eventually pay off at par, erasing the interim mark-downs that will come when interest rates rise. * * * In the 1950s, when I was a kid, I watched old movies on TV when I got home from school. One from the 1940s was called It Happened Tomorrow. In it, a struggling young journalist made a deal with the devil to be given a peek at the next day’s news. His scoops brought him huge success, and everything ran smoothly until he received a newspaper headlined “Reporter Shot Dead at Racetrack.” He tried all he could to avoid it, but as a result of some very clever plot devices, he of course ended up at the track (where he learned that the headline had resulted from a case of mistaken identity). I go through all of the above to explain that – try as I might to avoid it – my memos on excessive risk bearing and what to do about it invariably end up back at the same place: my favorite Buffettism: . . . the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs. I repeat Warren’s injunction for the simple reason that you just can’t put it any better. When others are acting imprudently, making the world a riskier place, our caution level should rise in response.

© OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED. CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. Rather, investors swing wildly from optimistic to pessimistic – and from over-confident to terrified – and as a result asset prices can lose all connection with intrinsic value. In addition, investors often fail to unearth all of the relevant information, analyze it systematically, and step forward to adopt unpopular positions. These are some of the elements that give rise to what are called “inefficiencies,” academics’ highfalutin word for “mistakes.” I absolutely believe that markets can be efficient – in the sense of “quick to incorporate information” – but certainly they aren’t sure to incorporate it correctly. Underpricings and overpricings arise all the time. However, the shortcomings described in the paragraph just above render those mispricings hard to profit from. While market prices are often far from “right,” it’s nearly impossible for most investors to detect instances when the consensus has done a faulty job of pricing assets, and to act on those errors. Thus theory is quite right when it says the market can’t be beat . . . certainly by the vast majority of investors. People should engage in active investing only if they’re convinced that (a) pricing mistakes occur in the market they’re considering and (b) they – or the managers they hire – are capable of identifying those mistakes and taking advantage of them.

Too many people simply vote their wallets: self- interest usually trumps ideology. While we can disagree with Ryan’s approach, we should applaud the rare politician who is willing to tackle this unpopular subject. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved Washington’s spending has recently been higher as a percentage of the nation’s economic output than at any time since World War II. But by the same measure, Washington’s revenues are the lowest in more than 60 years.  The government is spending far more than it brings in. The current deficit is in excess of $1 trillion, and “the U.S. is borrowing about 36 cents of every dollar spent so far this year. It borrowed 37 cents on the dollar last year, and 40 cents in 2009.”  There’s no way to change these facts in the short run. In particular: The largest components of federal spending are Social Security and Medicare programs for the elderly (33.5 percent of total outlays in 2010) and national defense (20.1 percent). Interest payments on federal debt . . . accounted for 5.7 percent of all federal spending. Thus revenues (which equate to 64% of spending) just slightly more than cover the 59.3% of the budget that went for these inescapable expenditures. What about cutting programs that are unpopular and more discretionary? That wouldn’t accomplish much: Foreign aid . . . amounts to less than 1 percent of the entire budget. . . . All agriculture programs – including farm subsidies – make up just over one-half of 1 percent.  When deficit spending is unavoidable, we have to borrow.  Since we’re at the current debt ceiling, continuing to borrow requires that the ceiling be raised.

” Buying at low prices relative to intrinsic value (rigorously and conservatively derived) holds the key to earning dependably high returns, limiting risk and minimizing losses. It’s not the only thing that matters – obviously – but it’s something for which there is no substitute. Without doing the above, “investing” moves closer to “speculating,” a much less dependable activity. When investors are serene or even euphoric, rather than discomforted, prices rise and we become less likely to find the bargains we want. So if you could ask just one question regarding an individual security, asset class or market, it should be “is it cheap?” Oaktree’s investment professionals try to ask it, in different ways, every day. And what makes for cheapness? In sum, the attitudes and behavior of others. I try to get away from it, but I can’t. The quote I return to most often in these memos, even 17 years after the first time, is another from Warren Buffett: “The less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs.” When others are paralyzed by fear, we can be aggressive. But when others are unafraid, we should tread with the utmost caution. Other people’s fearlessness invariably translates into inflated prices, depressed potential returns and elevated risk.

 Concentrate investments in “special niches and special people”; by this I meant emphasizing strategies offering exceptional bargains and managers with enough skill to wring value-added returns from assets of moderate riskiness. Of all of these, I consider reaching for return to be the most flawed, especially if it’s done without being fully conscious (which is often the case when return becomes hard to come by). I’ve described this approach as “insisting on achieving high returns in a low-return world” and reminded people of Peter Bernstein’s admonition: “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.” Here’s what I wrote in May 2005: Given today’s paucity of prospective return at the low-risk end of the spectrum and the solutions being ballyhooed at the high-risk end, many investors are moving capital to riskier (or at least less traditional) investments. But (a) they’re making those riskier investments just when the prospective returns on those investments are the lowest they’ve ever been; (b) they’re accepting return increments for stepping up in risk that are as slim as they’ve ever been; and (c) they’re signing up today for things they turned down (or did less of) in the past, when the prospective returns were much higher. This may be exactly the wrong time to add to risk in pursuit of more return. You want to take risk when others are fleeing from it, not when they’re competing with you to do so.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved The essential element in any real solution: The country is so thoroughly given up to the spirit of the party, that not to follow blindfolded the one or the other is an inexpiable offense. Between both, I see the impossibility of pursuing the dictates of my own conscience without sacrificing every prospect, not merely of advancement, but even of retaining that character and reputation that I have enjoyed. Yet my choice is made; I am at least determined to have the approbation of my own reflections. (John Quincy Adams in his diary, on sticking to his principles and supporting the British embargo, knowing that it would harm his home state of Massachusetts and get him thrown out of the Federalist party) The world has awakened to the undesirability of ever-growing government debt. Repairing the situation will require difficult decisions and great sacrifices, especially on the part of lawmakers required to vote for unpopular solutions. This would be a great time to start taking positive steps. July 21, 2011 © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. But what Obama doesn’t acknowledge is that the alternative path could lead to a different country as well – a more stagnant and balkanized society, in which our promise to the elderly crowds out the fundamental promise of America itself. (Emphasis added) Will we keep the promise of entitlement programs or cut them back? Given the prominence of entitlements in the U.S. budget, in large part it comes down to that. Over the last 80 years, politicians in the U.S. created entitlement programs that we cannot afford. Likewise, to varying degrees citizens throughout the developed world have been given promises their governments can’t keep. That a day of reckoning would arrive is not news – credible observers have warned of our current problems for decades – but few politicians have been willing to fall on the sword of unpopular solutions. Whatever action is taken now, it will not be pain-free. The unpayable debts run up in the past will have to be dealt with. And as for the future, there are only three possibilities: the promises will have to be scaled back, the tax burden will have to grow, and/or the deficits will have to be permitted to increase. If nations are to limit deficits – and it seems they may be forced to – there is no alternative to the first two of these. This fundamental truth will constitute a major portion of the public debate in coming years.

© Oaktree Capital Management, L.P. All Rights Reserved than currency? What does have real value? Maybe just things with actual usefulness and not just monetary value, like farms. It certainly does get complicated.) We can talk about the fact that gold’s value isn’t intrinsic or quantifiable. But the question really comes down to whether people’s faith in gold will increase or erode. Relevant here is a profound observation regarding markets from John Maynard Keynes. In Keynes’s time, a London newspaper ran photos of a large number of young women, with a prize going to the reader whose list of the five prettiest most closely paralleled the votes of all readers. The winning strategy wouldn’t be to try to pick the prettiest contestants, but rather the ones most voters will say are the prettiest. In other words, one’s contest submission shouldn’t be based on intrinsic merit, but on guesses regarding the other participants’ views of intrinsic merit. The same is true for investments, including gold. Thus it’s not whether gold has value, but whether people will impute value to it. But it goes further. Especially in the short run, the superior investor may not be the one who’s right about the merit of something, or even the one who’s right about the consensus view of merit. Rather, the superior investor may be the one who’s right about the judgments other people will make about the consensus view of merit.

The panic of late 2008 was a textbook illustration of the pendulum swinging to its extreme. The same investors who had been eager buyers of complex structures at thin spreads became eager sellers of high-quality assets at distressed prices. The psychology moved from greed to fear in a period of weeks, and the price action reflected that swing far more than any change in underlying asset values. The contrarian case for buying in that environment was obvious in the abstract and difficult in the execution. The reason it was difficult is that the prices were falling every day, and every day the decision to wait looked smarter than the decision to act. The investor who bought on October 10, 2008 was down meaningfully by November; the investor who waited until March 2009 captured better prices but missed the chance to deploy capital in size before the rebound began. There is no clean resolution to this tension. The practical answer is to scale in — to deploy gradually as prices fall, knowing that you will look wrong at every step, but trusting that the average entry price will be attractive in retrospect. The investor who requires certainty before acting will never act in a crisis, and the investor who never acts in a crisis will miss the dislocations that define a generation of returns.

” With their focus on short-run performance and short-run compensation, many of the things they advocate – like spin-offs, stock buy-backs and oversized dividends – can be less than optimal for the long run. But that’s not their concern. This kind of behavior exemplifies the debate over laissez-faire described in “The Aviary” in May. In the long run, it should be good for society to have capital in the hands of sophisticated, focused, bright managers who are free of guidelines and can go anywhere in pursuit of profit. In theory, it should be a positive that they’re willing to bet against the herd, adopt unpopular positions and take on unresponsive managements. But in the short run, they can have a destabilizing effect, especially when several act in common. Maybe it just proves that free-market solutions – like just about everything else – have both positive and negative aspects. If Chuck Prince had taken Citigroup to the sidelines in 2005, it’s highly likely that some hedge funds would have tried to force him out. And with Citi looking unduly conservative, the board might not have been in a position to resist. So being right isn’t always enough when you run a public company. You have to be right in the short run. And in choosing a course of action, the one that’s right for the short run generally will be preferred over the one that’s right for the long run. None of this seems ideal.

© Oaktree Capital Management, L.P. All Rights Reserved When I came into this business in the 1960s, Moody’s and Standard & Poor’s made their money selling subscriptions to their publications. Thus their customers were investors, and they weren’t beholden to the issuers. But when they began to derive most of their revenue from the issuers, the agencies understood who was buttering their bread. There’s a further problem: only above-average judgment can make you a superior investor. The consensus view of the future is incorporated in market prices. Only someone more astute than the consensus can help you do better than average. Now let’s turn to the rating process. Anyone can compute current financial ratios and see how a company’s doing today. And the future looks the same to the average person as it does to the consensus. Thus, for a helpful assessment of a company’s prospects, you need someone who can foresee possibilities and risks better than most. But if someone possesses above-average insight into bonds’ prospects, will he assign credit ratings for a living, or will he get a job managing investments? Money isn’t everything, but most people tend toward their highest and best use. I think it’s fair to say the rating agencies don’t attract bond gurus. Since the ratings business is highly competitive and profit margins are slim, agency analysts tend to be paid for high ratings and “responsiveness,” as opposed to unique insight.

From neither party do we hear anything about sacrificing today for a better tomorrow. In some ways, our most formidable challenge may be our leaders’ baffling indifference to our fiscal metastasis. As former Treasury Secretary Larry Summers puts it, “The only thing we have to fear is the lack of fear itself.” (Emphasis added) It doesn’t require higher math to see that we face serious problems in areas such as Federal deficits, the balance of payments, international competitiveness, energy, Social Security, Medicare and education. Certainly those problems won’t solve themselves. But when did you last hear of any serious debate on them? Take the Social Security system. There are only four possibilities: (1) higher taxes, (2) lower benefits, (3) privatization, or (4) dealing with the system’s insolvency when it occurs. But the first two are unpopular, and the third is politically contentious, given that it’s inherently less egalitarian than the current system and could result in the government being on the hook as the payer of last resort. So that leaves the fourth . . . which is where we stay. This just is not an acceptable approach to problem solving. Likewise, everyone knows the tax code is overly complex, indecipherable and larded with provisions benefiting special interests. It desperately needs reworking from the ground up, but no one considers that politically doable.

© Oaktree Capital Management, L.P. All Rights Reserved The Unhelpful Consensus The bottom line is that what “everyone knows” isn’t at all helpful in investing. What everyone knows is bound to already be reflected in the price, meaning a buyer is paying for whatever it is that everyone thinks they know. Thus, if the consensus view is right, it’s likely to produce an average return. And if the consensus turns out to be too rosy, everyone’s likely to suffer together. That’s why I remind people that merely being right doesn’t lead to superior investment results. If you’re right and the consensus is right, your return won’t be anything to write home about. To be superior, you have to be more right than the average investor. Let me give you an outstanding example of a dangerous consensus. Historic data, buttressed by two decades of good returns, produced near unanimity in the late 1990s regarding future equity returns. Ask 100 institutional investors and consultants in 1999, and virtually 100 would say “about 11%.” There was little serious dissent. As a result, equity allocations were ratcheted up. Those who’d fallen behind because they were underweighted in equities earlier in the decade capitulated and bought more. Where did the support for that 11% number come from? It’s simple: recent results.

My advice: expect CEOs, regulators, rating agencies and other market participants to make mistakes. Expect things to go wrong and cycles to swing to extremes and then recover. Worry about outcomes, and hire worriers. Doing these things is sure to stand between you and top returns in up-cycles, but it will deliver some degree of safety when things turn bad. Ensuring the protection of capital under adverse circumstances is incompatible with maximizing returns in good times, and thus investors must choose between the two. That’s the real lesson. The things discussed above are just a few of the details. What Next? Lots of people are asking whether this is going to get ugly. Is this the beginning of a credit crunch? Will it lead to a recession? How bad will it get? When will the bottom be reached? How long will the recovery take? The answer’s simple: no one knows. Some of the psychological and technical preconditions for a challenging market environment have been met. The bubble of positive investor psychology has been pricked and could become seriously deflated. When others are aggressive, we should be worried, but when others are worried, we can be confident. That’s the essence of contrarianism, and by that standard these are better times. The easy-money machine has had some sand thrown in its gears and seems to be grinding to a halt. Previously, anyone could get any amount of money for any purpose.

and take chances. Especially as to that last point, unusual success cannot lie in doing the obvious. Two specific examples: • New managers – Someone has to fund them (or else they’ll never become established managers). But clearly that decision can’t be based on reams of data. It involves making a bet on people and their investment approaches. Hiring new managers can pay off very well . . . when it’s done right. • Underperforming managers – Retain or fire . . . or add money? That’s the real question. Good investors hold fast to their approach and discipline. But every approach goes out of favor from time to time, and the manager who adheres most firmly can do the worst. (Page 217 of the book “Hedgehogging” provides fascinating data on some great managers’ terrible times.) A lagging year or two doesn’t make a manager a bad one . . . maybe just one whose market niche has been in the process of getting cheap. But how often are managers given more money when they’re in a slump (as opposed to being fired)? Buck the Trend As in manager selection, bucking the trend is a key element in all aspects of the pursuit of superior investment results. First, going along with the crowd will, by definition, lead to average performance. Second, the crowd is usually in broad agreement – and wrong – at the extremes. That’s what creates the extremes (and the highly profitable recoveries therefrom). But going against the crowd isn’t easy.

Of course, the efficient market crowd would say someone will get rich doing everything – even playing the lottery or flipping coins – simply because the tails of a probability distribution usually aren’t entirely unpopulated. But who it is that gets rich that way may be purely random. If that’s the case, the mere existence of a few winners doesn’t in itself prove that something is an “alpha” activity in which hard work and skill will produce consistent performance, or that large numbers of people can pull it off. I believe firmly that the markets for commodities and currencies are generally efficient. That means a lot of highly motivated people participate; many are intelligent and computer-literate; they all have access to similar information; and they’re willing to take either side of most propositions. These people cause all of the available information to instantly be incorporated in the market price of each asset, such that the market price always reflects the consensus view of the significance of the available information. As a further consequence, few people if any can dependably identify and profit from instances when the market price is wrong. That, in turn, makes it difficult to consistently achieve high absolute returns or perform better than others. That difficulty constitutes the ultimate proof that a market’s efficient. Take currencies for example.

© Oaktree Capital Management, L.P. All Rights Reserved Given today’s paucity of prospective return at the low-risk end of the spectrum and the solutions being ballyhooed at the high-risk end, many investors are moving capital to riskier (or at least less traditional) investments. But (a) they’re making those riskier investments just when the prospective returns on those investments are the lowest they’ve ever been; (b) they’re accepting return increments for stepping up in risk that are as slim as they’ve ever been; and (c) they’re signing up today for things they turned down (or did less of) in the past, when the prospective returns were much higher. This may be exactly the wrong time to add to risk in pursuit of more return. You want to take risk when others are fleeing from it, not when they’re competing with you to do so. “If you can’t get the return you need from safe investments, make risky investments.” When put that way, it doesn’t make much sense. In fact, it reminds me of my father’s joke about the inveterate gambler who said, “I hope I break even, because I need the money.” * * * If you look back at the recurring mistakes listed at the beginning of this memo, you’ll see some common threads. They all express wishful thinking, an inevitable part of human nature. They stem from an excessive proclivity to believe the positives – and disregard the negatives – prompted by the desire to make money.

© Oaktree Capital Management, L.P. All Rights Reserved being average in up markets. Oaktree portfolios are set up to outperform in bad times, and that’s when we think outperformance is essential. Clearly, if we can keep up in good times and outperform in bad times, we’ll have above average results over full cycles with below average volatility, and our clients will enjoy outperformance when others are suffering. We think that’s a winning long-term combination. Our game plan is built around defense. But that’s not enough. We still need players with superior skills. UFinding Your Role Model An article in the Wall Street Journal of August 8, entitled “Greatness in Our Midst,” supplied the immediate impetus for this memo. It attempted to determine “who’s the greatest living baseball player?” I’m no expert on baseball, but I liked the Journal’s analytical approach and loved its conclusions. Of the five players discussed, Barry Bonds came in fifth. “If you’re looking for a peak- value player – a guy to play one season as well as anyone ever has – this is your guy. His past two campaigns have been other-worldly . . .” Bonds has a ton of ability, but he has yet to prove that he’s “the greatest.” Lots of fence-swinging investors have had otherworldly years, but few have completed outstanding careers. Stan Musial placed fourth: outstanding at the plate, but below average on defense according to the Journal. It’s tough to be the best without strong defense. The #3 pick was Willie Mays.

Because of the fluctuation of both fundamental developments and investor behavior, assets are sometimes offered for sale at bargain prices and at other times at prices that are too high. A technique that works most dependably is putting money into things that are out of favor. Although investors often seem not to grasp it, it shouldn’t be hard to understand: only unpopular assets can be truly cheap. And those that are in favor are likely to be dear. For example, one of the best reasons for the profitability of distressed debt over the years is that there’s no such thing as a distressed company everybody loves. By the time they’ve made their way to our arena, distressed debt companies can no longer be on what I call “the pedestal of popularity.” We buy at low dollar prices from depressed owners at a time when corporate performance is well off from the top. Not a bad formula. Certainly that doesn’t have to mean that the investment’s cheap enough, but at least there’s a low probability it’s pumped up on hot air (or investors’ ardor). The momentum player buys what’s up and bets that it’ll keep going up. The style devotee buys one thing whether it’s up or down. But the contrarian, or value investor, buys something that other people aren’t interested in, in the belief that it’s cheap and will become less cheap someday.profit,

© Oaktree Capital Management, L.P. All Rights Reserved but I think this one stacks the cards in your favor. As Sir John Templeton put it, “To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage but provides the greatest profit.” The most important thing is patient opportunism. At Oaktree we try to sit on our hands. We don’t go out with a “buy list”; rather, we wait for the phone to ring (while we do our research and analysis). If we call the owner and say, “You own x and we want to buy it,” the price will go up. But if the owner calls us and says, “We’re stuck with x and we’re looking for an exit,” the price will go down. Thus, rather than initiating transactions, we react opportunistically. One of our mottos is “we don’t look for our investments; they find us.” In general, that means investing from the bottom up, not from the top down – from the list of things that are available cheap, not in things we think it’d be great to have a position in. When you’re a top-down investor, you predetermine that a given percentage of the portfolio should be invested in a certain sector, and then you proceed to look for the best bargains in that sector. The bottom-up investor has no such preconception; he looks for the best bargains, regardless of where they can be found. Sector allocation falls out largely of its own accord (but hopefully with concentrations held to tolerable levels).

” And he hasn’t changed his spots since. “I’m once again calling for events that few expect,” he says. “His work is as relevant now as it ever was,” says Henry Van der Erb. “A quack,” says Michael Thorson. And that’s the point. His forecast certainly is non-consensus, and if you follow him and he’s right, you’ll make a fortune (or at least avoid losing one). But who’ll follow him? As I wrote in “The Value of Predictions II,” It’s difficult with regard to a non-consensus view of the future (1) to believe in it, (2) to act on it, (3) to stand by it if the early going suggests it’s wrong, and (4) to be right. How much do idiosyncratic forecasters like Robert Prechter really know about the future? How much can their forecasts help you to know? And how much are you willing to bet on their being right? UReliance on Weak Data Investment experts love to dredge up data supporting their observations, and ever since computers began to be applied to the stock market in the 1960s, a remarkable number of phenomena have been discovered and documented. On December 11, the Wall Street Journal went into detail concerning “the so-called January effect – the tendency of certain stocks to rise in January after money managers tweak their holdings for tax purposes.”

That phrase is always heard UafterU the losses have piled up – be it in portfolio insurance, "market neutral" funds, dot-coms, or Enron. My career in money management has been based on the conviction that free lunches do exist, but not for everyone, or where everyone's looking, or without hard work and superior skill. Skepticism needn't make you give up on superior risk-adjusted returns, but it should make you ask tough questions about the ease of accessing them. Thus I also advocate modest expectations. To shoot for top-quartile performance every year, you have to hold an idiosyncratic portfolio that exposes you to the risk of being outside the pack and dead wrong. It's behavior like that that leads to managers being carried off the field when things go poorly – and to clients losing lots of money. It's far more reasonable just to try for performance that's consistently a little above average. Even that's not easy to achieve, but if accomplished for a long period it will result in an outstanding track record. I think humility is essential, especially concerning the ability to know the future. Before acting on a forecast, we must ask whether there's good reason to think we're more right than the consensus view already embodied in prices. I think it's possible to get a knowledge advantage with regard to under-researched companies and securities, but only through hard work and skill. Finally, I'm a strong believer in investing defensively.

 Market prices for assets already incorporate the views of the consensus of forecasters. Thus holding a consensus view, even if it's right, can't help you make above-average returns.  Non-consensus views can make you a lot of money, but to do so they must be right. Because the consensus reflects the forecasting efforts of a large number of intelligent and informed people, however, it's usually the closest we can get to right. In other words, I doubt there's anyone out there with non-consensus views that are right routinely.  Most of the time, the consensus forecast extrapolates current observations. Predictions for a given parameter usually bear a strong resemblance to the level of the parameter prevailing at the time they're made. Thus predictions are often close to right when nothing changes radically, which is the case most of the time, but they can't be counted on to foretell the important sea changes. And as my friend Ric Kayne says, "everything important in financial history has taken place outside of two standard deviations." It's in predicting radical change that extraordinary profit potential exists. In other words, it's the UsurprisesU that have profound market impact (and thus profound profit potential), but there's a good reason why they're called surprises: it's hard to see them coming!  Each time a radical change occurs, there's someone who predicted it, and that person gets to enjoy his fifteen minutes of fame.because

© Oaktree Capital Management, L.P. All Rights Reserved opportunity for unusual profits. Unskeptical belief that the silver bullet is at hand eventually leads to capital punishment. USeventhU, you must be aware of what's going on around you in terms of investor psychology. I don't believe in the ability of forecasters to tell us where prices are going, but an understanding of where we are in terms of investor psychology can give us a hint. When investors are exuberant, as they were in 1999 and early 2000, it's dangerous. When the man on the street thinks stocks are a great idea and sure to produce profits, I'd watch out. When attitudes of this sort make for stock prices that assume the best and incorporate no fear, it's a formula for disaster. I find myself using one quote, from Warren Buffett, more often than any other: "The less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs." When others are euphoric, that puts us in danger. When others are frightened and pull back, their behavior makes bargains plentiful. In other words, what others are thinking and doing holds substantial ramifications for you. And that brings us full circle to the importance of contrarianism. * * * I've cataloged above the "mental arsenal" I feel is needed in the battle for investment success.

There's a whole profession built around doing so. Academics try to understand the economy, and professionals try to predict its course. Personally, I'd stick to the former. I think we can gain a good grasp of how the economy works, but I do not think we can predict its fluctuations. I have written ad nauseam on this subject, but I will repeat a few of the observations I consider relevant:  There are hundreds, or more likely thousands, of people out there trying to predict the movements of the economy, but no one has a record much better than anyone else. Certainly no one who was consistently capable of accurately predicting the economy's movements would be among those distributing their forecasts gratis.  The markets already incorporate the views of the consensus of economists, and thus holding a consensus view can't help you make above-average returns (even if it's right).  Non-consensus views can make money for you, but to do so they must be right. Because the consensus reflects the efforts of a large number of intelligent and informed people, however, it's usually the closest we can get to right. In other words, I doubt there's anyone out there with non-consensus views that are right routinely.

Stocks are less homogenous, and there's more to choose between them, but I still think the market for popular stocks is efficient. That's the reason why, when I left equity research in 1978, I told Citibank I would "do anything other than spend the rest of my life choosing between Merck and Lilly." I believed in efficient markets then, and I believe in them now. But what do I mean? When I say efficient, I mean it in the sense of "speedy," not "right." I agree that because investors work hard to evaluate every new piece of information, asset prices immediately reflect the consensus view of the information's significance. I do not, however, believe the consensus view is necessarily correct. In January 2000, Yahoo! sold at $237. In April 2001 it was at $11. Anyone who argues that the market was right both times has his head in the clouds; it has to have been wrong on at least one of those occasions. But that doesn't mean many investors were able to detect and act on the market's error. If prices in efficient markets already reflect the consensus, then sharing the consensus view will make you likely to earn just an average return. To beat the market you must hold an idiosyncratic, or non-consensus, view. But because the consensus view is as close to right as most people can get, a non-consensus view is unlikely to make you more right than the market (and thus to help you beat the market).

That's because, in my view, alpha is best thought of as " UdifferentialU advantage," or skill that others don't possess. Alpha isn't knowing something, it's knowing something others don't know. If everyone else shares a bit of knowledge, it provides no advantage. It certainly won't help you beat the market, given that the market price embodies the consensus view of investors – who on average know what you know. Alpha is entirely personal. It's idiosyncratic, an art form. It's superior insight; some people just "get it" better than others. Some of them are mechanistic quants; others are entirely intuitive. Hard work is a common thread among the best investors I know, but hard work alone is absolutely insufficient to explain their superior performance. Alpha is zero for someone with no skill (i.e., a dart thrower). Warren Buffett, on the other hand, seems to have lots of alpha – even in a market most people think of as efficient. It's possible to have negative alpha if you're wrong more often than not. Someone who's always wrong would have lots of negative alpha, but he'd be a great guy to know (since you could be right all the time by doing the opposite of what he says). Everyone knows it's a cornerstone of investment theory that there's no such thing as alpha . . . Clearly this underlies the Efficient Market Hypothesis. The market is more right than any investor. No investor is better than any other. No one is capable of consistently outperforming.

© Oaktree Capital Management, L.P. All Rights Reserved Stock Investors Show a "Comfort" Level; Rate Cut Spurs 113.76-Point Rise . . . the Fed said the Sept. 11 terrorist attacks "have significantly heightened" uncertainty in an already weak economy. Yet despite the Fed's concern, signs are spreading that some professional investors are gradually putting money back into stocks. "The market has reached a level that makes people feel a lot more comfortable that we have seen the worst of what could happen," . . . I can't tell you how much I hope we've seen the worst, both in terms of world events and in the markets. But I am not willing to bet heavily on that assumption. And if I'm supposed to be more afraid when others are less afraid, articles like this one tell me there's plenty to worry about. I always stress that investments must leave a substantial margin for error and allow for the possibility that negatives will arise. The terrorist attacks, while certainly not imaginable, show the importance of allowing for adverse surprises. Only when asset prices are clearly at irrationally low levels can this caution be ignored. In my view, with investors' sangfroid having bounced back so strongly, most stocks aren't at such levels. USo What Do We Do Now?U – We could assume that the combination of further weakening of the already-weak economy plus continued terrorism will make for a very difficult environment.

© Oaktree Capital Management, L.P. All Rights Reserved The bottom line for me: Efficiency and accuracy are two very different things. As I wrote in my May memo, investors rapidly incorporate new information into their estimates of security values, and the market rapidly reflects the consensus view of values,...but that doesn't mean the consensus is right. Information isn't knowledge. The mere fact that investors have data doesn't mean they understand its significance. If investors' knowledge was really growing, stock volatility wouldn't be increasing as dramatically as it is. As the adage says of the fool, “he knows the price of everything and the value of nothing.” November 16, 2000

Or as George Gilder recently wrote in the Wall Street Journal: Stock markets are world-wide webs of information. So why half the time do they behave like members of some candy mountain mystical sect, torn between dreams of eternal wealth and horror of a bottomless pit? In response, I want to give my view of market efficiency. I want to say up front that academics don't share my view and theory says I'm wrong. But my approach works for me, and I want to share it with you. In my opinion, the market for many stocks is highly efficient. That's what I was taught at the University of Chicago in the mid-'60s, when capital market theory was being developed. And in 1978, when I left equity research, I told Citibank I'd do anything but “spend the rest of my life choosing between Merck and Lilly.” I believed in market efficiency then and I believe in it now. But what does that mean? When I say efficient, I mean “speedy,” not “right.” My formulation is that analysts and investors work hard to evaluate all of the available information such that:  the price of a stock immediately incorporates that information and reflects the consensus view of its significance, and  thus, it is unlikely that anyone can regularly outguess the consensus and predict a stock's movement.

© Oaktree Capital Management, L.P. All Rights Reserved UNever forget valuationU – The focus may shift from dividend yield to p/e ratio, and people may stop looking at book value, but that doesn't mean valuation is irrelevant. In the tech bubble, buyers didn't worry about whether a stock was priced too high because they were sure someone else would be willing to pay them more for it. Unfortunately, the "greater fool theory" only works until it doesn't. Valuation eventually comes into play, and those who are holding the bag when it does are forced to face the music. UBe conscious of investor psychologyU – I don't believe in the ability of forecasts or forecasters to tell us where prices are going, but I think an understanding of investor psychology can give us a hint. When investors are exuberant, as they were in 1999 and early 2000, it's dangerous. When the man on the street thinks stocks are a great idea and sure to produce profits, I'd watch out. When attitudes of this sort make for stock prices that assume the best and incorporate no fear, it's a formula for disaster. I find myself using one quote, from Warren Buffett, more often than any other: "The less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs." When others are euphoric, that puts us in danger. When others are terrified, the prices they set are low, and we can be aggressive.

On December 22, in "Consumer Mood Swings to Angst," the New York Times employed a new phrase: "irrational anxiety." If that sentiment does come to be widespread, replacing irrational exuberance, it can signal a buying opportunity. UCheck your own mindsetU – For me, mindset holds many of the keys to success. We at Oaktree believe strongly in contrarianism. As suggested in the paragraph above, that means leaning away from the direction chosen by most others. Sell when they're euphoric, and buy when they're afraid. Sell what they love, and buy what they hate. Closely related to contrarianism is skepticism. It's a simple concept, but it has great potential for keeping us out of trouble. If it sounds too good to be true, it probably is. That phrase is always heard UafterU the losses have piled up – be it in dot-coms, portfolio insurance, "market neutral" funds or the "Asian miracle." Oaktree was founded on the conviction that free lunches do exist, but not for everyone, or where everyone's looking, or without hard work and superior skill. Skepticism needn't make you give up on superior risk-adjusted returns, but it should make you ask tough questions about the ease of accessing them. We think humility is essential, especially concerning the ability to know the future. Before we act on a forecast, we ask if there's good reason to think we're more right than the consensus view already embodied in prices. As to macro projections, we never assume we're superior.

In short, we believe (and have witnessed many times over) that the easiest way to make unusually high risk-adjusted returns is to buy from depressed sellers and sell to euphoric buyers...thus to buy when assets are underpriced and sell when they're overpriced. The opposite is a nightmare. The greatest extremes in our experience include 1970, when the New York banks believed the Nifty- Fifty companies were so good that it essentially didn't matter what price you paid for their stocks (subsequent declines of 70% to 90% soon became common among the stocks of America's greatest companies), and 1990, when investors acted as if any company experiencing an iota of difficulty was practically worthless (the distressed debt funds we created that year returned about 50% per annum). John Maynard Keynes said (roughly) that "a speculator is someone who takes risks of which he is aware, and an investor is someone who takes risks of which he is unaware." We think speculating, according to this definition, is more prudent than investing. It makes a lot of sense to purchase unpopular assets that promise excessive compensation for knowingly bearing risk. Buying high- priced, popular assets which "everyone knows have no risk" often proves terribly dangerous. Here's a case in point: © 1997 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

By the way, there's an important analogy to be drawn here: Efficient market advocates don't say it's impossible to beat the market; lots of people do it every year. (Remember, half the observations in any sample are above the median.) They only assert that no one can consistently do so in risk-adjusted terms. Finally, can macro-forecasts be used to gain an advantage? I pointed out in my 1993 memo that most of the time, you can't get superior results with inaccurate forecasts or with accurate forecasts that reflect the consensus. (This is because the consensus view of the future is already embedded in the price of an asset at the time you buy it). To bring above average profits, a forecast generally must be different from the consensus and accurate. But, as I described in 1993, it's difficult with regard to a non-consensus view of the future (1) to believe in it, (2) to act on it, (3) to stand by it if the early going suggests it's wrong, and (4) to be right. Those who invest based on fringe predictions are often wrong to an embarrassing and costly extent. At Oaktree, we don't spend our time attempting to guess at the future direction of economies, rates and markets, things about which no one seems to know more than anyone else. Rather, we devote ourselves to specialized research in market niches which others find uninteresting, unseemly, overly complicated, beyond their competence or not worth the effort and risk.

© Oaktree Capital Management, L.P. All Rights Reserved Memo To: Clients From: Howard S. Marks, TCW Re: "Risk in Today's Markets" Revisited Seven weeks ago, we put out a memorandum entitled "Risk in Today's Markets." Its essence was that the excellent returns earned in risky strategies through 1993 had eroded the fear factor in many markets and, coupled with the low yields available on conservative fixed income investments, had caused many investors to take "one giant step forward" on the risk curve. It also pointed out that just as declining rates had acted to raise prices and generate good returns, rate movements could cut the other way too. Lastly, it cautioned that when others are acting imprudently, driven by greed and without much fear, it is important that we raise UourU level of prudence. Unfortunately, the events of the intervening seven weeks have shown these observations to be in order. It is the purpose of this follow-up memo to review the developments of the intervening time period, attempting to make sense out of what has happened and searching for lessons that can be drawn. It's about understanding basics of investing which don't come and go. The current "correction" dates from February 4, when the Federal Reserve Bank raised short term interest rates a small amount in order to choke off inflationary thought and action. The air quickly came out of the bond markets, and the decline has been swift and deep.

© Oaktree Capital Management, L.P. All Rights Reserved An investment that "everyone" knows to be undervalued is an oxymoron. If everyone knows it's undervalued, why haven't they bought it and driven up its price? And if they have bought, how can the price still be low? Yogi Berra said, "nobody goes to that restaurant; it's too popular." The equally oxy-moronic investment version is "Everybody likes that security because it's so cheap." 5. Book the bet that no one else will. If everyone likes the favorite in a football game and wants to bet on it, the point spread will grow so wide that the team -- as good as it is -- is unlikely to be able to cover the spread. Take the other side of the bet -- on the underdog. Likewise, if everyone is too scared of junk bonds to buy them, it will become possible for you to buy them at a yield spread which not only overcompensates for the actual credit risk, but sets the stage for their being the best performing fixed income sector in the world. That was the case in late 1990. The bottom line is that one must try to be on the other side of the question from everyone else. If everyone likes it, sell; if no one likes it, buy. 6. As Warren Buffet said, “the less care with which others conduct their affairs, the more care with which you should conduct yours." When others are afraid, you needn't be; when others are unafraid, you'd better be. It is usually said that the market runs on fear and greed.