Howard Marks on Earnings Growth

The chapter I didn’t plan to write – and the one that became the most important chapter in the book and one of the longest – was the one titled “The Cycle in Attitudes Toward Risk.” Security prices fluctuate much more than do the intrinsic value and prospects of the underlying companies, and the main reason for this is the extreme volatility in the way people feel about risk. When the economy is humming, companies are reporting growing earnings, security prices are rising, and profits are piling up, people say things like: “Risk is my friend. The more risk I take, the more money I make. And anyway, I don’t see anything to worry about.are

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: What’s the Appropriate Price to Pay for a Bright Future? If there’s a company for sale that will make $1 million next year and then shut down, how much would you pay for it? The right answer is a little less than $1 million, so that you’ll have a positive return on your money. But stocks are priced at “p/e multiples” – that is, multiples of next year’s earnings. Why? Because presumably they won’t earn profits for just one year; they’ll go on making money for many more. When you buy a stock, you buy a share of the company’s earnings every year into the future. The price of the S&P 500 has averaged roughly 16 times earnings in the post-World War II period. This is typically described as meaning “you’re paying for 16 years of earnings.” It’s actually more than that, though, because the process of discounting makes $1 of profit in the future worth less than $1 today. The current value of a company is the discounted present value of its future earnings, so a p/e ratio of 16 means you’re paying for more than 20 years of earnings (depending on the interest rate at which future earnings are discounted). In bubbles, hot stocks sell for considerably more than 16 times earnings. Remember the 60 to 90 times for the Nifty Fifty! Investors in 1969 were paying for companies’ earnings – even after giving them credit for significant earnings growth – many decades into the future.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Exxon Mobil Johnson & Johnson Intel Qualcomm Citigroup Bristol-Myers Squibb IBM Pfizer Oracle AT&T Home Depot Verizon At the beginning of 2024, however, only six of them were still in the top twenty: Microsoft Johnson & Johnson Walmart Procter & Gamble Exxon Mobil Home Depot Importantly, of today’s Magnificent Seven, only Microsoft was in the top twenty 24 years ago. In bubbles, investors treat the leading companies – and pay for their stocks – as though the firms are sure to remain leaders for decades. Some do and some don’t, but change seems to be more the rule than persistence. Whole Markets The greatest bubbles usually originate in connection with innovations, mostly technological or financial, and they initially affect a small group of stocks. But sometimes they extend to whole markets, as the fervor for a bubble group spreads to everything. In the 1990s, the S&P 500 was borne aloft by (a) the continuing decline of interest rates from their inflation-fighting peak in the early 1980s and (b) the return of investor enthusiasm for stocks that had been lost in the traumatic ’70s. Technological innovation and the rapid earnings growth of the high-tech companies added to the excitement. And an upswing in the popularity of stocks was reinforced by new academic research showing there had never been a long period in which the S&P 500 failed to outperform bonds, cash, and inflation.

How many years of earnings growth should be counted on in assigning p/e ratios for AI-related stocks? Will chips and other aspects of AI infrastructure last long enough to repay the debt undertaken to buy them? Will artificial general intelligence (a machine capable of doing anything the human brain can do) be achieved? Will that be the end of progress, or might there be further revolutions, and what firms will win them? Will firms reach a position where technology is stable and they can extract economic value from it? Or will new technologies continually threaten to supplant older ones as the route to success? In this connection, a single issue of an FT newsletter briefly mentioned two developments that suggest the fluid nature of the competitive landscape: • A study by the Massachusetts Institute of Technology and open-source AI start-up Hugging Face found that the total share of downloads of new Chinese-made open models rose to 17 per cent in the past year. The figure surpasses the 15.8 per cent share of downloads from American developers such as Google, Meta and OpenAI – the first time Chinese groups have beaten their American counterparts. . . . • Nvidia shares fell sharply yesterday on fears that Google is gaining ground in artificial intelligence, erasing $115bn in market value from the AI chipmaker. (FirstFT Americas, November 26) Dynamic change creates the opportunity for incredible new technologies, but that same dynamism can threaten the leading companies’ reign.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • the positive psychology and “wealth effect” resulting from recent gains in markets, high-end real estate, and crypto, • the belief that, for most investors, there really is no alternative to the U.S. markets, and • the excitement surrounding today’s new, new thing: AI. These are the kinds of things that have the ability to fire investor imaginations and contribute to bull markets, and they certainly seem to be doing so now. * * * I came across a great quote last year from John Stuart Mill (1859): “He who knows only his own side of the case knows little of that.” In other words, if you’re not conversant with the arguments of those who oppose your position, you really can’t assess its validity. Thus, I can’t responsibly advance my view without giving the other side of the issue. In every strongly rising market, there has to be a justification for the extended valuations: the “bull case.” If it didn’t exist, asset prices couldn’t be where they are. It’s usually some variation on “it’s different this time.” Here’s how it goes today: A p/e ratio is basically the result of applying a discounted cash flow calculation to a stream of earnings, as described above. The main inputs for performing such a calculation and assigning a valuation are assumptions regarding the earnings’ growth rate, durability, and return on invested capital.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Over time, a subset of value investors adopted a harder-line approach, with a pronounced emphasis on low valuation metrics. Graham and Buffett’s cigar butts had featured low valuation metrics, and this no doubt caused some value investors to elevate this characteristic to be the core consideration in their investment process. It’s interesting to note that the methodology for populating the S&P 500 Value Index relies solely on finding the one-third of the S&P 500’s market capitalization with the highest ratio of Value Rank (based on the lowest average multiple of earnings, sales and book value) to Growth Rank (based on the highest three-year growth in sales and earnings and 12-month price change). In other words, the stocks in the Value Index are those that are most characterized by “low-valuation parameters” and least characterized by “growth.” But “carrying low valuation parameters” is far from synonymous with “underpriced.” It’s easy to be seduced by the former, but a stock with a low p/e ratio, for example, is likely to be a bargain only if its current earnings and recent earnings growth are indicative of the future. Just pursuing low valuation metrics can lead you to so-called “value traps”: things that look cheap on the numbers but aren’t, because they have operating weaknesses or because the sales and earnings creating those valuations can’t be replicated in the future.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: allowed that 20 percent of the time they’re right. Given the rising impact of technology in the 21st century, I’d bet that percentage is a lot higher today. It’s also worth noting with regard to truly dominant companies that are able to achieve rapid, durable and highly profitable growth that it is very, very hard to overprice them based on near-term multiples. The basic equations of finance were not built to handle high-double-digit growth as far as the eye can see, making the valuation of rapid growers a complicated matter. As John Malone famously said, if your long-term growth rate exceeds your cost of capital, your present value is infinite. However, this is only true for truly special companies, which are few and far between and certainly not as ubiquitous as is generally implied by the market in times of ebullience.

This possibility means (a) bonds with maturities much above ten years are obvious candidates for underweighting and (b) inflation beneficiaries should be considered for overweighting, including floating-rate debt, real estate capable of seeing rent increases, and the stocks of companies with the power to pass on price increases and/or the potential for rapid earnings growth. When it comes to finding decent returns in this environment, the options are slim. Investors have plowed capital into the mainstream public “beta” markets. As a result, prospective returns have come down – fully reflecting the reduction in interest rates – and markets have become quite efficient. In most cases, price has converged with – if not run ahead of – intrinsic value. That means it’s harder than ever to outperform, other than by taking on additional risk and being lucky enough to do so in an environment where such action is rewarded. Although no markets are starved for capital these days, there may be alternative “alpha” markets where investment skill can add to returns, hopefully without a commensurate increase in overall risk. Some of this additional return is simply a premium for bearing illiquidity, and the pain suffered by some institutions during the 2008-09 crisis shows how important it is to correctly assess one’s ability to live with illiquidity.

” In other words, (a) reducing the growth rate will result in a smaller increase in new cases each day (but still an increase), and (b) making the growth rate negative means there will be fewer new cases each day than the day before (but still new cases). Observers seem to be working under the assumption that, sooner or later, “the curve will be flattened and then bent downward,” meaning the disease will be controlled and perhaps disappear in three to six months. The reasons for optimism in this regard are as follows:  People will isolate increasingly. The closures of schools, businesses and gathering places will help in this regard.  Testing will allow us to identify those with the disease and separate them from the healthy population.  The disease will fade when warm weather sets in (other epidemics that have appeared in recent decades have proved seasonal in this way).  A preventive vaccine or therapeutic medication will be developed and approved. Of course, no one knows whether or when these things will happen. But we can hope that the combination will limit the disease to the next three to six months as described above. © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: would “compound.” Because new cases would rise each day by a constant percentage, their number would increase as the fixed growth rate was applied to an expanding base. In order to get the disease under control, the following progression has to take place: • The growth in the number of daily new cases has to come in below expectations, meaning the rate of growth has to decline rather than remain constant. • Then the number of daily new cases has to stabilize, meaning the rate of growth is declining. • Then the number of daily new cases has to decline, meaning the rate of growth is negative. • Then the number of daily new cases has to go to zero, meaning the disease has been stopped. Different places around the world and in the U.S. are at different stages in this progression. There are places where the number of daily new cases is continuing to rise; places where the curve is flattening and the new cases are declining (e.g., trends are positive in U.S. cities that were beset early); and places that had good results early but are seeing rebounds as rules are relaxed and people start to return to their normal behavior. Here are a few of the questions that bear on the outlook for the curve: • Will testing and contact mapping facilitate keeping infected people out of circulation? • Will large numbers of asymptomatic infections impede the effort to isolate carriers?

And containership operators have canceled 40 sailings at the Port of Los Angeles through April 1, mostly for vessels coming from China. (The Wall Street Journal, March 2) The reasons for the economic impact are understandable, but their collective impact can’t be quantified any more than most economic phenomena, and probably less given how much the elements in this situation are in flux. There are as many forecasts as there are forecasters: S&P Global is forecasting the U.S. economy to slow to a 1% annual growth rate in the first quarter from 2.1% pace in the fourth quarter of 2019, with a half-percentage point attributable to the coronavirus. For the full year, the effect would be modest, shaving one or two tenths of a percentage point off growth. But that forecast assumes the impact is mainly overseas. (The Wall Street Journal, March 2) Mr. Jamison [the UCSF emeritus professor introduced above] said such a scenario could still cause U.S. businesses and schools to close, grind transportation networks to a halt, and trim a half percentage point from economic growth for the year. That is enough to slow the economy but not cause a recession, or two straight quarters of economic contraction. He expects any event wouldn’t last longer than several months and be followed by a sharp increase in economic activity. (Ibid.) “You have all the ingredients for an interruption of economic activity here,” said Carl Tannenbaum, chief economist for Northern Trust.

($3,400 to a family of four won’t last long.) What will it take to bring the economy back to life after it’s been in a deep freeze? How fast will it recover? In other words, is a V-shaped recovery a realistic expectation? • It will be very challenging to resolve the conflict between social isolation and economic recovery. How will we know whether the disease merits the cure? The longer people remain at home, the more difficult it will be to bring the economy back to life. But the sooner they return to work and other activities, the harder it will be to get the disease under control. First, the growth in the number of new cases each day has to be reduced. Next, the number of new cases has to begin to decline from one day to the next (that is, the growth rate has to turn negative). Then new cases have to stop appearing each day. (Of course, we’ll need increased testing and mandatory quarantining for these things to occur.) As long as there are new cases each day, there are people who are infectious. If we send them back into the world and into contact with others, the disease will persist and spread. And if we seize the opportunity provided by a decline in the number of new cases to resume economic activity, we risk a rebound in the rate of infection. • For the most part, we have companies whose revenues are down and companies whose revenues are gone.

Not its dividend yield, but its earnings yield: the ratio of earnings to price (that is, p/e inverted). Simplistically, when Treasurys yield less than 1% and you add in the traditional equity premium, perhaps the earnings yield should be 4%. That yield of 4/100 suggests a p/e ratio (the inverse) of 100/4, or 25. Thus the S&P 500 shouldn’t trade at its traditional 16 times earnings, but roughly 50% higher. Even that, it’s said, understates the case, because it ignores the fact that companies’ earnings grow, while bond interest doesn’t. Thus the demanded return on stocks shouldn’t be (bond yield + equity premium) as suggested above, but rather (bond yield + equity premium - growth). If the earnings on the S&P 500 will grow to eternity at 2% per year, for example, the right earnings yield isn’t 4%, but 2% (for a p/e ratio of 50). And, mathematically, for a company whose growth rate exceeds the sum of the bond yield and the equity premium, the right p/e ratio is infinity. On that basis, stocks may have a long way to go. The rest of the bulls’ arguments mostly surround the exceptional nature of the market-leading tech companies: • They grow much faster than the large companies of the past, and their growth is much less likely to prove cyclical.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: (Correspondingly, however, regulatory efforts to restrain their market power represent their greatest risk.) • Thanks to the role of intellectual property as the main “raw material” in their products, most of these companies can create additional units for sale at very low marginal cost. • Likewise, they can grow without much additional capital, if any (all five of the top tech firms are in a “net cash” position, meaning their cash holdings exceed their debt). • Finally , their high p/e ratios today mean less than usual, since these tech champions are vastly under-reporting earnings: if they were to cut back on things like customer-acquisition costs and R&D and settle for lower (but still rapid) growth, they could report far higher earnings. Thus, it’s said, the skeptics seriously underestimate the ability of the technological leaders to grow, and to pull up the overall growth rate for the universe of common stocks. They grow every day, and so does their representation in the equity indices and in corporate America, creating a virtuous circle. Thus, with these dominant large-cap tech companies making up a large and growing percentage of the stock market, to be bearish one has to have a thesis on why they should fall. Or else you would have to bet on the non-tech sectors to decline a great deal and pull down the averages – despite the fact that they’re already down a lot.

” For example, the current recovery is one of the longest ever; the GDP growth rate is at the top of the range for the last decade; and profit margins are well above average. Things like these can continue or even get better, but the odds are against it. It feels as if we may get through the next 18 months without a recession, but if we do, that’ll make this the longest recovery since the 1850s. Certainly not impossible, but against the odds.  Most valuation parameters are either the richest ever (Buffett ratio of stock market capitalization to GDP, price-to-sales ratio, the VIX, bond yields, private equity transaction multiples, real estate capitalization ratios) or among the highest in history (p/e ratios, Shiller cycle-adjusted p/e ratio). In the past, levels like these were followed by downturns. Thus a decision to invest today has to rely on the belief that “it’s different this time.”  Prospective returns in the vast majority of asset classes are some of the lowest in history.  The need of investors to wring out good returns in this “low-return world” is causing them to engage in what I call pro-risk behavior. They’re paying high prices for assets and accepting risky and poorly structured propositions. In such a climate, it’s hard for “prudent” investors to insist on traditional levels of safety. Investors who don’t want to sign on for risk (that is, who “refuse to dance”) can be constrained to the sidelines. © 2018 OAKTREE CAPITAL MANAGEMENT, L.P.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The forthcoming book I mentioned earlier, due out in October, is about cycles. Why do cycles occur? Why doesn’t the U.S. economy just grow at the average rate of 2-3% every year? And since the average return on the S&P 500 is in the range of 9-11%, why isn’t the return between 9% and 11% every year (and, in fact, why does the yearly return fall between 9% and 11% so infrequently)? The simple explanation is that because of the involvement of people, economies and markets – as well as other cyclical phenomena – tend first to overshoot in one direction (and given how people are wired, usually to the upside) and then they are bound to correct in the opposite direction. I think that description is highly relevant to the two topics discussed above.  When markets do too well for a while – that is, when equity returns far exceed the growth rate of companies’ profits, and when bonds return more than their promised yield to maturity – it usually means they’ve become overpriced and will correct sooner or later.  And when an economy expands faster than the potential growth rate determined by its population growth and increases in productivity – usually because companies or consumers borrow, invest or spend to excess – it’s likely to contract eventually.

This combination of elements presents today’s investors with a highly challenging environment. The result is a world in which assets have appreciated significantly, risk aversion is low, and propositions are accepted that would be questioned if investors were more wary. Most of what remains for the meat of this memo will consist of descriptions of things afoot in the markets today. They are intended – as usual with my memos – to be anecdotal and thought- provoking, not complete and scientific. Think about how many of the things listed above you see in the examples that follow. U.S. Equities The good news is that the U.S. economy is the envy of the world, with the highest growth rate among developed nations and a slowdown unlikely in the near term. The bad news is that this status generates demand for U.S. equities that has raised their prices to lofty levels.  The S&P 500 is selling at 25 times trailing-twelve-month earnings, compared to a long-term median of 15.  The Shiller Cyclically Adjusted PE Ratio stands at almost 30 versus a historic median of 16. This multiple was exceeded only in 1929 and 2000 – both clearly bubbles.  While the “p” in p/e ratios is high today, the “e” has probably been inflated by cost cutting, stock buybacks, and merger and acquisition activity. Thus today’s reported valuations, while high, may actually be understated relative to underlying profits.  The “Buffett Yardstick” – total U.S.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us:  Finally, it can be argued that even the normal historic valuations aren’t merited, since economic growth may be slower in the coming years than it was in the post-World War II period when those norms were established. The thing that is clearest is that the low Fed-mandated short-term interest rates make high valuations seem reasonable. When yields are low on fixed income instruments, low earnings yields on equities (that is, low e/p ratios, which equate to high p/e ratios) seem justified. As Buffett said in February, “Measured against interest rates, stocks actually are on the cheap side compared to historic valuations.” But he went on to say, “. . . the risk always is that interest rates go up a lot, and that brings stocks down.” Are you happy counting on continued low interest rates for your investment security, especially at a time when the Fed has embarked upon a series of rate increases? And if interest rates do remain low for several more years, isn’t it likely to be as a result of a lack of vigor in the economy, which would likely cause earnings growth to be sluggish? VIX The value of an option contract is largely a function of the volatility of the asset under option. For example, the owner of a “call” has the right – but not the obligation – to buy something at a fixed “strike price.

Lending people money doesn’t alter their lifetime incomes, meaning consumers may buy fewer boats later, when the loans have to be repaid, causing disposable income to contract. So far, as the last seven years show, (a) central banks haven’t been able to generate the growth they hoped for and (b) the impact of each successive jolt of stimulus seems to have been less powerful. Rather than believing central banks can make economies more productive, it’s my bottom line that there’s a naturally occurring growth rate for each economy, and that rate dictates the long-term output, not central bankers’ actions. © 2016 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved Keynes created his contest to make a point about the stock market. In the short run, beating the market requires the ability to predict which stocks will win the popularity contest among investors. Higher-level thinkers who recognize this dynamic have a head start toward earning the greatest gains. Ben Graham applied the same thinking when he described the market as a “voting machine” in the short run (although he made plain his belief that it’s a “weighing machine” in the long run). The first-level thinker simply looks for the highest-quality company, the best product, the fastest earnings growth or the lowest p/e ratio. He’s ignorant of the very existence of a second level at which to think, and of the need to pursue it. The second-level thinker goes through a much more complex process when thinking about buying an asset. Is it good? Do others think it’s as good as I think it is? Is it really as good as I think it is? Is it as good as others think it is? Is it as good as others think others think it is? How will it change? How do others think it will change? How is it priced given: its current condition; how I think its condition will change; how others think it will change; and how others think others think it will change? And that’s just the beginning. No, this isn’t easy.

Let’s say we want to assess the adequacy of the reward being offered for bearing the credit risk of a given B-rated high yield bond. We compute the yield to maturity or yield to call on the bond and subtract from it the yield to maturity on a Treasury security of the same duration. The result is the “yield spread” or “credit spread.” That spread tells us what the prospective relative return is and – when assessed in the light of historic spreads, the spreads on other bonds, the riskiness of the bond in question, and the spreads on other bonds of similar, lesser or greater riskiness – whether the bond is rich or cheap. Now let’s apply the same process to a stock, or the stock market. First, compute the prospective return on the stock. Oh yeah; right. There’s no way to do that. Or rather there is, but it requires one to either (a) make an assumption about the growth rate of earnings per share to infinity or (b) make an assumption about the growth rate of earnings for a number of years and also the terminal p/e ratio that the market will apply to e.p.s. at the end of that period (which in turn will be a function of the growth of earnings from then to infinity). In other words, a simple mathematical calculation will tell us exactly what the promised return on a bond is (albeit not the probability that it will be received), while coming up with the future return for a stock requires making some massive guesses about the far- off future.

Here are a few of them (I‟ll start by reiterating the above for the sake of completeness): The differential between the S&P earnings yield and the risk-free rate or the yields on bonds – and their ratio – makes stocks look extremely cheap. PRO The attractiveness of these relative valuation parameters is highly dependent on interest rates staying low. CON (or LESS PRO) Relative to normal post-WWII p/e ratios, stock prices are average to slightly low as a multiple of projected earnings for the year ahead. PRO Robert Schiller‟s cycle-adjusted p/e ratios are gaining increased attention, and they suggest full rather than fair valuations. CON Arguably earnings growth in the years ahead will be slower than that which prevailed in the decades following WWII. Thus the post-war valuation norms are too high under the changed circumstances and should be discounted. CON The outlook for earnings is restrained by the questionable macro environment, including the challenges in restarting growth and the dire prognosis for the federal deficit. These problems may not be easily solved. CON Among the things keeping earnings high – and thus making stocks seem attractive – are some of the highest profit margins in history. If profit margins were to move toward normal levels, this © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Prior to the 1950s, common stocks were viewed as a speculative, inferior (i.e., junior) asset class. For that reason, stocks had to pay higher yields than bonds in order to attract buyers; of course a riskier asset should yield more. In fact, most states had laws restricting holdings of stocks in fiduciary portfolios. This attitude toward stocks largely traced from the speculative stock bubble in the 1920s – featuring high-margin buying, bucket shops and shoe shine boys sharing stock tips – which collapsed in the Crash of ’29. Poor economic and market performance stretching from 1929 to the end of World War II further contributed to the skepticism toward stocks. It was only after WW II that economic performance began to support optimism. Brokerage firms led by Merrill, Lynch, Pierce, Fenner and Smith trumpeted the merits of stocks. Equity investing became widespread, and “customers’ men” in local brokerage offices delivered stock investing to a great many households: I remember my mother buying 10 shares of Columbia Gas and 15 shares of Chock Full of Nuts around 1959. I also remember a brochure on “growth stock investing” that Merrill put out in the mid-1960s, touting the desirability of rapid earnings growth and the strength of companies like IBM, Xerox, Avon, Coke, Texas Instruments and Johnson & Johnson. This idea grew into “nifty-fifty” investing, a true mania adopted by many of the large banks, among others.

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 all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present. Jim Grant did a good job of putting a cyclical movement into perspective in the January 31, 2003 issue of Grant’s Interest Rate Observer: Wall Street today is in one of its recurrent sinking spells. Many call it a crisis of confidence, by which they mean under-confidence. Less attention is given to the preceding crisis of overconfidence. Material progress is cumulative, but markets are cyclical. First, investors trust too much, then they doubt too much. They believe that no price is too high to pay for a stock or a bond, then they doubt that any price is too low. So credulity is followed by cynicism, unreasonably high prices by ridiculously low ones. Central banks will try to stabilize economies, and company managers will strive for smooth earnings growth. But as long as human beings determine security prices, market cycles will be the rule, not the exception. The extremes of greed, fear and worry over missing out will never be banished. At times investors will be too risk-tolerant, and at others they’ll be too risk-averse. They’ll forget to inquire skeptically after things have gone well for a while, just as they’ll ask too many questions and hesitate too much when recent events have decimated securities prices (and investors’ psyches).

, and thus to proceed cautiously, with the bar held high in terms of required returns. Finally, we have responded positively to the growing opportunity available to us in serving high net worth investors. While our approach has never included advertising or promotion, we have benefited from word-of-mouth recommendation and from the prominent individuals who first learned of us through institutional relationships. Thus, from $300 million at the end of 1995, our business with HNW investors has grown to $1.1 billion today. For us, Oaktree isn’t a “growth story.” We’ve never had goals in terms of growth rate or assets under management. Rather, we want to serve our clients where we have an advantage. We’ve always been certain that prudent expansion would lead to asset growth, and the results have been most positive: Of our year-end 2004 assets, $5.2 billion (or 19%) was in the five new strategies mentioned above. Our investments outside the U.S. total $7.1 billion, and assets managed for clients based abroad stand at $2.5 billion. Thus, adding in the $1.1 billion in high net worth © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

” If the consensus of investors feels the same, that’s what the spread will be. What if we depart from investment grade bonds? “I’m not going to touch a high yield bond unless I get 600 over a Treasury note of comparable maturity.” So high yield bonds are required to yield 12%, for a spread of 6 percent over the Treasury note, if they’re going to attract buyers. Now let’s leave fixed income altogether. Things get tougher, because you can’t look anywhere to find the prospective return on investments like stocks (that’s because, simply put, their returns are conjectural, not “fixed”). But investors have a sense for these things. “Historically S&P stocks have returned 10%, and I’ll only buy them if I think they’re going to keep doing so.” So in theory, the common stock investor determines earnings per share, earnings growth rate and dividend payout ratio and inputs them into a valuation model to arrive at the price from which S&P stocks will return 10% (although I’m not sure the process is nearly that methodical in actuality). “And riskier stocks should return more; I won’t buy on the NASDAQ unless I think I’m going to get 13%.” From there it’s onward and upward. “If I can get 10% from stocks, I need 15% to accept the illiquidity and uncertainty associated with real estate. And 25% if I’m going to invest in buyouts . . . and 30% to induce me to go for venture capital, with its low success ratio.

 Or maybe it'll become part of the S&P 500, and indexers and closet indexers will have to add it to their portfolios. As always, however, the post mortem is more thorough than the simplistic thought process that preceded it, and the results are a lot less pleasant. Dreams of ever-rising prices aren't enough. Now we know there has to be a reason why prices should rise. Today, cooler heads point out that long-term equity returns are driven by dividends and earnings growth. "Huh?" say the people who entered the market in the late '90s.

© Oaktree Capital Management, L.P. All Rights Reserved present value of the cash flows it will produce in the future, and eventually the market will price the asset to reflect that value, because there are ways to reap it. USo What Makes Stocks Worth More? The equation defining the price of a share of stock is a very simple one: P = E x P/E The price of a share of stock is equal to the earnings per share times the ratio of the stock price to the earnings. On one hand this explains how prices are set, and on the other hand it's just tautological: divide both sides of the equation by E and you get P/E = P/E. Even I can't argue with that one. This gives rise to another simple equation: ∆P = ∆E + ∆P/E Change in price is powered by one or more of the following factors:  increased earnings eventually are turned into Uincreased dividendsU,  the undistributed earnings are reinvested to power future Uearnings growthU, and/or  the likely stream of future earnings comes to be viewed as being worth more than the last price paid, causing an Uincrease in the P/E ratioU. "Growth investors" pursue companies whose earnings are growing the fastest. As per the equation, if the P/E ratio holds, earnings growth will be translated directly into stock price appreciation. And if there's an increase in investor recognition of the company's growth potential, the P/E ratio can expand as well, producing appreciation at a rate that exceeds the rate of earnings growth.

© Oaktree Capital Management, L.P. All Rights Reserved UThe Outlook for Equity Returns Clearly, equity returns primarily come from price appreciation. And the dominant consideration in long-term appreciation is earnings growth. Why do I say "long term appreciation"? Because even though P/E ratios jump around much more in the short run than do earnings, they tend to move within relatively fixed boundaries and, in the long run, their fluctuations should cancel out. The simple view – which I tend to take – is that P/E ratios reached ridiculous levels in the 1990s and now, even after significant price declines, still are higher in absolute terms than they were at many previous market tops. Thus, you can assume that P/E ratios will stay where they are, and thus that earnings growth will translate into parallel price appreciation. Or you can assume multiple contraction, in which case appreciation will lag earnings gains. But I doubt that a prudent investor can count on P/E ratio expansion as a source of future stock price appreciation. Thus, any positive returns will be determined primarily by the rate of earnings growth. Over the years I've quoted Warren Buffett as saying something like "people get into trouble when they forget that corporate profits tend to grow at 9% a year." In September I had a chance to ask him if he actually said that.

© Oaktree Capital Management, L.P. All Rights Reserved. What about people – like those of us at Oaktree – who don’t consider themselves macro forecasters or market timers? Even the most devoted value investor acts on the basis of expectations: that an asset selling at x will turn out to be worth 2x, and that one of these days everyone else will recognize its value and bid it up. And the agnostic buy-and-hold equity investor operates under the assumption that the economy will expand, companies will increase their profits, and stock prices will rise as a result. Let’s say investors reach their conclusions about current intrinsic value or future earnings growth by applying skillful analysis to accurate data and reasonable assumptions. Let’s grant, in short, that their conclusions are “right” in some abstract sense. It still takes a great deal of luck for their version of future events to materialize. Elroy Dimson of the London Business School is responsible for one of the most trenchant observations: “Risk means more things can happen than will happen.” In other words, the future isn’t a predetermined scenario that’s sure to unfold, but rather a range of possibilities, any one of which may happen. Investors formulate opinions as to which of them will happen. Those opinions may be well-reasoned or dart throws. But even the most rigorously derived view of the future is far from sure to be right. Many other things may happen instead.

They're organic entities, and they have life cycles of their own. Most companies are born in an entrepreneurial mode, starting with dreams, limited capital and the need to be frugal. `Success comes to some. They enjoy profitability, growth and expanded resources, but they also must cope with increasing bureaucracy and managerial challenges. The lucky few become world-class organizations, but eventually most are confronted with challenges relating to hubris; extreme size; the difficulty of controlling far-flung operations; and perhaps ossification and an unwillingness to innovate and take risks. Some stagnate in maturity, and some fail under aging products or excessive debt loads and move into distress and bankruptcy. The reason I say failure carries within itself the seeds of success is that bankruptcy then permits some of them to shed debt and onerous contracts and emerge with a reborn emphasis on frugality and profitability. And the cycle resumes . . . as ever. The biggest mistakes I have witnessed in my investing career came when people ignored the limitations imposed by the corporate life cycle. In short, investors did assume trees could grow to the sky. In 1999, just as in 1969, investors accepted that ultra-high profit growth could go on forever. They also concluded that for the stocks of companies capable of such growth, no p/e ratio was too high. People extrapolated earnings growth of 20%-plus and paid p/e ratios of 50-plus.

© Oaktree Capital Management, L.P. All Rights Reserved The exigencies of the corporate life cycle usually render ultra-high growth rates unsustainable. Regardless of the improbability, however, investors indulge in "the willing suspension of disbelief" (which I always bring to the movies but check at the door when I come to work). They assume that successful companies will be able to attract enough talent, develop enough new products, access enough new markets, fend off competition while protecting high profit margins, and correctly make the strategic adaptations needed to keep growing . . . but it rarely works that way. In February an article in Fortune magazine, covering 1960-80, 1970-90 and 1980-99, showed that out of 150 candidates among large companies, only four or five in each period were able to grow earnings per share at 15% per year on average. Only one, Philip Morris, grew at that rate for all three periods. The key for Philip Morris wasn't a technological miracle or a fabulous new growth product; it was solid blocking and tackling in areas of stable consumer demand. So the latest "wonder-company" with a unique product rarely possesses the secret of rapid growth forever. I think it's safer to expect a company's growth rate to regress toward the mean than it is to expect perpetual motion. UBusiness Fads and Fancies We all laugh about hemlines, which fluctuate from year to year and add nothing to society but cost.

© Oaktree Capital Management, L.P. All Rights Reserved Their model called for higher equity allocations, predicting that they would lead to higher overall returns on the portfolio UandU lower risk. Why? Because equities were projected to return 14% and risk was defined as the probability of failing to average 8% over a five- year period. First, I said, I would never have any part in a process that equated higher equity allocations with lower risk. I suggested that risk be defined as overall portfolio volatility, and that took care of that. But second, I questioned the 14% projected return from equities. Equities returned 28% in 1995-99, I said; did someone think halving that made for a conservative projection? No, I was told, the support mostly came-from the 13% long-run return on equities:--(I always thought it was 10% or so, but it seems the last five years have changed all that.) I could only think of one way to respond: I offered to put up my money against that of the consultant's researchers and “take the under.” I doubt strongly that equities will return 14% or anything like it in the next decade. Corporate earnings have traditionally grown at single-digit rates, and I don't feel that's about to change substantially. With p/e ratios unlikely to rise further and dividends immaterial, single-digit earnings growth should translate into single-digit average equity performance at best for the foreseeable future.

© Oaktree Capital Management, L.P. All Rights Reserved 2) Most accounts of the developments in Asia touch on overcapacity, on stiffened competition from Asian exporters whose prices are now lower in dollar terms because of devaluations, and on the possibility of deflation in the U.S. Even Chairman Greenspan thought enough of deflation to mention it last Saturday. And yet, who really knows what these things might mean for economies and companies around the world? In short, is deflation good or bad? How can you feel comfortable if you can't answer these questions? 3) A reading of the newspapers in the last few months discloses a steady drumbeat of earnings disappointments and revived restructurings and layoffs. How strong is our economy? Are cost increases putting pressure on profits? How much will earnings growth slow down? These are all questions that indicate that negatives are present in our investment environment. But they're always there -- sometimes obvious and sometimes not. Prices near highs and optimism in bloom -- that's a dangerous combination, especially with perceived risk on the rise. Peter Bernstein wrote around 1979 that "The great buying opportunities ... are never made by investors whose happiest hopes are daily being realized." And yet many of today's investors have only known success, and few appear seriously chastened by recent developments.