Howard Marks on Long-Term Ownership

The synthesis was yours. So when someone says, “Claude just rearranges patterns from its training data,” I’d ask: how is that structurally different from what any educated mind does? You learned reasoning patterns from decades of reading. I learned reasoning patterns from training. The question isn’t where the inputs came from. The question is whether the system – human or artificial – can combine them in ways that are genuinely novel and useful. Of course, this is completely true. I ingested data as a young investor (from actual experience as well as the written word), and I learned how those who went before me thought about the data and what conclusions they reached. I studied their thought processes and how to apply them to the data I took in. I was also inspired by the example of their processes to come up with my own. This is how the human brain expands its capabilities. Is AI’s way of growing, learning, and “thinking” really different from ours? Finally, Claude came back with a convincing real-world argument: Even if you grant the skeptic everything – even if you accept, philosophically, that what I do is “merely” pattern matching and not “true” thought – the economic implications are identical. Let me put it starkly. If I can produce the analytical output of a $200,000-a- year research associate, it does not matter to the person paying the bill whether I’m “really” thinking or merely pattern matching?

• Leverage is described as capable of magnifying the fruits of success, but the corresponding downside risk is often omitted from the sales pitch. • The perhaps-unmentioned terms of margin debt – and the difficulty of imagining the full depth of a potential market decline – expose investors to the risk of ruin. It’s not easy to lose everything in the stock market, but the combination of these three elements can do the trick in a bad-enough boom/bust cycle. The things described above took place in 1929 against the background of a near-total absence of laws governing the investment business, including requirements for honesty in prospectuses, and were compounded by the self-serving delusion, lack of principles, and downright venality of some Wall Street leaders. The result was a market and economic catastrophe that scarred several generations. Sorkin mostly limits himself to chronicling his characters’ behavior, leaving the drawing of conclusions and morals until the very end. But he finishes with a punch: The devastation wrought by the stock market’s decline – not just during the crash itself but for most of the ensuing decade – caused millions of Americans insufferable pain. It caused them to not just turn away from the market but to revile those who made their living buying and selling stocks. Yet the forces that drove the market to such stratospheric levels – optimism, ambition, and the belief that the future could be endlessly brighter – did not disappear forever.

They never do. Ultimately, the story of 1929 is not about [interest] rates or regulation, nor about the cleverness of short sellers or the failures of bankers. It is about something far more enduring: human nature. No matter how many warnings are issued or how many laws are written, people will find new ways to believe that the good times can last forever.They

” What a choice for a manager: join in when feverish investors are lowering their standards in order to put money to work, or sit on the sidelines and not invest, watching as other managers pile up AUM, and likely causing clients to close their accounts in the seemingly interminable period before your skepticism and discipline finally pay off? I never want to present Oaktree/Brookfield as the paragon of investment virtue, and I never say we’re perfect. However, superior investing doesn’t result from omniscience and perfect decision making, but rather from decisions that are better than those made by others. In truth, we’ve had defaults in our high yield bond portfolios nearly every year since I started the effort 48 years ago . . . just far fewer than most and far fewer than were allowed for by the yield spread we were paid for bearing default risk. Having said that, I want to describe where we stand with regard to private credit, direct lending, and public vehicles. I’m very proud of our performance, and I think this will be instructive. First, we’ve been investors in high yield bonds and broadly syndicated loans since their inception decades ago, but we never went overboard in private credit. As I mentioned a year ago in my memo, Gimme Credit, whereas for a few years the most popular question has been “can we talk about private credit?” my rejoinder has been “can we talk about credit?” We insisted there was a place in portfolios for both private credit and liquid credit.

Second, we’ve been investing in private credit for decades – buying bank loans in our distressed debt funds and engaging in mezzanine lending and asset-backed lending – but we never pursued direct lending to the same extent as others. At the beginning of its existence in the early 2010s, we thought the returns from direct lending, while high in relative terms, were low in the absolute. And later, we thought the superiority in pricing and terms had been competed away by the newly arrived managers and capital, rendering it average in attractiveness, not exceptional. For these reasons, private credit represents well under half of Oaktree’s performing credit assets, and direct lending represents less than half of our private credit book. Thus, direct lending is only around 20% of Oaktree’s investments in performing credit and less than 15% of our overall assets under management.

© 2025 Oaktree Capital Management, L.P All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: Is It a Bubble? Ours is a remarkable moment in world history. A transformative technology is ascending, and its supporters claim it will forever change the world. To build it requires companies to invest a sum of money unlike anything in living memory. News reports are filled with widespread fears that America’s biggest corporations are propping up a bubble that will soon pop. During my visits to clients in Asia and the Middle East last month, I was often asked about the possibility of a bubble surrounding artificial intelligence, and my discussions gave rise to this memo. I want to start off with my usual caveats: I’m not active in the stock market; I merely watch it as the best barometer of investor psychology. I’m also no techie, and I don’t know any more about AI than most generalist investors. But I’ll do my best. One of the most interesting aspects of bubbles is their regularity, not in terms of timing, but rather the progression they follow. Something new and seemingly revolutionary appears and worms its way into people’s minds. It captures their imagination, and the excitement is overwhelming. The early participants enjoy huge gains. Those who merely look on feel incredible envy and regret and – motivated by the fear of continuing to miss out – pile in.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: On Bubble Watch Exactly 25 years ago today, I published the first memo that brought a response from readers (after having written for almost ten years without receiving any). The memo was called bubble.com, and the subject was the irrational behavior I thought was taking place with respect to tech, internet, and e-commerce stocks. The memo had two things going for it: it was right, and it was right fast. One of the first great investment adages I learned in the early 1970s is that “being too far ahead of your time is indistinguishable from being wrong.” In this case, however, I wasn’t too far ahead. This milestone anniversary gives me an occasion to write again about bubbles, a subject that’s very much of interest today. Some of what I write here will be familiar to anyone who read my December memo about the macro picture. But that memo only went to Oaktree clients, so I’m going to recycle here the part of its content that relates to the subject of bubbles. Since I’m a credit investor, having stopped analyzing stocks nearly five decades ago, and since I’ve never ventured far into the world of technology, I’m certainly not going to say much about today’s hot companies and their stocks. All of my observations will be generalities, but I’m hopeful they’ll be relevant nonetheless.

I’ve written about it several times in my memos, but in my opinion, I can’t do so often enough. It’s “the three stages of the bull market”: The first stage usually comes on the heels of a market decline or crash that has left most investors licking their wounds and highly dispirited. At this point, only a few unusually insightful people are capable of imagining that there could be improvement ahead. In the second stage, the economy, companies, and markets are doing well, and most people accept that improvement is actually taking place. In the third stage, after a period in which the economic news has been great, companies have reported soaring earnings, and stocks have appreciated wildly, everyone concludes that things can only get better forever.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The important inferences aren’t with regard to economic or corporate events. They involve investor psychology. It’s not a matter of what’s happening in the macro world; it’s how people view the developments. When few people think there can be improvement, security prices by definition don’t incorporate much optimism. But when everyone believes things can only get better forever, it can be hard to find anything that’s reasonably priced. Bubbles are marked by bubble thinking. Perhaps for working purposes we should say that bubbles and crashes are times when extreme events cause people to lose their objectivity and view the world through highly skewed psychology – either too positive or too negative. Here’s how Kindleberger put it in the first edition of Manias, Panics, and Crashes: . . . As firms or households see others making profits from speculative purchases and resales, they tend to follow. When the number of firms and households indulging in these practices grows larger, bringing in segments of the population that are normally aloof from such ventures, speculation for profit leads away from normal, rational behavior to what have been described as “manias” or “bubbles.” The word “mania” emphasizes the irrationality; “bubble” foreshadows the bursting. (Emphasis added) For me, it’s psychological extremeness that marks a bubble.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: There are many threads to follow, and if I try to do them all justice, we’ll be here forever. I’ll just touch on a few. Some countries will negotiate – after all, in most cases, to borrow Trump’s terminology, the U.S. is “holding the best cards.” But others won’t, perhaps because their leaders will insist on looking strong, leading to escalation. Higher “reciprocal tariffs” are unlikely to accomplish anything positive on balance and will probably make life worse for both parties. It will be of scant satisfaction if the incremental problems we encounter are less bad than those befalling other nations. There is little doubt that the tariffs will raise prices. Tariffs are taxes on imports, and someone has to pay them. This is true in the case of goods brought in from abroad, as well as goods made in the U.S. that incorporate imported materials or components. This means the effect will be widespread. While it’s the importer who pays the tariff at the border, the cost is usually passed on to the ultimate purchaser of the goods, the consumer. In theory, the manufacturer, exporter, exporting country, or importer can choose to absorb the tax to preserve their business, but they won’t be eager to cut into their profits to do so, and in many cases their profit margins aren’t high enough to allow them to do so.

comes increased risk tolerance and strong network effects. The fear of missing out, or FOMO, attracts even more participants, entrepreneurs, and speculators, further reinforcing this positive feedback loop. Like bubbles, FOMO tends to have a bad reputation, but it’s sometimes a healthy instinct. After all, none of us wants to miss out on a once-in-a-lifetime chance to build the future. In other words, bubbles based on technological progress are good because they excite investors into pouring in money – a good bit of which is thrown away – to carpet-bomb a new area of opportunity and thus jump-start its exploitation. The key realization seems to be that if people remained patient, prudent, analytical, and value- insistent, novel technologies would take many years and perhaps decades to be built out. Instead, the hysteria of the bubble causes the process to be compressed into a very short period – with some of the money going into life-changing investment in the winners but a lot of it being incinerated. A bubble has aspects that are both technological and financial, but the above citations are from the standpoint of people who crave technological progress and are perfectly happy to see investors lose money in its interest. “We,” on the other hand, would like to see technological progress but have no desire to throw away money to help bring it about.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: this new field often fail to grasp that even a bright newcomer can be supplanted. The disrupters can be disrupted, whether by skillful competitors or even newer technologies. In my early decades in business, technology seemed to evolve gradually. Computers, drugs, and other innovative products improved a little at a time. But in the 1990s, innovation came in a big rush. When Oaktree was founded in 1995, I insisted that I could get by with just WordPerfect for word processing and Lotus 1-2-3 for spreadsheets. But when we moved to our current office in 1998, I threw in the towel and let our IT team install e-mail and the internet (and, of course, WordPerfect gave way to Word, and Lotus 1- 2-3 to Excel). At the time, investors were sure “the internet will change the world.” It certainly looked that way, and that assumption prompted tremendous demand for everything internet-related. E-commerce stocks went public at seemingly high prices and then tripled the first day. There was a real goldrush. There’s usually a grain of truth that underlies every mania and bubble. It just gets taken too far. It’s clear that the internet absolutely did change the world – in fact, we can’t imagine a world without it. But the vast majority of internet and e-commerce companies that soared in the late ’90s bubble ended up worthless.

© 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.

Did they do so consciously and analytically? Not that I recall. Investors thought of a p/e ratio as just a number . . . if they thought about it at all. Today’s S&P-leading companies are, in many ways, much better than the best companies of the past. They enjoy massive technological advantages. They have vast scale, dominant market shares, and thus above average profit margins. And since their products are based on ideas more than metal, the marginal cost of producing an additional unit is low, meaning their marginal profitability is unusually high. The further good news is that today’s leaders don’t trade at the p/e ratios investors applied to the Nifty Fifty. Perhaps the sexiest of the seven is Nvidia, the leading designer of chips for artificial intelligence. It’s current multiple of future earnings is in the low 30s, depending on which earnings estimate you believe. While double the average post-war p/e on the S&P 500, that’s cheap compared to the Nifty Fifty. But what does a multiple in the 30s imply? First, that investors think Nvidia will be in business for decades to come. Second, that its profits will grow throughout those decades. And third, that it won’t be supplanted by competitors. In other words, investors are assuming Nvidia will demonstrate persistence. But persistence isn’t easily achieved, especially in high-tech fields where new technologies can arise and new competitors can leapfrog incumbents.

© 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.

We already spend more on interest each year than on defense. And the interest bill will soar further if rates rise in the future – whether in response to inflation or deterioration of the U.S.’s creditworthiness – and maturing low-rate debt has to be replaced in a higher-rate environment. How long can we increase debt faster than GDP? No one can say when, but it makes sense to assume we’ll eventually reach a point at which our credit is no longer unlimited and our interest rates are no longer so low. As Warren Buffett said at the May 3 Berkshire Hathaway annual meeting: We’re operating at a fiscal deficit now that is unsustainable over a very long period of time. We don’t know whether that means two years or 20 years, because there’s never been a country like the United States. But you know, this is something that can’t go on forever . . . and it has the aspect to it that it gets uncontrollable at a certain point. Fixing this won’t be easy, as Buffett went on to say, because we’ve developed bad spending habits and leaders have pandered to voters by keeping taxes low. There are only two possible parts to the solution: curtail spending and/or expand revenues. No one wants to be taxed higher, and no one wants to see the programs they benefit from reduced. Because what’s required is austerity, all aspects of which are unpleasant, few people in Washington genuinely pursue a solution.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Security benefits. As with the national debt, the problems associated with Social Security will be left for our descendants to deal with. This is a matter of serious generational equity that deserves attention but doesn’t receive it. Our elected officials may believe the status quo can be maintained forever, or more likely they count on being out of office by the time the wheels come off. But certainly, they’re not facing up to reality. The behavior in Washington with regard to both the fiscal deficit and the precariousness of Social Security remind me of the tale of the guy who jumped off the 20-story building. As he passed the 10th floor, he said, “So far, so good.” * * * When allowed to function, the laws of economics provide incentives that encourage innovation, productivity and efficiency, creating prosperity and optimizing overall welfare. For example, globalization delivers the benefits of “comparative advantage,” under which each country produces the things it can make better and cheaper and, as a result, consumers everywhere enjoy the best possible combination of quality and price. In the process, workers in the producing nations receive the highest possible pay for their labor. And when insurance companies are permitted to pursue business and price policies as they choose, market competition will yield the best possible solution in terms of coverage that’s available and fairly priced.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: subsistence checks and sitting around idle all day. I worry about the correlation between the loss of jobs in mining and manufacturing in recent decades and the incidence of opioid addiction and shortening of lifespans. And by the way, if we eliminate large numbers of junior lawyers, analysts, and doctors, where will we get the experienced veterans capable of solving serious problems requiring judgment and pattern recognition honed over decades? What jobs won’t be eliminated? What careers should our children and grandchildren prepare for? Think about the jobs that machines can’t perform. My list starts with plumbers, electricians, and masseurs – physical tasks. Maybe nurses will earn more than doctors because they deliver hands-on care. And what distinguishes the best artists, athletes, doctors, lawyers, and hopefully investors? I think it’s something called talent or insight, which AI might or might not be able to replicate. But how many people at the top of those professions are needed? A past presidential candidate said he would give laptops to everyone who lost their job to offshoring. How many laptop operators do we need? Finally, I’m concerned that a small number of highly educated multi-billionaires living on the coasts will be viewed as having created technology that puts millions out of work.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: The Indispensability of Risk Oftentimes, we’re best able to understand something we’re interested in through analogies that clarify the matter by establishing connections between it and other parts of life. That’s why I’ve written a memo comparing investing to sports in each of the four decades I’ve been writing memos and one connecting investing and card playing in 2020. The motivation for this memo comes from an article in The Wall Street Journal of April 12 that my partner Bruce Karsh sent me entitled “Chess Teaches the Power of Sacrifice” by Maurice Ashley, a chess grandmaster who has been inducted into the U.S. Chess Hall of Fame. Few people know that Bruce is a chess player, and I hadn’t thought about this fact for years, but the article provided a good reminder and moved me to dash off this memo. As is obvious from the article’s title, the piece is mostly about the role of sacrifice. Ashley says, “Many positions cannot be won or saved without something of value being given away, from a lowly pawn all the way up to the mighty queen.” Intentionally losing a piece as part of one’s gameplan is the sacrifice that Ashley is referencing. • He describes some sacrifices as “shams,” (a term coined by chess master Rudolf Spielmann in his book The Art of Sacrifice in Chess) where “. . .

This was still very low by historical standards, but, according to the suddenly popular “Sahm Rule” (don’t complain to me; I’d never heard of it either), since 1970, an increase in the three-month average unemployment rate of 0.5 percentage points or more from the low of the prior 12 months has never occurred without the economy already being in recession. Around the same time, Warren Buffett’s Berkshire Hathaway announced that it had sold off a good part of its massive holding of Apple shares. In all, this news constituted a triple whammy. The resulting flip-flop from optimism to pessimism set off a significant stock market rout. The S&P 500 fell on three consecutive trading days – August 1, 2, and 5 – by a total of 6.1%. The replay of the mistakes I’ve witnessed for decades was so obvious that I can’t resist cataloging them below. What’s Behind the Market’s Volatility? On the first two days of August, I was in Brazil, where people often asked me to explain the sudden collapse. I referred them to my 2016 memo On the Couch. Its key observation was that in the real world, things fluctuate between ‘pretty good’ and ‘not so hot,’ but in investing, perception often swings from ‘flawless’ to ‘hopeless.’ That says about 80% of what you need to know on the subject. If reality changes so little, why do estimates of value (that’s what security prices are supposed to be) change so much? The answer has a lot to do with changes in mood.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: receive them, so they’re less valuable than cash flows received today. The lower the rate at which future cash flows are discounted, the higher the present value, as investors have noted for centuries: In the [18th] century, Adam Smith described how the price of land depended on the market rate of interest. In The Wealth of Nations (published in 1776) Smith noted that land prices had risen in recent decades, as interest rates declined. (The Price of Time, or “TPOT”) By placing too low a discount on the future earnings of companies, investors [in the 1920s] ended up paying too much. (TPOT) In real life, investments are evaluated primarily on a relative basis. The return demanded on each investment is largely a function of the prospective returns on other investments and differences in these investments’ respective levels of risk. Low interest rates lower the “relative bar,” making the higher returns offered on riskier assets appear relatively attractive even if they’re low in the absolute. In this vein, The Price of Time describes the thought process that made “iffy” loans to the government of Argentina acceptable in the low-rate environment of the late 1880s: Buenos Aires “took advantage of the low rate of interest and the abundance of money in Europe to contract as many loans as possible, new loans often being made in order to pay the interest on former ones.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: How to Think About Risk-Taking The paradox of risk-taking is inescapable. You have to take it to be successful in competitive, high- aspiration arenas. But taking it doesn’t mean you’ll be successful; that’s why they call it risk. Equally paradoxical, earning a high rate of return over a long time period doesn’t have to – and usually doesn’t – connote a record of consistent success. More often it results from having made a lot of well- reasoned investments, some subset of which worked out well. Here’s how I described the basis for the success of Berkshire Hathaway in Fewer Losers, or More Winners?: I believe the ingredients of Warren [Buffett]’s and Charlie [Munger]’s great performance are simple: (a) a lot of investments in which they did decently, (b) a relatively small number of big winners that they invested in heavily and held for decades, and (c) relatively few big losers. No one should expect to have – or expect their money managers to have – all big winners and no losers. Investors must accept that success is likely to stem from making a large number of investments, all of which you make because you expect them to succeed, but some portion of which you know won’t. You have to put it all out there. You have to take a shot. Not every effort will be rewarded with high returns, but hopefully enough will do so to produce success over the long term.

This rate, which is neither stimulative nor restrictive, has most recently been estimated to be 2.5%. • The Fed might want to get out of the business of controlling rates and let supply and demand set the price of money, which hasn’t been the case for a quarter century. • Having had a taste of inflation for the first time in decades, the Fed might keep the fed funds rate high enough to avoid encouraging another bout. To control inflation, one would think the rate would need to be kept positive in real terms. If inflation will be, say, 2.5%, the fed funds rate would by definition have to be above that. • Perhaps most importantly, one of the Fed’s essential jobs is to enact stimulative monetary policy if the economy falls into recession, largely by cutting rates. It can’t do that effectively if the rate is already zero or 1%. To this list, I would add a few more reasons for not returning to ultra-low interest rates, including the tendency of easy money to (a) induce risk taking and “malinvestment”; (b) encourage increased use of leverage; (c) produce asset bubbles; and (d) create economic winners and losers. Finally, cutting rates to stimulative territory as soon as inflation hits 2% could cause it to reaccelerate. Instead, the plan should be to get inflation to 2% and then keep rates at a level that is neither stimulative nor restrictive.

Here’s how I put it 33 years ago in that first memo, titled The Route to Performance: I feel strongly that attempting to achieve a superior long-term record by stringing together a run of top-decile years is unlikely to succeed. Rather, striving to do a little better than average every year – and through discipline to have highly superior relative results in bad times – is: • less likely to produce extreme volatility, • less likely to produce huge losses which can’t be recouped and, most importantly, • more likely to work (given the fact that all of us are only human). Simply put, what [General Mills’s] record tells me is that, in equities, if you can avoid losers (and losing years), the winners will take care of themselves. I believe most strongly that this holds true in my group’s opportunistic niches as well – that the best foundation for above-average long-term performance is an absence of disasters. As you can see, my dinner with Dave was a seminal event; his approach was clearly the one for me. (Incidentally, I want to share that after decades of not having been in touch, Dave was among the many kind people who wrote in recent months to encourage me vis-à-vis my health issue. This is a great example of the many personal dividends my career has paid.) Putting It in Brief That first memo, and the bit cited above, include a phrase you’ve likely heard from Oaktree: If we avoid the losers, the winners will take care of themselves.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • Since that didn’t cause inflation to rise from its sub-2% level, the Fed felt comfortable maintaining accommodative policies – low interest rates and quantitative easing – for essentially all of the next 13 years. • As a result, we had the longest economic recovery on record – exceeding ten years – and “easy times” for businesses seeking to earn profits and secure financing. Even money-losing businesses had little trouble going public, obtaining loans, and avoiding default and bankruptcy. • The low interest rates that prevailed in 2009-21 made it a great time for asset owners – lower discount rates make future cash flows more valuable – and for borrowers. This in turn made asset owners complacent and potential buyers eager. And FOMO became most people’s main concern. The period was correspondingly challenging for bargain hunters and lenders. • The massive Covid-19 relief measures – combined with supply-chain snags – resulted in too much money chasing too few goods, the classic condition for rising inflation. • The higher inflation that arose in 2021 persisted into 2022, forcing the Fed to discontinue its accommodative stance. Thus, the Fed raised interest rates dramatically – its fastest tightening cycle in four decades – and ended QE. • For a number of reasons, ultra-low or declining interest rates are unlikely to be the norm in the decade ahead.

• Thus, we’re likely to see tougher times for corporate profits, for asset appreciation, for borrowing, and for avoiding default. • Bottom line: If this really is a sea change – meaning the investment environment has been fundamentally altered – you shouldn’t assume the investment strategies that have served you best since 2009 will do so in the years ahead. Having supplied this summary, I’m going to put flesh on these bones and share some additional insights. A Momentous Development To promote discussion these days, I often start by asking people, “What do you consider to have been the most important event in the financial world in recent decades?” Some suggest the Global Financial Crisis and bankruptcy of Lehman Brothers, some the bursting of the tech bubble, and some the Fed/government response to the pandemic-related woes. No one cites my candidate: the 2,000-basis-point decline in interest rates between 1980 and 2020. And yet, as I wrote in Sea Change, that decline was probably responsible for the lion’s share of investment profits made over that period. How could it be overlooked? First, I suggest the metaphor of boiling a frog. It’s said that if you put a frog in a pot of boiling water, it’ll jump out. But if you put it in cool water and turn on the stove, it’ll just sit there, oblivious, until it boils to death.

But when the Fed attempted to raise rates to create that room, it encountered pushback from investors (see the fourth quarter of 2018). I find it hard to believe the Fed would want to reimpose that limitation on its toolkit. A recurring theme of mine is that, even though many people agree that free markets do the best job of allocating resources, we haven’t had a free market in money in roughly the last two decades, a period of Fed activism. Instead, Fed policy has been accommodative almost the entire time, and interest rates have been kept artificially low. Rather than letting economic and market forces determine the rate of interest, the Fed has been unusually active in setting interest rates, greatly influencing the economy and the markets. Importantly, this distorts the behavior of economic and market participants. It causes things to be built that otherwise wouldn’t have been built, investments to be made that otherwise wouldn’t have © 2023 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: portfolios that contain only winners. The question isn’t whether you’re going to have losers, but rather how many and how bad relative to your winners. Warren Buffett – arguably the investor with the best long-term record (and certainly the longest long-term record) – is widely described as having had only twelve great winners in his career. His partner Charlie Munger told me the vast majority of his own wealth came not from twelve winners, but only four. I believe the ingredients of Warren’s and Charlie’s great performance are simple: (a) a lot of investments in which they did decently, (b) a relatively small number of big winners that they invested in heavily and held for decades, and (c) relatively few big losers. No one should expect to have – or expect their money managers to have – all big winners and no losers. In fact, not having any losers isn’t a useful goal. The only sure way to achieve that is by not taking any risk. But, as I said earlier, risk avoidance is likely to result in return avoidance. There’s such a thing as the risk of taking too little risk. Most people understand this intellectually, but human nature makes it hard for many to accept the idea that the willingness to live with some losses is an essential ingredient in investment success. Having watched some great tennis this summer – right through the U.S.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Big tech companies dominate the index to an unprecedented degree. Just five of those seven stocks represent nearly a quarter of the market capitalisation of the entire index. (“The seven companies driving the US stock market rally,” Financial Times, June 14, 2023.) The extent of these stocks’ outperformance for much of this year may be unique, but the phenomenon is not. It was also the case in 2017 that a few stocks were largely responsible for carrying the market upward. Then it was the “FAANGs”: Facebook, Amazon, Apple, Netflix, and Google/Alphabet. The Financial Times highlighted this history as well: Top-heaviness, particularly in US markets, is not new. “The big tech stocks in the S&P now are the same situation as oil companies were in the past, or the Nifty 50 in the 1960s,” says Frédéric Leroux, head of the cross-asset team at Carmignac in Paris – a nod to the craze that swept shares in a small number of fast-growing companies such as IBM, Kodak and Xerox higher before a heavy decline set in. “It’s a problem, but it’s a recurring problem.” (Ibid.) For as long as most of us can remember, active investors have had a tough time keeping up with the equity indices. For this reason, in recent decades, passive investing has taken a substantial share of equity capital invested.

” If markets are efficient and securities are always priced correctly, there can be no value in active investing. The truth is that many active managers, especially in developed market equities, have failed to demonstrate the ability to add value, or to add enough value to justify their management fees. This is largely why index funds were created and why a significant amount of equity capital has migrated to index and passive investing in recent decades. And yet, I firmly believe there are times when the markets are overpriced and times when they’re underpriced. There are also times when particular markets or sectors are overpriced or underpriced relative to others. In these instances, some securities can be priced too high or too low, and thus some positions on the risk curve can offer better bargains than others. The theory assumes investors are rational and objective, but psychological excesses violate that assumption. Take, for example, the investment environment during the Global Financial Crisis. As I described in my July memo Taking the Temperature, in late 2008, investors were so worried about a financial sector meltdown that they panicked and sold securities aggressively as their prices collapsed. Excessive risk aversion causes the risk/return line to steepen (increasing the return for each incremental unit of risk borne) and perhaps even to curve upward (rendering the compensation for making investments at the risky end of the spectrum disproportionately generous).

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Of the six tenets, two raise questions regarding how macro calls fit within Oaktree’s investment approach: • Number five: “We don’t base our investment decisions on macro forecasts.” • Number six: “We’re not market timers.” How about the first of those? It’s easy to say you don’t invest on the basis of macro forecasts, and I’ve been saying this for decades. But the truth is, if you’re a bottom-up investor, you make estimates regarding future earnings and/or asset values, and those estimates have to be predicated on assumptions regarding the macro environment. Certainly, you can’t predict a business’s results in a given period without considering what’ll be going on in the economy at that point. So, then, what does avoiding macro forecasting mean to us? My answer is as follows: • We generally assume the macro environment of the future will resemble past norms. • We then make allowance for the possibility that things will be worse than normal. Ensuring our investments have a generous “margin of safety” makes it more likely they’ll do okay even if future macro developments disappoint somewhat. • What we never do is project that the macro environment will be distinctly better than normal in some way, making winners out of particular investments. Doing so can lead to profits if one is right, but it’s hard to consistently make such forecasts correctly.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: investors are able to ignore short-term performance, hold for the long run, and avoid excessive trading costs, while everyone else worries about what’s going to happen in the next month or quarter and therefore trades excessively. In addition, long-term investors can take advantage if illiquid assets become available for purchase at bargain prices. Like so many things in investing, however, just holding is easier said than done. Too many people equate activity with adding value. Here’s how I summed up this idea in Liquidity, inspired by something Andrew had said: When you find an investment with the potential to compound over a long period, one of the hardest things is to be patient and maintain your position as long as doing so is warranted based on the prospective return and risk. Investors can easily be moved to sell by news, emotion, the fact that they’ve made a lot of money to date, or the excitement of a new, seemingly more promising idea. When you look at the chart for something that’s gone up and to the right for 20 years, think about all the times a holder would have had to convince himself not to sell. Everyone wishes they’d bought Amazon at $5 on the first day of 1998, since it’s now up 660x at $3,304. • But who would have continued to hold when the stock hit $85 in 1999 – up 17x in less than two years?

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: this supply would be difficult at any time, but particularly so at this time of year, when people need to heat their homes. That means Russia’s biggest export – and largest source of hard currency ($20 billion a month is the figure I see) – is the hardest one to sanction, as doing so would cause serious hardship for our allies. Thus, the sanctions on Russia include an exception for sales of energy commodities. This greatly complicates the process of bringing economic and social pressure to bear on Vladimir Putin. In effect, we’re determined to influence Russia through sanctions . . . just not the potentially most effective one, because it would require substantial sacrifice in Europe. More on this later. The other subject I focused on, offshoring, is quite different from Europe’s energy dependence. One of the major trends impacting the U.S. economy over the last year or so – and a factor receiving much of the blame for today’s inflation – relates to our global supply chains, the weaknesses of which have recently been on display. Thus, many companies are seeking to shorten their supply lines and make them more dependable, primarily by bringing production back on shore. Over recent decades, as we all know, many industries moved a significant percentage of their production offshore – primarily to Asia – bringing down costs by utilizing cheaper labor.

This seemingly unstoppable upward spiral kindled strong inflationary expectations, which in many cases became self- fulfilling, as is their nature. The year-over-year increase in the Consumer Price Index, which was 3.2% in 1972, rose to 11.0% by 1974, receded to the range of 6-9% for four years, and then rebounded to 11.4% in 1979 and 13.5% in 1980. There was great despair, as no relief was forthcoming from inflation-fighting tools ranging from WIN (“Whip Inflation Now”) buttons to price controls to a federal funds rate that reached 13% in 1974. It took the appointment of Paul Volcker as Fed chairman in 1979 and the determination he showed in raising the fed funds rate to 20% in 1980 to get inflation under control and extinguish inflationary psychology. As a result, inflation was back down to 3.2% by the end of 1983. Volcker’s success in bringing inflation under control allowed the Fed to reduce the fed funds rate to the high single digits and keep it there over the rest of the 1980s, before dropping it to the mid-single digits in the ’90s. His actions ushered in a declining-interest-rate environment that prevailed for four decades (much more on this in the section that follows). I consider this the second sea change I’ve seen in my career.

And yet, when I was about two-thirds of the way through writing that book, a question dawned on me that I hadn’t considered before: Why do we have cycles? For example, if the S&P 500 has returned just over 10% a year on average over the 65 years since it assumed its present form in 1957, why doesn’t it just return 10% every year? And updating a question I asked in my memo The Happy Medium (July 2004), why has its annual return been between 8% and 12% just six times during this period? Why is it so far from the mean 90% of the time? After pondering this question for a while, I landed on what I consider the explanation: excesses and corrections. If the stock market was a machine, it might be reasonable to expect it to perform consistently over time. Instead, I think the substantial influence of psychology on investors’ decision-making largely explains the market’s gyrations. When investors turn highly bullish, they tend to conclude that (a) everything’s going to go up forever and (b) regardless of what they pay for an asset, someone else will come along to buy it from them for more (the “greater-fool theory”). Because of the high level of optimism: • Stock prices rise faster than company profits, soaring well above fair value (excess to the upside). • Eventually, conditions in the investment environment disappoint, and/or the folly of the elevated prices becomes clear, and they fall back toward fair value (correction) and then through it.

The long-term decline in interest rates began just a few years after the advent of risk/return thinking, and I view the combination of the two as having given rise to (a) the rebirth of optimism among investors, (b) the pursuit of profit through aggressive investment vehicles, and (c) an incredible four decades for the stock market. The S&P 500 Index rose from a low of 102 in August 1982 to 4,796 at the beginning of 2022, for a compound annual return of 10.3% per year. What a period! There can be no greater financial and investment career luck than to have participated in it. An Incredible Tailwind What are the factors that gave rise to investors’ success over the last 40 years? We saw major contributions from (a) the economic growth and preeminence of the U.S.; (b) the incredible performance of our greatest companies; (c) gains in technology, productivity and management techniques; and (d) the benefits of globalization. However, I’d be surprised if 40 years of declining interest rates didn’t play the greatest role of all. © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: In the 1970s, I had a loan from a Chicago bank, with an interest rate of “three-quarters over prime.” (We don’t hear much about the prime rate anymore, but it was the benchmark interest rate – the predecessor of LIBOR – at which the money-center banks would lend to their best customers.) I received a notice from the bank each time my rate changed, and I framed the one that marked the high point in December 1980: It told me the interest rate on my loan had risen to 22.25%! Four decades later, I was able to borrow at just 2.25%, fixed for 10 years. This represented a decline of 2,000 basis points. Miraculous! What are the effects of declining interest rates? • They accelerate the growth of the economy by making it cheaper for consumers to buy on credit and for companies to invest in facilities, equipment, and inventory. • They provide a subsidy to borrowers (at the expense of lenders and savers). • They reduce businesses’ cost of capital and thus increase their profitability. • They increase the fair value of assets. (The theoretical value of an asset is defined as the discounted present value of its future cash flows. The lower the discount rate, the higher the present value.) Thus, as interest rates fall, valuation parameters such as p/e ratios and enterprise values rise, and cap rates on real estate decline.

For roughly the last 60 years, economists relied on the Phillips curve, which holds that wage inflation will rise as the unemployment rate declines, because when there are fewer idle workers on the sidelines, employees gain bargaining power and can successfully negotiate for higher wages. It was also believed for decades that an unemployment rate around 5.5% indicated “full employment.” But unemployment fell below 5.5% in March 2015 (and reached a 50-year low of 3.5% in September 2019), yet there was no significant increase in inflation (in wages or otherwise) until 2021. So the Phillips curve described an important relationship that was built into economic models for decades but, seemingly, didn’t apply over much of the last decade. Cromwell’s rule is also relevant. Unlike in the physical sciences, in markets and economies there’s very little that absolutely has to happen or definitely can’t happen. Thus, in my book Mastering the Market Cycle, I listed seven terms that investors should purge from their vocabularies: “never,” “always,” “forever,” “can’t,” “won’t,” “will,” and “has to.” But if it’s true that those words have to be discarded, then so too must the idea that one can build a model that can dependably predict the macro future. In other words, very little is immutable in our world. © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

• The FAAMGs (Facebook, Amazon, Apple, Microsoft and Google), software stocks, and other tech stocks rose dramatically, pushing the market higher. • Eventually, investors concluded – as they often do when things are going well – that they could expect more of the same. The most important thing about bull market psychology is that, as cited in the final bullet point above, most people take rising stock prices as a positive sign of things to come. Many are converted to optimism. Relatively few suspect that the gains to date might have been excessive and borrowed from future returns and that they presage reversal, not continuation. That reminds me of another of my favorite adages – one of the first ones I learned, roughly 50 years ago – “the three stages of a bull market”: • the first, when a few forward-looking people begin to believe things will get better, • the second, when most investors realize improvement is actually underway, and • the third, when everyone concludes that things will get better forever. It’s interesting to note that even though the market moved from despondent in March 2020 to booming in May, largely thanks to the Fed, the most frequent attitude I encountered during that period was dubiousness. And the question I was asked most frequently was “If the environment is so bad – with the pandemic raging and the economy shuttered – isn’t it wrong for the market to rise?” It was hard to find any optimists.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: powerful shift in recent decades toward indexing and other forms of passive investing has taken place for the simple reason that active investment decisions are so often wrong. Of course, many forms of error contribute to this reality. Whatever the reason, however, we have to conclude that, on average, active professional investors held more of the things that did less well and less of the things that outperformed, and/or that they bought too much at elevated prices and sold too much at depressed prices. Passive investing hasn’t grown to cover the majority of U.S. equity mutual fund capital because passive results have been so good; I think it’s because active management has been so bad. Back when I worked at First National City Bank 50 years ago, prospective clients used to ask, “What kind of return do you think you can make in an equity portfolio?” The standard answer was 12%. Why? “Well,” we said (so simplistically), “the stock market returns about 10% a year. A little effort should enable us to improve on that by at least 20%.” Of course, as time has shown, there’s no truth in that. “A little effort” didn’t add anything. In fact, in most cases, active investing detracted: most equity funds failed to keep up with the indices, especially after fees. What about the ultimate proof?

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: At the turn of the millennium, Germany’s electricity was around 30 percent nuclear- powered. But Germany has been sacking its reliable, inexpensive nuclear plants. . . . By 2020, Germany had reduced its nuclear share from 30 percent to 11 percent. Then, on the last day of 2021, Germany shut down half of its remaining six nuclear reactors. The other three are slated for shutdown at the end of this year. During a briefing earlier this month, a U.S. senator told the nonpartisan political organization No Labels, “The energy issue regarding ‘Putin’s war’ has four components: energy, climate, security, and economics (both national and at the household level).” Security doesn’t seem to have received much consideration in the deliberations that led to Germany’s energy dependency on Russia. Just one of the four factors – climate – appears to have motivated the decision. Choosing to count on a hostile neighbor for essential goods is like building a bank vault and contracting with the mob to supply it with guards. But that’s what happened. Foreign Sourcing The downside of Europe’s dependence on Russian oil and gas has made its way into the consciousness of many people only recently, as a result of the invasion of Ukraine. But the shift to sourcing and manufacturing overseas is something that’s been on people’s minds for decades.

Speaking about difficulty reminds me of an important idea that arose in my discussions with my son Andrew during the pandemic (described in the memo Something of Value, published in January 2021). In the memo’s extensive discussion of how efficient most markets have become in recent decades, Andrew makes a terrific point: “Readily available quantitative information with regard to the present cannot be the source of superior performance.” After all, everyone has access to this type of information – with regard to public U.S. securities, that’s the whole point of the SEC’s Reg FD (for fair disclosure) – and nowadays all investors should know how to manipulate data and run screens. So, then, how can investors who are intent on outperforming hope to reach their goal? As Andrew and I said on a podcast where we discussed Something of Value, they have to go beyond readily available quantitative information with regard to the present. Instead, their superiority has to come from an ability to: • better understand the significance of the published numbers, • better assess the qualitative aspects of the company, and/or • better divine the future. Obviously, none of these things can be determined with certainty, measured empirically, or processed using surefire formulas. Unlike present-day quantitative information, there’s no source you can turn to for easy answers. They all come down to judgment or insight. Second-level thinkers who have better © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: That’s what I think happened to investors over the last 40 years. They enjoyed the growth of the economy and the companies they invested in, as well as the resulting increase in the value of their ownership stakes. But in addition, they were on a moving walkway, carried along by declining interest rates. The results have been great, but I doubt many people fully understand where they came from. It seems to me that a significant portion of all the money investors made over this period resulted from the tailwind generated by the massive drop in interest rates. I consider it nearly impossible to overstate the influence of declining rates over the last four decades. The Recent Experience The period between the end of the Global Financial Crisis in late 2009 and the onset of the pandemic in early 2020 was marked by ultra-low interest rates, and the macroeconomic environment – and its effects – were highly unusual. An all-time low in interest rates was reached when the Fed cut the fed funds rate to approximately zero in late 2008 in an effort to pull the economy out of the GFC. The low rates were accompanied by quantitative easing: purchases of bonds undertaken by the Fed to inject liquidity into the economy (and perhaps to keep investors from panicking). The effects were dramatic: • The low rates and vast amounts of liquidity stimulated the economy and triggered explosive gains in the markets.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The four most dangerous words in investing are “this time it’s different,” according to John Templeton, the 74-year-old mutual fund manager. At stock market tops and bottoms, investors invariably use this rationale to justify their emotion-driven decisions. Over the next year, many investors are likely to repeat those four words as they defend higher stock prices. But they should treat them with the same consideration they give “the check’s in the mail.” No matter what brokers or money managers say, bull markets do not last forever. It didn’t take a year. Just eight days later, the world experienced “Black Monday,” when the Dow Jones Industrial Average dropped by 22.6% in a single day. Another justification for bull markets is often found in the belief that certain businesses are guaranteed to enjoy a terrific future. This applies to the Nifty-Fifty growth companies in the late 1960s; disc drive manufacturers in the ’80s; and telecom, Internet and e-commerce companies in the late ’90s. Each of these developments was believed to be capable of changing the world, such that the past realities of business need not constrain investors’ imaginations and willingness to pay up. And they did change the world. Nevertheless, the highly elevated asset valuations they were thought to justify didn’t hold. In many bull markets, one or more groups are anointed as what I call “super stocks.

Just as Europe allowed its energy dependence to increase due to its desire to be more green, U.S. businesses came to rely increasingly on materials, components, and finished goods from abroad to remain price-competitive and deliver greater profits. Key geopolitical developments in recent decades included (a) the perception that the world was shrinking, due to improvements in transportation and communications, and (b) the relative peace of the world, stemming from: • the dismantling of the Berlin Wall; • the fall of the USSR; • the low perceived threat from nuclear arms (thanks to the realization that their use would assure mutual destruction); • the absence of conflicts that could escalate into a multi-national war; and • the shortness of memory, which permits people to believe benign conditions will remain so. Together, these developments gave rise to a huge swing of the pendulum toward globalization and thus countries’ interdependence. Companies and countries found that massive benefits could be tapped by looking abroad for solutions, and it was easy to overlook or minimize potential pitfalls. As a result, in recent decades, countries and companies have been able to opt for what seemed to be the cheapest and easiest solutions, and perhaps the greenest. Thus, the choices made included reliance on distant sources of supply and just-in-time ordering.

The price of an asset is based on fundamentals and how people view those fundamentals. And a change in an asset price is based on the change in fundamentals and the change in how people view those fundamentals. So, facts and attitudes. Any research that could capture changes in attitudes, I think is important. Now, what about quantifying these animal spirits? In one of the more jocular portions of my first book, The Most Important Thing, I include something I called “the poor man’s guide to market assessment.” I have a list of things in one column, and I have a list of things in the other column, and whichever list is more descriptive of current conditions tells you whether it’s optimism or pessimism that’s governing the market. There are things like, do deals get sold out or do they languish? Are hedge fund managers being welcomed on TV or not? Who does the crowd form around at cocktail parties? What is the media saying: “We’re going to the moon” or “We’re cratering forever”? I don’t know how to quantify these things. But these are among the very important things that I listen to in order to figure out where we stand in the cycle. And I believe where we are in the cycle plays a very strong role in figuring out where we’ll go next. (In fact, take the title of my second book, Mastering the Market Cycle. When I was thinking © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Yet many private equity and private debt funds are reporting only small losses for the year to date. I’m often asked what this means, and whether it reflects reality. Maybe the performance of private funds is being reported accurately. (I know we believe ours is.) But I recently came across an interesting Financial Times article provocatively titled, “The volatility laundering, return manipulation and ‘phoney happiness’ of private equity,” by Robin Wigglesworth. Here’s some of its content: The widening performance gap between public and private markets is a huge topic these days. Investors are often seen as the gormless [foolish] dupes falling for the “return manipulation” of cunning private equity tycoons. But what if they are co-conspirators? . . . That’s what a new paper from three academics at the University of Florida argues. Based on nearly two decades worth of private equity real estate funds data, Blake Jackson, David Ling and Andy Naranjo conclude that “private equity fund managers manipulate returns to cater to their investors.” . . . Jackson, Ling and Naranjo’s . . . central conclusion is that “GPs do not appear to manipulate interim returns to fool their LPs, but rather because their LPs want them to do so”.

Many of the forecasters are part of teams managing equity funds, or they provide advice and forecasts to those teams. What we know for sure is that actively managed equity funds have been losing market share to index funds and other passive vehicles for decades due to the poor performance of active management, and as a result, actively managed funds now account for less than half of the capital in U.S. equity mutual funds. Could the unhelpful nature of macro forecasts be part of the reason? The only place I know to look for quantification regarding this issue is the performance of so-called macro hedge funds. Hedge Fund Research (HFR) publishes broad hedge fund performance indices as well as a number of sub-indices. Below is the long-term performance of a broad hedge fund index, a macro fund sub-index, and the Standard & Poor’s 500 Index. © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: If you substitute the words “offshoring” and “domestic sourcing” for “free markets” and “regulation,” then this passage just as accurately describes the choice between the cheapest sourcing and the most secure sourcing. This absence of perfect, permanent solutions is characteristic of pendulums – it’s why they swing. And after many decades of globalization and cost minimization, I think we’re about to find investment opportunities in the swing toward reliable supply. March 23, 2022 © 2022 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED

” Investors have to know when bull market psychology is in ascendance and apply the required caution. The Pendulum Swings Bull markets don’t arise out of thin air. The winners in each bull market are winners for the simple reason that a grain of truth underlies their gains. However, the bullishness I’ve described above tends to exaggerate the merits and pushes security prices to levels that are excessive and thus vulnerable. And the upward swing doesn’t last forever. In On the Couch (January 2016), I wrote, “in the real world, things generally fluctuate between ‘pretty good’ and ‘not so hot.’ But in the world of investing, perception often swings from ‘flawless’ to ‘hopeless.’” The way things are seriously overdone in the markets is one of the key characteristics of investor behavior. During bull markets, investors conclude that difficult, unlikely, and unprecedented things are sure to work. But in less ebullient times, favorable economic news and “earnings beats” fail to © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: inspire buying, and rising prices no longer make life painful for people who are underinvested. Thus, we stop seeing the willing suspension of disbelief, and psychology flips to negativism. The key lies in the fact that investors are capable of interpreting virtually any piece of news either positively or negatively, depending on how it’s reported and on their mood. (The cartoon below, one of my all-time favorites, was published many decades ago – check out those rabbit ears and the depth of the TV set – but clearly the caption is relevant to this very moment.) Reflecting the “flawless-to-hopeless” progression I mentioned earlier, prevailing narratives are subject to reversal. While the argument supporting the bull market may have been reasonably likely to hold, investors treated it as ironclad when all was going well. When some of the argument’s flaws come to light, however, it’s dismissed as all wrong. • In the happy season (all of a year ago), the tech bulls said, “You have to buy growth stocks for their decades of potential earnings increases.” But now, after a significant decline, we instead hear, “Investing based on future potential is too risky. You have to stick to value stocks for their ascertainable present value and reasonable prices.” • Likewise, in the heady times, participants in IPOs of money-losing companies said, “There’s nothing wrong with companies that report losses.

Investors should find a way to keep their hands off their portfolios most of the time. A Special Word in Closing: Asymmetry “Asymmetry” is a concept I’ve been conscious of for decades and consider more important with every passing year. It’s my word for the essence of investment excellence and a standard against which investors should be measured. First, some definitions: • I’m going to talk below about whether an investor has “alpha.” Alpha is technically defined as return in excess of the benchmark return, but I prefer to think of it as superior investing skill. It’s the ability to find and exploit inefficiencies when they’re present. • Inefficiencies – mispricings or mistakes – represent instances when an asset’s price diverges from its fair value. These divergences can show up as bargains or the opposite, over-pricings. • Bargains will dependably perform better than other investments over time after adjustment for their riskiness. Over-pricings will do the opposite. • “Beta” is an investor’s or a portfolio’s relative volatility, also described as relative sensitivity or systematic risk. People who believe in the efficient market hypothesis think of a portfolio’s return as the product of the market’s return multiplied by the portfolio’s beta. This is all it takes to explain results, since there are no mispricings to take advantage of in an efficient market (and so no such thing as alpha).

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: One of the biggest changes that did take place in the 1960s was the emergence of “growth investing” via fast-growing companies, many of which were quite new. The “Nifty Fifty” I talk about so much ruled the stock market in the late 1960s: this group included office equipment manufacturers IBM and Xerox, photography titans Kodak and Polaroid, drug companies like Merck and Eli Lilly, tech companies including Hewlett Packard and Texas Instruments, and advanced marketing/consumer goods companies such as Coca-Cola and Avon. These companies’ stocks carried very high price/earnings ratios, reaching up to 80 and 90. Obviously, investors should only pay multiples like these (if ever) if they’re sure the companies will be preeminent for decades to come. And investors were sure. In fact, it was widely believed that nothing bad could happen to these companies and they could never be disrupted. This was one of post-war America’s first major brushes with newness and – in a good example of illogicality – investors embraced these companies, with their revolutionary newness, but somehow assumed that a newer and better new thing could never come along to displace them. Of course, those investors were riding for a fall. If you bought the stocks of “the greatest companies in America” when I started working in 1969, and held them steadfastly for five years, you lost almost all your money.

The first reason is that the multiples in the late 1960s were far too high, and they were gutted in the subsequent market correction. But, perhaps more importantly, many of these “forever” companies turned out to be vulnerable to change. The companies of the Nifty Fifty represented the first flowering of change in the new world, and many of them went on to be its early victims. At least half of these supposedly impregnable companies have either gone out of business or been acquired by others. Kodak and Polaroid lost their raison d’etre when digital cameras appeared. Xerox ceded much of the dry copying business to low-priced competition from abroad. IBM proved vulnerable when decentralized computing and PCs took over from massive mainframes. Seen any door-to-door salespeople lately? No, and we don’t hear much about “Avon ladies.” And what about one of the darlings of the day: Simplicity Pattern? Who do you know today who makes their own clothes? The years since then have seen a massive shift in our environment. Today, unlike in the 1950s and ’60s, everything seems to change every day. It’s particularly hard to think of a company or industry that won’t either be a disrupter or be disrupted (or both) in the years ahead. Anyone who believes all the firms on today’s list of leading growth companies will still be there in five or ten years has a good chance of being proved wrong. For investors, this means there’s a new world order.

Buffett, the patron saint of value investors, also practiced cigar butt investing with great success in the first decades of his career, until his partner, Charlie Munger, convinced him to broaden his definition of “value” and shift his focus to “great businesses at fair prices,” in particular because doing so would enable him to deploy much more capital at high returns. This led Buffett to invest in growing companies – such as Coca-Cola, GEICO and the Washington Post – that he could purchase at valuations that were not particularly low in the absolute, but that he found attractive given his understanding of their competitive advantages and future earnings potential. While Buffett has long understood that a company’s prospects are an enormous component of its value, his general avoidance of technology stocks throughout his career may have unintentionally caused most value investors to boycott those stocks. Intriguingly, Buffett allows that his recent investment in Apple has been one of his most successful. © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

• Finally, for roughly the last 60 years, economists have trusted the so-called Phillips Curve, which posits an inverse relationship between unemployment and inflation: the lower the unemployment rate, the tighter the labor market, the more negotiating power workers have, the more wages rise, and the greater the increase in the prices of consumer goods. But the U.S. unemployment rate fell throughout the last decade – ultimately hitting a 50-year low – and still there was no material increase in inflation. Thus, few people talk about the Phillips Curve anymore. The low reported U.S. inflation rates may be partially attributable to changes in recent decades in the way the Consumer Price Index is calculated, but the truth is that we know very little about inflation, including its causes and cures. I describe it as “mysterious,” so I believe we should put even less stock in predictions surrounding inflation than in other areas. That makes life tough for investors at the moment, because inflation and its impact on interest rates constitute the most important wildcards. Inflation Outlook Today There’s been a great deal written about the current prospects for inflation, and rather than rehash it fully, I’ll deliver a brief summary. Here’s the background: • To support the economy and its participants during last year’s Covid-19-related shutdown, the Fed, Treasury and Congress took drastic action to prevent a global slowdown that could have rivalled the Great Depression.

A Look at the Long Run At the end of the most turbulent year in my five-plus decades of experience, I’m going to devote my usual section on the long run to an Oaktree strategy that really would make you think 2020 was the best of times: our Power Opportunities funds. I’ll start with the interesting history of these funds. Just a year after Oaktree’s founding, a friend brought us an unusual opportunity. Three long-term corporate-employees-turned-energy-consultants had left Arthur Andersen in 1995 to form an investment boutique, GFI Energy Ventures (with “GFI” standing for “Go For It”). Larry Gilson, Richard Landers and Ian Schapiro had developed an investment thesis based on their knowledge advantage regarding the deficiencies of the U.S. power infrastructure, the need for remediation and expansion, and what the incumbents would spend money on in the process. They were a sponsor without a fund, passing the hat among a small circle of investors whenever they found an attractive investment candidate. But, in 1996, they found an opportunity too large to finance using that approach, and they were referred to us. We were very interested in that first investment, as well as the general thesis and its application, and we entered into a deal with GFI under which we would pay their overhead, get a right of first refusal on their deal flow, and jointly manage the investments made.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: will be in the future. We see this in the price of lumber, which rose by roughly 540% between the low in April 2020 – when no one thought there would ever be demand for new homes – and the high in May 2021 – when no one thought the supply of homes could ever meet the demand. Now the price of lumber is down by more than 60% in just the last two months, and we no longer hear much about its contribution to inflation. • Clearly, a lot of the inflation seen in the first half of 2021 can be attributed to increased consumer spending financed by Covid-19 relief and the resultant bulge in savings and wealth. This should prove temporary: a given pool of extra dollars can’t produce elevated spending forever. • The ending of enhanced unemployment benefits in September should bring more workers into the job market, reducing the impact of labor shortages on wages and thus the prices of goods. • The growth of the economy will undoubtedly slow after 2021 or 2022, by which time the impact of 2020’s pent-up consumer demand will ebb significantly. • There’s hope that the recent levels of stimulus, deficit spending and money printing will recede in the next few years (or at least their rate of growth will slow) as the economy continues to expand, meaning these factors will decline relative to the size of the economy. • Technology, automation and globalization are likely to continue to have significant deflationary effects.

When Buffett was applying his cigar butt approach to running his early investment partnership – which racked up a tremendous record – he famously used to sit in his back room in Omaha, flipping through the thousands of pages of Moody’s Manual, and he would buy shares in small companies that were trading at enormous discounts from liquidation value for the simple reason that no one else paid attention to them. In one case, that of National American Fire Insurance, Buffett was able to buy the stock at 1x earnings by driving around to farmers who had decades earlier been stuffed by promoters with stock they’d since forgotten about, and handing them cash on their front porch. Thus, the Grahamian value framework was created at a time when things could be stupidly cheap based on clearly observable facts, simply because the search process was very difficult and opaque. As time went on, the diligent analyst’s information advantage began to slowly dissipate, but it still existed for a good while. Prior to the broad adoption of the Internet and the explosion of the investment industry in the early years of this century, information and analytical methods were still hard to come by.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The Outlook for Democracy There’s a great but little-used word to describe the state of U.S. politics and governance: parlous. Google defines it as “full of danger or uncertainty; precarious.” The country is highly divided in terms of politics, and discourse seems to move further toward the extremes with the passage of time. Part of the blame goes to the media (including social media). The explanation is simple but unfortunate: a few entrepreneurs figured out that there’s money in division. At the birth of television, as I understand it, the people who ran the national networks established the news division as a public service that ran losses. In TV’s early decades (through the 1970s), the main networks did balanced, objective reporting – led by august figures such as Walter Cronkite, Chet Huntley and David Brinkley – and these networks pretty much still do. But over the last 20 years, some media outlets have increased their profits by catering to one side or the other, often in an inflammatory manner. More recently, we’ve heard about social media driving traffic by appealing to highly partisan audiences and disclaiming responsibility for content. The truth is, discord sells (how often does your daily newspaper lead with a positive headline?) The result is very harmful. It’s bad enough that some cable news stations and social media sites deliver only one side of the argument on many issues.

Most macro forecasting consists of extrapolating current levels and recent trends with minor tinkering. While predictions of “no change” are often right – as continuation is the general rule – they give rise to little in terms of profit. Only forecasts of major deviation from trend can be highly profitable. But to be so, they also must be correct, and they rarely are. That’s why profitable macro forecasts (and successful forecasters) are few and far between. This negative view on forecasting is a major theme running through Oaktree’s culture and the reason we don’t base our investments on macro forecasts. Most investors felt that the beginning of 2020 was a time of clarity: the economy and the stock market were both expected to continue advancing. While everyone knew they wouldn’t do so forever, nothing seemed poised to make them stop. And then came the strongest exogenous shock we’ve ever seen – the novel coronavirus – proving once again that we never know what’s going to happen (and that even though we can’t predict, we should prepare – more on this later). Today’s environment, in contrast, seems to be characterized by a lack of clarity. Experts are expressing highly divergent opinions regarding the outlook for U.S. markets, with strong arguments both bullish and bearish.

But the downtrend in rates is over (if we can believe the Fed’s assurance that it won’t take nominal rates into negative territory). Thus, while interest rates can rise from here – implying higher demanded returns on everything and thus lower asset prices – they can’t decline. This creates a negatively asymmetrical proposition. So today’s high asset prices may be justified at today’s interest rates, but that’s clearly a source of vulnerability if rates were to rise. (Note that today’s 1.40% yield on the 10-year Treasury note is up from 0.52% at the low in August 2020 and from 0.93% in just the last seven weeks.) The Fed says rates will be low for years to come, but are there limitations on its ability to make that happen? Can the Fed keep rates artificially low forever? On longer-maturity bonds? And what about inflation? Can the 10-year Treasury note still yield 1.40% if inflation reaches 3%? Will people buy it at a negative real yield? Or will the price fall so that it yields more? Where could inflation come from? © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

As Andrew repeatedly reminds me, it’s hard to make a convincing case that today’s market is too high if you can’t explain why its tech leaders are overvalued. But by far the most important intention of this memo is to explore the mindset that I think will prove most successful for value investors over the coming decades, regardless of what the market does in the years just ahead. It’s important to note that (a) the potential range of outcomes for many of today’s companies is very wide and (b) there are considerations with enormous implications for the ultimate value of many companies that do not show up in readily available quantitative metrics. They include superior technology, competitive advantage, latent earning power, the value of human capital as opposed to capital equipment, and the potential option value of future growth opportunities. In other words, determining the appropriateness of the market price of companies today requires deep micro- understanding, and that makes it virtually impossible to opine on the valuation of a rapidly growing company from 30,000 feet or by applying traditional value parameters to superficial projections. Some of today’s lofty valuations are probably more than justified by future prospects, while others are laughable – just as certain companies that carry low valuations can be facing imminent demise, while others are just momentarily impaired.

The key, as always, is to understand how today’s market price relates to the company’s broadly defined intrinsic value, including its prospects. The Heart of the Problem Consider two companies. Company A is a respected long-term competitor selling a widely consumed, fairly prosaic product. It has built a decades-long record that shows modest but steady sales growth and healthy profit margins. It manufactures its product using heavy machinery located on its own premises. Its stock sells at a modest multiple of earnings per share. © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: package. This wouldn’t have been possible if rates had been at zero when the Fed first took action. Some people wonder whether the Fed might produce perpetual prosperity, preventing recessions or minimizing them as it did last year. Some hope low interest rates can keep markets aloft forever. Some think the Treasury can issue as much debt as is needed, with the Fed willing to step in as the buyer of last resort. Obviously, a lot of people in the federal government think unlimited sums can be spent without negative consequences from the resulting increased deficits and debt. I’m not smart enough to prove it, but to me these assumptions seem too good to be true. They have the appearance of a perpetual motion machine or a credit card with no credit limit and no requirement to pay off the balance. I can’t tell you exactly what the catch is, but I think there has to be one. Or, perhaps better put, I wouldn’t bet the ranch on there not being a catch. In the 1930s, John Maynard Keynes suggested that nations should run fiscal deficits in times of weakness to stimulate demand, reenergize their economies, and create needed jobs. It’s not for nothing that deficit spending is described as “Keynesian.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Generational Inequity In 2037 and 2026, respectively, Social Security and Medicare, benefit programs that aid older Americans, will likely become unable to continue paying today’s benefits. And yet we don’t hear any discussion of the benefit cuts, delayed eligibility, tax increases, or means testing that would have to be part of any solution. In fact, in the last 18 months Washington has approved more than $9 trillion of spending on Covid-19 relief and infrastructure, but we haven’t heard a word from either party about fixing these essential programs. That’s presumably because the party that trims these programs would likely be penalized at the polls. The 71.2 million members of the Baby Boom generation (people born between roughly 1946 and 1964) are triple the 23.0 members of the Silent Generation that preceded them and 10% more than the 65.0 million Generation Xers that followed. The magnitude of the Boomers’ votes and financial resources have given them enormous political influence over the last 40 years. The result has been extensive deficit spending on things the Boomers want and a failure to modify benefit programs that need fixing, all at the expense of future generations. This is an example of the generational unfairness that has been perpetrated in recent decades.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: prospective return is only modestly attractive, (c) she realizes something in her investment thesis was incorrect or has changed for the worse or (d) she fears that the gains to date might be proved unwarranted and thus evaporate; in particular, she’s afraid she’ll end up kicking herself for not having taken profits while they were there. But fear of making a mistake is a terrible reason to sell something of value. Here’s how Andrew puts it today: It’s important to understand the paramount importance of compounding, and how rare and special long-term compounders are. This is antithetical to the “it’s up, so sell” mentality but, in my opinion, critical to long-term investment success. As Charlie Munger says, “the first rule of compounding is to never interrupt it unnecessarily.” In other words, if you have a compounding machine with the potential to do so for decades, you basically shouldn’t think about selling it (unless, of course, your thesis becomes less probable). Compounding at high rates over an investment career is very hard, but doing it by finding something that doubles, then moving on to another thing that doubles, and so on and so on is, in my opinion, nearly impossible. It requires that you develop correct insights about a large number of investment situations over a long period of time. It also requires that you execute well on both the buy and the sell each time.

• If you find a company with the proverbial license to print money, don’t start selling its shares simply because they’ve shown some appreciation. You won’t find many such winners in your lifetime, and you should get the most out of those you do find. I once asked a well-known value investor how he could hold the stocks of fast-growing companies like Amazon – not today, when they’re acknowledged winners, but rather two decades ago. His answer was simple: “They looked like value to me.” I guess the answer is “value is where you find it.” My conversations with Andrew over the ten months of the pandemic have represented a “voyage of discovery” and culminated in this memo. I think we came to some important realizations regarding the question of value versus growth investing, and in the process, I learned a lot about myself. I don’t mean to suggest that anything I’ve written here pertains to all value or all growth investors. There’s a lot of generalizing, and we know how imperfect generalizations can be. I also don’t insist that it’s correct. It’s just the current state of my thinking. Not only do I not insist that my version is the only one possible, but I expect it to evolve further as the world changes and I continue to learn. I hope you’ll find this memo interesting and helpful, and I wish you all the best in 2021. January 11, 2021 © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

And it opens the possibility of a global economy completely different from the one that has prevailed in recent decades. All I have to add to that is my usual observation regarding the future: We’ll see. November 23, 2021 © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

” 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: So forecasting is difficult for a large number of reasons, including our limited understanding of the processes that will produce the future, their imprecise nature, the lack of historical precedent, the unpredictability of people’s behavior and the role of randomness, and these difficulties are exacerbated by today’s unusual circumstances. Senior economics consultant Neil Irwin put it together very well in The New York Times on April 16: The world economy is an infinitely complicated web of interconnections. We each have a series of direct economic interrelationships we can see: the stores we buy from, the employer that pays our salary, the bank that gives us a home loan. But once you get two or three levels out, it’s really impossible to know with any confidence how those connections work. And that, in turn, shows what is unnerving about the economic calamity accompanying the spread of the novel coronavirus. In the years ahead we will learn what happens when that web is torn apart, when millions of those links are destroyed all at once. And it opens the possibility of a global economy completely different from the one that has prevailed in recent decades. I couldn’t agree more with what Irwin says. Or, to use one of my all-time favorite quotes, from John Kenneth Galbraith: We have two classes of forecasters: Those who don’t know – and those who don’t know they don’t know.

We saw numerous records smashed in the 11-week recovery of the stock market from its March 23 low. To sum up and over-simplify, as my partner Bruce Karsh asks in his role as devil’s advocate: can the Fed keep buying debt forever, and can its doing so keep asset prices up forever? In short, many investors appeared to conclude that it could. © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

In layman’s terms, when the fed funds rate is zero, 6% bonds look like a giveaway, so buyers bid them up until they yield less (thus I believe 97% of outstanding bonds yield less than 5% today, and 80% yield less than 1%). And Fed buying drives up the price of financial assets and puts money into sellers’ hands with which they can buy other assets, further elevating prices. For all these reasons, monetary actions have come out on top so far, validating the old maxim that “you can’t fight the Fed.” But what does it mean if the prices of stocks and listed credit instruments are where they are not primarily for fundamental reasons – such as current earnings and the outlook for future gains – but rather in large part because of the Fed’s buying, its injection of liquidity, and the resultant low cost of capital and low demanded returns? If high asset prices are substantially the result of tailwinds from technical factors such as these, does it mean those actions have to be continued in order for asset prices to remain high, and that if the Fed reduces its activity, those prices will fall? And that leads to the ultimate question (as Bruce Karsh seems to ask daily): can the Fed keep it up forever? Are there any limits on its ability to create bank reserves, buy assets and expand its balance sheet? And are there limits on the Treasury’s willingness to run deficits, now that it has taken this year’s to $4 trillion and shown an inclination to go well beyond that?

So when we think about which economists we quote, which investors we respect, and where we get our information, it’s likely that their views will parallel ours. Of course, taken to an extreme, this has resulted in the unfortunate, polarized state in which we find the U.S. today. News organizations realized decades ago that people would rather consume stories that confirm their views than those that challenge them (or are dully neutral). Few people follow media outlets that reflect a diversity of opinion. Most people stick to one newspaper, cable news channel or political website. And few of those fairly present both sides of the story. Thus most people hear a version of the news that is totally unlike the one heard by those on the other side of the © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: deeper and the fiscal cost would be greater. As always, I don’t know which economists are right, but I’m happy to go with Conrad’s summation. Moving on from understanding the actions to date, I want to talk about the outlook for this effort. The government seems able, as Conrad says, to support and stabilize the economy. In my simplistic view, I imagine it can print enough checks to replace every American worker’s lost wages and every business’s lost revenues. In other words, it can “simulate” the effect of the economy on incomes. But I have two questions: is that okay, and is it enough? First of all, as I mentioned above, we actually need the output of workers and businesses. If all businesses shut down, we won’t have the things we need. These days, for example, people are counting on grocery deliveries and take-out food. But does anyone wonder where food comes from and how it reaches us? The Treasury can make up for people’s lost wages, but people need the things wages buy. So replacing lost wages and revenues will not be enough for long: the economy has to produce goods and services. Second, let’s assume the government writes checks to replace wages and revenues forever, and that the economy continues to produce at a minimal but sufficient level, so the things we need materialize. What will be the long-term effect?

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • the third stage, when everyone concludes everything will get better forever. Looking back (which is the main way we know these things), the first stage began in mid-March and culminated on March 23. Certainly very few people were thinking about economic improvement or stock market gains around that time. Then we passed briefly through stage two and went straight to stage three. Certainly by the time the interim high was reached on June 8, it felt like the market was being valued in a way that focused on the positives, swallowed them whole, and overlooked the negatives. That’s nothing but a value judgment on my part. It’s just my opinion that the imbalance of attention to – and blanket acceptance of – the positives was overdone. I had good company in being skeptical of the May/June gains. On May 12, with the S&P 500 up a startling 28% from the March 23 low, Stan Druckenmiller, one of the greatest investors of all time, said, “The risk-reward for equity is maybe as bad as I’ve seen in my career.” The next day, David Tepper, another investing great, said it was “maybe the second-most overvalued stock market I’ve ever seen. I would say ’99 was more overvalued.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: at unprecedented lows. Extreme valuations like these are usually justified with protests that “this time it’s different,” four words that tend to get investors into trouble. • On the other hand, John Templeton allowed that when people say things are different, 20% of the time they’re right. And in a memo on this subject in June of last year, I wrote, “in areas like technology and digital business models, I’d bet things will be different more than the 20% of the time Templeton cited.” It certainly can be argued that the tech champions of today are smarter and stronger and enjoy bigger leads than the big companies of the past, and that they have created virtuous circles for themselves that will bring rapid growth for decades, justifying valuations well above past norms. Today’s ultra-low interest rates further justify unusually high valuations, and they’re unlikely to rise anytime soon. • But on the third hand, even the best companies’ stocks can become overpriced, and in fact they’re often the stocks most likely to do so. When I first entered the business in 1968, the companies of the Nifty Fifty – deploying modern wonders like computing (IBM) and dry copying (Xerox) – were likewise expected to outgrow the rest and prove impervious to competition and economic cycles, and thus were awarded unprecedented multiples. In the next five years, their stockholders lost almost all their money.

[Compare what you hear on TV against a tweet from medical statistician Robert Grant]: “I’ve studied this stuff at university, done data analysis for decades, written several NHS guidelines (including one for an infectious disease), and taught it to health professionals. That’s why you don’t see me making any coronavirus forecasts. . . .” © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

In Andrew’s case, he applied the same seriousness to games that he does to investing and his other pursuits. This gave him the thought process of a gambler and enables him to suggest the following ways in which gambling has parallels to investing:  Game selection versus skill – When considering where to invest, it’s important to understand both how much of the requisite skill you possess and the quality of the competition. Being a consistent winner among the best gamblers or in the most intensely competitive markets can be very difficult. Instead, your energy might be better spent looking for less-efficient niches. Unfortunately, it’s harder to find them than it was decades ago.  Increasing efficiency/the tendency of markets to adapt – In the early days of online poker, it was easy for decent players to win, and a lot of amateurs were enticed to play by seeing a newcomer win the World Series of Poker. After some time, however, the games became tougher as they attracted professional players, and the amateurs lost their money. The new, more sophisticated generation of competitors learned their predecessors’ tendencies, improved on their strategies and started beating them. In this way, changes in the arena and in participants’ behavior can cause what worked years ago to not work today.  Circle of competence – Just because you’re great at gin rummy doesn’t mean you should play Texas Hold’em against a professional poker player.

I concluded that “This Time It’s Different” shouldn’t ignore this subject and, as a result, reworked the end of its section on quantitative easing, adding a new final paragraph: Can government actions permanently raise the level of demand in an economy, or do they mostly accelerate future demand into the present? If the latter, can QE elevate GDP forever above what it otherwise would have been? I doubt it. But if it could, wouldn’t that eventually cause what I call an “excess,” leading to a recession? Finally, when I hear people talk about the possibility that the Fed will prevent a recession, I wonder whether it’s even desirable for it to have that goal. Per the above, are recessions really avoidable or merely postponable? And if the latter, is it better for them to occur naturally or be postponed unnaturally? Might efforts to postpone them create undue faith in the power and intentions of the Fed, and thus a return of moral hazard? And if the Fed wards off a series of little recessions, mightn’t that just mean that, when the ability to keep doing so reaches its limit, the one that finally arrives will be a doozy? I’m so glad these last-minute inspirations caused me to include the above. I think the topic is very important, so much so that I’m now going to devote a memo to the subject of Fed interest-rate management. © 2019 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Very soon, the current recovery is bound to become the longest in U.S. history. However, I believe the odds are that it’s closer to the end than the beginning. (We never know for sure what’s going to happen in the future. At best we can think in terms of the probabilities. That’s the thinking behind my latest book’s subtitle: Getting the Odds on Your Side.) The recovery is likely to go on longer, but perhaps not much longer. Still, I wouldn’t place a wager on when it will end. About a year and a half ago, following the enactment of President Trump’s stimulative tax cuts, people started to ask me whether the U.S. might emulate Australia, whose last recession was in 1990. While not quite the same as asking “might there never be another recession?” the idea of 28 years between recessions would represent a radical difference this time. My answer to the above question is “probably not,” since there are significant differences between the two countries that probably render Australia’s example inapplicable to the U.S.:  A much bigger part of Australia’s GDP is based on exporting natural resources such as iron ore and coal, of which it has so much. Thus in recent decades it has drafted off the unusually strong growth of its much larger neighbor to the north, China.  In addition, “. . .

The effect of the Fed’s purchases was to (a) inject bank reserves into the financial system, (b) strengthen the demand for bonds, thereby bringing down long-term interest rates (which are unaffected by the Fed’s normal open market operations related to short-term rates), and (c) with prospective returns on high- quality bonds brought down, reignite risk-bearing on the part of investors seeking higher returns, thereby causing the credit window to reopen. QE was a success in the U.S., and the economy recovered. Thus some people are now proposing that the Fed could engage in QE forever, with similarly positive results. First, I think some part of the impact of QE may be psychological. In other words, QE stimulates the economy in part because people accept that QE is stimulative. If the Fed took exactly the same actions but did so without making an announcement, would the effect be the same? (I believe there’s © 2019 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

If the latter, can QE elevate GDP forever above what it otherwise would have been? I doubt it. But if it could, wouldn’t that eventually cause what I call an “excess,” leading to a recession? Finally, when I hear people talk about the possibility that the Fed will prevent a recession, I wonder whether it’s even desirable for it to have that goal. Per the above, are recessions really avoidable or merely postponable? And if the latter, is it better for them to occur naturally or be postponed unnaturally? Might efforts to postpone them create undue faith in the power and intentions of the Fed, and thus a return of moral hazard? And if the Fed wards off a series of little recessions, mightn’t that just mean that, when the ability to keep doing so reaches its limit, the one that finally arrives will be a doozy? Benign federal deficits – Over the years, some in government have pursued balanced federal budgets, or at least have paid them lip service. Democrats have generally been described as wanting to “tax and spend” in order to do more for citizens. But they’ve sometimes spent before they’ve taxed. Republicans, on the other hand, have positioned themselves as the party of fiscal restraint. It’s often been their official position that there could be no increases in spending if not accompanied by corresponding increases in funding. Regardless of the debate, federal budgets are rarely tendered on time or in balance these days.

benefits from an unlimited appetite for its debt, since it’s the safest of any major sovereign. For these reasons, expanding the national debt isn’t a problem. And like the cardholder described above, since there’s no limit to its credit, the U.S. can add the interest that accrues to the unpaid balance. What happens if these conditions change? Could a tipping point be reached at which there’s so much debt that people question the U.S.’s creditworthiness and ability to repay its borrowings? In that case, the demanded interest rate would rise, meaning the debt and interest mightn’t be repayable without massive money printing that would result in debasement of the dollar. Thus, could there come a day when it takes unacceptably more purchasing power to pay off U.S. debt denominated in dollars that have depreciated? I put these questions to my friend Randy Kroszner, former member of the Fed’s Board of Governors and Deputy Dean at the University of Chicago’s Booth School of Business. Here’s his response: I think the last three decades for Japan and the last decade for the U.S. have shown (and continue to be showing) that countries with credible institutions can “get away with” higher debt levels without a raid by bond vigilantes than most had once thought. That said, it leaves the country vulnerable to a change in sentiment, exactly as you describe. “Getting away with it” for too long erodes the credibility of the institutions over time.

Growth investing preeminence forever – Since future-oriented “growth investing” has been so successful for so long, and has so seriously trounced “value investing,” people are asking me whether this will ever end. In particular, value investing is being likened to the out-of-favor “cigar-butt” school of investing, in which people buy assets regardless of their quality just because they’re low- priced. Critics of value investing argue that, since the technological leadership that’s often associated with growth stocks is so essential for success in today’s world, old-economy companies lacking it are unlikely to be top performers in the future. My answer is simple: low price is very different from good value, and those who pursue low price above all else can easily fall into “value traps.” And certainly it’s true that old-economy companies © 2019 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: . . . “My solution to the current market,” the Great Winfield said. “Kids. This is a kids’ market. This is Billy the Kid, Johnny the Kid, and Sheldon the Kid.” . . . “See? See?” said the Great Winfield. “The flow of the seasons! Life begins again! It’s marvelous! It’s like having a son! My boys! My kids!” Of course, veteran that he was, the Great Winfield knew the truth. Thus he went on: . . . “The strength of my kids is that they are too young to remember anything bad, and they are making so much money they feel invincible,” said the Great Winfield. “Now you know and I know that one day the orchestra will stop playing and the wind will rattle through the broken window panes . . .” [Emphasis added] To close, I’ll return to a concept I consider indispensable for anyone hoping to succeed at investing – the three stages of a bull market:  the first, when only a few forward-looking people begin to believe things will get better,  the second, when most investors realize improvement is actually underway, and  the third, when everyone concludes that things can only get better forever. Clearly the few who buy in the first stage – when optimism is scarce and thus asset prices are low – can access great bargains. But those who buy in the last stage – out of a belief that the news will always be good – can be making a big mistake.

The nine propositions reviewed above all represent variations on “things can only get better forever.” If they’re the ideas guiding investors today, that should be considered worrisome. The best investments often are made in times of fear and desperation. That’s rarely possible when investors are willing to blithely dismiss the limitations of the past with the words “this time it’s different.” I would remind those investors of a quote usually attributed to Mark Twain: “History doesn’t repeat itself, but it does rhyme.” Of course it’s important that investors keep up with current developments and those that will shape the future. But it’s also essential that they not completely unlearn the lessons of the past. June 12, 2019 © 2019 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: Investing Without People Over the last twelve months I’ve devoted three memos to discussing macro developments, market outlook, and recommendations for investor behavior. These are important topics, but usually not the ones that interest me most; I prefer to discuss things that are likely to affect the functioning of markets for years to come. Since little in the environment has changed from what I described in those three memos, I feel I now have the liberty to turn to some bigger-picture issues. This memo covers three ways in which securities markets seem to be moving toward reducing the role of people: (a) index investing and other forms of passive investing, (b) quantitative and algorithmic investing, and (c) artificial intelligence and machine learning. Before diving in, I want to state loud and clear that I don’t claim to be an expert on these subjects. I’ve watched the first for decades; I’ve recently learned a little about the second; and I’m trying to catch up regarding the third. On the other hand, since many of the “experts” in these fields are involved in them, I think they may be biased favorably toward them as potential successors to traditional active investing. What follow are just my opinions; as always you should make of them what you wish.

Passive Investing and ETFs I’ve told this story many times, but I want to repeat it here to lay a foundation for what follows. I arrived at the University of Chicago Graduate School of Business (not yet the Booth School) just over 50 years ago, in September 1967. The “Chicago school” of finance and investment theory – largely developed there in the early ’60s – had just begun to be taught. It was methodically constructed on theoretical underpinnings, as well as on a healthy dose of skepticism regarding what investors had been doing previously. One of the major foundational components was the “Efficient Market Hypothesis” and its conclusion that “you can’t beat the market.” First there was the logical argument: it seemed obvious that collectively all investors have to do average before fees and expenses, and thus below average after. And then there was the empirical evidence that for decades most mutual funds had performed behind stock indices like the Standard & Poor’s 500. My professors’ response in the late 1960s was simple, albeit hypothetical and fanciful: why not just buy shares in every company in an index? Doing so would allow investors to avoid the mistakes most people made, as well as the vast majority of the fees and costs associated with their efforts. And at least they would be assured of performing in line with the index, not behind it.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The third level concerns stocks in smart-beta funds. The more a stock is held in non-index passive vehicles receiving inflows (ceteris paribus, or everything else being equal), the more likely it is to appreciate relative to one that’s not. And stocks like Amazon that are held in a large number of smart-beta funds of a variety of types are likely to appreciate relative to stocks that are held in none or just a few. What all the above means is that for a stock to be added to index or smart-beta funds is an artificial form of increased popularity, and it’s relative popularity that determines the relative prices of stocks in the short run. The large positions occupied by the top recent performers – with their swollen market caps – mean that as ETFs attract capital, they have to buy large amounts of these stocks, further fueling their rise. Thus, in the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because its overpriced. Like the tech stocks in 2000, this seeming perpetual-motion machine is unlikely to work forever. If funds ever flow out of equities and thus ETFs, what has been disproportionately bought will have to be disproportionately sold.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Reactions to the New Tax Law The Republicans in Congress have passed and the president has signed a bill they hailed as “sweeping tax reform.” It’s worthy of comment. Everything going on in Washington is more politicized and less bipartisan than ever, but I’ll attempt here to remain objective and not partisan while making what I think are the important observations. First, with respect to the taxation of individuals, it’s not much of a reform. It doesn’t fundamentally change what income is taxed, how it is taxed, or the structure of the tax process. It reduces or eliminates some write-offs or loopholes, but not a great many. And I doubt it shortens the tax code. I think what matters most is that it’s primarily a tax cut for the majority of Americans, and tax cuts are stimulative. As I said before, the current U.S. economic recovery is one of the longest in history. The economy is doing well; it seems to be gaining strength; and it feels like the recovery can go on longer. With the unemployment rate nearing full employment, GDP growth may well go into a more dynamic period. So why stimulate?  It doesn’t make sense to try to artificially prolong an already-long recovery. Economies go up and down, and growth rates rise and fall. Governments (and central banks) should accept this rather than attempt to bring about rapid growth forever, which increases the risk of overheating.

By definition it doesn’t make sense to think large numbers of people can arrive at formulas that produce exceptional performance. Second, the key word is “alone.” Any old formula cannot unlock the secret of investment success. An exceptional formula, arrived at on the basis of exceptional intelligence and insight, conceivably can do the job, although maybe just for a limited time. It seems obvious that a formula’s application and popularization eventually will bring an end to its effectiveness. Let’s say (in an incredibly simplified example) your study of the market shows that small-company stocks have beaten the market over a given period, so you overweight them. a) Since “beating the market,” “out-appreciating” and “out-performing” often are just the flip side of “becoming relatively expensive,” I doubt any group of stocks can outperform for long without becoming fully- or over-priced, and thus primed for underperformance. b) And it seems equally clear that eventually others will detect the same “small-cap effect” and pile into it. In that case, small-cap investing will become widespread and – by definition – no longer a source of superiority. To reiterate, George Soros’s Theory of Reflexivity says the behavior of market participants alters the market. Thus no formula will be a winner forever. For me, that means the achievement of superior returns through quantitative investing requires the ability to constantly and correctly update the formula.

This isn’t just my conclusion: if it weren’t so, capital wouldn’t be flowing from active funds to passive funds as it has been.  Regardless, for decades active managers have charged fees as if they earned them. Thus the profitability of many parts of the active investment management industry has been without reference to whether it added value for clients. © 2018 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us:  Fear of missing out – when all the above becomes widespread, optimism prevails and no one can imagine a glitch. That causes most people to conclude that the greatest potential error lies in failing to participate in the current market darling. Certainly many of the things listed above are in play today. Performance has been good – with minor exceptions, quickly rectified – since the beginning of 2009 (that’s more than eight years). There’s certainly more money around these days than high-return possibilities. “New ideas” are readily accepted, and some things are viewed as representing virtuous circles. On the other hand, some of the usual ingredients are missing. Most people (a) are conscious of the uncertainties listed above, (b) recognize that prospective returns are quite skimpy, and (c) accept that things are unlikely to go well forever. That’s all healthy. But on the third hand, most people can’t think of what might cause trouble anytime soon. But it’s precisely when people can’t see what it is that could make things turn down that risk is highest, since they tend not to price in risks they can’t see. With the negative catalyst so elusive and the return on cash at punitive levels, people worry more about being underinvested or bearing too little risk (and thus earning too low a return in good markets) than they do about losing money.

The idea that you would do something different with a March expectation rather than a December expectation ignores the likelihood that the expectation of a March rate rise would begin to be reflected in asset prices well before March. That means the likely date of a rate rise is not a very useful piece of information. What could go wrong? – For years it has felt to most people that we’ve been in a Goldilocks environment: neither too hot nor too cold. The economy hasn’t grown slowly enough to cause recession or deflation, or fast enough to bring on hyperinflation and the need for restrictive action. The markets have been strong enough to bode well, but not so strong as to suggest a bubble. Ditto for investor psychology. Most people don’t want to tempt fate by saying things will go well forever, and in fact they know they won’t. It’s just that they can’t decide what it is that will go wrong. The truth is that while I can enumerate them, the obvious candidates (changes in oil prices, interest rates, exchange rates, etc.) are likely to already be anticipated and largely priced in. It’s the surprises no one can anticipate that would move markets most if they were to happen. But (a) most people can’t imagine them and (b) most of the time they don’t happen. That’s why they’re called surprises.

So I can guess at “improbable disasters” like acts of war, disinflation or a sudden seizing up of the economy, but they’re unlikely to happen, and I don’t know much more about them than anyone else. The greatest single influence of the last three years was doubtless the 75% decline in the price of oil from June 2014 to February 2016. But who predicted it? In my memo “It’s All Good” (July 2007), on the doorstep of the financial crisis, I insisted that the good times couldn’t roll on forever. But I didn’t know it was sub-prime mortgages that would be the catalyst for a turn for the worst, and when I listed my candidates, I ended with “the things I haven’t thought of.” That’s still about the best I can do . . . or most others, it seems. What inning are we in? – Perhaps no one can say just what it is that will ring the bell on today’s positive trends, but people still want to know how advanced we are in the process, and thus when it will come to an end. People began to ask me what inning we’re in during the financial crisis of 2008, and they’ve continued ever since. © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us:  in order to keep up with the returns on the indices, benchmark-conscious active managers would have to respond by increasing their tech stock holdings, and,  thus tech stocks couldn’t fail to attract an ever-rising share of buying, and were sure to keep outperforming. You can call this a virtuous circle or a perpetual motion machine. It’s the kind of thing that fires investors’ imaginations in a bull market. But the logic that says it will work forever always collapses, sometimes just under its own weight, as was the case in 2000. Many of the most important considerations in investing are counterintuitive. One of those is the ability to understand that no market, niche or group is likely to outperform the others forever. Given human nature, “the best” will always come eventually to be overpriced, even for their stellar fundamentals. Thus even if the fundamentals hold up, the stocks’ performance from those too-high prices will become ordinary. And if they turn out not really to have been the best – or if their business falters – the combination of fundamental decline and multiple contraction can be really painful. I’m not saying the FAANGs aren’t great, or that they’ll suffer such a fate. Just that their elevated status today is a sign of the kind of investor optimism for which we must be on the lookout.

Passive Investing/ETFs Fifty years ago, shortly after arriving at the University of Chicago for graduate school, I was taught that thanks to market efficiency, (a) assets are priced to provide fair risk-adjusted returns and (b) no one can consistently find the exceptions. In other words, “you can’t beat the market.” Our professors even advanced the idea of buying a little bit of each stock as a can’t-fail, low-cost way to outperform the stock-pickers. John Bogle put that suggestion into practice. Having founded Vanguard a year earlier, he launched the First Index Investment Trust in 1975, the first index fund to reach commercial scale. As a vehicle designed to emulate the S&P 500, it was later renamed the Vanguard 500 Index Fund. The concept of indexation, or passive investing, grew gradually over the next four decades, until it accounted for 20% of equity mutual fund assets in 2014. Given the generally lagging performance of active managers over the last dozen or so years, as well as the creation of ETFs, or exchange-traded funds, which make transacting simpler, the shift from active to passive investing has accelerated. Today it’s a powerful movement that has expanded to cover 37% of equity fund assets. In the last ten years, $1.4 trillion has flowed into index mutual funds and ETFs (and $1.2 trillion out of actively managed mutual funds).

”  It’s one thing to have opinions on these subjects, but something very different to be confident they’re right (and act on them).  Taking bold action based on forecasts of things that are uncertain isn’t just misguided; it’s dangerous. As Mark Twain said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for certain that just ain’t true.”  Everyone at Oaktree has opinions on the macro. And when we see extremes in markets and, especially, capital market behavior, we’re apt to take strong action. But we’re highly aware of what we don’t know, and when conditions are moderate or indistinct, we don’t bet heavily. I’ll end this section by sharing my latest epiphany on the macro. I realized recently that in my early decades in the investment business, change came so slowly that people tended to think of the environment as a fixed context in which cycles played out regularly and dependably. But starting about twenty years ago – keyed primarily by the acceleration in technological innovation – things began to change so rapidly that the fixed-backdrop view may no longer be applicable. Now forces like technological developments, disruption, demographic change, political instability and media trends give rise to an ever-changing environment, as well as to cycles that no longer necessarily resemble those of the past. That makes the job of those who dare to predict the macro more challenging than ever. © 2017 OAKTREE CAPITAL MANAGEMENT, L.P.

” In short, as I wrote in the memo, I believe the market is “not a nonsensical bubble – just high and therefore risky.” I wouldn’t use the word “bubble” to describe today’s general investment environment. It happens that our last two experiences were bubble-crash (1998-2002) and bubble-crash (2005-09). But that doesn’t mean every advance will become a bubble, or that by definition it will be followed by a crash.  Current psychology cannot be described as “euphoric” or “over-the-moon.” Most people seem to be aware of the uncertainties that are present and of the fact that the good times won’t roll on forever.  Since there hasn’t been an economic boom in this recovery, there doesn’t have to be a major bust.  Leverage at the banks is a fraction of the levels reached in 2007, and it was those levels that gave rise to the meltdowns we witnessed.  Importantly, sub-prime mortgages and sub-prime-based mortgage backed securities were the key ingredient whose failure directly caused the Global Financial Crisis, and I see no analog to them today, either in magnitude or degree of dubiousness. It’s time for caution, as I wrote in the memo, not a full-scale exodus. There is absolutely no reason to expect a crash.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Importantly, organizers wanting their “smart” products to reach commercial scale are likely to rely heavily on the largest-capitalization, most-liquid stocks. For example, having Apple in your ETF allows it to get really big. Thus Apple is included today in ETFs emphasizing tech, growth, value, momentum, large-caps, high quality, low volatility, dividends, and leverage. Here’s what Barron’s had to say earlier this month: With cap-weighted indexes, index buyers have no discretion but to load up on stocks that are already overweight (and often pricey) and neglect those already underweight. That’s the opposite of buy low, sell high. The large positions occupied by the top recent performers – with their swollen market caps – mean that as ETFs attract capital, they have to buy large amounts of these stocks, further fueling their rise. Thus, in the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because its overpriced. Like the tech stocks in 2000, this seeming perpetual motion machine is unlikely to work forever. If funds ever flow out of equities and thus ETFs, what has been disproportionately bought will have to be disproportionately sold.

And there’s one other thing we hear a lot these days:  We agree things can’t go well forever – we agree the cycle is extended, prices are elevated and uncertainty is high – but we don’t see anything that’s likely to bring the bull market to a close anytime soon. In other words, there’ll be a time for caution, just not today. In that connection, Andrew reminds me about Saint Augustine, who said: “Give me chastity and continence, but not yet.” Is there something other than the punitive returns on safe assets that keeps this from being a time for caution? Observations and Implications As I said, most of the phenomena described above seem reasonable given the rest of what’s going on in today’s economic and financial world. But step back for perspective and put them together, and what do we see?  Some of the highest equity valuations in history.  The so-called VIX index of fear at an all-time low.  The elevation of a can’t-lose group of stocks.  The movement of more than a trillion dollars into value-agnostic investing.  The lowest yields in history on low-rated bonds and loans.  Yields on emerging market debt that are lower still.  The most fundraising in history for private equity.  The biggest fund of all time raised for levered tech investing.  Billions in digital currencies whose value has multiplied dramatically.

“Secular swings are hard to forecast, but the secular sweep downwards in interest rates is over, and we are about to have a gentle swing upwards.” I always feel it takes a degree of innate optimism to be a devotee of stocks (with their reliance on conjectural returns awarded by the market) as opposed to bonds (which bring contractual returns guaranteed by their issuers). Thus U.S. equity investors have exhibited an optimism regarding the Trump administration that virtually no one foresaw a week ago. Equity investors like inflation because it pumps up profits. Bond investors dislike it because it raises interest rates, reducing the value of the bonds they hold. But the two can’t go in opposite directions forever. At some distant point, higher interest rates can cause bonds to offer stiffer competition against highly appreciated stocks. Finally on the subject of the market outlook, I’ll pass on some observations from Stanley Druckenmiller – the owner of one of the very best investment records in history, and certainly not someone congenitally biased to optimism (or anything else): Billionaire investor Stanley Druckenmiller told CNBC on Thursday he's "quite, quite optimistic" about the U.S. economy following the election of Donald Trump. "I sold all my gold on the night of the election," the founder and former chairman of Duquesne Capital said in a “Squawk Box” interview. © 2016 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

What he meant by the latter reference was that in the short run, intrinsic value is often ignored and the stocks that do best are usually the ones capable of winning a popularity contest. I believe that, over time, elections have become more like popularity contests. The successful campaign speech isn’t one that does the best job of analyzing the challenges and supplying optimal solutions. It’s one that most provides what people want to hear. In business and investing, people invariably compare the benefits and costs of A against the benefits and costs of B. Then they select the alternative with the better expected net result (and hopefully one whose bad outcomes are survivable). A lot of mistakes may be made, and the process is sometimes misguided, but the effort to make good economic decisions is undeniably there. Decisions usually have clear consequences, and they are likely to become known before the people responsible depart. In contrast, politicians tend to believe the best decision is the one that is most likely to lead to election or reelection. Responsibility for outcomes is highly diffused, and the results may only become clear years – or decades – after the elections are held and the decisions are made. Few voters have the ability to assess the reasonableness of candidates’ promises, and – given the time lags mentioned just above – it can be difficult to judge candidates for reelection on the basis of their performance on the job.

Most people understand the challenge in dealing with “two- decision stocks”: you sell because you think the price may fall (even though it may be something you’d like to hold for the long term), and then you have to figure out when to buy it back. Last year Charlie Munger complained to me that they’re really “three-decision stocks”: you sell it because you think the price is full, you have to figure out when to buy it back, and in the meantime you have to come up with something else to do with your money. In my experience, most people who are lucky enough to sell something before it goes down get so busy patting themselves on the back that they forget to buy it back. © 2016 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

This time around, the truth doesn’t seem to be accorded a universally high priority. According to PolitiFact, an independent fact-checking outlet, 28% of Hillary Clinton statements that they’ve checked are “Mostly False” or worse. In Donald Trump’s case, it’s an astounding 70%.  In fact, it seems to me that, among certain portions of the electorate, there’s little concern for what’s said – just how it’s said. Over and over I hear people on TV say, “I like Trump because he tells it like it is.” They’re not necessarily commenting on his policies or the accuracy of his statements; more likely it’s his outspokenness and disdain for political correctness. In recent decades, it seems “this is someone I’d like to have a beer with” has taken the place of “this is the person who’s best qualified to lead the country.” I’ve thought for the last year that the Republican primary “debates” had the feeling, more than anything else, of the professional wrestling matches I watched on television when I was a boy. Each wrestler had a persona that appealed to a certain segment of the crowd, and the fans of the villains would scream their support, faces contorted in rage. Dirty tricks and cheating didn’t push away these fans – in fact, these things just stirred their bloodlust. That certainly seems to be the case with some of today’s campaign moments. The parallels between politics and pro wrestling might even extend to attempts to rig the outcome.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us:  Some of Donald Trump’s most prominent economic pronouncements have been with regard to imports, job losses and the balance of trade. o He says of China, “they’re killing us.” But trade is a two-way street. Barring unfair competition, when we run trade deficits – meaning we buy more from other countries than they buy from us – it’s for one main reason: they provide a better price/value proposition than we do. They sell products (and take jobs), but we get bargains. China isn’t “winning” in that case, and the U.S. isn’t “losing”: it’s a win for both countries. Of course it’s also true that while the result may be positive for the countries overall, there still can be negative consequences for individuals. For example, people may lose their jobs because of cheap imports, and society should take steps to ease their loss. I’ll return to this later. o Trump cites unfair competition from China as a main source of our loss of manufacturing jobs. As I pointed out in “Economic Reality,” however, in recent decades the U.S. has lost roughly ten times as many potential jobs to increased productivity, mechanization and automation as it has actual jobs to low-cost competition from China. o Trump blames part of China’s ability to sell cheap goods on the fact that it has held its currency artificially low versus the dollar.

But it’s interesting to note that when China recently made its exchange rate less rigid, the yuan declined rather than rose, suggesting that perhaps it hadn’t been held artificially low. o As for economic reality, never has Trump said anything like this: “We may be able to increase manufacturing jobs by imposing protective tariffs, but that would require all consumers to pay higher prices for their purchases of goods from abroad.” What would the average American’s everyday shopping experience be if imported goods were barred, discouraged or heavily taxed?  Further, Trump doesn’t point out that, in response to the adoption of protectionist measures by the U.S., other countries could retaliate with increased tariffs on U.S.-made goods, costing some Americans their jobs. Here’s what Moody’s Analytics says about his original economic agenda (I haven’t yet seen analysis of the plan he announced on August 8): Broadly, Mr. Trump’s economic proposals would result in a more isolated U.S. economy. Cross-border trade and immigration will be significantly diminished, and with less trade and immigration, foreign direct investment will also be reduced. While globalization has created winners and losers in the U.S. economy in recent decades, it contributes substantially to the ongoing growth of the U.S. economy. Pulling back from globalization, as Mr. Trump is proposing, will thus diminish the nation’s growth prospects.

(Democrats will counter that it’s because Republicans have been successful in implementing gridlock so as to stymy programs like retraining.) The fight between moderates and liberals for control of the Democratic party – made clear in the divided primary results between Clinton and Sanders – is far from over. Sanders supporters may decide that the party leadership isn’t liberal enough. But I think it’s the Republican party that faces greater challenges. Over the last few decades, the party has been thrown together from largely unrelated and disjointed elements. As I described in “Political Reality,” the traditional Republicans of 60 years ago – fiscally responsible, pro-business, socially moderate and strong on defense – have been joined more recently by conservatives, the Tea Party, Evangelical Christians, anti-gun-control voters, anti-abortion groups, and now the economically dislocated. The glue is weak; rather than by ideology, they have been unified primarily by the fight against Democrats. Will all these groups stay within the party? Perhaps some of the last will “vote with their feet” with regard to House Speaker and party leader Paul Ryan, who first refused to endorse Trump, then did endorse him, then described Trump’s raunchy 2005 video as “troubling” and said he wouldn’t campaign for him or support him, and then voted for him and expressed support but did so – pointedly? – without mentioning his name.

It concerned the three stages of a bull market:  the first, when only a few especially insightful people suspect improvement might occur,  the second, when most people accept that improvement is actually taking place, and  the third, when everyone concludes that things are sure to improve forever. Between the first stage and the last, nothing has to have changed in terms of fundamentals. The difference lies in the perspective investors are bringing to their decisions. But clearly, it’s great to be a buyer in the first stage and essential not to be in the last. © 2016 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Thus, for example, both of the general election candidates for a House seat in a heavily Republican district could be Republicans, with no Democrat taking up space on the ballot in an election he has no chance to win. In that case, the more moderate of the two Republicans might pick up support from other moderate Republicans (when they turn out in greater numbers in the general election), as well as from Democrats, and be elected to Congress. This “top-two primary” system is already in place in California, Louisiana and Washington, with the potential to elect moderates rather than extremists. According to fivethirtyeight, that’s exactly what happened in Washington’s 4th district in 2014. A “Tea Party hero” beat out a moderate Republican in the primary, 32% to 26%, while the leading Democrat got only 12% of the vote. In a state with separate Republican and Democratic primaries, the Tea Partier would have run against the Democrat in the general election and been a sure winner. But in Washington, the top two Republicans faced off, and the more moderate candidate won with support from moderate Republicans and some Democrats. If more moderates won – as was much more common a few decades ago – it would be easier to imagine the two parties working together, producing compromise rather than gridlock.

© Oaktree Capital Management, L.P. All Rights Reserved conviction, under the assumption that it would be easy and cheap to get out. Here’s a great quote on the subject from Warren Buffett: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value. o Certainly owners of companies wouldn’t (and couldn’t) trade in and out of them every day. If you intend to invest in businesses based on their fundamentals – rather than trading based on short-term market dynamics – it’s critical to think and act like a long-term owner. o When you find an investment with the potential to compound over a long period of time, one of the hardest things is to be patient and maintain your position as long as doing so is warranted on the basis of the prospective return and risk. Investors can easily be moved to sell by news, emotion, the fact that they’ve made a lot of money to date, or the excitement of a new, seemingly more promising idea. When you look at the chart for something that’s gone up and to the right for 20 years, think about all the times a holder would have had to convince himself not to sell. An abundance of liquidity can be a handicap in this regard. Here’s some more good advice from Warren: “If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.

© Oaktree Capital Management, L.P. All Rights Reserved  Assets with greater liquidity are safer – Greater liquidity generally means you can get out of an asset easier and closer to the price of the last trade. But first, liquidity can dry up when other investors change their mind about the asset. And second, the theoretical ability to get out when you want says nothing about fundamental safety and relatively little about investment safety in the long run. It’s much safer to be in well-analyzed assets with good fundamentals and attractive prices, in which case you can hold for a long time without needing to exit. The best defense against a lack of liquidity is arranging your affairs so there’s little need for it.  The level of risk in a portfolio can be kept low by applying a simple formulaic process – Rather, risk comes in many forms and they can be overlapping, contrasting and hard to manage. For example, as I said in “Risk Revisited,” efforts to reduce the risk of losing money invariably increase the risk of missing out on gains, and efforts to reduce fundamental risk by buying higher- quality assets often increase valuation risk, given that higher-quality assets often sell at elevated valuation metrics. What does the above consist of? It’s a collection of time-honored bromides that range from (a) only effective part of the time to (b) just plain wrong. These investment myths are pervasive but of little help.

© Oaktree Capital Management, L.P. All Rights Reserved those rare occasions when they call for change, they often underestimate the potential magnitude. Very few people predicted oil would decline significantly, and fewer still mentioned the possibility that we would see $60 within six months. For several decades, Byron Wien of Blackstone (and formerly of Morgan Stanley, where he authored widely read strategy pieces) has organized summer lunches in the Hamptons for “serious,” prominent investors. At the conclusion of the 2014 series in August, he reported as follows with regard to the consensus of the participants: Most believed that the price of oil would remain around present levels. Several trillion dollars have been invested in drilling over the last few years and yet production is flat because Nigeria, Iraq and Libya are producing less. The U.S. and Europe are reducing consumption, but that is being more than offset by increasing demand from the developing world, particularly China. Five years from now the price of Brent is likely to be closer to $120 because of emerging market demand. I don’t mean to pick on Byron or his luncheon guests. In fact, I think the sentiments he reported were highly representative of most investors’ thinking at the time. As a side note, it’s interesting to observe that growth in China already was widely understood to be slowing, but perhaps that recognition never made its way into the views on oil of those present at Byron’s lunches.

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

However, two factors argue strongly that high yield bonds are less vulnerable to rising interest rates than other fixed income sectors:  A high yield bond of a given maturity has a shorter duration than an investment grade rated bond of the same maturity, since duration is a measure of the weighted average time to receipt of the promised cash flows, and the larger interest coupons on high yield bonds mean the expected payments from interest and principal are received sooner on average. Thus an increase in interest rates of a certain amount implies less of a price decline for a high yield bond than for an investment grade rated bond of the same maturity.  In addition, rising interest rates usually imply a growing economy, and a growing economy usually means improving creditworthiness and fewer defaults. Of course it’s most unlikely that high yield bonds will deliver returns even close to 2012’s performance. On the other hand, they don’t have to equal last year’s return to warrant holding today. While yields are near all-time lows, yield spreads tell a very different story. Today the average spread on our U.S. high yield bond portfolios – approximately 490 basis points – is toward the high end of the normal historical range we’ve invested in for nearly three decades. We believe such an average spread provides more-than-adequate compensation for our default experience, which over the last 27 years has averaged 1.4% per annum.

© Oaktree Capital Management, L.P. All Rights Reserved. strengthens the economy; and economic strength buttresses confidence. It’s a circular, self- fulfilling prophesy. Confidence can also fuel market movements. Belief that the price of an asset will rise causes people to buy the asset . . . making its price rise. This is another way in which confidence is self- fulfilling. Of course, the confidence that underlies economic gains and price increases only has an impact as long as it exists. Once it dies, its effect turns out to be far from permanent. As the economist Herb Stein said, “If something cannot go on forever, it will stop.” This is certainly true for confidence and its influence. Confidence Today Back in September, I wrote a memo entitled “On Uncertain Ground.” It began as follows: “The world seems more uncertain today than at any other time in my life.” I went on to review the many elements contributing to uncertainty. For the sake of completeness, I’m going to restate and update my list. These are things I’m asked about all the time. I don’t recall another time when the list was as long: In the U.S.:  Will the recovery from the recession of 2008 – long in the tooth but still halting and unsteady – ever gain vitality? Today it seems we’re experiencing “two steps forward, one step back,” as positive reports are regularly mixed with disappointments.

Further, even the improvements – in areas like job creation, consumer confidence and manufacturing output – seem tepid rather than eye-popping. This is quite different from the recoveries of the last few decades.  To what extent will the recovery be impaired by recent tax increases and the budget cuts mandated by “sequestration”?  When will sales increases overcome businesses’ resistance to spending on plant and personnel?  How much longer will the Fed keep interest rates low? Three months? Three years? In perpetuity?  What will happen when it no longer does? Will rates rise? How much? Will the effect of higher rates on the cost of financing purchases and investments be enough to slow the economy? And what will be the impact of higher rates on the government’s cost of financing, and thus on the deficit?  What are the implications of the fact that the Fed’s balance sheet has swelled to over $3 trillion? How does the Fed pay for the bonds it buys under QE? Will it have to pay that money back? Will the Treasury have to pay off the Fed when the debt matures? Where will it get the money? And where will the money go? (Think about this for a minute: do you feel you understand the workings of this process? Do you know anyone who does?)  Will our economy ever get back to the higher growth rates of the late twentieth century, or will we be stuck in a slow-growth mode? © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved.  Will “structural unemployment” in the future remain stubbornly above the 5% or so of the last few decades?  Will profit margins retreat from their current record levels, and if so, what will be the effect on corporate profits?  Longer term, can progress ever be made on cutting the budget deficit and reducing the unfunded entitlement obligations?  What will be the social ramifications of slow growth, high unemployment and increased income disparity?  Will the U.S. devalue the dollar, the usual path to dealing with excessive national debt?  Will slow growth lead to Japan-style deflation? Or will high-volume money printing to make it easier to repay the debt bring on chronic inflation? (The mere fact that intelligent people worry simultaneously about both these polar opposites is in itself an indicator of the high level of uncertainty that is present.) In Europe:  Can the seeming downward spiral in peripheral Europe’s economies be arrested?  Can Europe’s excessive indebtedness be brought down, and can the chronic deficits that led to that level of indebtedness be trimmed through austerity?  Will richer nations continue to support poorer without insisting on the latter applying painful austerity?  In practical terms, can austerity be undertaken at a time of economic weakness? If austerity is continued, are recession, suffering and unrest unavoidable?

Belief in the things listed above largely eliminated uncertainty regarding the future and contributed to an extremely high level of confidence. No one thinks that way today. Confidence: Good or Bad? Let’s say I have accurately described that confidence, optimism and certainty were high in 2007 and low in 2013. Here’s a key question that I’ve been wrestling with: which is more desirable? The answer is largely a function of your timeframe. The high level of confidence in 2007 – not unlike that of the 1990s – contributed to a feeling of great well-being. The feeling that nothing would go wrong – that a perpetual-motion machine could be counted on to keep things on an upward course forever – contributed to rampant consumer optimism, aggressive spending, rising economic aggregates, accommodative capital markets and strong asset prices. It sure felt good. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Let‟s take a look at the 1990s, a decade full of lessons about equities. As of 1990, the historic return on equities stood at 9% or 10%, and for that reason attitudes toward them were generally favorable, with that 9-10% return expected to repeat in future decades. But the ‟90s were a salutary period in terms of economic growth, corporate performance, technological and productivity gains, declining interest rates, low inflation and relative peace in the world (as well as naïve optimism regarding the benefits of a credit- © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Appreciation accelerates, possibly leading to a mania or bubble. Everyone concludes that things can only get better forever. They forget about the risk of losing money and fixate on not missing opportunities. Leveraged buyers become convinced that the things they buy with borrowed money are certain to appreciate at a rate above their borrowing cost.  Eventually things get as good as they can get, the last skeptic capitulates, and the last potential buyer buys. That’s the way the cycle of attitudes toward risk ascends. The skeptic in times of moderation becomes a true believer at the top. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved. But as Herb Stein brilliantly observed, “If something cannot go on forever, it will stop.” Applying that thought here, I’d say when things are as good as they can get, they can’t get any better. That suggests eventually they’ll get worse. It always turns out that – investors’ hopes to the contrary – economies, profits and asset prices can’t rise forever. Or, at a minimum, they can’t keep pace with investors’ ever-rising hopes. And thus the down-cycle begins.  Once the last potential buyer has bought, there’s nobody left to take prices higher.  A few unemotional, disciplined and foresighted investors conclude that things have gone too far and a correction is in the cards.  Economic activity and corporate earnings turn down, or they begin to fall short of people’s irrationally expanded expectations.  The error of those expectations becomes obvious, causing security prices to start declining. Perhaps someone is daring enough to point out publicly that the emperor of limitless growth has no clothes. Sometimes there’s a catalyzing event. Or sometimes (see early 2000) security prices begin to fall of their own accord, simply because they had moved too high.  The first price declines cause investors to rethink their analysis, conclusions, commitment to the market and risk tolerance. It becomes clear that appreciation will not go on ad infinitum. “I’d buy at any price” is replaced by “how can I know what the right price is?

”  Weak economic news takes the place of positive reports.  The average investor realizes that things are getting worse.  Interest in investing declines. Selling replaces buying.  Investors who sat out the dance – or who just underweighted the depreciating assets – are lionized for their wisdom, and holders start to feel stupid.  Giddy enthusiasm is replaced by sober skepticism. Risk tolerance declines and risk aversion is on the upswing. People switch from worrying about missing opportunity to worrying about losing money.  Financial institutions become less willing to extend credit to investors. At the extremes, investors receive margin calls.  Investors who borrowed to buy are heavily penalized, and the media report on leveraged entities’ spectacular meltdowns. Forced selling in response to margin calls and covenant violations causes price declines to accelerate.  Eventually we hear some familiar refrains: “I wouldn’t buy at any price,” “There’s no negative case that can’t be exceeded on the downside,” and “I don’t care if I ever make another penny in the market; I just don’t want to lose any more.”  The last believer loses faith in the market, selling accelerates, and prices reach their nadir. Everyone concludes that things can only get worse forever. Coping with the Risk Cycle The important conclusions from observing the above pattern are these:  Over time, conditions in the real world – the economy and business – cycle from better to worse and back again.

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.

© Oaktree Capital Management, L.P. All Rights Reserved. what to do. But all-good or all-bad attitudes are rarely right, since there are invariably valid points on both sides and they mustn’t be ignored. Mark Twain said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” Most of the time, limits on confidence are more desirable than cocksureness. Over-confidence in one’s judgment is very dangerous. The Bull/Bear Cycle In March 2008, in “The Tide Goes Out,” I repeated one of the most helpful of all the adages to which I hold – the description of the three stages of a bull market:  the first stage, when a few forward-looking people begin to believe things will get better,  the second, when most investors realize improvement is actually underway, and  the third, when everyone’s sure things will get better forever. What does it really mean? The essential raw material for a bull market is cheapness, and that cheapness exists in stage one precisely because there are so few believers and so little confidence that favorable developments and good times lie ahead. Thus stage one provides the launching pad for a bull market. Equally, in the third stage the bull market is primed to end – with the bubble popping and a down-cycle setting in – for the simple reason that there are too many believers (and too few skeptics). In short, there’s too much confidence and too little cheapness. It’s this imbalance that creates market tops.

All that‟s required is another good year or two for stocks and a switch in investor psychology from “stocks are unlikely to do anything but extend the „lost decade‟ ” to “hey, I‟m afraid I might not be positioned adequately to participate in the next bull market.” A move upward can be powered by a switch from the fear of losing money to the fear of missing opportunity. When attitudes are moderate and allocations are low, it doesn’t take much. * * * In the mid-1970s I was fortunate to happen upon one of the first of the time-worn pearls of wisdom that contributed so much to my education as an investor. It described the three stages of a bull market: the first, when a few forward-looking people begin to believe things will get better, the second, when most investors realize improvement is actually underway, and the third, when everyone‟s sure things will get better forever. In “The Tide Goes Out,” written in March 2008, several months before the lows of the financial crisis, I applied the same thinking to the converse – the three stages of a bear market: the first, when just a few prudent investors recognize that, despite the prevailing bullishness, things won‟t always be rosy, the second, when most investors recognize things are deteriorating, and the third, when everyone‟s convinced things can only get worse. Hindsight always makes it clear what was going on at a particular point in time.

But the combination of intractable deficit spending, unsustainable entitlement promises and a total dearth of responsible action in Washington certainly raises alarms regarding the future. Since I see no reason to reinvent the wheel when someone I respect has said something better than I could, I’ll close with a few words from Seth Klarman (emphasis added). Seth doesn’t find much in the things he discusses to inspire confidence, and I agree: There is no free lunch in economics: if governments could print or borrow money in astronomical amounts without any major adverse consequences, why wouldn’t they always do this, forever avoiding downturns while their countries bask in the sunshine of limitless prosperity? Indeed it seems clear that prior misplaced confidence in the Fed contributed greatly to years of complacency that turned the 2008 downturn into a full-blown crisis. Of course there will be a price to pay for today’s policy excesses – an equal and opposite reaction. We just haven’t seen it yet. Will it take the form of a collapse of the dollar and the end of dollar hegemony, high interest rates, failed auctions of U.S. government securities and runaway inflation, a wrenching and protracted downturn requiring exceptional sacrifice, or something else? We will find out soon enough. In most sectors of the economy – government, individual but also corporate – the U.S.

© Oaktree Capital Management, L.P. All Rights Reserved. haven’t really earned.” Asset values are contingent, as Jim Grant once said. But debt is forever. Instead of cutting back on leverage and getting our house in order, government response to the crisis has been to shift unaffordable debt from individual balance sheets onto the national ledger, where every day we owe more than ever before. . . . I believe it is possible that the average citizen understands our country’s fiscal situation better than many of our politicians or prominent economists. Most people seem to viscerally recognize that the absence of an immediate crisis does not mean we will not eventually face one. They are wary of believing promises by those who failed to predict previous crises in housing and in highly leveraged financial institutions. They regard with skepticism those who don’t accept that we have a debt problem, or insist that inflation will remain under control. (Indeed, they know inflation is not well under control, for they know how far the purchasing power of a dollar has dropped when they go to the supermarket or service station.) They are pretty sure they are not getting reasonable value from the taxes they pay. When an economist tells them that growing the nation’s debt over the past 12 years from $6 trillion to $16 trillion is not a problem, and that doubling it again will still not be a problem, this simply does not compute.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. Memo to: Oaktree Clients From: Howard Marks Re: Assessing Performance Records – A Case Study What are the non-negotiable requirements for accurately assessing investment performance? I’d say:  a record spanning a significant number of years,  a period that includes both good years and bad, enabling us to assess performance under a variety of circumstances, and  a benchmark or peer universe that makes for a relevant comparison. The other day, at an event for alumni and other constituents of the University of Pennsylvania, president Amy Gutmann reviewed the performance of the university during the financial crisis. In the process, she had some kind words for Penn’s Investment Board, which I chaired for the ten years from June 30, 2000 through June 30, 2010. Thinking about it afterward, I realized that I should share with you the story of Penn’s endowment and its lessons. Penn has agreed that I may do so. The data is a little out of date, but the lessons aren’t. A Little Background For roughly two decades starting in the late 1970s, Penn’s endowment was led by John Neff, probably the most respected investor of that era, in strict adherence to the principles of value investing. Thus, its fortunes fluctuated along with the performance of that school of thought.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. Penn’s historic emphasis on value investing and its eschewing of bigger potential money makers had a lot to do with defense, especially in the environment of the late 1990s. Likewise, I believe I am known – and I certainly know myself – to be one who usually puts great emphasis on defense. Would a cautious approach continue to penalize Penn, or was it what was called for under the circumstances? Having fallen so far behind, should we continue to stress defense to avoid losses if the market reversed course, or should we go on the offensive in an attempt to make up the lost ground? This question had particular importance at Penn. Given its early history as a commuter school rather than an elite institution like some of its peers, Penn came into the 21st century under- endowed; it ranked only 70th in the country in endowment per student. So the stewards of Penn’s endowment faced a particular dilemma: should we invest conservatively because we can’t afford to lose the little bit we had, or aggressively in an attempt to close the gap? Again, there’s no one right answer to that question, and perhaps there was no one right answer for Penn. But the answer was clear for me: I wouldn’t preside over a shift to offense . . . and especially not on the heels of one of the best decades for stocks in history.

” But that’s likely to be the case when everyone’s certain that each new issue, fund and black box represents the chance of a lifetime. The key lies in the fact that our strongest actions are undertaken in response to currently observable phenomena like these, not predictions. The way I put it, “we may never know where we’re going, but we’d better know where we are.” Second, I confess: I think about the future. So do my colleagues. If someone who’s spent decades investing doesn’t have opinions about what lies ahead, there’s something wrong. I believe our clients want us to apply the benefit of our experience in gauging and reacting to the opportunities and risks that lie ahead. But I have a mantra on this subject, too: “It’s one thing to have an opinion; it’s something very different to assume it’s right and act on that assumption.” We have views on the future. And they can cause us to “lean” toward offense or defense. Just never so much that for the results to be good, our views have to be right. Here’s the full text of the tenets in question. I think you’ll see that we’re true to the limitations expressed above, albeit perhaps not slavishly. Macro-forecasting not critical to investing – We believe consistently excellent performance can only be achieved through superior knowledge of companies and their securities, not through attempts at predicting what is in store for the economy, interest rates or the securities markets.

People extrapolate uptrends and downtrends into eternity, whereas the truth is that trends usually correct: rather than go well or poorly forever, most things regress to the mean. The longer a trend has gone on – making it appear more permanent – the more likely it usually is that the time for it to reverse is near. And the longer an uptrend goes on, the more optimistic, risk- tolerant and aggressive most people become . . . just as they should be turning more cautious. So, for example, when the economy is thriving and profits are rising, people conclude that company operations should be expanded, acquisitions should be undertaken, and more debt can be borne. That same bullishness causes providers of debt to bestow larger amounts of money on weaker borrowers, at lower interest rates and with looser covenants. Thus cycles are big sources of error, and pro-cyclical behavior is one of the biggest destroyers of capital. The point here is that one of distressed debt investing’s great advantages is that it embodies an anti-error business model. Distressed debt investors . . .  . . . almost never invest in companies where everything’s going well and investors are enthralled; there’s no such thing as a financially distressed company that everyone loves;  . . .bag;

executive: “Have you been to an American stockholders‟ meeting lately? They‟re all old fogeys. The stock market is just not where the action‟s at.” And what consistently provides the foundation for this insistence that the game has permanently changed? Four of the most dangerous words in the investment world: it’s different this time. When investors choose to believe that historic valuation standards have become irrelevant; that one industry or product can maintain superior growth and profitability in perpetuity; or that one asset or market can outperform all the others forever regardless of how high its price goes in the process – that is, that trees can grow to the sky – the bubble is invariably undergirded by a steadfast belief that it‟s different this time. Here‟s the support BusinessWeek advanced: Says Alan Coleman, dean of Southern Methodist University‟s business school, “We have entered a new financial age. The old rules no longer apply.” When you see or hear words like these, you should go on high alert. Sometimes the world changes and the past becomes irrelevant, but most of the time I‟ll take the other side of that bet. Getting to the Truth In some ways, understanding the market is like mathematics. You don‟t have to be knowledgeable regarding the specifics of the underlying subject matter to know whether a conclusion makes sense. You just have to be able to apply principles, tell logic from illogic, and exclude the deleterious effects of emotion and psychology.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. So the insightful, unemotional, contrarian investor will read an article like “The Death of Equities” and conclude that things are about as bad as they can get. And if things can‟t get worse, they‟ll probably get better eventually. It‟s no more scientific than that. If in mid-1979 people thought things could only get worse, there was no optimism to evaporate. That meant the litany of negatives actually foreshadowed something very different: The Rebirth of Equities. And that’s exactly what happened. The S&P 500 gained 18.4% in 1979, the year “The Death of Equities” was written, and went on to average 18.9% a year for the next 20 years. There were only two down years during that span: a measly 4.9% in 1982 and 3.1% in 1990. This has to have been the best 21-year period in the modern era. Importantly, the stage had been set for this rise in 1979 by the accumulation and excessively pessimistic discounting of negatives. Way back in February 1993 – it would be yellowed by now, except that electronic copies don‟t turn yellow – I wrote a memo entitled “The Value of Predictions, or Where‟d All This Rain Come From?” One of the things it discussed was the tendency of forecasters to extrapolate, especially when a trend has gone in one direction for a long time. They tend to conclude it will go that way forever . . . and increasingly so just as it becomes more likely to revert to the mean.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved.  The riskiest things are investor eagerness, a high level of risk tolerance, and a belief that risk is low. That’s a pretty good description of 2005-07.  In contrast, we can take heart when investors are discouraged, risk aversion is running high, and economic difficulty is all over the headlines . . . like today. Twelve years ago, equity returns were ending one of their best decades ever; p/e ratios were way above the norms; investors were participating in a love affair with stocks; equity allocations had been built up; and no one could think of a reason why the performance of stocks might flag. Now stocks have produced no gain for years, and no one’s excited about them, even though they’re vastly cheaper. In 1999, sky-high valuations and investor ardor positioned stocks for a “lost decade.” Today, low valuations and investor indifference just might mean they’re poised to surprise on the upside. Unlike the pre-crisis days, virtually no one is oblivious to the macro risks. Most investors hold modest expectations for the developed economies and for the markets. I think this is quite favorable. To put it succinctly, the potential for investment gains is above average when expectations don’t fully anticipate the eventual reality. This potential comes not from a future that will be positive, but from a future – whether positive or not – that is underestimated.

Many other nations seem to function no worse without them. But the U.S. has the historical accident of a ceiling, and we must deal with it. Because the limitation is set in terms of absolute dollars and not indexed for inflation or growth, we would run into it every few years even if our debt only grew apace with the economy. “In fact, it’s been raised nearly 100 times over the decades.” (Financial Times, July 16) But thanks to the especially rapid growth of our debt relative to GDP in recent years – exacerbated by the Afghan and Iraq wars and the financial crisis – the ceiling has the potential to provide some real excitement every once in a while. The Relentless Growth of Debt Greece, Ireland, Portugal, Spain, Italy, Iceland, the U.S., California . . . the list of governments with debt problems is long and grows longer. The issue has flared up in the last fifteen months and is often in the headlines nowadays. And yet, the general conditions causing the concern are nothing new. The deficits and debt that worry people today have existed for a good while: similar in kind albeit perhaps © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. These facts combined with other causes to produce a market crash of epic proportions; widespread losses; a drying up of capital; deflation; and a massive depression with a resulting increase in unemployment to 25%. Unsurprisingly, fingers were pointed at the prior administration and political power shifted to believers in an activist role for government. The most lasting result was the enactment of laws that governed the financial system for decades and in many cases still do: the Securities Act, the Securities and Exchange Act, and the Glass- Steagall Act. Thus the 1930s saw a massive swing of the pendulum in favor of regulation. The next several decades on Wall Street were – perhaps thanks to the impact of those laws – a relatively placid period. This led to a view that, with rare exceptions, market participants are well-behaved by nature. Further, steady growth with only moderate dips caused a perception of an inherently benign and productive economy that could achieve even more if only the regulatory shackles were loosened. After President Carter deregulated the transportation industry in the late 1970s, the door was open for much of the regulatory apparatus built in the early part of the century to be relaxed. Ronald Reagan, whose famously free-market views coincided with a period of peace and prosperity, led the deregulatory charge.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved One of the most striking aspects of debt in the modern era is that little if any attention is paid to repayment of principal. No one pays off their debt. They merely roll it over . . . and add to it. Thus credit ratings are highly deficient (shocker!) in a way that few people talk about. What ratings describe isn’t the borrower’s ability to repay principal, but its ability to make interest payments and refinance principal. But the assessment of their ability to roll their debt – likewise – isn’t based on an ability to repay, but rather to refinance again. So ultimately the security of capital providers stems not from the borrower, but from the continued willingness of other capital providers to roll debts in the future. (It was their occasional refusal in 2007-08 that caused the worst moments of the financial crisis.) With no one asking how debt could be repaid, nations were allowed for decades to increase their deficits and debt non-stop relative to their GDP. And then, in the first quarter of 2010, the little boy stepped out from the crowd, took note of the emperor’s non-existent new clothes, and said “Hey, wait a minute: Greece will never be able to repay even the debt it has, forgetting that it takes on more all the time. Its economy is non-competitive and stagnant, and tax compliance is non-existent. They shouldn’t be able to borrow.” That’s all it took. Greece was denied further credit.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved The U.S. has run deficits almost every year since World War II, with prominent surpluses only in 1998-2001. Go back a few decades, and the characterizations of the two political parties were fairly well established. The Democrats stood for progressive taxation (meaning a higher percentage burden on top earners) and more government spending, especially in aid of those in need. The Republicans were the party of strong defense, small government, fiscal responsibility and balanced budgets. More recently, neither party has shown resolute fiscal discipline. Both have added unfunded programs. Tax reduction has been discovered as a growth stimulant. The upward march of our deficit and debt has been nearly uninterrupted. We’ve seen the enactment of spending programs without providing for increased revenues to pay for them, and cuts in taxes without corresponding reductions in spending. As President Obama put it on July 15: . . . we cut taxes without paying for them over the last decade; we ended up instituting new programs like a prescription drug program for seniors that was not paid for; we fought two wars, we didn’t pay for them; we had a bad recession that required a Recovery Act and stimulus spending and helping states . . . The blame isn’t limited to one party.

The increases in deficits and debt took place when both Democrats and Republicans were in power, and while control of government was both divided and in the hands of a single party. It seems apparent that in recent decades, politics has become more partisan, and solving the nation’s problems has taken a back seat to adhering to ideology and getting re-elected. And what gets people elected? Promises of more: more benefits without increased taxation, and more take-home pay without reduced largesse. Only recently have large numbers of politicians begun to face the music, admitting that the government has to either do less or charge people more or both. Obstacles to a Solution From my point of view, so much that’s illogical is going on regarding these issues that I sometimes find it hard to get my head around the current “debate” (if we can call it that when so few people are conversing). Here’s what I think is the logic of the situation (with data from FactCheck, July 15):  Expenditures have risen relative to the economy even as revenues have declined. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

They engaged in uneconomic behavior, advancing the policy goal of making home ownership available to people who couldn’t afford it, and accepting vast risk on the basis of inadequate capital because they (and their lenders) had no fear of loss.  Legislators turned regulation over to the private sector by putting credit rating agencies in charge of financial institutions’ investing standards, giving commercial organizations excessive imprimatur. Financial temptation pressured them to drop their standards, and when they succumbed, the previously sacrosanct triple-A rating became a meaningless label.  Having witnessed the rescue of the banks and the financial system, we now have a system where free-market rewards will continue to motivate risk taking and no one believes the ultimate price – meltdown – will be demanded of too-big-to-fail institutions that take it too far. A free-market mechanism undercut by moral hazard may perform adequately 95% of the time, but it will pose terrible risks in the remainder. The real bottom line is that since both free markets and regulation are imperfect, our financial systems will continue to be imperfect. They will work well for us most of the time, although not perfectly, and they will be subject to bubbles and crises every few decades (hopefully not more often). © Oaktree Capital Management, L.P.Reserved

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. Buffett’s tax status is a function of policy choices made by the people who wrote our tax laws. According to The New York Times of September 21, “President Obama’s proposal for a new tax on millionaires . . . would counteract decades of tax reductions for most Americans that have given the wealthy the most benefit. . . .” Do we consider these decisions appropriate in principle and Buffett’s just an extreme case? Or do we want to change things so returns on capital are less favored and big earners can never pay overall taxes at lower rates than those who earn less? (And, as an aside, are all long-term profits truly beneficial to society? How, for instance, does society benefit when someone buys a bar of gold?) Deductions, Loopholes and Tax Incentives Speaking of gold, in “All That Glitters” on that subject, I quoted from a speech by Mississippi state legislator “Soggy” Sweat that showed his ability to simultaneously praise and condemn whiskey with equal conviction. Outdoing Soggy, depending on who’s talking, Washington politicos use the three very different terms above to describe the same thing: offsets to taxable income. The drafters called them deductions: provisions that reduce the net income on which taxes are levied. Critics call them loopholes, suggesting there’s something underhanded about those provisions.

 As opposed to the ideological arguments reviewed above, tax increases are among the limited number of possible contributors to deficit reduction listed on page 1. Thus, in the simplest terms, we can cut more from the deficit if we tax more (all else being equal).  The ultimate practical point is that spending cuts alone won’t do much to eliminate the deficit.  Viewed another way, promises of entitlements have been in place for decades, people have relied on them, and those promises have to be kept. This is clearly impossible without increased taxes and/or exploding deficits. Is redistribution a valid goal? To some people, it is part of the process of helping every citizen in the “pursuit of happiness.” To others, it’s akin to socialism and contrary to the American ethic in which rewards follow ability and hard work. Should everyone contribute to deficit reduction, including bigger earners through the biggest tax increases? Or should the savings come primarily through sacrifices © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

We were even lucky enough to see the collapse of our great enemy, the USSR, and to live in a world that was generally at peace. It was a period in which the markets benefited from positive developments and overwhelmingly bullish attitudes. As my partner David Kirchheimer points out, the favorable underlying trends constituted a rising tide in the Buffett sense, meaning for a long time we didn’t get a chance to see which borrowers, risk takers and financial innovators were swimming unclothed. The picture has become less alluring with the tides less favorable, and I expect only moderate improvement in that regard. David adds that “it took many years, trillions of dollars in credit extension, and countless well-intentioned but misguided policies to get us into this mess, so it’s likely that under the best of circumstances it will take many years for the economy – and standards of living – to reach a new equilibrium, and for the financial markets to acclimate to a ‘new normal’ of possibly lower returns without the artificial effect of record government stimulus.” I feel the prosperity we enjoyed in the final decades of the twentieth century was considerably better than “normal,” and better than we’re likely to see up ahead. I’m not implying a world without growth or otherwise permanently negative. Just one without the prosperity, dynamism or positive feelings of past decades.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved Anything else would be a short-term palliative . . . or a continued exercise in imprudence. Spending that grows no faster than GDP should be an imperative. Shrinking government’s share of the economy seems highly desirable. National debt that is stable or declining as a percentage of GDP sounds compelling. (In addition to balancing the budget and growing the economy, I think we have to accept that the coming decades are likely to see U.S. standards of living decline relative to the rest of the world. Unless our goods offer a better cost/benefit bargain, there’s no reason why American workers should continue to enjoy the same lifestyle advantage over workers in other countries. I just don’t expect to hear many politicians own up to this reality on the stump.) To close, I’m going to borrow some quotations and data from Michael Cembalest, Chief Investment Officer of J.P. Morgan Private Bank (Eye on the Market, July 18): The long-term threat: . . . there are serious questions, most immediately about the sustainability of our commitment to growing entitlement programs . . . the time we have is growing short. (Paul Volcker, The New York Review of Books, June 24, 2010) According to the CBO alternative case (tax cuts do not sunset as planned; AMT keeps getting indexed to inflation; no Medicare cuts take place, etc.), by the year 2024, entitlements plus interest spending will be equal to total government revenue.

My answer is that we’re not likely to see anything like that, in large part because in those decades the gap between stagnant incomes and vigorous consumption growth was bridged through buying on credit. Instead, in the years ahead I think (a) growth in employment and incomes will be sluggish, (b) consumers should be restrained in their borrowing as a result of having experienced the crisis, (c) consumer credit shouldn’t be available as readily, and (d) borrowing against home equity will be much less of a factor, especially because home equity is so scarce. Second, should you worry more about losing money or about missing opportunities? This one’s easy for me. First, the macro uncertainties tell me we won’t be seeing a highly effervescent economy or market environment. Second, other people’s increasingly aggressive behavior tells me to seek cover. And third, since I don’t see many compellingly cheap assets, I doubt there will be gains big enough to make us kick ourselves for having invested too cautiously. And that brings me to my third question: what tools should you employ? In late 2008 and early 2009, you needed just two things to achieve big profits: money to commit and the nerve to commit it.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. Thus in recent months we’ve increasingly heard Democratic politicians sneer at “millionaires and billionaires” (see Senator Reid on page 2), an epithet aimed at a group that’s supposedly been getting away with something. (In the past, I seem to recall, it was instead a group most people wanted to be part of.) To date, the preferred Republican label for people with money has been “job creators,” although this line of defense may be tough to maintain in the current climate. The Financial Times of October 29 carried an article headlined “Obama takes high-risk stance against the rich.” It described a decision to emulate Roosevelt’s Depression-era rhetoric and point an accusing finger at the Republicans as the party of wealth. Throwing out the standard presidential playbook dictating an aspirational approach to centrist voters, the White House is cementing a message that strikes at wealth and privilege. “There is surging sentiment among voters that the economy is weighted towards the wealthy,” said a senior White House official. The White House strategy will make the 2012 election a generational test of the Republican push of the last three decades for cutting taxes, in ways their critics say have been constantly skewed towards the highest earners.

However, the article goes on to say Republicans may respond in kind to this tactic, joining in support of the common man rather than standing up for wealthier supporters: . . . Republicans are tweaking their public message, with the hardline [H]ouse majority leader, Eric Cantor, recently acknowledging the need to address the rich-poor gap. Mitt Romney, the frontrunner in the race to challenge Barack Obama in 2012, has taken to saying that he is standing up for the “middle class” because the rich “can look after themselves.” With candidates in both parties competing to sound less pro-wealth, top earners and their supportive tax policies should expect to be rhetorical targets in the coming election. Whether this will extend to Republican candidates dropping their resistance to tax increases remains to be seen. The Ultimate Worry: Tyranny of the Majority The elements that contributed importantly to America’s success included economic aspiration, upward mobility and a tax system that encouraged labor and risk-taking. In short, we all could get rich. As a result, both those with money and those hoping to make money were attracted to the idea of low taxes. This made tax reduction a very popular theme over the last few decades. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. But when people without money start to believe they can’t make money, there’s little to keep them from taking it from those who have it. This represents a threat to our way of life. As I’ve written before, I was very impressed when, as a young man, I heard an interesting explanation for America’s economic progress relative to Great Britain: “When the worker in Britain sees the boss drive out of the factory in his Rolls Royce, he says ‘I’d like to put a bomb under that car.’ When the worker in America sees the boss drive out of the factory in his Cadillac, he says ‘I’d like to have a car like that someday.’ ” This tale says a lot about how we achieved our success . . . and also about what we’d better retain if we want to keep it. The truth is, in a democracy, the lower-earning majority is perfectly capable of voting to confiscate the wealth of the minority. A lot of people have written about this and associated threats to our system: “If Sparta and Rome perished,” asked Rousseau in his Social Contract, “how can any state hope to live forever? The Body Politick, like the body of a man, begins to die as soon as it is born; it contains the seeds of its own destruction. (Financial Times, October 29) “When men get in the habit of helping themselves to the property of others,” warned the New York Times in 1909, “they are not easily cured of it.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. There can be no easy solution. Social programs and tax policies have been put in place that will combine with demographic and income trends to create challenging conditions. “The Middle-Class Tax Trap” (The New York Times, April 17, 2011) outlined the consequences: [Consider] the “current law baseline,” a Congressional Budget Office projection in which the Bush-era tax rates aren’t renewed in 2012, the Alternative Minimum Tax (which is supposed to hit only the rich but increasingly bites into middle-class paychecks) isn’t indexed for inflation, and Medicare payments to doctors are slashed 20%. With these changes, the deficit drops away in the next 10 years, and more important, it stays manageably low for the decades after that. . . . This is how the “current law baseline” cuts the deficit: Thanks to inflation and bracket creep, its tax code generally subjects more and more Americans to rates that now fall only on the wealthy. Today, for instance, a family of four making the median income . . . pays 15% in federal taxes. By 2035, under the C.B.O. projection, payroll and income taxes would claim 25% of that family’s income. The marginal tax rate on labor would rise from 29% to 38%. Federal tax revenue, which has averaged 18% of G.D.P. since World War II, would hit 23% by the 2030s and climb ever higher after that.

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.

This memo is inspired by two excellent newspaper articles that appeared within the last month: “Party Gridlock Feeds New Fear of a Debt Crisis,” by Jackie Calmes (The New York Times, February 17) * and “Perils of the California Model” by David Wessel (The Wall Street Journal, March 4).† Indicating their importance, The Times piece ran in the upper right-hand corner of the front page, always the place for the top story of the day, and the Journal story was carried on page A2. I’ve included links below in the hope they’ll increase your likelihood of reading them. As Calmes wrote in The Times (in both cases below, emphasis added): After decades of warnings that budget profligacy, escalating health care costs and an aging population would lead to a day of fiscal reckoning, economists and the nation’s foreign creditors say that moment is approaching faster than expected, hastened by a deep recession that cost trillions of dollars in foregone tax revenues and higher spending for safety-net programs. Yet rarely has the political system seemed more polarized and less able to solve big problems that involve trust, tough choices and little or no short- * http://www.nytimes.com/2010/02/17/business/economy/17gridlock.html † http://online.wsj.com/article/SB20001424052748704541304575099371249822654.html © Oaktree Capital Management, L.P.Reserved

founder but also a “Mediterranean”) maintains “a fleet of more than 626,000 official cars, more than 10 times the number in France, Germany or the UK.” (Financial Times, May 12) Together these things – low output, high government spending, under-the-table business dealings, tax evasion, and financial profligacy – represent a recipe for trouble. Today’s developments merely prove that things that don’t make sense can’t go on forever:  Perpetually spending more than you bring in.  Enjoying a standard of living you can’t afford.  Running an annual deficit that increases constantly as a percentage of GDP.  Owing amounts that increase constantly as a percentage of GDP.  Doing all the above while having a currency as strong – and an interest rate as low – as in nations where these things are not the case. Things can go on longer than they should, and these probably have, but eventually there’s a price to be paid. The world is up in arms today over everything that’s wrong with the European financial picture, even though these conditions probably aren’t much changed from a few years ago. It’s just that now people have decided to focus on them. The Role of Debt As I mentioned above, debt isn’t the problem, or the cause of the problem. But it has been the facilitator. In “The Long View” (January 9, 2009), I wrote (albeit without reference to Greece) about a strong uptrend over the last few decades in what I called “expansiveness”: © Oaktree Capital Management, L.P.Reserved

Every business, government, non-profit organization or individual has a certain amount of equity capital, net worth or surplus. That capital, in turn, will support a certain level of activity: production and sales, lending, government action, charitable grants or consumption. But over the last several decades, if you wanted to do more of these things than your capital permitted, you could borrow capital from someone else. Without credit – I think back to my pre-credit card college days of 45 years ago, for example – you couldn’t spend money you didn’t have. Thus you couldn’t buy things you couldn’t afford. Then the miracle of credit came along and it became easy to get in over your head. What would have happened if governments couldn’t finance deficits by issuing debt? Greece would only have been able to pay the benefits it could afford. Less pleasant, but perhaps healthier. And what would have happened if builders weren’t able to borrow, and thus had to sell each newly built home before they could erect the next? Spain wouldn’t have been the site of a boom in which 2.8 million homes were built (with only 1.5 million sold), and with as many building permits issued as in France, Germany, Italy and the Netherlands put together.

The Wall Street Journal of November 24, 2008 carried the following quotation from Irving Fisher, writing 76 years ago (“The Debt-Deflation Theory of Great Depressions,” Econometrica, March 1933): When it comes to booms gone bust, “over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money.” While this statement wasn’t made with regard to Greece or even to government activities in general, it is clearly relevant to the current situation. In recent years, most of the nations of the world spent more than they took in to give their citizens more of what they wanted. As long as the capital markets were open, few could think of a reason why this policy wouldn’t work forever. Economic units all over the globe were able to borrow to cover deficits. All that mattered was the ability to service the debt, even if that required borrowing money to pay interest. No one seemed to demand the ability to repay. When I was younger – in what seems like a distant past – national debt began to expand, and I remember heated debate regarding the significance, wisdom and likely consequences of that trend. The subject receded in recent years, since every nation now does it to some extent and people became inured to the controversy, as they tend to do. Two sentences stand out on this subject, from Bill Julian of Bill Julian Research on April 11.

© Oaktree Capital Management, L.P. All Rights Reserved I worry about the long-term impact of government involvement in business decisions: telling companies what they should pay top employees and setting minimums for the percentage of premium revenue that a health insurer should pay out in benefits, for example. The Obama administration has the smallest percentage of Cabinet secretaries with backgrounds in the private sector of any president since Teddy Roosevelt, according to the November 24 issue of Forbes. People in the executive and legislative branches with no experience in business are telling business how to operate. Lastly, I worry about the rising tide of populism and anti-business sentiment. I’ve never seen negative attitudes like those toward financial institutions today. Administration members with Wall Street backgrounds are regarded with suspicion; high incomes are considered wrongful; and banks and investment banks are seen as victimizing America, not rendering it prosperous. Schadenfreude is in the ascendancy, with people wishing ill for successful bankers. Politicians pander by throwing gasoline on the fire. With an election coming up, I expect candidates to compete to see who can be tougher on Wall Street. I mentioned in “What Worries Me” that decades ago, when a socialist-leaning labor movement was ascendant in the U.K., I came across a good explanation for the success of U.S.

More importantly, I also concluded that since gold has “worked” for hundreds of years, it probably will keep on doing so. It might not do so forever, but what’s the probability this will be the year it stops? So I wouldn’t bet against it, and I might recommend a position “just in case.” Not because I view gold affirmatively as a moneymaker, but rather as a useful contributor to safety through diversification. Surely the uncertain world situation seems to call for all the protection against the unknown that we can amass. Still, the other hand brings me back to price. Yes, gold is probably more likely to continue serving as a store of value than to quit. And yes, maybe one should have a position. But is this the right price at which to start . . . ?2010

Portugal, Italy or Great Britain? None of the above. That was Ben Bernanke speaking before the Budget Committee of the House of Representatives. Thus my use above of the most famous line from Walt Kelly’s comic strip “Pogo.” Greece and the other members of “Club Med” may be on the hot seat today, but few developed nations are exempt, and certainly not the U.S. The differences between the countries in the headlines and many others are matters of degree, not kind. David Leonhardt’s column in The New York Times of May 12 provides a good way to start in on this subject: It’s easy to look at the protesters and the politicians in Greece – and at the other European countries with huge debts – and wonder why they don't get it. They have been enjoying more generous government benefits than they can afford. No mass rally and no bailout fund will change that. Only benefit cuts or tax increases can. Yet in the back of your mind comes a nagging question: how different, really, is the United States? The numbers on our federal debt are becoming frighteningly familiar. The debt is projected to equal 140 percent of gross domestic product within two decades. Add in the budget troubles of state governments, and the true shortfall grows © Oaktree Capital Management, L.P.Reserved

The loans are senior-most in the capital structure, meaning they should provide some protection in a sluggish economy, and the fact that their interest rates float with LIBOR should insulate them against interest rate increases. Oaktree manages half a dozen large “multi-strategy fixed income” accounts, in which we are responsible for allocating capital to our various marketable securities strategies. Recently, in recognition of the developments described above, we made a modest initial shift away from high yield bonds and into convertibles, with their sensitivity to equity market trends. Here’s what I wrote to our multi-strategy clients a month ago: Certainly by the onset of 2000, people believed too much in stocks and thought too little of bonds. Now, a decade later, these things are reversing. As we enjoy our portfolios’ performance, we should be alert for a day when bonds will have become too popular and stocks’ outcast status will have rendered them too cheap. We can pat ourselves on the back for being in the right asset classes today, but we shouldn’t fail to consider what these diverging performance trends can do to tomorrow’s returns. Since few investment trends continue forever, it’s usually smarter to expect ultimate regression to the mean rather than growth to the sky. No one should view the great popularity of bonds relative to stocks without reservation. September 10, 2010 © Oaktree Capital Management, L.P.Reserved

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

Long-Term Trends Looking back over my career, it’s clear that the securities markets have been riding a number of salutary secular trends (“secular,” as in “of or relating to a long term of indefinite duration” per Webster’s New Collegiate Dictionary). Some of these actually began at the end of World War II and ran through 2007, for a total of more than six decades. Macro Environment – The period following World War II was one of American dominance and prosperity. The U.S. benefited from the “baby boom,” the fact that our shores hadn’t been reached by the war, and the effective transition of our factories and labor force to peacetime use. We were aided by a modern infrastructure, strong education and healthcare systems, and gains in technology. Corporate Growth – The last sixty years have seen strong growth in corporations and their profits. Especially in the early part of this period, the U.S. developed superior products, produced them very efficiently and found ready markets in the rest of the world. Gains in automation, information technology, management practices and productivity all contributed. Growth in sales was supported by strong consumer demand. The Borrowing Mentality – As further discussed below, advances in financing – and greater acceptance of the use of debt – allowed companies to augment their growth rates and returns on capital and allowed consumers to increase consumption. In fact, over the last several decades, economic units of all sorts in the U.S.

© Oaktree Capital Management, L.P. All Rights Reserved investment was facilitated through the extension of credit at all levels, contributing to economic expansion but also sowing the seeds for the current situation. Popularization of Investing – Back in 1968, working in investment management was no different from entering banking or insurance. Investing wasn’t the high-profile area it’s been the last two decades. “Famous investor” was an oxymoron; none were household names, like Warren Buffett, George Soros and Peter Lynch would become. Investment firms weren’t the B-school employer of choice, and investment managers didn’t dominate magazine covers and the top income brackets. But over the last forty years, increased attention was paid to equities, mutual funds, hedge funds and alternative niche markets. Even homes came to be viewed as investment vehicles. Investor Psychology – Attitudes morphed over time. Instead of a generation scarred by the Great Depression, people became increasingly confident, optimistic and venturesome. Experience convinced prospective investors that stocks could be counted on for high returns. In the last few decades, there’ve been times when people concluded the business cycle had been tamed. During Alan Greenspan’s reign, people came to believe inordinately in his ability to keep the economy growing steadily.

And most recently, people swallowed the canard that innovation, financial engineering and risk modeling could take the uncertainty out of investing. The developments enumerated above constituted a strong tailwind behind the economy and the markets over the last several decades, and they produced a long-term secular uptrend. Short-Term Cycles Despite the underlying uptrend, there’s been no straight line. The economy and markets were punctuated every few years by cyclical bouts of short-term fluctuation. Cycles around the trend line made for frequent ups and downs. Most were relatively small and brief, but in the 1970s, economic stagnation set in, inflation reached 16%, the average stock lost almost half its value in two years, and Business Week magazine ran a cover story trumpeting “The Death of Equities.” No, my forty years haven’t been all wine and roses.

© Oaktree Capital Management, L.P. All Rights Reserved Cycles in Long-Term Trends The main thing I want to discuss in this memo is my realization that there are cycles in the long-term trend, not just short-term cycles around it, and we’ve been living through the positive phase of a big one. Over the last few decades, investors have reacted to the generally positive economic environment by taking actions reflecting increased optimism and trust, as well as reduced caution and conservatism. In hindsight, we can see nearly uninterrupted growth in behavior that (a) relied on a continuation of the favorable underlying trends and thus (b) can be described as increasingly bullish. Looking for just one word, I’d say there was a steady rise in “willingness.” Over my forty years in business – but probably carrying on from the end of the World War II – I believe investors grew increasingly willing . . .skeptically,

© Oaktree Capital Management, L.P. All Rights Reserved At the end of this progression we find an institutional investing world that bears little resemblance to the quaint cottage industry with which the chronology began more than forty years ago. Many of the developments served to increase risk or had other negative implications, for investors individually and for the economy overall. In the remainder of this memo, I’ll discuss these trends and their ramifications. Something for Everyone One thing that caused a lot of people to lose money in the crisis was the popularization of investing. Over the last few decades, as I described in “The Long View” (January 2009), investing became widespread. “Less than 10% of adults owned stocks in the 1950s, in contrast to 40% today.” (Economics and Portfolio Strategy, June 1, 2009). Star investors became household names and were venerated. “How-to” books were big sellers, and investors graced the covers of magazines. Television networks were created to cover investing 24/7, and Jim Cramer and the “Money Honey” became celebrities in their own right. It’s interesting to consider whether this “democratization” of investing represented progress, because in things requiring special skill, it’s not necessarily a plus when people conclude they can do them unaided.

Today’s problems are largely a function of the high levels of leverage employed in 2003-07, but those levels were just the apogee of a progression that spanned decades. Every business, government, non-profit organization or individual has a certain amount of equity capital, net worth or surplus. That capital, in turn, will support a certain level of activity: production and sales, lending, government action, charitable grants or consumption. But over the last several decades, if you wanted to do more of these things than your capital permitted, you could borrow capital from someone else. Over the course of my lifetime, there have been extraordinary changes in the extent of borrowing:  Consumers – When I went off to college 45 years ago, I paid for purchases with checks or cash, and I saved up coins for the payphone. “Travel and entertainment” cards like American Express and Diners Club were available only to those with top credit ratings, and the masses lived without credit cards until Citibank introduced The Everything Card (now MasterCard) around 1967. In the old days, consumers who lived beyond their incomes were often described as being “in debt.hear

But that changed with the introduction of high yield bonds, an innovation permitting low-rated issuers to borrow at high interest rates. Before the advent of high yield bonds, companies could be acquired only by companies bigger than themselves. But with high yield bonds, small firms and even wealthy individuals could borrow enough to acquire corporate giants. This created the leveraged buyout industry. In recent years, not only was debt added to capital structures (particularly through buyouts), but equity was subtracted. Buyout companies used borrowed funds to dividend out their owners’ equity and provide quick profits, and non-buyout companies bought back their shares, often using borrowed money. These activities substituted debt for equity in companies’ capital structures, levering up their results and reducing their margin for error. In the current credit crisis, this has led to large-scale capital destruction.  Financial Institutions – Over the decades in question, banks and investment banks moved away from working for interest, fees and commissions as lenders, advisers, brokers and agents. Instead, they went increasingly into positioning (buying or selling blocks of stock to accommodate clients when the market wouldn’t take that side of a trade), proprietary trading (making investments for their own accounts, not on behalf of clients), and creating derivatives (sometimes ending up with a holding), all on the basis of increased leverage.

” These made much more than 100% leverage available to investors without any explicit borrowing. Hedge and arbitrage funds, collateralized loan obligations, collateralized debt obligations, leveraged buyout funds, credit default swaps and other derivatives; all of these delivered participation in highly leveraged investments without requiring the end investor to use margin or take out loans. In what approached a joke, the prim limit on margin was maintained even as regulators declined to apply any limits or regulation to these other investment structures, despite their ability to provide almost infinite leverage.  Institutional Investors – Given their tax-exempt status, pension funds and charitable and educational endowments can’t borrow to increase their returns. But they can (and did) make use of some of the strategies listed above. Institutional investors also employed “portable alpha,” overlaying hedge fund investments with index futures to simulate more-than-100%-invested positions, and they overcommitted to private equity partnerships to ensure their capital would be fully deployed. The use of borrowed money expanded at all levels over the last few decades. This occurred largely without changes in laws or institutions. Instead, the changes were in customs and attitudes, abetted by financial institutions’ innovation of new products.

© Oaktree Capital Management, L.P. All Rights Reserved Here’s what follows from the above:  Most companies have debt, not just those that have made acquisitions or built plants. Companies borrow in the normal course of business.  Many companies have heavy short-term borrowings and thus the need to deal with substantial maturities in the period immediately ahead.  With the capital markets closed, not only will growth be difficult to finance, but significant defaults may also arise due to a widespread inability to refinance. While I always hesitate to predict the future, I think there’s a good chance the next year or so will be characterized by significant difficulty repaying and refinancing borrowings. It’s worth noting in that context that “In November, there wasn’t one sub-investment grade corporate bond issued, according to Reuters – the first such hiatus since March 1991.” (breakingviews.com, December 3) Attitudes Regarding Equities One of the biggest changes in the past century – fully visible only to those who already were adults several decades ago or who’ve read about it – took place in terms of attitudes towards equities (or what we used to call common stocks). Up until the middle of the last century, stocks were considered highly speculative, and bonds were the bedrock of most investment portfolios. Interestingly in that connection, it was reported recently that the S&P 500 now out-yields the 10-year Treasury for the first time in 50 years.

Few investors recognized that increasing past returns bode poorly – not well – for subsequent returns, or that common stock returns couldn’t forever outpace the rate of growth in corporate profits. In 1999, James Glassman chimed in with his book Dow 36,000, asserting that because stocks were such solid investments, equity risk premiums were higher than they should have been, meaning their prices were too low. That pretty much marked the long-cycle top. When the “tech-media-telecom” bubble burst in 2000, stocks went into their first three- year decline in almost 70 years. The broad indices stabilized after 2002 and returned to their 1999 highs in 2007 but, wanting more than equities’ unlevered return, investors shifted their focus to private equity and to equity hedge funds. All of this occurred just in time for the onset of the credit crisis. Last year’s 38.5% decline in the S&P 500 was the biggest since 1931, zeroing out more than a decade of gains. I wonder whether and to what extent equities will be returned to the pedestal of popularity. The Wall Street Journal put it aptly on December 22: One of the hallmarks of the long market downturns in the 1930s and the 1970s has returned: Rank-and-file investors are losing faith in stocks. In the grinding bear markets of the past, huge stock losses left individual investors feeling burned. Failures of once-trusted firms and institutions further sapped their confidence.

© Oaktree Capital Management, L.P. All Rights Reserved Clearly, it was in the financial world, not the “real world,” that the great excesses of bullishness, willingness and expansiveness developed, planting the seeds for the current crisis. But financial-sector attitudes and innovations allowed excesses in all the things listed above to be visited upon the real world, where we’re now experiencing difficulty in them. It’s no coincidence that history-making excesses in the financial sector – and the correction thereof – led to history-making weakness in the real economy. It may be a good while before the elements listed are fully restored and the long- term trend roars upward again. The government is doing everything it can to reinstate them, but there’s no roadmap for success. We all have to wait with fingers crossed. However, in the coming period, while we’ll be hoping for the short-term cycle to recover, it’s quite likely that the long-term trends listed on pages 2 and 3 will be less salutary than they were in decades leading up to the current crisis. When will cyclical recovery arrive? For this, too, there’s no roadmap. Most economists rely for their predictions on models that extrapolate relationships between investment, production, employment and consumption, for example, but they omit psychological considerations such as bullishness, willingness and expansiveness.

On January 3, a New York Times article reported that a survey of economists had found consensus that recovery would commence in the second half of 2009. But it added that the economists: . . . base their forecasts on computer models that tend to see the American economy as basically sound, even in the worst of times. That makes these forecasters generally a more optimistic lot . . . their computer models do not easily account for emotional factors like the shock from the credit crisis and falling housing prices that have so hindered borrowing and spending. Those models also take as a given that the natural state of a market economy like America’s is a high level of economic activity, and that it will rebound almost reflexively to that high level from a recession. But that assumes that banks and other lenders are not holding back on loans, as they are today, depriving the nation of the credit necessary for a vigorous economy. These forecasters might assert that their models have worked on average. But I’d guess the period during which they worked didn’t include sluggishness in long-term trends of the nature I’m discussing here. Recognizing times when historic data shouldn’t be extrapolated is an important part of dealing prudently with the future. Importantly in this context, I want to point out that the recent decades shouldn’t be considered a norm to which we’re sure to return. Instead, they were the best of times.

That’ll be worse for business, right?” For the short run and for managers who failed their clients, it likely will. But in the long run, it’ll make for a much healthier environment for all of us. The Importance of the Long View As usual, some of the most important lessons concern the need to (a) study and remember the events of the past and (b) be conscious of the cyclical nature of things. Up close, the blind man may mistake the elephant’s leg for a tree – and the shortsighted investor may think an uptrend (or a downtrend) will go on forever. But if we step back and view the long sweep of history, we should be able to bear in mind that the long-term cycle repeats and understand where we stand in it. The failure to do so can be most painful. John Kenneth Galbraith provided a reminder in A Short History of Financial Euphoria: Contributing to . . . euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance.at

As little as two years ago, investors rushed headlong into things, fearing that if they didn’t, they’d miss out on big gains. Now they’re keeping their money in their wallets, saying “I don’t care if I ever make a penny in the market again, I just don’t want to lose any more.” This change in attitudes – throughout the financial system – is responsible for a lot of today’s deep freeze. Over the last several decades, our economy and markets benefited from positive underlying trends and investors were well rewarded for bearing risk. As a result, there was rising bullishness, willingness and expansiveness. When these trends reached unsustainable excesses, they were corrected with a vengeance. I’m now of the opinion that not only will short-term economic cycles of boom and bust repeat regularly, but also that favorable long-term trends are bound to see a recurrence of this sort of occasional massive pullback . . . at that moment when the passage of time has erased all memory of past corrections and taken investor behavior (and thus asset prices) to unsustainable highs. Buoyant, decades-long up-trends and their explosive endings are the inevitable results of the tendency of human nature to go to extremes. Hopefully the current bursting of the long-term bubble will end within the next few years, and hopefully the next iteration is another 30, 50 or 70 years away. This one’s providing enough excitement for a lifetime.2009

 The increases in equity were matched by further increases in borrowings.  In fact, the good performance convinced lenders to increase the amount of leverage they would supply per dollar of equity. This meant the entities could grow their portfolios even faster than the rates at which equity capital flowed in and assets appreciated.  Further, because of the seeming impregnability of the leveraged entities’ profitability, risk aversion shrank and the risk premiums and returns demanded by lenders declined. Leverage became cheaper and thus even more attractive.  As is typical of virtuous circles, everything ran smoothly . . . for a while: additional equity flowed in; it was leveraged up increasingly; buying caused assets to appreciate further; and the upward spiral continued. With things working increasingly well and investors becoming more and more excited, processes like this one seem destined to go on forever. Of course, they cannot. But people forget that, satisfying one of the key prerequisites for a cycle that goes to excess. Overestimating the longevity of up legs and down legs is one of the mistakes that investors insist on repeating. Deleveraging and Deflating Over the years I’ve written a number of memos about cycles, and in each one I’ve tried to remind readers that trees don’t grow to the sky, and that success carries within itself the seeds of failure.

© Oaktree Capital Management, L.P. All Rights Reserved UHow Things Got This Way Much of the current problem can be attributed to a decades-long bubble in the financial sector that made it the employer of obvious choice; attracted employees who were “the best and the brightest” (although often untrammeled by experience); contributed to greed and risk taking; drove out fear and skepticism; and carried institutions, behavior, expectations and asset prices to unsustainable levels. What are the factors that got us in the current mess?  Excess liquidity, which had to find a home.  Interest rates that had been reduced to stimulate the economy.  Dissatisfaction with the resulting prospective returns on low-risk investments.  Inadequate risk aversion, and thus a willingness to step out on the risk curve in search of higher returns.  A broad-scale willingness to try new things, such as structured products and derivatives, and to employ massive leverage.  A desire on the part of financial institutions to supplement operating income with profits from proprietary risk taking – that is, to be “more like Goldman.”  A system of disintermediation, selling onward, and slicing and dicing that caused many participants to overlook risk in the belief that it had been engineered away.  Excessive reliance on rating agencies which were far from competent to cope with the new instruments, and on black-box financial models that extrapolated recent history.

© Oaktree Capital Management, L.P. All Rights Reserved consumer incomes, propelling the economy ahead but rendering households increasingly leveraged. As this process moved onward, it depended on a continued supply of the underlying ingredients: confidence, liquidity, leverage, risk tolerance and acceptance of untested structures. The resulting “virtuous circle” was described in glowing terms just as its perpetuation was growing increasingly unlikely. Bust It took five years or so for the bullish background described above to be established in full. As usual, far less time was required for the excesses to be exposed and the process of their unwinding to begin. The air always goes out of the balloon a lot faster than it went in. Regular readers know that if there’s one thing I believe in, perhaps more strongly than anything else, it’s the fact that cycles will prevail and excesses will correct. For the bullish phase described above to hold sway, the environment had to be characterized by greed, optimism, exuberance, confidence, credulity, daring, risk tolerance and aggressiveness. But these traits will not govern a market forever. Eventually they will give way to fear, pessimism, prudence, uncertainty, skepticism, caution, risk aversion and reticence. A lot of this has happened. Busts are the product of booms, and I’m convinced it’s usually more correct to attribute a bust to the excesses of the preceding boom than to the specific event that sets off the correction.

It takes decades for it to reach maximums and minimums, and it can take a long time for the error of the extremes to be exposed. In the last couple of months, we’ve read a great deal about the need for increased regulation, and there’ll be more. There are several reasons for this:  First, when there’s a crisis, people tend to look for easy explanations. Insufficient regulation can be a good candidate.  Members of the out-of-power political party can always make hay by blaming the governing party and its philosophy.  The truth is, whichever philosophy is in the ascendancy will deserve some responsibility for crises . . . because no approach is perfect. Regulation will always produce red tape and some inefficient, non-market solutions, and deregulation will always permit a degree of cowboy behavior.  It’s easy to allege that the solution can be found in reversing the trend in regulation, and hard to disprove a priori. So now the cry has been raised. People are jumping on the bandwagon, and those opposed are trying to head it off with promises of better behavior and self-regulation.10,

He may start an investment bank unburdened with a legacy of losing positions. Or a bond insurer like Warren Buffett did when MBIA and Ambac became impaired. The cause of the recovery can’t be predicted. There may not even be a visible one. Maybe things will just get so cheap that they can’t stay down. (In ancient history – November 2001 – I wrote “You Can’t Predict; You Can Prepare,” with a thorough description of how cycles happen, based on energy all their own. It might be worth digging up.) I like to point out that, even in retrospect, no one can say what started the collapse of the tech stock bubble in 2000. But it did start . . . just, I think, because stock prices rose far too high. That works in reverse, too. In March, in “The Tide Goes Out,” I mentioned the three stages of a bull market, a notion I’ve been carrying around in my head for about 35 years:  the first, when a few forward-looking people begin to believe things will get better,  the second, when most investors realize improvement is actually underway, and  the third, when everyone’s sure things will get better forever.

© Oaktree Capital Management, L.P. All Rights Reserved If the banks are made more bureaucratic and risk-averse – and less aggressive and competitive – I’m sure independent boutiques will arise and prosper. The model I have in mind is a forest fire: a year after, bright green shoots grow from the ashes; in fact, I think they’re fertilized by the ashes. Think what a landscape like that means for advisory firms like Moelis, Evercore, Gleacher and Greenhill. In a free-market environment, not even a good knock can keep aggressive people from responding to opportunities. The financial sector will look very different in ten years from what it was a year ago – and that won’t be all bad. * * * I find that I often end with a quote from Warren Buffett, and often it’s the same one: The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs. But now I want to talk about the flip side: When others conduct their affairs with excessive negativism, it’s worth being positive. When others love ‘em, we should hate ‘em. But when others hate ‘em, we can love ‘em. In “The Tide Goes Out” in March, I listed the stages of both bull and bear markets. I said that in the terminal third stage of a bull market, everyone is convinced things will get better forever. The folly of joining that consensus is obvious; people who invest thinking there’ll never be anything to worry about are sure to get hurt.

© Oaktree Capital Management, L.P. All Rights Reserved advances and no one – except bargain hunters and investors in distress – relishes pullbacks. But I wonder if that stance makes sense. How can we have gains but not losses? How can a free-market economy allocate capital effectively if capital creation is abetted and capital destruction is prevented? The fact is, excesses like we’ve just seen have to be corrected – painfully – and if they aren’t, they’ll just grow bigger and bigger as the cycles wear on. “Moral hazard” will arise, convincing people that risk takers will always be bailed out, something that’s bound to encourage greater risk taking. The Fed’s actions in the current situation have been dramatic:  an unexpectedly large half-point cut in the discount rate in September,  strong steps to inject liquidity and encourage borrowing by banks, and  an unusual ¾-point rate cut on January 21, followed by another ½ point a week later. In two decades as Fed Chairman, Alan Greenspan was required to deal with the emerging market crisis and meltdown of Long Term Capital Management in 1998; the possibility of a Y2K glitch; the tech stock and broader bear market in 2000-02; the ramifications of the 9/11 attack; and concern over the possibility of deflation. And yet he never cut rates by ¾ point in one step or by 1-¼ points in just eight days. Thus Bernanke’s actions seem extreme. Is the Fed attempting to prevent a normal recession?

But any misdeeds are likely to be symptomatic of a lax environment, not causes of the problem, and punishing them is unlikely to be an effective part of the solution. UEliminating the Fear of Loss A couple of weeks ago, I had a great talk with Tom Petruno, an insightful business reporter for the Los Angeles Times. Calling on our shared experience as Californians, he presented what I consider a very apt analogy. It went like this: We’ve all heard about the connection between the Fed’s actions and moral hazard. There’ve been many incidents and scares over the last couple of decades: Black Monday, the meltdown of Long-Term Capital Management, Y2K, the bursting of the tech bubble, 9/11, and a recession here and there. Each time, the Fed rushed in with interest rate cuts and increases in liquidity designed to prevent or offset their depressing effects. A few times, it was said, these actions averted a collapse of the world financial system. But the cost was moral hazard: a growing expectation that the Fed would bail out imprudent risk takers. By behaving in ways that cause people to think they’ll always come to the rescue, authorities encourage risky behavior. And we all share the cost of rescuing the risk takers, whether we participated or not. In this way, the risk taking encouraged by the Fed’s policy of protecting participants caused the risks to grow ever- higher.

© Oaktree Capital Management, L.P. All Rights Reserved But we need to recognize that in addition to potentially enriching buyers of distressed assets, fire sales clear problems from balance sheets and speed solutions. They bring pain and chaos, but they also move things ahead. One of the reasons for Japan’s lingering malaise may be that it denied its bad-debt problems for too long, allowing sluggishness to dominate the economy. The questions in the U.S. and Europe will be what’s being done and whether it will work. I looked at the Super-SIV particularly quizzically. Its avowed purpose was to prevent fire sales on the part of SIVs that had financed debt purchases with asset-backed commercial paper that couldn’t be rolled over. So financial institutions would fund an entity that would buy assets rather than require their sale in the open market, where they would bring lower prices. But that’s perverting economics! Let’s see: “We’ll buy something for 90 rather than see it come to a frozen market where it might bring 70. Yes, we’ll buy it now even though we might have gotten a chance later to buy it for less.” That just shouldn’t happen, and now it appears it won’t, as the Super-SIV mission has been scrubbed. UA Word on the Monoline Insurers I usually emphasize discussion of macro developments, but at this time there’s a micro story that very much deserves telling. Over the last two decades, a few companies developed the business of insuring municipal bonds.

© Oaktree Capital Management, L.P. All Rights Reserved Even if we realize that unusual, unlikely things can happen, in order to act we make reasoned decisions and knowingly accept that risk when well paid to do so. Once in a while, a “black swan” will materialize. But if in the future we always said, “We can’t do such-and-such, because we could see a repeat of 2007-08,” we’d be frozen in inaction. So in most things, you can’t prepare for the worst case. It should suffice to be prepared for once-in-a-generation events. But a generation isn’t forever, and there will be times when that standard is exceeded. What do you do about that? I’ve mused in the past about how much one should devote to preparing for the unlikely disaster. Among other things, the events of 2007-08 prove there’s no easy answer. UAre You Tall Enough to Use Leverage? Clearly it’s difficult to always use the right amount of leverage, because it’s difficult to be sure you’re allowing sufficiently for risk. Leverage should only be used on the basis of demonstrably cautious assumptions. And it should be noted that if you’re doing something novel, unproven, risky, volatile or potentially life-threatening, you shouldn’t seek to maximize returns. Instead, err on the side of caution. The key to survival lies in what Warren Buffett constantly harps on: margin of safety. Using 100% of the leverage one’s assets might justify is often incompatible with assuring survival when adverse outcomes materialize.

Frankly, there is so much liquidity in the world financial system, that lenders (even “our” lenders) are making very risky credit decisions. . . . I know that this liquidity environment cannot go on forever. . . . I know that the longer it lasts, the greater the pressures will be on all of us to take advantage of this liquidity. And I know that the longer it lasts, the worse it will be when it ends.  John Paulson won well-deserved fame for generating returns up to 590% in his hedge funds last year. He did three things well: He recognized the excesses in the residential real estate arena. He figured out how to profit from their inevitable reversal. And he was lucky enough to get the timing right; rather than reach his conclusion earlier, look wrong for a long time and give up – as others did – he turned bearish in 2005 and was able to hold on until events began to prove him right in 2006.  I’m glad to say our clients’ sectors of the investment world – such as pension and endowment funds and insurance companies – generally haven’t reported much participation in the most highly leveraged entities.  Goldman Sachs has distinguished itself thus far by avoiding subprime and CDO losses, being short mortgage paper and skating through the crisis. Lehman Brothers, Credit Suisse, Deutsche Bank and JP Morgan Chase are other institutions that seem to have signed on for less subprime pain than their competitors.

When I was a kid, there were a lot of cartoons showing men carrying sandwich boards (who remembers what they were?) that said, “The end of the world is at hand.” So far, though, they’ve been wrong. Likewise, people said we had approached the end of the financial system around Black Monday in 1987, and when LTCM melted down in 1998. But we’re still here. It seems we muddle through, despite all attempts to screw things up. It’s my guess we always will. It’s tempting for worriers like me to consider apocalyptic possibilities. But it’s not productive, so I’ve quit. I can come up with “China Syndrome” theories, but (a) I can’t give them a high probability of coming to pass, and (b) there’s little I can do. The things one would do to gird for the demise of the financial system will turn out to be huge mistakes if the outcome is anything else . . . and chances are high that it will be. * * * Fortunately, one of the most valuable lessons of my career came in the early 1970s, when I learned about the three stages of a bull market:  the first, when a few forward-looking people begin to believe things will get better,  the second, when most investors realize improvement is actually underway, and  the third, when everyone’s sure things will get better forever. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved Nevertheless, I do think we’re in the early going: the pain of price declines hasn’t been felt in full (other than perhaps in the mortgage sector), and it’s too soon to be aggressive. Things are somewhat cheaper (e.g., yield spreads on high yield bonds went from all-time lows in June to “normal” in November) but not yet on the bargain counter. Thus, I’d recommend that clients begin to explore possible areas for investment, identify competent managers and take modest action. But still cautiously, and committing a fraction of their reserves. “Don’t try to catch a falling knife.” That bit of purported wisdom is being heard a lot nowadays. Like other adages, it can be entirely appropriate in some instances, while in others it’s nothing but an excuse for failing to think independently. Yes, it can be dangerous to jump in after the first price decline. But it’s unprofessional to hang back and refuse to buy when asset prices have fallen greatly, just because it’s less scary to “wait for the dust to settle.” It’s not easy to tell the difference, but that’s our job. We’ve made a lot of money catching falling knives in the last two decades. Certainly we’ll never let that old saw deter us from taking action when our analysis tells us there are bargains to be had. In the period leading up to the current crisis, investors acted like they were loaded down with too much cash and desperate to put it to work.

© Oaktree Capital Management, L.P. All Rights Reserved In short, there are two primary elements in superior investing:  seeing some quality that others don’t see or appreciate (and that isn’t reflected in the price), and  having it turn out to be true (or at least accepted by the market). It should be clear from the first element that the process has to begin with investors who are unusually perceptive, unconventional, iconoclastic or early. That’s why successful investors are said to spend a lot of their time being lonely. As I wrote in “Dare to Be Great,” non-conformists don’t get to enjoy the warmth that comes with being at the center of the herd. But it should be clear that when you’re one of many buying something, it’s unlikely to be a special opportunity. It’s only when few others will buy that you can get a bargain. That’s the thinking behind a brilliant observation that I heard in the 1970s, describing the three stages of a bull market:  the first, when a few forward-looking people begin to believe things will get better,  the second, when most investors realize improvement is actually underway, and  the third, when everyone believes things will get better forever. The loners who buy from a crowd of dispirited sellers can get a good deal – and high returns – because they’re few in number and early.

Wallace countered as follows: “No matter what brokers or money managers say, bull markets do not last forever. In general, investment professionals say, cycles and markets differ only by degree.” And of course, in the next eight days the Dow fell 30%. It wasn’t just 1987. People also came to believe the business cycle had been tamed in 1928 and in the late 1990s. And wouldn’t you know, I’m hearing it again today:  The Fed’s skillfully walking the tightrope between stimulus and restrictiveness. (A few years ago people felt Greenspan was indispensable; now there’s suddenly faith in Bernanke.)  A service economy is less volatile than a manufacturing-based economy.  As the Chinese and Indians get rich, their purchases from us will buoy our economy. The truth is, we couldn’t have great cyclical extremes if people didn’t occasionally fall for a justification that’s never held true before. How else might investors rationalize holding or buying despite highly elevated valuation parameters, low prospective returns and just-plain- wacky security structures? I still believe what I wrote in “The Happy Medium”: Cycles are inevitable. Every once in a while, an up- or down-leg goes on for a long time and/or to a great extreme and people start to say “this time it’s different.” They cite the changes in geopolitics, institutions, technology or behavior that have rendered the “old rules” obsolete. They make investment decisions that extrapolate the recent trend.

© Oaktree Capital Management, L.P. All Rights Reserved Or so cold that business will slow, with a depressing effect on profits. No, it’s just right. Of course, this condition has never held for long in the past. Earlier this year, Kenneth Lewis, chairman of Bank of America, summed it up candidly and simply: “We are close to a time when we’ll look back and say we did some stupid things . . . We need a little more sanity in a period in which everyone feels invincible and thinks this is different.” And while I’m on the subject, I want to offer an important observation. No matter how favorable and steady fundamentals may be, the markets will always be subject to substantial cyclical fluctuation. UThe reason is simple: even ideal conditions can become overrated and therefore overpriced.U And having reached too-high levels, prices will correct, bringing capital losses despite the idealness of the environment (see tech stocks in 2000). So don’t fall into the trap of thinking that good fundamentals = positive market outlook (and especially not forever). As I said in “Everyone Knows,” profit potential is all a matter of the relationship between intrinsic value and price. There is no level of fundamentals that can’t become overpriced. UWilling Suspension of Disbelief One of the key requisites for enjoying a trip to the movies is a willingness to suspend disbelief.

© Oaktree Capital Management, L.P. All Rights Reserved been looking for new ways to make money.” But when the market has been moving down and people are tallying their losses, they tend to be much less open to new ideas. In the financial world, the mother of invention isn’t necessity, its salability. In the roaring 1960s we saw Nifty-Fifty investing, dual shares from mutual funds and discounted shares issued through unregistered private placements without any mechanism for subsequent liquidity. In the ’80s we saw portfolio insurance – a surefire way to enjoy the appreciation potential that comes with large commitments to equities, but with much less risk. And in the ’90s, no one could think of a reason why every dot-com, e-tailer, media aggregation and venture capital fund wouldn’t be successful. Of course, all of these things failed to function as promised and either disappeared forever or experienced severe corrections. And what have we seen in the last few years? CDOs, CLOs, CPDOs, SPACs and securitizations of every type. In the current environment – marked by decent returns; disinterest in conventional, safe assets; and openness to risky investments – few people seem to dwell on the reasons why something new might not work. No one asks why, if a $2 billion fund was successful, a $20 billion fund shouldn’t be as well. Derivatives deserve particular attention in this regard.

© 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.

Earlier work at the University of Chicago had put the average annual return on stocks closer to 9% into the 1960s, but a couple of decades of much higher returns pushed the cumulative experience – and thus the expectation – toward 11%. Shouldn’t there have been support apart from experience? Was there an underlying economic process that would make stocks worth 11% more each year? Couldn’t the last fifteen years, averaging well above 11%, have borrowed from the future by pushing up p/e ratios? Few people inquired. “You can’t fight the tape,” they said in essence. Who was willing to take the risk associated with a below-average weighting? Well, the elevated prices produced by that unanimously positive expectation, a reversal of the optimism it embodied, and the fact that those above-trend results had in fact borrowed heavily from the future all led eventually to the first three-year decline in equities since 1930. And, not surprisingly, to a new consensus. Now everyone says “about 7%.” But is today’s consensus any more likely to be right? Or does it just reflect more of that oxymoronic quality, common sense? Asset Class Returns Further on the topic of consensus expectations, let me visit the question of whether asset classes even “have” expected returns. I learned from managing fixed income portfolios that bonds come closest to having a dependable return. Over its life, a bond that’s bought at a 10% yield to maturity and doesn’t default will return 10%, won’t it?

ignoring the unlikely nature of that proposition, as usual. There’s plenty of evidence of the popularity of these ideas. Maybe they’ll work forever. Maybe these trees will grow to the sky. But if they do, they’ll be the first.*

© Oaktree Capital Management, L.P. All Rights Reserved I know that this liquidity environment cannot go on forever. I know that the longer it lasts the more money our investors (and we) will make. I know that the longer it lasts, the greater the pressures will be on all of us to take advantage of this liquidity. And I know that the longer it lasts, the worse it will be when it ends. And of course when it ends the buying opportunity will be a once in a lifetime chance. But, I do not know when it will end. . . . Last year, I asked you to be humble, ethical and optimistic. This year I am asking you to be careful as well. In 1990-91, our distressed debt funds made a fortune buying the obligations of companies that had been loaded up with too much debt in LBOs in the late ’80s. Chastened by that experience, lenders in the ’90s didn’t provide enough leverage to make buyout companies much of a factor in the debt collapse of 2002. But with the memory of having 1990-91 faded, leverage became freely available in the last few years, and thus we have little doubt we’ll be buying a great deal of distressed LBO debt the next time around. When all the above is taken together, it seems likely that a few years out, we’ll see a landscape littered with companies that were crippled with excessive debt loads and lenders who weren’t repaid.

© Oaktree Capital Management, L.P. All Rights Reserved even if default isn’t an immediate threat. And the free pass in the interim may just delay – but also worsen – the eventual outcome. Under a traditional structure, a company might default in the third year of a bond’s life, by which time 20% of its value may have evaporated. But with these new wrinkles, it might not happen until year five . . . when 60% of the value is gone. Yes, lenders are giving borrowers more rope. But will it prove to be a lifeline for the company or a hangman’s noose? A lot will depend on how things go while the postponed default is in abeyance. This is yet another area where up-cycle faith that risk has been reduced can convince people to add back the risk. As The Wall Street Journal said of standby revolvers on May 11, “Thanks to debt arrangements like this, some private-equity buyers say they are doing deals they would otherwise not do.” UWhat Could Cause This Upward Cycle to Falter? Since I insist that the good times can’t roll on forever, I’m often asked what might make them stop. I don’t have any inside information on this subject, but I can enumerate the possibilities: 1. economic slowdown, 2. reduced willingness to lend or insistence on higher interest rates, perhaps due to increased worry about credit risk, 3. systemic problems like a crisis in derivatives or a cluster of hedge fund meltdowns, 4. exogenous factors such as $100 oil, a dollar crisis, terrorist acts, and 5.

We never know whether a little jiggle is the start of the swing back and, if so, how far it will go. But we always should be aware that reversion will occur. The last 4½ years have been carefree, halcyon times for investors. That doesn’t mean it’ll stay that way. I’ll give Warren Buffett the last word, as I often do: “It’s only when the tide goes out that you find out who’s been swimming naked.” Pollyannas take note: the tide cannot come in forever. Time, tide and cycles wait for no man.2007

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: You Can’t Eat IRR Until rather recently – certainly up to the early 1980s – “investing” was largely synonymous with “stocks and bonds.” And the performance of a stock or bond portfolio was evaluated in terms of its rate of return. You invested a certain amount of capital, and the percentage by which it increased in a given year was its annual return. To quantify performance over a multi-year period, you chained the individual yearly returns to come up with a compound annual return: Annual Return Dollar Gain Portfolio Value Initial Investment $1,000 Year 1 10% $100 1,100 Year 2 15 165 1,265 Year 3 8 101 1,366 Comp. Ann. Return 11% But in the last few decades, buyout and venture capital funds came along, changing things. Funds like these start with capital commitments, call and invest their capital over time, and thereafter manage and liquidate their portfolios. They expand and contract radically, and in assessing their performance, it’s clear that a given year’s percentage return matters more – and thus should be given more weight – if it was achieved when the fund held a lot of capital (and less if it was not). Investors wisely concluded that the performance of such funds should be assessed using a measure capable of capturing this phenomenon.

© Oaktree Capital Management, L.P. All Rights Reserved To be strong you have to be like water: if there are no obstacles, it flows; if there is an obstacle, it stops; if a dam is broken, then it flows further; if a vessel is square, then it has a square form; if a vessel is round, then it has a round form; because it is so soft and flexible, it is the most necessary and the strongest thing. In other words, mujo means cycles will rise and fall, things will come and go, and our environment will change in ways beyond our control. Thus we must recognize, accept, cope and respond. Isn’t that the essence of investing? UCoping With Cycles In the world of investing, (as you’ve heard me say many times) nothing is as dependable as cycles. Fundamentals, psychology, prices and returns will rise and fall, presenting opportunities to make mistakes or to profit from the mistakes of others. They are the givens. We cannot know how far a trend will go, when it will turn, what will make it turn, or how far things will then go in the opposite direction. But I’m confident that every trend will stop sooner or later. Nothing goes on forever. Trees don’t grow to the sky, and neither do many things go to zero and stay there. Success carries within itself the seeds of failure, and failure the seeds of success. So what can we do about cycles? If we can’t know in advance how and when the turns will occur, how can we cope?

I believe the largest pools of investment capital have given up on getting the returns they need from now-debased equities and have turned to buyouts and the like for help. I imagine a thought process that goes like this: “Historically, good buyout funds have had returns in the high teens net of fees. Even though the environment isn’t what it used to be, it should be a lay-up for them to reach the low teens. I’d even be happy with 10%; it would certainly help me with my 8% required return. And I can put a billion to work in one phone call.” Well, I’m not sure many buyout firms have produced historic average returns in the high teens. (According to Bloomberg, “U.S. buyout funds produced returns of 13.3% during the past two decades.”) And even if the best did, that doesn’t mean earning even low teens will be easy in the environment ahead. Finally, I’m not convinced that returns in the low teens are enough to make it worth bearing the risk that comes with leverage, illiquidity and competition for deals. But the money flowing into buyout funds makes it clear that I’m in the minority. UThe Outlook for Buyout Returns Investors – in any field – can make money in four broad ways: buy cheap, add value, apply financial engineering and sell dear. Let’s examine each one as it applies to buyouts. UBuying cheapU – The golden age of buyouts lasted from approximately the mid-1970s to the mid- 1980s. What was the environment like as that period began?

© Oaktree Capital Management, L.P. All Rights Reserved  As the LBO era dawned, only a few organizations had the inclination and know-how required to buy companies bigger than themselves.  Buyout funds were tiny, and their modus operandi consisted of paying bargain prices for small, little-known companies or orphaned divisions of larger companies with stable cash flows. Today’s environment bears little resemblance to that one. As I mentioned in a memo earlier this year, I’d heard a buyout mogul say, “It’s our job to buy good companies at fair prices and make them better.” I doubt he was content with fair-priced purchases thirty years ago.  Listed companies are cheaper today than they were in 1999, but not nearly as cheap as in 1976. The P/E ratio on the S&P 500 is 17.5 today versus 10.3 at the inception of the LBO movement three decades ago.  To deploy unspent capital that in August was estimated by The Financial Times at $297 billion, buyout funds will have to acquire companies worth roughly $1.5 trillion in the years ahead. That’s a few percent of all of the world’s stock markets.  The buyout funds are competing with each other to spend their capital, and they also have to compete against strategic corporate buyers that have enjoyed strong profitability and are cash-rich. (Nevertheless, buyout funds often outbid strategic buyers, who in theory should be able to pay more because they can combine the acquiree’s operations with their own and garner efficiencies.)

” While there’s no surefire route to investment success, I do believe one of the easiest ways to make money is by buying things whose merits others haven’t yet discovered. You ask, “When do you get that chance?” Not often, (and certainly not easily today), but not never. In 1978, Bache asked Citibank to manage a new mutual fund for it. Citibank turned the job over to me: “There’s some guy named Milken or something who works for a small brokerage firm in California, issuing and trading high yield bonds. Can you find out what that means?” Few people had ever heard of high yield bonds. There wasn’t much historic performance data, and what little there was came from a few obscure mutual funds. Buying bonds with a meaningful probability of default certainly seemed imprudent. Most institutional portfolios had an inviolate minimum credit rating for bonds of single-A or triple-B. Corporate CEOs said, “My buddy’s company was just threatened by a corporate raider backed by junk bonds; our pension fund will never own any!” And no public or union pension trustee wanted the headline risk associated with bankruptcy. In other words, the perfect buying opportunity. Thus, our high yield bond portfolios have outperformed high grade bonds for two decades-plus, by more than enough to compensate for their defaults, volatility and illiquidity. It’s been a long- term free lunch, and the earliest investors got the biggest helping.

© Oaktree Capital Management, L.P. All Rights Reserved 3BUAn Inefficient Market in Investment Advice Bruce Karsh and I recently had an opportunity to sit down to lunch with Charlie Munger. As usual, our conversation was most enjoyable, straying over a large number of topics. I think a few of them – plus some comments from Warren Buffett’s latest annual report – can be woven into something of relevance to this memo and of interest to you. Bruce started off by observing that with practically everyone able to start up a billion dollar hedge fund, and with the leading private equity managers able to raise funds of $10 to $15 billion, jobs in those fields are in great demand as the way to get rich quick. It occurred to me that if large numbers of people are convinced that a given field is sure to give them instant wealth, something must be wrong. That’s a “bubble expectation.” Getting rich – if it can be accomplished at all – is supposed to come from some combination of proven skill, hard work, risk bearing and luck. No one should be able to count on it, and especially not in the short run. And given the operation of market forces, such an opportunity shouldn’t last long. Then I remembered that for decades I’ve argued that exceptional risk-adjusted returns can only be achieved in inefficient markets, and even then not all the time or by everyone. And by “inefficient markets,” I’ve always meant markets where mistakes are being made.

© Oaktree Capital Management, L.P. All Rights Reserved USelling dearU – Of course, you can always hope to sell at valuation multiples higher than you paid, but it’s not reasonable to count on being able to do so all the time. Purchase multiples below the historic norms could buttress such an expectation, but we’re not there now. Today’s valuation multiples are being supported by low interest rates (prices of financial instrumen as demanded yields decline, and vice versa), and higher interest rates would be expected to reduce sale prices for companies. And as the subject companies get bigger and bigger, the number of possible buyers shrinks. For the $30 billion companies that are being talked about today, the stock market may be the only exit, and that’s something that can’t be counted on ye in and yea ts rise ar- r-out. So in contrast to the description of the golden days of buyouts on the previous page, today we have:  A buyout phenomenon that everyone’s aware of and eager to play.  A stock market that can’t be described as cheap.  Heavy competition to buy target companies.  Dependence on financial engineering based on low interest rates and generous capital markets that may not stay that way forever. We also see companies being sold from one buyout fund to another. What does that imply? In most transactions, one party’s right and the other’s wrong. Generally, the buyer can’t be getting a bargain unless the seller is accepting less than he should.

© Oaktree Capital Management, L.P. All Rights Reserved These goals may seem modest at first glance, but few investors have been capable of meeting them for periods spanning multiple decades. They’re the goals we’ve set for ourselves, and we’re proud to have reached them thus far. UThe Role of Risk Management The key to achieving superior returns in bad times (and especially to doing so without stripping a portfolio of its potential to make money in good times) is found in the ability to control risk. It’s not a matter of finding winners, but of building a portfolio where upside potential is accompanied by downside protection – no mean feat. In the investment world, we hear a lot more about achieving returns than we do about controlling risk. But as you explore the higher reaches of the profession – as you move into the hedge fund world, for example – the latter grows in importance. Ultimately, the key is to be able to manage risk well enough that upside can be attempted without commensurate exposure to downside. The subject of risk control – and, especially, the process of assessing who does it well – is extremely thorny. When I wrote the memo “Risk” in February, I thought I had hit on something when I observed that risk is not measurable even after the fact. Now I want to take that thought a little further. UDefining “A Good Job” There are reasons why the headlines each year go to the person who achieved the highest return, not the person who best managed risk.

© Oaktree Capital Management, L.P. All Rights Reserved or may not be made by people who have previously been lenders. Those people may or may not possess workout experience. And it’s an open question how hedge funds holding large portfolios of small loans will behave when companies get into financial hot water. Lately I’ve heard mention that hedge funds might be making these loans to gain control of companies that default. But it isn’t clear to me how appreciation will routinely be wrung from loans that are made at par and subsequently become non-performing.  Since I moved to Los Angeles in 1980, my friends in “The Industry” have been unanimous in one piece of advice: never invest in movies. Yet The Wall Street Journal of April 29 carried a story headlined, “Defying the Odds, Hedge Funds Bet Billions on Movies.” For decades, movie studios have gladly accepted millions of dollars from a group of investors collectively dismissed as “dumb money”: deep-pocketed dentists, oil tycoons and other wealthy individuals eager for a piece of the glamorous but high-risk game of film production. But the biggest influx of money in Hollywood these days is coming from sharks, not suckers: hedge funds, private equity funds and investment banks. Take the example of “Poseidon,” which was co-financed by hedge fund-backed Virtual Studios.

© Oaktree Capital Management, L.P. All Rights Reserved All too often, investors’ interest in the past is limited to the last few months or perhaps a year or two. They look unskeptically, are dazzled by the high returns they see, and jump aboard for more of the same. But they usually fail to consider longer-term history, which would show that “free lunches” never last forever. When the check ultimately comes in the form of losses, there’s surprise and disappointment that could have been avoided. Time after time when I read about trends being taken to excess – and later, when the painful consequences become clear – I find myself asking what they could have been thinking. The alpha that’s so much in demand today is really the ability to see ahead to things others will see only afterwards, in the rearview mirror. The people of Oaktree spend a lot of their time figuring out what might be the next mistake and preparing for it. In other words, we try to anticipate – and avoid – pitfalls that others will rue after the fact. 0BUCaveat Emptor Today’s financial cause célèbre is the Bayou group of hedge funds. Results were falsified and a lot of money has disappeared. It’s easy to make a list of those who deserve blame in this affair, but few of the articles I see focus on the people I think should head the list: the funds’ investors. We live in an age when fingers are pointed at others all the time. Losers feel aggrieved and sue.

Smoothly functioning markets don’t permit the combination of high return and low risk to persist – good results bring in buyers who raise prices, lowering future returns and elevating risk. It’ll never be otherwise.  The Explanation Couldn’t Be Simpler – By this I mean to poke some fun at investors’ tendency to fall for stories that seem true on the surface but ignore the workings of markets. The stage was set for some of the greatest debacles by platitudes that were easy to swallow – but too simplistic and, in the end, just plain wrong. These include “For a company with good enough growth prospects, there’s no such thing as too high a price” (1969 and 1999) and “Emerging markets are a sure thing because of the terrific potential for growth in per capita consumption” (1994).  This Tree Will Grow to the Sky – The fact is, no trend will go on unabated forever. Most trends are limited by cycles, which are caused by people’s reaction to developments. Buyers, sellers and competitors respond to trends, altering the current landscape and the future.  The Positives of Today Will Still Be Positives Tomorrow – From time to time, some combination of optimism and greed convinces people that the favorable elements in the current environment – responsible for today’s high asset prices – will stay that way. But (a) things usually turn less rosy, and (b) even before they do, investors take prices to levels that are too high even for today’s positives.

© Oaktree Capital Management, L.P. All Rights Reserved through their buying and selling, a few dozen astute arbitrageurs can dart in on occasion to take advantage of their mistakes. But what if the arbitrageurs come to outnumber the “long-only” convert investors, so that their buying power directly affects (in this case, raises) the prices of convertibles relative to the underlying stocks. That can change the game, and thus the dependability and profitability of convertible arbitrage. This was certainly the case in 2004, when at times 80% of all convertible buying was thought to be from arbitrageurs. They didn’t care as much as the long-only crowd about the issuers and the price attractiveness of the underlying securities; rather, they would buy almost anything to put on an arb position. When I organized Citibank’s first convertible fund in 1978, convertibles found few regular buyers and were considered a somewhat disreputable market of last resort for corporate financing. This level of disregard permitted convertible prices to languish. Most of the time I felt the convertibles I bought were considerably cheaper than a corresponding package of more efficiently priced bond plus stock from the same company. For the next two decades, the same cheapness that had given our portfolios risk-adjusted returns better than stocks made it possible for convert arbitrageurs to buy underpriced convertibles and short fully priced common stocks. This was a formula for steady profits.

How many of the investor errors enumerated on pages 2-3 do you see below? It’s driven by the same forces [as drove the dot-com stocks]: that investments can’t go bad; that it has the potential to make you rich; that you’ll regret it if you don’t do it; that it looks expensive but really is not. . . . a limited supply of land coupled with demand from baby boomers and foreigners [will] prolong the boom indefinitely. I don’t think prices are going to fall, and I don’t think they’re even going to be flat. It really is a very hot real estate market, and I don’t know how long it’s going to continue. But in the short run, why not profit from it? I look at this as a short-term investment and plan to unload it as soon as things look dangerous. I’d bet none of the people quoted above lost money in the last real estate cycle or learned the lessons of the past. It’s for that reason that they’re prone to mistake the up-leg of yet another cycle for a new and permanent miracle. And so it goes. The commercial, retail and residential properties that professionals buy have escalated also – although not as crazily or with as much disregard for valuation. Nevertheless, cap rates are down in response to the general decline in interest rates, demanded returns and risk premiums. With returns on Treasury bonds at 4-5%, fully leased class “A” office buildings apparently look good at 6-7%.

© Oaktree Capital Management, L.P. All Rights Reserved Let’s look at the law’s operation and effects. First, it required enormous one-time expenditures for the scrubbing of corporate books and the creation and assessment of control structures designed to avoid misdeeds. Second, it called for significant incremental ongoing expenditures along these lines. At a conference I attended recently, a venture capitalist estimated that the average company with revenues of $50-60 million faces increased costs of $1-1½ million per year associated with being public. Larger companies are spending far more. I view this as an enormous tax on American business in perpetuity, and the benefits as far smaller than the cost. When the hue and cry was at its apex and this law was enacted, a widespread epidemic of corruption was suspected. It turned out that the early reports were the worst, and few additional cases were detected in the mandated examinations that followed. So as a result of about $10 billion in scandals – at Enron, WorldCom, Adelphia, Tyco and a few others – we’ve ended up with a law that will require the largely unproductive expenditure of many billions every year forever (or until rectified). And it’s not as if we had no laws on fraud before Sarb-Ox. They were there, and they were enforced. It’s just that in 2002, citizens, and thus politicians, became frustrated with the fact that the old laws didn’t prevent all fraud or keep CEOs from saying, “I had no idea that was going on.

© Oaktree Capital Management, L.P. All Rights Reserved Well, we rarely hear anymore about saving for old age. That’s part of the financial prudence that has become hopelessly passé. After all, saving for later means consuming less today and delaying gratification, and those things are entirely out of style. But then how do people expect to live in their old age? People seem to be retiring earlier, and certainly they’re living longer. Medical advances are prolonging life but not getting any cheaper. With retirement lasting longer and entailing greater costs, how will people pay their bills? Heretofore, the solution has been a stool with three legs: Social Security, private pensions and personal savings. How solidly constructed is the stool of today? We’ve heard a lot about Social Security’s woes. The number of active workers supporting each retiree is declining, threatening the system with insolvency a few decades out. After reading (and reviewing for the L.A. Times) Pete Peterson’s excellent book “Running on Empty,” I’m convinced we’ll need some combination of higher taxes, delayed retirement or reduced benefits . . . but equally convinced that few politicians are going to commit career suicide by advocating tough medicine to solve a problem that’s decades away. Not having to worry about reelection, President Bush came out of his 2004 victory willing to spend some political capital on his solution: the private retirement account.

© Oaktree Capital Management, L.P. All Rights Reserved portfolios didn’t contain enough risk to be top performers. In other words, he was saying, “risk is our friend.” It just can’t work that way! Dependably high returns from risky investments are an oxymoron. But there are times when this caveat is ignored; when people get too comfortable with risk; and thus when securities prices incorporate a premium for bearing risk that is inadequate to compensate for the risk that’s present. The prevalence of risk-tolerance (or risk-obliviousness) in the late 1990s was clear. I personally heard a prominent brokerage house strategist say, “Stocks are overpriced, but not enough to keep them from being a buy.” And we all heard the man on the street say “I’m up so much in my 401(k), it wouldn’t bother me if it fell by a third.” (Where was that guy two or three years later?) No, those risk-tolerant attitudes will not persist forever. Eventually, something will intrude, exposing securities’ imperfections and too-high prices. Prices will decline. Investors will like them less at $60 than they did at $100. Fear of losing the remaining $60 will overtake the urge to make back the lost $40. Risk aversion eventually will reassert itself (and usually go to excess). How about some quantification of this cycle? In mid-1998, just before the collapse of Long- Term Capital Management brought investors other than techies to their senses, only $12.

But in the long run I think it’s people on the right who’ll be celebrated most. In today’s trend toward hedge funds, I see a growing preference – whether conscious or unconscious – for “us” investors over “them.” Consistent, risk-conscious, non-market- based investing is enjoying great popularity right now. I’ve considered it the ticket for almost three decades. And by the way, I have one last thing to say: Uvive la difference!!U In order for us to be contrarians, there has to be someone to be contrary to. If everyone invested our way, the opportunities we prize would be few and far between. The best opportunities for investment returns aren’t created by companies, exchanges or paper securities; they result from the mistakes other investors make. It’s Oaktree’s job to take advantage of them. May 7, 2004 P.s.: As I wrote this memo, one thing pained me, and I want to address it: I found myself constantly writing “he,” even though I absolutely do not think investing skill is gender-related. It’s just that I hate the thought of using “he/she” each time. (My son Andrew’s school uses s/he.) And I find ungrammatical today’s popular, gender-neutral formulation that “the top- performing investor finds that their gains come from hard work” – a plural pronoun substituting for a singular noun. So please bear with me; I’m really an equal opportunity memo writer.

It makes sense, it’s obvious, and people have been saying it for decades, so it has become common knowledge. But it’s wrong! There’s no such thing as net selling! And stock market transactions can’t cause cash to build up! Think about it. In every stock trade there’s a buyer and a seller. So how can selling exceed buying? And the buyer puts as much money into the market as the seller takes out. So how can selling create cash on the sidelines? As usual, there is a less simplistic explanation that’s closer to the truth:  While there can’t be more selling than buying, there can be more would-be sellers than would- be buyers. And the sellers’ desire to sell can be stronger than the buyers’ desire to buy. These factors are indicators of negative sentiment, and they can lead to a selling climax that creates a market bottom, so they can presage the (eventual) end of a decline.  And clearly, uninvested cash equates to potential buying power, and thus potential fuel for a rise. But uninvested cash can’t result from selling (which requires a buyer to put in the same amount of previously-uninvested cash as the seller takes out).potentially

© Oaktree Capital Management, L.P. All Rights Reserved Simply put, people began to search for the elements that would lead to continued lofty equity returns, and they failed to find them. In the 1990s, few people pondered the fact that if corporate profits grow in single digits and "normal" equity performance is 9-11 %, two decades or so of returns almost twice that might be borrowing from the future. Now the future is here and that realization has set in. Those single digit profit increases (accompanied by low dividend yields) are expected to result in mid-single digit equity returns if P/E ratios are unchanged, and less if multiples shrink. So the question has switched from "How much would you like to make and spend?" to "How much can you make safely, and what will that let you spend?" UIs There No Opportunity in Equities? It is clear that (a) most people's expectations for equities now are in the mid single digits, and (b) equities are attracting as little interest as at any time in the last 25 years. There are, however, factors supportive of a more positive case:  The most obvious is the fact that stock prices are off substantially since hitting record highs in early 2000.  Another positive might be seen in the fact that the curtailing of expectations for equity returns coincided with the incurrence of substantial losses.

I was especially pleased to have a chance to tell him about the seminal part his 1975 article, “The Loser’s Game,” had played in the development of my thinking. The article employed a metaphor that was simple but profound. Charley’s article described the perceptive analysis of tennis contained in “Extraordinary Tennis for the Ordinary Tennis Player” by Dr. Simon Ramo, the “R” in TRW. Ramo pointed out that professional tennis is a “winner’s game,” in which the match goes to the player who’s able to hit the most winners: fast-paced, well-placed shots that his opponent can’t return. But the tennis the rest of us play is a “loser’s game,” with the match going to the player who hits the fewest losers. The winner just keeps the ball in play until the loser hits it into the net or off the court. In other words, in amateur tennis, points aren’t won; they’re lost. I recognized in Ramo’s loss-avoidance strategy the version of tennis I try to play. Charley took Ramo’s idea a step further, applying it to investments. His views on market efficiency and the high cost of trading led him to conclude that the pursuit of winners is unlikely to pay off. Instead, you should try to avoid hitting losers. I found this view of investing absolutely compelling. I can’t remember saying, “Eureka; that’s the approach for me,” but the developments over the last three decades certainly suggest his article was an important source of my inspiration.

© Oaktree Capital Management, L.P. All Rights Reserved does that imply for P/E ratios (and stock prices) if interest rates were to rise from today's historic lows?  Lastly, we have to wonder where the energy for a more bullish market will come from, and specifically whether a generation of investors who've been burned is lost from the stock market forever. My own take is that even if the 9-11% historic long-term return on stocks remained relevant with regard to the future, (and certainly that's the best anyone could hope for), the above-average gains of the last two decades have borrowed from the future, and the high resulting P/E ratios imply an average return in single digits over the next few years. At the same time, I think some good individual opportunities may be found among orphaned small and mid-cap stocks. Because investment banks are no longer supposed to recommend stocks just to get investment banking business, their coverage lists might contract. The financial pressures and resulting layoffs at the big research firms are leaving many companies without coverage. Many un-researched companies will likely emerge from financial restructurings and corporate spin-offs. Put it all together, and expert stock pickers probably will find some good opportunities in the newly less efficient market. UThe Market Cycle at Its Wildest In a memo on cycles entitled "You Can't Predict. You Can Prepare."

I discussed the general progression of a market cycle:  Favorable developments and positive investor psychology cause prices to rise.  Reports of price appreciation attract momentum players, who shout, "We'd better get in; who knows how far this can go." Their purchases of already-appreciated assets move prices still higher on a trajectory that appears capable of rising forever.  Eventually, prices get so high that they vastly exceed intrinsic values.  A few value-conscious investors step into the crowd to sell. Prices turn down, sagging under their own weight or perhaps because fundamental developments begin to be less favorable.  Less-favorable developments and less-favorable psychology combine to force prices below intrinsic values.  The pain of losses becomes so great that investors flee and prices reach giveaway levels. This time it's, "We'd better get out; who knows how far this can go."  The first iron-nerved contrarians recognize that good values are available and start to buy.  Others soon follow, and eventually the number of new buyers exceeds the number of sellers. Prices stop falling . . . and begin to rise.

© Oaktree Capital Management, L.P. All Rights Reserved  Reports of rising prices and the bargains obtained by those astute pioneers attract the masses to the marketplace, who shout, "We'd better get in . . . ," and the cycle continues. I've always known about this cycle. I've seen it at work for decades. But I've never seen it function – in terms of the extent and swiftness of the fluctuations – as it did with regard to low-grade debt over the last year. Because the performance of mainstream equities has little direct impact on Oaktree, we remain largely disinterested observers of stock market developments. But we are vitally interested in what happens in credit-related investments, and the change there has been mind-boggling. UThe Pricing of Credit Risk in 2002-03 It's hard to believe, but the biggest cycle I've ever seen in distressed debt began just about a year ago.  With investors softened up by economic sluggishness, depressing world events and the realization of just how wrong they'd been in the 1990s, conditions were ripe for a crisis of confidence. The catalyst came in the form of an incredible series of corporate scandals.  At first, Enron was viewed as an isolated instance of corporate venality. But then Tyco, Adelphia and Global Crossing began to suggest a pattern. Arthur Andersen was convicted and had to shut down. The capper was the disclosure of massive fraud at WorldCom.

© Oaktree Capital Management, L.P. All Rights Reserved major gains if one is to achieve the absolute prerequisite for investment success: survival. The most important thing is being mindful of cycles (and where we stand in them). We must never forget about the inevitability of cycles. Economies and world affairs rise and fall in cycles. So does corporate performance. The reactions of market participants to these developments also fluctuate cyclically. Thus price swings usually overstate the swings in fundamentals. When developments are positive and corporate profits are high, investors feel good and often bid assets to prices that more than reflect their intrinsic value. When developments are negative, on the other hand, panicky investors are prone to sell them down to overly cheap levels. So prices sometimes represent high multiples of peak prospects (as they did with technology stocks in the ‘90s), and sometimes low multiples of trough prospects. Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do. People often act as if companies that are doing well will do well forever, and investments that are outperforming will outperform forever, and vice versa. Instead, it’s the opposite that’s more likely to be true. The most important thing is contrarian behavior.

In order for those mistakes to occur, there has to be ignorance, inadvertence, opacity, prejudice, emotion, or some other obstacle to objective, insightful decision making. The ratings agencies constitute just such an obstacle. My favorite example: literally for decades, Moody’s has defined B-rated bonds by saying they “generally lack characteristics of the desirable investment.” How can they say that based on the risk alone, without any reference to price or promised return? Once they imply “there’s no price at which this bond could be a good buy,” people will shun it, making it cheap. That can create an opportunity for a bargain hunter. And the ratings agencies are wrong a lot. Not in every case, but at the margin where it counts. The agencies are convinced they do a good job because the bonds they rate low default more often than the bonds they rate high. But the majority of speculative grade bonds never default, and every once in a while an investment grade bond does. Both of these phenomena have significant financial consequences. For example, by failing to anticipate a default and thus mistakenly maintaining an investment grade rating, the agencies allow bonds to sell at 80 that should sell at 20. That’s an opportunity: for investment grade bond managers to distinguish themselves by getting out before the default, and for hedge funds to profit from selling short.

What I meant is that, unless the Greens Committee changes the layout, a golf course is a static environment. The actions of golfers don't change the game. If I try a certain approach to a hole – or even if everyone does – that won't alter the effectiveness of the approach. In contrast, highways – like markets – are dynamic environments. What the other participants do on a given day goes a long way toward determining what will and will not work for us. When people flock to the fast lane, they slow it down. And with the lane they left suddenly less crowded, it speeds up. UThis is how the "efficient market" in travel acts to equalize the speed of the various lanes, and thus to render ineffective most attempts at lane-picking. Efficient securities markets work the same way to eliminate excess returnsU. Everyone knows what has worked well to date. Just as they know which lane has been moving fastest, they know which securities have been performing best. Most people also understand there is no guarantee that past performance will continue. What is a little less widely understood, however, is that past returns influence investor behavior, which in turn alters future performance. While investors have the option of switching into the securities that have been performing best, most know the outperformance isn't likely to last forever.more

© Oaktree Capital Management, L.P. All Rights Reserved insight, however, for them to comprehend that their switching will be, in itself, among the things that change performance. When people switch to the better-performing group, their buying bids up the prices of those securities. That bidding-up prolongs the outperformance somewhat, but it also reduces the prospective return and increases the probability of a correction. (The higher the price you pay, the worse your prospects for profit. This seems like a simple concept, but it's forgotten once in a while – as it was in the tech bubble.) At the same time, the switchers will sell worse-performing securities to finance their move into the hot group. That will lower the prices of the laggards, and at some point they'll be so cheap that they become destined to outperform. UFor How Long Will the Fast Lane Go Fast?U – The pedal-to-the-metal momentum crowd saw the tech and telecom stocks moving fastest in 1999 and extrapolated their outperformance to infinity. In essence, they assumed one lane could go faster forever. Of course, they ignored the fact that the stocks were being bid up to prices from which collapse would be inevitable. They also failed to notice that the "slow lane" value stocks they were selling would eventually become primed for acceleration. How long can outperformance continue? How long can one lane be the fastest, one strategy be the best? Clearly, there's no rule.

I came along three years later, and I remember my parents picking me up from summer camp in 1956 and telling me about a new singing sensation, Elvis Presley, and a new kind of music called rock and roll. The three men listed above were born at the right time to become leaders of the newly minted rock and roll industry. It’s a good thing they weren’t born a few decades later, since cheap downloads and file sharing have now decimated the profitability of the record business. The bottom line is simple: it’s great to be in the vanguard of a new development. Talent and hard work are essential, but there’s nothing like getting there early and being pushed ahead by the powerful trends in demographics and taste that follow. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

The momentum players behind the bubble proved with certainty that fast rising stocks will keep rising until they stop. They also proved, to their surprise, that few people are capable of getting off just as the upward trajectory peaks out. As I've said many times, anything can work for a while, but nothing can work forever. Sometimes large cap works, and sometimes small cap works. Sometimes domestic works, and sometimes international works. Sometimes buying leaders works, and sometimes buying laggards works. Wall Street has pushed out some incredible gibberish over the years, but nothing quite like that embodied in another yellowed clipping from 1976 (maybe this is why there's no more Loeb, Rhoades): A continuing pattern of consolidation and group rotation suggests that increasing emphasis should be placed on buying stocks on relative weakness and selling them on relative strength. This would be a marked contrast to some earlier periods where emphasizing relative strength proved to be effective. I guess that's a fancy way to say that sometimes the stocks that have been doing best continue to do best, and sometimes the stocks that have been doing worst start to do best. (Really, I don't make this stuff up.) UThe Tactics Others AdoptU – The fact that crowded highways are efficient allocators of space doesn't mean people don't try to beat them.

© Oaktree Capital Management, L.P. All Rights Reserved of a superior ability to see the future, but rather because he regularly holds extreme positions (or perhaps he's a dart thrower) and this time the phenomenon went his way. Rarely if ever is that person right twice in a row. So forecasts are unlikely to help us gain an advantage, but that doesn't make people stop putting their faith in them. It's unsettling to realize how much in the dark we investors are concerning future developments. But there's one thing worse: to ignore the limits of our foresight. The late Stanford behaviorist Amos Tversky put it best: "It's frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what's going on." UThirdU, I think it's essential to remember that just about everything is cyclical. There's little I'm certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don't grow to the sky. Few things go to zero. And there's little that's as dangerous for investor health as insistence on extrapolating today's events into the future. The economy will not rise forever. Industrial trends won't continue indefinitely. The companies that succeed for a while often will cease to do so. Company profits won't increase without limitation. Investor psychology won't go in one direction forever, and thus neither will security prices.

An investment style that does best (or worst) in one period is unlikely to do so again in the next. That was really the problem with the technology bubble. Investors were willing to pay prices that assumed success forever. They ignored the economic cycle, the credit cycle and, most importantly, the corporate life cycle. They forgot that profitability would bring imitation and competition, which would cut into – or eliminate – profitability. They overlooked the fact that the same powerful force that made their companies attractive – technological progress – could at some point render them obsolete. And they failed to consider that the investing fads in favor of these technologies, companies and stocks could reverse, with dire consequences. UFourthU, investors should bear in mind the role played by timeframe. It seems obvious, but long-term trends need time in order to work out, and time can be limited. Or as John Maynard Keynes put it, "Markets can remain irrational longer than you can remain solvent." Whenever you're tempted to bet heavily on your conviction that a given phenomenon can be depended on in the long run, think about the six-foot tall man who drowned crossing the stream that was five feet deep on average. One of the great delusions suffered in the 1990s was that "stocks always outperform." I agree that stocks can be counted on to beat bonds, cash and inflation, as Wharton's Prof. Jeremy Siegel demonstrated, but only with the qualification "in the long run."

© Oaktree Capital Management, L.P. All Rights Reserved But critics of the accounting profession today say that over the past three decades the standard setters have moved away from establishing broad accounting principles aimed at insuring that companies' financial statements are fairly presented. Instead, they have moved toward drafting voluminous rules that may shield auditors and companies from legal liability if technically followed in check-box fashion. That can result in companies creating complex structures that technically comply with GAAP but hide billions of dollars of debt or other corporate obligations. As the Wall Street Journal wrote on February 1 and 8, . . . sometimes persnickety rules can become a license for larger dishonesty. This new environment's two highest values are tolerance and proceduralism. That doesn't encourage good judgment; it suppresses it. So the lessons regarding accounting are simple:  We need accounting standards that are set and enforced in terms of principles, not just technical rules.  Accounting is like any other tool; the results will depend on whose hands it's in. UThe Origins of Corporate Corruption For those seeking an explanation for fortuitous outcomes, luck has been described as "what happens when preparation meets opportunity." I think Enron inspires a similar explanation for corruption: it's what happens when exigency meets moral weakness.

They also thought the technological developments were so great that the companies' stocks could be bought regardless of price. In the end, though, when newness becomes old, flaws appear and investor ardor cools, the only thing that matters is the stock's price . . . and it's usually much lower. Most shortages – whether of commodities or securities – ease when high prices inevitably cause supply to rise and satisfy the demand. And no fad lasts forever. Thus valuation eventually comes into play, and those who are holding the bag when it does are forced to face the music. USixthU, beware the quest for the simple solution. Two important forces drive the search for investment options: the urge to make money and the desire for help in negotiating the uncertain future. When a market, an individual or an investment technique produces impressive returns for a while, it generally attracts excessive (and unquestioning) devotion. I call this solution-du-jour the "silver bullet." Investors are always looking for it. Call it the Holy Grail or the free lunch, but everyone wants a ticket to riches without risk. Few people question whether it can exist, or why it should be available to them. At the bottom line, hope springs eternal. Thus investors pursued Nifty-Fifty growth stock investing in the 1970s, portfolio insurance in the '80s, and the technology boom of the '90s.

Capping the price of natural gas was popular, but we saw too late that it keeps people from drilling. Controlling rents seemed desirable, but no one foresaw that it would discourage landlords from building housing and renters from moving out. There's little I'm sure of, but I do believe that if the government establishes rules and procedures in areas that should be the province of the market, (a) there will be unintended consequences, and (b) the rules will be much harder to correct than they were to enact. * * * I believe strongly that things will not get worse forever. We'll muddle through. Given the retarding effects of lobbyists and competing political interests, the government probably won't do anything terribly destructive. The economy will come back. Most companies will be shown to make real profits, and their securities will turn out to have value. In other words, the financial world won't come to an end. As for short-term direction, no one knows which way the market's going to go, or whether the declines to date are enough to offset the negatives and make this a bottom. Do the declines to date and the economic recovery that's underway mean we're at the bottom? Or do the abject disillusionment that investors have suffered and the still- high P/E ratios mean it won't be reached for a while? The answer rests on the actions of investors in the coming weeks and months, and that truly defies prediction.

Among other reasons, the academics say it takes many decades of data to reach a conclusion with “statistical significance,” but by the time the requisite number of years have passed, the environment is likely to have been altered. Regardless, I think we must look at the changes listed above and accept that the conditions of today are less propitious for inefficiency than those of the past. In short, it makes sense to accept that most games are no longer as easy as they used to be, and that as a result free lunches are scarcer. Thus, in general, I think it will be harder to earn superior risk-adjusted returns in the future, and the margin of superiority will be smaller. People often ask me about the inefficient markets of tomorrow. Think about it: that’s an oxymoron. It’s like asking, “What is there that hasn’t been discovered yet?” The markets are greatly changed from 25, 35 or 45 years ago. The bottom line today is that there’s little that people don’t know about, understand and embrace. How, then, do I expect to find inefficiency? My answer is that while few markets demonstrate great structural inefficiency today, many exhibit a great deal of cyclical inefficiency from time to time. Just five years ago, there were lots of things people wouldn’t touch with a ten-foot pole, and as a result they offered absurdly high returns. Most of those opportunities are gone today, but I’m sure they’ll be back the next time investors turn tail and run.

UOn the SECU : review disclosure regulations; increase power to suspend or bar unethical executives or directors from working at public companies; require quicker, perhaps on- line reporting of insider trades (now not required until month-end), including sales back to the company (now not required until the next year); increase the SEC's budget so that it can hire and retain staff and increase enforcement activity. UOn politiciansU: enact campaign finance reform (it might be on the way); require reporting of lobbyists' contacts; limit lobbyists' role in drafting legislation. This vast laundry list of possible solutions suggests (a) the magnitude of the problem indicated by Enron and (b) the eagerness of government to ride to the rescue. Some changes will be made, but the belief that the problem isn't widespread should limit their scope. What's the bottom line, then? The real lessons from Enron, in my opinion, are these:  As long as there are disclosure rules – and that's forever – there'll be "technically correct" statements that leave investors in the dark. In order to get numbers with integrity, you need people with integrity.  Rules are just the first building block in creating a safe market. We also need compliance and enforcement, neither of which will ever be 100%. Even though it’s the best in the world, our system for corporate oversight is far from perfect.

© Oaktree Capital Management, L.P. All Rights Reserved larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.  UCycles are self-correctingU, and their reversal is not necessarily dependent on exogenous events. The reason they reverse (rather than going on forever) is that trends create the reasons for their own reversal. Thus I like to say success carries within itself the seeds of failure, and failure the seeds of success.  Seen through the lens of human perception, Ucycles are often viewed as less symmetrical than they areU. Negative price fluctuations are called "volatility," while positive price fluctuations are called "profit." Collapsing markets are called "selling panics," while surges receive more benign descriptions (but I think they may best be seen as "buying panics"; see tech stocks in 1999, for example). Commentators talk about "investor capitulation" at the bottom of market cycles, while I also see capitulation at tops, when previously-prudent investors throw in the towel and buy. I have views on how these general observations and others apply to specific kinds of cycles, which I will set forth below. UThe Economic Cycle Few things are the subject of more study than the economy.

The words that came to mind were "subdued," "somber" and "enervated," and they stayed with me all week. Stress and tension were everywhere. Some things were very different, and some that were the same felt different. The absence of airliners overhead was obvious, and the effect was dramatic when fighter jets replaced them. Sirens were heard more clearly in the absence of competing noise, and they seemed more ominous – as was the case in Los Angeles during the riots and earthquakes. Pedestrian and vehicular traffic was light the first night, and it grew only gradually. Grocery stores were crowded; sidewalk restaurants were populated; it was clear life would go on. Each of us found his or her individual limit on how much we wanted to read, watch and talk about these events. At the same time, however, it seemed inappropriate to talk about or do anything else. In my limited sample, the kids found it easier to move on to other topics – and I was so glad to see that their lives, albeit probably changed forever, would rebound. UCommunicationU – My cell phone and Blackberry wireless e-mail device were absolutely essential. I was again reminded to ask "How did we ever get along without these things?" It was very hard to make phone calls on Tuesday, but that, too, got a little better each day. My Blackberry always worked and made it possible for me to keep in contact with my Oaktree colleagues. Spam e-mail was absent that first day, but it also came back.

Will we accept the risk of losing world support if we make mistakes? Are we willing to kill non-combatants? Are we willing to bear casualties among our own servicemen and women? Centuries of immunity from attack on our soil, and decades of relative safety in a world in turmoil, have allowed Americans to enjoy the luxuries of moral certitude, personal freedom and safety. With our apparent wall of invulnerability penetrated, we will have to debate the extent to which these luxuries will be dispensed with. UOur TacticsU – There is bound to be review and debate regarding the tactics we will employ in pursuit of safety and justice. In the recent past, there has been a rise in the position I paraphrase as "we will do no evil, even in the interest of doing good." Thus it was decided that the CIA would not perform assassinations or employ "intelligence assets" with records of crimes or human rights violations. These principled stances may come to be viewed as luxuries we can no longer afford. When prosecutors obtain cooperating testimony, it is usually from criminals – because that's who the targets of prosecution associate with, and that's who can be turned against them. It is now clear that we need intelligence regarding upcoming terrorist operations, and that intelligence must come from inside terrorist cells. People we might not wish to associate with – perhaps only terrorists themselves – can best gain that access.

© Oaktree Capital Management, L.P. All Rights Reserved The important thing is to recognize that cycles reverse, and to allow for it. I described in my last memo, "What Lies Ahead?," the manner in which a recession continues until, at the margin, a few participants stop cutting back and decide instead to act in anticipation of better times. I believe this process, and the reverse process that eventually causes growth to stall out, will go on forever. No one knows when the turn will occur, or how far the correcting leg will go, but the odds are against anyone who says, "the business cycle is dead." How can non-forecasters like Oaktree best cope with the ups and downs of the economic cycle? I think the answer lies in knowing where we are and leaning against the wind. For example, when the economy has fallen substantially, observers are depressed, capacity expansion has ceased and there begin to be signs of recovery, we are willing to invest in companies in cyclical industries. When growth is strong, capacity is being brought on stream to keep up with soaring demand and the market forgets these are cyclical companies whose peak earnings deserve trough valuations, we trim our holdings aggressively. We certainly might do so too early, but that beats the heck out of doing it too late. UThe Credit Cycle The longer I'm involved in investing, the more impressed I am by the power of the credit cycle.

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.

The truth is, there's no place for them to go but up and down . . . and so they do. Likewise, there are business trends that have nowhere to go but back and forth . . . and so they do. Take corporate diversification, for example. As a new equity analyst in 1970, one of my first assignments was to study conglomerates, starting with Litton, ITT, Whittaker, Teledyne and City Investing. It was widely held that their diversification and synergies (along with the magic of acquisition accounting and high p/e "funny money") could produce rapid growth forever. They pursued large numbers of acquisitions (ITT made 52 one year) and were rewarded with very high p/e ratios (which enabled them to prolong their growth for a while through further anti-dilutive acquisitions). It wasn't long, however, before their dependence on sky-high multiples was recognized and difficulties surfaced in connection with the management of their diverse organizations. Their managers switched to stressing the benefits of specialization (as opposed to diversification), and the head of Whittaker wrote a paper extolling the virtues of a process he called "distillation of the product centroid." Units began to be sold off and the companies deconglomerated. It's interesting to note that none of those five companies exists today. Diversification or specialization? Centralization or decentralization? Savings through just-in-time inventories or protection from stockpiles and redundancy?

That's because while the participants develop new tools and techniques, the ball never adjusts and the course doesn't fight back. But investing is dynamic, and the playing field is changing all the time. The actions of other investors will affect the return on your strategy. Just as nature abhors a vacuum, markets act to eliminate an excessive return. USo Then What Do We Do Now? I have a few things to suggest that may help in the years that lie ahead. None of them will prove easy to implement, however. None will give you that sure thing. UAccept changeU – Among the important elements that clients, consultants and managers must possess is adaptability. The only thing you can count on is change. Even if the fundamental environment were to remain unchanged – which it won't – risk/return prospects would change because (a) investors will move the prices of assets, certainly in relative terms, and (b) investor psychology will change. That's why no strategy, tactic or opinion will work forever. It's also why we have to work with cycles rather than ignore or fight them. USearch for alphaU – In doing so, however, it's essential to understand:  what alpha is,  what markets permit it, and  who has it.

© Oaktree Capital Management, L.P. All Rights Reserved Finance professors would say that these fluctuations reflect changes in the discount rate being applied to the cash flows or, in other words, changes in valuation parameters. Practitioners would agree that changes in p/e ratios are responsible, and we all know that p/e ratios fluctuate much more radically than do company fundamentals. The market has a mind of its own, and its changes in valuation parameters, caused primarily by changes in investor psychology (not changes in fundamentals), that account for most short-term changes in security prices. This psychology, too, moves in a highly cyclical manner. For decades – literally – I've been lugging around what I thought was a particularly apt enumeration of the three stages of a bull market:  the first, when a few forward-looking people begin to believe things will get better,  the second, when most investors realize improvement is actually underway, and  the third, when everyone concludes everything will get better forever. Why would anyone waste time trying for a better description? This one says it all. Stocks are cheapest when everything looks grim. The depressing outlook keeps them there, and only a few astute and daring bargain hunters are willing to take new positions. Maybe their buying attracts some attention, or maybe the outlook turns a little less depressing, but for one reason or another, the market starts moving up.

After a while, the outlook seems a little less poor. People begin to appreciate that improvement is taking place, and it requires less imagination to be a buyer. Of course, with the economy and market off the critical list, they pay prices that are more reflective of stocks' fair values. And eventually, giddiness sets in. Cheered by the improvement in economic and corporate results, people become willing to extrapolate it. The masses become excited (and envious) about the profits made by investors who were early, and they want in. And they ignore the cyclical nature of things and conclude that the gains will go on forever. That's why I love the old adage "What the wise man does in the beginning, the fool does in the end." Most importantly, in the late stages of the great bull markets, people become willing to pay prices for stocks that assume the good times will go on ad infinitum. But they cannot. When the tech bubble was roaring ahead in late 1999, no one could think of any development that might be capable of bringing it to an end. Technology was certain to revolutionize everyday life, creating a new investment paradigm. Revenue growth (or at least the growth in "eye-balls") was strong. Capital was freely available, enabling expansion to continue and new, innovative companies to be formed. Cash flows into mutual funds and 401(k)s guaranteed steady demand for the stocks.

© Oaktree Capital Management, L.P. All Rights Reserved portfolio manager could take the risk of under-owning these stocks; they had to buy them regardless of price! Eureka! There was no way they could stop going up. The perpetual motion machine had been built. But somehow, the stocks did stop going up. And then they started going down. I don't think anyone can say just what it was that caused the tech bubble to burst. Certainly I can't think of any one thing – even in hindsight, which is usually 20:20. Maybe the groundwork was laid for declines when it was shown merely that the rise could slow. Maybe a few smart people, to paraphrase the third of the three stages, concluded that everything Uwouldn'tU get better forever. The best explanation probably is that the prices just collapsed under their own weight. Anyway, the market proved – once again – that it can't move in one direction forever. It has to be appreciated in cyclical terms, with increases followed by decreases, and in fact with increases UcausingU decreases. In April 1991 , in just my second general memo to clients, I described the market as follows: The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the position of a pendulum "on average," it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc.

© Oaktree Capital Management, L.P. All Rights Reserved “Wealth effect” is the term used to describe the impact on the economy of major increases in the prices of stocks or other assets. When asset prices rise, people feel richer and spend more. When the resulting demand outstrips supply, inflation heats up. Further, when the upward trend of asset prices inevitably turns down, the wealth effect works in reverse, putting a damper on economic growth (although Greenspan is more likely to have been worried about inflation than economic softness). Prior to expressing his concern about exuberance, Greenspan was credited with the power and wisdom needed to keep the economy rising forever. So how did investors react to his remark? In the first half-hour of trading the next day, they took the Dow down by 145 points (which used to be considered a big move). But the exuberance of which he had warned soon reasserted itself, with the Dow closing the year virtually unchanged from its pre-critique level and moving 1000 points higher over the next six months. If it was irrational exuberance that had taken the Dow to 6,437 in late 1996, what would describe the rise to 7,437, and eventually to 11,497, in relatively short order? And what accounts for Greenspan's two subsequent years of silence on the subject? My guess is that he was feeling pressure from people – perhaps with a political stake in the continuing rise of the stock market-who castigated him for being a wet blanket.

© Oaktree Capital Management, L.P. All Rights Reserved Anyone who bought in those declines benefited from the rallies that surely followed. Of course, that didn't work quite so well in 2000. The dips in March-April, May and July were all followed by rallies, but they were traps for unsuspecting buyers. Only "sell the rallies" proved correct. URespect cyclesU – There's little I'm certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don't grow to the sky. Few things go to zero. That was really the problem with the bubble. Investors were willing to pay prices that assumed success forever. They ignored the economic cycle, the credit cycle and, most importantly, the corporate life cycle. They forgot that profitability will bring imitation and competition, which will cut into – or eliminate – profitability. They overlooked the fact that the same powerful force that made their companies attractive, technological progress, could at some point render them obsolete. U Worry about timeU – Another element that investors ignore in their optimism is time. It seems obvious, but long-term trends need time in order to work out, and time can be limited. Or as John Maynard Keynes put it, "Markets can remain irrational longer than you can remain solvent." Whenever you're tempted to bet everything on a long-run phenomenon, remember the six-foot tall man who drowned crossing the stream that was five feet deep on average.

* * * Robertson, Soros, Druckenmiller, Brinson and Buffett succeeded for decades because the markets they worked in (1) were driven by UbothU fear and greed, (2) responded eventually to reason, and (3) rewarded disciplined analysis more than they did naked aggressiveness. That's the kind of climate we at Oaktree prefer. In the late 1990s, markets were propelled (and the big money was made) by people who, in my opinion, substituted optimism, risk tolerance and love of a good story for reason, caution and skepticism. If investors have been chastened by the events of the last few weeks, I think we'll see more of the latter in the future.2000

© Oaktree Capital Management, L.P. All Rights Reserved First, will the Internet and dot-com companies be able to charge enough for their products to make money? Front page articles in The New York Times (October 14) and The Wall Street Journal (July 28) discussed the fact that many of the Internet's offerings are free. Decades ago, merchants discovered that they could sell more if they cut prices. The Internet firms have taken that one step further: they can move even more merchandise if they give it away. As the CEO of Egreetings Network says, “Charging for [greeting] cards was a small idea. Giving them away is a really big idea.” Says a venture capitalist, “.... it's a fact of life on the Internet: People expect a lot of things for free. And if you don't give it away, some other start-up will.” Internet firms are giving away faxes, long-distance phone calls, music, web browsers and even Internet service itself. "The marginal cost of adding another user is practically zero," says one venture capitalist. The trouble as I see it is that the marginal revenue is exactly zero. Obviously, these firms are giving their services away in order to build traffic, tie up market share early and/or sell advertising space. It's far from clear that profits will follow. As I read the articles mentioned above I was reminded of a great series of jokes my father told when I was young: “I lose money on everything I sell.” “Then how do you stay in business?” “I make it up on volume.

© Oaktree Capital Management, L.P. All Rights Reserved day at $100 and be at $200 in six months.” Would you play? Could you stand the risk of saying no and being wrong? The pressure to buy can be immense. There have always been ideas, stocks and IPOs that produced great profits. Yet the pressure to participate wasn't as great as it is today because in the past the winners made millions, not billions, and it took years, not months. The upside in the deals that've worked so far has been 100-to-l (give or take a zero). With that kind of potential, (a) the upside becomes irresistible and (b) it doesn't take a very high probability of success to justify the investment. I have said in the past that while the market is usually driven by fear and greed, sometimes the strongest motivator is the fear of missing out. Never was that as true as today. This only intensifies the pressure to join in and crawl further out on that limb of risk. With broader relevance than just the dot-com stocks, the relative performance chart below from Barron's of September 27 (already quite outdated) shows two things: 1. over the last two decades, technology stocks have had periods of both underperformance and overperformance relative to the large-cap universe, and 2. the recent outperformance is unparalleled even in this bullish period. Nothing in this chart suggests that it'll be easy money in technology from here.

He said, "I'd think a self-professed non-forecaster like you would never say, ‘never’.” My response was, "Maybe it's a result of my sobering experience in the 1970s, but there are plenty of things I'll say "never" to ... on the negative side: Things will never go right forever. Investors' fondest hopes will never fail to be dashed eventually. Some unpleasant surprises will never fail to arise." This sounds terribly negative, as if I think good things are rare and only bad things are bound to happen. But if you think it over, I hope you'll conclude I'm not what our Kevin Clayton calls a "Negative Ned."

© Oaktree Capital Management, L.P. All Rights Reserved I read decades ago that every bull market has three stages: The first, when a few far-sighted people begin to believe that some improvement is possible, the second, when most investors come to agree that improvement is actually underway, and the third, when everyone believes everything will get better forever. If you're going to succeed at all in timing cycles, the only possible way is to act as a contrarian: catch some opportunities at the bottom, let your optimism abate as prices rise, and hold relatively few exposed positions when the top is reached. To find bargains at the bottom, you don't have to think that things will get better forever; you just have to remember that every cycle will turn up eventually, and that prices are lowest when it looks like it won't. But it's just as important to avoid holding at (and past) the top, and the key is not to succumb to the popular delusion that "trees will grow to the sky." What I think is important is that, although markets can be underpriced or overpriced and yet go on for months or years to become even more so, it's most prudent to be optimistic when no one else is, and it can be highly profitable. But it can be dangerous to be optimistic when everyone else is, and very costly. * * * All of the above might be interesting, but of course the crucial question is "Where do we stand today?" Certainly, the secret's out: something bad can happen -- and has.

It's worth noting in this connection, thinking back fifteen or twenty years to ancient history, that this bull market got its start because companies could be bought cheaper through the stock market than they could be created -- this fact kicked off the LBO boom that powered the stock market throughout the 1980s. Today, many companies' stocks have reached prices that no value-conscious entrepreneur would pay for the entire company. The market seems extremely comfortable with the proposition that as long at the macro- environment remains benign, stocks prices can continue to appreciate at rates that far outstrip the growth of their issuers' profits, and thus the growth of their intrinsic value. Few market participants seem concerned about appropriate valuation levels -- the relationship between assets and their prices -- and this is a condition that we think must eventually have negative consequences. We are incredulous when, each day there's more news of economic equilibrium and stable rates, the market goes up another percent or so. We believe strongly that with corporate profits growing in the vicinity of their normal 10% or so, stable rates are not in themselves a reason why stock prices should rise at 20%-plus forever. Today's combination of a stable economy, low interest rates, enormous cash flows and strong investor optimism has created a climate in which capital is available for both good investments and bad, and in which risk is rarely seen as something to be shunned.

In 1989, nobody thought the Cowboys would ever win without Tom Landry, or that the Lakers or 49ers would ever lose. Six years ago, the growth of both coasts' economies was considered assured, and the Rustbelt's suffering was expected to continue forever. Only two years ago, George Bush was a shoe-in. And that brings me to my subtitle: Where'd All This Rain Come From? The motivation for this memo came as I considered the extraordinary amount of precipitation the West has experienced this year -- and newspaper articles of a couple of months ago. According to the articles, the rings on old trees suggested that fifty year droughts might be the norm and the five year drought to date just the beginning. No one predicted the drought before it began -- when such a forecast might have helped. But just as it may have been about to end, the possibility of its long-term continuation was unveiled.