Howard Marks on Margin of Safety

© 2026 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Everything Claude learned came from human-written text. It has no experiences, no embodied understanding of the world, no genuine comprehension. Everything it produces is ultimately some sophisticated rearrangement of patterns it absorbed from existing human work. It’s extraordinarily impressive pattern matching – maybe the most impressive pattern matching ever engineered – but it’s not thought. It’s not reasoning. It’s statistical recombination. And if that’s true, then there’s a ceiling. It can remix what humans have already figured out, but it can’t break genuinely new ground. It’s a very talented cover band, not a composer. Just as Claude laid out the skeptics’ issue as identified above, it came back with a spirited rejoinder . . . framed in terms of me (talk about knowing how to argue a point): Howard, everything you know about investing came from other people. Benjamin Graham taught you about margin of safety. Buffett taught you about quality. Charlie Munger taught you about mental models from multiple disciplines. John Kenneth Galbraith taught you about the psychology of financial manias. You read thousands of books, memos, case studies, and annual reports over fifty years. Every input was someone else’s thinking. . . . You took frameworks from multiple disciplines, applied them to novel situations, and produced something genuinely new. . . . The raw material came from others.

© 2026 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Lenders derive their eventual security from the performance of the companies they lend to and the margin of safety they receive from being senior in the capital structure. Lenders who performed skillful due diligence, upheld high standards, and made good credit decisions will be successful (note that high yield bonds and broadly syndicated loans, the precursors of direct lending, did fine in multi-year periods that included the Global Financial Crisis). Even if some borrowers have to delever, decent company performance should permit the payment of interest and principal. Of course, the outlook is less good if business models falter or lower valuations are assigned to companies, as that reduces the lender’s margin of safety, especially with regard to junior debt tranches. * * * Illustrating the tendency of developments to rhyme, I’ll close with something Bob O’Leary wrote to me the other day: It strikes me that there are interesting parallels between credit markets today and the late 1980s/early ’90s, when you and Bruce started the first Special Credits funds. Back then, there was a new financial innovation (high yield bonds) that many investors had over- indulged in. The market suddenly got spooked by a war in the Middle East, and investors couldn’t dump high yield fast enough.

As far as I’m concerned, the main one is the possibility that some managers have been in such a hurry to scoop up capital and put it to work – so they could come back for more – that they relaxed their credit standards and failed to demand a sufficient margin of safety. If there’s ever another difficult period in the economy and the market, we’ll see the result. Note: this isn’t a sweeping concern about the loans themselves, just a question about the behavior of individual managers. • Connected to the above (and to the absence of marking to market), we don’t know what’ll happen if and when a difficult environment does arrive. Is there a limit on the ability of managers to keep marks too high? Is it right for fund returns to ignore deteriorated fundamentals? Can managers avoid recognizing credit difficulties by granting forbearances and “kicking the can down the road”? For how long? Are there ill effects on fund investors in the meantime? Since private credit managers are mostly unregulated, will the truth come out? Which truth? Questions like these also are answered only when the tide goes out. • Lastly, I don’t believe private credit represents a systemic risk. People have been on the lookout for systemic risk ever since the GFC, in which troubled banks brought trouble to other banks and took them down.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The graph, from J.P. Morgan Asset Management, has a square for each month from 1988 through late 2014, meaning there are just short of 324 monthly observations (27 years x 12). Each square shows the forward p/e ratio on the S&P 500 at the time and the annualized return over the subsequent ten years. The graph gives rise to some important observations: • There’s a strong relationship between starting valuations and subsequent annualized ten-year returns. Higher starting valuations consistently lead to lower returns, and vice versa. There are minor variations in the observations, but no serious exceptions. • Today’s p/e ratio is clearly well into the top decile of observations. • In that 27-year period, when people bought the S&P at p/e ratios in line with today’s multiple of 22, they always earned ten-year returns between plus 2% and minus 2%. In November, a couple of leading banks came out with projected ten-year returns for the S&P 500 in the low- to mid-single digits. The above relationship is the reason. It shouldn’t come as a surprise that the return on an investment is significantly a function of the price paid for it. For that reason, investors clearly shouldn’t be indifferent to today’s market valuation.

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. . . . The riskier the underlying assets, the less leverage should be used to buy them. Conservative assumptions on this subject will keep you from maximizing gains but possibly save your financial life in bad times. The right way to think about debt may be best captured by one of the oldest maxims: “There are old investors, and there are bold investors, but there aren’t many old bold investors.” Using a moderate amount of borrowed capital balances the desire for enhanced gains against the awareness of the potential negative consequences. It’s only in this way that one can hope to attain the longevity of Morgan Housel’s 500-year-old success stories. May 8, 2024 © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 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.

• Decide whether your approach will lean more toward aggressiveness or defensiveness. Will you try to find more and bigger winners or focus on avoiding losers, or both? Will you try to make more on the way up or lose less on the down, or both? (Hint: “both” is much harder to achieve than one or the other.) In general, people’s investment styles should fit their personalities. • Think about what your normal risk posture should be – your normal balance between aggressiveness and defensiveness – based on your or your clients’ financial position, needs, aspirations, and ability to live with fluctuations. Consider whether you’ll vary your balance depending on what happens in the market. • Adopt a healthy attitude toward return and risk. Understand that “the more return potential, the better” can be a dangerous rule to follow given that increased return potential is usually accompanied by increased risk. On the other hand, completely avoiding risk usually leads to avoiding return as well. • Insist on an adequate margin of safety, or the ability to weather periods when things go less well than you expected. • Stop trying to predict the macro; study the micro like mad in order to know your subject better than others. Understand that you can expect to succeed only if you have a knowledge advantage, and be realistic about whether you have it or not. Recognize that trying harder isn’t enough.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: How Is Investing Like Gambling? Hidden information, luck and skill can play a part in investing. In active investing involving public companies, for example, all three are involved.  Clearly, no one knows all the relevant facts. The SEC tries to make sure all investors have equal access to information, but not necessarily complete access. For example, investors won’t know about first-quarter developments at a company until it reports earnings in May. And no one is supposed to know the results of drug trials and beta tests until they’re made public.  Luck – random, unpredictable, often-exogenous events – affects companies and their stocks all the time. Many aspects of corporate performance and profitability can be influenced by weather, for example. And the TV network carrying the World Series is likely to enjoy much greater ad revenue if the teams playing come from major markets rather than small ones.  Finally, the superior investor has the skill required to better assess revenue and profit potential, where we stand in the cycle, the fairness of an asset’s price and the margin of safety it affords. No one gets these things right all the time, but the superior investor does so more often than most. Not all investing, however, entails all – or necessarily any – of the three elements. Take, for example, index investing. The index fund manager’s job is to produce the same return as the relevant index.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: But when does reason-based confidence turn into hubris and obstinateness? That’s the key question. Holding and adding to declining positions is only a good idea if the underlying thesis turns out to be right and things eventually go as expected. In other words, when do you allow for the possibility that you’re wrong? From the very beginning of my investing career, I’ve felt a sense of uncertainty. But I don’t think that’s a bad thing: • “Investing scared” – a less glamorous term than “applying appropriate risk aversion” – will push you to do thorough due diligence, employ conservative assumptions, insist on an ample margin of safety in case things go wrong, and invest only when the potential return is at least commensurate with the risk. In fact, I think worry sharpens your focus. Investing scared will result in making fewer mistakes (although perhaps at the price of failing to take maximum advantage of bull markets). • When I started investing in high yield bonds in 1978, and when Bruce Karsh and I first targeted distressed debt in 1988, it seemed clear that the route to long-term success in such uncertain areas lay in limiting losses rather than targeting maximum gains. That approach has permitted us to still be here, while many one-time competitors no longer are. • I can tell you that in the Global Financial Crisis, following the bankruptcy of Lehman Brothers, we felt enormous uncertainty.

© Oaktree Capital Management, L.P. All Rights Reserved The truth is, the herd is wrong about risk at least as often as it is about return. A broad consensus that something’s too hot to handle is almost always wrong. Usually it’s the opposite that’s true. I’m firmly convinced that investment risk resides most where it is least perceived, and vice versa:  When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all. Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price.  And, of course, as demonstrated by the experience of Nifty Fifty investors, when everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky. No risk is feared, and thus no reward for risk bearing – no “risk premium” – is demanded or provided. That can make the thing that’s most esteemed the riskiest. This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high-quality assets can be risky, and low-quality assets can be safe. It’s just a matter of the price paid for them. For me, it follows from the above that the bottom line is simple: the riskiest thing in the world is the widespread belief that there’s no risk. That’s what most people believed in 2006-07, and that belief abetted the careless behavior that brought on the Great Financial Crisis.

© Oaktree Capital Management, L.P. All Rights Reserved you can’t be confident about what the right price is, then you can’t be definite about financial decisions regarding oil. In the last few years, as I said in The Role of Confidence (August 2013), investor sentiment has been riding high. Or, as Doug Kass pointed out this past summer, there’s been “a bull market in complacency.” Regardless, it seems that a market that was unconcerned about things like oil and its impact on economies and assets now has lost its composure. Especially given the pervasive role of energy in economic life, uncertainty about oil introduces uncertainty into many aspects of investing. “Value investing” – the form of investing Oaktree practices – is supposed to be about buying based on the present value of assets, rather than conjecture about profit growth in the far-off future. But you can’t assess present value without taking some position on what the future holds, even if it’s only assuming a continuation of present conditions or perhaps – for the sake of conservatism – a considerably lower level. Recent events cast doubt on the ability to safely take any position. One of the things that’s central to risk-conscious value investing is ascertaining the presence of a generous cushion in terms of “margin of safety.” This margin comes from conviction that conditions will be stable, financial performance is predictable, and/or an entry price is low relative to the asset’s intrinsic value.

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

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

© Oaktree Capital Management, L.P. All Rights Reserved. had come not from the value added by a dependable process, but from the fact that in essence the futures had allowed people to be more than 100% invested in a rising market.  And more recently, “risk parity investing” worked through volatile times because it gave its followers greater strategic diversification, defensiveness and bond exposure than most other investors had. But it, like most other things, failed to prevent losses when Ben Bernanke spooked the market by threatening to ease off bond buying and let interest rates rise. This year’s results for risk parity show that nothing works all the time. The point is that no mechanical tools can enable investors to prosper under all circumstances. They can provide tilts or reduce exposures, but the tool that promises a mix of good results and great results without the possibility of bad results is too good to be true. And when excessive confidence develops in such things, investors are heading for trouble. The same is true for the Greenspan put and its successor, the Bernanke put. Alan Greenspan’s tenure as Fed chairman was marked by efforts to avoid problems by injecting liquidity and lowering interest rates. Investors put great stock in his ability to keep things moving ever upward. His policies prevented occasional corrections along the way, but the price paid was a big one: the financial crisis of 2008.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. performance. While we can’t know these things with certainty, specialized expertise can help us do a better job of assessing prospects and estimating intrinsic value.  We can try to find bargains and avoid overpriced securities. By applying a disciplined approach to security selection, a manager should be able to judge the relationship between the price of each security and its intrinsic value. This can’t be done flawlessly, of course, and at any rate the impact of this relationship on performance is often outweighed in the short run by trends in investor psychology and perception. Thus, like everything else, this won’t work every time. But on balance the superior manager should be able to assemble portfolios whose holdings have a higher collective probability of moving in the right direction.  We can limit risk. The risk in investing increases along with the degree to which the future is unknowable. Recognizing this, managers who acknowledge the limits on their foresight tend to incorporate a good measure of risk control in their portfolios. They try to make fewer investments whose success is heavily dependent on knowing what the future holds, thereby creating an increased margin of safety. This approach to investing shouldn’t be expected to maximize return – especially in good times – but rather to maximize risk-adjusted return. This is a mission-critical part of the investment manager’s job.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. It’s my belief that things went better in the late twentieth century than we have reason to expect in the years ahead. We could get lucky again, of course, but it would be downright imprudent to make investments predicated on that assumption. Thus at Oaktree we’re making allowance for things that may go less well than they did in past periods. Cheapness provides a margin of safety today, but only so much. We’re moving forward, but cautiously. September 7, 2011 © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

” I don’t doubt that, but what if that “better life” comes to be defined as having more savings and less debt, rather than a new car or another handbag? According to The Wall Street Journal of December 17: . . . businesses ranging from shoemakers to financial services to luxury hotels don’t expect American consumers to return to their spendthrift ways anytime soon. They see consumers emerging from the punishing downturn with a new mindset: careful, practical, more socially conscious and embarrassed by flashy shows of wealth. Prudence dictates that people should have savings. But I hasten to point out that “should” isn’t the same as “will.” There’s a maxim that “No one ever went broke underestimating the intelligence of the American consumer.” I’d prefer to see consumers save rather than return to over-spending – it’s healthier for families and for the economy in the long run, providing reserves in case of emergency and capital for investment. But I won’t be shocked if they don’t. The Outlook for Real Estate Just as happened in homes, commercial real estate saw an explosion of excesses in the years leading up to the crisis. Investors and funds – perhaps pursuing the myth that real estate is a good inflation hedge regardless of the price paid – were aggressive buyers. Capitalization rates or “cap rates” (the demanded ratio of net operating income to price) fell to 4% and sometimes less, implying price/earnings ratios of 25 or more.

powder” and intestinal fortitude with which to buy. That’s the background. Where do we stand today? Signs of the Times Optimism, adventurousness and unworried behavior characterized the pre-crisis period, and investor behavior reflected those attitudes. In my memo “It’s All Good” (July 16, 2007), just before the onset of the crisis, I mentioned some of the warning signs in the credit markets: Unlike the historic norm, it’s routine today to issue CCC-rated bonds. It’s easy to borrow money for the express purpose of distributing cash to equity holders, magnifying the company’s leverage. It’s so easy to issue bonds with little or no creditor protection in the indenture that a label has been coined for them: “covenant-lite.” And it’s possible to issue bonds whose interest payments can be paid in more bonds at the option of the borrower. The first requirement for an elevated opportunity in distressed debt is the unwise extension of credit, which I define as the making of loans which borrowers will be unable to service if things get a little worse. This happens when lenders fail to require a sufficient margin of safety. . . . The default rate in the high yield bond universe is at a 25-year low on a rolling-twelve-month basis. Under such circumstances, how could the average supplier of capital be expected to maintain a high level of risk aversion and prudence, especially when doing so means ceding all the loan making to others?

© Oaktree Capital Management, L.P. All Rights Reserved profits with low risk. But their buying drove up both the cost of the assets and the riskiness of the environment, transforming their “low-risk” strategies into high-risk ones. The consequences have become clear. Greenspan and Bubbles One of the most obvious ways in which investors change the environment is through the creation of asset bubbles, like the one that popped in the summer of 2007. In a process that invariably looks silly after the fact, they reach the conclusion that an investment is a sure winner, usually on the basis of simplistic platitudes that simply can’t hold up under scrutiny. These include “Internet stocks must rise because these companies are going to change the world,” “real estate (or gold) is a good hedge against inflation,” “home prices can never decline nationwide,” “oil will appreciate because it’s being consumed faster than it’s being found,” and “alternative investments (or hedge funds or private equity funds) hold the key to meeting investment goals.” Because of the strength attributed to these platitudes, investors go on to conclude that the investments they support will be profitable regardless of the price at which they’re undertaken. How can this be right? It’s not possible that something can be a good investment regardless of the price paid. But when a logical-seeming platitude is adopted by the stampeding herd, that belief is the result. That’s how we get bubbles.

But the second group was better prepared when the crash unfolded, and they had more capital available (and more-intact psyches) with which to profit from purchases made at its nadir. Never Forget the 6'-Tall Man Who Drowned Crossing the Stream That Was 5' Deep on Average The range of possibilities – the environments with which we must deal – invariably will include some bad ones. We must prepare for them, and the unavoidable prerequisite for doing so is being aware of them. Following from the section above, the key is to view the future as a range of possibilities, not a reliable point estimate. How does the successful investor prepare for the uncertain future? By building in what Warren Buffett calls “margin for error” or “margin of safety.” It’s having this margin that enables us to do okay even when things don’t go our way. If an investor prepares for a single future and attempts to maximize under the assumption that his view will prove right, he’ll be in big trouble if it doesn’t. The investor who backs off from the maximizing position is likely to do better when negative surprises occur. Thus it’s essential to realize a few things:  It’s not sufficient to think about surviving “on average” – investment survival has to be achieved every day, under all circumstances.  The ability to survive under adverse conditions comes from a portfolio’s margin for error.  Ensuring sufficient margin for error and attempting to maximize returns are incompatible.

The use of leverage illustrates a special case of the above. Leverage increases the gains if you succeed and the losses if you fail. Thus leverage increases the probability of maximizing under favorable outcomes and reduces your margin of safety under unfavorable ones.and

 Among the innovations, collateralized debt obligations, or CDOs, deserve particular mention. CDO originators would issue tranches of debt with varying levels of priority regarding the cash flows from debt portfolios assembled with the proceeds. In many cases, the portfolios consisted heavily of residential mortgage-backed securities, each comprised of large numbers of mortgages, often subprime. I find it inconceivable that buyers of CDO debt really understood the riskiness of the tranched debt of leveraged pools of tranched mortgage securities underlaid by thousands of anonymous loans. But solid ratings made the debt highly salable.  With vast sums available for high-fee investment products, managers’ incentives favored the rapid amassing and deploying of large pools of capital. The usual effect of such a process is to drive up asset prices, drive down prospective returns and narrow investors’ margin of safety. It was no different this time.  Due to widespread prosperity, large amounts of capital flowing into the mortgage market, and the flowering of the American dream of home ownership (and of wealth therefrom), rapid home price appreciation became a prominent feature of this period. Price gains further inflamed the people’s hopes, and behavior regarding residential real estate grew increasingly speculative.than

© 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.

 And, of course, as demonstrated by the experience of Nifty Fifty investors, when everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky. No risk is feared, and thus no reward for risk bearing – no “risk premium” – is demanded or provided. That can make the thing that’s most esteemed the riskiest. This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them. The foregoing must be what Lord Keynes had in mind when he coined one of my favorite phrases: “. . . a speculator is one who runs risks of which he is aware and an investor is one who runs risks of which he is unaware.” In 1978, triple-A bonds were considered respectable investments, while buying B-rated bonds was viewed as irresponsible speculation. Yet the latter have vastly outperformed the former, few of which remain triple-A today. Elevated popular opinion, then, isn’t just the source of low return potential, but also of high risk. Broad distrust, disregard and dismissal, on the other hand, can set the stage for high returns earned with low risk. This observation captures the essence of contrarianism.

” If the amount raised in 2005 was triple the 2002 level, as I believe was the case, that means private equity funds deployed capital in 2005 roughly nine times as fast as they had in 2002. No one of these is evidence of misfeasance or terminal laxness by itself. But together they describe a market where a desire for quantity and speed has taken over from an insistence on quality and caution. And with that insistence goes the margin of safety that Warren Buffett urges investors to demand. UThe Amazing Disappearing Covenant Evaluating and negotiating covenants is an important part of the high yield bond investor’s job. The law says a company’s board of directors has a fiduciary duty to its shareholders, but generally speaking there is no analogous duty to creditors such as banks and bondholders. In fact, some companies behave as if they feel a responsibility to actively take value from creditors and transfer it to the shareholders. Because companies can do anything to creditors that isn’t prohibited by law or the bond indenture, covenants are a key component in creditor safety. It’s important to bondholders, for example, that the companies to which they lend money remain as little changed as possible. They want the creditworthiness they lend against to still be there years down the road, and strong covenants can do a lot to ensure that’s the case. Bondholders can’t prevent problems in the economy, the company’s markets, its products’ competitiveness or its executive suite.a

Perhaps Myron Scholes put it most succinctly (The Wall Street Journal, March 6): “My belief is that because the system is now more stable, we’ll make it less stable through more leverage, more risk taking.” UThe L Word Some of the most glaring innovation this time around has taken place in the area of leverage. It’s not that leverage hasn’t been available and been used before: In the late 1980s, companies like RJR were the subject of leveraged buyouts in which 95% of the purchase price was borrowed. Nowadays, debt rarely constitutes much more than 80% of buyout capital structures, but the terms of the debt and the ease of obtaining it are startlingly accommodating. Unlike the historic norm, it’s routine today to issue CCC-rated bonds. It’s easy to borrow money for the express purpose of distributing cash to equity holders, magnifying the company’s leverage. It’s so easy to issue bonds with little or no creditor protection in the indenture that a label has been coined for them: “covenant-lite.” And it’s possible to issue bonds whose interest payments can be paid in more bonds at the option of the borrower. The first requirement for an elevated opportunity in distressed debt is the unwise extension of credit, which I define as the making of loans which borrowers will be unable to service if things get a little worse. This happens when lenders fail to require a sufficient margin of safety. Here the interrelatedness of cycles is quite evident.

© Oaktree Capital Management, L.P. All Rights Reserved stay afloat and hopefully outgrow their problems. Today that’s called “rescue finance”; in less rosy times it might be called “throwing good money after bad.” The default rate in the high yield bond universe is at a 25-year low on a rolling-twelve-month basis. Under such circumstances, how could the average supplier of capital be expected to maintain a high level of risk aversion and prudence, especially when doing so means ceding all the loan making to others? It’s not for nothing that they say “The worst of loans are made in the best of times.” UThe Downside of Leverage If lenders are acting in an imprudent fashion, what’s the effect on the borrowing companies? If loans are available too readily, is it right or wrong to borrow? These are among the most interesting questions of the day. Lots of good things have been said about leverage. In the late 1980s, when venerable American companies were being bought in leveraged buyouts structured with debt/equity ratios of 25-to-one, we were told that an underleveraged balance sheet is indicative of a sub-optimal capital structure and excessive use of high-cost equity, and that significant leverage sharpens management’s focus on cash flow and leads to better expense control. The only thing omitted was the reminder that equity – which doesn’t require the periodic payment of interest or the repayment of principal at maturity – represents a company’s margin of safety.

I’ll tick off his credentials for inclusion (as I see them) and throw in a few quotes from his recent writings.  He never bases his investment actions on forecasts for the economy or market. “. . . the cemetery for seers has a huge section set aside for macro forecasters. We have in fact made few macro forecasts . . , and we have seldom seen others make them with sustained success.”  Rather, his actions are strictly determined by the availability of attractive investment opportunities. “Under any market or economic conditions, we will be happy to buy businesses that meet our standards.”  He’s a solid investor in value – be it derived from current cash flow, unique market position or special human resources.  Because of his risk awareness and desire to avoid losers, he always insists on a generous “margin of safety.”  He is absolutely unconcerned if an index or competitor outperforms him for a year or two, but he insists on avoiding losses. Losing less than his competitors is not his definition of success.  When attractive investment opportunities are few, he’s willing to stand at the plate with the bat on his shoulder – something he says he’s doing a lot of nowadays. In 2003, that caused his holdings of cash to triple. “Our capital is underutilized now . . . . It’s a painful condition to be in – but not as painful as doing something stupid.”

© Oaktree Capital Management, L.P. All Rights Reserved Oaktree follows a clearly defined route that it trusts will bring investment success: If we avoid the losers, the winners will take care of themselves. We think the most dependable way for us to generate the performance our clients seek is by avoiding losing investments. We don’t claim that this is the only way to invest well; others may choose more aggressive approaches, and they may work for them. This is the way for us. Investing defensively can cause you to miss out on things that are hot and get hotter, and it can leave you with your bat on your shoulder in trip after trip to the plate. You may hit fewer home runs than another investor . . . but you’re also likely to have fewer strikeouts and fewer inning-ending double plays. The ingredients in defensive investing include (a) insistence on solid, identifiable value at a bargain price, (b) diversification rather than concentration, and (c) avoidance of reliance on macro-forecasts and market timing. Warren Buffett constantly stresses “margin of safety.” In other words, you shouldn’t pay prices so high that they presuppose (and are reliant on) things going right. Instead, prices should be so low that you can profit – or at least avoid loss – even if things go wrong. Purchase prices below intrinsic value will, in and of themselves, result in larger gains, smaller losses, and easier exits. “Defensive investing” sounds very erudite, but I can simplify it: Invest scared!

Worry about the possibility of loss. Worry that there’s something you don’t know. Worry that you can make high quality decisions but still be hit by bad luck or surprise events. Investing scared will prevent hubris; will keep your guard up and your mental adrenaline flowing; will make you insist on adequate margin of safety; and will increase the chances that your portfolio is prepared for things going wrong. And if nothing does go wrong, surely the winners will take care of themselves. The most important thing is avoiding bad years. Preparing for bad times is akin to attempting to avoid individual losers, and equally important. Thus time is well spent making sure the downside risk of our portfolios is limited. There’s no need to prepare for good times; like winning investments, they’ll take care of themselves. The mantra “beat the market” has been vastly overdone in the last 25 years, when outperforming an index has become the sine qua non of good management. But why should this be the case? Keeping up with the market while bearing less risk is at least as great an accomplishment, although few people talk about it in the same glowing terms. At Oaktree we believe strongly that in the good times, it’s good enough to be average.that

© Oaktree Capital Management, L.P. All Rights Reserved adjusted returns, it’s not likely to be by doing the same things everyone else is doing. The best and most safely earned profits are apt to be found outside the mainstream, not inside. The most important thing is being leery of leverage. The key elements in Oaktree’s investment approach include focusing on what’s out of favor; ascertaining intrinsic value and trying to buy for less; and adding value by working with assets once we own them. If done well, these things can simultaneously increase prospective return and reduce risk. Leverage, on the other hand, increases prospective return and UincreasesU risk. There’s nothing magic about leverage. It increases upside potential, but it also reduces or eliminates the margin of safety. Leverage is just an application of the Las Vegas maxim, “The more you bet, the more you win when you win.” But I think people tend to omit “. . . and the more you lose when you lose.” As Warren Buffett puts it, “It’s a very sad thing. You can have somebody whose aggregate performance is terrific, but they have a weakness – maybe it’s alcohol, maybe it’s susceptibility to taking a little easy money – it’s the weak link that snaps you. And frequently, in the financial markets, the weak link is borrowed money” (emphasis added).

© Oaktree Capital Management, L.P. All Rights Reserved I remember having a spirited discussion on this topic with my father in the late 1960s. I came home from the University of Chicago filled with the notion that the value of a share of stock is the present value of its future dividends. "Baloney," my father said, "no one buys stocks for the dividends; they buy them for appreciation." "But what makes them appreciate?" I asked. We never have reached agreement on this matter. I think we were both right and both wrong. Certainly in a real-world sense, people don't buy stocks for dividends. Dividends provided a small portion of the total return on stocks in the 1960s and far less in the 1990s. Yes, most people buy stocks for appreciation. But what causes appreciation? There has to be an underlying process at work. We're in trouble if all we can say is "we buy stocks in the hope they'll go up, and they'll go up if new buyers are willing to pay more than the last price." To explain what'll make the buyers pay more than the last price, we either have to (1) identify what I call an underlying process or (2) fall back on the bromides listed above that led investors off the cliff in the 1990s. The "underlying process" has to be related to financial parameters. By that I mean the asset values and/or cash flows must be recognized as being worth more than the last price paid. That's what causes appreciation.

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