Howard Marks on Mistakes & Learning

© 2026 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Questions and Limitations As part of my tutorial, Claude volunteered a few limitations that AI has and a few unanswered questions. They include the following: • It’s unclear whether AI will be able to solve questions that haven’t been solved before. Since this is something I’ve long felt was the case, I’m glad to have Claude’s confirmation: I want to be honest with you about where genuine uncertainty lies, because your credibility depends on nuance. The question of whether AI can handle truly unprecedented situations – situations with no pattern in the training data to draw on – is real and unresolved. In domains with rich historical data, AI’s performance is extraordinary. In genuinely novel situations, the kind where your own judgment is most valuable precisely because you’ve developed intuition that goes beyond pattern recognition – there, AI is weaker. How much weaker, and whether that gap is closing, is legitimately debatable. • AI isn’t always aware that it doesn’t know an answer. I’m told AI is highly motivated to provide the best answer it can (without sharing that it could be wrong), as opposed to ever saying the answer is beyond it. It does so not because it’s obstinate or egotistical, but because it has “hallucinations” that make it believe it knows the answers. • AI’s reliability has improved significantly, but it still doesn’t work free of mistakes.

But in every instance, new jobs materialized and employment continued uninterrupted, and it’ll be so this time as well. • First, I admit the tendency to extrapolate from this history isn’t unreasonable. • Second, there’s no such thing as being able to prove something won’t happen. • Third, I’m neither enough of a futurist to imagine the new jobs that may be created nor enough of an optimist to trust that they’ll materialize. That certainly doesn’t mean they won’t. Some of the same optimists hasten to share the “good news” regarding the future: people won’t have to work. I simply cannot imagine that’ll be good for society. A friend wrote to me recently that he’d rather be an optimist and wrong than a pessimist and right. Me too. I wish I could be confident that my worrying is unwarranted. That’s all I have to add for now. At the current rate, I’ll probably have more soon.

© 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.

They want their constituents to be able to continue renting apartments in their districts and not lose out to others who can pay more. To deliver on this aspect of constituent service, they pass laws to limit rent increases. Now people who otherwise couldn’t afford to live in the jurisdiction can do so. Those tenants are happy, and that makes the elected officials happy, as happy constituents tend to vote for incumbents. But not everyone is happy. Landlords are unhappy about not being able to charge the full rent they could charge in a free market, so they stop investing in their apartments and sometimes take them off the market. Developers who might be interested in building new apartments refrain from doing so out of concern that they won’t be able to earn a sufficient return. Also unhappy are people who would like to live in that location and can afford to pay market rents but are unable to find vacant apartments because they’re occupied by people paying below-market rents. There are at least two things wrong with this situation. The first is that governments are choosing winners and losers, rather than letting market forces do so. In the case of rent control, the people who occupy apartments (and potentially political incumbents) are the winners, but landlords, developers, and people looking for apartments are the losers.

The recurring roller coaster of psychology and the resulting behavior is the most important of them. The key observation is that good times lead to complacency, risk tolerance, and carelessness, as people bid aggressively for assets and compete to make loans. And then, bad times expose the results of that carelessness, as investments that were entered into without an adequate investigation and margin for error fail to hold up in a hostile environment. This is nothing new. As financial historian Edward Chancellor wrote in his 2022 book The Price of Time: The Manchester banker John Mills commented perceptively [in 1865] that “as a rule, panics do not destroy capital; they merely revealed the extent to which it has previously been destroyed by its betrayal into hopelessly unproductive works.” In other words, many flawed decisions, which the economist Friedrich Hayek aptly described as “malinvestment,” are made in booms and exposed in busts. It will ever be so. This is summed up most concisely in a great banking adage: “The worst of loans are made in the best of times.” A Good Bezzle Charlie Munger and I used to enjoy talking about the economist John Kenneth Galbraith. Galbraith was the source of many of my favorite expressions with regard to the financial markets. One I haven’t mentioned since my memo The Long View in 2009 is the “bezzle,” a concept Galbraith introduced in his book The Great Crash 1929. What’s a bezzle?

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: analyst named Walter Deemer: “When the Time Comes to Buy, You Won’t Want To.” The negative developments that make for the greatest price declines are terrifying, and they discourage buying. But, when unfavorable developments are raining down, that’s the optimal time to step up. Lastly, given Trump’s tactical focus, it’s important to bear in mind that absolutely everything is subject to change. It shouldn’t surprise anyone if he extracts concessions and declares victory . . . or if he responds to other countries’ retaliation by escalating further. Thus, I told a Wharton conference on Friday that if anyone thinks they know what a given tariff rate will be three months from now, I’ll bet good money they’re wrong – even without knowing what they think the answer is. Tariffs What are President Trump’s reasons for enacting his tariffs, and are they valid? On the day of the announcement, I heard a TV commentator credit Trump’s “impulses” as having some justification. What are his goals? They include some or all of the following: • support U.S. manufacturing • encourage exports • discourage imports • shrink or eliminate our trade deficit • make supply chains more secure through onshoring • deter unfair trade practices aimed at the U.S. • force other countries to the negotiating table • generate revenue for the U.S.

And, intelligently, the crooks are most active in times when conducting due diligence is in retreat and loose change becomes more readily accessible. It shouldn’t come as a surprise in the years ahead if the last sixteen years of largely uninterrupted economic growth, rising markets, and profitable risk taking are shown to have produced a bumper crop of frauds. Nowadays, I’m often asked whether the issues described above are “systemic.” In other words, are they “pertaining to the system” or “affecting the system,” as opposed to idiosyncratic occurrences that don’t say anything about the system. For an example of something systemic, consider the counterparty risk that arose during the Global Financial Crisis. Because financial institutions had entered into hedging transactions with each other, one bank’s weakness weakened the others, impacting the system overall. I think “hardwired into the system” is a good way to describe something that’s systemic. I don’t think today’s issues are systemic in the sense that there’s something wrong with the lending system, or that they will trigger other defaults and lead to a breakdown of the system. In simpler words, there’s nothing wrong with the plumbing. But imprudent loans and business frauds often occur in clusters for the simple reason that people who make investments and loans are highly prone to error in good times.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Hobart and Huber go on to describe in greater depth the process through which bubbles finance the building of the infrastructure required by the new technology and thus accelerate its adoption: Most novel technology doesn’t just appear ex nihilo [i.e., from nothing], entering the world fully formed and all at once. Rather, it builds on previous false starts, failures, iterations, and historical path dependencies. Bubbles create opportunities to deploy the capital necessary to fund and speed up such large-scale experimentation – which includes lots of trial and error done in parallel – thereby accelerating the rate of potentially disruptive technologies and breakthroughs. By generating positive feedback cycles of enthusiasm and investment, bubbles can be net beneficial. Optimism can be a self-fulfilling prophecy. Speculation provides the massive financing needed to fund highly risky and exploratory projects; what appears in the short term to be excessive enthusiasm or just bad investing turns out to be essential for bootstrapping social and technological innovations . . . A bubble can be a collective delusion, but it can also be an expression of collective vision. That vision becomes a site of coordination for people and capital and for the parallelization of innovation. Instead of happening over time, bursts of progress happen simultaneously across different domains. And with mounting enthusiasm . . .

When a bubble burst in my early investing days, The Wall Street Journal would run a box on the front page listing stocks that were down by 90%. In the aftermath of the TMT Bubble, they’d lost 99%. When something is on the pedestal of popularity, the risk of a decline is high. When people assume – and price in – an expectation that things can only get better, the damage done by negative surprises is profound. When something is new, the competitors and disruptive technologies have yet to arrive. The merit may be there, but if it’s overestimated it can be overpriced, only to evaporate when reality sets in. In the real world, trees don’t grow to the sky. The foregoing discussion centered on the risk of overestimating fundamental strength. But optimism surrounding the power and potential of the new thing often causes the error to be compounded through the assignment of too high a stock price. • As mentioned above, for something new, there by definition is no historical indicator of what an appropriate valuation might be. • Further, the companies’ potential hasn’t yet been turned into steady-state profits, meaning the thing that’s being valued is conjectural. In the TMT Bubble, the companies didn’t have earnings, so p/e ratios were out. And as startups, they often didn’t have revenues to value.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Equity investors deal with this challenge by looking primarily – often almost exclusively – at a stock’s p/e ratio, or the ratio of a company’s share price to the amount of earnings attributable to each share of its common stock. It’s easy to calculate the p/e ratio for one stock or the average for a stock market or index, and thus to know how the current p/e ratio compares to p/e ratios on other stocks or at other points in time. Deviations from those p/e norms are examined in light of the factors that distinguish the company from other companies (based on aspects of fundamentals beyond the current earnings) or that distinguish today from past times, and investors reach conclusions as to whether the asset is overpriced, fairly priced, or underpriced given those considerations. Of course, basing an investment decision on a single metric, such as a stock’s p/e ratio, represents a vast oversimplification of the decision, and thus introduces the possibility of error. Getting Up to Date Now we can start getting current and concrete. Where were we when 2025 began? • The S&P 500 stock index is the most watched barometer of the U.S. stock market. Toward the end of last year, its forward-looking p/e ratio (the ratio of its price to its estimated earnings over the coming year) was around 23, significantly above its historical average. • At the time, J.P.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Even granting the possibility that Etched won’t become the biggest company of all time, if success could give them a valuation just one-fifth of Nvidia’s peak – a mere $1 trillion – what probability of success would be required to justify an investment of $120 million? Assuming for simplicity’s sake that the investment was for a 100% ownership stake, all you need is a belief that achieving the trillion-dollar value has a probability of one-tenth of a percent for an expected return of over eight times your money. Who’s to say Etched doesn’t have that chance? And in that case, why would anyone not play? The foregoing is what I call “lottery-ticket thinking,” in which the dream of an enormous payoff justifies – no, compels – participation in an endeavor with an overwhelming probability of failing. There’s nothing wrong with calculating expected values this way. Leading venture capitalists engage in it every day to great effect. But assumptions regarding the possible payoffs and their probabilities must be reasonable. Thinking about a trillion-dollar payout will override reasonableness in any calculation. Will AI produce profits, and for whom? Two things we know little or nothing about are the profits AI will produce for vendors and its impact on non-AI companies, primarily meaning those who employ it.

Compared to the past, today’s S&P 500 is increasingly made up of companies that (a) grow faster, (b) are less cyclical, (c) require less incremental capital to grow, enabling them to generate more free cash flow, and (d) have much stronger competitive positions or “moats.” Thus, they deserve above average p/e ratios. This explanation makes complete sense. It cites factors that really might be different. And per Sir John Templeton, the first person that I know talked about the trap of “it’s different this time,” 20 percent of the time things really are; today I’d bet it’s more than 20 percent. So, on one hand, “it’s different this time” is a recurring bull-market cliche that always bears scrutiny, and on the other hand, failing to recognize when things actually are different is something that stands between the average investor and superiority. I just have no idea which of those two concerns is more valid today. But investors should bear three things in mind: • the enormous likelihood that AI and related developments will change the world, • the possibility that it is “different” for some companies – those that truly embody the factors listed above and will demonstrate the “persistence” I described in On Bubble Watch, but also • the fact that in most “new, new things,” investors tend to treat far too many companies – and often the wrong ones – as likely to succeed.

This promises even more social and political division than we have now, making the world ripe for populist demagoguery. I’ve seen incredible progress over the course of my lifetime, but in many ways I miss the simpler world I grew up in. I worry that this will be another big one. I get no pleasure from this recitation. Will the optimists please explain why I’m wrong? Interestingly in this connection, Vanguard’s Joe Davis points out that more Americans are turning 65 in 2025 than in any preceding year, and that approximately 16 million baby boomers will retire between now and 2035. Could AI merely make up for that? There’s an optimistic take for you.HM

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: been right if only some unexpected event hadn’t transpired. But, in either case, the chance for the unexpected – and thus for forecasting error – was present. In the latter instance, the unexpected materialized, and in the former, it didn’t. But that doesn’t say anything about the likelihood of the unexpected taking place. Macro Economics In 2021, the U.S. Federal Reserve held the view that the bout of inflation then underway would prove “transitory,” which it has subsequently defined as meaning temporary, not entrenched, and likely to self- correct. I think the Fed might have been proved right, given enough time. Inflation might have retreated of its own accord in three or four years, after (a) the Covid-19 relief funds that caused the surge in consumer spending were spent down and (b) the global supply chain returned to its normal operations. (However, not slowing the economy would have brought the risk that inflationary psychology might take hold in those 3-4 years, necessitating even stronger action.) But because the Fed’s view wasn’t borne out in 2021 and waiting longer was untenable, the Fed was forced to embark on one of the fastest programs of interest rate increases in history, with profound implications. In mid-2022, there was near certainty that the Fed’s rate increases would precipitate a recession. It made sense that the dramatic increase in interest rates would shock the economy.

In each case, the two are inseparable. As Ashley says, no risk, no reward. No pain, no gain. The risk inherent in not taking enough risk is very real. Individual investors who eschew risk may end up with a return that is insufficient to support their cost of living. And professional investors who take too little risk may fail to keep up with their clients’ expectations or their benchmarks. Like chess (and most card games), backgammon requires the calculation of when to take risk and when to avoid it. In backgammon, two players move their checkers around the board based on throws of a pair of dice. One player moves clockwise and the other counterclockwise. When players’ checkers come near each other, the player who’s moving often has a choice between (a) landing on one of the other player’s checkers, sending it back to the start (but at the risk of leaving the moving checker in a vulnerable position), and (b) avoiding doing so to play it safe. No one wants to be exposed and get hit. But most beginners play it too safe, and because they put so much emphasis on avoiding getting hit, they rarely win. Relevant lessons from sports (included in past memos) are easily accessed and also very helpful: • “You miss 100% of the shots you don’t take.” – Wayne Gretzky, NHL Hall of Famer • “You have to give yourself a chance to fail.” – Kenny “The Jet” Smith, two-time NBA champion I’ll sum up with a paragraph from my memo of last September, Fewer Losers, or More Winners?

Further, history clearly showed that major central bank tightening has almost always led to economic contraction rather than a “soft landing.” And yet, no recession has materialized. Instead, late in 2022, the consensus among market observers shifted to the view that (a) inflation was easing, and this would permit the Fed to start cutting interest rates, and (b) rate cuts would enable the economy to avoid recession or ensure that any contraction would be mild and short-lived. This optimism ignited a stock market rally in late 2022 that persists today. And yet, the anticipated rate reductions in 2023 that undergirded the rally didn’t transpire. Then, in December 2023, when the “dot plot” of Fed officials’ views called for three interest rate cuts in 2024, the optimists driving the market doubled down, pricing in an expectation of six. Inflation’s stubbornness has precluded any rate cuts thus far, with 2024 more than half over. Now the consensus has coalesced around the idea of a first cut in September. And the stock market keeps hitting new highs. The optimists today would likely say, “We were right. Look at those gains!” But, regarding interest rate cuts, they were simply wrong. For me, all this does is serve as another reminder that we don’t know what’s going to happen or how markets will react to what does happen. Conrad DeQuadros of Brean Capital, my favorite economist (how’s that for an oxymoron?)

Price gouging is generally defined as sellers taking advantage of market power or temporary supply/demand imbalances to raise prices to levels that otherwise wouldn’t prevail. And food prices did rise significantly in 2021 and 2022, leading to suspicion of food retailers. But might there be reasons for the price increases other than a malevolent decision to gouge on the part of sellers? Here are a few possibilities: • When the pandemic began in March 2020, most people stayed home and cooked their own meals, significantly increasing the demand for groceries and depleting inventories. • The production system was disrupted, with inputs in short supply or in the wrong places relative to the needs. This led to the much-discussed “supply-chain problems.” Too few goods – when coupled with too much money chasing them – constitute the classic reason for inflation. • The federal government sent taxpayers massive amounts of Covid-19 relief. Many more people received benefits than had been hurt financially by the pandemic. Those people came out ahead, capturing trillions of dollars for future spending. © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • When the Delta variant of Covid popped up in mid-2021, people again stayed home and shrunk from contact with others, spending more on goods and less on services than they otherwise might have. Demand for goods was strong as a result, outstripping the limited supplies and causing prices to rise. Profit margins in the supermarket industry are low – about 1% to 2% of sales – and that changed only a little in 2021-22. So, was there gouging? And if gouging is the explanation for the price increases, why did it occur in those years, rather than sooner? Again, might today’s high prices be explained by something other than gouging? The New York Times, rarely a defender of capitalism, wrote the following on August 15: Researchers from the Federal Reserve Bank of Kansas City reported last year that rapid job growth in the U.S. economy, and the wage increases that came with it, were major contributors to rising grocery prices. A number of factors contributed to the increase in food prices, many of them linked to the macro economy. But the bottom line is that conditions allowed food sellers to raise prices, and they did so. Is Raising Prices Wrong? The above is the key question. Definitions of price gouging invariably include words like “unfair,” “excessive,” and “exorbitant.” These are subjective terms that are open to judgment and debate.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Markets The rare person who in October 2022 correctly predicted that the Fed wouldn’t cut interest rates over the next 20 months was absolutely right . . . and if that prediction kept them out of the market, they’ve missed out on a gain of roughly 50% in the Standard & Poor’s 500 index. The rate-cut optimist, on the other hand, was absolutely wrong about rates but is likely much richer today. So, yes, market behavior is very tough to gauge correctly. But I’m not going to take time here to catalog the errors of market savants. Instead, I’d like to focus on why so many market forecasts fail. The performance of economies and companies might tend toward predictability given that the forces governing them are somewhat . . . shall I say . . . mechanical. In these areas, one might say “if A, then B” with some degree of confidence. Predictions here might, therefore, have some chance of being correct, albeit that’s mostly the case when trends continue unabated and extrapolation works. But markets swing more than economies and companies. Why? Because of the importance and unpredictability of market participants’ psyches or emotions. Thanks to further help from Conrad DeQuadros, I can illustrate the greater variability of markets, as follows: 40-Year Standard Deviation of Annual Percentage Changes GDP 1.8% Corporate profits 9.4 S&P 500 price 13.

The propriety of behavior with regard to these words is usually in the eye of the beholder. The seller’s highly reasonable price increase is the customer’s gouging. The difficulty of defining gouging reminds me of those who say, “we’re not out to soak the rich; we just want to make them pay their fair share in taxes.” I’m far from saying the rich shouldn’t pay their “fair share,” but what’s the standard for a fair share, and who gets to set it? In the same way, who determines whether prices are fair, and how? When a supermarket raises the price of a necessity like bread, is that gouging? The answer is that it’s complicated, and that’s what makes it hard to regulate prices fairly. • If the farmer pays more for fertilizer and labor and then charges the baker more for wheat, can the baker fairly pass that on to the supermarket in the form of a higher price for bread? • If the baker raises the price he charges the supermarket for bread, is it wrong for the supermarket to pass on the increase to the consumer? • If the supermarket’s employees demand higher pay, can it offset the increase by raising the prices of the things it sells? • If demand increases because a hit TV show popularizes sandwiches, is it wrong for people in the supply chain to take advantage and charge more for bread? In a free market, prices are determined by supply and demand. Is it wrong per se for providers of goods and services to raise prices in response to reduced supply or increased demand?

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: This was a tough day in the markets: interest rates were rising thanks to the actions of the Fed and other central banks, and asset prices were under significant pressure as a result. But take a look at the table. Every country’s equity index was down significantly. Every currency was down relative to the dollar. Every commodity was down. Only one thing was up: bond yields . . . meaning bond prices were down, too. Wasn’t there one asset or country whose value didn’t decline that day? What about gold, which is supposed to do well in difficult times? My point here is that, during big market moves, no one performs rational analysis or makes distinctions. They just throw out the baby with the bathwater, primarily because of psychological swings. As the old saying goes, “in times of crisis, all correlations go to 1.” Further, the data in the table exhibit an additional phenomenon that’s often present during extreme moves: contagion. Something goes wrong in the U.S. market. European investors take that as a sign of trouble, so they sell. Asian investors detect that something negative is afoot, so they sell overnight. And when U.S. investors come in the next morning, they’re spooked by the negative developments in Asia, which confirm their pessimistic inclinations, so they sell.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: But I don’t remember ever writing about his second factor, which Galbraith says is “the specious association of money and intelligence.” When people get rich, others take that to mean they’re smart. And when investors succeed, it’s often assumed their intelligence can lead to similarly good results in other fields. Further, successful investors often come to believe in the strength of their own intellect and opine about fields with no connection to investing. But investors’ success can be the result of a string of lucky breaks or a propitious environment, rather than any special talents. They may or may not be intelligent, but often they don’t know any more than most others about subjects outside of investing. Nevertheless, many are unsparing with their opinions, and those opinions often are highly valued by the general populace. That’s the specious part. And today we find some of them speaking with conviction on all sides of the issues related to the election. A lot has been said about those who express certainty. We all know people we’d describe as “often wrong but never in doubt.” This reminds me of another of my favorite quotes, one that’s attributed (perhaps tenuously) to Mark Twain: “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.

” Back in mid-2020, when the pandemic seemed to have become a more or less understood phenomenon, I slowed the pace of my memo writing from the one-a-week pattern of March and April. In May, I took the opportunity for two non-Covid-related memos titled Uncertainty and Uncertainty II, in which I devoted a significant amount of space to the subject of intellectual humility. While these memos were on one of my favorite topics, they generated little response. So, I’ll quote a bit from Uncertainty and hopefully give you reason to look back at them. Here’s part of the article that first brought the subject of intellectual humility to my attention: As defined by the authors, intellectual humility is the opposite of intellectual arrogance or conceit. In common parlance, it resembles open-mindedness. Intellectually humble people can have strong beliefs, but recognize their fallibility and are willing to be proven wrong on matters large and small. (Alison Jones, Duke Today, March 17, 2017) . . . To put it simply, intellectual humility means saying “I’m not sure,” “The other person could be right,” or even “I might be wrong.” I think it’s an essential trait for investors; I know it is in the people I like to associate with. . . . No statement that starts with “I don’t know but . . .” or “I could be wrong but . . .” ever got anyone into big trouble. If we admit to uncertainty, we’ll investigate before we invest, double-check our conclusions and proceed with caution.

But if the government puts its thumb on the scale in favor of one party or the other, it distorts the workings of the free market and keeps it from functioning efficiently on behalf of society overall. More on this later. There are forms of seller behavior that are clearly wrong. These include collusion, price fixing, and predatory pricing designed to drive competitors out of the market. But laws prohibiting these behaviors are already on the books. Additional laws designed to prohibit and punish price increases that someone views as unfair, excessive or exorbitant – as opposed to being the result of improper conduct – are sure to prove difficult to enforce and counter-productive. Would a Law Against Price Gouging Work? Just as history is full of failed command economies, it also shows the ineffectiveness of attempts to regulate prices. In 1974, when the OPEC oil embargo set off inflation that made life difficult for millions, the U.S. government countered by distributing “WIN” buttons, standing for Whip Inflation Now. I still have mine, but neither it nor the voluntary consumer actions that were supposed to follow were enough to keep inflation from reaching 13.5% in 1980. The buttons were derided, with some skeptics wearing them upside down, according to Wikipedia. “Worn that way, ‘NIM’ stood for ‘No Immediate Miracles,’ ‘Nonstop Inflation Merry-go-round,’ or ‘Need Immediate Money.’ ’’ © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

We may sub-optimize when times are good, but we’re unlikely to flame out or melt down. On the other hand, people who are sure may dispense with those things, and if they’re sure and wrong, as the Twain quote suggests, the outcome can be catastrophic. . . . . . . maybe Voltaire said it best 250 years ago: Doubt is not a pleasant condition, but certainty is absurd. There simply is no place for certainty in fields that are influenced by psychological fluctuations, irrationality, and randomness. Politics and economics are two such fields, and investing is another. No one can predict reliably what the future holds in these fields, but many people overrate their ability and © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: There’s more recent experience with price controls, in Venezuela. Here’s what I said about it in Economic Reality: A case in point is the price controls, which have expanded to apply to more and more goods: food and vital medicines, yes, but also car batteries, essential medical services, deodorant, diapers, and, of course, toilet paper. The ostensible goal was to check inflation and keep goods affordable for the poor, but anyone with a basic grasp of economics could have foreseen the consequences: When prices are set below production costs, sellers can’t afford to keep the shelves stocked. Official prices are low, but it’s a mirage: The products have disappeared. (Atlantic Monthly, May 12, 2016, emphasis added) Here’s a shocker: you can set prices for goods, but you can’t make people produce them. That sounds a lot like economic reality. This is an example of the fact that officials may believe they can control economic developments with a stroke of the pen, but they’ll be thwarted by second-order consequences that complicate the effort. There’s nothing wrong with trying to bring down the cost of necessities. However, the best way to do this is to encourage additions to supply. Another way is to not overstimulate demand by injecting excessive liquidity into the economy. Mandating lower prices is generally the least effective way to get them.

This is one of the biggest mistakes you can make. As Ben Graham pointed out, the day-to-day market isn’t a fundamental analyst; it’s a barometer of investor sentiment. You just can’t take it too seriously. Market participants have limited insight into what’s really happening in terms of fundamentals, and any intelligence that could be behind their buys and sells is obscured by their emotional swings. It would be wrong to interpret the recent worldwide drop as meaning the market “knows” tough times lay ahead. (It’s Not Easy, September 2015) My bottom line is that markets don’t assess intrinsic value from day to day, and certainly they don’t do a good job during crises. Thus, market price movements don’t say much about fundamentals. Even in the best of times, when investors are driven by fundamentals rather than psychology, markets show what the participants think value is, rather than what value really is. Value is something the market doesn’t know any more about than the average investor. And advice from the average investor obviously can’t help you be an above average investor. Fundamentals – the outlook for an economy, company or asset – don’t change much from day to day. As a result, daily price changes are mostly about (a) changes in market psychology and thus (b) changes in who wants to own something or un-own something. These two statements become increasingly valid the more daily prices fluctuate. Big fluctuations show that psychology is changing radically.

3%, per year. Improvements in regulated apartments are also regulated. Expenditures on improvements are limited to a very small amount in any 15-year period, and the investment can be recouped only through an increase in the monthly rent equal to a tiny percentage of the cost of the improvements. Thus, making improvements is generally uneconomic: Many landlords do not fill their vacant rent stabilized units, as the operational and renovation costs may exceed the legal maximum rent. As of 2022, there are roughly 20,000 vacant rent stabilized apartments in New York City. (Wikipedia) Might there be something wrong with a system where (a) there’s strong demand for apartments but (b) it’s more profitable to keep apartments vacant than rent them out? Apartments aren’t much different from bread or toilet paper. Officials can limit the price people have to pay, which is popular with consumers, but other than in the most dictatorial jurisdictions, they can’t force suppliers to produce goods for sale at the regulated prices. As I’ve tried this year to keep up with articles about New York’s apartment situation, I’ve noticed that the following factors are usually listed as discouraging apartment creation: (a) a lack of tax incentives and subsidies, (b) resistance to construction of affordable apartment buildings in the suburbs, and (c) high interest rates (albeit the last one can’t be used to explain the low level of apartment construction in the 2010s).

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Easy Money Observed The behavior brought on by low rates takes place in plain sight. Some people take note of it, and a subset of them talk about it rather than let it pass unremarked. Fewer still understand its real implications. And almost no one alters their investment approach to take them into account. The low-rate period that immediately preceded the Global Financial Crisis of 2008-09 was marked by the kind of spirited competition to make investments and provide financing described above. It was in this climate that Chuck Prince, then CEO of Citi, made the statement for which he is remembered: When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. (July 14, 2007) When money is easy, few people opt to sit out the dance, even though the adverse results described above can reasonably be anticipated. When faced with the choice between (a) maintaining high standards and missing deals and (b) making risky investments, most people will choose the latter. Professional investment managers especially may fear the consequences of idiosyncratic behavior that’s bound to look wrong for a while. Abstaining demands uncommon strength when doing so means departing from herd behavior.

And this gives me a great opportunity to reference one of my favorite quotations from John Kenneth Galbraith’s wonderful book on market excesses: Contributing to and supporting this 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. . . . There can be few fields of human endeavor in which history counts for so little as in the world of finance. (A Short History of Financial Euphoria) The lessons from past periods of easy money usually fall on deaf ears since they come up against (a) ignorance of history, (b) the dream of profit, (c) the fear of missing out, and (d) the ability of cognitive dissonance to make people dismiss information that is inconsistent with their beliefs or perceived self-interest. These things are invariably enough to discourage prudence in times of low interest rates, despite the likely consequences. As you no doubt know, Charlie Munger passed away on November 28 at the age of 99. I want to pay a small tribute to Charlie’s life and wisdom by sharing something he wrote me in 2001: “Maybe we have a new version of Lord Acton’s law: easy money corrupts, and really easy money corrupts absolutely.” Will We Go Back to Easy Money? Before I turn to the above question, I want to answer the one I’m asked most often these days: “Are you saying interest rates are going to be higher for longer?

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Finally, what will we see moving forward? It now appears that sometime in 2024, the Fed will declare victory against inflation and begin to reduce the fed funds rate from today’s somewhat restrictive 5.25- 5.50%. The current “dot plot,” which summarizes the views of Fed officials, shows three 25-bps rate cuts in 2024, bringing the rate to 4.60%, and then more cuts in 2025, taking it to the mid-3s. However, today’s consensus thinking among investors seems to be considerably more optimistic than that, anticipating more/earlier/bigger rate cuts. While on the subject of consensus thinking, I’ll point out the following: • Eighteen months ago, it was near-universally accepted that the Fed’s aggressive program of rate increases would result in a recession in 2023. That was wrong. • Twelve months ago, the optimists who launched the current stock market rally were motivated by their belief that the Fed would pivot to dovishness and start cutting rates in 2023. That was wrong. • Six months ago, there was a consensus that there would be one more rate increase in late 2023. That was wrong. I find it interesting that the current stock market rally began as a result of optimism powered by consensus thinking that was generally off target. (See the second bullet point just above.)

At present, I believe the consensus is as follows: • Inflation is moving in the right direction and will soon reach the Fed’s target of roughly 2%. • As a consequence, additional rate increases won’t be necessary. • As a further consequence, we’ll have a soft landing marked by a minor recession or none at all. • Thus, the Fed will be able to take rates back down. • This will be good for the economy and the stock market. Before going further, I want to note that, to me, these five bullet points smack of “Goldilocks thinking”: the economy won’t be hot enough to raise inflation or cold enough to bring on an economic slowdown. I’ve seen Goldilocks thinking in play a few times over the course of my career, and it rarely holds for long. Something usually fails to operate as hoped, and the economy moves away from perfection. One important effect of Goldilocks thinking is that it creates high expectations among investors and thus room for potential disappointment (and losses). FT Unhedged recently expressed a similar view: Yesterday’s letter suggested that we think the market’s current expectation of solid growth and six rate cuts seemed likely to be wrong in one direction or the other: either strong growth will limit the Fed to close to the three rate cuts it currently forecasts, or growth will be weak and there will be as many cuts as the market expects. In this sense, the market does look to be pricing in too much good news.

(December 20, 2023) I don’t have an opinion as to whether the consensus described above is correct. However, even granting that it is, I’ll still stick with my guess that rates will be around 2-4%, not 0-2%, over the next few years. Do you want more specificity? My guess – and that’s all it is – is that the fed funds rate will average between 3.0% and 3.5% over the next 5-10 years. If you think I’m wrong, ask yourself whether you’d put your money on a different half-point range. (Before readers protest my uncharacteristic descent into forecasting, I’ll point out that, at Oaktree, we say it’s okay to have opinions on the macro; it’s just not okay to bet clients’ money on them. We invest with an awareness of current macro conditions, but our investment decisions are always based on bottom-up analysis of companies and securities, not macro forecasts.) © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: Lessons from Silicon Valley Bank This isn’t going to be another history of the meltdown of Silicon Valley Bank. Dozens of those have appeared in my inbox over the past month, as I’m sure they have in yours. Thus, rather than merely recount the developments, I’m going to discuss their significance. My sense is that the significance of the failure of SVB (and Signature Bank) is less that it portends additional bank failures and more that it may amplify preexisting wariness among investors and lenders, leading to further credit tightening and additional pain across a range of industries and sectors. One-off or a Harbinger of Things to Come? A number of things about SVB made it somewhat of a special case – which means it probably won’t turn out to be the first of many: • The bank’s business was heavily concentrated in a single sector – venture capital-backed startups in tech and healthcare – and a single region – Northern California. Many regional banks’ businesses are similarly concentrated, but not usually in sectors and regions that are both highly volatile. • The boom in its sector and region caused SVB’s business to grow very rapidly. • In recent years, startups were a major destination for investors’ cash, a good deal of which they deposited at SVB. This caused SVB’s deposits to triple, from $62 billion at the end of 2019 to $189 billion at the end of 2021.

Rather, it was the fact that my Oaktree co-founder Bruce Karsh and I were spending much of each day trudging to each other’s offices to complain about the crazy deals – characterized by low returns, high risk for investors, and a lot of optionality for issuers – that were easily being brought to market. “If deals like this can get done,” we agreed, “there’s something wrong with the market.” Few people, we thought, were demonstrating prudence, discipline, value consciousness, or the ability to resist the fear of missing out. Investors are supposed to act as disciplinarians, preventing undeserving securities from being issued, but in those days, they weren’t performing that function. This signaled a worrisome state of affairs. These observations – along with an awareness of the generally high prices and low prospective returns that prevailed at the time – convinced us to dramatically increase our usual emphasis on defensiveness. In © 2023 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

• Thus, interest rates can’t be counted on to stay “lower for longer” and produce perpetual prosperity, as many thought was the case in late 2020. • Also in late 2020, Modern Monetary Theory was accepted by some as meaning deficits and national debt could be disregarded in countries “with control of their currencies.” (We no longer hear anything about this notion.) In Sea Change, I listed several reasons why I don’t think interest rates are going back to that period’s lows on a permanent basis, and I still find these arguments compelling. In particular, I find it hard to believe the Fed doesn’t think it erred by sticking with ultra-low interest rates for so long. As noted above, to fight the GFC, the Fed took the fed funds rate to roughly zero for the first time in late 2008. Macro conditions were frightening, as a vicious cycle capable of undermining the entire financial system appeared to be underway. For this reason, aggressive action was certainly called for. But I was shocked when I looked at the data and saw that the Fed kept the rate near zero for nearly seven years. Setting interest rates at zero is an emergency measure, and we certainly didn’t have a continuous emergency through late 2015. To me, those sustained low rates stand out as a mistake not to be repeated. Further, by 2017-18, with the fed funds rate around 1%, it had become clear to many that there wasn’t room for the Fed to reduce rates if necessary to stimulate the economy during a recession.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: achieved 74 winners to Medvedev’s 52, and he aggressively rushed the net 67 times (for 44 winners) compared to Medvedev’s 8 (for 4 winners). These are great offensive stats. The problem is that – as I’ve experienced firsthand many times – if you’re up against a player who’s better than you are, you have to attempt shots that aren’t firmly within your competence in order to have a hope of winning. Thus, along with his 74 winners, Eubanks was guilty of 55 unforced errors (mistakes that aren’t forced by good shots from one’s opponent; the easy way to make an unforced error is to go for a winner and miss). In comparison, Medvedev committed only 13 unforced errors. Bottom line: Eubanks had considerably more winners than Medvedev, but he had three unforced errors for every four winners, whereas Medvedev had only one per four. Medvedev won 53% of the points played versus Eubanks’s 47%, and thus he won the match. The lesson is that it’s not enough to have more winners. To win – in tennis as in investing – you have to have a favorable relationship between winners and losers. You can win by having a few winners but fewer losers or by having a lot of losers but more winners. Neither maximizing winners nor minimizing losers is necessarily enough. It’s all in the balance. And that leads me to the Wimbledon men’s final.

Active investing’s shortfall has been attributed primarily to the combination of market efficiency, management fees, and investor error. I think there’s another reason: active investors’ need for winners. What if you didn’t own the magnificent seven earlier this year? Clearly, you’d be far behind the indices. What if you owned them, but in smaller proportions than their weightings in the indices? You’d still lag, but by a smaller amount. So, by definition, keeping up with the indices requires having exposure to the big winners that is at least equal to their representation in the indices. That much seems clear. Now, think about that representation. Let’s say you started off 20 years ago – in the summer of 2003 – with an index-sized helping of Apple at a split-adjusted price of $0.37. The key question is simple: Would you have held on as it rose? As I described in my memo Selling Out (January 2022), most investors subscribe to the conventional wisdom of “taking profits,” “taking some money off the table,” or “topping the trees.” After all, as the old saying goes, “No one ever went broke taking profits.” Investors often sell off some of their winners for the simple reason that they’re afraid to watch as they give up their gains, which can lead to regret, criticism from clients, and/or lost accounts. Most people would have sold part or all of their Apple holding by the time the price reached $15 in the summer of 2013.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: What’s the downside? How could this be a mistake? • First, individual borrowers can default and fail to pay. It’s the main job of the credit manager to weed out the non-payers, and history shows it can be done. Isolated defaults are unlikely to derail a well-selected and well-diversified portfolio. And if you’re worried about a wave of defaults hitting your credit portfolio, think about what the implications of that environment would be for equities or other ownership assets. • Second, by their nature, credit instruments don’t have much potential for appreciation. Thus, it’s entirely possible that equities and levered investment strategies will surprise on the upside and outperform in the years ahead. There’s no denying this, but it should be borne in mind that the “downside risk” here consists of the opportunity cost of returns forgone, not failing to achieve the return one sought. • Third, bonds and loans are subject to price fluctuations, meaning having to sell in a weak period could cause losses to be realized. But credit instruments are far from alone in this regard, and the magnitude of the fluctuations on “money-good” bonds and loans is constrained significantly by the magnetic “pull to par” exerted by the promise of repayment upon maturity. • Fourth, the returns I’ve been talking about are nominal returns.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Moral Hazard One problem with government solutions of any kind – like the so-called “Greenspan put” – is the possibility that they’ll generate moral hazard. That is, players will conclude that they’ll be rescued if they make a mistake. This suggests they can freely engage in high-risk, high-return behavior; if it works, they’ll get rich, but if it fails, they’ll be bailed out. People sometimes refer to this as “privatizing profits and socializing losses.” On March 9, when SVB was hanging by a thread while experiencing massive withdrawals, people started talking about a possible government guarantee of all deposits. One of the arguments against such a bailout was that it would create moral hazard. If people know they’ll be protected from losses, they’ll have no reason to examine the solidity of a bank before depositing money, meaning the diligence function won’t be performed. Consequently, poorly run, poorly capitalized banks will be permitted to stay in business and grow. But we simply cannot expect depositors to perform that function. Since banks’ operations are characterized by mismatched assets/liabilities and a dependence on depositors’ trust, it’s terribly hard to assess their financial health from the outside (maybe sometimes from the inside, too, since SVB succumbed to what in retrospect seem to have been obvious managerial mistakes).

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: A prospectus for the Credit Suisse AT1s highlights from the very first page the possibility of a wipeout when there is what’s known as a writedown event. In this scenario, interest on the notes would stop accruing and the full outstanding amount of the bonds would be automatically and permanently written down to zero. Finma has the power to decide that a type of writedown event known as a “viability event” has occurred if a bank’s efforts to improve capital adequacy are “inadequate or unfeasible,” or if there is “extraordinary public support” to avoid a bankruptcy, insolvency or halt to regular business. Bloomberg’s Matt Levine explained how this worked in Credit Suisse’s case: If the bank’s common equity tier 1 capital ratio – a measure of its regulatory capital – falls below 7%, then the AT1 is written down to zero: It never needs to be paid back; it just goes away completely. . . . These securities are, basically, a trick. To investors, they seem like bonds: They pay interest, get paid back in five years, feel pretty safe. To regulators, they seem like equity: If the bank runs into trouble, it can raise capital by zeroing the AT1s. If investors think they are bonds and regulators think they are equity, somebody is wrong. The investors are wrong. In particular, investors seem to think that AT1s are senior to equity, and that the common stock needs to go to zero before the AT1s suffer any losses.

• Remember that in extreme times, because of the above, the secret to making money lies in contrarianism, not conformity. When emotional investors take an extreme view of an asset’s future and, as a result, take the price to unjustified levels, the “easy money” is usually made by doing the opposite. This is, however, very different from simply diverging from the consensus all the time. Indeed, most of the time, the consensus is as close to right as most individuals can get. So to be successful at contrarianism, you have to understand (a) what the herd is doing, (b) why it’s doing it, (c) what’s wrong with it, and (d) what should be done instead and why. • Bear in mind that much of what happens in economies and markets doesn’t result from a mechanical process, but from the to and fro of investors’ emotions. Take note of the swings and capitalize whenever possible. • Resist your own emotionality. Stand apart from the crowd and its psychology; don’t join in! © 2023 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • Be on the lookout for illogical propositions (such as “stocks have fallen so far that no one will be interested in them”). When you come across a widely accepted proposition that doesn’t make sense or one you find too good to be true (or too bad to be true), take appropriate action. See something; do something. Obviously, there’s a lot to grapple with when taking the temperature of the market. In my opinion, it has more to do with clear-eyed observations and assessments of the implications of what you see than with computers, financial data, or calculations. I’ll go into additional depth on a couple of points: On pattern recognition: You may have noticed that the first of the five calls described above was made in 2000, when I had already been working in the investment industry for more than 30 years. Does this mean there were no highs and lows to remark on in those earlier years? No, I think it means it took me that long to gain the insight and experience needed to detect the market’s excesses. Most notably, whereas I spent two pages above describing the profound error in “The Death of Equities,” you may have noticed that I didn’t say anything about my having called out the article when it appeared in Businessweek in 1979. The reason is simple: I didn’t.

I had only been in this business for about a decade at that point, so (a) I didn’t have the experience needed to recognize the article’s error and (b) I had yet to develop the unemotional stance and contrarian approach needed to depart from the herd and rebel against its thesis. The best I can say is that my eventual development of those attributes enabled me to catch the same error when it arose again 33 years later. Pattern recognition is an important part of what we do, but it seems to require time in the field – and some scars – rather than just book learning. On cycles: In my book Mastering the Market Cycle, I defined cycles not as a series of up and down movements, each of which regularly precedes the next – which I believe is the usual definition – but as a series of events, each of which causes the next. This causality holds the key to understanding cycles. In particular, I think economies, investor psychology, and thus markets eventually go too far in one direction or another – they become too positive or too negative – and afterward they eventually swing back toward moderation (and then usually toward excess in the opposite direction). Thus, in my opinion, these cycles are best understood as stemming from “excesses and corrections.

That amount will be a function of (a) how companies or assets fare in fundamental terms (e.g., how their profits grow or decline) and (b) how people feel about those fundamentals and treat asset prices. • On average, all investors will do average. • If you’re happy doing average, you can simply invest in a broad swath of the assets in question, buying some of each in proportion to its representation in the relevant universe or index. By engaging in average behavior in this way, you’re guaranteed average performance. (Obviously, this is the idea behind index funds.) • If you want to be above average, you have to depart from consensus behavior. You have to overweight some securities, asset classes, or markets and underweight others. In other words, you have to do something different. • The challenge lies in the fact that (a) market prices are the result of everyone’s collective thinking and (b) it’s hard for any individual to consistently figure out when the consensus is wrong and an asset is priced too high or too low. • Nevertheless, “active investors” place active bets in an effort to be above average. o Investor A decides stocks as a whole are too cheap, and he sells bonds in order to overweight stocks. Investor B thinks stocks are too expensive, so she moves to an underweighting by selling some of her stocks to Investor A and putting the proceeds into bonds.

Mainstream economics, also known as mechanical economics, which partners the unlikely bedfellows of Neoclassical and Neo-Keynesian economics, views and treats the market as some automaton, in a way, that can be centrally engineered, planned, and steered. If instead we view the market as embodying our collective extended mind, acknowledging its warts and all, which obviously is our thesis, which two episodes in your career would be best suited to study the market mind? HM: Russell’s question about the two episodes, contained in your last sentence, would limit me too much. So, if you don’t mind, I’m going to go way beyond that, because I think my answer to this question is central to our whole discussion today. Your first few words, when you discussed what Russell said, refer to the economy as mechanical, and I think that isn’t helpful. Applying the word “mechanical” (again, as with the first question) suggests that it’s governed by the rules of physics, the laws of nature, that it’s a science, that it performs the same each time, that it’s repeatable, studiable and extrapolable. And I think these are all wrong. And in fact, I aggressively remind people that I’m not an economist, but also that economics is called the “dismal science.” And I’m not sure it’s a science at all, but if it is, it’s certainly dismal, in the sense that it’s not like physics, where if you do A, you always get B. Sometimes you get C or sometimes nothing at all.

o Investor X decides a certain stock is too cheap and overweights it, buying from investor Y, who thinks it’s too expensive and therefore wants to underweight it. • It’s essential to note that in each of the above cases, one investor is right and the other is wrong. Now go back to the first bullet point above: Since the total dollars earned by all investors collectively are fixed in amount, all active bets, taken together, constitute a zero-sum game (or negative-sum after commissions and other costs). The investor who’s right earns an above average return, and by definition the one who’s wrong earns a below average return. • Thus, every active bet placed in the pursuit of above average returns carries with it the risk of below average returns. There’s no way to make an active bet such that you’ll win if it works © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: but not lose if it doesn’t. Financial innovations are often described as offering some version of this impossible bargain, but they invariably fail to live up to the hype. • The bottom line of the above is simple: You can’t hope to earn above average returns if you don’t place active bets, but if your active bets are wrong, your return will be below average. Investing strikes me as being very much like golf, where playing conditions and the performance of competitors can change from day to day, as can the placement of the holes. On some days, one approach to the course is appropriate, but on other days, different tactics are called for. To win, you have to either do a better job than others of selecting your approach or executing on it, or both. The same is true for investors. It’s simple: If you hope to distinguish yourself in terms of performance, you have to depart from the pack. But, having departed, the difference will only be positive if your choice of strategies and tactics is correct and/or you’re able to execute better. Second-Level Thinking In 2009, when Columbia Business School Publishing was considering whether to publish my book The Most Important Thing, they asked to see a sample chapter. As has often been my experience, I sat down and described a concept I hadn’t previously written about or named.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: If you sell an appreciated asset, that puts the gain “in the books,” and it can never be reversed. Thus, some people consider selling winners extremely desirable – they love realized gains. In fact, at a meeting of a non-profit’s investment committee, a member suggested that they should be leery of increasing endowment spending in response to gains because those gains were unrealized. I was quick to point out that it’s usually a mistake to view realized gains as less transient than unrealized ones (assuming there’s no reason to doubt the veracity of the unrealized carrying values). Yes, the former have been made concrete. However, sales proceeds are generally reinvested, meaning the profits – and the principal – are put back at risk. One might argue that appreciated securities are more vulnerable to declines than new investments in assets currently deemed to be attractively priced, but that’s far from a certainty. I’m not saying investors shouldn’t sell appreciated assets and realize profits. But it certainly doesn’t make sense to sell things just because they’re up. Selling Because It’s Down As wrong as it is to sell appreciated assets solely to crystalize gains, it’s even worse to sell them just because they’re down. Nevertheless, I’m sure many people do it. While the rule is “buy low, sell high,” clearly many people become more motivated to sell assets the more they decline.

• 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: your opinion, meaning you’ll sell it. The person you sell it to, however, will buy it because he thinks it’s worth still more. We used to talk about this process as being reliant on the Greater Fool Theory: No matter what price I pay for a stock, there will always be someone who will buy it from me for more, despite the fact that I’m selling because I’ve concluded that it has reached full value. Every buyer is motivated by the belief that the stock will eventually be worth more than today’s price (a view the seller presumably doesn’t share). The key question is what type of thinking underlies these purchases. Are the buyers buying because this is a company they’d like to own a piece of for years? Or are they merely betting that the price will go up? The transactions may look the same from the outside, but I wonder about the thought process and thus the soundness of the logic. Each time a stock is traded, one side is wrong and one is right. But if what you’re doing is betting on trends in popularity, and thus the direction of price moves over the next month, quarter, or year, is it realistic to believe you’ll be right more often than the person on the other side of the trade? Maybe the decline of active management can be attributed to the many active managers who placed bets on the direction of stock prices in the short term, instead of picking companies they wanted to own part of for years.

© 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?

The essential ingredient in Oaktree’s investments in distressed debt – bargain purchases – has emanated from the great opportunities sellers gave us. Negativity reaches a crescendo during economic and market crises, causing many investors to become depressed or fearful and sell in panic. Results like those we target in distressed debt can only be achieved when holders sell to us at irrationally low prices. Superior investing consists largely of taking advantage of mistakes made by others. Clearly, selling things because they’re down is a mistake that can give the buyers great opportunities. When Should Investors Sell? If you shouldn’t sell things because they’re up, and you shouldn’t sell because they’re down, is it ever right to sell? As I previously mentioned, I described the discussions that took place while Andrew and his family lived with Nancy and me in 2020 in Something of Value. That experience truly was of great value – an unexpected silver lining to the pandemic. That memo evoked the strongest reaction from readers of any of my memos to date. This response was probably attributable to (a) the content, which mostly related to value investing; (b) the personal insights provided, and especially my confession regarding my need to grow with the times; or (c) the recreated conversation that I included as an appendix. The last of these went like this, in part: Howard: Hey, I see XYZ is up xx% this year and selling at a p/e ratio of xx.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The bull market of 2020 was unprecedented in my experience, in that there was essentially no first stage and very little of the second. Many investors went straight from hopeless in late March to highly optimistic later in the year. This is a great reminder that, while some themes do recur, it’s a big mistake to expect history to repeat exactly. Optimistic Rationales, Super Stocks, and the New, New Thing Raging bull markets are examples of mass hysteria. At the extreme, thinking and thus behavior become unmoored from reality. In order for this to occur, however, there has to be some factor that activates investors’ imagination and discourages prudence. Thus, special attention should be paid to an element that almost always characterizes bull markets: a new development, invention or justification for the rising stock prices. Bull markets are, by definition, characterized by exuberance, confidence, credulousness, and a willingness to pay high prices for assets – all at levels that are shown in retrospect to have been excessive. History has generally shown the importance of keeping these things in moderation. For that reason, the intellectual or emotional rationale for a bull market is often based on something new that history can’t be used to discount. Those last six words are very important.

What Doesn’t Matter: Short-Term Performance Given the possible contributors to short-term investment performance, reported results can present a highly misleading picture, and here I’m talking mostly about superior gains in good times. I feel there are three ingredients for success during good times – aggressiveness, timing, and skill – and if you have enough aggressiveness at the right time, you don’t need that much skill. We all know that in good times, the highest returns often go to the person whose portfolio incorporates the most risk, beta, and correlation. Having such a portfolio isn’t a mark of distinction or insight if the investor is a perma-bull who’s always positioned aggressively. Finally, random events can have an overwhelming impact on returns – in either direction – in a given quarter or year. One of the recurring themes in my memos is the idea that the quality of a decision cannot be determined from the outcome alone. Decisions often lead to negative outcomes even when they’re well-reasoned and based on all the available information. On the other hand, we all know people – even occasionally ourselves – who’ve been right for the wrong reason. Hidden information and random developments can © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

For this reason, it can be important to part company with the herd and behave in a way that’s contrary to the actions of most others. Contrarianism received its own chapter in The Most Important Thing. Here’s how I set forth the logic: • Markets swing dramatically, from bullish to bearish, and from overpriced to underpriced. • Their movements are driven by the actions of “the crowd,” “the herd,” and “most people.” Bull markets occur because more people want to buy than sell, or the buyers are more highly motivated than the sellers. The market rises as people switch from being sellers to being buyers, and as buyers become even more motivated and the sellers less so. (If buyers didn’t predominate, the market wouldn’t be rising.) • Market extremes represent inflection points. These occur when bullishness or bearishness reaches a maximum. Figuratively speaking, a top occurs when the last person who will become a buyer does so. Since every buyer has joined the bullish herd by the time the top is reached, bullishness can go no further, and the market is as high as it can go. Buying or holding is dangerous. • Since there’s no one left to turn bullish, the market stops going up. And if the next day one person switches from buyer to seller, it will start to go down. • So at the extremes, which are created by what “most people” believe, most people are wrong. • Therefore, the key to investment success has to lie in doing the opposite: in diverging from the crowd.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: This business – I shouldn’t say “this business”; that sounds derogatory – the idea that inefficiencies will be arbitraged away by the operations of the market ignores one of the key elements that I think describes reality, and that is mass hysteria. And I think the markets – economies too, but more importantly the markets – are subject to mass hysteria. I think it was in On the Couch that I said, “in the real world, things fluctuate between pretty good and not so hot. But in the markets, they go from flawless to hopeless.” Just think about that one sentence. If it’s true – and I believe it’s true – that shows you the error, because nothing is flawless and nothing is hopeless. But markets, I believe, treat things as flawless and hopeless, and there’s the error. The book I mentioned, Mastering the Market Cycle (I’m going to keep repeating the title in the hope that everybody will buy a copy) . . . You know, I’m a devotee of cycles. I’m a student of cycles. I’ve lived through a half a dozen important cycles in my career. I’ve thought about them. I think they dominate what I do. And I got about two-thirds of the way through writing that book and something dawned on me, a question: Why do we have cycles? The S&P 500 – I mentioned Jim Lorie – the Center for Research in Security Prices told us almost 60 years ago, that from 1928 to ’62, the S&P 500 had returned an average of 9.2% a year.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: of which is part of what creates opportunities in stocks to begin with. Ultimately, it’s only the long term that matters. (There’s a lot of “a-b-c” in our house. I wonder where Andrew got that.) H: But if it’s potentially overvalued in the short term, shouldn’t you trim your holding and pocket some of the gain? Then if it goes down, (a) you’ve limited your regret and (b) you can buy in lower. A: If I owned a stake in a private company with enormous potential, strong momentum and great management, I would never sell part of it just because someone offered me a full price. Great compounders are extremely hard to find, so it’s usually a mistake to let them go. Also, I think it’s much more straightforward to predict the long-term outcome for a company than short-term price movements, and it doesn’t make sense to trade off a decision in an area of high conviction for one about which you’re limited to low conviction. . . . H: Isn’t there any point where you’d begin to sell? A: In theory there is, but it largely depends on (a) whether the fundamentals are playing out as I hope and (b) how this opportunity compares to the others that are available, taking into account my high level of comfort with this one. Aphorisms like “no one ever went broke taking a profit” may be relevant to people who invest part-time for themselves, but they should have no place in professional investing.

In The Most Important Thing Illuminated, an annotated edition of my book, four professional investors and academics provided commentary on what I had written. My good friend Joel Greenblatt, an exceptional equity investor, provided a very apt observation regarding knee-jerk contrarianism: “. . . just because no one else will jump in front of a Mack truck barreling down the highway doesn’t mean that you should.” In other words, the mass of investors aren’t wrong all the time, or wrong so dependably that it’s always right to do the opposite of what they do. Rather, to be an effective contrarian, you have to figure out: • what the herd is doing; • why it’s doing it; • what’s wrong, if anything, with what it’s doing; and • what you should do about it. Like the second-level thought process laid out in bullet points on page four, intelligent contrarianism is deep and complex. It amounts to much more than simply doing the opposite of the crowd. Nevertheless, good investment decisions made at the best opportunities – at the most overdone market extremes – invariably include an element of contrarian thinking. The Decision to Risk Being Wrong There are only so many topics I find worth writing about, and since I know I’ll never know all there is to know about them, I return to some from time to time and add to what I’ve written previously. Thus, in 2014, I followed up on 2006’s Dare to Be Great with a memo creatively titled Dare to Be Great II.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: portfolio rather than making the change? Or perhaps you don’t plan to reinvest the proceeds. In that case, what’s the likelihood that holding the proceeds in cash will make you better off than you would have been if you had held onto the thing you sold? Questions like these relate to the concept of “opportunity cost,” one of the most important ideas in financial decision-making. Switching gears, what about the idea of selling because you think a temporary dip lies ahead that will affect one of your holdings or the whole market? There are real problems with this approach: • Why sell something you think has a positive long-term future to prepare for a dip you expect to be temporary? • Doing so introduces one more way to be wrong (of which there are so many), since the decline might not occur. • Charlie Munger, vice chairman of Berkshire Hathaway, points out that selling for market-timing purposes actually gives an investor two ways to be wrong: the decline may or may not occur, and if it does, you’ll have to figure out when the time is right to go back in. • Or maybe it’s three ways, because once you sell, you also have to decide what to do with the proceeds while you wait until the dip occurs and the time comes to get back in. • People who avoid declines by selling too often may revel in their brilliance and fail to reinstate their positions at the resulting lows.

Thus, even sellers who were right can fail to accomplish anything of lasting value. • Lastly, what if you’re wrong and there is no dip? In that case, you’ll miss out on the ensuing gains and either never get back in or do so at higher prices. So it’s generally not a good idea to sell for purposes of market timing. There are very few occasions to do so profitably and very few people who possess the skill needed to take advantage of these opportunities. Before I close on this subject, it’s important to note that decisions to sell aren’t always within an investment manager’s control. Clients can withdraw capital from accounts and funds, necessitating sales, and the limited lifespan of closed-end funds can require managers to liquidate holdings even though they’re not ripe for selling. The choice of what to sell under these conditions can still be based on a manager’s expectations regarding future returns, but deciding not to sell isn’t among the manager’s choices. How Much Is Too Much to Hold? Certainly there are times when it’s right to sell one asset in favor of another based on the idea of relative selection. But we mustn’t do this in a mechanical manner. If we did, at the logical extreme, we would put all of our capital into the one investment we consider the best. Virtually all investors – even the best – diversify their portfolios. We may have a sense for which holding is the absolute best, but I’ve never heard of an investor with a one-asset portfolio.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: I followed that with a discussion of the challenges associated with being different: Most great investments begin in discomfort. The things most people feel good about – investments where the underlying premise is widely accepted, the recent performance has been positive, and the outlook is rosy – are unlikely to be available at bargain prices. Rather, bargains are usually found among things that are controversial, that people are pessimistic about, and that have been performing badly of late. But then, perhaps most importantly, I took the idea a step further, moving from daring to be different to its natural corollary: daring to be wrong. Most investment books are about how to be right, not the possibility of being wrong. And yet, the would-be active investor must understand that every attempt at success by necessity carries with it the chance for failure. The two are absolutely inseparable, as I described at the top of page three. In a market that is even moderately efficient, everything you do to depart from the consensus in pursuit of above average returns has the potential to result in below average returns if your departure turns out to be a mistake. Overweighting something versus underweighting it; concentrating versus diversifying; holding versus selling; hedging versus not hedging – these are all double-edged swords. You gain when you make the right choice and lose when you’re wrong.

One of my favorite sayings came from a pit boss at a Las Vegas casino: “The more you bet, the more you win when you win.” Absolutely inarguable. But the pit boss conveniently omitted the converse: “The more you bet, the more you lose when you lose.” Clearly, those two ideas go together. In a presentation I occasionally make to institutional clients, I employ PowerPoint animation to graphically portray the essence of this situation: • A bubble drops down, containing the words “Try to be right.” That’s what active investing is all about. But then a few more words show up in the bubble: “Run the risk of being wrong.” The bottom line is that you simply can’t do the former without also doing the latter. They’re inextricably intertwined. • Then another bubble drops down, with the label “Can’t lose.” There are can’t-lose strategies in investing. If you buy T-bills, you can’t have a negative return. If you invest in an index fund, you can’t underperform the index. But then two more words appear in the second bubble: “Can’t win.” People who use can’t-lose strategies by necessity surrender the possibility of winning. T- bill investors can’t earn more than the lowest of yields. Index fund investors can’t outperform. • And that brings me to the assignment I imagine receiving from unenlightened clients: “Just apply the first set of words from each bubble: Try to outperform while employing can’t-lose strategies.” But that combination happens to be unavailable.

– Mark Twain As I mentioned in my recent memo Thinking About Macro, in the 1970s we used to describe an economist as “a portfolio manager who never marks to market.” In other words, economists make forecasts; events prove them either wrong or right; they go on to make new forecasts; but they don’t keep track of how often they get it right (or they don’t publish the stats). Can you imagine hiring a money manager (or being hired, if you are a money manager) without reference to a track record? And yet, economists and strategists stay in business, presumably because there are customers for their forecasts, despite there being no published records. Are you a consumer of forecasts? Are there forecasters and economists on staff where you work? Or do you subscribe to their publications and invite them in for briefings, as was the case with my previous employers? If so, do you know how often each has been right? Have you found a way to rigorously determine which ones to rely on and which to ignore? Is there a way to quantify their contributions to your investment returns? I ask because I’ve never seen or heard of any research along these lines. The world seems incredibly short on information regarding the value added by macro forecasts, especially given the large number of people involved in this pursuit. Despite the lack of evidence regarding its value, macro forecasting goes on.

In short, when burning optimism takes over from levelheadedness: • asset prices rise, • greed grows relative to fear, • fear of missing out replaces fear of losing money, and • risk aversion and caution evaporate. It’s essential to bear in mind that it’s risk aversion and the fear of loss that keep markets safe and sane. The developments listed above typically combine to lift markets, drive out cautious investigation and deliberation, and make the markets a dangerous place. In my 2007 memo The Race to the Bottom, I explained that when there’s too much money in the hands of investors and providers of capital and they’re too eager to put it to work, they bid too aggressively for securities and the chance to lend. Their spirited bidding drives down prospective returns, drives up risk, weakens security structures, and reduces the margin for error. • The cautious investor, sticking to her guns, says, “I insist on 8% interest and strong covenants.” • Her competitor responds, “I’ll accept 7% interest and demand fewer covenants.” • The least disciplined, not wanting to miss the opportunity, says, “I’ll settle for 6% interest and no covenants.” This is the race to the bottom. This is why it’s often said that “the worst of loans are made in the best of times.” This is something that can’t happen when people are smarting from recent losses and afraid of experiencing more.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: enlightenment.” I think of my fortune that way because it raises a question I find paradoxical and capable of leading to enlightenment. But what does the fortune mean? That you should be cautious, because cautious people seldom make mistakes? Or that you shouldn’t be cautious, because cautious people rarely accomplish great things? The fortune can be read both ways, and both conclusions seem reasonable. Thus the key question is, “Which meaning is right for you?” As an investor, do you like the idea of avoiding error, or would you rather try for superiority? Which path is more likely to lead to success as you define it, and which is more feasible for you? You can follow either path, but clearly not both simultaneously. Thus, investors have to answer what should be a very basic question: Will you (a) strive to be above average, which costs money, is far from sure to work, and can result in your being below average, or (b) accept average performance – which helps you reduce those costs but also means you’ll have to look on with envy as winners report mouth-watering successes. Here’s how I put it in Dare to Be Great II: How much emphasis should be put on diversifying, avoiding risk, and ensuring against below-pack performance, and how much on sacrificing these things in the hope of doing better?

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: HFRI Hedge Fund Index* HFRI Macro (Total) Index S&P 500 Index 5-year annualized return* 5.2% 5.0% 12.8% 10-year annualized return* 5.1 2.8 13.8 * Performance through July 31, 2022. The broad hedge fund index shown is the Fund Weighted Composite Index. What the table above shows is that, according to HFR, the average hedge fund woefully underperformed the S&P 500 in the period under study, and the average macro fund did considerably worse (especially in the period from 2012 to 2017). Given that investors continue to entrust roughly $4.5 trillion of capital to hedge funds, they must deliver some benefit other than returns, but it’s not obvious what that could be. This seems to be especially true for the macro funds. To support my opinion regarding forecasts, I’ll cite a rare example of self-assessment: a seven-page feature that appeared in the Sunday Opinion section of The New York Times on July 24 titled “I Was Wrong.” In it, eight Times opinion writers opened up about incorrect predictions they made and flawed advice they had given. The most relevant here is Paul Krugman, who wrote a confession titled “I Was Wrong About Inflation.” I’ll string together some excerpts: In early 2021, there was an intense debate among economists about the likely consequences of the American Rescue Plan . . . . I was on [the side that was less concerned about the impact on inflation].

And here’s how I described some of the considerations: Unconventional behavior is the only road to superior investment results, but it isn’t for everyone. In addition to superior skill, successful investing requires the ability to look wrong for a while and survive some mistakes. Thus each person has to assess whether he’s temperamentally equipped to do these things and whether his circumstances – in terms of employers, clients and the impact of other people’s opinions – will allow it . . . when the chips are down and the early going makes him look wrong, as it invariably will. You can’t have it both ways. And as in so many aspects of investing, there’s no right or wrong, only right or wrong for you. A Case in Point The aforementioned David Swensen ran Yale University’s endowment from 1985 until his passing in 2021, an unusual 36-year tenure. He was a true pioneer, developing what has come to be called “the Yale Model” or “the Endowment Model.” He radically reduced Yale’s holdings of public stocks and bonds, and invested heavily in innovative, illiquid strategies such as hedge funds, venture capital, and private equity at a time when almost no other institutions were doing so. He identified managers in those fields who went on to generate superior results, several of whom earned investment fame. Yale’s resulting performance beat almost all other endowments by miles.

As it turned out, of course, that was a very bad call. . . . . . . history wouldn’t have led us to expect this much inflation from overheating. So something was wrong with my model . . . . One possibility is that history was misleading . . . . Also, disruptions associated with adjusting to the pandemic and its aftermath may still be playing a large role. And of course both Russia’s invasion of Ukraine and China’s lockdown of major cities have added a whole new level of disruption. . . . In any case, the whole experience has been a lesson in humility. Nobody will believe this, but in the aftermath of the 2008 crisis, standard economic models performed pretty well, and I felt comfortable applying these models in 2021. But in retrospect I should have realized that in the face of the new world created by Covid-19, that kind of extrapolation wasn’t a safe bet. (Emphasis added) I salute Krugman for this incredible bout of candor (although I have to say I don’t remember a lot of 2009-10 market forecasts that were optimistic enough to capture the reality of the subsequent decade). Krugman’s explanation for his error is fine as far as it goes, but I don’t see any mention of abstaining from modeling, extrapolating, or forecasting in the future. Humility may even be seeping into one of the world’s biggest producers of economic forecasts, the U.S. Federal Reserve, home of more than 400 Ph.D. economists.

© 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.

Yet, we realize that if we want to be above average, our reaction to those inputs – and thus our behavior – should in many instances be different from that of others. Regardless of the reasons, if millions of investors are doing A, it may be quite uncomfortable to do B. And if we do bring ourselves to do B, our action is unlikely to prove correct right away. After we’ve sold a market darling because we think it’s overvalued, its price probably won’t start to drop the next day. Most of the time, the hot asset you’ve sold will keep rising for a while, and sometimes a good while. As John Maynard Keynes said, “Markets can remain irrational longer than you can remain solvent.” And as the old adage goes, “Being too far ahead of your time is indistinguishable from being wrong.” These two ideas are closely related to another great Keynes quote: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” Departing from the mainstream can be embarrassing and painful. Uninstitutional behavior from institutions – We all know what Swensen meant by the word “institutions”: bureaucratic, hidebound, conservative, conventional, risk-averse, and ruled by consensus; in short, unlikely mavericks. In such settings, the cost of being different and wrong can be viewed as highly unacceptable relative to the potential benefit from being different and right.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • Since investing consists of positioning capital to benefit from future events, how can anyone expect to do a good job without a view regarding what those events will be? We need forecasts, even if they’re imperfect. This summer, at the suggestion of my son Andrew, I read an extremely interesting book: Mistakes Were Made (but Not by Me): Why We Justify Foolish Beliefs, Bad Decisions, and Hurtful Acts, written by psychologists Carol Tavris and Elliot Aronson. Its topic is self-justification. The authors explain that “cognitive dissonance” arises when people are confronted with new evidence that calls into question their pre-existing positions and that when it does, unconscious mechanisms enable them to justify and uphold those positions. Here are some selected quotes: If you hold a set of beliefs that guide your practice and you learn that some of them are incorrect, you must either admit you were wrong and change your approach or reject the new evidence. Most people, when directly confronted by evidence that they are wrong, do not change their point of view or plan of action but justify it even more tenaciously. Once we are invested in a belief and have justified its wisdom, changing our minds is literally hard work. It’s much easier to slot that new evidence into an existing framework and do the mental justification to keep it there than it is to change the framework.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: To use his words, these actions probably appeared “downright imprudent in the eyes of conventional wisdom.” Swensen’s behavior was certainly idiosyncratic and uninstitutional, but he understood that the only way to outperform was to risk being wrong, and he accepted that risk with great results. One Way to Diverge from the Pack To conclude, I want to describe a recent occurrence. In mid-June, we held the London edition of Oaktree’s biannual conference, which followed on the heels of the Los Angeles version. My assigned topic at both conferences was the market environment. I faced a dilemma while preparing for the London conference, because so much had changed between the two events: On May 19, the S&P 500 was at roughly 3,900, but by June 21 it was at approximately 3,750, down almost 4% in roughly a month. Here was my issue: Should I update my slides, which had become somewhat dated, or reuse the LA slides to deliver a consistent message to both audiences? I decided to use the LA slides as the jumping-off point for a discussion of how much things had changed in that short period. The key segment of my London presentation consisted of a stream-of-consciousness discussion of the concerns of the day. I told the attendees that I pay close attention to the questions people ask most often at any given point in time, as the questions tell me what’s on people’s minds.

The mechanisms that people generally employ when responding to evidence that throws their beliefs into doubt include these (paraphrasing the authors’ words): • an unwillingness to heed dissonant information; • selectively remembering parts of their lives, focusing on those parts that support their own points of view; and • operating under cognitive biases that ensure people see what they want to see and seek confirmation of what they already believe. I have little doubt that these are among the factors that cause and enable people to continue making and consuming forecasts. What specific form might they take in this case? • thinking of macro forecasts as an indispensable part of investing; • pleasantly recalling correct forecasts, especially any that were bold and non-consensus; • overestimating how often forecasts were right; • forgetting or minimizing the ones that were wrong; • not keeping records regarding forecasts’ accuracy or failing to calculate a batting average; • focusing on the “pot of gold” that will reward correct forecasts in the future; • saying “everyone does it”; and • perhaps most importantly, blaming unsuccessful forecasts on having been blindsided by random occurrences or exogenous events. (But, as I said earlier, that’s the point: Why make forecasts if they’re so easily rendered inaccurate?)

Accept my son Andrew’s view that merely possessing “readily available quantitative information regarding the present” won’t give you above average results, since everyone else has it. • Recognize that psychology swings much more than fundamentals, and usually in the wrong direction or at the wrong time. Understand the importance of resisting those swings. Profit if you can by being counter-cyclical and contrarian. • Study conditions in the investment environment – especially investor behavior – and consider where things stand in terms of the cycle. Understand that where the market stands in its cycle will strongly influence whether the odds are in your favor or against you. • Buy debt when you like the yield, not for trading purposes. In other words, buy 9% bonds if you think the yield compensates you for the risk, and you’ll be happy with 9%. Don’t buy 9% bonds expecting to make 11% thanks to price appreciation resulting from declining interest rates. © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: few do). I find it incredibly simple: If you wait at a bus stop long enough, you’re guaranteed to catch a bus, but if you run from bus stop to bus stop, you may never catch a bus. I believe most investors have their eye on the wrong ball. One quarter’s or one year’s performance is meaningless at best and a harmful distraction at worst. But most investment committees still spend the first hour of every meeting discussing returns in the most recent quarter and the year to date. If everyone else is focusing on something that doesn’t matter and ignoring the thing that does, investors can profitably diverge from the pack by blocking out short-term concerns and maintaining a laser focus on long-term capital deployment. A final quote from Pioneering Portfolio Management does a great job of summing up how institutions can pursue the superior performance most want. (Its concepts are also relevant to individuals): Appropriate investment procedures contribute significantly to investment success, allowing investors to pursue profitable long-term contrarian investment positions. By reducing pressures to produce in the short run, liberated managers gain the freedom to create portfolios positioned to take advantage of opportunities created by short-term players. By encouraging managers to make potentially embarrassing out-of-favor investments, fiduciaries increase the likelihood of investment success.

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.

” (* What accounts for the difference between the average error of 3.5 percentage points cited in the first bullet point and this 12.9? I assume the latter to be the average of the “absolute value” of the error. When you think in terms of absolute value, being too high by 3% in year one and then too low by 2% in year two means the absolute values of the errors add up to 5%, rather than netting out to only 1%.) © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Many of the great bonanzas for value investors have come in periods of panic following the bursting of bubbles, and this fact has probably led value investors to be very skeptical of market exuberance, especially when concerning companies whose assets are intangible. Skepticism is important for any investor; it’s always essential to challenge assumptions, avoid herd mentality and think independently. Skepticism keeps investors safe and helps them avoid things that are “too good to be true.” But I also think skepticism can lead to knee-jerk dismissiveness. While it’s important not to lose your skepticism, it’s also very important in this new world to be curious, look deeply into things and seek to truly understand them from the bottom up, rather than dismissing them out of hand. I worry that value investing can lead to the rote application of formulas and that, in times of great change, applying formulas that are based on past experience and models of the prior world can lead to massive error. John Templeton warned about the risk that’s created when people say, “it’s different this time,” but he also © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The bottom line is that hundreds or perhaps thousands of people make their living as professional market forecasters, despite the fact that the median forecast is of no value: wrong on average, positive in good years and bad, and way off target when an accurate forecast would have been most profitable. The Role of the Fed A great deal of the current debate over the macro outlook surrounds the Fed and its policies and behavior. In March 2020, the Fed triggered the recovery we’re enjoying by cutting the key federal funds rate to 0-0.25%, initiating loan and grant programs, and buying vast amounts of bonds. This combination was very successful, producing powerful recoveries in the economy and the financial markets. However, the same actions helped create the threat of persistently higher inflation. The Fed has two primary assignments: (a) making sure the economy grows enough to create jobs, leading to full employment, and (b) keeping inflation under control. To some extent, these tasks are in conflict. Stronger economic growth risks overheating and inflation. Higher inflation leads investors to demand higher interest rates to more than compensate for the loss of purchasing power. Higher interest rates threaten to slow the economy. The economic outlook turned positive last summer in response to the Fed/Treasury actions and then was further bolstered by the success of vaccines.

Company B, on the other hand, is at an early stage in its development, its profit margins are far from maximized, and its greatest assets go home every night rather than residing on the balance sheet. Valuing it requires guesses about the ultimate success of its products; its ability to come up with new ones; the response from competitors and the targeted industry; its growth runway; and the extent to which it will be able to increase profitability once doing so becomes its focus. Company B seems more conceptual in nature and more dependent on developments in the distant future that are subject to significant uncertainty, so valuing it might have to be done on the basis of broad ranges for future sales and profitability rather than reliable point estimates. Assessing its value also requires conversance with a technologically complex field. For all these reasons, value investors are likely to consider Company B hard to value, “speculative” and thus not investable under the canon. Certainly, the range of potential outcomes – both good and bad – appears greater with respect to Company B than Company A, and thus Company B seems less predictable. But Company A’s track record may suggest stability that could ultimately prove fleeting. And even if one can’t exactly predict the future of Company B, British philosopher and logician Carveth Read reminds us that we’d rather be vaguely right than exactly wrong.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: dichotomy, value investing should instead consist of buying whatever represents a better value proposition, taking all factors into account. Dealing with Winners A couple of times this past year, I’ve committed the sin of asking Andrew how he felt about selling part of some highly appreciated holdings and “taking some money off the table.” The results haven’t been pretty; he has made plain my error, as described below. Much of value investing is based on the assumption of “reversion to the mean.” In other words, “what goes up must come down” (and what comes down must go up). Value investors often look for bargains among the things that have come down. Their goal, of course, is to buy underpriced assets and capture the discounts. But then, by definition, their potential gain is largely limited to the amount of the discount. Once they’ve benefitted from the closing of the valuation gap, “the juice is out of the orange,” so they should sell and move on to the next situation. In Graham’s day, cigar butts could be found in good supply, valued precisely, bought very cheaply with confidence, and then sold once the price had risen to converge with the value. But Andrew argues that this isn’t the right way to think about today’s truly world-class companies, with their vast but unquantifiable long-term potential.

Andrew insists that when you’re talking about today’s great growth companies, the approach of “buy in cheap, set a target price, sell as it rises, and exit fully when it reaches the target” is dead wrong. A dispassionate look at history makes clear that taking profits in a rapidly growing company with durable competitive advantages has often been a mistake. Given the properties of today’s leading companies, it can be even more wrong now. Instead, as he says, you have to talk yourself out of selling. I think winners are sold for four primary reasons: (a) the investor concludes that the investment has accomplished everything it’s capable of, (b) she thinks it has appreciated to the point that its © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 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.

When you multiply together the probabilities of succeeding at a large number of challenging tasks, the probability of doing them all correctly becomes very low. It’s much more feasible to have great insights about a small number of potentially huge winners, recognize how truly rare such insights and winners are, and not counteract them up by selling prematurely. As I was working on this memo, I came across a very helpful article from the Santa Fe Institute: When it comes to investing and businesses, the mental models in our head help us answer the question, ‘what does the future hold?’. . . [But] applying the mental model of ‘mean reversion’ for a ‘fade-defying’ business model will lead to an erroneous conclusion. (Investment Master Class, December 21, 2020) The last sentence struck a very responsive chord in me. It suggested to me that my background had biased me toward assuming “mean reversion” and thus sometimes caused me not to fully grasp the potential of “fade-defying business models.” This bias caused me to conclude that one should “scale out” of things as they rose and “take some money off the table.” I even formulated a saying on the subject: “If you sell half, you can’t be all wrong.” But I now see that this high- sounding verbiage can lead to premature selling, and that cutting back a holding with great potential can be a life-altering mistake. Note that, according to Charlie Munger, he’s made almost all his money from three or four big winners.

Then if it goes down, (a) you’ve limited your regret and (b) you can buy in lower. A: If I owned a stake in a private company with enormous potential, strong momentum and great management, I would never sell part of it just because someone offered me a full price. Great compounders are extremely hard to find, so it’s usually a mistake to let them go. Also, I think it’s much more straightforward to predict the long-term outcome for a company than short-term price movements, and it doesn’t make sense to trade off a decision in an area of high conviction for one about which you’re limited to low conviction. H: Well for one thing, the p/e ratio is awfully high. A: The p/e ratio is just a very quick heuristic that doesn’t necessarily tell you much about the company. You can’t say a stock is overvalued just because its p/e ratio is high relative to historic average p/e’s for the market. All that matters is thinking about how much cash flow the company can produce over a long period of time, discounting that at a reasonable discount rate, and comparing the resultant present value against the current price. There are lots of things – about both the company’s present condition and its future potential – that don’t get picked up in a p/e ratio, so a high multiple alone shouldn’t scare you off. H: Aha! That’s just what they said during the Nifty Fifty bubble around the time I started working. “No price too high,” was a widespread mantra.

We are not well designed, it seems, to live in uncertainty. Rousseau exaggerated only slightly when he said that when things are truly important, we prefer to be wrong than to believe nothing at all. . . . Apart from the actual biology of the coronavirus – which we are only beginning to understand – nothing is predestined. How many people fall ill with it depends on how they behave, how we test them, how we treat them and how lucky we are in developing a vaccine. The result of those decisions will then limit the choices about reopening that employers, mayors, university presidents and sports club owners are facing. Their decisions will then feed back into our own decisions, including whom we choose for president this November. And the results of that election will have the largest impact on what the next four years will hold. The pandemic has brought home just how great a responsibility we bear toward the future, and also how inadequate our knowledge is for making wise decisions and anticipating consequences. Perhaps that is why our prophets and augurs can’t keep up with the demand for foresight. © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: famous for saying he likes hamburgers, and when hamburgers go on sale, he eats more hamburgers. My roughly quarterly memos pale when compared to the output of Doug Kass, who writes at least daily. His March 11 note had a terrific title: “When the Time Comes to Buy, You Won’t Want To.” The best time to buy generally comes when nobody else will; other people’s unwillingness to buy tends to make securities cheap. But the factors that render others averse to buying will affect you, too. The contrarian may push through those feelings and buy anyway, even though it’s not easy. As I put it, “All great investments begin in discomfort.” One thing we know is that there’s great discomfort today. Latest Update – to clients March 19, on website March 24 This memo was issued with the S&P 500 down 29% and within a few days of the low (down 34%) that would be reached on March 23. The panic we were observing, and the great purchases we made that week, convinced me to take a firmer tone in arguing for buying. I took the position that it would be a mistake to wait for an ascertainable bottom before doing so. What do we know? Not much other than the fact that asset prices are well down, asset holders’ ability to hold coolly is evaporating, and motivated selling is picking up. I’ll sum up my views simply – since there’s nothing sophisticated to say: • “The bottom” is the day before the recovery begins.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: had experienced a rally on March 24-26 that delivered the best three-day gain since the 1930s, leaving the S&P 500 down just 24%. . . . the market prices of assets have responded to the events and outlook (in a very micro sense, I feel last week’s bounce reflected too much optimism, but that’s me). I would say assets were priced fairly on Friday [March 27] for the optimistic case but didn’t give enough scope for the possibility of worsening news. Thus my reaction to all the above is to expect asset prices to decline. You may or may not feel there’s still time to increase defensiveness ahead of potentially negative developments. But the most important thing is to be ready to respond to and take advantage of declines. My message wasn’t uniform across the four memos, but there were some common threads. • My observations waxed and waned, in particular as security prices did. • I never urged selling, as I thought a fair bit of the damage had been done. In other words, it was probably too late to make portfolios less risky. • I talked about the reasonableness of buying – to varying degrees – primarily in response to the extent securities had cheapened. • I never said it was the time to buy (or that it wasn’t). I urged an incremental approach, not all-in or all-out. • The most consistent observation was probably that not buying anything at the new low prices would be a mistake.

They may well know much more than most about the medical and public health aspects of the coronavirus and how it should be dealt with, and their advice is likely to keep the most people alive. But on the other hand, since they’re not economists, we should assume they’re only answering from the standpoint of minimizing deaths. They may not take into consideration the importance of restarting the economy or how to balance the two considerations. On the other hand, we see businesspeople and economists talking about the need to reopen in order to minimize the damage done to the economy by keeping it in a deep freeze. But what do they know about the cost in human lives? And certainly there is no algorithm or accepted process for deciding between the two. It’s a matter of judgment, not expertise. I recently read an article about an often-cited libertarian lawyer and legal scholar (unnamed here because of my general practice of not criticizing individuals) who predicted in mid-March that no more than 500 people would die from Covid-19 in the U.S. (revised upward to 5,000 when he later found a statistical error in his analysis). While he admitted to having no medical expertise, he said he did know more than the doctors about evolutionary theory and its applicability to the virus. His opinion apparently carried great weight at the time in conservative quarters. Reporters, not being experts themselves, have to consult experts in order to write their stories.

The vagueness and variation of the message summarized above make it less than concrete and perhaps less than satisfying for someone who’s looking for unequivocal advice. In my opinion, however, there’s simply no room for certainty in investing, and today more so than usual. Portfolio Positioning One of the benefits I derive from writing my memos is that the more I work on a memo about something, the more it comes into focus. Thus the four March memos gave me a great opportunity to ponder what the events imply for investment behavior. I’m glad to say I’ve reached a conclusion on that subject. I feel strongly that it’s right . . . and I fully expect to amend it in the future. (To set the scene, the next few paragraphs will be repeat things I’ve said in the past.) In recent years I’ve become more and more convinced that the fund manager’s most important job for the intermediate term isn’t to decide the allocation of capital between stocks versus bonds; U.S. versus foreign; developed markets versus emerging; large-cap versus small-cap; high-quality versus low-quality; or growth versus value. And it isn’t choosing among strategies, funds and managers. The most important job is to strike the appropriate balance between offense and defense. Those other things won’t help much if you get offense/defense wrong. And if you get offense/ defense right, those other things will take care of themselves. © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

The root cause of this mistake is to look at average responses from past events. But the reality is not like that. (Juan-Luis Perez, head of research, Evidence Lab and Analytics, at UBS, the Financial Times, April 22, emphasis added) © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Thinking in Bets In a past memo, I told a story from my days as a buy-side analyst following the business equipment industry for First National City Bank. In 1970, one of the bank’s portfolio managers asked me whom I considered to be the best brokerage-house analyst on Xerox. “Well,” I answered, “the one who most agrees with me is so-and-so.” In other words, we tend to respect people who think like we do. Did you ever hear someone say, “I think Bob’s a genius, and he thinks my views are all wrong”? That’s something few people would ever say. No, we tend to think highly of people whose opinions mirror ours. And that brings me to the source of the inspiration for this memo: a book called Thinking in Bets: Making Smarter Decisions When You Don’t Have All the Facts by Annie Duke. (I provided a blurb for the dust jacket when it was published in 2018.) Duke completed the coursework and dissertation for a Ph.D. in psychology from the University of Pennsylvania but stopped short of receiving her degree, and for many years she was the best-known female professional poker player (with over $4 million of tournament winnings). I was rereading Duke’s book while on vacation, and so many of her thoughts on poker and on decision-making in general agreed with mine that I became motivated to start on the memo you’re reading now.

In it, he told the story of two friends with whom he regularly took the risk of skiing out of bounds at the resort they frequented as teens. One day, his friends went out for a second run while he begged off for no particular reason, and a freak avalanche took their lives. Here’s his summation: I don’t know if Brendan and Bryan’s death actually affected how I invest. But it opened my eyes to the idea that there are three distinct sides of risk: • The odds you will get hit. • The average consequences of getting hit. • The tail-end consequences of getting hit. The first two are easy to grasp. It’s the third that’s hardest to learn, and can often only be learned through experience. We knew we were taking risks when we skied. We knew that going out of bounds was wrong, and that we might get caught. But at 17 years old we figured the consequences of risk meant our coaches might yell at us. Maybe we’d get our season pass revoked for the year. Never, not once, did we think we’d pay the ultimate price. But once you go through something like that, you realize that the tail-end consequences – the low-probability, high-impact events – are all that matter. In investing, the average consequences of risk make up most of the daily news headlines. But the tail-end consequences of risk – like pandemics, and depressions – are what make the pages of history books. They’re all that matter. They’re all you should focus on.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: times of prosperity. No one wants a recession, but using up our ammunition preemptively may not have been smart. The Fed/government’s tool for fighting the economic impact of coronavirus are very limited. Thus I believe it’s undesirable to be highly sanguine about their powers at this juncture. What to Do? These days, people have been asking me whether this is the time to buy. My answer is more nuanced: it’s probably a time to buy. There can be no unique time to buy that we can identify. The only thing we can be sure of today is that stock prices, for example, are a lot lower in the absolute than they were two weeks ago. Will stocks decline in the coming days, weeks and months? This is the wrong question to ask . . . primarily because it is entirely unanswerable. Since we don’t have answers to the questions about the virus listed on page two, there’s no way to decide intelligently what the markets will do. We know the market declined by 13% in seven trading days. There can be absolutely no basis on which to conclude that they’ll lose another 13% in the weeks ahead – or that they’ll rise by a like amount – since the answer will be determined largely by changes in investor psychology. (I say “largely” because it will also be influenced by developments regarding the virus . . .

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: debate. When all the facts and opinions you hear confirm your own beliefs, mental life is very relaxed but not very enriching. What’s the ideal? A calm, open mind and an objective process. Wouldn’t we all be better off if those things were universal? In Praise of Doubt Another favorite theme of mine – and I’m mildly apologetic for its repetition in these memos – is how important it is to acknowledge what we don’t know. First of all, if we’re going to out-invest the rest, we need a game plan. There are a lot of possible routes to success on which to base your process: in-depth research into companies, industries and securities; arbitrage; algorithmic investing; factor investing; even indexation. But if I’m right about the difficulty of macro forecasting, for most people that shouldn’t be it. Second, and probably more importantly, excessive trust in forecasting can be dangerous to your financial health. It’s never been put better than in the quote that’s often attributed to Mark Twain, but also to several others: 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. Just a few words, but a great deal of wisdom. No statement that starts with “I don’t know but . . .” or “I could be wrong but . . .” ever got anyone into big trouble. If we admit to uncertainty, we’ll investigate before we invest, double-check our conclusions and proceed with caution.

We may sub- optimize when times are good, but we’re unlikely to flame out or melt down. On the other hand, people who are sure may dispense with those things, and if they’re sure and wrong, as the quote suggests, the outcome can be catastrophic. Investing is challenging in this way, as in so many others. Active investors have to be confident. Yale’s David Swensen said it as well as it can be said (that’s why I go back to this quote so often in my memos and books): Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom. (Pioneering Portfolio Management) To do better than most, you have to depart from the crowd. As I said in my April 6 memo Calibrating, echoing Swensen, all great investments begin in discomfort, since the things everyone likes and feels good about are unlikely to be on the bargain counter. But to invest in things that are out of favor – at the risk of standing out from the crowd and appearing to have made a big mistake – takes confidence and resolve. It also requires confidence to hold onto a position when it declines – and perhaps add to it at lower prices – in the period before one’s wisdom becomes clear and it turns into a winner. And it takes confidence to continue holding a highly appreciated investment you think still has upside potential, at the risk of possibly giving up some of the gains to date.

” On the days those two spoke, both the plain vanilla forward-looking p/e ratio and the Shiller cyclically adjusted price-to-earnings ratio were well above normal levels, disregarding all the uncertainties present and the big declines that lie ahead for GDP and earnings. And yet, over the next four weeks leading up to the June 8 high, the S&P 500 rose an additional 13%. What this proves is that either (a) “overpriced” isn’t synonymous with “sure to decline soon” or (b) Druckenmiller and Tepper were wrong. I’ll go with (a). On June 8, Druckenmiller described himself as “humbled.” (In this line of work, if you never feel humbled, it just means you haven’t realistically appraised your performance.) All I know is that a lot of smart, experienced investors concluded that asset prices had become too high for the fundamentals. Time will tell. * * * There’s no way to determine for sure whether an advance has been appropriate or irrational, and whether markets are too high or too low. But there are questions to ask: • Are investors weighing both the positives and the negatives dispassionately? • What’s the probability the positive factors driving the market will prove valid (or that the negatives will gain in strength instead)? • Are the positives fundamental (value-based) or largely technical, relating to inflows of liquidity (i.e., cash-driven)? If the latter, is their salutary influence likely to prove temporary or permanent? • Is the market being lifted by rampant optimism?

© 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.

If you didn’t, there was something wrong with you, since there was a meaningful possibility the financial system would collapse. When we started buying, Bruce came to me often saying, “I think we’re going too slow,” and then the next day, “I think we’re going too fast.” But that didn’t keep him from investing an average of $450 million per week over the last 15 weeks of 2008. I think Bruce’s ability to grapple with his doubts helped him arrive at the right pace of investment. The topic of dealing with what you don’t know brings me to a phrase I came across a few years ago and think is very important: intellectual humility. Here’s part of the article that first brought it to my attention: “Intellectual humility” has been something of a wallflower among personality traits, receiving far less scholarly attention than such brash qualities as egotism or hostility. Yet this little-studied characteristic may influence people’s decision-making abilities in politics, health and other arenas, says new research from Duke University. . . . As defined by the authors, intellectual humility is the opposite of intellectual arrogance or conceit. In common parlance, it resembles open-mindedness. Intellectually humble people can have strong beliefs, but recognize their fallibility and are willing to be proven wrong on matters large and small, Leary said.

The opportunities for losses will be that much greater. Treasury is backstopping losses, but the taxpayer risks here are greater than what the Fed took on in 2008-2009. The Fed may feel all of this is essential to protect the financial system’s plumbing and reduce systemic risk until the virus crisis passes, but make no mistake that the Fed is protecting Wall Street first. The goal seems to be to lift asset prices, as the Fed did after the financial panic, and hope that the wealth effect filters down to the rest of the economy. The bank bailout of 2008 has been roundly cited as a case of the government putting Wall Street ahead of Main Street, and it contributed significantly to the populism that has riven American politics ever since. This recent step to rescue leveraged lenders may add further fuel to that fire. * * * The market seems to have passed judgment with regard to the future. U.S. deaths have reached 23,000 and continue to rise. Weekly unemployment claims are running at 10 times the all-time record. The GDP decline in the current quarter is likely to be the worst in history. But people are cheered by the outlook for therapies and vaccines, and investors have concluded that the Fed/Treasury will reduce the pain and bring on a V-shaped recovery. There’s an old saying that “you can’t fight the Fed” – that is, the Fed can accomplish whatever it wants – and investors are buying it.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: opinions might be incorrect. . . . Some definitions of IH include other features or characteristics – such as low defensiveness, appreciating other people’s intellectual strengths, or a prosocial orientation . . . One conceptualization defines intellectual humility as recognizing that a particular personal belief may be fallible, accompanied by an appropriate attentiveness to limitations in the evidentiary basis of that belief and to one's own limitations in obtaining and evaluating relevant information. This definition qualifies the core characteristic (recognizing that one’s belief may be wrong) with considerations that distinguish IH from mere lack of confidence in one’s knowledge or understanding. IH can be distinguished from uncertainty or low self-confidence by the degree to which people hold their beliefs tentatively specifically because they are aware that the evidence on which those beliefs are based could be limited or flawed, that they might lack relevant information, or that they may not have the expertise or ability to understand and evaluate the evidence. (The Psychology of Intellectual Humility, Mark Leary, Duke University, emphasis added) “Attentiveness to limitations in the evidentiary basis” (or to the limitations imposed by future uncertainty) is a very important further concept.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: But fifty years ago, the Nifty Fifty appeared impregnable too; people were simply wrong. If you invested in them in 1968, when I first arrived at First National City Bank for a summer job in the investment research department, and held them for five years, you lost almost all your money. The market fell in half in the early 1970s, and the Nifty Fifty declined much more. Why? Because investors hadn’t been sufficiently price-conscious. In fact, in the opinion of the banks (which did much of the institutional investing in those days) they were such good companies that there was “no price too high.” Those last four words are, in my opinion, the essential component in – and the hallmark of – all bubbles. To some extent, we might be seeing them in action today. Certainly no one’s valuing FAAMG on current income or intrinsic value, and perhaps not on an estimate of e.p.s. in any future year, but rather on their potential for growth and increased profitability in the far-off future. And note that a lot of the strength and potential of today’s tech leaders derives from their dominant market shares and market power. This same element creates one of their greatest vulnerabilities: potential exposure to anti-trust action. Bigness and the successful tactics that led to it are enough to make some people call for constraints on the incumbents.

Rather, the goal is to figure out who the favorite is and whether the odds are fair or not.  If the odds are fair, as illustrated above, there’s no reason (other than sentiment) to bet on one team or the other.  If the odds don’t penalize the favorite enough – let’s say the odds on the above matchup are only 6-to-5 – you should bet on the favorite. Team A will win two-thirds of the time. The one time out of three when they lose, the $6 you pay won’t offset the total of $10 you win on the two occasions when they come out ahead.  But if the odds are tilted against the favorite – the odds are “too long,” maybe 4-to-1 – it’s better to bet on the underdog. You’ll still lose $1 two times out of three (for a total of $2), but on the one game you win, the $4 payoff will more than compensate. A great example can be seen in the world of backgammon. The player who’s ahead can offer to double the stakes from $5 to $10 by “turning the cube,” in which case the other player has to choose between surrendering for $5 or playing on for $10. Since the leader offers to double because he’s ahead, does that mean it’s a mistake for the player who’s behind to accept? Not necessarily.  Clearly, if the laggard surrenders, he loses $5.  But what if, let’s say, he has a 25% chance of winning and plays on for $10? In that case, his expected outcome is ($10 loss x .75) + ($10 gain x .25), which works out to the same $5 loss.

The S&P 500 is basically flat on the year, but without FAAMG (Facebook, Apple, Amazon, Microsoft and Google, its five heaviest-weighted components) and other tech/software stocks, it would be considerably lower. (The top five are up by an average of 36% so far this year, while the median change for all 500 stocks is minus 11%.) Does it make sense that the FAAMG-plus- tech/software stocks are up a lot in this context? It seems that it does, because (a) Covid-19 has accelerated tech adoption in many ways, and thus these companies’ growth, and (b) today’s ultra-low interest rates justify much higher p/e ratios (see above). If instead the tech giants were flat against this backdrop – or had just performed in line with the rest of the index – we’d probably say something was wrong. I don’t know whether these bullish arguments are absolutely correct or merely have gained luster thanks to their having driven the 46% gain of the S&P 500 over the last four months. Regardless, I want to share the bull case as a public service and because it has obvious merit . . . and certainly has won out thus far.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: To put it simply, intellectual humility means saying “I’m not sure,” “The other person could be right,” or even “I might be wrong.” I think it’s an essential trait for investors; I know it is in the people I like to associate with. As so often happens when I’m thinking about a memo, I recently got an incredibly helpful note from my friend Leslie Lichtenstein at the University of Chicago, connecting the concept of humility to the current episode. Here’s what she wrote: This morning I read an article from Behavioral Scientist by Erik Angner [professor of practical philosophy at Stockholm University] called “Epistemic Humility – Knowing Your Limits in a Pandemic,” which made me think of you and several of your recent memos. The article opens with a quote from Charles Darwin in 1871 – “Ignorance more frequently begets confidence than does knowledge.” It goes on to say, “Being a true expert involves not only knowing stuff about the world but also knowing the limits of your knowledge and expertise.” (Emphasis in Leslie’s note) I couldn’t agree more. People who are always sure are no more helpful than people who are never sure. The real expert’s confidence is reason-based and proportional to the weight of the evidence. Leslie’s note sent me to the original of the article she cited, and I found so much to share: In the middle of a pandemic, knowledge is in short supply.

” And if you bought those stocks the day I arrived and held them firmly for five years, you lost almost all of your money . . . investing in the best companies in America. All the companies were considered future winners. Some actually were, but far from all. (What happened to Kodak, Polaroid and my favorite, Simplicity Pattern?) The proposition was wrong: they were priced as if they couldn’t lose, and it turned out several would. Then, in 1978, I switched to Citi’s bond department, and I was asked to start a high yield bond fund. Now I was investing in the bonds of the worst public companies in America – all rated speculative grade, or “junk.” And I was making good money safely and steadily. Not because the companies © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Since her book provided the impetus for this memo, I’ll let Annie Duke sum up. She’ll be talking about poker, but it’ll sound a lot like investing [emphasis added]: When we think probabilistically, we are less likely to use adverse results alone as proof that we made a decision error, because we recognize the possibility that the decision might have been good but luck and/or incomplete information (and a sample size of one) intervened. Maybe we made the best decisions from a set of unappealing choices, none of which were likely to turn out well. Maybe we committed our resources on a long shot because the payout more than compensated for the risk, but the long shot didn’t come in this time. Maybe we made the best choice based on the available information, but decisive information was hidden and we could not have known about it. Maybe we chose a path with very high likelihood of success and got unlucky. . . . But it also means we must redefine “right.” If we aren’t wrong just because things didn’t work out, then we aren’t right just because things turned out well. . . . First the world is a pretty random place. The influence of luck makes it impossible to predict exactly how things will turn out, and all the hidden information makes it even worse. If we don’t change our mindset, we’re going to have to deal with being wrong a lot. . . . Poker teaches that lesson.

A great poker player who has a good sized advantage over the other players at the table, making significantly better strategic decisions, will still be losing over 40% of the time at the end of eight hours of play. That’s a whole lot of wrong. And it’s not just confined to poker. . . . How can we be sure that we are choosing the alternative that is best for us? What if another alternative would bring us more happiness, satisfaction, or money? The answer, of course, is we can’t be sure. Things outside our control (luck) can influence the result. The futures we imagine are merely possible. They haven’t happened yet. We can only make our best guess, given what we know and don’t know, at what the future will look like. . . . When we decide, we are betting whatever we value . . . on one of a set of possible and uncertain futures. That is where the risk is. Investing is a game of skill – meaning inferior players can’t expect to be above average winners in the long run. But it also includes elements of chance – meaning skill won’t win out every time. In the long run, superior skill will overcome the impact of bad luck. But in the short run, luck can overwhelm skill, and the two can be indistinguishable. © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

No choices need be made: candidates can promise it all. And there are no consequences. If something might have negative consequences in the real world, politicians seem to feel free to ignore them. . . . The purpose of this memo is to describe what happens when political behavior collides with economic reality, as illustrated in one area where the government is taking steps – tariffs – and another in which debate among politicians is heating up – restrictions on the capitalist system. Before I move forward, I’d like to state up front, as I did in Economic Reality in 2016, that I’m not writing to make political judgments or to make any politician or party look bad. But economic pronouncements can’t be separated from the people who make them. If you read through to the end, you’ll see I find something to complain about in the approach of members of both parties. Tariffs Tariffs are very much in the news these days, and their complexity renders them ripe for error and thus appropriate for discussion here. © 2019 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

” Sound bites like these find receptive audiences among people who are unhappy with their lot, whereas detecting the error in these statements requires an insight, sense of history and understanding of economics that many people lack. What’s Going On? In the January memo, I set forth my view that in the last 10-20 years, the rising economic tide had stopped lifting all boats. In addition, major social and economic trends contributed to increases in economic inequality. These developments, I said, were largely behind the rise of populism. Ray Dalio and Bridgewater actually beat my memo by two days, publishing on January 28 an excellent note titled Populism + Weakening Economy + Limited Central Bank Power to Ease + Elections = Risky Markets and Risky Economies. I was particularly drawn to the following passage: Disparity in wealth, especially when accompanied by disparity in values, leads to increasing conflict and, in the government, that manifests itself in the form of © 2019 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

 We can have economic strength without inflation.  Interest rates can remain “lower for longer.”  The inverted yield curve needn’t have negative implications.  Companies and stocks can thrive even in the absence of profits.  Growth investing can continue to outperform value investing in perpetuity. I rarely participate in a meeting these days without someone asking about one or more of these propositions. The bottom line is that for any of the nine to be true, things really have to be different this time. I’ll discuss the outlook for each below. The avoidable recession – The questions I get most often these days are “Is the U.S. heading for a recession?” and “When will it start?” My answer to the first is a simple “yes.” (At least I can never be proved wrong.) We’ve always had economic cycles, and I believe we always will. Eventually, favorable developments will lead people to engage in behavior premised on excessively optimistic assumptions, and eventually the over-optimism of those assumptions will be exposed and the excesses will correct in a period of negative growth. Moreover, even economies that aren’t marked by excesses are subject to exogenous shocks. When people ask about the coming recession, what they mostly mean is “Might it be a long way off?” Well, the longest U.S. recovery on record lasted ten years, and the current one is in the twelfth month of its tenth year.

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Under compound interest, by not withdrawing interest as it is earned, not only does an investor earn interest on his principal year after year (as with simple interest), but each year he also earns interest on the interest that was earned in the preceding years. Thus principal can grow powerfully if left invested for a long period. (At 10%, $100 grows to $300 in 20 years under simple interest, but to $673 if allowed to compound.) What a wonder! There’s one problem, however. The miracle of compound interest works in reverse if the interest rate is negative, making Einstein wrong about its virtue. Who would want to reinvest income at negative rates? And where would income come from for that purpose? It’s not just Einstein’s observation that may be rendered invalid. Negative rates turn a lot of the usual processes upside down. Here are several examples:  Negative rates make life more difficult in a TINA (“there is no alternative”) world. Many investors don’t want to knowingly sign on for negative rates. That makes risky investments preferable, even if they promise historically low prospective returns. In this way, risk aversion is discouraged. “I have no choice but to go into risky assets, because I can’t accept a negative return on safe ones.” There is clear evidence that this is happening among institutional investors.

I believe here, as elsewhere, the workings of economics are too uncertain for a perpetual motion machine like MMT to be relied upon. In other words, Modern Monetary Theory is just that: a theory. What if it’s wrong? . . . when the University of Chicago’s Booth School of Business asked top scholars about a couple of [MMT’s] claims, they split between the 28 percent who disagreed and the 72 percent who strongly disagreed. (ibid.) © 2019 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: economies and central banks. This means the task of managing an economy is difficult, and its goals shouldn’t be thought of as dependably achievable. I think a recent article from The Times provides a great picture of how challenging the job is, and how many ways there are to be wrong. Here’s most of it: Heading into their policy decision and news conference Wednesday [June 19], there were a lot of ways Federal Reserve officials could have messed things up. One possibility was a repeat of the meeting in December, when markets judged Chairman Jerome Powell and the Fed to be oblivious about negative forces building in the markets and in the global economy, and sold off precipitously over the next days. But the opposite risk was present as well — that out of fear of repeating the December episode, Mr. Powell would exhibit too much of a hair-trigger reaction to recent signs of a slowdown in inflation pressures and industrial activity. If those turn out to be false alarms, a rate cut now would be counterproductive by signaling pessimism and making the Fed look jittery and perhaps even overly influenced by President Trump’s threats to try to demote Mr. Powell over interest rate policy. . . . In effect, Fed officials are indicating they think it’s pretty likely they will need to cut rates, but are waiting for more evidence.

Thus there’s great interest in tech companies (including ones like Uber and Lyft that are applying technology to enable new business models) and willingness to pay high prices today for the possibility of profits far down the road. There’s nothing wrong with this, as long as the possibility is real, not over-rated and not over-priced. The issue for me is that in a period when profitless-ness isn’t an impediment to investor affection – when projected tech-company profitability commencing years from now is valued as highly as, or higher than, the current profits of more mundane firms – investing in these companies can be a big mistake. Today there are a lot of investors who weren’t around to see the 2000 bursting of the TMT bubble, in which large numbers of Internet and e-commerce companies were given the benefit of the doubt, only to end up worthless. Venture capital funds showed triple-digit annual returns in the late 1990s, but the ones started around 2000 performed very poorly (and people began to ask me if venture capital was a legitimate asset class). Today, some tech and venture investments have again produced great results, and the doubts seem to be gone. In investing, however, the truth usually lies somewhere between the extremes of infinite value and worthlessness. Investor sentiment seems to be closer to the positive end of the pendulum’s arc these days, but it’s unlikely to stay there in perpetuity.

© 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.

But then Jack Bogle formed the Vanguard Group in 1974, and Vanguard’s First Index Investment Trust went operational on the last day of 1975. At the time, it was heavily derided by competitors as being “un-American” and the fund itself was seen as “Bogle’s folly.” Fidelity Investments Chairman Edward Johnson was quoted as saying that he “[couldn’t] believe that the great mass of investors are going to be satisfied with receiving just average returns.” Bogle’s fund was later renamed the Vanguard 500 Index Fund, which tracks the Standard & Poor’s 500 Index. It started with comparatively meager assets of $11 million but crossed the $100 billion milestone in November 1999. (Wikipedia) The merits of index investing are obvious: vastly reduced management fees, minimal trading and related market impact and expenses, and the avoidance of human error. Thus index investing is a “can’t lose” strategy: you can’t fail to keep up with the index. Of course it’s also a “can’t win” strategy, since you also can’t beat the index (the two tend to go together). Index or passive investing got off to a relatively slow start. In the early years, I feel it was treated as a bit of an oddity or sideline: perhaps a candidate to take the place of one or two of an institutional investor’s active managers.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: For years my description of the factors characterizing the markets has been essentially unchanged:  a large number of big-picture uncertainties,  sub-par prospective returns,  above average valuations, and  pro-risk investor behavior. For as long as I have been discussing this view, no one has ever taken issue with any of these observations. Do you? That’s the key question. And if not, what will you do about it? You could have made the above four points a year ago, and two years ago, and three years ago, etc. And in general I did. Thus it was possible to argue for raising some cash at a variety of times over the last few years. However, going meaningfully to cash would have been a big mistake – certainly based on how markets performed, but also on the merits – and I think it still would be wrong today. When I came up with the mantra that has governed at Oaktree over the last several years – “move forward, but with caution” – I described my position as follows:  the outlook is not so bad, and prices are not so high, that it’s time for maximum defensiveness (and if you turn to maximum defense today, your return will be near zero, something most people can’t stomach), but  the outlook is not so good, and prices are not so low, that it’s right to be aggressive. In fact, the only thing I was sure of was that there was no place for aggressiveness. So I didn’t say, “Get out now,” and I still wouldn’t.

But I think this continues to be a time to incorporate a good helping of defensiveness in portfolio management. Being fully invested in a cautious portfolio has been an appropriate stance over the last few years. It gave Oaktree performance that in general was respectable or better. Aggressiveness would have produced higher returns, of course, but I don’t think it could have been justified a priori. (Is an incorrect decision one that didn’t work out well, or one that was wrong at the time it was made? I insist it’s the latter, as you know.) And today? What has changed? To the four descriptors of the investment environment listed above, I would add three more:  the economy is strengthening, not slowing, and Washington is supporting its progress,  prices are even higher and valuation metrics have moved up,  and, as I said, the easy money has been made. Thus the current environment is still mixed – better fundamentally and worse price-wise. The positive near-term economic outlook, lowness of interest rates, need of most investors for return and moderate psychology all seem to suggest it would be a mistake to get out. On the other hand, the extremely high asset prices, macro-fragility and risky behavior going on all around us argue for considerable caution.

At times when the economy does well, risk doesn’t rear its head, risk-takers prosper and the returns on low-risk alternatives are unattractive, investors tend to drop their prudence and conclude that high prices aren’t a problem in and of themselves. This usually turns out to be a mistake, but it can take years. For authority, I’ll cite a passage that seconds that view: © 2018 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

That makes this form of lending less attractive than it used to be, all else being equal. Has direct lending reached the point at which it’s wrong to do? Nothing in the investment world is a good idea or a bad idea per se. It all depends on when it’s being done, and at what price and terms, and whether the person doing it has enough skill to take advantage of the mistakes of others, or so little skill that he or she is the one committing the mistakes. At the present time, the managers raising and investing large funds are showing the most growth. But in the eventual economic correction, they may be shown to have pursued asset growth and management fees over the ability to be selective regarding the credits they backed. Lending standards and credit skills are seldom tested in positive times like we’ve been enjoying. That’s what Warren Buffett had in mind when he said, “It’s only when the tide goes out that you learn who has been swimming naked.” Skillful, disciplined, careful lenders are likely to get through the next recession and credit crunch. Less-skilled managers may not. Signs of the Times Unfortunately, there is no single reliable gauge that one can look to for an indication of whether market participants’ behavior at a point in time is prudent or imprudent. All we can do is assemble anecdotal evidence and try to draw the correct inferences from it. Here are a few observations regarding the current environment (all relating to the U.S.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Question number five: “Is there anything innately wrong with ETFs and their popularity?” ETFs are just another vehicle for buying stocks and bonds. They’re neither good nor bad per se. But there is a way in which I worry about ETFs’ impact, and it has to do with the expectations of the people who invest in them. My thinking goes back to the reason ETFs gained popularity in the first place: the ability to buy or sell them anytime the market is open. I’d bet a lot of the people who make use of ETFs do so for the simple reason that they think they’re “more liquid.” There are a couple of problems with this. First, as I wrote in “Liquidity” (March 2015), the fact that something is able to be sold legally, or the fact that there’s a market for it, can be very different from the fact that it can always be sold at a price that’s intrinsically fair or close to the last price at which it sold. If bad news or a downturn in investor psychology causes the market to drop, invariably there’ll be a price at which an ETF holder can sell, but it may not be a “good execution.” The price received may represent a discount from the value of the underlying assets, or it may be less than it would have been if the market were functioning on an even keel. If you withdraw from a mutual fund, you’ll get the price at which the underlying stocks or bonds closed that day, the net asset value or NAV.

But the price you get when you sell an ETF – like any security on an exchange – will only be what a buyer is willing to pay for it, and I suspect that in chaos, that price could be less than the NAV of the underlying securities. Mechanisms are in place that their designers say should prevent the ETF price from materially diverging from the underlying NAV. But we won’t know if “should” is the same as “will” until the mechanisms are tested in a serious market break. Some people may have invested in ETFs in the mistaken belief that they’re inherently more liquid than their underlying assets. For example, high yield bond ETFs have been very popular, probably because it’s far easier to buy an ETF than to assemble a portfolio of individual bonds. But what’s the probability that in a crisis, a high yield bond ETF will prove more liquid than the underlying bonds (which themselves are likely to become quite illiquid)? The weakness lies in the assumption that a vehicle can provide more liquidity than is provided by its underlying assets. There’s nothing wrong with the fact that ETFs may prove illiquid. The problem will arise if the people who invested in them did so with the expectation of liquidity that isn’t there when they need it.

We arrived at a price where we thought it would constitute a good investment for us. But the owners wanted twice as much . . . and they got it from a buyout fund. “We are generally seeing financial sponsors being very aggressive, pricing to perfection with very little room for error, on the back of very liberal lending practices by banks and non-traditional lenders. We all know how this will end.”  A year ago, a buyout fund financed the acquisition of company G by one of its portfolio companies with 100% debt and took out a dividend for itself. The deal was marketed with an adjusted EBITDA figure that was 190% of the company’s reported EBITDA. Based on the adjusted figure, total leverage was more than 7x, and based on the reported figure it was 13.5x. The bonds are now trading above par, and the yield spread to worst on the first lien notes is below 250 bps.  Company H is a good, growing company that we were ready to exit, and our bankers sent out 100 “teasers.” We received 35 indications of interest: three from strategic buyers and 32 from financial sponsors. “The strategic buyers offered the lowest valuations; it’s always a big warning sign when financial sponsors with no hope of synergies are offering prices much © 2018 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

” Here’s what the OCC head said on the subject: “What we are telling banks is you have capital and expected loss models and so if you are reserving sufficient capital against expected losses, then you should be able to make that decision.” (The quotes above are from Debtwire.) And here’s my response: how did that work out last time? David goes on: “Not surprisingly, bankers have told me they are now testing the waters with 7.5x levered LBOs. A banker recently told me that for the first time since 2007, he has been in a credit review and heard the credit deputy rationalize approving a risky deal because it is a small part of a larger portfolio so they can afford for it to go wrong, and if they pass on the deal they will lose market share to their competitors.” That sounds an awful lot like “if the music’s playing, you’ve gotta dance.” I repeat: how’d that work out last time? The bottom-line question is simple: does the sum of the above evidence suggest today’s market participants are guarded or optimistic? Skeptical or accepting of easy solutions? Insisting on safety or afraid of missing out? Prudent or imprudent? Risk-averse or risk-tolerant? To me, the answer in each case favors the latter, meaning the implications are clear.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: This time around, it’s mainly public and private debt that’s the subject of highly increased popularity, the hunt by investors for return without commensurate risk, and the aggressive behavior described above. Thus it appears to be debt instruments that will be found at ground zero when things next go wrong. As often, Grant’s Interest Rate Observer puts it well: Naturally, the lowest interest rates in 3,000 years have made their mark on the way people lend and borrow. Corporate credit, as [Wells Fargo Securities analyst David] Preston observes, is “lower-rated and higher-levered. This is true of investment- grade corporate debt. This is true in the loan market. This is true in private credit.” So corporate debt is a soft spot, perhaps the soft spot of the cycle. It is vulnerable not in spite of, but because of, resurgent prosperity. The greater the prosperity (and the lower the interest rates), the weaker the vigilance. It’s the vigilance deficit that crystalizes the errors that lead to a crisis of confidence. Conditions overall aren’t nearly as bad as they were in 2007, when banks were levered 32-to-1; highly levered investment products were being invented (and swallowed) daily; and financial institutions were investing heavily in investment vehicles built out of sub-prime mortgages totally lacking in substance. Thus I’m not describing a credit bubble or predicting a resulting crash.

Remember that The Race to the Bottom, which in retrospect seems to have been correct and timely, was written in February 2007, whereas the real pain of the Global Financial Crisis didn’t set in until September 2008. Thus there were 19 months when, according to the old saying, “being too far ahead of one’s time was indistinguishable from being wrong.” In investing we may have a sense for what’s going to happen, but we never know when. © 2018 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

It may be that AI and machine learning will someday permit computers to act as full participants in the markets, analyzing and reacting in real time to vast amounts of data with a level of judgment and insight equal to or better than many investors. But I doubt it will be anytime soon, and Soros’s Theory of Reflexivity reminds us that all those computers are likely to affect the market environment in ways that make it harder for them to achieve success. The Impact on Investing It’s only taken me until page fourteen to get to the issue that prompted me to start in on this memo: what these things imply for the future of our profession. For me, the situation regarding index and passive investing is clear:  Most people can’t and don’t beat the market, especially in markets that are more-efficient. On average, all portfolios’ returns are average before taking costs into account.  Active management introduces considerations such as management fees; commissions and market impact associated with trading; and the human error that often leads investors to buy and sell more at the wrong time than at the right time. These all have negative implications for net results.  The only aspect of active management with potential to offset the above negatives is alpha, or personal skill. However, relatively few people have much of it.  For this reason, large numbers of active managers fail to beat the market and justify their fees.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: It’s important to note that the trend toward passive investing hasn’t occurred because the returns there have been great. It’s because the results from active management have been poor, or at least not good enough to justify the fees charged. Now clients have wised up, and unless something changes with regard to the above, the trend toward passive investing is going to continue. What could arrest it?  More active managers could become capable of delivering alpha (but that’s not likely).  The markets could become easier to beat (that’ll probably happen from time to time).  Fees could come down so that they’re competitive with passive investment fees (but in that case it’s not clear how the active management infrastructure would be supported). Unless there are flaws in the above reasoning, the trend toward passive investing is likely to continue. At the very least, it reduces or eliminates management fees, trading costs, overtrading and human error: not a bad combination. Of course, there are active investors who outperform. Not most, and not half. But there’s a minority who do earn their fees, and they should continue to be in demand. * * * Moving on to quantitative investing, it’s particularly interesting to assess the future.

The good news about quantitative investing is that it corrects many of the shortcomings of active management:  It can do much of what people do, generally without making “human mistakes.”  It can handle infinitely more data.  It excludes emotion; it never buys on euphoria or sells in panic.  It never forgets to rebalance: to sell the things that are expensive and buy the things that are cheap. Quantitative investing makes good use of the ability of computers to handle vast amounts of data and their freedom from human error. In short, I think computers can do more than the vast majority of investors, and do it better. Now for limitations. I think of quantitative investing as also a free-riding strategy: it profits from disequilibria caused by others. The supply of “nickels and dimes” is limited to the extent of those disequilibria, and thus only a limited amount of capital can be run this way to great advantage. There has to be a reason why the best quant firm – Renaissance Technologies – has returned all outside capital from its flagship Medallion Fund; if an investment approach is infinitely scalable, by definition it’s never economic to limit the capital under management. (Of course, all “alpha strategies” are based on taking advantage of the errors of others; thus the opportunities are limited to the scale of the errors – see “It’s All a Big Mistake” from June 20, 2012.)

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: Yet Again? “There They Go Again . . . Again” of July 26 has generated the most response in the 28 years I’ve been writing memos, with comments coming from Oaktree clients, other readers, the print media and TV. I also understand my comments regarding digital currencies have been the subject of extensive – and critical – comments on social media, but my primitiveness in this regard has kept me from seeing them. The responses and the time that has elapsed have given me the opportunity to listen, learn and think. Thus I’ve decided to share some of those reflections here. Media Reaction The cable news shows and blogposts delivered a wide range of reactions – both positive and negative. The best of the former came from a manager who, when asked on TV what he thought of the memo, said, “I’d like to photocopy it and sign it and send it out as my quarterly letter.” Love that guy. I haven’t spent my time reveling in the praise, but rather thinking about those who took issue. (My son Andrew always reminds me about Warren Buffett’s prescription: “praise by name, criticize by category.” Thus no names.) Here’s some of what they said: 1. “The story from Howard Marks is ‘it’s time to get out.’ ” 2. “He’s right in the concept but wrong to execute right now.” 3. “The market is a little expensive, but you should continue to ride it until there are a couple of big down days.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: There They Go Again . . . Again Some of the memos I’m happiest about having written came at times when bullish trends went too far, risk aversion disappeared and bubbles inflated. The first and best example is probably “bubble.com,” which raised questions about Internet and e-commerce stocks on the first business day of 2000. As I tell it, after ten years without a single response, that one made my memo writing an overnight success. Another was “The Race to the Bottom” (February 2007), which talked about the mindless shouldering of risk that takes place when investors are eager to put money to work. Both of those memos raised doubts about investment trends that soon turned out to have been big mistakes. Those are only two of the many cautionary memos I’ve written over the years. In the last cycle, they started coming two years before “The Race to the Bottom” and included “There They Go Again” (the inspiration for this memo’s title), “Hindsight First, Please,” “Everyone Knows” and “It’s All Good.” When I wrote them, they appeared to be wrong for a while. It took time before they were shown to have been right, and just too early.

The math is irresistible.” We all know the result. The opinions of experts concerning the future are accorded great weight . . . but they’re still just opinions. Experts may be right more often than the rest of us, but they’re unlikely to be right all the time, or anything close to it. This year’s election season gave us plenty of opportunities to see expert opinion in action. I’ll start this memo by reflecting on them. The Year Polls Stopped Working Pollsters got off to a tough start last year with the June referendum concerning Britain’s membership in the European Union. Right up to the end, both pollsters and bookmakers considered U.K. citizens 70% likely to vote to remain a member. But, in the end, “Leave” won by a few percent. The reaction was shock. Voters on both sides of the issue were unprepared for the outcome. Within a day or two, the leaders of Britain’s main political parties had stepped down. People began to seriously discuss what that outcome meant and how “Brexit” would be accomplished. The explanations for the pollsters’ error centered around Britain’s lower level of experience with, and expertise in, polling. It couldn’t happen in the U.S. In fact, in the 2008 and 2012 presidential elections, Nate Silver, the proprietor of website FiveThirtyEight, correctly predicted the outcome in all 50 states once and in 49 the other time.

” Numbers three and four – arguing that it’s too early to sell even if the market is expensive or holdings are past their sell point – are interesting. They’re either (a) absolutely illogical or (b) signs of the investor error and lack of discipline that are typical in bull markets.  If the market is expensive, why wouldn’t you lighten up?  Why would you prefer to sell after a few big down days, rather than today? (What if the big down days are the start of a slide so big that you can’t get out at anything close to fair value? What if there’s a big down day followed by a big up day that gets you right back where you started? Does the process re-set? And is it three big down days in a row, or four?)  And if you continue to hold past your sell points, what does “sell point” mean? Bottom line: I think these things translate into “I want to think of myself as disciplined and analytical, but even more I want to make sure I don’t miss out on further gains.” In other words, fear of missing out has taken over from value discipline, a development that is a sure sign of a bull market. The fifth and final comment – that one should exercise the same degree of care and risk aversion at all times – gives me a lot to talk about.

For some reason, in 2016 pollsters in all three countries either failed to talk to a representative sample of voters, failed to elicit honest responses, or failed to accurately interpret the data. Thus their opinions may be accorded less weight in the future. So Much for the Experts I’m struck by how dramatically opinion can flip-flop:  During the run-up to the election, Clinton’s campaign organization and “ground game” were considered sophisticated, efficient and unstoppable, and Trump’s were thought of as rag-tag, underfunded and uncoordinated. Now Trump’s machine is described as having been highly effective, and Clinton’s as having missed important signs and opportunities.  Clinton’s message was thought likely to carry a lot of weight with a broad swath of the electorate, while Trump’s was viewed as appealing deeply to a few fervent but narrow fringe constituencies without enough voters for him to win. After the fact, Trump is described as having had “perfect pitch” and Clinton as having a “tin ear.”  In particular, now it’s considered to have been a big mistake for Clinton to fail to address the concerns of white men and set out a solution for those who lost jobs and were omitted from economic progress. But during the campaign, no one pointed to this error. * It should be noted – to his credit – that Silver insisted repeatedly that Trump could win.

” Its thrust was that (a) history tends to repeat, (b) thus my memos often return to the same topics and (c) if I’ve handled them well in the past, rather than re-invent the wheel, I might as well borrow from what I’ve written before. Ergo, “ditto.” Few topics are more susceptible to this treatment than the process through which (a) investment fundamentals fluctuate cyclically; (b) investors overreact to the fluctuations; (c) the level of risk aversion incorporated in investor behavior fluctuates between excessive and inadequate; and thus (d) market conditions swing from depressed to elevated and treacherous. Here’s how I summed up on this topic in “There They Go Again” (May 2005): Given today’s paucity of prospective return at the low-risk end of the spectrum and the solutions being ballyhooed at the high-risk end, many investors are moving capital to riskier (or at least less traditional) investments. But (a) they’re making those riskier investments just when the prospective returns on those investments are the lowest they’ve ever been; (b) they’re accepting return increments for stepping up in risk that are as slim as they’ve ever been; and (c) they’re signing up today for things they turned down (or did less of) in the past, when the prospective returns were much higher. This may be exactly the wrong time to add to risk in pursuit of more © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

The person who said “there is no better or worse time” was on TV with me, giving me a chance to push back. What he meant, he said, was that the vast majority of people lack the ability to discern where we stand in this regard, so they might as well not try. I agree that it’s hard. Up-and-down cycles are usually triggered by changes in fundamentals and pushed to their extremes by swings in emotion. Everyone is exposed to the same fundamental information and emotional influences, and if you respond to them in a typical fashion, your behavior will be typical: pro-cyclical and painfully wrong at the extremes. To do better – to succeed at being contrarian and anti-cyclical – you have to (a) have an understanding of cycles, which can be gained through either experience or studying history, and (b) be able to control your emotional reaction to external stimuli. Clearly this isn’t easy, and if average investors (i.e., the people who drive cycles to extremes) could do it, the extremes wouldn’t be as high and low as they are. But investors should still try. If they can’t be explicitly contrarian – doing the opposite at the extremes (which admittedly is hard) – how about just refusing to go along with the herd?

Here’s what I wrote with respect to the difficulty of doing this in “On the Couch” (January 2016): I want to make it abundantly clear that when I call for caution in 2006-07, or active buying in late 2008, or renewed caution in 2012, or a somewhat more aggressive stance here in early 2016, I do it with considerable uncertainty. My conclusions are the result of my reasoning, applied with the benefit of my experience (and collaboration with my Oaktree colleagues), but I never consider them 100% likely to be correct, or even 80%. I think they’re right, of course, but I always make my recommendations with trepidation. When widespread euphoria and optimism cause asset prices to meaningfully exceed intrinsic values and normal valuation metrics, at some point we must take note and increase caution. And yet, invariably, the market will continue to march upward for a while to even greater excesses, making us look wrong. This is an inescapable consequence of trying to know where we stand and take appropriate action. But © 2017 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.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: These days the news media shows little resemblance to what it was 30, 40 or 50 years ago. Many outlets are highly biased to one side or the other and make it possible to read, watch and listen all day and never be exposed to all aspects of the issues. Thus most people find something to complain about in the media coverage of the 2016 presidential election. Today’s media personalities rarely express the confusion Murrow did. Rather, they tend to state forecasts as certainties. When do you hear a TV commentator say “I think” or “it seems to me”? In fact, they often remind me of the description of economists I heard in the 1970s: “portfolio managers who never mark to market.” That is, they find it easy to overlook the times when they’re wrong. In August or September of 2015, when Donald Trump was beginning to achieve success in his pursuit of the Republican nomination, a New York Times columnist flatly stated that because Trump couldn’t stand the prospect of losing, he would drop out of the race before the primaries began in January. We didn’t see that happen . . . or any further mention of his assertion. What to Do About the Media Given the nature of the candidates for the presidency, the starkness of the choice, and the recent trends in media coverage, I spent a great deal of time last year following political developments via websites, newspapers and television coverage.

It prompted me to sit down with people ranging from some of my Oaktree colleagues to Steven Bregman and Murray Stahl of Horizon Kinetics (my July memo incorporated some of Steven’s observations on ETFs), and I learned that I’ve been looking at Bitcoin the wrong way. In particular, I realized that the memo incorporated the wrong joke from my father; instead of “the half-million-dollar hamster,” it should have been this one: Two friends meet in the street, and Jim tells Sue he has some great sardines for sale. The fish are pedigreed and pure-bred, with full papers and high IQs. They were individually de-boned by hand and packed in the purest virgin olive oil. And the label was painted by a world-renowned artist. Sue says, “That sounds great. I could use a tin. How much are they?” and Jim tells her they’re $10,000. Sue responds, “That’s crazy, who would eat $10,000 sardines?” “Oh,” says Jim, “these aren’t eating sardines; these are trading sardines.” I had been thinking about digital currencies like Bitcoin as investing sardines, and that may have been a mistake. Their fans tell me they’re spending sardines, and while that may be the case, I think at the moment they’re being treated largely as trading sardines. The question remains open as to whether Bitcoin is (a) a currency, (b) a payment mechanism, (c) an asset class, or (d) a medium for speculation. The main complaint expressed in my memo was as follows: © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us:  Eight of the eleven pickers were right more than half the time. But since it costs about 5% per week on average to bet with the bookies, virtually none of the eleven experts’ overall picks added value after fees (sound familiar?) Even the average of the experts’ “best bets” wouldn’t have produced a positive return after fees. Two additional observations:  In week 16, all eleven of the experts predicted the favored New York Giants would beat the Philadelphia Eagles, and five of the eleven thought the underdog New York Jets would beat the New England Patriots (in both cases, after adjusting the scores for the “point spread” that the bookies impose to equalize the two teams’ chances of winning). When the games were played, the favored Giants lost by five points (meaning they did even worse after the 2½- point spread was subtracted from their score), and the Jets (who were expected to lose by 16½ points) lost by 38 instead. In other words, (a) the experts may have been heavily biased in favor of the New York teams and (b) they were wrong 73% of the time on these two games.  Bettors also have the option to bet on the “over/under” in a game – that is, whether the two teams’ combined score will exceed or fall short of a threshold set by the bookies. It’s just another way for bettors to get “action.” The results show the experts were right in 128 games (52% of the time) and wrong in 123 (there were five ties).

Again no value added, especially after fees. If economists won’t publish their performance data, the Post at least performs a service by showing how its football experts did. The bottom line is that their opinions are of little help, and the related coverage omits all discussion of their lack of predictive value. The Importance of the Macro Interest in “macro” has amped up meaningfully over the last dozen years or so. I think it largely started with the increased activism on the part of the Greenspan Fed, and investors’ heightened interest in it. Today many analysts seem preoccupied with central bank behavior, government actions, trends in interest rates and currencies, and the movement of markets, as opposed to the fortunes of individual companies. These things are almost all we hear about. And most people think knowledge regarding the outlook for them holds the key to investment success. Thus I want to make this a major topic here. Since I speak a lot to clients, prospects, CFA societies and student groups, I get a lot of chances to hear what’s on people’s minds. And usually they focus on a relatively small number of questions. Over the last few years, the ones I’ve gotten most often have been these:  What month will the Fed raise interest rates?  What could go wrong in the economy or the market?  What inning are we in?  And in each country I visit, how’s the outlook for that country? © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

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.

Again” are at work in the Bitcoin surge: (a) there is a grain of underlying truth as set out above; (b) there’s the prospect of a virtuous circle: widespread demand will lead to wider acceptance as legal tender, which will lead to widespread demand; and (c) thus this tree may grow to the sky, as there is no obvious limit to this logic. None of these things necessarily make Bitcoin a mistake. They merely say elements that contributed to past bubbles can be detected today with regard to Bitcoin.  Finally, Bitcoin isn’t alone. There are hundreds of digital currencies already – including eleven with market capitalizations over a billion dollars – and no limits on the creation of new ones. So even if digital currencies are here to stay, who knows which one will turn out to be the winner? Hundreds of e-commerce start-ups appreciated rapidly in the tech bubble based on the premise that “the Internet will change the world.” It did, but most of the companies ended up worthless. © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

However, I can report that the concerns discussed above have caused us to begin an internal process to develop guidelines intended to mitigate the risks of subscription lines while preserving their benefits. The key to financial security – individual or societal – doesn’t lie in counting on things to work in good times or on average. Rather, it consists of figuring out what can go wrong in bad times, and of only doing things that will prove survivable even if they materialize. Has anyone thought through all the implications of closed-end funds’ increasing use of subscription lines? Are they all tolerable, for the individual parties and for the financial system? I haven’t read much on this subject, but we should all be thinking about it. That’s the reason I’m writing today. April 18, 2017 © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Thanks to the people who took the time to educate me, I’m a little less of a dinosaur regarding Bitcoin than I was when I wrote my last memo. I think I understand what a digital currency is, how Bitcoin works, and some of the arguments for it. But I still don’t feel like putting my money into it, because I consider it a speculative bubble. I’m willing to be proved wrong. Passive Investing Passive investing can be thought of as a low-risk, low-cost and non-opinionated way to participate in “the market,” and that view is making it more and more popular. But I continue to think about the impact of passive investing on the market. One of the most important things to always bear in mind is George Soros’s “theory of reflexivity,” which I paraphrase as saying that the efforts of investors to master the market affect the market they’re trying to master. In other words, how would golf be if the course played back: if the efforts of golfers to put their shot in the right place caused the right place to become the wrong place? That’s certainly the case with investing. It’s tempting to think of the investment environment as an unchanging backdrop, that is, an independent variable. Then all you have to do is figure out the right course of action and take it. But what if the environment is a dependent variable? Does the behavior of investors alter the environment in which they work? Of course it does.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: You might have thought this would be a hard thing to sell. After all, Argentina had defaulted on its debts eight times in its 200-year history, with no fewer than five defaults in the past century alone, most recently in 2014 amid a legal dispute with the Elliott hedge fund. . . . But investors do not seem to care: there were $9.75bn of bids. And Argentina is not the only peculiar event in bond markets this month. Take a look, for example, at Ivory Coast. In recent weeks, this West African nation underwent yet another military uprising. But this month it sold 16-year bonds with a 6.25 per cent yield – and these were also heavily oversubscribed. Places such as Senegal and Egypt have also seen hot demand for their debt. (Financial Times, June 27) To conclude on this subject, I can’t resist citing (but am too polite to name) the head of research and strategy for a likewise-unnamed broker/investment bank: “It’s just shocking that they exit default and their bond issue is a century bond,” said [Ms. X]. . . Nevertheless, she is advising her clients to buy the bonds as at least a short term trade. Let me get this straight: it’s incredible that Argentina is able to issue this thing, but it’s a good buy for a moment. It’s a sign of the times: “something may go wrong, but probably not soon.

But there is one course of action – one classic mistake – that I most strongly feel is wrong: reaching for return. The events of 2007 and 2008 showed this observation to have been prudent and appropriate. And given today’s similarities to the last cycle, I think it’s applicable again. Here’s a great observation on the subject from Berkshire-Hathaway’s 2010 letter to shareholders: We agree with investment writer Ray DeVoe’s observation, “More money has been lost reaching for yield than at the point of a gun.” Or as Peter Bernstein put it, “The market is not an accommodating machine; it won’t give you high returns just because you need them.” The key strategic decision for anyone shaping investment strategy is whether to apply aggressiveness or defensiveness at a given point in time. In other words, should we worry more today about losing money or about missing opportunity? The answer at all times depends on what’s available in the investment environment.  I have no doubt that the ascent to the apex from which the Global Financial Crisis took place was powered by the willing acceptance of risk in the low-return world of 2004-07. In other words, excessive risk tolerance and the resulting incautious behavior provided the foundation for the vast losses experienced in the move from peak to trough.

” The duration, pace, amplitude and details of each investment cycle are different from those of its predecessors, but the basic themes and essential ingredients are usually vaguely familiar. What Twain calls rhyming history I describe as “common threads.” The themes or threads that repeatedly characterize too-bullish markets are the ones listed on page 4. While they don’t all have to be present for a top, bull market or boom to form, (a) usually many are present when one does and (b) it’s hard for a full-throated bubble to come into existence without them. They truly are the raw materials for market excesses on the upside. On the other hand, the keys to avoiding the classic mistakes also recur, and I listed them in “There They Go Again”:  awareness of history,  belief in cycles rather than unabated, unidirectional trends,  skepticism regarding the free lunch, and  insistence on low purchase prices that provide lots of room for error. Adherence to these things – all parts of the canon of defensive investing – invariably will cause you to miss the most exciting part of bull markets, when trends reach irrational extremes and prices go from fair to excessive. But they’ll also make you a long-term survivor. I can’t help thinking that’s a prerequisite for investment success. The checklist for market sanity and safety is simple, and the answers will tell you what to do: © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: Political Reality My last memo, in May, was on the subject of “Economic Reality.” Its goal was to describe the realities imposed by economics and point out the many ways in which governments and, especially, candidates for elected office ignore and promise to override them. Since then I have been struck by the way developments have moved economic reality to center stage. Of course, foremost among them has been the affirmative vote of June 23 on Brexit: whether the United Kingdom should leave the European Union. I have no interest in writing a memo about Brexit itself. There’s a huge number of moving parts, too little past experience, too many varying opinions, and zero clarity on how the departure will be handled. There are many pundits out there telling us what the consequences of Brexit will be. The only thing I’m sure of is that most of them are wrong, and if I were to join their ranks, I’d probably be wrong, too. Economic Reality: Choices and Consequences The May memo described the ways in which economics defines and constrains reality in business, investing and everyday life. Economics establishes the rules of the game and the boundaries of the playing field, and these things can’t be ignored. They can be altered, but not without consequences. The realities of economics are stark and consistent, but also logical.

This is one of the biggest mistakes you can make. As Ben Graham pointed out, the day-to-day market isn’t a fundamental analyst; it’s a barometer of investor sentiment. You just can’t take it too seriously. Market participants have limited insight into what’s really happening in terms of fundamentals, and any intelligence that could be behind their buys and sells is obscured by their emotional swings. It would be wrong to interpret the recent worldwide drop as meaning the market “knows” tough times lay ahead. The rest of this memo will be about fleshing out this theme (meaning you can stop reading here if you’ve had enough or are short on time). The Nature of Consensus Opinion I based the above reference to Ben Graham on his famous observation that in the long run the market’s a weighing machine, but in the short run it’s a voting machine. In other words, in the long term the consensus of investors figures out what things are really worth and moves the price there. But in the short term, the market merely reflects consensus opinion regarding an asset’s future popularity, something that’s highly susceptible to the ups and downs of psychology. So, what does the market know? First it’s important to understand for this purpose that there really isn’t such a thing as “the market.” There’s just a bunch of people who participate in a market. The market isn’t more than the sum of the participants, and it doesn’t “know” any more than their collective knowledge.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: interprets everything negatively. The market often fails to act rationally in the short run, primarily because of the role played by people in determining its course. Thus two key observations can be made based on last week’s developments:  First, no one really knows what events are going to transpire.  And second, no one knows what the market’s reaction to those events will be. These observations reinforce my belief that it’s a mistake to base investment decisions on macro forecasts. But you knew that. Impact on the Markets Of course there’s logic to the market’s rise last week, just a logic different from that which would have made it go up if Clinton had won. The reasons one might cite are these:  As a businessman, Trump doubtless intends to be a pro-business president. In fact, he’ll probably make more of an effort to nurture business than Clinton would have (especially when being pushed to the left by Sanders and Elizabeth Warren), and more than I think characterized the Obama administration.

We want to buy things whose price underestimates the value of the underlying assets or earnings (value investing) or the future potential (growth investing). In either case, we’re looking for instances when the market is wrong. If we thought the market was always right – the efficient market hypothesis – we wouldn’t spend our lives as active investors. Since we do, we’d better believe we know more than the consensus. So by definition we must not think the market – that is, the sum of all other investors – knows everything, or knows more than we do, or is always right. That’s point number two. And that leads logically to point number three: why take instruction from a group of people who know less than you do? In “On the Couch,” I wrote that it all seems obvious: investors rarely maintain objective, rational, neutral and stable positions. Do you agree with that or not? Is the market a clinical and rational fundamental analyst, or a barometer of investor sentiment? Does the market’s behavior these days look like something a mature adult should emulate? It seems clear to me: the market does not have above average insight, but it often is above average in emotionality. Thus we shouldn’t follow its dictates. In fact, contrarianism is built on the premise that we generally should do the opposite of what the crowd is doing, especially at the extremes, and I prefer it. A Case in Point – The Crash of 2008 The year 2008 culminated in the greatest panic I’ve ever seen.

They contacted Schlesinger, and he listened attentively as they recounted their experience: they had, in fact, been able to acquire vast amounts of wood for $50 a cord, and they’d been able to sell all they had for $40 a cord. How could they be broke? Where had they gone wrong? Schlesinger puffed on his ever-present pipe and said: “The answer’s obvious: you need a bigger truck.” * * * While it certainly wasn’t the case with Schlesinger (despite what the above tale suggests), most ordinary citizens don’t have what it takes to figure out what is and isn’t economically feasible. Since we’re in the midst of election season, with promises of cures for our economic woes being thrown around, this seems like a particularly appropriate time to explore what can and can’t be achieved within the laws of economics. Those laws might not work 100% of the time the way physical laws do, but they generally tend to define the range of outcomes. It’s my goal here to point out how some of the things that central banks and governments try to do – and election candidates promise to do – fly in the face of those laws. * * * When I was in high school, one of my buddies convinced me to take a class in accounting. I found the double-entry bookkeeping we learned to be logical, symmetrical and unambiguous. After accounting I moved on to economics, and I found it equally logical. The die was cast for my career in business.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: today, preferring to put off the possible consequences until tomorrow (they seem to assume tomorrow will never come – see page 4). This is a very practical stratagem, since elected officials often leave office well before consequences appear, and at any rate, there’s no consolation prize for losing an election, so a candidate might as well do everything he can to win.  Potential consequences are often overlooked or not understood. Of course, the ramifications of a Brexit referendum couldn’t be known in 2013; even now in 2016 no one knows what they’ll be, although the decision to leave is a fait accompli. It was a glaring error to leave a decision of this importance and permanence up to a simple majority of those going to the polls. The referendum could have been structured so that a decision to leave required a supermajority of those voting, or a majority of registered voters (whether they voted or not). Since neither of these was required, the decision was made to take the UK out of the EU – possibly tearing the country asunder (e.g., Scotland may well secede from the UK, since it was tempted to do so before and strongly wishes to be part of the EU) – because 37% of registered voters said that’s what they wanted (whereas 35% voted to Remain and the other 28% didn’t vote).  The decision was likely influenced by factual inaccuracies and false promises.

Some compared it to the “China Syndrome”: a 1979 movie with Jane Fonda and Michael Douglas in which an out-of-control nuclear reaction threatens to propel reactor components through the earth’s core, from the U.S. to China. Thus the stock of panic-ridden Morgan Stanley (for example) fell 82%, to less than $10. But it’s important to note that the negative feedback loop described above was able to continue without reference to – and not necessarily in reasonable relationship to – actual developments at the banks or changes in their intrinsic value. Eventually, however, the Treasury restricted short selling in the stocks of 19 financial institutions deemed “systemically important.” Morgan Stanley secured a $9 billion injection of convertible equity from Mitsubishi UFJ Financial Group. The panic subsided. The economy and capital markets recovered. And Morgan Stanley’s stock traded at $33 a year later. Do you wish you had taken the market’s instruction in 2008 and sold bank stocks? Or do you wish you had rejected its advice and bought instead? In short, did the market know anything? There are three possible answers:  The market was flat wrong in 2008 when it took Morgan Stanley’s stock so low.  The market was right; it properly reflected the possibility of a meltdown that could have happened but didn’t.  The market was wrong in the case of Morgan Stanley in 2008, but most of the time it isn’t. I like the first, and the second is appealing as well.

“If it wasn't for the messy conflict of rates rising with the stronger economic growth through [fiscal] policy, I would think there's so much low-hanging fruit in terms of deregulation and tax reform, we could get a jolt of 4 percent [growth] for about 18 months," he said. "I do think interest rates could cut that back into the high 2s, low 3s [percent]," he continued, adding markets are pointing to the cost of borrowing money going up a lot. "I think the market is going to force this. The market is going to push them to raise interest rates if my hopeful scenario turns out to be right." (CNBC on-line) I usually inveigh against macro forecasting and macro investing, but Stan is the exception who proves I’m far from 100% right. I supply his words unabridged. No one should ignore them. Why Were the Forecasters So Wrong? Trump won in 30 states, whereas Clinton won in 20 states and the District of Columbia. Trump won in three states that were expected to go for Clinton plus the two largest of the three states rated “toss- ups,” while Clinton didn’t upset Trump in any of the states people expected him to win. Trump won vastly more counties than Clinton (although not the most populated, obviously), including those populated by both below-average and above-average incomes. Many of these things came as surprises. © 2016 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Here’s how I explained it in “It’s Not Easy,” published in September on the heels of the events in China: Especially during downdrafts, many investors impute intelligence to the market and look to it to tell them what’s going on and what to do about it. This is one of the biggest mistakes you can make. As Ben Graham pointed out, the day-to-day market isn’t a fundamental analyst; it’s a barometer of investor sentiment. You just can’t take it too seriously. Market participants have limited insight into what’s really happening in terms of fundamentals, and any intelligence that could be behind their buys and sells is obscured by their emotional swings. It would be wrong to interpret the recent worldwide drop as meaning the market “knows” tough times lay ahead. Rather, China came out with some negative news and people panicked, especially Chinese investors who had © 2016 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Not really. Trump didn’t win the popular vote as USC predicted; he lost it (by just under half a percent). Thus you can’t say USC had it right. They were wrong. Or rather, they were right about a Trump victory, but for the wrong reason. (How often do we see that in the investment world?) In the end, who was more right: USC (which said he would win the popular vote) or the others (who were correct in saying Clinton would win it – only to see her lose the election)? That’s what I would call a Talebian question. The bottom line is that popular vote polls get headlines, but the presidency is determined in the Electoral College. The latter made Trump the winner – as USC had said, but not for the reason it had predicted. (More on the Electoral College later.) Outlook for the Trump Presidency I was in Australia on Election Day, and right away I was asked what the future holds. First, I said, there’s far too much we don’t know to permit any conclusions. Here are a few of the key open questions:  How much of what Trump said while campaigning did he mean?  How much of what he actually meant will he try to implement?  And how much of what he tries to implement will he be able to effect?  Will he seek advice? (While campaigning he gave the impression he thinks he knows best.)  Will he appoint expert, experienced advisors?  Will he heed their advice? Second, I’d look for some initial signs.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: medium” and rather little in the range of reasonableness. First there’s denial, and then there’s capitulation. The Sources of Error To explain why these bipolar episodes occur, I want to spend a little time on some of the factors behind investor psychology. For the most part they’re easily observed and dissected, and not mysterious. I discussed some of them in “It’s Not Easy”: Emotion is one of the investor’s greatest enemies. Fear makes it hard to remain optimistic about holdings whose prices are plummeting, just as envy makes it hard to refrain from buying the appreciating assets that everyone else is enjoying owning. Confidence is one of the key emotions, and I attribute a lot of the market’s recent volatility to a swing from too much of it a short while ago to too little more recently. The swing may [result] from disillusionment: it’s particularly painful when investors recognize that they know far less than they had thought about how the world works. It’s important to remain moderate as to confidence, but instead it’s usually the case that confidence – like other emotions – swings radically. While China was the “proximate cause” of the recent volatility, other things often contribute, and last month was no exception. The word that always comes to mind for me is “confluence.” Investors can usually keep their heads in the face of one negative.

But when they face more than one simultaneously, they often lose their cool. One additional negative last month was the glitch in Bank of New York Mellon’s SunGard software, and the bank’s consequent inability to price 1,200 mutual funds and ETFs that it administers. It was another dose of disillusionment: no one enjoys learning that the market mechanisms they need to work can’t be depended on. Another area of error – be it the result of flawed perception or inadequate insight and analysis – can be seen in investors’ repeated failure to understand the potential for ramifications and second- order consequences. One instance was the general lack of concern about contagion from sub-prime mortgage backed securities that prevailed between early 2007 – when mortgages began to default in large numbers – and the tumultuous events of mid/late 2008. Most people overlooked the potential for contagion, and thus (for example), as of May 2008 the S&P 500 was essentially unchanged from the first quarter of 2007. Yet sub-prime mortgage defaults contributed significantly to the subsequent bank collapses and bailouts, the bankruptcy filing of Lehman Brothers, and the late-2008 emergence of fear of a financial system meltdown. As a consequence, between May 2008 and March 2009 the S&P lost 52%. The events that produced such extreme distress in late 2008 and early 2009 were unforeseen and unimagined just a few months before . . . even though the clues had been there for a year.

There are many more ways in which non-objective, non-rational quirks commonly affect behavior. As Carol Tavris points out in her May 15, 2015 Wall Street Journal review of Professor Thaler’s book: As a social psychologist, I have long been amused by economists and their curiously delusional notion of the “rational man.” Rational? Where do these folks live? Even 50 years ago, experimental studies were demonstrating that people stay with clearly wrong decisions rather than change them, throw good money after bad, justify failed predictions rather than admit they were wrong, and resist, distort or actively reject information that disputes their beliefs. © 2016 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: * * * I want to end by making one thing completely clear. I’m not saying the market is never right when prices go down (or up). I’m merely saying the market has no special insight and conveys no consistently helpful message. It’s not that it’s always wrong; it’s that there’s no reason to presume it’s right. It is the goal of some investors to sell on declines when the subsequent movements will be down, but “buy the dips” when the subsequent movements will be up. If you think you can tell which is which from watching the market movements themselves, then we – again – have a fundamental disagreement. Future price movements can only be predicted on the basis of the relationship between price and fundamentals. And, given the market’s short-term volatility and irrationality, this can only be done in the long-term sense. The market has nothing useful to contribute on this subject. January 19, 2016 © 2016 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Case In Point – Interest Rates The FT also pointed out that investors were reacting to the likelihood the Fed would raise interest rates, even though that should have been a foregone conclusion: Next week, the Federal Reserve will raise interest rates. That at least now appears likely. Anything else would be the biggest shock of a year in which markets and monetary authorities have had serious misgivings. Let us assume for now that it happens. This will be the longest-awaited and most-previewed tightening of monetary policy in history. There’s something wrong if an event that has been widely anticipated for years – and considered a near certainty for months – can be thought capable of significantly impacting the market when it becomes a fact. People’s expectations should be incorporated into the prices they assign to assets. So a negative reaction to the imminence of a widely heralded interest-rate increase must imply that either (a) investors are too dense to have incorporated it into prices before this, (b) the increase will be a bigger deal than people thought, or (c) the market is irrational. On December 15, Dow Jones published the following quote: “It’s been more shoot first, ask questions later” in the shares of large asset managers, said Kenneth Hill, an analyst at Barclays PLC. “The concern is largely that as rates move higher, investors think returns will move lower and there will be some rotation out of fixed income.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: financing,” now it’s hard for companies – especially those experiencing any degree of difficulty – to obtain capital. On December 7, Oaktree held a dinner in New York for equity analysts who follow our publicly traded units. Bob O’Leary, a co-portfolio manager of our distressed debt funds, planned to be among the hosts. But he called me on December 3 with a question I hadn’t heard in a long time from my distressed debt colleagues: “Would you mind if I don’t come? There’s too much going on for me to leave the office.” The change in investor attitudes had created investment opportunities where they hadn’t existed just a few months before – in some cases out of proportion to the change in fundamentals. Developments like these are indicative of rising pessimism, skepticism and fear. They’re largely what Oaktree hopes for, since – everything else being equal – they make for vastly improved buying opportunities. But note that we may be just in the early stages of a downward spiral in corporate performance and credit market behavior. Thus, while this may be “a time” to buy, I’m far from suggesting it’s “the time.” My Prescription To help investors deal with their potential for “human error,” this shrink would prescribe a number of elements that can help with the task:  The first essential element in coping with markets’ irrationality is understanding.

The importance of psychology and its influence on markets must be recognized and dealt with.  The second key lies in controlling one’s emotions. An investor who is as subject as the crowd to emotional error is unlikely to do a superior job of surviving the markets’ swings. Thus it is absolutely essential to keep optimism and fear in the appropriate balance.  Emotional self-control isn’t enough. It’s also important to have control over one’s circumstances. For professionals, that primarily means structuring one’s environment so as to limit the impact on them of other people’s emotional swings. Examples include inflows to and outflows from funds, fluctuations in market liquidity, and pressure for short-term performance. At Oaktree we never fail to appreciate the benefit we enjoy from being able to reject “hot money” and limit our funds’ redemption provisions.  And finally there’s contrarianism, which can convert other investors’ emotional swings from a menace into a tool. Going beyond just fending off emotional fluctuation, it’s highly desirable to become more optimistic when others become more fearful, and vice versa. I’m lucky to have received many gifts of investment insight early in my career. Perhaps foremost among them is one I picked up in New York about 40 years ago, at a lunch meeting of what we called the Third Thursday Group.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: * * * I wrote this memo to explain what happened in the UK this year and what I think is happening in the U.S. I wanted to point out that politics rarely hews to economic reality; rather, it has a reality all its own. The recent trends in income, wealth, trade and employment are causing a lot of dissatisfaction in the U.S. and Europe, and I expect them to have a strong impact on politics for years to come. Widespread economic dislocation can cause voters to choose the wrong leaders. The U.S. is not exempt, and we must be highly vigilant in this regard. August 17, 2016 P.S.: Some readers may feel it’s wrong for me to make any statements regarding the presidential candidates, and to criticize what I see as Trump’s take on economic issues. Others may simply disagree with my views – but they are my views, and I hope you’ll feel I have the right to express them. I’ve tried hard to stick to matters of economics and fact, rather than non-economic policy or programs, opinion or personal preference. I’m sorry if my statements cause unhappiness. Anyone who takes factual issue with anything I say here is welcome to let me know. © 2016 Oaktree Capital Management, L.P. All Rights Reserved.

For them to be truly liquid in this latter sense, one has to be able to move them promptly and without the imposition of a material discount. Liquidity Characterized I often say many of the important things in investing are counter-intuitive. Liquidity is one of them. In particular, it’s probably more wrong than right to say without qualification that something is or isn’t “liquid.” If when people ask whether a given asset is liquid they mean “marketable” (in the sense of “listed” or “registered”), then that’s an entirely appropriate question, and answering it is straightforward. Either something can be sold freely to the public or it can’t. But if what they want to know is how hard it will be to get rid of it if they change their mind or want to take a profit or avoid a possible loss – how long it will take to sell it, or how much of a markdown they’ll have to take from the last price – that’s probably not an entirely legitimate question. It’s often a mistake to say a particular asset is either liquid or illiquid. Usually an asset isn’t “liquid” or “illiquid” by its nature. Liquidity is ephemeral: it can come and go. An asset’s liquidity can increase or decrease with what’s going on in the market. One day it can be easy to sell, and the next day hard. Or one day it can be easy to sell but hard to buy, and the next day easy to buy but hard to sell. In other words, the liquidity of an asset often depends on which way you want to go . . .

© Oaktree Capital Management, L.P. All Rights Reserved find your position is highly liquid: you can sell it quickly, and at a price equal to or above the last transaction. But if you want to sell when everyone else wants to sell, you may find your position is totally illiquid: selling may take a long time, or require accepting a big discount, or both. If that’s the case – and I’m sure it is – then the asset can’t be described as being either liquid or illiquid. It’s entirely situational. There’s usually plenty of liquidity for those who want to sell things that are rising in price or buy things that are falling. That’s great news, since much of the time those are the right actions to take. But why is the liquidity plentiful? For the simple reason that most investors want to do just the opposite. The crowd takes great pleasure from buying things whose prices are rising, and they often become highly motivated to sell things that are falling . . . notwithstanding that those may be exactly the wrong things to do. Further, the liquidity of an asset is very much a function of the quantity involved. At a given time, a stock may be liquid if you want to sell a thousand shares but highly illiquid if you want to sell a million. If so, it can’t be said categorically that the stock is either liquid or illiquid. But people do it all the time. Investment managers are often asked how long it would take to liquidate a given portfolio.

© 2015 Oaktree Capital Management, L.P. All Rights Reserved  He was regularly among the catchers with the fewest passed balls and errors committed.  He had around 450-650 at bats most years, but over his entire career he averaged only 24 strikeouts per year, and there was never one in which he struck out more than 38 times. (In 1950 he did so only 12 times in nearly 600 at bats.) Thus, ten times between 1948 and 1959 he was among the ten players with the fewest strikeouts per plate appearance. In short, Yogi rarely messed up. Consistency and minimization of error are two of the attributes that characterized Yogi’s career, and they can also be key assets for superior investors. They aren’t the only ways for investors to excel: some great ones strike out a lot but hit home runs in bunches the way Reggie Jackson did. Reggie – nicknamed “Mr. October” because of his frequent heroics in the World Series – was one of the top home run hitters of all time. But he also holds the record for the most career strikeouts, and his ratio of strikeouts to home runs was four times Yogi’s: 4.61 versus 1.16. Consistency and minimization of error have always ranked high among my priorities and Oaktree’s, and they still do. Yogi Berra, Philosopher Although Yogi was one of the all-time greats, his baseball achievements may be little-remembered by the current generation of fans, and few non-sports lovers are aware of them.

The bottom line is that it can be wrong to assume it’ll be easy and painless to get out of your holdings, and especially to exit a position after its price has begun to drop. Liquidity and Opportunities We watch TV, listen to radio or read newspapers. I’m always amused when the pundits say, “stocks went up today because several companies beat analysts’ earnings forecasts” or “the market dropped because of increased uncertainty regarding the price of oil.” How do they know? Where do buyers or sellers register their motivations, such that the media can discern them so definitively? There’s only one indisputable explanation for why the market went up on a given day: there were more buyers than sellers. When buyers have greater influence in the market than sellers – because would-be © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

But also how error-prone, in that it ignores the possibility that a company with a good product can have a bad business; the good product can become obsolete; or the stock can be priced too high to be a good investment. On the other hand, second-level thinkers double-think (and triple-think) every angle of every situation. A good example can be seen in the hypothetical newspaper contest John Maynard Keynes wrote about in 1936. Readers would be shown 100 photos and asked to choose the six prettiest girls, with prizes going to the readers who chose the girls readers voted for most often. Naive entrants would try to win by picking the prettiest girls. But note that the contest would reward the readers who chose not the prettiest girls, but the most popular. Thus the road to winning would lie not in figuring out which were the prettiest, but in predicting which girls the average entrant would consider prettiest. Clearly, to do so, the winner would have to be a second-level thinker. (The first-level thinker wouldn’t even recognize the difference.) Wikipedia points out that one vying to win the contest might go beyond this distinction: This can be carried one step further to take into account the fact that other entrants would each have their own opinion of what public perceptions are. Thus the strategy can be extended to the next order and the next and so on, at each level attempting to predict the eventual outcome of the process based on the reasoning of other agents.

But when the goal, as it is in investing, is to outdo other people in a largely mental pursuit involving a lot of psychology – while they’re trying to do the same to you – the challenge is much more complex. The investor’s basic goal of buying desirable assets at fair prices is sensible and straightforward. But the deeper you look, the more you see how many aspects of successful investing are counterintuitive and how much of what seems obvious is wrong. There’s a lot more that matters, of course, but these realizations are key. The Things Everyone Likes The most outstanding characteristic of first-level thinkers – and of the investing herd – is that they like things with obvious appeal. These are the things that are easy to understand and easy to buy. But that’s unlikely to be the path to investment success. Here’s how I put it in “Everyone Knows” (April 2007): © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved What’s clear to the broad consensus of investors is almost always wrong. First, most people don’t understand the process through which something comes to have outstanding moneymaking potential. And second, the very coalescing of popular opinion behind an investment tends to eliminate its profit potential. Take, for example, the investment that “everyone” believes to be a great idea. In my view by definition it simply cannot be so.  If everyone likes it, it’s probably because it has been doing well. Most people seem to think outstanding performance to date presages outstanding future performance. Actually, it’s more likely that outstanding performance to date has borrowed from the future and thus presages sub-par performance from here on out.  If everyone likes it, it’s likely the price has risen to reflect a level of adulation from which relatively little further appreciation is likely. (Sure it’s possible for something to move from “overvalued” to “more overvalued,” but I wouldn’t want to count on it happening.)  If everyone likes it, it’s likely the area has been mined too thoroughly – and has seen too much capital flow in – for many bargains to remain.  If everyone likes it, there’s significant risk that prices will fall if the crowd changes its collective mind and moves for the exit. Superior investors know – and buy – when the price of something is lower than it should be.

© 2015 Oaktree Capital Management, L.P. All Rights Reserved By the time December 28 had rolled around, the eleven forecasters had tried to predict the winner of each of the 237 games that had been played to date, as well as what they thought were their 47 or so “best bets.” By “the winner,” I assume they meant the team that would win net of the bookies’ “point spread.” (Without doing something to even the odds, it would be too easy for bettors to win by backing the favorites. To make betting more of a challenge, the bookies establish a spread for each game: the number of points by which the favored team has to beat the underdog in order to be deemed the winner for betting purposes.) How often were the Post’s picks correct? Here’s the answer: Percentage correct Total picks (2,607 games) Best bets (522 games) All forecasters 50.9% 49.4% Median forecaster 50.6 47.9 Best forecaster 58.5 56.2 Worst forecaster 44.8 39.6 An incorrigible optimist – or perhaps the Post – might say these results show what a good job the forecasters did as a group, since some were right more often than they were wrong. But that’s not the important thing. For me, the key conclusions are these:  The average results certainly make it seem that picking football winners (net of the points spread) is just a 50/50 proposition. Evidently, the folks who establish the point spreads are pretty good at their job, so that it’s hard to know which team will win.

And the price of an investment can be lower than it should be only when most people don’t see its merit. Yogi Berra is famous for having said, “Nobody goes to that restaurant anymore; it’s too crowded.” It’s just as nonsensical to say, “Everyone realizes that investment’s a bargain.” If everyone realizes it, they’ll have bought, in which case the price will no longer be low. So the things with the most obvious merit become the things that everyone likes. They’re also likely to be the things that are most hotly pursued and most highly priced, and thus least promising and most treacherous. What are some examples? When I first showed up for work in First National City Bank’s investment research department in 1968, the bank was investing heavily in the “Nifty Fifty”: the stocks of America’s best, fastest growing companies. Since these were companies where nothing could go wrong, the official dictum said it didn’t matter much what price you paid. It didn’t seem unreasonable to pay p/e ratios of 80 or 90 given these companies’ growth rates. But it turned out that the price you pay does matter, and 80-90 times earnings had been too high. Thus, when the market ran into trouble in the early 1970s, many of these stocks lost the vast majority of their value, and investors learned the hard way that it’s possible to like a good thing too much.

Unsurprisingly, it also turned out that predictions of a flawless future can be wrong, as once-dominant companies such as Kodak, Polaroid and Xerox eventually went bankrupt or required turnarounds. Roughly ten years ago, everyone was gaga over real estate, especially residential. This was underpinned by some bits of “accepted wisdom” that seemed compelling, such as “you can always live in it,” “home © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved prices always go up” and “real estate is a hedge against inflation.” Conservative debt investors (rather than buyers of homes themselves) were persuaded to buy levered and tranched mortgage-backed securities by the fact that “there has never been a nationwide wave of mortgage defaults.” But in 2007 it turned out that home prices can go down as well as up, and mortgage loans extended casually based on their flawless record can have flaws. Homes and mortgages, bought when everyone liked them, turned out to be terrible investments. The fact is, painful bubbles can’t come into existence if there isn’t an underlying grain of truth. The Nifty Fifty were generally terrific companies. Home prices do tend to rise over time and offset inflation. Mortgages generally are repaid or carry adequate collateral. The Internet would change the world. Oil at $147/barrel was indispensable and in short supply. But in each case the merits were too obvious; the investment ideas became too popular; and asset prices consequently became dangerously high. Following the trends that are popular at a point in time certainly isn’t a formula for investment success, since popularity is likely to lead investors on a path that is comfortable but pointed in the wrong direction. Here’s more from “Everyone Knows”: The fact is, there is no dependable sign pointing to the next big moneymaker: a good idea at a too-low price.

Most people simply don’t know how to find it. . . . Large amounts of money (and by that I mean unusual returns, or unusual risk-adjusted returns) aren’t made by buying what everybody likes. They’re made by buying what everybody underestimates. 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. Risk and Counterintuitiveness If what’s obvious and what everyone knows is usually wrong, then what’s right? The answer comes from inverting the concept of obvious appeal. The truth is, the best buys are usually found in the things most people don’t understand or believe in. These might be securities, investment approaches or investing concepts, but the fact that something isn’t widely accepted usually serves as a green light to those who’re perceptive (and contrary) enough to see it. A great example can be found in the area of risk (again from “Everyone Knows”): “I wouldn’t buy that at any price – everyone knows it’s too risky.” That’s something I’ve heard a lot in my life, and it has given rise to the best investment opportunities I’ve participated in.

(Had USC made the two yards and earned a first down, they would have retained the ball and been able to run out the clock, sealing a victory.) Something very similar happened in this year’s Super Bowl. The Seattle Seahawks were trailing the New England Patriots by a few points. On second down, with just 26 seconds to go and one timeout remaining, the Seahawks had the ball on the Patriots’ one-yard line. Everyone was sure they would try a run by Marshawn Lynch (who in the regular season had ranked first in the league in rushing touchdowns and fourth in rushing yards), and that he would score the winning touchdown. But the Seahawks’ maverick coach, Pete Carroll – ironically, also the coach of USC’s losing Rose Bowl team – tried a pass play instead. The Patriots intercepted the pass, and the Seahawks’ dreams of a championship ended. “What an idiot Carroll is,” the fans screamed. “Everyone knows that when you throw a pass, only three things can happen (it’s caught, it’s dropped or it’s intercepted) and two of them are bad.” The Seahawks lost a game they seemed to be on the verge of winning, and Carroll was vilified for being too bold and wrong . . . again. His decision was unsuccessful. But was it wrong? © 2015 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 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.

Further, Lynch had been handed the ball at the one-yard line five times in 2014, but he scored only once, for a success rate of 20%. Thus it was no sure thing that Lynch would be able to gain that needed yard against a defense expecting him to run. To the first-level thinker, Carroll’s decision to pass looks like a clear mistake. Maybe that’s because great running backs seem so dependable, or because passing generally seems like an uncertain proposition. Or maybe it’s just because the pass was picked off and the game lost: outcomes strongly bias perceptions. The second-level thinker sees that the obvious call – to run – was far from sure to work, and that doing the less-than-obvious – passing – might put the element of surprise on the Seahawks’ side and represent better clock management. Carroll made his decision and it was unsuccessful. But that doesn’t prove he was wrong. Here’s what my colleague Warren wrote me: The media and “talking heads” completely buried the decision to throw because of one data point: the pass was intercepted and the Seahawks lost the game. But I don’t believe this was a bad decision. In fact, I think this was a very well-informed decision that more people possessing all the data might have made given ample time to analyze the situation. As you always say, you can’t judge the quality of a decision based on results.

 The earning of a profit proves the investor made a good decision.  A low price makes for an attractive investment.  Assets that are appreciating deserve your attention.  Contrarianism will bring consistent success.  It’s important to do what feels right.  Assets with greater liquidity are safer.  The level of risk in a portfolio can be kept low by applying a simple formulaic process. My answer is that all sixteen reflect potential misconceptions, and they have to be (a) understood at the second level, not the first, and (b) dismissed as always holding the keys to success. Here’s why:  The market is “efficient,” meaning asset prices reflect all available information and thus provide accurate estimates of intrinsic value – The efficient market hypothesis assumes people are rational and objective. But since emotion so often rules in place of reason, the market doesn’t necessarily reflect what’s true, but rather what investors think is true. Thus prices can range all over the place. Sometimes they’re fair, but sometimes they’re way too high or low. It’s a big mistake to impute rationality to the market and believe its message.  Because people are risk-averse, risky deals are discouraged and the market awards appropriate risk premiums as compensation for incremental risk – The truth is that investors’ risk-averseness fluctuates between too much and too little.

© 2015 Oaktree Capital Management, L.P. All Rights Reserved But should this one victory – which swung on a single play – really place the Patriots and Tom Brady among the greatest? And was Carroll actually wrong? All of this goes back to one of my favorite themes from Fooled by Randomness by Nassim Nicholas Taleb, for me the bible on how to understand performance in an uncertain world. In his book, Taleb talks about “alternative histories,” which I describe as “the other things that reasonably could have happened but didn’t.” Sure, the Seahawks lost the game. But they could have won, and Carroll’s decision would have made the difference in that case, too, making him the hero instead of the goat. So rather than judge a decision solely on the basis of the outcome, you have to consider (a) the quality of the process that led to the decision, (b) the a priori probability that the decision would work (which is very different from the question of whether it did work), (c) the other decisions that could have been made, (d) all of the events that reasonably could have unfolded, and thus (e) which of the decisions had the highest probability of success. Here’s the bottom line:  There are many subtle but logical reasons for arguing that Coach Carroll’s decision made sense.  The decision would have been considered a stroke of genius if it had been successful.  Especially because of the role of luck, the correctness of a decision cannot necessarily be judged from the outcome.

 You clearly cannot assess someone’s competence on the basis of a single trial. What all the above really illustrates is the difference between superficial observation and deep, nuanced analysis. The fact that something worked doesn’t mean it was the result of a correct decision, and the fact that something failed doesn’t mean the decision was wrong. This is at least as true in investing as it is in sports. The Victor’s Mindset It often seems that just as I’m completing a memo, a final inspiration pops up. This past weekend, the Financial Times carried an interesting interview with Novak Djokovic, the number one tennis player in the world today. What caught my eye was what he said about the winner’s mental state: I believe that half of any victory in a tennis match is in place before you step on the court. If you don’t have that self-belief, then fear takes over. And then it will get too much for you to handle. It’s a fine line. (Emphasis added) Djokovic’s statement reminded me of a conversation I had earlier this month, on a subject I’ve written about rarely if ever: self-confidence. It ranks high among the attributes that must be present if one is to achieve superior results. To be above average, an athlete has to separate from the pack. To win at high-level tennis, a player has to hit “winners” – shots his opponents can’t return. They’re hit so hard, so close to the lines or so low over the net that they have the potential to end up as “unforced errors.

© 2015 Oaktree Capital Management, L.P. All Rights Reserved better said, they involve doing things with which most people are uncomfortable. To achieve great performance you have to believe in value that isn’t apparent to everyone else (or else it would already be reflected in the price); buy things that others think are risky and uncertain; and buy them in amounts large enough that if they don’t work out they can lead to embarrassment. What are examples of actions that require self-confidence?  Buying something at $50 and continuing to hold it – or maybe even buying more – when the price falls to $25 and “the market” is telling you you’re wrong.  After you’ve bought something at $50 (thinking it’s worth $200), refusing to “prudently take some chips off the table” when it gets to $100.  Going against conventional wisdom and daring to “catch a falling knife” when a company defaults and the price of its debt plummets.  Buying much more of something you like than it represents in the index you’re measured against, or entirely excluding an index component you dislike. In each of these cases, the first-level thinker does that which is conventional and easy – and which doesn’t require much self-confidence. The second-level thinker views things differently and, as a consequence, is willing to take actions like those described above. But they’re unlikely to be done in the absence of conviction.

The great investors I know are confident second-level thinkers and entirely comfortable diverging from the herd. It’s great for investors to have self-confidence, and it’s great that it permits them to behave boldly, but only when that self-confidence is warranted. This final qualification means that investors must engage in brutally candid self-assessment. Hubris or over-confidence is far more dangerous than a shortage of confidence and a resultant unwillingness to act boldly. That must be what Mark Twain had in mind when he 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.” And it also has to be what Novak Djokovic meant when he said, “It’s a fine line.” So there you have some of the key lessons from sports:  For most participants, success is likely to lie more dependably in discipline, consistency and minimization of error, rather than in bold strokes – high batting average and an absence of strikeouts, not the occasional, sensational home run.  But in order to be superior, a player has to do something different from others and has to have an appropriate level of confidence that he can succeed at it. Without conviction he won’t be able to act boldly and survive bouts of uncertainty and the inevitable slump.  Because of the significant role played by randomness, a small sample of results is far from sure to be indicative of talent or decision-making ability.

© Oaktree Capital Management, L.P. All Rights Reserved discounted in advance in the price of the asset, and the fact that it rolls on as expected doesn’t necessarily produce profit. For a forecast to be highly profitable, it has to be idiosyncratic. But, given how often trends continue, idiosyncratic forecasts aren’t often right.  A forecast has to be correct in order to be profitable – Just as correct forecasts aren’t necessarily profitable, profitable forecasts don’t have to be correct. A forecast – even if it’s not correct – can be profitable if it’s merely less wrong than others. If a trend that everyone else extrapolates turns out not to continue, a prediction of the deviation can be very profitable . . . even if it’s not exactly on target.  The earning of a profit proves the investor made a good decision – One of the first things I learned at Wharton was that you can’t necessarily tell the quality of a decision from the outcome. Given the unpredictability of future events and, especially, the presence of randomness in the world, a lot of well-reasoned decisions produce losses, and plenty of poor decisions are profitable. Thus one good year or a few big winners may tell us nothing about an investor’s skill. We have to see a lot of outcomes and a long history – and especially a history that includes some tough years – before we can say whether an investor has skill or not.

 A low price makes for an attractive investment – I talked at the bottom of page seven about the importance of price in determining whether an investment is risky. But if you reread the part in bold, you’ll see it doesn’t say a low price is the essential element. An asset may have a low absolute dollar price, a low price compared to the past, or a low p/e ratio, but usually the price has to be low relative to the asset’s intrinsic value for the investment to be attractive and for the risk to be low. It’s easy for investors to get into trouble if they fail to understand the difference between cheapness and value.  Assets that are appreciating deserve your attention – Most people impute intelligence to the market, and thus they think rising prices signal fundamental merit. They may be attracted to “momentum investing,” which is based on the belief that something that has been appreciating is likely to continue doing so. But the truth is, the higher the price (everything else being equal), the less attractive an asset is. Momentum investing works until it stops, at which time the things that have been doing worst – and may be most undervalued – take over market leadership.  Contrarianism will bring consistent success – It’s true that the investing herd is often wrong. In particular, it behaves more aggressively the more prices rise, and more cautiously the more they fall – the opposite of what should happen.

But doing the opposite of what the crowd does isn’t a sure thing either. Much of the time there isn’t anything dramatic to either do or avoid. Contrarianism is most effective at the extremes, and then only for those who understand what the herd is doing and why it’s wrong. And they still have to summon the nerve to do the opposite.  It’s important to do what feels right – The best investors know intellectually what the right thing to do is. But while this knowledge gives them comfort, they have to tamp down their feelings in order to follow it. The best ideas are ones others haven’t tumbled to, and as I wrote in “Dare to Be Great,” “Non-consensus ideas have to be lonely. By definition, non-consensus ideas that are popular, widely held or intuitively obvious are an oxymoron. . . . Most great investments begin in discomfort.” Good investors are subjected to the same misleading influences and emotions as everyone else. They’re just more capable of keeping them under control. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 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.

It’s important to remain moderate as to confidence, but instead it’s usually the case that confidence – like other emotions – swings radically.  Especially during downdrafts, many investors impute intelligence to the market and look to it to tell them what’s going on and what to do about it. This is one of the biggest mistakes you can make. As Ben Graham pointed out, the day-to-day market isn’t a fundamental analyst; it’s a barometer of investor sentiment. You just can’t take it too seriously. Market participants have limited insight into what’s really happening in terms of fundamentals, and any intelligence that could be behind their buys and sells is obscured by their emotional swings. It would be wrong to interpret the recent worldwide drop as meaning the market “knows” tough times lay ahead. Rather, China came out with some negative news and people panicked, especially © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Here’s how I put it last year in “Dare to Be Great II”:  If you invest, you will lose money if the market declines.  If you don’t invest, you will miss out on gains if the market rises.  Market timing will add value if it can be done right.  Buy-and-hold will produce better results if timing can’t be done right.  Aggressiveness will help when the market rises but hurt when it falls.  Defensiveness will help when the market falls but hurt when it rises.  If you concentrate your portfolio, your mistakes will kill you.  If you diversify, the payoff from your successes will be diminished.  If you employ leverage, your successes will be magnified.  If you employ leverage, your mistakes will be magnified. Each of these pairings indicates symmetry. None of the tactics listed will add value if it’s right but not subtract if it’s wrong. Thus none of these tactics, in and of itself, can hold the secret to dependably above average investment performance. There’s only one thing in the investment world that isn’t two-edged, and that’s “alpha”: superior insight or skill. Skill can help in both up markets and down markets. And by making it more likely that your decisions are right, superior skill can increase the expected benefit from concentration and leverage. But that kind of superior skill by definition is rare and elusive. . . . © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Superior investors and their well-thought-out approaches can produce superior returns on average in the long run. But even they are far from perfect. The best they can hope for is that they’ll be right more often than they’re wrong, and that their successful decisions will add more than their mistakes subtract. So, in the end, there’s only one absolute truth about investing. Charlie’s right: it isn’t easy. September 9, 2015 © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

This year many investing institutions are underperforming the passive benchmarks and attributing part of the shortfall to the fact that their fixed income holdings have been too short in duration to allow them to benefit from the decline of interest rates. While this has nothing to do with oil, I mention it to provide a reminder that what “everyone knows” is usually unhelpful at best and wrong at worst.  Not only did the investing herd have the outlook for rates wrong, but it was uniformly inquiring about the wrong thing. In short, while everyone was asking whether the rate rise would begin in December 2014 or April 2015 (or might it be June?) – in response to which I consistently asked why the answer matters and how it might alter investment decisions – few people I know were talking about whether the price of oil was in for a significant change. Back in 2007, in It’s All Good, I provided a brief list of some possibilities for which I thought stock prices weren’t giving enough allowance. I included “$100 oil” (since a barrel was selling in the $70s at the time) and ended with “the things I haven’t thought of.” I suggested that it’s usually that last category – the things that haven’t been considered – we should worry about most. Asset prices are often set to allow for the risks people are aware of. It’s the ones they haven’t thought of that can knock the market for a loop.  In my book The Most Important Thing, I mentioned something I call “the failure of imagination.

Can it be predicted and quantified a priori? What’s the best way to manage it?  How reliably do you believe a disciplined process will produce the desired results? That is, how do you view the question of determinism versus randomness?  Most importantly for the purposes of this memo, how will you define success, and what risks will you take to achieve it? In short, in trying to be right, are you willing to bear the inescapable risk of being wrong? Passive investors, benchmark huggers and herd followers have a high probability of achieving average performance and little risk of falling far short. But in exchange for safety from being much below average, they surrender their chance of being much above average. All investors have to decide whether that’s okay. And, if not, what they’ll do about it. The more I think about it, the more angles I see in the title Dare to Be Great. Who wouldn’t dare to be great? No one. Everyone would love to have outstanding performance. The real question is whether you dare to do the things that are necessary in order to be great. Are you willing to be different, and are you willing to be wrong? In order to have a chance at great results, you have to be open to being both. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved portfolio will venture. How much emphasis should be put on diversifying, avoiding risk and ensuring against below-pack performance, and how much on sacrificing these things in the hope of doing better? In the memo I mentioned my favorite fortune cookie: “the cautious seldom err or write great poetry.” Like the title Dare to Be Great, I find the fortune cookie thought-provoking. It can be taken as urging caution, since it reduces the likelihood of error. Or it can be taken as saying you should avoid caution, since it can keep you from doing great things. Or both. No right or wrong answer, but a choice . . . and hopefully a conscious one. It Isn’t Easy Being Different In the 2006 memo, I borrowed two quotes from Pioneering Portfolio Management by David Swensen of Yale. They’re my absolute favorites on the subject of institutional behavior. Here’s the first: Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom. “Uncomfortably idiosyncratic” is a terrific phrase. There’s a great deal of wisdom in those two words. What’s idiosyncratic is rarely comfortable . . . and in order for something to be comfortable, it usually has to be conventional. The road to above average performance runs through unconventional, uncomfortable investing.

© Oaktree Capital Management, L.P. All Rights Reserved Dare to Be Wrong “You have to give yourself a chance to fail.” That’s what Kenny “The Jet” Smith said on TV the other night during the NCAA college basketball tournament, talking about a star player who started out cold and as a result attempted too few shots in a game his team lost. It’s a great way to make the point. Failure isn’t anyone’s goal, of course, but rather an inescapable potential consequence of trying to do really well. Any attempt to compile superior investment results has to entail acceptance of the possibility of being wrong. The matrix on page two shows that since conventional behavior is sure to produce average performance, people who want to be above average can’t expect to get there by engaging in conventional behavior. Their behavior has to be different. And in the course of trying to be different and better, they have to bear the risk of being different and worse. That truth is simply unarguable. There is no way to strive for the former that doesn’t require bearing the risk of the latter. The truth is, almost everything about superior investing is a two-edged sword:  If you invest, you will lose money if the market declines.  If you don’t invest, you will miss out on gains if the market rises.  Market timing will add value if it can be done right.  Buy-and-hold will produce better results if timing can’t be done right.  Aggressiveness will help when the market rises but hurt when it falls.

 Defensiveness will help when the market falls but hurt when it rises.  If you concentrate your portfolio, your mistakes will kill you.  If you diversify, the payoff from your successes will be diminished.  If you employ leverage, your successes will be magnified.  If you employ leverage, your mistakes will be magnified. Each of these pairings indicates symmetry. None of the tactics listed will add value if it’s right but not subtract if it’s wrong. Thus none of these tactics, in and of itself, can hold the secret to dependably above average investment performance. There’s only one thing in the investment world that isn’t two-edged, and that’s “alpha”: superior insight or skill. Skill can help in both up markets and down markets. And by making it more likely that your decisions are right, superior skill can increase the expected benefit from concentration and leverage. But that kind of superior skill by definition is rare and elusive. The goal in investing is asymmetry: to expose yourself to return in a way that doesn’t expose you commensurately to risk, and to participate in gains when the market rises to a greater extent than you participate in losses when it falls. But that doesn’t mean the avoidance of all losses is a reasonable objective. Take another look at the goal of asymmetry set © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

” I’d rather have an order-of-magnitude approximation of risk from an expert than a precise figure from a highly educated statistician who knows less about the underlying investments. British philosopher and logician Carveth Read put it this way: “It is better to be vaguely right than exactly wrong.” © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved Or as Charlie Munger told me, “It’s not supposed to be easy. Anyone who finds it easy is stupid.” In other words, anyone who thinks it can be easy to succeed at investing is being simplistic and superficial, and ignoring investing’s complex and competitive nature. Why should superior profits be available to the novice, the untutored or the lazy? Why should people be able to make above average returns without hard work and above average skill, and without knowing something most others don’t know? And yet many individuals invest based on the belief that they can. (If they didn’t believe that, wouldn’t they index or, at a minimum, turn over the task to others?) No, the solution can’t lie in rigid tactics, publicly available formulas or loss-eliminating rules . . . or in complete risk avoidance. Superior investment results can only stem from a better-than- average ability to figure out when risk-taking will lead to gain and when it will end in loss. There is no alternative. Dare to Look Wrong This is really the bottom-line: not whether you dare to be different or to be wrong, but whether you dare to look wrong. Most people understand and accept that in their effort to make correct investment decisions, they have to accept the risk of making mistakes. Few people expect to find a lot of sure things or achieve a perfect batting average.

While they accept the intellectual proposition that attempting to be a superior investor has to entail the risk of loss, many institutional investors – and especially those operating in a political or public arena – can find it unacceptable to look significantly wrong. Compensation cuts and even job loss can befall the institutional employee who’s associated with too many mistakes. As Pensions & Investments said on March 17 regarding a big West Coast bond manager currently in the news, whom I’ll leave nameless: . . . asset owners are concerned that doing business with the firm could bring unwanted attention, possibly creating headline risk and/or job risk for them. . . . One [executive] at a large public pension fund said his fund recently allocated $100 million for emerging markets, its first allocation to the firm. He said he wouldn’t do that today, given the current situation, because it could lead to second-guessing by his board and the local press. “If it doesn’t work out, it looks like you don’t know what you are doing,” he said. As an aside, let me say I find it perfectly logical that people should feel this way. Most “agents” – those who invest the money of others – will benefit little from bold decisions that work but will suffer greatly from bold decisions that fail. The possibility of receiving an “attaboy” for a few © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Saying we can’t do the former doesn’t mean we can’t do the latter. The information we’re able to estimate – the list of events that might happen and how likely each one is – can be used to construct a probability distribution. Key point number one in this memo is that the future should be viewed not as a fixed outcome that’s destined to happen and capable of being predicted, but as a range of possibilities and, hopefully on the basis of insight into their respective likelihoods, as a probability distribution. Since the future isn’t fixed and future events can’t be predicted, risk cannot be quantified with any precision. I made the point in Risk, and I want to emphasize it here, that risk estimation has to be the province of experienced experts, and their work product will by necessity be subjective, imprecise, and more qualitative than quantitative (even if it’s expressed in numbers). There’s little I believe in more than Albert Einstein’s observation: “Not everything that counts can be counted, and not everything that can be counted counts.” I’d rather have an order-of-magnitude approximation of risk from an expert than a precise figure from a highly educated statistician who knows less about the underlying investments. British philosopher and logician Carveth Read put it this way: “It is better to be vaguely right than exactly wrong.” By the way, in my personal life I tend to incorporate another of Einstein’s comments: “I never think of the future – it comes soon enough.

In this case, the following questions must be answered:  In trying to achieve superior investment results, to what extent will we concentrate on investments, strategies and managers we think are outstanding? Will we do this despite the potential of our decisions to be wrong and bring embarrassment?  Or will fear of error, embarrassment, criticism and unpleasant headlines make us diversify highly, emulate the benchmark portfolio and trade boldness for safety? Will we opt for low-cost, low-aspiration passive strategies? © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Pitchers who were afraid of those things were easy pickings for Lou Brock. Fear of looking bad ensured their failure. Looking Right Can Be Harder Than Being Right Fear of looking bad can be particularly debilitating to an investor, client or manager. This is because of how hard it is to consistently make correct investment decisions. Some of this comes from my last memo, on the role of luck.  First, it’s hard to consistently make decisions that correctly factor in all of the relevant facts and considerations (i.e., it’s hard to be right).  Second, it’s far from certain that even “right” decisions will be successful, since every decision requires assumptions about what the future will look like, and even reasonable assumptions can be thwarted by the world’s randomness. Thus many correct decisions will result in failure (i.e., it’s hard to look right).  Third, even well-founded decisions that eventually turn out to be right are unlikely to do so promptly. This is because not only are future events uncertain, their timing is particularly variable (i.e., it’s impossible to look right on time). This brings me to one of my three favorite adages: “Being too far ahead of your time is indistinguishable from being wrong.” The fact that something’s cheap doesn’t mean it’s going to appreciate tomorrow; it can languish in the bargain basement. And the fact that something’s overpriced certainly doesn’t mean it’ll fall right away; bull markets can go on for years.

© Oaktree Capital Management, L.P. All Rights Reserved Alan Greenspan warned of “irrational exuberance” in December 1996, but the stock market continued upward for more than three years. A brilliant manager I know who turned bearish around the same time had to wait until 2000 to be proved correct . . . during which time his investors withdrew much of their capital. He wasn’t “wrong,” just early. But that didn’t make his experience any less painful. Likewise, John Paulson made the most profitable trade in history by shorting mortgage securities in 2006. Many others entered into the same transactions, but too early. When the bets failed to work at first, the appearance of being on the wrong track ate into the investors’ ability to stick with their decision, and they were forced to close out positions that would have been extremely profitable. In order to be a superior investor, you need the strength to diverge from the herd, stand by your convictions, and maintain positions until events prove them right. Investors operating under harsh scrutiny and unstable working conditions can have a harder time doing this than others. That brings me to the second quote I promised from Yale’s David Swensen: . . . active management strategies demand uninstitutional behavior from institutions, creating a paradox that few can unravel. Charlie Munger was right about it not being easy.

I’m convinced that everything that’s important in investing is counterintuitive, and everything that’s obvious is wrong. Staying with counterintuitive, idiosyncratic positions can be extremely difficult for anyone, especially if they look wrong at first. So-called “institutional considerations” can make it doubly hard. Investors who aspire to superior performance have to live with this reality. Unconventional behavior is the only road to superior investment results, but it isn’t for everyone. In addition to superior skill, successful investing requires the ability to look wrong for a while and survive some mistakes. Thus each person has to assess whether he’s temperamentally equipped to do these things and whether his circumstances – in terms of employers, clients and the impact of other people’s opinions – will allow it . . . when the chips are down and the early going makes him look wrong, as it invariably will. Not everyone can answer these questions in the affirmative. It’s those who believe they can that should take a chance on being great. April 8, 2014 © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

” In times of crisis, success over the long run can become irrelevant.  When credit risk, illiquidity risk, concentration risk and leverage risk are borne intelligently, it is in the hope that the investor’s skill will be sufficient to produce success. If so, the potential incremental returns that appear to be offered as risk compensation will turn into realized incremental returns (per the graphic at the top of page 6). That’s the only reason anyone would do these things. As the graphic at the bottom of page 6 illustrates, however, investing further out on the risk curve exposes one to a broader range of investment outcomes. In an efficient market, returns are tethered to the market average; in an inefficient market, they’re not. Inefficient markets offer the possibility that an investor will escape from the “gravitational pull” of the market’s average return, but that can be either for the better or for the worse. Superior investors – those with “alpha,” or the personal skill needed to achieve outsized returns for a given level of risk – have scope to perform well above the mean return, while inferior investors can come out far below. So hiring an investment manager introduces manager risk: the risk of picking the wrong one. It’s possible to pay management fees but get decisions that detract from results rather than add. Some or all of the above risks are potentially entailed in our new credit strategies.

I touched above on concentration risk, but we should also think about the flip side: the risk of over- diversification. If you have just a few holdings in a portfolio, or if an institution employs just a few managers, one bad decision can do significant damage to results. But if you have a very large number of holdings or managers, no one of them can have much of a positive impact on performance. Nobody invests in just the one stock or manager they expect to perform best, but as the number of positions is expanded, the standards for inclusion may decline. Peter Lynch coined the term “diworstification” to describe the process through which lesser investments are added to portfolios, making the potential risk- adjusted return worse. While I don’t think volatility and risk are synonymous, there’s no doubt that volatility does present risk. If circumstances cause you to sell a volatile investment at the wrong time, you might turn a downward fluctuation into a permanent loss. Moreover, even in the absence of a need for liquidity, volatility can prey on investors’ emotions, reducing the probability they’ll do the right thing. And in the short run, it can be very hard to differentiate between a downward fluctuation and a permanent loss. Often this can really be done only in retrospect. Thus it’s clear that a professional investor may have to bear consequences for a temporary downward fluctuation simply because of its resemblance to a permanent loss.

© Oaktree Capital Management, L.P. All Rights Reserved Most of the time, risk bearing works out just fine. In fact, it’s often the case that the people who take the most risk make the most money. However, there also are times when underestimating risk and accepting too much of it can be fatal. Taking too little risk can cause you to underperform your peers – but that beats the heck out of the consequences of taking too much risk at the wrong time. No one ever went bankrupt because of an excess of risk consciousness. But a shortage of it – and the imprudent investments it led to – bears responsibility for a lot of what went on in 2007. The Many Forms of Risk The possibility of permanent loss may be the main risk in investing, but it’s not the only risk. I can think of lots of other risks, many of which contribute to – or are components of – that main risk. In the past, in addition to the risk of permanent loss, I’ve mentioned the risk of falling short. Some investors face return requirements in order to make necessary payouts, as in the case of pension funds, endowments and insurance companies. Others have more basic needs, like generating enough income to live on. Some investors with needs – particularly those who live on their income, and especially in today’s low- return environment – face a serious conundrum. If they put their money into safe investments, their returns may be inadequate.

© Oaktree Capital Management, L.P. All Rights Reserved Long-Term’s failure was also attributable to model risk. Decisions can be turned over to quants or financial engineers who either (a) conclude wrongly that an unsystematic process can be modeled or (b) employ the wrong model. During the financial crisis, models often assumed that events would occur according to a “normal distribution,” but extreme “tail events” occurred much more often than the normal distribution says they will. Not only can extreme events exceed a model’s assumptions, but excessive belief in a model’s efficacy can induce people to take risks they would never take on the basis of qualitative judgment. They’re often disappointed to find they had put too much faith in a statistical sure thing. Model risk can arise from black swan risk, for which I borrow the title of Nassim Nicholas Taleb’s popular second book. People tend to confuse “never been seen” with “impossible,” and the consequences can be dire when something occurs for the first time. That’s part of the reason why people lost so much in highly levered subprime mortgage securities. The fact that a nationwide spate of mortgage defaults hadn’t happened convinced investors that it couldn’t happen, and their certainty caused them to take actions so imprudent that it had to happen. As long as we’re on the subject of things going wrong, we should touch on the subject of career risk.

© Oaktree Capital Management, L.P. All Rights Reserved tall man who drowned crossing the stream that was five feet deep on average.” In times of crisis, success over the long run can become irrelevant.  When credit risk, illiquidity risk, concentration risk and leverage risk are borne intelligently, it is in the hope that the investor’s skill will be sufficient to produce success. If so, the potential incremental returns that appear to be offered as risk compensation will turn into realized incremental returns (per the graphic at the top of page 8). That’s the only reason anyone would do these things. As the graphic at the bottom of page 8 illustrates, however, investing further out on the risk curve exposes one to a broader range of investment outcomes. In an efficient market, returns are tethered to the market average; in an inefficient market, they’re not. Inefficient markets offer the possibility that an investor will escape from the “gravitational pull” of the market’s average return, but that can be either for the better or for the worse. Superior investors – those with “alpha,” or the personal skill needed to achieve outsized returns for a given level of risk – have scope to perform well above the mean return, while inferior investors can come out far below. So hiring an investment manager introduces manager risk: the risk of picking the wrong one. It’s possible to pay management fees but get decisions that detract from results rather than add.

 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. At bottom, it’s the inability to arrive at a single formula that simultaneously minimizes all the risks that makes investing the fascinating and challenging pursuit it is. The fifth is that the task of managing risk shouldn’t be left to designated risk managers. I’m convinced outsiders to the fundamental investment process can’t know enough about the subject assets to make appropriate decisions regarding each one. All they can do is apply statistical models and norms. But those models may be the wrong ones for the underlying assets – or just plain faulty – and there’s little evidence that they add value. In particular, risk managers can try to estimate correlation and tell you how things will behave when combined in a portfolio. But they can fail to adequately anticipate the “fault © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

If circumstances cause you to sell a volatile investment at the wrong time, you might turn a downward fluctuation into a permanent loss. Moreover, even in the absence of a need for liquidity, volatility can prey on investors’ emotions, reducing the probability they’ll do the right thing. And in the short run, it can be very hard to differentiate between a downward fluctuation and a permanent loss. Often this can really be done only in retrospect. Thus it’s clear that a professional investor may have to bear consequences for a temporary downward fluctuation simply because of its resemblance to a permanent loss. When you’re under pressure, the distinction between “volatility” and “loss” can seem only semantic. Volatility is not “the” definition of investment risk, as I said earlier, but it isn’t irrelevant. One example of a risk connected with volatility – or the deviation of price from what might be intrinsic value – is basis risk. Arbitrageurs customarily set up positions where they’re long one asset and short a related asset. The two assets are expected to move roughly in parallel, except that the one that’s slightly cheaper should make more money for the investor in the long run than the other loses, producing a small net gain with little risk. Because these trades are considered so low in risk, they’re often levered up to the sky. But sometimes the prices of the two assets diverge to an unexpected extent, and the equity invested in the trade evaporates.

That unexpected divergence is basis risk, and it’s what happened to Long-Term Capital Management in 1998, one of the most famous meltdowns of all time. As Long-Term’s chairman John Meriwether said at the time, “the Fund added to its positions in anticipation of convergence, yet . . . the trades diverged dramatically.” This benign-sounding explanation was behind a collapse some thought capable of bringing down the global financial system. Long-Term’s failure was also attributable to model risk. Decisions can be turned over to quants or financial engineers who either (a) conclude wrongly that an unsystematic process can be modeled or (b) employ the wrong model. During the financial crisis, models often assumed that events would occur according to a “normal distribution,” but extreme “tail events” occurred much more often than the normal distribution says they will. Not only can extreme events exceed a model’s assumptions, but excessive belief in a model’s efficacy can induce people to take risks they would never take on the basis of qualitative judgment. They’re often disappointed to find they had put too much faith in a statistical sure thing. Model risk can arise from black swan risk, for which I borrow the title of Nassim Nicholas Taleb’s popular second book. People tend to confuse “never been seen” with “impossible,” and the consequences can be dire when something occurs for the first time. That’s part of the reason why people lost so much © OAKTREE CAPITAL MANAGEMENT, L.

Risk control is unnecessary in times when losses don’t occur, but that doesn’t mean it’s wrong to have it. The best analogy is to fire insurance: do you consider it a mistake to have paid the premium in a year in which your house didn’t burn down? Taken together these six observations convince me that Charlie Munger’s trenchant comment on investing in general – “It’s not supposed to be easy. Anyone who finds it easy is stupid.” – is profoundly applicable to risk management. Effective risk management requires deep insight and a deft touch. It has to be based on a superior understanding of the probability distributions that will govern future events. Those who would achieve it have to have a good sense for what the crucial moving parts are, what will influence them, what outcomes are possible, and how likely each one is. Following on with Charlie’s idea, thinking risk control is easy is perhaps the greatest trap in investing, since excessive confidence that they have risk under control can make investors do very risky things. Thus the key prerequisites for risk control also include humility, lack of hubris, and knowing what you don’t know. No one ever got into trouble for confessing a lack of prescience, being highly risk- conscious, and even investing scared. Risk control may restrain results during a rebound from crisis conditions or extreme under-valuations, when those who take the most risk generally make the most money.

© Oaktree Capital Management, L.P. All Rights Reserved in highly levered subprime mortgage securities. The fact that a nationwide spate of mortgage defaults hadn’t happened convinced investors that it couldn’t happen, and their certainty caused them to take actions so imprudent that it had to happen. As long as we’re on the subject of things going wrong, we should touch on the subject of career risk. As I mentioned in Dare to Be Great II, “agents” who manage money for others can be penalized for investments that look like losers (that is, for both permanent losses and temporary downward fluctuations). Either of these unfortunate experiences can result in headline risk if the resulting losses are big enough to make it into the media, and some careers can’t withstand headline risk. Investors who lack the potential to share commensurately in investment successes face a reward asymmetry that can force them toward the safe end of the risk/return curve. They are likely to think more about the risk of losing money than about the risk of missing opportunities. Thus their portfolios may lean too far toward controlling risk and avoiding embarrassment (and they may not take enough chances to generate returns). There are consequences for these investors, as well as for those who employ them. Event risk is another risk to worry about, something that was created by bond issuers about twenty years ago.

Today I feel it’s important to pay more attention to loss prevention than to the pursuit of gain. For the last three years Oaktree’s mantra has been “move forward, but with caution.” At this time, in reiterating that mantra, I would increase the emphasis on those last three words: “but with caution.” Economic and company fundamentals in the U.S. are fine today, and asset prices – while full – don’t seem to be at bubble levels. But when undemanding capital markets and a low level of risk aversion combine to encourage investors to engage in risky practices, something usually goes wrong eventually. Although I have no idea what could make the day of reckoning come sooner rather than later, I don’t think it’s too early to take today’s carefree market conditions into consideration. What I do know is that those conditions are creating a degree of risk for which there is no commensurate risk premium. We have to behave accordingly. September 3, 2014 © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

But those models may be the wrong ones for the underlying assets – or just plain faulty – and there’s little evidence that they add value. In particular, risk managers can try to estimate correlation and tell you how things will behave when combined in a portfolio. But they can fail to adequately anticipate the “fault lines” that run through portfolios. And anyway, as the old saying goes, “in times of crisis all correlations go to one” and everything collapses in unison. “Value at Risk” was supposed to tell the banks how much they could lose on a very bad day. During the crisis, however, VaR was often shown to have understated the risk, since the assumptions hadn’t been harsh enough. Given the fact that risk managers are required at banks and de rigueur elsewhere, I think more money was spent on risk management in the early 2000s than in the rest of history combined . . . and yet we experienced the worst financial crisis in 80 years. Investors can calculate risk metrics like VaR and Sharpe ratios (we use them at Oaktree; they’re the best tools we have), but they shouldn’t put too much faith in them. The bottom line for me is that risk management should be the responsibility of every participant in the investment process, applying experience, judgment and knowledge of the underlying investments. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved The sixth is that while risk should be dealt with constantly, investors are often tempted to do so only sporadically. Since risk only turns into loss when bad things happen, this can cause investors to apply risk control only when the future seems ominous. At other times they may opt to pile on risk in the expectation that good things lie ahead. But since we can’t predict the future, we never really know when risk control will be needed. Risk control is unnecessary in times when losses don’t occur, but that doesn’t mean it’s wrong to have it. The best analogy is to fire insurance: do you consider it a mistake to have paid the premium in a year in which your house didn’t burn down? Taken together these six observations convince me that Charlie Munger’s trenchant comment on investing in general – “It’s not supposed to be easy. Anyone who finds it easy is stupid.” – is profoundly applicable to risk management. Effective risk management requires deep insight and a deft touch. It has to be based on a superior understanding of the probability distributions that will govern future events. Those who would achieve it have to have a good sense for what the crucial moving parts are, what will influence them, what outcomes are possible, and how likely each one is.

© Oaktree Capital Management, L.P. All Rights Reserved from Chuck Prince, Citigroup’s CEO from 2003 to 2007, anyone who’s totally unwilling to dance to today’s fast-paced music can find it challenging to put money to work. It’s the job of investors to strike a proper balance between offense and defense, and between worrying about losing money and worrying about missing opportunity. Today I feel it’s important to pay more attention to loss prevention than to the pursuit of gain. For the last four years Oaktree’s mantra has been “move forward, but with caution.” At this time, in reiterating that mantra, I would increase the emphasis on those last three words: “but with caution.” Economic and company fundamentals in the U.S. are fine today, and asset prices – while full – don’t seem to be at bubble levels. But when undemanding capital markets and a low level of risk aversion combine to encourage investors to engage in risky practices, something usually goes wrong eventually. Although I have no idea what could make the day of reckoning come sooner rather than later, I don’t think it’s too early to take today’s carefree market conditions into consideration. What I do know is that those conditions are creating a degree of risk for which there is no commensurate risk premium. We have to behave accordingly. June 8, 2015 (updating Risk Revisited published September 3, 2014) © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved. Miscellany:  Will China’s credit-abetted economy experience a hard landing or a soft one?  If China’s growth slows, what will be the effect on nations such as Brazil, Australia and Canada that have prospered by supplying it with commodities? What will happen to commodity prices?  Will Prime Minister Abe’s monetary and fiscal program be enough to wake Japan’s economy from its lethargy?  Will fracking allow the U.S. to achieve energy self-sufficiency? If so, what will that do to its manufacturing competitiveness and to the price of oil?  What will happen in hot spots such as the Middle East, Iran and North Korea? Significant uncertainty is one of the outstanding characteristics of today’s investing environment. It discourages optimism regarding the future and limits investors’ certainty that the future is knowable and controllable. In other words, it saps confidence. This is a major difference from conditions in the pre-crisis years. Confidence in 2007 When I think about how the investment environment of today differs from earlier times, the greatest change of all jumps out at me. Let’s go back to just before the onset of the sub- prime crisis in mid-2007. I think in those days most people were 100% certain they knew:  what made the global economy tick,  what the economic and business world would look like in five or ten years, and  what it would take to fix something that went wrong.

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.

© Oaktree Capital Management, L.P. All Rights Reserved. While the pendulum moves with regard to all these things, the swinging movement, the extent and the error all reflect common themes. They’re all examples of the ways in which, as Mark Twain said, history rhymes. Let’s take for an example one regard in which the pendulum swings: investor attitudes toward emerging markets. Sometimes they’re considered scary and exotic places, and sometimes they’re the attractive high-growth alternative to the stagnant developed world. When people have confidence in the emerging markets and see only their virtues, the stocks sell at U.S.-style p/e ratios (where they’re described as being cheap given the superior growth rates). But when problems emerge and confidence falters, investors will only buy emerging market stocks at discount p/e’s so as to have the benefit of the risk premiums they consider necessary. I’ve seen this swing – just like the others – numerous times. I’m thinking back to 1994, when NAFTA was enacted, easing trade in North America. People were in awe of Mexico: “It’s just like the U.S., but it grows much faster.” So money flowed to Mexican stocks, and they boomed. But then, in short order, there occurred a revolt in the state of Chiapas, the assassination of a presidential candidate, and the devaluation of the Mexican peso, triggering the so-called “Tequila Crisis.” And the pendulum swung back toward concern: “Oh, right – there are differences.

© Oaktree Capital Management, L.P. All Rights Reserved. It is essential to observe that investor attitudes in this regard are far from constant. A memo called The Happy Medium (July 21, 2004) said that while it would be good for most investors (the ones not suited to be contrarians) to always hold a moderate position that balances risk aversion and risk tolerance – and thus the fear of losing money and the fear of missing opportunities – this is something very few people can do. Rather, attitudes toward risk cycle up and down, usually counter- productively. Becoming more and less risk averse at the right time is a great way to enhance investment performance. Doing it at the wrong time – like most people do – can have a terrible effect on results. How does the up-cycle in risk taking develop?  When economic growth is slow or negative and markets are weak, most people worry about losing money and disregard the risk of missing opportunities. Only a few stout- hearted contrarians are capable of imagining that improvement is possible.  Then the economy shows some signs of life, and corporate earnings begin to move up rather than down.  Sooner or later economic growth takes hold visibly and earnings show surprising gains.  This excess of reality over expectations causes security prices to start moving up.  Because of those gains – along with the improving economic and corporate news – the average investor realizes that improvement is actually underway. Confidence rises.

© 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?

© Oaktree Capital Management, L.P. All Rights Reserved. As we’ve seen endless times, investors reach the overconfident state when things have been going well for a while, meaning prices have already soared. And, alternatively, the latter hopeless state is inevitably reached after a bubble has been punctured, the news has turned unremittingly negative, and prices have collapsed. This is the pattern that makes the herd wrong at the extremes and creates the rewards for contrarianism. And it’s behind my favorite Warren Buffett quote: “the less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” When most investors are driven to drop their prudence by an excess of confidence, we should be terrified. In the same way, when most investors become devoid of confidence and flee the market, we should turn aggressive. All Good or All Bad? One of the things worth noting about the swing in confidence is not merely that it rises and falls, but that it is often marked by “all-good” or “all-bad” thinking. In short, when investors are optimistic regarding the future:  They tend to see the positives, by which they’re incredibly impressed, and overlook the negatives.  If they consider negatives at all, they fall for rationalizations that refute them. Foremost here is the old standby: “It’s different this time.”  Isolated positive developments, often random or fortuitous, are generalized into an irresistible virtuous circle.

Nowadays, investors are much more likely to trade in an effort to profit from – or at least avoid losses connected to – economic, corporate and market developments. However, when most investors unite behind a macro trading decision, they’re usually wrong in the ways described above. This is the reason why contrarianism often pays off big. In order to be a successful contrarian, you have to do the opposite of what the herd does. And to do that, you have to diverge from the conventional cycle in attitudes toward risk. Everyone would like to profitably resist this error-prone and thus costly cycle. The fact that most people succumb anyway shows how strong its power is, and that most people are not above average in this regard (of course). Markets move in response to decisions made by the majority of investors. Most investors are guilty of the sin of overreacting (and, even worse, the sin of moving in the wrong direction), demonstrating that the ability to resist the cycle is uncommon. To be a successful contrarian, you have to be able to:  see what most people are doing,  understand what’s wrong about most people’s behavior,  possess a strong sense for intrinsic value, which most people ignore at the extremes,  resist the psychological pressures that make most people err, and thus  buy when most people are selling and sell when most people are buying. And one other thing: you have to be willing to look wrong for a while.

If the herd is doing the wrong thing, and if you’re capable of seeing that and doing the opposite, it’s still highly unlikely that the wisdom of what you do will become apparent immediately. Usually the crowd’s irrational euphoria will continue to take prices higher for a while – possibly a long while – or its excessive negativism © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved. will continue to take prices lower. The contrarian will appear wrong, and the fact that his error comes in acting differently from most people will make him look like nothing but an oddball loser. Thus, in addition to the five requirements listed above, successful contrarianism requires the ability to stick with losing positions that, as David Swensen has written, “frequently appear downright imprudent in the eyes of conventional wisdom.” If you can’t stand living with the embarrassment of being unconventional and wrong, contrarianism may not be for you. Rather than trying to do the difficult opposite of what the crowd is doing, you might have to settle for merely refusing to join in its errors. That would be a very good thing. But even that is not easy. Risk and Return Today (2004 Version) The name of this section served as the title of a memo in October 2004. It was one of my first cautionary responses to the vertiginous market ascent that would be exposed by the sub-prime mortgage collapse in 2007 and would culminate in the global financial crisis in 2008. In the memo I observed that the “capital market line” connecting risk and return had become “lower and flatter.” The lowness meant that the line started off with low returns on low-risk assets (due to the Fed’s efforts to stimulate the economy through low interest rates) and, as one moved out the risk curve, even riskier investments offered low potential returns.

© Oaktree Capital Management, L.P. All Rights Reserved. . . . would-be buyers are optimistic, unafraid, undemanding in terms of return, and moving en masse to small asset classes. Holders of assets, who play a part in setting market prices by deciding where they’ll sell, also are optimistic. The result is an unappetizing, risk- tolerant, high-priced investment landscape. . . . There are times when the investing errors are of omission: the things you should have done but didn’t. Today I think the errors are probably of commission: the things you shouldn’t have done but did. There are times for aggressiveness. I think this is a time for caution. In other words, everything seemed positive, attitudes toward risk bearing were on the upswing, and security prices moved higher, bringing down potential returns. That memo may have been too early, but it wasn’t wrong. There was a fair bit of money to be made in the next few years, but its pursuit brought investors close to the peril that lay ahead. Risk and Return Today (2013 version) For about a year from the middle of 2011 to the middle of 2012, I was thinking and saying that given the many problems and uncertainties afflicting the investment environment, the biggest plus I could find was the near-total lack of optimism on the part of investors. And I thought it was a major plus. There’s little that’s as helpful for the availability of bargains as widespread low expectations.

© Oaktree Capital Management, L.P. All Rights Reserved. vulnerable, and that there had been too much reliance on the Fed keeping rates low. All of a sudden investors were less sure the world looked right, what the future held, and how to make money in it. Investors remain uncertain, and that’s good. Now that a bout of worry has been experienced, the credit markets are healthier (e.g., offering higher returns) than they were two months ago. If the economy continues to recover and the Fed’s bond buying eases off, interest rates are likely to go further on the upside. But given the modest level of confidence at play, the markets should not turn out to be perilous. Most assets are neither dangerously elevated (with the possible exception of long-term Treasury bonds and high grades) nor compellingly cheap. It’s easier to know what to do at the extremes than it is in the middle ground, where I believe we are today. As I wrote in my book, when there’s nothing clever to do, the mistake lies in trying to be clever. Today it seems the best we can do is invest prudently in the coming months, avoiding aggressiveness and remembering to apply caution. * * * A word about the long run: While conditions, confidence and asset prices all seem moderate today, meaning there’s nothing brilliant to say about the short-term outlook, the long term remains worrisome. Because the U.S. is still able to attract capital from abroad and print money, our financial problems aren’t pressing at the moment.

I feel I should come down on one side or the other. Thus I’m quite comfortable imagining a few years of equity performance that provide a pleasant surprise relative to what I think is the prevailing expectation of 6% or so per year. And if I‟m wrong – if there is no rotation from fixed income to stocks – I‟m not that worried that I‟ll end up with great regret over having failed to pile into T-bills yielding zero or the 10-year note guaranteeing 2.0%. When attitudes are moderate and allocations are low, like I feel is currently the case with equities, there‟s little likelihood of investing being a big mistake. And when interest rates are among the lowest in history, it would take deflation, depression or calamity to make failing to invest in Treasurys and high grade bonds a serious omission. March 13, 2013 © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED. CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. Memo to: Oaktree Clients From: Howard Marks Re: It’s All a Big Mistake Mistakes are a frequent topic of discussion in our world. It’s not unusual to see investors criticized for errors that resulted in poor performance. But rarely do we hear about mistakes as an indispensible component of the investment process. I’m writing now to point out that mistakes are all that superior investing is about. In short, in order for one side of a transaction to turn out to be a major success, the other side has to have been a big mistake. There’s an old saying in poker that there’s a “fish” (a sucker, or an unskilled player who’s likely to lose) in every game, and if you’ve played for an hour without having figured out who the fish is, then it’s you. Likewise, in every investment transaction you’re part of, it’s likely that someone’s making a mistake. The key to success is to not have it be you. Usually a buyer buys an asset because he thinks it’s worth more than the price he’s paying. But the seller sells the asset because he thinks the price he’s getting exceeds its value. It’s pretty safe to say one of them has to be wrong. Strictly speaking, that doesn’t have to be true, thanks to differences in things like tax status, timeframe and investors’ circumstances. But in general, win/win transactions are much less common than win/lose transactions.

If you’re setting out for a drive and recognize that you don’t know the way, you’re likely to check a map, follow your GPS, ask directions and drive slowly, watching for indications you’ve gone off course. But if you’re sure you know the way, you’re more likely to skip these things, and if it turns out you didn’t know, that’ll make it much harder to reach your destination. Rather than commit the error of overconfidence, at Oaktree we consider it essential to acknowledge the limits of our capabilities and act accordingly. What Can’t We Do? The main thing we can’t do is see the future, and particularly the macro future. That simple statement has serious ramifications. It means a lot that we’d love to know is beyond us:  we can’t know what the economies of the world will do,  we can’t know whether markets will go up or down, and by how much and when,  we can’t know which market or sub-market will do best, and  we can’t know which securities in a given market will be the top performers. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

When the dust has settled after most trades, the buyer and seller are unlikely to be equally happy. I consider it highly desirable to focus on the topic of investing mistakes. First, it serves as a reminder that the potential for error is ever-present, and thus of the importance of mistake minimization as a key goal. Second, if one side of every transaction is wrong, we have to ponder why we should think it’s not us. Third, then, it causes us to consider how to minimize the probability of being the one making the mistake. Investment Theory on Mistakes According to the efficient market hypothesis, the efforts of motivated, intelligent, objective and rational investors combine to cause assets to be priced at their intrinsic value. Thus there are no mistakes: no undervalued bargains for superior investors to recognize and buy, and no over- valuations for inferior investors to fall for. Since all assets are priced fairly, once bought at fair prices they should be expected to produce fair risk-adjusted returns, nothing more and nothing less. That’s the source of the hypothesis’s best-known dictum: you can’t beat the market. I’ve often discussed this definition of market efficiency and its error. The truth is that while all investors are motivated to make money (otherwise, they wouldn’t be investing), (a) far from all of them are intelligent and (b) it seems almost none are consistently objective and rational.

Unless both of those things are true, any time, effort, transaction costs and management fees expended on active management will be wasted. Active management has to be seen as the search for mistakes. Behavioral Sources of Investment Error As described above, investment theory asserts that assets sell at fair prices, and thus there’s no such thing as superior risk-adjusted performance. But real-world data tells us that superior performance does exist, albeit far from universally. Some people find it possible to buy things for less than they’re worth, at least on occasion. But doing so requires the cooperation of people who’re willing to sell things for less than they’re worth. What makes them do that? Why do mistakes occur? The new field of behavioral finance is all about looking into error stemming from emotion, psychology and cognitive limitations. If market prices were set by a “pricing czar” who was (1) tireless, (2) aware of all the facts, (3) proficient at analysis and (4) thoroughly rational and unemotional, assets could always be priced right based on the available information – never too low or too high. In the absence of that czar, if a market were populated by investors fitting that description, it, too, could price assets perfectly. That’s what the efficient marketers theorize, but it’s just not the case. Very few investors satisfy all four of the requirements listed above.

As a result of holding a highly idiosyncratic portfolio, Penn experienced performance that deviated – unfavorably – from that of its peers to an extent that became intolerable. This necessitated change. Do It Now? Upon starting in on the job, I was immediately confronted by one of the truly classic investment dilemmas: You take on the management of a portfolio, and you just know it’s structured wrong in principle. In Penn’s case, it was clearly unwise – probably in terms of optimizing risk and return, and certainly in terms of keeping up with peers, and thus expectations – to completely omit the things that had been excluded from Penn’s portfolio. I knew right away that Penn’s portfolio should include some exposure to growth, tech, buyouts and venture capital. But the reason their exclusion had become so painful is that they had done so well for a half-decade. So in principle you should own something, but its price is sky- high. Should you hold your nose and buy at what may be excessive prices? Or should you wait for a correction, at the risk of continuing to underperform if it goes higher (since we know how often things that are overpriced can continue upward)? Whenever I’m presented with this dilemma, I trot out a 1957 cartoon from The New Yorker Magazine that was reproduced in the Financial Analysts Journal in 1975. It’s my absolute favorite, and I’ve been waiting for an opportunity to share it with you: © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. For me, this cartoon frames the question precisely: Should we do the thing that’s right in principle, or should we alter our behavior to reflect today’s real-world conditions? There’s no one right answer; it goes back to expectations. If it’s important to track the competition, you should start to make the portfolio less idiosyncratic, regardless of price attractiveness. But if you care more about absolute performance, achieved with risk under control, you should refuse to buy sky-high assets. The latter is my preference, and it was reflected in my decision. Penn held off from buying tech and growth stocks. But I had declared my intention before taking the job. To put it in horribly mixed metaphors, having missed the boat for six years, I said I wouldn’t jump on the bandwagon just in time to ride it over the cliff. I hoped making this clear would condition expectations and provide cover in case our actions initially proved wrong. Offense or Defense? The dilemma just discussed relates to the biggest single issue facing anyone tasked with structuring a portfolio: whether to stress offense – trying for high returns – or defense – reducing the likelihood of losses. Of course most investors balance these two things. The question is in what proportion. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

 We can control our egos and emotions. The biggest errors are made when the investing herd is driven by emotion: to buy at the top by greed and excitement, and to sell at the bottom by fear and despondency. These errors are compounded when investors – even professionals – surrender to their egos and overestimate the degree to which their judgments are correct. Superior managers can help their clients by refusing to mirror these flaws.  We can act as contrarians. Given the way the emotion-led consensus is wrong at the extremes as described above, there’s money to be made by doing the opposite. Objectivity, insight and ego control are all you need. But it’s far from easy. The successful contrarian has to have a sense for what the herd is doing, understand what’s wrong with its behavior, resist the emotions driving it and do the opposite – all of this despite being “only human” and thus not immune to the forces driving others.  We can behave counter-cyclically. The cycles in economies and markets conspire to cause investment mistakes. For example, in advanced up-cycles: o the economic indicators show gains, o companies report earnings increases, o assets appreciate, o investors enjoy good returns, o riskier approaches outperform, o leverage adds to gains, and o the capital markets eagerly provide financing. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED. CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. in a continuous, instantaneous auction through which market prices are updated. The goal is to set prices such that the relationship between each asset’s potential return and risk – that is, its prospective risk-adjusted return – is fair relative to all other assets. Inefficiencies – mispricings – are instances when one asset offers a higher risk-adjusted return than another. For example, A and B might seem equally risky, but A might appear to offer a higher return than B. In that case, A is too cheap, and people will sell B (lowering its price, raising its potential return and reducing its risk) and buy A (raising its price, lowering its potential return and increasing its risk) until the risk-adjusted returns of the two are in line. That condition is called “equilibrium.” It’s one of the jobs of a functioning market to eliminate opportunities for extraordinary profitability. Thus market participants want to sell overpriced assets and buy underpriced assets. They just don’t do so consistently. Most investment error can be distilled to the failure to buy the things that are cheap (or to buy enough of them) and to sell the things that are dear. Why do people fail in that way? Here are just a few reasons:  Bias or closed-mindedness – In theory, investors will shift their capital to anything that’s cheap, correcting pricing mistakes.

© OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED. CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. The foregoing goes a long way to support Yogi Berra’s observation that “In theory there is no difference between theory and practice. In practice there is.” Theory has no answer for the impact of these forces. Theory assumes investors are clinical, unemotional and objective, and always willing to substitute a cheap asset for a dear one. In practice, there are numerous reasons why one asset can be priced wrong – in the absolute or relative to others – and stay that way for months or years. Those are mistakes, and superior investment records belong to investors who take advantage of them consistently. A Case In Point Bruce Karsh and his distressed debt team have averaged returns of roughly 23% per year before fees and 18% after fees for more than 23 years without any use of borrowed capital. All eighteen of their funds have been profitable, and money-losing years have been quite scarce. I consider this record nothing short of aberrant. You’re simply not supposed to be able to make that kind of return for that long, and especially without the use of leverage. Investing skill aside, what made it possible?  Is it because it’s called “distressed debt”? That can’t be it; there’s nothing in a name.  Is it because distressed debt is an undiscovered market niche?

It’s essential, however, to remember that it can be just as wrong to see things as hopeless as it is to consider an environment risk-free. One mustn’t overreact in either direction. Potential economic pluses do exist, and they tend to be overlooked in downcast periods like today. These include the incipient housing recovery; the possibility of energy self-sufficiency; the fact that U.S. manufacturing has slimmed down and our Chinese competitors have seen costs rise; and the fact that the U.S. still leads in higher education, creativity and entrepreneurship. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

This one reminds me of my absolute favorite Yogi-ism: “Nobody goes [to that restaurant] anymore. It‟s too crowded.” Wait a minute: how can a restaurant be crowded if nobody goes there? Likewise, in this case, according to the writer, it will take a bull market to attract investor interest and confidence. That sounds reasonable. But isn‟t investor interest and confidence a prerequisite for a bull market? Without it, how can a bull market get started? The answer is that when prices are low enough, stocks can begin to rise without help from a full- fledged bull market, just as when they‟re high enough, stock prices can collapse under their own weight. The bottom line here is simple, and I‟m thoroughly convinced of it: Common sense isn’t common. The crowd is invariably wrong at the extremes. In the investing world, everything that’s intuitively obvious is questionable and everything that’s important is counter-intuitive. And investors prove repeatedly that they can be less logical than Yogi. The Penalty of Youth Let‟s think back to Galbraith‟s statement that “Past experience . . . is dismissed as the primitive refuge of those who do not have insight to appreciate the incredible wonders of the present.” In other words, when a hot new investment fad gets rolling and an idea is elevated to bubble status, © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

The results have included unrest and may continue to do so. And yet – despite attempts at austerity and delevering – in many countries the ratio of total public and private debt to GDP is now greater than it was five years ago (according to Jamil Baz of GLG Partners). People ask all the time what will happen in Europe. I tell them the situation is enormously complex, murky and uncertain, but I’m absolutely sure of three things: (a) I don’t know, (b) nobody knows, and (c) if you ask an expert for advice and follow it, you’ll probably be making a mistake. When people invest in an Oaktree fund, it’s on the basis of a limited partnership agreement that spends a few pages on what we’re going to do and dozens more on things like the rules we’ll follow and what happens if we don’t. I get the impression that in the case of the European Union, politicians wrote the first section based on glowing hopes but forgot about the rest. When faced with conditions like these, in my view, there’s absolutely no alternative to saying we have no idea what the future holds. Period. Since the nuts and bolts stuff was omitted, there’s no schematic diagram or instruction manual for Europe. There are no procedures for ensuring nations don’t run excessive deficits, or for moving a member state out of the European Union. Any actions that are taken will require unanimous decisions on the part of elected officials from nations with divergent interests.

” 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.

And the performance of the endowment, the CIO and the Investment Board – and, as I said earlier, yours truly – became the subject of some very nice words. What If? – Part I All of the above is history. It presented taxing dilemmas and important choices, but other than as to degree, nothing portfolio managers, CIOs and investment committees don’t face routinely. But there are two hidden issues – both somewhat philosophical – that I find far more interesting, provocative and important. They surround questions of timing and chance. Sometimes investors feel something is going to happen in the period ahead, and that they should do something about it in their portfolios. And sometimes they’re right. But rarely do the anticipated events occur as expected, and thus rarely are investors’ actions proved correct immediately. Overpriced assets continue to appreciate, and cheap stocks decline further. Even if they do the right thing, very few investors do it at just the right time. Thus timing – and in particular the selection of the beginning point and end point for studying a performance record – plays an incredibly important role in perceptions of success or failure. In his important book Fooled by Randomness, Nassim Nicholas Taleb points out how easily random events can make good decisions look wrong and bad decisions look right. Clearly one of the reasons for this is that events don’t happen on schedule.

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;

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. – or even possible. Or it may just happen at a time other than when it “should” have. The bottom line is that investors are often “right for the wrong reason,” and vice versa. So the first key observation is this: I came into the job at the end of a highly bullish period, maintained a cautious approach, and it worked. What if I’d gotten the job two years earlier? I probably would have done many of the same things. But now my tenure would have included the horrendous FY2000, with Penn’s 3,000 basis point underperformance. And it would have omitted FY2009, in which Penn lost 1,200 basis points less than many peers and avoided being hamstrung. If I had led Penn’s endowment to take the same actions in FY1999- 2008 as it did in FY2001-2010, which is quite likely, I’d be considered a very average chairman . . . at best. The principle lesson of this tale is the observation that investment timing is imprecise and difficult but extremely significant in terms of outcomes. The bottom line: be understanding when evaluating track records, and refuse to accept the results at first glance. Taleb reminds us to wonder about “alternative histories” – the other things that reasonably, probably could have happened. Doing so isn’t easy, but it’s essential in any field in which randomness plays a big part. What If?

© OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED. CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved.  . . . are in business to buy debt at significant discounts, often from forced or highly motivated sellers. “Distressed debt at par” is an oxymoron and, at least in theory, distressed debt investors are bargain hunters whose ardor rises as prices fall . . . not the reverse like so many other investors. It’s not that distressed debt investors can’t make mistakes; just that their likelihood of doing so is reduced by the very nature of their investment activity. Anything that decreases an investor’s chance of erring – even an involuntary safety mechanism – works to his advantage. Distressed debt is, by definition, an area where:  borrowers and lenders have made grave mistakes,  at least some of those mistakes have come to light, and  the stress, unpleasantness and uncertainty that attend a downturn often make debt holders sell out at the wrong time and price. In other words, it’s an area where negativism and error are crystallized, maximized and magnified. And nothing is more likely to make an asset too cheap than excessively negative psychology. When we’re out raising a new fund, investors often ask whether people have wised up such that they’ll no longer make these mistakes. Thus far the answer has been no, and in fact there’s no reason to believe there’s been any progress at all up the learning curve. The proof?

– Part II The second philosophical question is similar but even simpler: what if the global financial crisis hadn’t occurred? My tenure as chairman of Penn’s endowment was marked by my characteristic preference for being able to survive bad times over acting to take maximum advantage of good times. And the worst financial event in eighty years materialized, making that the right approach for the times. But was I “right”? As I said before, during my tenure, Penn underperformed by a bit: 5½% versus 6-7%, a very reasonable sacrifice in exchange for side-stepping the pain of the crisis. But if we take out FY2009, the results for the other nine years were 8% for Penn versus 10½-11½% for its peers. Is that still a reasonable sacrifice? It was largely the arrival of the crisis – with its influence on the ten-year record and its highly visible impact on university operations – that made my tenure a successful one. But could the crisis reasonably have been anticipated, making my caution appropriate? Or was it unforeseeable and thus fortuitous, meaning I was right for the wrong reason? I wonder about this a lot, in order to derive the significance of my tenure as chairman and learn from it. (If you want to read more about “what if” questions like these, you might enjoy the section called “What’s Real?” in my memo Pigweed, from December 7, 2006.) © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

The distressed debt opportunities that built up in 2005-07 and flowered in the crisis of 2008 were some of the best we’ve ever encountered, and certainly the most plentiful. One Classic Mistake I want to take this occasion to touch on a favorite thought of mine. Investing consists of just one thing: choosing which assets to hold in order to profit in the future. Thus there’s no getting away from the need to make decisions concerning the future. In deciding which future to prepare for, you need two things: (a) an opinion about what’s likely to happen and (b) a view on the probability that your opinion is right. Everyone knows about the former, but I think relatively few think about the latter. In short, most people believe in their opinions. “Of course they do,” you might say. “If they didn’t have faith in their opinions, they wouldn’t hold them.” And that’s the point. Everyone’s entitled to his or her opinion. But one of our favorite sayings around Oaktree states that “it’s one thing to have an opinion, and something very different to act as if it’s right.” Clearly, our opinions are our opinions because we believe them. (We rarely hear anyone say “Here’s what I think, and I’m probably wrong.”) But just as clearly, we believe (or should believe) more in some of our opinions than others.the

He sees outflows of capital that, rather than being a negative, have lowered prices and can give rise to a strong price rebound when and if they reverse. Most of all, he sees an asset class to which no optimism is being applied. If I were asked to name just one way to figure out whether something’s a bargain or not, it would be through assessing how much optimism is incorporated in its price. No matter how good the fundamental outlook is for something, when investors apply too much optimism in pricing it, it won‟t be a bargain. That was the story of the Internet bubble; the Internet was expected to change the world, and it did, but when the optimism surrounding it proved to have been excessive, stock prices were decimated. Conversely, no matter how bad the outlook is for an asset, when little or no optimism is incorporated in its price, it can easily be a bargain capable of providing outsized returns with limited risk. Even with a bad “story,” the price of an asset is unlikely to decline (other than perhaps in the very short term) unless the story deteriorates further or the optimism abates. And if there‟s no optimism built into its price, certainly the latter can‟t happen. It was primarily this line of reasoning that allowed me to feel positive in the teeth of the financial crisis in late 2008. The outlook was as bad as it could get – total meltdown – and prices clearly incorporated zero optimism. How, then, could buying be a mistake (providing the world didn‟t end)?

© OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED. CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. weather tomorrow in California, a B-rated bond issuer paying its debts, and Greece being part of the European Union in three years is different in each case. Few people would take issue with that. If that’s true, the reliance we place on each prediction – and the action we take in that reliance – should vary. Yet, as I see it, most people who believe in forecasting come up with their opinions and then act on them with equal amounts of confidence. This is one of the greatest sources of investment error. It’s perfectly okay to say you don’t know something. It’s also okay to say you have a view on what might happen but you’re not so sure you’re right. In that case you’re likely to moderate your actions and emerge intact even if you turn out to be wrong. As Mark Twain put it, “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.” Or as Treasury Secretary Robert Rubin told the 1999 graduating class of the University of Pennsylvania, “. . . understanding the difference between certainty and likelihood can make all the difference.” Forecasting error is much less likely to prove fatal in the absence of excess conviction. I’ve mentioned before the frequency with which I feel I come across a particularly apt quote just when I need it for a memo in the making.

Thus I’ll close this section with one on the present subject from Yaser Anwar’s “Exclusivo Listserv” of May 29: . . . while every one well knows himself to be fallible, few . . . admit the supposition that any opinion, of which they feel very certain, may be one of the examples of the error to which they acknowledge themselves to be liable. (John Stuart Mill, “On Liberty,” 1859) In other words, nearly everyone accepts that his or her opinion might be wrong . . . just not this time. A Big Mistake in the News A vast amount of ink and airtime is being devoted to the subject of JP Morgan’s loss of multiple billions of dollars in its effort to hedge credit risk. People – and especially politicians – have seized on the loss to prove that Jamie Dimon isn’t perfect and bank regulation is inadequate. Clearly, JP Morgan made a mistake – or more than one. Jamie Dimon has described the hedge as “poorly designed,” “sloppy” and “a terrible, egregious mistake.” How could that be the case – and how could the result be such an enormous loss – in a field as inherently defensive as hedging? The answer’s simple: as Charlie Munger once said to me about investing, “It’s not supposed to be easy. Anyone who finds it easy is stupid.” The truth is, it’s hard to get it all right all the time, and that’s just as true of hedging as it is of investing. Hedging sounds easy: you own something, so you sell something to lessen the impact if your investment performs badly.

Were the actions taken at Penn right? Wrong? Or right for the wrong reason? We should insist on engaging in this kind of examination. Only then can we draw reliable conclusions and hope to improve our decision making. Let me know if Oaktree can help in this regard. February 15, 2012 © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED. CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved.  Hedging with the wrong thing. Let’s say you own some A but don’t want to suffer the full impact if its price declines. Why not just sell short an equal amount of A to hedge? The answer is that owning A and simultaneously shorting A is the same as not owning anything. The long and short positions exactly offset each other, meaning you can’t make (or lose) any money. That’s not hedging, that’s negating. You want to dampen fluctuations, not eliminate them. So you hedge by selling short something you think will move in sympathy with A, but not exactly. The hope is that by doing it very well, you can eliminate more of the risk of loss than you do of the potential for gain. That’s the meaning of a “positive arbitrage.” Buying Ford stock and simultaneously shorting Ford accomplishes nothing. So perhaps you buy Ford and short General Motors, which you think will perform less well, going up less than Ford or down more. But by transacting in two different assets, you by definition introduce the possibility of an unfavorable divergence. This is called “basis risk.” In short, it’s the risk that the behavior of the two assets relative to each other will differ from what you expected.

For example, Ford goes down, giving you a loss, but rather than go down in sympathy (which would give you an offsetting gain on the short position), a favorable development at GM makes it go up, compounding your loss as the hedge goes against you.  Hedging in the wrong amount. You hold 1,000 Ford shares, and you think that – given their likely relative performance – you should short 500 GM shares to hedge your risk. But it turns out that while they move in opposite directions, their relative movements aren’t what you expected. Thus you either hedged too much (and thus you lose more on the hedge than you make on the underlying position) or you hedged too little (so the protection you sought doesn’t materialize). There’s no sure way to choose the right “hedge ratio.”  Time risk. The two sides of the position may work as you expect, but not when you expect. Thus the hedge may fail to work in the short run, meaning the loss on one side of the hedge may occur before the gain on the other, in which case you’ll look flat-out wrong for a while. And if you’re required (by regulation, margin call, capital withdrawals, etc.) to close out the position at that point, the result could be quite negative.  Insufficient liquidity. If conditions or goals change, you might want to adjust or remove your hedge. But market developments in terms of liquidity might make it impossible to alter one or both sides of the position.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. Again the enemy was extrapolation. The average annual return had risen from about 10% for 1929 to 1980, to 20.4% for 1980 to 1989, and to 28.6% for 1995 to 1999. But investors drew the wrong conclusions, the inverse of those of “The Death of Equities”: they thought the good times could only roll on. However: They forgot that in the long run the gains of stocks stem primarily from growth in corporate profits, and that profits don‟t grow anywhere near 20-30% a year. They ignored the possibility that the ultra-high returns of the 1990s had borrowed from future returns. They failed to wonder whether the adoration of stocks had lifted their prices to dangerous heights. They asked “What has been the historic return on stocks?” and bought based on the favorable answer. But they didn‟t ask “What has been the historic return on stocks after they‟re risen almost 19% a year for 21 years?” or “What has been the historic return on stocks if bought at price/earnings ratios in the 30s?” The answer to these latter questions would have been very different. Extrapolation was at the root of these omissions, disregarding the possibility that events had changed the environment and thus the outlook. What did I say about the drought and rain? Of course, after stocks had done well enough in the 1990s to encourage maximum bullishness and maximum allocations, their returns were primed for regression to the mean.

© OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED. CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. wrong about which asset to hedge with, how much to hedge, or whether the two sides of the hedge will move simultaneously. But, just like everyone else in the investment world, would-be hedgers must understand that relationships that held in the past can’t be counted on to hold in the future. And let’s remember, as The New York Times wrote on May 26, “Yes, Morgan lost big – but, as Mitt Romney has pointed out, someone else won.” That’s the bottom line on all investing. There’s generally a right side and a wrong side to every investment. Which will you be on? * * * Risk control isn’t an action so much as it is a mindset. It stems largely from putting at least as much emphasis on avoiding mistakes as on doing great things. Risk control – and consistent success in investing – requires an understanding of the fact that high returns don’t just come along for the picking; others must create them for us by making mistakes. And looked at that way, we’ll do a better job if we force ourselves to understand the mistake we think is being made, and why. Risk control requires that we avoid the analytical and psychological errors to which others succumb. In particular, risk control requires that we temper our belief in our opinions with acceptance of our fallibility. In the end, superior investing is all about mistakes . . .

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. when valuations are high and prices embody great optimism, and they‟re much less risky when the reverse is true (see 1979). It says “the longer you hold [stocks], the better your chances of getting blindsided by a downturn.” I find this highly misleading. The longer you do anything, the better the chance that something bad will happen. But that doesn‟t mean you shouldn‟t do it, or that it‟s safer to do it for just a short time. Maybe the participant for a short period will time it just wrong and run straight into a bad patch. And maybe by holding stocks for just a short time he‟ll miss out on the long-term benefits. The question isn‟t whether something bad can happen to the long-term investor in equities, but what‟s likely to happen overall, considering good times as well as bad. And whether, given his particular circumstances, an investor can survive the bad while waiting for the good to arrive. In deciding how much risk a prospective retiree can bear, the authors make reference to not wanting to see 2008-style losses of 30% to 40% ever again. But using the worst time in generations to argue against investing in stocks is no better than using the best time to argue for it. What matters isn‟t the best or worst possible outcome (or even the single most likely outcome). What matters is the range of outcomes and their respective probabilities and consequences.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. The story isn‟t as hopeless as it was in 1979, but it is uniformly negative. Thus, while I don‟t expect an equity rally anything like what followed on the heels of “The Death of Equities,” I don‟t find it hard to conjure up positive scenarios. * * * The media usually gets it wrong, and the pieces that get the most attention tend to be highly sensational and to get it the most wrong. This is one of the many reasons why the deck is stacked against the average investor. “The Death of Equities” would have gotten you out or kept you out of the stock market at very attractive levels in 1979. Professor Siegel‟s work would have gotten you to increase your holdings at high prices in the 1990s. And this new article argues against stocks at a time when valuations are below average, investors have turned against them, and companies are doing well. The great irony here is that the extrapolator actually thinks he‟s being respectful of history: he‟s assuming continuation of a trend that has been underway. But the history that deserves his attention isn‟t the recent rise or fall of an asset‟s price, but rather the fact that most things eventually prove to be cyclical and tend to swing back from the extreme toward the mean.

© Oaktree Capital Management, L.P. All Rights Reserved. * * * The simplistic view says that because the world is uncertain today, we shouldn’t venture forth. But I think it’s much wiser to say that despite the uncertainty, we shouldn’t automatically settle for assets believed to be entirely safe – especially since (a) flight of capital to their seeming safety has rendered their promised returns low and (b) that safety can prove to be illusory. Instead we should attempt to take control of our fate and strive for reasonable returns with the risks handled responsibly. And one of the most interesting aspects of investing stems from the fact that you can’t just do nothing. In the investing world, even doing nothing is doing something. It’s choosing to stay with what you have rather than switch to what you could have. It’s deciding to deal with the environment passively rather than actively. And it’s avoiding the risky to stay with the seemingly safe. These are significant actions, and they must be undertaken on the basis of serious analysis and active decision making. The challenge today is that while you can get less-than-safe things relatively cheap because the crowd is desperate for safety, the crowd’s concerns are not imaginary. If you turn up the risk because you think the premium being paid for safety is too high, there are scenarios under which you will have made a big mistake.

Thus the goals of financial regulation are roughly as follows:  to limit risk, especially risk to the overall financial system,  to restrict the concentration of economic power,  to protect customers, especially “the little guy,”  to prevent error, fraud, misrepresentation and theft, and  to democratize finance and make it a tool of social policy. © Oaktree Capital Management, L.P.Reserved

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. If ethics, self-regulation, personal responsibility, respect for risk and a sense of limits could be counted on, we wouldn’t need much in the way of regulation. But, sadly, they can’t. Since the profit motive can lead financial institutions to aggressive risk taking, error and even misdeeds, regulation is counted on to prevent these things. There’s also concern that individuals’ self-interest might drive them to actions that collectively might injure their companies and society. Free markets do a great job of allocating economic resources – especially on average over the long run – but the interim fluctuations produced by miscalculation can be intolerable and have to be modulated. This makes regulation indispensable. Bottom line: the financial system can’t be entrusted to untrammeled free markets. Regulation is Imperfect and Harmful – Free Markets Do It Best On the other hand, regulation is too imperfect to be relied on. (Thanks to “Soggy” Sweat for this dialectical approach – see “All that Glitters,” December 17, 2010.) It’s easy to write hard- and-fast rules, but rules sometimes impose undue costs or restrict activity in undesirable ways. And their specificity often makes them capable of being circumvented. Because financial institutions are intent on innovation, rules rarely keep pace and regulators usually find themselves playing catch-up.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. presses to pay its debts, the dollars with which it does so will likely have diminished purchasing power.)  The truth is that an AA+ rating is far from meaning “default-prone.” Since only a few percent of single-B bonds default each year on average, at worst AA+ must imply a probability of default of a small fraction of a percent. In fact, many potential triple- As opt for AA+ instead in order to be able to carry more debt. That’s one reason S&P rates only four companies triple-A.  Getting a little more esoteric, what does it mean for a debtor to “meet financial commitments”? As I mentioned in “Down to the Wire,” debtors generally aren’t expected to pay off their debts; rather, it’s the normal expectation that interest will be paid and principal will be refinanced. Interesting, then: even triple-A doesn’t necessarily connote an ability to extinguish one’s debts.  While credit ratings are explicitly defined as relative, relating primarily to the likelihood of payment, I’ve always thought triple-A has a connotation for most people that absolutely nothing can go wrong. For that matter, U.S. Treasurys have traditionally been described as “riskless,” which sounds pretty absolute to me. If that’s a fair description, it doesn’t seem to fit the political process we’ve witnessed in the last few months.

 The events of July suggest some of those currently in control in Washington don’t think failing to meet commitments would be a big deal. Certainly it seemed possible on July 31 that some of the people to whom the U.S. owed money might go unpaid within a few days. So, is the risk on Treasurys really non-existent?  If the U.S. was triple-A in 2000, when it was running a surplus, its national debt was far smaller, and Washington functioned much more constructively, mightn’t it deserve a lower rating today?  Our deficits are far bigger than ever, and the commitment to do what it takes to reduce them seems quite weak. As I wrote in “I’d Rather be Wrong” (March 2010), “Everyone wants to see the deficit narrowed, but today’s circumstances seem to prohibit both expenditure reduction and revenue increases. Everything else is on the table.” The process of governing seems to be running less well than ever.  The long-term outlook is particularly bleak. In “Down to the Wire” I described how entitlement programs endanger our fiscal future. I failed, however, to mention that the present value of our future unfunded obligations is estimated at $64 to $99 trillion depending on the source (per J.P. Morgan), a burden that dwarfs our current national debt of $14.3 trillion. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. So S&P and Egan-Jones downgraded U.S. debt (while Moody’s and Fitch didn’t). There was one main moving part on August 5: that’s the day S&P labeled U.S. debt less safe. What was the upshot? A buying panic in U.S. Treasury securities, with the yield on the 10-year note falling below 2%. As an aside, let’s spend a minute thinking about that reaction. If there had been near unanimity about anything, it was that a downgrade would raise the yield demanded on U.S. debt. Certainly the fact that so many people could be wrong about this supposedly simple linkage should disabuse investors of the notion that they know how markets work. The expected reaction was much more logical than the one that actually played out: after it was labeled less safe, the yield demanded on U.S. debt declined markedly. I find the explanation fully worthy of Yogi Berra: the downgrade of Treasurys made people so worried about the elevated risk in the world that they ran to Treasurys for safety. So much for the supposed rationality of markets. The bottom line for me in all the above is that, while on an emotional basis I find the debt situation depressing, intellectually I believe U.S. Treasury obligations will prove money good. At bottom I agree with former Treasury secretary Hank Paulson: While the players in Washington certainly haven’t performed at AAA level, I would certainly take U.S. Treasuries over other AAA sovereigns any day.

Their economies are growing strongly and generally not over-indebted. Rather, here the issues stem from the juxtaposition – as often seen – of investors’ high expectations with a new, less rosy reality. I’ve written in the past (e.g., in “Hemlines,” September 2010) about the propensity of markets to become captivated by simple themes, like “the Internet will change the world,” “equities are good” or “who needs bonds?” One such easy-to-swallow story line that prevailed over the past decade has been with regard to the “emerging market miracle” and, especially, the inevitability of China. I don’t mean in the least to suggest that the outlook for China, India and the rest of the emerging markets is less than bright. In fact, I’m sure they’ll out-grow the developed world over the remainder of the century. The problem, however, is that simplistic, mania-following investors elevated emerging markets to the pedestal of the “sure thing” where nothing can go wrong. And when prices incorporate unlimited virtue, the eventual result is bound to be disappointment, disillusionment and depreciation. Even favorable developments can lead to losses when they fail to measure up to expectations. That’s been the case in the emerging markets. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. Rather than end there, as I originally thought I would, I want to add a little about the longer-term future. I could prepare the way by repeating my standard confession that I’m given more to worrying than to enthusing, but you already know that. What I want to say is this: the worries concerning the U.S. economic outlook enumerated on page seven are not limited to the current short-term cycle. I touched on most of them in “What Worries Me” (August 2008), “The Long View” (January 2009) and “Tell Me I’m Wrong” (January 2010), and my view of their importance hasn’t changed. I think they’re likely to influence the environment for years. I feel today’s distribution of possible futures is shifted to the left – that is, generally less attractive – relative to the distribution that governed the late twentieth century. The picture in the U.S. is less positive today in terms of consumer-led growth and the supercharging impact of increased credit use, competitiveness and job creation, and the government’s fiscal situation (and thus its ability to stimulate the economy). I think we benefited greatly in that earlier period from the luck of the draw. Things went about as well as they could have for the economy (despite sluggish income growth). Inflation was very much under control, and we benefited from steadily declining interest rates.

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

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved Even six years later, I can’t think of any responses to a low-return world beyond those enumerated above. Limit risk, sacrificing return. Accept risk in pursuit of return, and pray the consequences will be tolerable. Or strive to find ways to augment returns through means other than risk bearing. None of these possible solutions is perfect and without pitfalls. In fact, each brings its own form of risk. Staying safe entails the risk of inadequate return. Reaching for return increases the risk of financial loss. And the search for “alpha” managers introduces the risk of choosing the wrong ones. But, as they say, “it is what it is.” When it’s a low-return world, there are no easy solutions devoid of downside. The Right Approach for Today One of the things that makes investing interesting is the ever-changing nature of the route to profit, the pitfalls that are present, and the tools and approaches that should be employed. Conscious decisions regarding these things should underlie all efforts to manage capital, and they must be revisited constantly as circumstances and asset prices change. What’s right today? First, should you prepare for prosperity or not? By prosperity I mean a return to the happy days of the 1980s and ’90s, when reported economic growth was strong and consumers were eager to spend.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. even nobility to the pursuit of higher after-tax income . . . and the fact that their supporters are self-interested doesn’t make them wrong. Finally, for whichever reason, a good portion of the electorate buys these arguments. And The New York Times reported on November 2 that “Americans for Tax Reform, a taxpayer advocacy group . . . says that 41 senators and more than 235 House members have pledged in writing to oppose all tax increases.” Topics in the News – Income Inequality One of the outstanding characteristics of the U.S. economy at this time is the rising dispersion between incomes. The percentage of total income going to higher earners has been increasing dramatically, whether because of (a) the rising importance of education and technological literacy or (b) the movement of work offshore, the declining availability of blue-collar jobs and the reduced power of private-sector unions to garner wage gains. And given the pattern of tax cuts and the special treatment given to income on capital, the tax system has magnified the divergence. A recent report from the Congressional Budget Office provided dramatic evidence of the divergent trends in income.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved But what if you had money and nerve in 2006 or early 2007? The results would have been disastrous. In those times you needed caution, conservatism, risk control, discipline and selectivity to stay out of trouble. In short, when the market is defaulting on its job of being a disciplinarian, discernment becomes our individual responsibility. So then, which is the right set of equipment for today? I think we’re back to needing the cautious attributes, not the aggressive. An unusually large number of thorny macro issues are outstanding, including:  the so-so U.S. recovery;  the U.S.’s deficit, debt ceiling impasse and dysfunctional political process;  the economic impact of deleveraging and austerity;  the over-indebtedness of peripheral eurozone countries;  the possibility of rekindled inflation and rising interest rates;  the uncertain outlook for the dollar, euro and sterling; and  the instability in the Middle East and resulting uncertainty over the price of oil. With all of these, plus prices that are fair to full and investor behavior that has increased in aggressiveness, I would rather gird for the things that can go wrong than ensure maximum participation if things go right. (Of course that’s not an unfamiliar refrain from me.)

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Tell Me I’m Wrong My readers treat me well. They indulge my penchant for dissecting the past, and they send kind messages of encouragement. To repay their generosity, I’m going to venture into something I usually avoid: the future of the U.S. economy. This memo won’t be about the future in general, just the elements I find worrisome. As I see it, every investor is either predominantly a worrier or predominantly a dreamer. I’ve come clean many times: I’m a worrier. By saying that, I absolve myself of having to describe the whole future. I’m going to cover the negatives, starting with the immediate and ending with the systemic (some of the latter repeats themes from “What Worries Me,” August 28, 2008). For the other side of the story, I’d suggest you consult the optimists who seem to be in charge of the markets these days. The Near Term One thing is indisputable: the rally in financial markets worldwide has outpaced the fundamentals. At the beginning of 2009, most onlookers expected a generally weak economy and were concerned that the behavior of consumers and banks would remain conservative. They were 100% right, and fundamentals are still tenuous. And yet, the rally has exceeded all expectations of which I’m aware.

Memo to: Oaktree Clients From: Howard Marks Re: Warning Flags For about a year, I’ve been sharing my realization that there are two main risks in the investment world: the risk of losing money and the risk of missing opportunity. You can completely avoid one or the other, or you can compromise between the two, but you can’t eliminate both. One of the prominent features of investor psychology is that few people are able to (a) always balance the two risks or (b) emphasize the right one at the right time. Rather, at the extremes they usually obsess about the wrong one . . . and in so doing make the other the one deserving attention. During bull markets, when asset prices are elevated, there’s great risk of losing money. And in bear markets, when everything’s at rock bottom, the real risk consists of missing opportunity. Everyone knows these things. But bull markets develop for the simple reason that most people are buying – ignoring the risk of loss in order to keep from missing opportunity – just when elevated prices imply losses later. Likewise, markets reach their lows because most people are selling, trying to avoid further losses and ignoring the bargains that are everywhere. The Never-Ending Cycle Why do people buy when they should sell, and sell when they should buy? The answer’s simple: emotion takes over. Price increases excite investors and encourage them to buy, and price declines scare them into selling.

Memo to: Oaktree Clients From: Howard Marks Re: I’d Rather Be Wrong Just a few weeks ago, I published “Tell Me I’m Wrong,” my latest list of things in the investment environment that I find worth worrying about. I’m going to devote a few pages here – I promise this’ll be the shortest memo in years – to a point I touched on in “What Worries Me” (August 28, 2008) but omitted from the more recent piece. This memo will be about one of the inarguably most depressing topics of our time: the seeming inability of governments and politicians to solve – or even tackle – the financial problems we face. Here’s the situation in Washington: • Many of our most sweeping financial problems, such as deficits, national debt, healthcare costs, Social Security and Medicare, are long-term problems. • It’s important that we tackle them early, since limiting their further growth can reduce the eventual cost and difficulty of fixing them. • But the process of solving them will be unpleasant in the short term, entailing bad-tasting medicine, while the benefits will only be seen in the long term, when today’s politicians will have left the stage. • Finally, most politicians’ main concern seems to be getting themselves and other members of their party elected. Voting for short-term pain in order to solve long-term problems is generally viewed as the wrong way to go about that.

© Oaktree Capital Management, L.P. All Rights Reserved equity loans.” The final element in the equation was the decline in the savings rate to roughly zero in the last decade. Thus consumers spent all they made and, in many cases, more. These trends enabled growth in spending to exceed the growth in incomes, adding substantially to the growth in GDP. Few people seemed to understand that increases in home prices weren’t inexorable, or that there was anything wrong with incurring debts without a foreseeable way to repay them. Shopping became a national pursuit, and fads like “investment dressing” and “investing in collectibles” made reckless spending seem rational. This all fell apart when the uptrend in home prices collapsed and consumer credit and home loans became unavailable. Fear suddenly replaced limitless optimism among consumers, shopping became dispensable, and the savings rate rebounded to around 5% – meaning spending suddenly grew slower than incomes (which themselves were contracting). The trend in consumer spending, which had buoyed the economy, now led its decline. Further, businesses saw no reason to expand inventories or factory capacity, transferring the slowdown to the manufacturing sector. What will happen in the future? Will spending rebound? Or will the swing toward frugality and savings be permanent? I recently read an article which dismissed the latter possibility, saying, “People still want a better life.

I hasten to state that I don’t view this as a question of one side being right and the other wrong. At this moment, with the Democrats in control of the White House and both houses of Congress, the Republican minority seems to be hell-bent on frustrating the Democrats’ plans (and capable of doing so). But my criticism isn’t reserved for today’s minority party. I have absolutely no doubt that unless something changes, the next time the Republicans are in power, the roles will be reversed and the Democrats will be the obstructionists. You can think the things President Obama wants to do are either right or wrong, but you can’t deny the fact that, even with majorities in both houses of Congress, he can’t do them. This truly is gridlock. Some people think gridlock is a good thing. They think either (a) government should do less rather than more or (b) government is incapable of doing anything right (or both). In my opinion, you have to hold attitudes like those in order to be optimistic about the situation in Washington. However, there are some things only government can do. Even the founding fathers, as leery of government as some were, created one. Many of today’s problems are government-created, so government will have to solve them. I believe most Americans want to see the problems solved. Of course, they disagree on how best to do so. But our leaders should work together to find solutions and explain to the voters why compromise is necessary.

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

June 30 to June 30 2007-08 2008-09 2009-10 three years 10-year Treasury bond 12.6% 7.3% 8.3% 30.8% Barclay’s Govt/Credit 7.2 5.3 9.7 23.8 Citi High Yield Index -0.5 -4.2 24.7 18.8 S&P 500 -13.1 -26.2 14.4 -26.6 MS EAFE Index -22.5 -26.1 7.1 -38.7 MS Emerging Markets 2.6 -30.0 20.6 -13.4 Clearly, the recent performance edge of bonds over stocks has been dramatic. What’s Going On Today? Now, suddenly, investors seem to have awakened to bonds’ attractions. This after failing to do so in time for the crisis, when holding bonds would have been of great value. Is this just another case of investors driving while looking in the rearview mirror? And are they shifting from stocks to bonds at just the wrong time? The headlines are dramatic and the facts are clear. In just the last few weeks, we’ve seen newspaper stories like these: “Investors Fleeing Stocks with Cash Flow Lure JP Morgan” (Bloomberg, August 16), “Treasury Bears Cave as Bond Yields Keep Tumbling” (The Wall Street Journal, August 16), and “Growing Concern over Bond Bubble” (Financial Times, August 21). Bloomberg reported as follows: About $33 billion flowed out of funds owning U.S. shares this year . . . About $185 billion was sent to bond funds through July 31, the most on record, according to the Investment Company Institute. These statistics relate to mutual funds and their retail investors. While not necessarily the same for institutions, they are indicative of trends in investor psychology.

Renewed economic uncertainty is testing American’s generation-long love affair with the stock market. . . . Small investors are “losing their appetite for risk.” . . . “Like everyone else, I lost” during the recent market declines [an individual investor] said. I needed to have a more conservative allocation.” . . . Investors pulled $19.1 billion from domestic equity funds in May, the largest outflow since the height of the financial crisis in October 2008. (August 22, 2010) Turning conservative after a crisis smacks of closing the barn door after the horse has left, but it’s a regular feature of investor psychology. Of course, there has to be a fundamental rationale for investor behavior, and the current low opinion of stocks is based on the spreading belief that the recovery will be anemic and there could be a double dip. Also behind it may be the expectation that tax rates on dividends and long-term capital gains will rise relative to the rates on ordinary income. And why is so much capital flowing to bonds? The analogy to hemlines serves well in this regard. Take a long-established style, stir in changed circumstances, and add a significant swing in psychology. Bonds became passé over a long period of time, and stocks caught everyone’s attention. When these trends had gone as far as they could, and the error of the fashion extreme ultimately was exposed, bonds came back into style.

© Oaktree Capital Management, L.P. All Rights Reserved  the ramifications of high debt levels and the necessary austerity measures,  the economic future of the developed world,  the impact of China and other emerging nations,  the likelihood of deflation versus hyperinflation, and  the soundness of currencies and sovereign debt. Thus it shouldn’t come as a surprise that people are groping for something they can depend on. Since gold acts as a barometer of expectations regarding inflation and concern about economies and currencies, its popularity has risen as sentiment regarding these things has declined. Being away from home tends to alter one’s perspective. While traveling, I was shocked to hear someone (okay, a gold producer possibly “talking his book”) describe the U.S. as having a corrupt political system in the grip of special interests and being committed to the debasement of the dollar. While I know the stimulative actions being undertaken may well cause the dollar to weaken, I like to think the part about corruption isn’t true. But I have to admit that I’m not all that happy with what’s going on in the U.S., and especially in Washington, D.C. (see “What Worries Me,” August 2008 and “I’d Rather Be Wrong,” March 2010). While other nations are enacting austerity measures to trim their deficits and debt, I don’t see much coming from Washington. So if not corrupt, then perhaps just weak-kneed.

* * * I started this memo in late April, but I didn’t get it out before Greece’s financial crisis burst into full bloom last week. This gives me an opportunity to discuss the significance of the recent developments (not the substance, however; that’ll have to await another memo). Investing defensively requires that when everything seems to be going well and investors are feeling positive, we must sense the implicit danger and prepare for negative developments. In the mid-2000s, I began to warn that with asset prices full, investors optimistic and their behavior aggressive, it was important to worry about things that could come along to derail the markets. When asked what they might be, my list of possibilities would go like this:  recession,  credit crunch,  $100 oil,  collapse of the dollar,  exogenous events such as terrorist attacks, or  something else. The most dangerous possibility, I pointed out, was the last one. Markets and market participants can adjust to things they see coming. What usually knocks them for a loop are things they don’t anticipate. “We’re not expecting any surprises” is one of my favorite oxymorons. By definition, surprises are things that aren’t anticipated, and thus their arrival can be traumatizing. Just a few months ago, I published a memo called “Tell Me I’m Wrong” (January 22), in which I listed a number of things that worried me.

scenario, whereas it really consists of a wide range of possibilities. (Remember Elroy Dimson’s trenchant observation that “risk means more things can happen than will happen.”) And to the extent they do consider a variety of possibilities, few people include ones that haven’t been part of recent experience. The uncertainties discussed above tell me today’s distribution of possibilities has a substantial left-hand (i.e., negative) tail, probably greater than at most times in the past. The proper response should be to discount asset prices, allowing a substantial margin for error. Forecasts should be conservative, yield spreads should incorporate ample risk premiums, valuation parameters should be below the long- term norms, and investor behavior should be prudent. Conspicuously missing from my list of worries was Greece (and all it entails); thus it falls firmly in the category of “something else.” Last week it dominated the headlines and depressed markets worldwide. Thus in this short time I have proved two things: first, I know little more than others about what the future will bring and, second, when most investors turn optimistic, it becomes important to worry. The issue of Greece and its debt has been on investors’ radar screens for months, but few people seem to have understood its ramifications and the risks it presented to the markets.

© Oaktree Capital Management, L.P. All Rights Reserved  big companies’ large cash holdings, delevered balance sheets and eagerness to respond to increased orders. When people ask me when we’ll get back to normal, I ask what they mean by normal. If they mean an environment like 1992-2007, I tell them those were unusually good times, not what the “normal” of the future is going to look like. The fifteen (or 25) years just prior to the credit crisis were marked by strong, consumer-led growth; rapidly increasing use of credit; American leadership in media, software, technology and financial products; and powerful bullishness and expansiveness. I doubt the years just ahead will be equally positive. My goal in this memo isn’t to express a forecast. I know no forecast – and certainly not mine – is likely to be correct. What I do want to do is caution that the considerable risks I see may be less than fully appreciated by those setting asset prices today. The greatest market risks lie in failure of the macro economy to live up to the expectations embodied in today’s prices. Please tell me if you think I’m wrong in letting the factors described above push me toward caution. In fact, I’d love it if you told me my worries are unfounded, and that our economic and business future will see a complete return to good times. Most people view the future as likely to repeat past patterns, which it may or may not do.

They tend to think of the future in terms of a single scenario, whereas it really consists of a wide range of possibilities. (Remember Elroy Dimson’s trenchant observation that “risk means more things can happen than will happen.”) And to the extent they do consider a variety of possibilities, few people include ones that haven’t been part of recent experience. The uncertainties discussed above tell me today’s distribution of possibilities has a substantial left-hand (i.e., negative) tail, probably greater than at most times in the past. The proper response should be to discount asset prices, allowing a substantial margin for error. Forecasts should be conservative, yield spreads should incorporate ample risk premiums, valuation parameters should be below the long-term norms, and investor behavior should be prudent. And yet, the powerful rally of 2009 has more than offset the decline of 2008 in many asset classes. To the extent that the resultant valuations incorporate optimism, I would argue for caution today. A lot of “easy money” was made last year; in retrospect, all you had to do was have access to capital and the guts required to invest it at the absurd low prices of late 2008/early 2009 and hold on during the wild recovery. Of course, those things were far from easy at the time. The profits ahead won’t be easy money.

They’ll require careful selection, appropriately high risk consciousness, insistence on margin for error, and cooperation from the forces that determine outcomes (such as luck). With most assets valued about fairly today, caution, discernment and discipline – not much needed in 2009 – have replaced guts as the essential elements in profitable investing.2010

(And while the emergency cash infusion helped the states keep their heads above water, it ultimately compounded their plight, since even though the federal funds are not necessarily recurring, the jobs and obligations they fund are.) This year, however, the federal stimulus money is going to be thinned dramatically. The Obama administration has asked for about $50 billion for 2011, but experts believe it would require another $160 billion in cash just to meet demands for the next two years. And this assumes there is no increase in unemployment or decrease in tax revenues. Even though there is scant appetite among election- susceptible Democrats in Washington to add more zeroes to the end of the federal deficit, there may be no alternative. If the federal government does not intervene, the entire U.S. economy could be put at risk. After all, aren’t California and Illinois, like the country’s banks, “too big to fail”? (Emphasis in the original) I touched on the subject of the states’ fiscal condition in “Tell Me I’m Wrong” (January 22); that and the passages above from Sokoloff’s piece should suffice for now. However, I do want to go into a bit more detail regarding one of the key contributors to Greece’s troubles: pensions. Pension promises have long been used in the U.S. as a budgetary quick fix.

© Oaktree Capital Management, L.P. All Rights Reserved but also quite painful. If the world is unwilling to live with such lessons from time to time – and if some institutions are considered to be “too big to fail” for society’s purposes – then free markets and self-interest have to be restrained. Greed may be good, but it can be permitted to run free only up to a point. Nothing’s More Risky Than a Widespread Belief That There’s No Risk The recent crisis came about primarily because investors partook of novel, complex and dangerous things, in greater amounts than ever before. They took on too much leverage and committed too much capital to illiquid investments. Why did they do these things? It all happened because investors believed too much, worried too little, and thus took too much risk. In short, they believed they were living in a low-risk world. In 2006 and early 2007, for instance, we heard a lot about the “wall of liquidity” that was coming toward us from China and the oil producing countries, a flow that could be counted on to provide capital and raise asset prices non-stop. Likewise, we were told (a) the Fed had tamed the business cycle through its adroit management, (b) securitization, tranching and disintermediation had reduced risk by putting it where it could best be handled, and (c) the “Greenspan put” could always be counted on to bail out investors who made mistakes. These and other things were said to have lowered the risk level worldwide.

© Oaktree Capital Management, L.P. All Rights Reserved Here’s how Thomas Friedman put it in The New York Times of January 31: Everyone is looking for the guy – the guy who can tell you exactly what ails the world’s financial system, exactly how we get out of this mess and exactly what you should be doing to protect your savings. . . . But here’s what’s really scary: the guy isn’t here. He’s left the building. . . . There is no magic bullet for this economic crisis, no magic bailout package, no magic stimulus. We have woven such a tangled financial mess with subprime mortgages wrapped in complex bonds and derivatives, pumped up with leverage, and then globalized to the far corners of the earth that, much as we want to think this will soon be over, that is highly unlikely. The “I know” school (which first appeared in a memo in 2001) is still making predictions. Statistical comparisons are being made to past recessions and solutions extrapolated from those experiences. Thus it’s the consensus of this school that the recovery will start during the first quarter of 2010. I also see people projecting a stock market rebound based on the average time between past declines and the recoveries therefrom. I think it’s a mistake to hold confident opinions about the events of today. Instead, I think this is a great time to reaffirm faith in the “I don’t know” school, of which I’m a card-carrying member. No one should feel certain they know what’s going to unfold, or when.

Bubble thinking is irrational, given that it’s built on a belief that there’s no price too high. This goes on to manifest itself in a variety of ways. In the 1970s, when hyper-inflation was rampant and interest rates were astronomical, people concluded that no matter the interest rate paid, borrowing to buy “inflation protected” assets like real estate would be profitable. That’s bubble thinking. In my forty-year career, I’ve seen bubbles in growth stocks, small stocks, oil stocks, emerging market stocks and tech stocks, as well as such surefire winners as silver, homes and buyouts. In each instance, there was a logical underlying rationale for the desirability of the subject assets, but people overlooked the possibility that bubble thinking had raised prices to dangerous levels. Alan Greenspan greatly influenced economic and market developments during his term as Fed Chairman from 1987 to 2006, and his record on the subject of bubbles was poor. He set the world on its ear in 1996 by railing against “irrational exuberance” as the Dow Jones Index soared past the 6,000 level, but he was quiet thereafter, rationalizing appreciation well beyond 10,000 based on gains in productivity. Here’s his position on bubbles: . . . bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong.

© Oaktree Capital Management, L.P. All Rights Reserved nationalization may be to return companies to private hands, the temptation to run them for political purposes would be immense. Obviously, there are arguments on both sides. One Proposal The other night, I had dinner with my friend Richard Ressler, principal and founder of CIM Group. He has an idea as to how things can be fixed (as usual), and it’s a pretty good one. I’ll summarize below his thoughts on the banking industry:  There are banking institutions which, because of their magnitude and significance, should be supported through deposit insurance, government guarantees and rescues.  These banks should engage only in the prosaic acts of accepting deposits and making loans. They should not take on ultra-high leverage or make exotic investments. And they shouldn’t do business through unregulated, off-balance-sheet subsidiaries.  Institutions that wish to do things that are off-limits to these banks should do so, but without the benefit of government protection. If they want to take on 30-times leverage and pursue proprietary profits, they should bear the consequences themselves.  Thus banking and risky investing should be separated. In The New York Times of February 2, Professor Paul Krugman of Princeton argued that we have to avoid “lemon socialism: taxpayers bear the cost if things go wrong, but stockholders and executives get the benefits if things go right.

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.

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 ability of any particular firm to resist imitating the overly risky, but law- compliant behavior of competitors will be compromised to the extent that managers face criticism or even removal for not keeping up with so-called industry leaders whose high, short-term returns have pleased a stock market filled with short-term investors looking for alpha. In “The Race to the Bottom” (February 14, 2007), I described the dangerous behavior that providers of capital engage in when the competition becomes heated. The formula is one of the simplest: when there’s too much money chasing too few deals, asset prices are driven up, prospective returns are driven down, and risk rises. Those seven little words – too much money chasing too few deals – represent an absolute death knell for the availability of good returns earned with safety. It should be possible to know when this is the case, as Prince did, but people tend to join in nevertheless. Often this is true because, even if they recognize the danger, they’re also aware that “being too far ahead of your time is indistinguishable from being wrong,” and they don’t want to be out of step. The way I see it, investors face two main risks: the risk of losing money and the risk of missing out. Although investors should balance the two, in reality this is yet another of those arcs along which the pendulum swings regularly between extremes.

it’s improbable events that brought on the credit crisis. Lots of bad things happened that had been considered unlikely (if not impossible), and they happened at the same time, to investors who’d taken on significant leverage. So the easy explanation is that the people who were hurt in the credit crisis hadn’t been skeptical – or pessimistic – enough. But that [realization] triggered an epiphany: Skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive. (“The Limits to Negativism,” October 15, 2008) The swing of the pendulum to one extreme or another is a constant in the investment world: from optimism to pessimism, from credulous to skeptical, from sanguine to panicked, from wide-open capital markets to windows slammed shut, from more buyers than sellers to more sellers than buyers and, consequently, from overpriced to underpriced. Thus I was thrilled when an article by my friend James Grant provided a quotation that beautifully sums up the end result of this process: To the English economist Arthur C. Pigou is credited a bon mot that exactly frames the issue. “The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant.” (The Wall Street Journal, September 19, 2009, emphasis added) Optimism thrives in bubbles.

© Oaktree Capital Management, L.P. All Rights Reserved One of the concepts that governed my early years, but about which I’ve heard little in recent years, is “fiduciary duty.” Fiduciary duty is the obligation to look out for the welfare of others, as opposed to maximizing for yourself. It can be driven by ethics or by fear of legal consequences; either way, it tends to cause caution to be emphasized. When considering a course of action, we should ask, “Is it right?” Not necessarily the cleverest practice or the most profitable, but the right thing? The people I think of perverting the mortgage securitization process never wondered whether they were getting an appropriate rating, but whether it was the highest possible. Not whether they were doing the right thing for clients or society, but whether they were wringing maximum proceeds out of a pile of mortgage collateral and thus maximizing profits for their employers and bonuses for themselves. A lot of misdeeds have been blamed on excessive emphasis on short-term results in setting compensation. The more compensation stresses the long run, the more it creates big-picture benefits. Long-term profits do more good – for companies, for business overall and for society – than does short-term self-interest. Focusing on the Wrong Risk The more I’ve thought about it over the last few months, the more I’ve concluded that investors face two main risks: (1) the risk of losing money and (2) the risk of missing opportunity.

© Oaktree Capital Management, L.P. All Rights Reserved In the years just before the crash, no view was considered too optimistic. There were few skeptics around to point out that a notion might be too good to be true. And then, as Pigou says, the opposite became true post-Lehman Brothers. There was no scenario of which someone wouldn’t suggest, “But what if it’s worse than that?” Now no idea was considered too negative to be true. The error is clear. The herd applies optimism at the top and pessimism at the bottom. Thus, to benefit, we must be skeptical of the optimism that thrives at the top, and skeptical of the pessimism that prevails at the bottom. Pigou makes an excellent additional point. Bubbles usually build gradually over time, the result of a steady accretion of logical basis, favorable developments, high returns being achieved, platitudes taken to extremes, willing suspension of disbelief, rising optimism and the recruitment of new buyers. But when the bubble’s faulty underpinnings are exposed, it tends to collapse in a rush. The excess of pessimism does arrive quickly, “born a giant.” Or as my partner Sheldon Stone puts it, “the air goes out of the balloon a lot faster than it went in.

” A recent report by Ian Kennedy and Richard Riedel of Cambridge Associates, entitled “Behavioral Risk,” provides an excellent explanation for this process and describes its effect: [During good times,] we suffer from what James Montier characterizes as “the illusion of control: the belief that if things go wrong, we will be able to sort them out.” When that illusion is shattered during a selling panic, we don’t know where to turn or what to think. . . . What happens when we humans (and, indeed, other animals) are slammed by shock? Unless trained otherwise, our instincts tell us to retreat, conserve, seek the comparative safety of groups, and search for a path out of danger. These are ancient survival instincts, hard-wired. Slammed by financial shock, the same instincts result in heightened risk aversion (gimme cash!), a dramatic foreshortening of our normal investment time horizon, an overwhelming impulse to flee with the herd, a tendency to extrapolate current trends all the way to Armageddon . . . In times of crisis, when risk aversion spikes, panicked investors tend to stampede for the exits. The temptation to join them is well-nigh irresistible because the whole financial edifice seems to be collapsing. Carefully wrought models are rendered irrelevant overnight, as correlations converge on 1.0, and “fat tail” risk wags the dog. . . . When markets are falling, we instinctively feel that risk is rising, and when markets are rising, that risk is ebbing.

In the short term, this instinct may be right since markets often run on momentum in the short run. But for long- term investors it is dead wrong. . . . As equity markets plummet, investors’ risk aversion rises even as the fundamental risk is in fact declining.added)

© Oaktree Capital Management, L.P. All Rights Reserved In other words, our instincts and emotions conspire to make us do the wrong thing at the wrong time: to trust at the top and worry at the bottom, and to think something’s riskier at $10 than it was at $100, as if the emotion-fed price decline is correct in suggesting that something’s wrong. Buy Low, Sell High Of all the adages that bear on the events of this extreme cycle we’re living through, the simple one just above – probably the first one any of us learned – is still the most important. In my early years in this business, people who spent all their time on security selection were told that asset allocation can be more important. I’d like to nominate a third candidate for primacy: countercyclical behavior. Consider any intermediate-term period of 3-5 years or so in which the market pendulum makes a significant swing (and that’s about all of them). The period 2004-08 presents a good example. Individual security selection had limited impact on the return from a diversified portfolio. Asset allocation mattered much more, but primarily because it determined your posture with regard to the market’s swing. By far the most pivotal thing is whether your investing was anti-cyclical or pro-cyclical. Did you buy more at the bottom or more at the top? Did you invest defensively at the top and aggressively at the bottom, or vice versa? In other words, did you buy low and sell high, or buy high and sell low?

The Cambridge study describes the importance of resisting the cycle and acting counter to it. It also outlines the difficulty of doing so, and some of the reasons. But it is the most important thing. Did you participate in the errors of 2004-08 or resist? That’s the key. Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult, including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that “being too far ahead of your time is indistinguishable from being wrong.”) Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian. A few things that can help, however. First, after even a little time spent in the investment business, everyone should know that the herd is usually wrong at the extremes and pays dearly for its error. Second, some contrarians have records that are very impressive. And third, an accurate reading of investor mood and behavior – perceptive inference of danger or opportunity based on what others are doing in the market – can give investors a good leg up toward being effective contrarians. I say we never know where we’re going, but we sure as heck ought to know where we are. The cycle isn’t unknowable or unbeatable.

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

That was really the problem: no scenario was too negative to be credible, and any scenario incorporating an element of optimism was dismissed as Pollyannaish. There was an element of truth in this, of course: nothing was impossible. But in dealing with the future, we must think about two things: (a) what might happen and (b) the probability it will happen. During the crisis, lots of bad things seemed possible, but that didn’t mean they were going to happen. In times of crisis, people fail to make that distinction. Since we never know much about what the future holds – and in a crisis, with careening causes and consequences, certainly less than ever – we must decide which side of the debate is more likely to be profitable (or less likely to be wrong).

© Oaktree Capital Management, L.P. All Rights Reserved institutions took on too many risky assets given the limitations of their equity capital. That, in a nutshell, is why institutions have disappeared. So what exactly did these institutions do wrong? Here are a few examples, using Bank X, with $10 billion of capital, to illustrate:  Bank X uses leverage to buy $100 billion of triple-A mortgage-related debt, under the assumption that it can’t lose more than 1%. Instead, home prices decline nationwide, causing it to write down its holdings by 10%, or $10 billion. Its capital is gone.  Alternatively (but in fact probably simultaneously), Bank X sells Hedge Fund G $10 billion of credit default swaps on the bonds of Company A, and it buys $10 billion of the same credit protection from Investment Bank H. Company A goes bankrupt, and Bank X pays Hedge Fund G $10 billion. But Investment Bank H goes bankrupt, too, so Bank X can’t collect the $10 billion it’s due. Its capital is gone.  Bank X lends $50 billion to Hedge Fund P with equity of $10 billion, which then buys $60 billion of securities. The value of the fund’s portfolio falls to $50 billion; the bank sends a margin call; no additional collateral can be posted; so the bank seizes and sells out the portfolio. But in the downward-spiraling market, the bank only realizes $40 billion. Its capital is gone.  Hedge Fund Q also borrowed to buy securities.

© Oaktree Capital Management, L.P. All Rights Reserved For forty years I’ve seen the manic-depressive cycle of investor psychology swing crazily: between fear and greed – we all know the refrain – but also between optimism and pessimism, and between credulity and skepticism. In general, following the beliefs of the herd – and swinging with the pendulum – will give you average performance in the long run and can get you killed at the extremes. Two or three years ago, the world was so different as to be almost beyond remembering. It was ruled by greed, optimism and credulity. In short, it was the opposite of the last few weeks: no story was too positive to be believed.  “There’s a worldwide ‘wall of liquidity’ that can never dry up.”  “Triple-A CDOs are as safe as triple-A corporate debt but will deliver higher returns.”  “Leverage holds the key to better investment results.”  “Tranching and selling onward are spreading the risk, thereby eliminating it.”  “Decoupling has reduced nations’ economic reliance on the U.S.” Boy, what a good time that was for a dose of skepticism! What benefits it could have provided (in terms of losses avoided). But when conventional wisdom is rosy, few can stand against it. People who do so too early look woefully wrong and are swept aside. That discourages others from trying the same thing, even as the cycle swings further to the positive extreme.

© Oaktree Capital Management, L.P. All Rights Reserved UCompulsory Short-Termism But is it right to say Prince and Citi could have avoided trouble by refusing to go along? Let’s do what some DVDs let you do nowadays: go back and consider an alternative ending. It’s July 2005 instead of July 2007. Presciently, Chuck Prince says, “When the music stops, in terms of liquidity, things will get complicated. We’re not going to get caught in that trap. As of today, we’re adopting a conservative stance toward loans, mortgages, subprime, CDOs and SIVs. The others can dance all they want; we’re sitting this one out.” What would’ve happened? Rather than lose his job in late 2007, he probably would have lost it sooner. Why? Because from whenever he made that statement until July 2007, Prince would have looked dumb. While other banks were gaining market share, Citi’s share would have been shrinking. And while other banks were borrowing on the cheap to make mortgage-related investments at seemingly attractive spreads, Citi would have been on the sidelines, forgoing easy profits. Shareholders would have been yelling for Prince’s scalp. The bottom line is one of my three favorite adages: Being too far ahead of your time is indistinguishable from being wrong. Of the two things I think are most wrong about American business, the worst is short-termism. (The other is the ability of executives to thrive while their companies do poorly.)

” Borrowers, home sellers, mortgage brokers and Wall Street all had a vested interest in seeing high values assigned. There’s something fundamentally wrong when there’s no party to a transaction who wants the appraisal to be conservative. But that became the case when far-away, ratings-assured buyers of sliced-and-diced mortgage securities took the place of lenders risking their own money and expecting to hold to maturity. Mortgage insurers played a similar role by lending their imprimatur and thus implying instruments were safe. Everyone thinks of taking out insurance as a cautious thing to do. When risks are insured, the people exposed to them believe they’re safe to behave differently than they otherwise would. But what happens when the insurers miscalculate the risks involved, and thus issue more coverage than their capital can support in tough times? In the extreme, losses can go unreimbursed, meaning the insureds don’t really have the protection they think they have and their situation is riskier than they intended. Certainly in this cycle, insufficiently cautious insurers abetted the bearing of risks that have exceeded expectations. Let’s remember that the mortgage borrowers don’t deserve a free pass. It was stupidity or cupidity, naïveté or moral turpitude. At best they took on massive financial responsibilities they didn’t understand, and at worst they were fraudsters.

 Unquestioning acceptance of financial platitudes without wondering whether altered circumstances and elevated asset prices had rendered them irrelevant: o Houses and condos are good investments and can be counted on to appreciate. o Mortgages rarely go into default. o There can never be a nation-wide decline in home prices. o It’s okay to grossly lever a balance sheet if you’ve hedged enough through derivatives. o It’s safe to borrow and invest funds equal to a huge multiple of your equity capital if the probabilistic expected value is positive, because “disasters rarely happen.”  Individuals such as mortgage brokers and mortgage borrowers who were given incentives to do the wrong thing.  Newly minted financial “masters of the universe” encouraged to maximize returns for themselves and their employers without concern for whether they were adding value to the financial system or endangering it. In general, the above can be summed up as a shortage of adult supervision, common sense, skepticism, ethical concern and good old-fashioned prudence. As often happens in booms, the kids shouldered the adults aside or impressed them too much. The list of errors can make you laugh . . . or cry. I mentioned in “Hindsight First, Please” how often financial people do things that look downright silly afterwards. But that never stops them from repeating the old mistakes or making new ones.

© Oaktree Capital Management, L.P. All Rights Reserved UThe Future I write a lot to dissect and explain past events, but I’ll try here to make a contribution by taking the riskier path of talking about the future. What do I see? As for the short term, it’s been amply demonstrated that governments and central banks will do everything they can to resolve the credit crisis. No stone will go unturned, and few options will be declined. Most people now believe that letting Lehman Brothers go was a big mistake: as a result of a calculated decision, discipline took precedence over rescue. The results were disastrous, as the commercial paper market froze up, money market funds “broke the buck,” and the crisis was ratcheted up several notches. Most people don’t repeat their mistakes; they make new ones. So we should expect that all key players will be rescued in the period ahead. Some elements of that effort will be mistakes, but at least those mistakes won’t pull down the financial system. Morgan Stanley was the next big worry but, after Lehman, it became unlikely that Morgan would be allowed to fail. I was asked, “Will the U.S. government guarantee a capital investment made by a Japanese institution?” Absolutely, if that’s what it takes. It beats the U.S. having to put up its own money. The sums being thrown around are the biggest ever: hundreds of billions, adding up to trillions. But there’s no hesitation: everything will be done.

© Oaktree Capital Management, L.P. All Rights Reserved UUnreliable Ratings Probably the group that had the most power and yet covered itself with the least distinction over the last few years – and has been outed to the greatest extent – are the credit rating agencies. The rating agencies were accorded quasi-official status as the policemen of the credit markets, and they failed miserably. This is nothing new. I’ve always considered the rating agencies to be error-prone, and much of my career has consisted of taking advantage of their mistakes. They’ve often rated seemingly safe bonds too high and risky bonds too low. They’ve been slow to adjust ratings, but when finally they did change, they usually overshot. The bottom line is that managing a bond portfolio according to ratings would be somewhere between unavailing and disastrous. Profits are more likely to be found in gaming against the ratings. Nevertheless, when the government felt Wall Street had to be policed and debt investors protected, they turned to the agencies. Before doing so, I doubt anyone checked to see how accurate ratings have been. Now we know. Thousands of ratings of structured mortgage securities turned out to be too high and were adjusted downward, often many notches at a time. The CDO tranche that didn’t have to be downgraded is the exception, not the rule. In other words, the ratings were grossly wrong.

© Oaktree Capital Management, L.P. All Rights Reserved  Thanks to disintermediation, financial institutions saw that they could earn fees for originating loans and selling them onward. Did the rewards for achieving volume displace the prudence they used to employ when putting their own capital at risk?  Once financial engineers had built their new tranched products, they could sell them at lower yields (higher prices), sell more of them, and earn bigger fees if they could get them rated higher. For a given instrument, single-A was good, double-A was better and triple-A was best. The investment bankers marshaled the data and fed it into their models, tweaked to yield the best possible result. I find it hard to believe they ever said, “Wait a minute; triple-A’s too high given the underlying collateral” or “It can’t be triple-A, because there are a few scenarios that, although unlikely, would yield terrible results.” I’m not suggesting these people engaged in illegal activity or consciously did the wrong thing. They were just trying to make more money for their employers and themselves. But I believe their economic self-interest caused them to go to extremes in an environment that allowed candor, skepticism and ethics to be forgotten in pursuit of revenue maximization. UA New Canard Takes Flight Government involvement in the private sector is like hemlines: it goes up and down. But it does so in very long cycles.

When they marshaled data with which to prove to customers and rating agencies that CDOs were secure, did they consider the data’s sparseness or limited relevance? Did they fail to disclose information regarding the “exceptions” in CDO portfolios – mortgages that didn’t meet minimum lending standards – as the New York Attorney General is investigating (WSJ, January 31)? Some of the same questions can be asked about the role of CDO managers. I haven’t been close to the process – Oaktree didn’t have any involvement – but I believe managers met with investment bankers who offered a near-turnkey proposal: “Here’s how it works. The documents are ready to go. We have the assets in inventory. The debt is teed up for issuance. Your fees will be x million per billion.” Did the managers vet the process? Did they undertake an independent effort to gauge the risks? Or did they just sign on to the magical fee machine? Next up, in my opinion, are the credit rating agencies. In summary, everything was wrong with the process through which CDO debt was rated, a process fed by the agencies’ hunger for profit. The agencies worked with CDO sponsors to design the products, so how could they then be objective in evaluating them? They accepted payment from the companies whose offerings they were rating; they all did, but that doesn’t mean the arrangement left them objective. They competed for the business, with the fees going to the agency that would assign the highest rating.

There is no perfect accounting standard – just choices, with each alternative stronger on some desired traits but weaker on others. “Cost” is objective but often out of date and far from accurate. “Lower-of-cost-or-market” is conservative but asymmetrical in its error. “Market value” is contemporary but not always reliable; it discloses value declines faster than Enron did, but it also requires subjective judgments and bakes in price fluctuations that may prove transitory. So when accounting regulators mandated mark-to-market, they decided in favor of currentness and transparency but against stability with regard to marketable securities and objectiveness with regard to privates. (When we began to organize closed-end funds in 1988, and for about fifteen years thereafter, Bruce and I established a policy for valuing privates based on “cost unless there’s been a change which is fundamental, material and permanent.” We felt it served us well. But since Enron and Sarbanes-Oxley, we’ve been forbidden to use that approach. Now funds are required to price each asset based on opinions regarding its worth. We preferred the old way. Who’s better served now?) Mark-to-market accounting turns out to be one of the main contributors to the current boom/bust cycle. In the old days, a bank (for example) would have carried assets at cost.

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,

© Oaktree Capital Management, L.P. All Rights Reserved were issued through a far different process and incentive system. But I can’t imagine any agency saying, “The risks are unknowable; we just can’t assign a rating.” How do we know the agencies bobbled the ball? The twelve-digit losses to date give a pretty good indication. An article in The Wall Street Journal of January 31 gives another: Standard & Poor’s downgraded or threatened to downgrade more than 8,000 mortgage investments and projected a widening array of financial institutions would ultimately face mortgage securities losses totaling more than $265 billion. . . S&P’s rating actions touched on $534 billion in mortgage-related investments, including 47% of the U.S. subprime mortgage bonds rated in 2006 and the first half of 2007. . . S&P . . . has now placed 69% of the triple-A rated subprime bonds from 2006 on negative watch. (emphasis added). I’d call that a thorough indictment. It indicates a flawed process, not occasional error. The situation is remarkably similar for the monoline insurers . . . but with an added wrinkle. These firms carved out a good but dull and slow-growing business in insuring municipal bonds. Since munis default so infrequently, they needed little in the way of capital to cover potential losses, and they probably started to feel they were pretty good at gauging losses. In the 1990s, they concluded that mortgage-backed securities were no more risky than munis.

© Oaktree Capital Management, L.P. All Rights Reserved During the first leveraged buyout boom in the late 1970s and the 1980s, it was a watchword that they should be done only with stable companies. But in bullish times, rules like that are forgotten or ignored, and we get buyouts of companies in cyclical industries like semiconductors or autos. Extremely leveraged companies have existed for more than a century. They’re called utilities. Because their profits are regulated by public commissions and fixed as a percentage of their stable asset bases, they’ve been extremely dependable. This shows that high leverage isn’t necessarily risky, just the wrong level of leverage given the company’s stability. It can be safe for life insurance companies to take risk on limited capital, because their operations are steady and their risks can be anticipated. They know everyone will die, and roughly when (on average). But if a firm like MBIA was going to guarantee mortgage securities, it should have recognized their instability and unpredictability and limited its leverage. The insurance industry’s way of saying that is that its capital should have been higher as a percentage of the risks assumed. MBIA insured $75 billion of residential and commercial mortgage paper on the basis of total capital – not capital devoted to its insuring mortgage securities, but total capital – of only $3 billion. Did anyone worry about the possibility that 5% of the mortgages would default?

Principled, conservative decisions aren’t rewarded, as is now plain to see. Moody’s disclosed in May that, because of a programming error, eleven European CPDOs (complex investment vehicles formed to write large amounts of credit insurance) had been incorrectly rated triple-A instead of double-A. Okay, everyone makes mistakes. But the plot thickens. According to The New York Times of July 2, the law firm of Sullivan & Cromwell conducted an investigation for Moody’s and found that the ratings hadn’t been corrected even after the error came to light. Its report, . . . blamed employees in charge of monitoring and adjusting ratings for considering “factors inappropriate to the rating process” after the errors were discovered. . . . In a statement, Moody’s said unidentified employees had violated a code that required analysts to consider only credit factors, not “the potential impact on Moody’s, or an issuer, an investor or other market participant.” It’s not exactly clear what happened, and I don’t think anyone’s trying to make it particularly clear. It seems, however, that Moody’s employees overlooked the ratings errors that came to light for “business reasons.Fitch,

© Oaktree Capital Management, L.P. All Rights Reserved much higher average ratings, you can make a lot of money. But the ability to do so means there’s something wrong. (In other words, if it’s possible to start with 100 pounds of hamburger and end up selling ten pounds of dog food, 40 pounds of sirloin and 50 pounds of filet mignon, the truth-in-labeling rules can’t be working.) In the case of CDOs, ratings and insurance were supplied by parties who underestimated the risk, and the end product was sold – and bought – by people who were willing to participate in this purported miracle without asking the hard questions. UThe Failure of Risk Management I’ve long been critical of risk management as a distinct investment discipline. Now, a convincing case for my view can be made on the basis of prima facie evidence: The fact that most financial institutions appointed risk managers after the collapse of Long-Term Capital Management in 1998 doesn’t seem to have helped them avoid the subprime mess. If you trust someone to be expert enough to make an investment, then that’s the person who can best assess its risk. If you trust someone to assemble portfolios, it’s they who can best judge how things will behave in combination. In the isolated risk management function, I feel people who know less about the underlying investments second guess the people who know more.

© Oaktree Capital Management, L.P. All Rights Reserved People probably think of their pension plans, IRAs and home ownership as eliminating the need for savings. But certainly recent events have shown the holes in that approach. U.S. consumers increase their debt continually, seemingly without ever thinking about paying off the balance or of how they might accomplish that (short of winning the lottery). It doesn’t seem to trouble people when they spend more than they earn, whether through the use of credit cards or by taking out loans, including borrowing and spending the equity in their homes. In all of these regards, the American consumer doesn’t seem to give any thought to how this movie will end (I last raised this in “Hindsight First, Please” in October 2005). It’s just a matter of people wanting to consume more than their income supports. Saying “I want it, but I can’t afford it” seems hopelessly old- fashioned in the America of today. Who Else? I wish only consumers acted this way. Go back three paragraphs, though, and ask whether my description of the typical American doesn’t also relate equally to our government: constant deficit spending and continually increasing debt. Our fiscal deficit and national debt aren’t enormous relative to other developed nations and to our GDP. And I don’t make a value judgment that it’s wrong to run deficits from time to time.

O.’s of real estate assets this week because of the ongoing threat of losing deals.” It doesn’t make sense for unregulated and sometimes unprofessional organizations, operating under the wrong incentives and performing tasks that are above their heads, to be appointed watchdogs of the capital markets. But that’s what happened. U When It’s Good to Be Bad Only in an Alice-in-Wonderland world can there be benefits in having a weak credit rating. But today’s complex, rules-based accounting system makes it possible. On May 18, The Wall Street Journal published the story of Radian Group, a bond and mortgage insurer. Although its business was poor, an accounting gain enabled it to report a $195 million net profit for the first quarter, as opposed to the $215 million loss it would have reported otherwise. However, this was an unusual gain. It didn’t arise because the value of Radian’s assets went up, but rather because the value of its liabilities went down.

I think federal ownership would be a very hairy matter. But in this case I do have a solution, at least regarding the prices at which the government resells the debt: Why not simply say that the government should receive half of the buyers’ return in excess of a 20% yearly rate, or some such? Ownership would present challenges, but sharing in the benefit would not. U Who’s In the Wrong? There’ll be cries for scalps, and politicians will play to the crowd by assigning blame. This should be primarily a side-show, but it can grow into a significant distraction. Short sellers are in the crosshairs most prominently. It is a simple fact that ever since the up-tick rule was revoked fourteen months ago, short sellers have had the ability to drive down stock prices, which they couldn’t do if a short sale could only take place at a price higher than the last trade. It’s also a fact that some financial stocks have fallen, and that their declines have added to worries about the companies, inducing further declines. Of course, no connection between the two has yet been proved. As a result of the recent market action, short selling was outlawed in roughly 800 financial stocks, including outliers such as General Electric. This action was coincident with last Friday’s rally, and people breathed a sigh of relief.been

© Oaktree Capital Management, L.P. All Rights Reserved 8. Regulatory proposals are also likely to include calls for more and better risk management. But the risk management profession’s exertions in the last ten years probably exceeded the sum of its efforts prior thereto. Those efforts certainly didn’t head off the current crisis. In fact, it’s highly likely that risk managers’ blessings led to a false sense of security in recent years, and thus to more confident (and greater) risk taking. 9. Since many of the biggest recent errors occurred in the area of credit ratings, it’s appropriate to ask whether regulation could make ratings more accurate. According to an article in the Herald Tribune of April 25, Senator Chris Dodd . . . practically begged Christopher Cox, the SEC chairman, to ask for new authority. He suggested that perhaps it would be a good idea to leave credit ratings to some kind of non-profit agency that would not have conflicts of interest. Both he and [Senator] Shelby suggested that the SEC should revoke the operating license of a credit rating agency that was wrong too often. Can you imagine anything along these lines working? Would you like to see credit ratings being set by an agency lacking economic motivation? Who would determine whether they’d been “wrong too often”? And would “wrong too often” include ratings that proved to be too low, or just too high? I’ve seen a lot of both in the last forty years. 10.

© Oaktree Capital Management, L.P. All Rights Reserved responsible for the demise of Lehman? Should short selling be banned? As usual, the answer isn’t clear. Balancing out the simple truths stated above, a number of factors argue in favor of short selling or against a ban:  Short selling isn’t “worse” than outright buying. One makes stocks go down; the other makes them go up. Why is shorting – selling what you don’t own – any worse than buying what you don’t own?  Short selling is a highly legitimate way for investors to act on their belief that a stock’s price is too high. Thus it tends to help stocks sell at fair prices.  Short selling can bring losses to those who hold stock, but unabated buying can force stock prices to too-high levels where no one should buy. What can we do to prevent injury from purchases during unjustified booms?  Sure you can keep stock prices from being forced down by outlawing short selling. But then why not outlaw all selling? Think of what that would do for stock prices! In the short run, protecting the financial system is more important than preserving market efficiency or heeding the above arguments. Thus I do not think it was a mistake to ban short selling for the time being. In the long run, however, I feel a ban on short selling is not in order, although I consider it desirable for the up-tick rule to be brought back. Finally, as with many other things, the real problem isn’t with short selling, but with abusive short selling.

© Oaktree Capital Management, L.P. All Rights Reserved  Healthcare is expensive, and the cost rises all the time, in part because costly new medicines and procedures are developed.  Americans are living far longer, so there are more years in which sickness is high and costs are elevated. In the modern era, few people (understandably) are content to slip into decline and death without a fight.  Remarkably in our advanced society, nutrition and health awareness seem to be going in the wrong direction, along with the level of exercise for large portions of the population. Obesity has become an epidemic, bringing with it serious health problems.  Patients want the best care, and doctors want to provide it. How can society respond to this demand when many patients can’t afford the care, or even a reasonable co- payment? I once read a Wall Street Journal op-ed piece on healthcare with a title something like, “If You’re Paying, I’ll Have Steak.” That’s the inevitable outcome when third parties foot much of the bill.  It’s hard to effect triage: who’ll tell an 80- or 90-year-old that he shouldn’t get a joint replacement or costly drug therapy? If a hospital or the insurance company wants to say “no,” all hell breaks loose.  The economics of medical care have become somewhat anti-social. Doctors face declining pay and status, and systems designed to control healthcare costs stick healthcare professionals with very distasteful administrative burdens.

© Oaktree Capital Management, L.P. All Rights Reserved Consider these tales from the front lines:  There had never been a national decline in home prices, but now the Case-Shiller index is down 26% from its peak in July 2006, according to the Financial Times of November 29.  In my twenty-nine previous years with high yield bonds, including four when more than 10% of all outstanding bonds defaulted, the index’s worst yearly decline was 7%. But in 2008, it’s down 30% (even though the last-twelve-months’ default rate is only about 3%).  Performing bank loans never traded much below par in the past, and holders received very substantial recoveries on any that defaulted. Now, even though there have been few defaults, the price of the average loan is in the 60s. The headlines are full of entities that have seen massive losses, and perhaps meltdowns, because they bought assets using leverage. Going back to the diagrams on pages 4-5, these investors put on leverage that might have been appropriate with moderate-volatility assets and ran into the greatest volatility ever seen. It’s easy to say they made a mistake. But is it reasonable to expect them to have girded for unique events? If every portfolio was required to be able to withstand declines on the scale we’ve witnessed this year, it’s possible no leverage would ever be used. Is that a reasonable reaction? (In fact, it’s possible that no one would ever invest in these asset classes, even on an unlevered basis.)

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.

© Oaktree Capital Management, L.P. All Rights Reserved error. But history isn’t a perfect guide. While we’ve made no use of leverage in the vast majority of our investment activities, three of our evergreen funds did borrow to buy bank loans: the senior-most debt of companies, which in the past always has traded around par. Another used it to buy low-priced Japanese small-cap stocks. The companies generally are doing fine, but the prices of their loans and equities have collapsed under current market conditions, causing the funds to suffer. This shows how tough it is to prepare for all eventualities . . . in other words, to know in advance how bad is bad. So I apologize if I ever come across as holier-than-thou. We’ve tried to use leverage only when it’s wise, but no one’s perfect. Certainly not us. * * * The financial markets have delivered a lifetime of lessons in just the last five years. Some of the most important ones center around the use and abuse of leverage.  Leverage doesn’t add value or make an investment better. Like everything else in the investment world other than pure skill, leverage is a two-edged sword – in fact, probably the ultimate two-edged sword. It helps when you’re right and hurts when you’re wrong.  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.

Most investment failures are preceded by a dearth of it. * * * I often think back to an early 1990s issue of Forbes on the subject of compensation. It quoted an experienced corporate director as saying something like, “I’ve given up on trying to get people to do what I tell them to do. They do what I pay them to do.” It’s clear that in recent years, improper incentives caused a lot of people to do the wrong thing. Loan originators with nothing riding on the loans’ long-term performance. Investment bankers who expected to package and resell loans before they went bad. Rating agencies and appraisers – the investor’s protectors – incentivized to come in high. Companies that (a) were lured by potential profit into areas where there was no way to understand what would happen in tough times, and thus (b) accepted risks for which they were unprepared. Financial institutions that failed to sit out when the markets became overheated. My wife Nancy says she likes this memo more than most, because the lesson is so easy to understand. “People can’t be counted on to do the right thing,” she said, “when they don’t have anything at risk.” Far more participants in this process covered themselves with dishonor than with distinction, as attested to by the magnitude and ubiquitousness of the losses.the

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.

Economic growth will slow: the question is whether it will remain slightly positive or go negative, satisfying the requirement for the label “recession.” Regardless, positive thinking and thus risk taking are likely to be diminished. All I can say for sure is that the world will be less rosy in financial terms, and results are likely to be less positive than they otherwise would have been. That can be enough to make highly leveraged transactions falter. I’ve said many times that for each period there’s a mistake waiting to be made. Sometimes it’s buying too much, and sometimes it’s buying too little. Sometimes it’s being too aggressive, and sometimes it’s not being aggressive enough. Which it is depends on the combination of the going-in opportunities and the environment that unfolds. What mistake is on offer today? How aggressive should one be? Although the extent of the coming softness has yet to be fully defined, I feel we’re in the second or third inning. (For readers who aren’t followers of baseball, that means the standard nine- inning game has barely begun.) I recently read a piece asserting that we’re still singing the national anthem before the start of a game destined to go beyond nine innings, but I find it hard to engage in such extreme thinking. The damage has begun to be felt and the correction has begun to take place.

The beauty contest approach [in which, rather than bet on who’s the prettiest contestant, people bet on who most people will judge to be the prettiest contestant], however, suggests that many professional investors are taking the view that however bad their private fears, the majority of their counterparts are looking through the immediate fallout to a rosier future. Just as markets anticipate eight of the next five recessions, so too they can look forward to eight of the next five bull market recoveries. (Emphasis added) I’m not saying the pessimists are right and the optimists are wrong, or that we truly face an ongoing crisis. Rather, I think the possibility is there and several more shoes remain capable of dropping. Importantly, while mortgage securities and leveraged loans have gone through the wringer and arguably might be cheap, most other assets are as yet unscathed or have rebounded. Stocks, in particular, do not seem to reflect the possibility that this economy’s goose is cooked, having declined only slightly from 2007’s all-time highs. * * * So you want to know, “Is it over?” Here’s my bottom line:  There’s been a significant correction of the excesses of a year ago. Prices are down and risk premiums are up. Fear and risk aversion have been brought back into the equation; unbridled optimism is no longer the norm.

© Oaktree Capital Management, L.P. All Rights Reserved  A good part of the losses have been recognized that relate to the fundamental deterioration – and especially the mortgage defaults – to date.  Psychology, which reached “end-of-the-world” levels in the days leading up to the rescue of Bear Stearns, is back from the brink and on the upswing. Although this could be a worrisome sign of inadequate caution, the risk that psychology will spur a massive downward spiral seems to be off the table for now.  However, the foreseeable future is not without significant risks, many of which are real, not psychological (to the extent the two can be distinguished in economics). There could easily be further house price depreciation, causing more mortgage defaults and requiring additional write-downs. American consumers, buffeted by rising prices for energy and food and concerned about the future, could easily slow their spending and further weaken the economy. And we continue to believe that many high-priced, highly leveraged private equity deals will fail to survive an economic slowdown. The outlook continues to call for prudence . . . although not as much or as urgently as a year or two ago. Then, people were investing at low returns in the belief that nothing could go wrong. Today, that optimism has been dispelled and prospective returns embody more generous risk premiums.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Everyone Knows _____________________________________________________________________________ par·a·dox n 1 a seemingly absurd or self-contradictory statement that is or may be true . . . 4 an opinion that conflicts with common belief. (Collins English Dictionary) I’m sometimes asked to speak about investing with the choice of topic wide open. I like to begin by saying the thing I find most interesting about investing is how paradoxical it is: how often the things that seem most obvious – on which everyone agrees – turn out not to be true. I’m not saying accepted investment wisdom is sometimes valid and sometimes not. The reality is simpler and much more systematic: What’s clear to the broad consensus of investors is almost always wrong. First, most people don’t understand the process through which something comes to have outstanding moneymaking potential. And second, the very coalescing of popular opinion behind an investment tends to eliminate its profit potential. I’ve been saving up ideas for a memo about how often the investing herd is wrong and accepted wisdom should be bet against. Then along came the March 1 issue of Mark Faber’s “Gloom, Boom and Doom Report” and its lead quotation from William Stanley Jevons (1835-1882).

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Now It’s All Bad? I’m a great believer in the cyclical nature of the markets, but I never cease to be amazed at how far they can go in one direction and for how long; the extremes they can reach, despite logical arguments to the contrary; and the swiftness of the swing back. It all reminds me of a point I made in my second memo, “First Quarter Performance” (April 1991): Although the midpoint of its arc best describes the location of the 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. Just seven weeks ago, I complained in “It’s All Good” that investors were acting as if nothing could go wrong. “Priced for perfection” was the concept underlying values, and people were more than willing to pay prices set that way. Now, of course, the prevailing attitude appears to have swung from “it’s all good” to “it’s all bad.” Pessimism has replaced optimism, perhaps also to excess. There are days on which no one seems able to tell me how the developing credit crisis might be resolved in short order and a full-scale meltdown avoided, and when no one seems able to find a ray of sunshine in the current situation (other than bargain hunters). It’s like the aspiring actor who takes acting classes, waits on tables and hustles auditions for a decade . . .

and then gets his big break and becomes an “overnight success.” Except that in this case, having built up great excesses over a period I date from November 2002, people are now acting as if this market has become an overnight flop. Some of us have been saying for years that a swing back of the market cycle was due, but it took a long time to happen (calling to mind, as so often in my case, the dictum that “being too far ahead of your time is indistinguishable from being wrong”). This delay does a good job of illustrating Lord Keynes’s famous observation that “markets can remain irrational longer than you can remain solvent.” Markets can swing in a single direction for a longer period and to a greater extent than anyone might expect. That’s crowd psychology. But the swing back can be equally surprising – in terms of what kicks it off and how fast it moves. I recently came across a great quote from Larry Summers: “in economics things happen slower than you expected they would but when they finally do, they happen faster than you imagined they could.” Certainly the recent transition from all good to all bad demonstrates this phenomenon.

Invariably when I hear the media and the herd describe something as a good buy, it’s without regard for price. They never say, “Internet stocks are a good buy at p/e ratios up to 50.” Or “class-A office buildings are a good buy as long as the cap rate exceeds 7%.” Or “private equity’s a good idea at purchase prices below seven times EBITDA.” Just “it’s a good buy.” My response is simple: There is no investment idea so good that it can’t be ruined by a too- high entry price. And there are few things that can’t be attractive investments if bought at a low-enough price. When investors forget these simple truths, they tend to get into trouble. How Money Is Made The fact is, there is no dependable sign pointing to the next big moneymaker: a good idea at a too-low price. Most people simply don’t know how to find it. If someone really knew, why would he share his knowledge? And when the investing herd or some media commentator expresses an opinion, they’re invariably pointing in the wrong direction. Large amounts of money (and by that I mean unusual returns, or unusual risk-adjusted returns) aren’t made by buying what everybody likes. They’re made by buying what everybody underestimates.

© Oaktree Capital Management, L.P. All Rights Reserved before. Collateralized loan obligations and collateralized debt obligations, for example, grew practically unchecked. These debt factories bought up vast amounts of raw material – in the form of underlying portfolio assets – in order to generate a salable product. The bottom line of it all: high leverage, untested vehicles and inadequate preparedness for adverse developments. Little awareness of risk, low credit standards, slender risk premiums and little margin for error. In short, a recipe for possible disaster. UThe Vicious Circle It’s easy to explain what happens at this point in the typical market cycle: eventually, everything goes the other way. That’s exactly what happened this summer. There’s a bump in the road. It doesn’t matter what it is, and it’s usually different each time. This year the problem occurred in the field of subprime mortgages. There was a surprising rise in delinquencies, the immediate effect of which was limited to a small segment of the economy and the few investors who’d bought securities backed by these loans. In the months leading up to July, the impact went largely undetected outside the subprime arena. But from time to time in the investment world, a chain reaction is set off – maybe you’d say a “tipping point” is reached – which causes one sort of problem to create others and to cascade from one asset class, market or region to others.

UMetastasis The fundamental, psychological and technical influences described above devastated the market for subprime investments, of course, but they also spread quickly to other assets and markets and metastasized into new forms of trouble. Investor psychology turned in all markets, even those totally unconnected to subprime loans. Caution replaced optimism. Risk aversion took over from risk tolerance (or risk- blindness). Skepticism and the concept of capital preservation were resurrected. Concern over being under-invested gave way to fear of buying too soon. Cash came to be viewed as a source of security and buying power, not a drag on results. All over the investment world, people started to think more about what can go wrong rather than what can go right. In short, the things that contributed to the virtuous circle began to be reversed, in ways that were unimaginable just two months ago. Bridge financing for buyouts represents an outstanding example. Buyouts were an area of great enthusiasm – and some of the greatest excesses, I think – in the 2002-07 up leg:  Vast sums were raised in buyout funds, likely increasing the managers’ motivation to buy companies.  Purchase prices for target companies were lifted by stock market strength, bidding wars and the demands of stockholders and boards.

© Oaktree Capital Management, L.P. All Rights Reserved So the Bank of Ireland entered the competition to lend money for home purchases and said, “I’ll lend four and a half times the borrower’s salary.” And Abbey said, “I’ll lend five times.” The so-called winner in this auction is the one who’ll put out the most money with the least safety. Whether that’s really winning or losing will become clear when the cycle turns, as it did in the U.S. last year. But certainly there’s a race to the bottom going on . . . a contest to become the institution that’ll make loans with the slightest margin for error. By the way, were the people who made those U.S. mortgages loans big losers? Defaults spiked last year, but often the originators of the loans had escaped by selling the loans onward to others, some of whom packaged them into mortgage-backed securities or CLOs and sold them once again or borrowed against them on a non-recourse basis. Since many of the people who make loans today flip them quickly, an aspect of “moral hazard” has entered the equation, in which decision makers are insulated from the consequences of their actions. Any way you slice it, standards for mortgage loans have dropped in recent years, and risk has increased. Logic-based? Perhaps. Cycle-induced (and exacerbated)? I’d say so.

By the time I got the call described above, Mike had joined Drexel Burnham Lambert, started the high yield bond department, moved it to California and begun to underwrite new issue high yield bonds for corporate borrowers. He visited me at the bank in the fall of 1978, and it was even more of a learning experience than the one I got from the Nifty Fifty. Mike’s logic was the direct opposite, and to me much more appealing. Here’s what he told me:  If you buy triple-A or double-A bonds, there’s only one way for them to go: down. The surprises are invariably negative, and the record shows that few top-rated bonds remain so for very long.  On the other hand, if you buy B-rated bonds and they survive, all the surprises will be on the upside.  Because the investment process is prejudiced against high yield bonds, they offer yields that more than compensate for the risk.  Thus you’ll earn a superior yield for having accepted the incremental credit risk, and favorable developments can lead to capital gains as well.  Your main goal should be to weed out bonds that may default.  But diversification is essential, too, because some of the bonds you hold will default anyway, and your positions in them mustn’t be large enough to jeopardize the overall return. What an object lesson! What an epiphany! Buy the stocks of the best companies in America at prices that assume nothing can go wrong?

© Oaktree Capital Management, L.P. All Rights Reserved “If we avoid the losers, the winners will take care of themselves.” Sound familiar? The motto we chose for Oaktree was inspired by a lot of people and events, but the morning I spent with Mike Milken in 1978 was the biggest single source of inspiration. The Perversity of Risk “I wouldn’t buy that at any price – everyone knows it’s too risky.” That’s something I’ve heard a lot in my life, and it has given rise to the best investment opportunities I’ve participated in. In fact, to an extent, it has provided the foundation for my career. In the 1970s and 1980s, insistence on avoiding non-investment grade bonds kept them out of most institutional portfolios and therefore cheap. Ditto for the debt of bankrupt companies: what could be riskier? 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.

In order for computers – or people lacking foresight, for that matter – to know what will happen in the future, they need reliable data regarding the past and an ability to expect that the future will be like the past. People were let down in both regards in 2007. Most people have heard of “value at risk,” or VAR, a worst-case estimate of a portfolio’s one-day loss potential. TThe EconomistT reported on November 1 that on no fewer than 16 trading days in the third quarter (a quarter of all the days), UBS’s trading losses exceeded the VAR calculated the preceding day. In all the preceding years since UBS began to use VAR in 1998, there hadn’t been one such day T. What went wrong? Maybe VAR isn’t a good measure. Maybe the data UBS used was erroneous. Maybe the model was based on a period that was atypical or too short to be statistically significant. Or maybe the world changed, invalidating the model. In the last few years, financial alchemy led to the creation of large numbers of high-rated securities out of pools of low-grade mortgages. Investors relied on the ratings, and I suppose the rating agencies relied on default rate assumptions that looked reasonable in the light of experience. But they didn’t allow for changed circumstances (e.g., for the fact that since mortgage initiators no longer risked their own money for long, they had stopped making lending decisions the way they used to). It’s for reasons like this that assumptions can turn out to be inappropriate.

It was a result of the unattractiveness of yields on high grade debt . . . which stemmed largely from the Fed’s campaign to lower interest rates in order to mitigate the depressant effect of the stock market slump and recession. It was abetted by the fact that after a few years of good results, many people forget how money is lost. Extensive use of leverage was behind many of the gains of the last few years, and it is at the root of many of the problems being suffered today. If I mistake not, the distress . . . was produced by an enemy more formidable than hostile armies; by a pestilence more deadly than fever or plague; by a visitation more destructive than the frosts of Spring or the blights of Summer. I believe that it was caused by a mountain load of DEBT. Flowery commentary on the crisis of 2007? No; according to the Financial Times, the quote from T.E. Burton’s Crises and Depressions refers to events that occurred in 1857. The point is that leverage is nothing new, and neither are its deleterious effects. There are numerous reasons to use debt to leverage results, and none of them is likely to evaporate any time soon: 1. Hope springs eternal, as my mother used to say, and greed usually drives markets. Thus any tool that has the power to magnify gains is very tempting.

There’s a belief that this process, too, makes the world less risky. I fail to see net benefits here as well. Instead, I think this process introduces great moral hazard. When the people making loans aren’t going to remain dependent on the borrowers they give money to, they have little incentive to actively police risk. Thus I have grave doubts about a lot of the credit decisions being made. For an extreme example, take a look at the subprime mortgage brokers. Were they motivated to make prudent credit decisions? No; they were motivated to create a lot of paper. There’s something wrong when it’s in someone’s best interests to lend money to unqualified borrowers, but this was the case in subprime mortgages. Obviously this occurred because mortgage brokers weren’t risking their own money. With selling onward so prevalent, an originator just had to hope the borrower would make the first few payments, so that delinquencies wouldn’t surface before the originator’s repurchase obligation expired and the loans became the buyer’s problem. How could buyers have been silly enough to purchase loans made by brokers operating under this set of incentives? Now, let’s combine structuring and selling onward. Here’s how I see it working:  A mortgage broker makes a bunch of loans without knowing much about creditworthiness (think about so-called “liar loans”) or caring much about creditworthiness (because he intends to sell them momentarily).

Oaktree bottom fishers who’ve felt like they’ve been cooling their heels for the last few years are smiling for a change. And mindfulness of cycles is on the way to being restored. When things can’t get better – as some buyout GPs pointed out earlier this year – they won’t. When the pendulum reaches the extreme of its arc, it will swing back. When markets are priced for perfection, they will disappoint. And when investors demand inadequate compensation for bearing risk, they will learn the error of their ways. With the word “eventually” implicit in these statements, I’m 100% sure they’re all correct.

© Oaktree Capital Management, L.P. All Rights Reserved income investing is, and how substantial is the “reinvestment risk.” And beyond bonds, it’s even more up for grabs. What rate of return is implicit in equity investing? Certainly we should look to more than just returns over the last ten or twenty years for the answer. The rate of growth in corporate profits provides a clue, but in the short run, changes in p/e ratios tend to swamp changes in profits. In 1999, investors asked, “What’s been the return on common stocks?” and were seduced by the 11% answer propounded by authorities like Prof. Jeremy Siegel in his book, “Stocks for the Long Run.” What they should have asked, however, is, “What’s been the return on common stocks bought when the Standard & Poor’s 500 was priced at 29 times earnings?” (which it was at the time). In other words, people made the mistake of believing that common stocks have a single rate of return you can depend on, regardless of entry point. They forgot the great extent to which the return on an asset is dependent on the price you pay for it. In the March/April 1997 issue of the Financial Analysts Journal, Peter Bernstein set forth a helpful way to consider returns from equities – one I’d thought about but had never seen in use. He calculated returns on the S&P 500 for periods spanning widely separated dates between which the p/e ratio didn’t change. He called the result “valuation-adjusted long-run equity returns.

Finally and importantly, most people view risk taking primarily as a way to make money. Bearing higher risk generally produces higher returns. The market has to set things up to look like that’ll be the case; if it didn’t, people wouldn’t make risky investments. But it can’t always work that way, or else risky investments wouldn’t be risky. And when risk bearing doesn’t work, it really doesn’t work, and people are reminded what risk’s all about. Most of the time, risk bearing works out just fine. In fact, it’s often the case that the people who take the most risk make the most money. However, there also are times when underestimating risk and accepting too much of it can be fatal. Taking too little risk can cause you to underperform your peers – but that beats the heck out of the consequences of taking too much risk at the wrong time. No one ever went bankrupt because of an excess of risk consciousness. But a shortage of it – and the imprudent investments it led to – bears responsibility for a lot of what’s going on now. Recapping the Lessons – Nothing New The markets are a classroom where lessons are taught every day. The keys to investment success lie in observing and learning, which is what I’ve tried to do in the 40 years since I got my first job at Citibank.

© 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.

© Oaktree Capital Management, L.P. All Rights Reserved I think the credit cycle that began around 2002 will go down as one of the most extreme on record and be the subject of discussion for years to come. It is one of the most important, potentially most serious financial episodes I’ve witnessed, and it presents a great learning experience. (Of course, it’s said that “experience is what you got when you didn’t get what you wanted.”) People were blindsided this summer when the financial markets went wobbly in just a few weeks on the basis of unhappiness in a remote corner of the mortgage market. But nothing that happened should have come as a surprise. While the details of each financial crisis may seem new and different, the major themes behind them are usually the same, and several were repeated in the current cycle. Not one of the following twelve lessons is specific to 2007 or to subprime mortgages or CDOs. And each one is something I’ve seen at work before. 1. Too much capital availability makes money flow to the wrong places. When capital is scarce and in demand, investors are faced with allocation choices regarding the best use for their capital, and they get to make their decisions with patience and discipline. But when there’s too much capital chasing too few ideas, investments will be made that do not deserve to be made. 2. When capital goes where it shouldn’t, bad things happen. In times of capital market stringency, deserving borrowers are turned away.

It’s the capital layer that absorbs the first blow in tough times without occasioning an event of default. While leverage may magnify gains in good times, it’s a healthy layer of equity that gets companies through the bad times. It’s inescapable that, all other things equal, greater leverage increases a company’s likelihood of experiencing financial distress. Thus, with lenders enjoying a carefree recent experience and consequently financing some unwise deals – and with borrowers eager for the enhanced upside potential that comes with leverage – it seems clear that we’ll see rising rates of default and bankruptcy a few years down the pike. This is especially true if, as has often been the case recently, debt is incurred not just to leverage the company’s equity, but to finance payouts to equity holders that reduce or eliminate the equity. So then, are private equity funds – raising much more equity capital than ever, and doing the biggest deals in history at a rapid-fire pace, at rising transaction prices and rising leverage ratios – doing a smart thing or making a mistake? It all depends on how you look at things. The funds seem to be looking in terms of optionality. UKetchup, Easy Money and Optionality I was a picky eater when I was a kid, but I loved ketchup, and my pickiness could be overcome with ketchup. I would eat hamburgers, frankfurters, veal cutlets, filet of sole and frozen fish sticks, but as far as I was concerned, they were all just vehicles for ketchup.

But when money’s everywhere, unqualified borrowers are offered money on a silver platter. The inevitable results include delinquencies, bankruptcies and losses. 3. When capital is in oversupply, investors compete for deals by accepting low returns and a slender margin for error. When people want to buy something, their competition takes the form of an auction in which they bid higher and higher. When you think about it, bidding more for something is the same as saying you’ll take less for your money. Thus the bids for investments can be viewed as a statement of how little return investors demand and how much risk they’re willing to accept. 4. Widespread disregard for risk creates great risk. “Nothing can go wrong.” “No price is too high.” “Someone will always pay me more for it.” “If I don’t move quickly, someone else will buy it.” Statements like these indicate that risk is being given short shrift. This cycle’s version saw people think that because they were buying better companies or financing with more borrower-friendly debt, buyout transactions could support larger and larger amounts of leverage. This caused them to ignore the risk of untoward developments and the danger inherent in highly leveraged capital structures. 5. Inadequate due diligence leads to investment losses. The best defense against loss is thorough, insightful analysis and insistence on what Warren Buffett calls “margin for error.

© Oaktree Capital Management, L.P. All Rights Reserved Finally, it’s important to remember that investment trends regularly go to great extremes, meaning “overpriced” and “overdone” are far from synonymous with “going down tomorrow.” As Lord Keynes said, “The market can remain irrational longer than you can remain solvent.” Thus, whatever it is the herd is favoring, a manager might either (a) hold a little to ensure that it doesn’t continue doing well without him on board, making constituents question his judgment, or (b) avoid holding any, but he should be prepared to look wrong for a while. Anyone who’s tempted to blow the whistle on a market trend just because it has gone too far or is priced too high must bear in mind one of the greatest adages of all: “Being too far ahead of your time is indistinguishable from being wrong.” There’s always a period – sometimes a long one – when those who follow the crowd look smart and the abstainers look dumb. But the roles are inevitably reversed in the long run. Insisting on buying value and controlling risk can seem awfully dowdy at times, but for us, there is no other way. April 26, 2007

I’m just speculating from the sidelines without knowledge of the facts in this situation, but I wonder whether this doesn’t show that to protect their own investment in their funds, managers can be driven to take actions that damage their LPs.  UThe unreliability of ratingsU – Many investors act in reliance on ratings, and some require ratings before taking actions they’re considering. But ratings must be taken with a big grain of salt. In fact, a lot of my career (and Oaktree’s success) has been based on conviction that the rating agencies are often wrong.overcorrect

© Oaktree Capital Management, L.P. All Rights Reserved 6. In heady times, capital is devoted to innovative investments, many of which fail the test of time. Bullish investors focus on what might work, not what might go wrong. Eagerness takes over from prudence, causing people to accept new investment products they don’t understand. Later, they wonder what they could have been thinking. 7. Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem. It’s easier to assess the return and risk of an investment than to understand how it will move relative to others. Correlation is often underestimated, especially because of the degree to which it increases in crisis. A portfolio may appear to be diversified as to asset class, industry and geography, but in tough times, non-fundamental factors such as margin calls, frozen markets and a general rise in risk aversion can become dominant, affecting everything similarly. 8. Psychological and technical factors can swamp fundamentals. In the long run, value creation and destruction are driven by fundamentals such as economic trends, companies’ earnings, demand for products and the skillfulness of managements. But in the short run, markets are highly responsive to investor psychology and the technical factors that influence the supply and demand for assets. In fact, I think confidence matters more than anything else in the short run.

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

That’s probably true as well of portfolio managers, consultants and investment committees and their members. (Of course you and I are in that 5%, but I have my doubts about the others.) The consensus opinion of market participants is baked into market prices. Thus, if investors lack insight that is superior to the average of the people who make up the consensus, they should expect average risk-adjusted performance. Few people are able to consistently identify cases where the market price is wrong and act on them to their advantage. “But how about Peter Lynch?” people respond. That’s just the point. His singular reputation is proof how rare the Peter Lynches are. As my mother used to say, it’s the exception that proves the rule. So, the first job in trying to access superior performance consists of getting in with the best funds and managers. Everyone wants above-average results, but far from everyone can achieve them. (Of course, the chore is complicated by the fact that the investment capacity of superior investment vehicles is limited, and the inrush of money can itself render them less superior, since the cost of investing will be pushed up as the money arrives.) Escape From the Crowd This just in: you can’t take the same actions as everyone else and expect to outperform. The search for superior results has to lead to the unusual, perhaps the idiosyncratic. Take manager selection. Above-average managers aren’t easy to find.

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

© Oaktree Capital Management, L.P. All Rights Reserved were going well, one of Long-Term’s principals had said, “We’re going around the world scooping up nickels and dimes.” There’s great appeal to his notion of profiting from a large number of small mispricings that others aren’t smart enough to seize upon. But he had left off a few key words from the end of his sentence: “. . . in front of a steamroller.” The steamroller enters the picture when so much leverage is employed that a fund can’t survive a moment of aberrant market behavior. TIn a memo on hedge funds in October 2004, I mentioned that when there’s a big increase in the number of little fish attempting to live off each big fish’s leavings (or in the number of hedge funds relative to mainstream investors), the pickings become slimmer. Given the increased efforts to exploit inefficiencies today and the fact that strong cash inflows and resultant high prices have depressed prospective returns in many markets, managers are often resorting to increased leverage in order to reach their return targets. But it’s essential to remember that leverage is the ultimate two-edged sword: it doesn’t alter the probability of being right or wrong; it just magnifies the consequences of both. TUThe Perils of Diversification TThe Amaranth saga demonstrates that the riskiness of a portfolio is not just a function of the fundamental nature of its holdings, but also of things like concentration and leverage.

Staying away from tech stocks in the late 1990s meant refusing to pay ridiculously high prices. It wasn’t risky in fundamental terms, but in that it required daring to be different. Those who moved to underweight tech stocks when they first became overpriced were on the hot seat for a long time. I don’t think any other stock group in history has done as well as the techs in the late 1990s, and the 1999 divergence between growth stock returns and value stock returns was the greatest ever. In the years leading up to March 2000, lots of managers were fired for having underweighted tech stocks. That didn’t make them wrong – just too early. While it wasn’t easy for them to stick to their guns – or for their clients to stay with them – it sure paid off. Unconventionality Unconventionality is required for superior investment results, especially in asset allocation. As I mentioned above, you can’t do the same things others do and expect to outperform. Unconventionality shouldn’t be a goal in itself, but rather a way of thinking. In order to distinguish yourself from others, it helps to have ideas that are different and to process those ideas differently. I conceptualize the situation as a simple 2-by-2 matrix: Of course it’s not easy and clear-cut, but I think that’s the general situation. If your behavior and that of your managers is conventional, you’re likely to get conventional results – either good or bad.

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

© Oaktree Capital Management, L.P. All Rights Reserved 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.

So if large numbers of alternative investment managers and would-be managers are planning on getting rich quick, the investment management market must be inefficient: they and/or someone else must be making a mistake. Who else could it be? Maybe it’s their clients. Today, as everyone knows, funds can be raised easily and at sizes no one imagined just three years ago. But assets are no longer as cheap as they used to be, interest rates are no longer as low, and the economic recovery isn’t as young. I recently heard a speech in which a top buyout manager said his fund’s goal (per my memory) is to buy companies at fair prices and make them worth more. In the past, he might’ve said they tried to buy companies cheap. On the plus side of the ledger for private equity, managers think more like owners than do many public company boards; are substantially incentivized to see the funds’ assets appreciate; and have the potential to improve their previously undermanaged companies. On the negative side, however, the three of us noted that clients are currently entrusting record amounts of money to these managers, along with management fees big enough to allow the managers to get rich without making successful investments, as well as a share in transaction fees that have the potential to put the interests of fund managers and their clients in conflict. I believe the investors in these funds feel they’ll be happy if they can earn net returns in the very low double digits.

When markets are booming, the best results often go to those who take the most risk. Were they smart to anticipate good times and bulk up on beta, or just congenitally aggressive types who were bailed out by events? Most simply put, how often in our business are people right for the wrong reason? These are the people Taleb calls “lucky idiots,” and in the short run it’s certainly hard to tell them from skilled investors. The point is that even after an investment has been closed out, it’s impossible to tell how much risk it entailed. Certainly the fact that an investment worked doesn’t mean it wasn’t risky, and vice versa. With regard to a successful investment, where do you look to learn whether the favorable outcome was inescapable or just one of a hundred possibilities (many of them unpleasant)? And ditto for a loser: how do we ascertain whether it was a reasonable but ill- fated venture, or just a wild stab that deserved to be punished? Did the investor do a good job of assessing the risk entailed? That’s another good question that’s hard to answer. Need a model? Think of the weatherman. He says there’s a 70% chance of rain tomorrow. It rains; was he right or wrong? Or it doesn’t rain; was he right or wrong? It’s impossible to assess the accuracy of probability estimates other than zero and 100 except over a very large number of trials. The celebrated investor is one whose actions yielded good results. Was she lucky or good? How much risk did she take?

TYours is the Earth and everything that's in it, TAnd – which is more – you’ll be a Man, my son! TLikewise, short-term gains and short-term losses are potential impostors, as neither is necessarily indicative of real investment ability (or the lack thereof). TSurprisingly good returns are often just the flip side of surprisingly bad returns. One year with a great return can overstate the manager’s skill and obscure the risk he took. Yet people are surprised when that great year is followed by a terrible year. Investors invariably lose track of the fact that they both can be impostors, and of the importance of digging deep to understand what underlies them. TOne gets the impression that no one at Amaranth asked the right question when Brian Hunter shot the lights out in 2005: “How’d you do that?” Or if they asked, they were satisfied with what turned out to be the wrong answer: skill, rather than leveraged aggression combined with luck. They let him move to Calgary, and they gave him a large enough capital and/or risk budget to enable him to bring down the firm. TBut The Wall Street Journal of September 19 laid out how this came about. “. . . late last year, the double-whammy of Hurricanes Katrina and Rita made Mr. Hunter a hero at Amaranth and a minor legend on Wall Street, as he made $1 billion for Amaranth.” Hunter liked to buy deep- out-of-the-money options.

© Oaktree Capital Management, L.P. All Rights Reserved 5BUSo Is It Risky Or Not? 6BCasual onlookers rarely see that as a tough question. But like most aspects of investing, the more obvious the answers seem, the less likely they are to be true. 7BMany considerations on the subject of risk are actually paradoxical. Investing requires us to deal with the future, and the difficulty of cracking the future is the source of most of the risk. The actual riskiness of many aspects of investing depends on the extent to which an investor is capable of knowing something about the future, or – perhaps better put – of knowing more than the average investor. 8BFor example, let’s consider diversification versus concentration. Is concentration risky? Not if you know what the future holds. Diversification by definition implies a willingness to trad off return for safety, motivated by acceptance of the fact that knowledge of the future is imperfect. Most investors rank their stocks by potential return, formally or informally, but no one I know buys just the one they expect to deliver the highest return. Why? Because they know their rankings might be wrong and don’t want to bet it all on black and see red come up. Concentration is risky for investors who can’t see the future with much clarity, but it wouldn’t be for one who can. For the latter, it’s the way to maximize performance, and diversification can hold it back. e What about illiquidity?

So then outcomes aren’t necessarily indicative of reality, meaning that alternative histories should be given significant weight. (I guess the ultimate step would be to suggest that USC actually won the game, the score notwithstanding. That would be going too far . . . although we often hear a losing team’s fans say, “We won that game.”) While we’re looking deeply into things, let’s spend a minute on Pete Carroll’s decision to go for it on fourth down. Was he right or wrong? He has gone for it on fourth down many times in his coaching career, and most of the time it worked. In fact, USC twice had run on fourth down earlier in the championship game, making the needed yardage once and scoring a touchdown. But on that final attempt they were unsuccessful. Does that mean Pete made a wrong decision? Or was it a right decision that just happened not to work on that occasion? One of the first things I learned at Wharton in 1963 was that you can’t judge the correctness of a decision from the outcome. This is another concept that many people find nonsensical. But good decisions fail to work all the time – just as bad ones lead to success – simply because it’s so hard to predict which history will materialize. It seems ridiculous for something as momentous as the label “best team ever” – and the measure of a team’s real worth over an entire season – to hinge on the outcome of one play that took four seconds.

They can introduce ideas they’re seeing in use elsewhere. They can support investors’ efforts to innovate while making sure they don’t go so far as to endanger the corpus. Because few institutions can afford to home-grow all of the resources that a good consultant has, consultants truly can be additive. Or, they can just be used as a source of cover. Their stamp of approval can be sought as protection against potential criticism. They can be used to ensure that the portfolio is never different enough from the herd to stand out. They can be hired – and motivated – to preclude innovation. Frighteningly, a consultant once told me, “I never initiate; if I did, I could be criticized for being wrong. I just opine when asked.” By supplying new ideas and needed data in support of an effort to be great, consultants clearly can add value. But left in bureaucratic mode, it is possible for them to contribute nothing other than protection. The choice – of consultant and modus operandi – is up to the client. Recognize That All Investors Aren’t Created Equal Wouldn’t it be great if the rules in Las Vegas were changed so there would be winners but no losers? Can’t capitalism allow some businesses to thrive without requiring that some fail? Can’t we have survival of the fittest without the demise of the less fit? Wouldn’t it be nice? And wouldn’t it be nice if everyone could make an equally positive contribution to investment results? But they can’t. © OAKTREE CAPITAL MANAGEMENT, L.P.

He includes among the elements that render a risk suitable for modeling (1) recurring situations, (2) processes that are subject to known rules, (3) conditions that can be counted on to remain stable, (4) controllable environments, (5) a limited range of outcomes, and (6) certainty that combinations of things will lead to known results. What could be UlessU descriptive of investing? Given the non-recurring situations we face, the fact that many of the rules are unknown, and the largely unlimited range of outcomes (among other things), I would argue strongly that models and modelers are of very limited utility in measuring investment risk at the extremes, where it really matters. 13BUBearing Risk for Profit A few years ago, one of my memos quoted Lord Keynes as having said, “. . . 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.” (I admitted at the time that I’d been unable to verify that he actually said it, but now I’ve identified the source.) Keynes makes an essential point. Bearing risk unknowingly can be a huge mistake, but it’s what those who buy the securities that are all the rage and most highly esteemed at a particular point in time – to which “nothing bad can possibly happen” – repeatedly do.

When I see 1% or ½% of portfolio capital invested with a trusted (and diversified) fund or manager, it strikes me as too little. A manager who has earned his clients’ confidence should be entrusted with enough money to make a difference in overall portfolio results. One pension plan was bold enough to let Oaktree manage 70% of its alternatives portfolio, and this led to a relationship that was wildly successful for both sides. How many investors would have taken that chance? • Limiting the percentage of a manager’s AUM – As a counterpoint to the above, I’ve heard committees say, “We don’t want to represent more than x% of the manager’s assets under management, or of the fund’s total capital.” But why not? Is the goal better performance, or is it safety in numbers? If you’re considering investing $10 million with a manager, why does it matter how much money she manages? Why is investing $10 million safe if she manages $1 billion but risky if she manages $50 million? If a manager is unusually skillful, aren’t you better off as her client (all else equal) if she manages less money rather than more? And if a manager was really good, wouldn’t you prefer that she managed only your money? Wouldn’t that be a great way to differentiate your performance (assuming you’re right)? The pension client referred to above committed 40% of the capital for the initial fund in a new Oaktree strategy. Mistake? Not with an after-fee gain of 118% over the next three years.

• Moderating – Committees often prefer to take baby steps, go slow, and invest less than the maximum possible. But in the pursuit of superior investment results, moderation is not a virtue in and of itself. When you look at the portfolios that do better than others over time, like the Yale and Harvard endowments, you usually see very substantial commitments to individual strategies, managers and funds. In fact, you invariably see commitments that could have gotten the decision makers into trouble if they’d gone wrong. • Managing toward peer allocations – Finally, I often see investors make reference to their peers’ portfolios when setting allocations. It’s unlikely that they’re looking for the “right” allocation, but rather one ensuring that performance won’t be far below the pack. But if you’ve mirrored the pack enough to be sure you can’t underperform, then it’s also likely that you won’t outperform. Like everything else in the investing world (other than “alpha,” or genuine personal skill), emulating the pack cuts both ways. My most specific and most heartfelt advice is this: The surest way to achieve superior performance is by investing significant amounts with individuals and firms that can be depended on for investment skill, risk control, and fair treatment of clients.

© Oaktree Capital Management, L.P. All Rights Reserved invests in hedge funds]. “They were more leveraged than they realized.” (The Wall Street Journal, September 20) TAfter the fall, the Journal quotes Mr. Maounis as saying Amaranth’s traders “were surprised not only by adverse market moves that triggered the losses but also by the lack of ability to exit the losing positions.” That’s it, right there: the word “surprise.” It’s one thing to make an investment you know is risky and have it come out wrong. It’s something entirely different to make an investment that entails risk of which you’re unaware. TMr. Maounis and Amaranth’s risk managers shouldn’t have been surprised. They should have been alerted by the volatility of the fund’s energy results. According to Till, its LPs should have been as well. “Investors would not have needed position-level transparency to realize that Amaranth’s energy trading was quite risky.” But the evidence of that potential risk came primarily in the form of outsized gains, and these are rarely recognized as the red flag they are. TAmaranth’s investors relied heavily on its vaunted risk management capability and on the assurance that risk was under control. But the fund failed to survive its seventh year. Quantitative risk managers can only opine on whether a disaster is likely or not. Even if they’re right about that, it’s up to you to decide whether you’re willing to bear the risk of an improbable disaster. They do happen!

When you’re dealing with investments where reliable probabilities can’t be assigned to the possible outcomes, or which entail the possibility of significant risk to the corpus (make-it-or- break-it-type risks), failing to diversify can be a big mistake. But when you know of managers and strategies that appear to offer high returns with bearable, controlled risks, and when reasonable judgments can be made about the probable outcomes, it’s failing to concentrate that can be the big mistake. In short, if you can get money to work with people that your experience shows you can rely on, load up! © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

* * * The bottom line on striving for superior performance has a lot to do with daring to be great. Especially in terms of asset allocation, “can’t lose” usually goes hand-in-hand with “can’t win.” One of the investor’s or the committee’s first and most fundamental decisions has to be on the question of how far out the portfolio will venture. How much emphasis should be put on diversifying, avoiding risk and ensuring against below-pack performance, and how much on sacrificing these things in the hope of doing better? I learned a lot from my favorite fortune cookie: The cautious seldom err or write great poetry. It cuts two ways, which makes it thought-provoking. Caution can help us avoid mistakes, but it can also keep us from great accomplishments. Personally, I like caution in money managers. I believe that in many cases, the avoidance of losses and terrible years is more easily achieved than repeated greatness, and thus risk control is more likely to create a solid foundation for a superior long-term track record. Investing scared, requiring good value and a substantial margin for error, and being conscious of what you don’t know and can’t control are hallmarks of the best investors I know. But in assembling a portfolio of managers and strategies, there has to be an element of boldness if you hope to enjoy superior returns. Too large a dose of caution in asset allocation can keep portfolios from outperforming the norm.

Time and time again, the post mortems of financial debacles include two classic phrases: “It was too good to be true” and “What were they thinking?” I’m writing to explore why these observations are so often invoked in the past tense. The combination of greed and optimism repeatedly leads people to pursue strategies they hope will produce high returns without high risk; pay elevated prices for securities that are in vogue; and hold things after they have become highly priced in the hope there’s still some appreciation left. Afterwards, hindsight shows everyone what went wrong: that expectations were unrealistic and risks were ignored. It is my point that:  Investors mustn’t dwell excessively on recent experience.  Instead, they must look to the future.  They must consider today’s developments critically.  That assessment must take place in the light of history’s lessons.

It’s when most investors take a trend to excess, or the price of an asset to an extreme, that the few people smart and resolute enough to abstain from herd behavior can make truly exceptional profits. I think both Buffett’s and Galbraith’s dim views of the average investor are well founded. Although there exist a few rules and reminders that can make it easier to avoid the costliest investing mistakes, most investors rarely heed them. Investors truly do make the same mistakes over and over. It may be different people doing it each time, and usually they do it in new fields and in connection with new assets, but it is the same behavior. As Mark Twain said, “History doesn’t repeat itself, but it rhymes.” Rarely is the same error repeated in back-to-back years. Usually enough time passes for the repetitive pattern to go unnoticed and for the lessons to be forgotten. Often it’s a new generation repeating the errors of their forefathers. But the patterns are there, if you observe with the benefit of objectivity and a long-term view of history.

© 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 time below to go through these areas and cite some rule violations I see occurring. (I’m not saying that these investment areas are without merit. It’s just that I wince when I see uncritical analysis and unsupported conclusions.) Let’s take the example of real estate. Almost twenty years ago, real estate was the site of many classic mistakes, and lots of money lost. In the mid-1980s, institutional investors charged into real estate, under banners like “They’re not making it any more” and “It’s a good inflation hedge.” What they missed was the fact that:  while it’s true that no one’s making more land, there’s a lot left to develop, and easy access to capital enables market-glutting buildings to be built on it,  something’s only an inflation hedge if bought at a fair price to start with, and  unlike the 1970s, inflation wouldn’t be an issue for the next twenty years, and thus inflation protection wasn’t worth paying up for. Tax reform in 1987 reduced the demand for tax shelter purposes, and the economic slowdown of the early 1990s turned real estate into a basket case. They UstillU weren’t making any more land, but that didn’t help institutional investors avoid huge losses. Today, real estate seems to be the site of investing error again – with no one harking back to the last time around. This is especially true in private homes, with individuals rather than professionals doing most of the “investing.

” They’re lining up to buy houses (often before they’re built) that they never expect to occupy, for holding periods too short to repay the transaction costs in the absence of substantial appreciation, and they’re financing them with maximum floating-rate mortgages, minimum amortization and little or no money down. On March 25, 2004, The New York Times compared attitudes toward home buying today and the “dot-com frenzy” of the late 1990s: . . . perhaps the most troubling similarity, some analysts say, is the claim that the rules have somehow changed. In an echo of the blasé attitude that “new economy” investors took toward unprofitable companies, the growing ranks of real estate investors are buying houses they never expect to be able to rent at a profit. Instead, they think the prices of houses will just keep rising. This paragraph points up a key error. In 1999, impassioned investors bought dot-com stocks, not to participate in the underlying companies’ profit streams, but to sell them at higher prices. But what could be depended on to make their prices go higher, if not favorable trends in profits? In the same way, rational investors won’t count on being able to sell a house at a profit because someone else will pay more for it, but rather because of an increase in its economic value (which usually can be seen in the obtainable rent).

© Oaktree Capital Management, L.P. All Rights Reserved common stock, with the likelihood that the stock would decline precipitously: no bet on the direction of the market or the company, and absolute preparedness for negative developments. That’s the position the arbs flocked to this year in General Motors. They assumed the debt they were long would hold up much better than the common they were short. What could go wrong? Well, something can always go wrong, and things are most dangerous when people agree they can’t (and price them accordingly). In the case of GM, the arbs got a double whammy:  Billionaire Kirk Kerkorian stunned the financial world on May 4 by announcing his intention to bid $31 for 28 million shares of GM common stock. This drove the price of the stock from roughly $28 to $32, creating big losses on the arbs’short positions.  Just the next day, S&P announced its long-expected downgrading of GM’s credit rating. This lowered the price of GM debt, giving the arbs losses on their long positions as well. In this way, something that “couldn’t happen” did: the prices of both assets went against the arbs simultaneously. If a company’s bonds decline because of deteriorating creditworthiness, can the stock possibly do better? It did this time – for a reason no one would have anticipated. (People are still mystified regarding Kerkorian’s motivation.)

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%.

I don’t think a company’s stock can do well for long if its bonds don’t (given the implication of serious fundamental problems). But the long run doesn’t matter when unexpected difficulties arise in leveraged portfolios. The effect on staying power can be very negative. Other things we’ve seen recently that “couldn’t happen”: GM and GMAC being downgraded simultaneously, and intermediate and long rates down substantially while short rates rose more than 200 basis points. As Long-Term Capital Management said in explaining its meltdown, “the convergence trades diverged.” In this case, I absolutely am not saying the arbs were foolhardy in putting on their GM positions. I simply want to point out that nothing in the investment world can be counted on to work 100% of the time. Allowance must always be made for the unexpected. 3BURule Number Three: Piling In Is Dangerous One of the phenomena we’ve witnessed lately – and it was particularly pronounced in the events surrounding Long-Term Capital Management – is the tendency of funds of a given type to flock to the same situations. The General Motors trade described above, for example, was particularly common among arbs. Thus, when it went wrong, they all suffered losses, and they all faced illiquidity when they went to unwind it. There’s little mystery surrounding the reason particular trades become widespread.

When investors as a group are feeling upbeat, the market is able to shrug off negatives as isolated and insignificant. When they’re depressed, investors generalize individual complications into an insurmountable web of negatives. I feel it’s very important that we be aware of whether the market is giving events their proper weight, versus overlooking or overrating them. When things develop that should be considered, it’s a matter of “Pay me now or pay me later.” U We’re from the Government and We’re Here to Help In 2002, at the height of the Enron/WorldCom corporate scandals, the federal government gazed unerringly into its own rearview mirror and demonstrated its ability to solve the last problem . . . and cause the next one. I’ve been looking for an opportunity to pop off on the subject of Sarbanes-Oxley, and here it is. There was little discussion or dissent before Congress passed – and the president signed – this piece of legislation designed to root out corporate corruption and hold executives responsible for future infractions. The vote should tell you something: 423 to 3 in the House and 99 to 0 in the Senate! Any time the Great Deliberators on both sides of the aisle agree on something so overwhelmingly, it’s probably being done in the heat of the moment and in response to rampant popular sentiment – and it’s probably a mistake.

© Oaktree Capital Management, L.P. All Rights Reserved line is that investors in real estate today have to stress value consciousness and selectivity. It’s not my intention here to pick on real estate in particular or to suggest that it’s worse than other markets. It’s just that the articles being written about it provide such good examples of some investors’ error-proneness. As I wrote in October, I think we’re seeing much of the same in hedge funds. Investors here are ignoring price also – this time not relating to the underlying assets, but to fund managers’ services. Out of frustration with public, long-only equities (based with the usual hindsight on the 2000-02 debacle), they’re looking for the silver bullet in “alpha managers” and “absolute return strategies.” And they’re suspending disbelief – just like they do at the movies – to accept that it’s possible each year to find thousands of new above-average managers who are capable of piloting thousands of new hedge funds to high returns with low risk in increasingly competitive markets. In recent weeks, private equity has shown up as the belle of the ball. Managers who startled the world with $3-6 billion funds a few years ago are pursuing $8-10 billion this time with good success. They’re able to get it because of recent performance swollen by generous capital market conditions, aided by the assertion that few funds will be big enough to compete for the mega-deals.

I don’t say these arguments are invalid, but I wonder if investors are worrying enough about some potentially troubling factors:  the fact that the funds’ managers are targeting their lowest returns ever – even though few of their past funds may have achieved their targets,  the impact on the market for companies of five new funds with $50 billion to spend – and the possibly underrated likelihood that additional managers will crowd into the “mega” space (I still hold that when the best are closed, the rest will be funded), and  the effect on the managers themselves of $100-plus million per year in non- performance-based fees. Lastly, the recent price surge has made crude oil fertile ground for simplistic platitudes and the resulting investor error. Not only aren’t they making any more, but our consumption increases every day; rapid growth in China and India implies massive further increases in demand; and much of the supply is in unreliable hands. None of these factors can be disputed. The key question is, “What do they make oil worth?” I think it’s important to note that, unlike cash flow-positive companies and profit- producing companies, it’s hard to state the intrinsic value of a commodity or currency. Are you persuaded by the arguments above? Sure you are – I am, too. Do they make oil a buy today, at $51 a barrel? Certainly. But weren’t they just as true a month ago, when oil hit $58? Didn’t they make it a buy then, too?the

But before taking this path, I’d suggest that you get a commitment from your investment committee or other constituents that they’ll ignore short-term losses.  Hold cash – but that’s tough for people who need to meet an actuarial assumption or spending rate; who want their money to be “fully employed” at all times; or who’ll be uncomfortable (or lose their jobs) if they have to watch for long as others make money they don’t.  Concentrate your investments in “special niches and special people,” as I’ve been droning on about for the last couple of years. But that gets harder as the size of your portfolio grows. And identifying managers with truly superior talent, discipline and staying power certainly isn’t easy. The truth is, there’s no easy answer for investors faced with skimpy prospective returns and risk premiums. But there is one course of action – one classic mistake – that I most strongly feel is wrong: reaching for return.

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

The key ingredients in being able to avoid these mistakes should be pillars in everyone’s investment approach:  awareness of history,  belief in cycles rather than unabated, unidirectional trends,  skepticism regarding the free lunch, and  insistence on low purchase prices that provide lots of room for error. Adherence to these things – all parts of the canon of defensive investing – invariably will cause you to miss the most exciting part of bull markets, when trends reach irrational extremes and prices go from fair to excessive. But they’ll also make you a long-term survivor. I can’t help thinking that’s a prerequisite for investment success.2005

This debt was a big red flag: “I’m buying something I can’t afford, with debt I can’t service on a current basis, hoping positive developments will bail me out.” Most of them went bankrupt in 1990 when the economy softened and debt couldn’t be refinanced. Now people are assuming increased financial risk to buy homes, often taking out interest- only loans at artificially low teaser rates. The September 2005 issue of The Gloom, Boom & Doom Report quoted Grant’s Interest Rate Observer quoting David Rosenberg of Merrill Lynch:  An estimated 42% of first-time buyers made no down payment on their home purchase in 2004.  In the hottest price areas in the U.S.A., ARMs [adjustable rate mortgages] now account for over 50% of new mortgage originations.  Over 60% of new mortgage loans in California this year have been interest-only loans or option ARMs. People are stretching to buy the most house they can with the biggest mortgage payment they can afford. But if they can barely cover today’s artificially reduced payments, what will they do when interest kicks in and/or rates rise? And what if their incomes fall? Where’s the margin for error? When I was young, the rule of thumb was that no more than one-quarter of your paycheck should go for shelter. Today lots of people are paying more than half.

© Oaktree Capital Management, L.P. All Rights Reserved commissions. The head of a charity draws a salary that reduces the amount left for the organization’s good work. The doctor collects for his services, and the more he charges, the fewer the people who can afford them. And we investment managers charge management fees, and sometimes a percentage of the profits, that cut into our clients’ net return. We all want to increase our incomes, but it should be possible to stick to the high road while doing so. The tradeoffs present challenges, but they can be overcome. I do not argue that mutual fund executives – or investment managers in general – should be expected to serve in an eleemosynary capacity. Certainly Oaktree doesn’t run on pure altruism. Vanguard comes close to the ideal, as a non-profit organization owned by its fund owners, but Vanguard’s people take compensation, not vows of poverty. The critical question in my mind isn’t whether people make money, or even how much, but what methods they employ to do so, how candid they are about those methods, and how the inevitable conflicts of interest are resolved. U What’s Wrong With a Little Salesmanship? My October memo “The Feeling’s Mutual” argued that late trading wasn’t the worst thing going on in the mutual fund industry. Rather, it pointed to questionable long-term practices relating to governance, marketing and compensation.

© Oaktree Capital Management, L.P. All Rights Reserved My point here, and my reason for reproducing part of Taleeb’s table, is my belief that there are people who see the things on the left, and there are people who see the things on the right, but few who see some of each. Some people think their ability to infer causality and analyze data makes them skilled investors capable of producing consistent outperformance. Others understand that luck plays a big part; that a lot of apparent causality is really coincidence; and that the person crowned the most skilled investor in a given year might be nothing more than a “lucky idiot.” Very few people mix aspects from both columns. I can think of many qualities that seem to go together to define one of the two main types of investor but not the other. I’ll discuss them below and attribute them to either the “Oaktree-style” investors with whom I tend to associate – “us” – or the other sort of investor – “them.” 1BUPersonality Type It would be great to either be middle-of-the-road and dispassionate all the time or, better yet, bullish or bearish at just the right time. But few people can achieve either of those ideals. Most investors are congenitally either bullish or bearish, and I’ve never seen anyone capable of flipping in an adroit and timely manner from one to the other. For most of us, it’s either bullish most of the time or bearish most of the time – right or wrong.

© Oaktree Capital Management, L.P. All Rights Reserved “arrangements under which fund firms direct trades to . . . brokerages in returns for its (sic) funds staying on their ‘preferred list.’” Sometimes funds allocate commissions to brokerage firms in order to pay off the revenue sharing obligations described above.  Sales incentives – In its article on Jones, the Journal also reported “more than half of the firm’s brokers are invited on [Caribbean cruises and African-wildlife tours paid for by fund companies on the preferred list], based on meeting certain overall sales targets.” At some brokerage firms, brokers have received higher commission rates for selling funds that generate revenue sharing. Elsewhere, the commissions for selling funds managed by the brokerage’s in-house money management arm have been higher than those on third-party-managed funds. On January 13 the Securities and Exchange Commission said that 14 out of 15 broker- dealers it examined had received cash payments from mutual fund companies. Is it wrong for brokerage firms and/or their brokers to receive compensation for emphasizing a company’s funds? After all, supermarkets accept compensation from food companies for giving them more desirable “shelf space.” Isn’t that a valid analogy? The answer lies in the significant distinction between an ordinary businessman and a trusted adviser.

For many of the outstanding investors I’ve come across, it’s the latter. And I shouldn’t say bearish – I’ve just used that word as shorthand for a number of others. But the “us-style” investor tends to be cautious and defensive, while the “they-style” investor tends to be optimistic, confident and aggressive. And the investors I like most are patient. Because they know they can’t be right every time, their real concern is with the long run. On the other hand, the “I know” investor feels he has a good handle on what lies ahead and thus plans to do an above-average job every year – an admirable goal, perhaps, but I don’t think highly achievable. 2BUHunt for Upside or Avoid Downside? One of the most significant ways in which these differences manifest themselves is in terms of attitude toward risk. If you’re confident that you know what the future holds, risk isn’t frightening. But if you’re convinced that you don’t have that good a handle on the future, it’s hard to be very cocky. Our kind of investor is preoccupied by risk, whereas I think the other is often oblivious to it. Our kind worries about what can go wrong, while the other revels in what might go right. Ours tries to avoid mistakes, and the other concentrates on finding winners. Ours obsesses about the losers he might buy or hold, while the other dwells on the opportunities he might miss. In short, it’s offense versus defense.

© Oaktree Capital Management, L.P. All Rights Reserved UAttitudes Toward the Market The actions of “they” investors are often driven by their views regarding the outlook for the market. They invest more aggressively when the outlook’s positive than they do when it’s negative (although, as I said before, they’re usually positive). “We” investors tend to invest from the bottom up, primarily basing investment decisions on whether attractive individual investment opportunities are available. In fact, I’m often struck by the fact that “they” are preoccupied with studying and assessing the behavior of “the market” – which collectively means studying themselves. My favorite investors – both inside and outside Oaktree – spend their time almost exclusively looking into individual companies and their securities. One of the greatest dichotomies is that “they” impute intelligence to the market while “we” are highly skeptical of it. Trillions of dollars were lost after 1998-99 because the mass of investors hadn’t sufficiently questioned the valuations of tech stocks. They’d been told, “The market’s efficient” and assumed that if a stock was selling at a price, that meant the price was justified. The investors I respect feel the market’s often wrong – either underpricing or overpricing securities – and more than anything else, they look for opportunities to profit from those errors. In their view, as Dickens said about the law, “the market’s an ass.” 4BUSo Where Do We Stand Today?

Holders of assets, who play a part in setting market prices by deciding where they’ll sell, also are optimistic. The result is an unappetizing, risk-tolerant, high-priced investment landscape. It’s for times like this that my favorite Warren Buffett quotation is most appropriate: “The less prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own affairs.” UImplications for Investing One way to improve investment results – which we try hard to apply at Oaktree – is to think about what “today’s mistake” might be and try to avoid it. There are times in investing when the likely mistake consists of:  not buying,  not buying enough,  not making one more bid in an auction,  holding too much cash,  not using enough leverage, or  not taking enough risk. I don’t think that describes today. I’ve always heard that no one awaiting heart surgery ever complained, “I wish I’d gone to the office more.” Well, likewise I don’t think anyone in the next few years is going to look back and say, “I wish I’d invested more in 2004.”

© Oaktree Capital Management, L.P. All Rights Reserved Rather, I think this year’s mistake is going to turn out to be:  buying too much,  buying too aggressively,  making one bid too many,  using too much leverage, and  taking too much risk in the pursuit of superior returns. There are times when the investing errors are of omission: the things you should have done but didn’t. Today I think the errors are probably of commission: the things you shouldn’t have done but did. There are times for aggressiveness. I think this is a time for caution. Not every investor has the option of holding a lot of cash. A pension fund has to pursue its actuarial return, and too many years spent earning money market rates can ensure it won’t be achieved. The same can be true for a foundation that has to spend 5% of its assets each year, and for an individual living on his or her investment income. But when I look today at the smart people I know who have the ability to hold cash, I see large balances. As Warren Buffett wrote in his 2003 Annual Report, “Our capital is underutilized now . . . . It’s a painful condition to be in – but not as painful as doing something stupid.” There are times when big funds are a good thing – when the market power that comes with more money is a help. I think this is generally a time for moderation in fund raising – a time when the selectivity and agility that come with smallness will prove to be key.

© Oaktree Capital Management, L.P. All Rights Reserved UTHEMU UUSU “I know” “I don’t know” Bullish by nature Bearish by nature Aggressive Defensive Confident Guarded Comfortable with risk Obsessed with risk What might go right? What might go wrong?low

When investors are chastened and afraid, they’ll buy very few new securities, and only those of high quality. When they’re euphoric and confident, they’ll buy greater quantities and attend less to matters of quality and downside protection. In the most overheated markets, when being underinvested is considered the biggest mistake one can make, buyers compete for new issues by paying higher prices and by demanding less in terms of quality and safety.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: The Most Important Thing As I meet with clients and prospects, I repeatedly hear myself say, “the most important thing is x.” And then ten minutes later it’s, “the most important thing is y” (and then z, and so on). Am I being disingenuous? Am I confusing the unimportant with the important? Is it that I can’t make up my mind? Or is memory loss setting in? I hope (and believe) it’s none of these things. If I have to come up with an explanation, maybe it’s that I have strong feelings on a lot of subjects. Whatever the reason, I thought I’d collect in one place the precepts that guide Oaktree. Some might be more important than others, but in my view each one qualifies as “the most important thing.” The most important thing – above all – is the relationship between price and value. For a value investor, price has to be the starting point. It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough. When people say flatly, “we only buy A” or “A is a superior asset class,” that sounds a lot like “we’d buy A at any price . . . and we’d buy it before B, C or D at any price.” That just has to be a mistake. No asset class or investment has the birthright of a high return. It’s only attractive if it’s priced right.

© Oaktree Capital Management, L.P. All Rights Reserved Memo To: Oaktree Clients From: Howard Marks Re: The Feeling's Mutual Throughout the recent, seemingly endless series of scandals, complaints, settlements, indictments and meltdowns involving corporations, auditors, brokerage firms, investment banks and hedge funds, the mutual fund industry remained untouched. That held true until September 3, when the Attorney General of New York State announced that Edward Stern of hedge fund Canary Capital Partners had paid $40 million to settle charges relating to improper dealings between Canary and a number of mutual funds. Since then, sordid disclosures involving mutual funds seem to be emerging on a regular basis. UThe Canary That Swallowed the Cat What did Canary do wrong? It admitted to "mutual fund timing" and "late trading." Both of these tactics take advantage of what I would call "temporal disconnects" in the process through which the price for transactions in mutual fund shares is set. A fund's Net Asset Value is supposed to reflect the per-share value of the assets held in the fund's portfolio, so that people buying or selling fund shares at that NAV pay or receive a fair price for their portion of the fund's portfolio. However, the process is non-dynamic, in that the NAV is set just once a day based on the underlying securities' latest closing prices and isn't updated for events that occur subsequent to the market closings or subsequent to the time of the calculation.

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

Hopefully, if I offered to sell you my car, you’d ask the price before saying yes or no. Deciding on an investment without carefully considering the fairness of its price is just as silly. But when people decide without disciplined consideration of valuation that they want to own something, as they did with tech stocks in the late 1990s – or that they simply won’t own something, as they did with “junk bonds” in the 1970s and early 1980s – that’s just what they’re doing. During the course of my 35 years in this business, investors’ biggest losses have come when they bought securities of what they thought were perfect companies – where nothing could go wrong – at prices assuming that degree of perfection . . . and more. They forgot that “good company” isn’t synonymous with “good investment.” Bottom line: there’s no such thing as a good idea regardless of price!commentator

© Oaktree Capital Management, L.P. All Rights Reserved cases involving infrequently traded securities, a timer may gain an advantage from knowledge that security prices haven't been updated for days or weeks. At first glance, this all appears relatively benign. It is not improper in itself to trade on knowledge that the prices of some fund holdings are stale. All investors have potentially equal access to this information, and they all have the same ability to enter orders for fund shares up to 4:00 p.m. Eastern Time. Further, most of these situations involve small pricing imperfections that relate to a small portion of the fund's portfolio, and trading on them isn't likely to materially change the return on a long-term investment in the fund. However, these trades can be highly profitable if the impact is magnified through minimization of the holding period. (E.g., taking advantage of a 1¢ error in a $10 NAV will add just .1% to the annual return if the fund shares are held for a year, but taking advantage of a new 1¢ disparity every day will increase the annual return by 25%!) Obviously, then, the key to achieving unusual profits through mutual fund timing lies in rapid-fire trading.

© Oaktree Capital Management, L.P. All Rights Reserved 5BUSo What’s The Point? I don’t begrudge people wanting to make money by expressing views that are beyond their ken and of no value. I guess it’s human nature. My complaint, however, is that it’s misleading and injurious to bystanders when people use serious platforms to state their unfounded views. They make it seem so easy to understand economic and market developments, and thus to profit from them. Just as no one should give legal advice or medical diagnoses on TV, the media should desist from providing economic and market analysis as well. I think some of the greatest contributors to the 1998-99 bubble were the talking heads of the media. For every event they provided a without-a-doubt explanation and quantified its profit implications. These “experts” were free with recommendations and exuded 100% certainty. As I’ve said before, there are a few things they never said: “darned if I know,” “it’s hard to predict these things,” and “but I could be wrong.” Nobody was well served by the veneration of the “I know” school in the late 1990s: Main Streeters were lured to invest in Wall Street without an understanding of the skills required or the risks entailed. The market and thus the economy were put through an extreme boom-bust cycle. Risk- taking investment gunslingers were anointed, and cautious value seekers were rendered irrelevant.

© 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!

© Oaktree Capital Management, L.P. All Rights Reserved that the NAV will rise tomorrow. On average, these trades can be highly profitable . . . if the holding period is short enough. Late trading is less ambiguous than fund timing. It's wrong (and illegal), and no one should be able to do it. It, too, takes away some of the profit that should have gone to the fund's long-term holders. Again, Canary made improper arrangements that allowed it to divert those profits to itself. Eliot Spitzer compared these two tactics to "betting today on yesterday's horse races." I seem to recall gamblers calling this "past-posting"; see the classic movie "The Sting" for a tutorial. You'd be surprised how easy it is to win when you bet on races that already have taken place. All you need is a way to get the bet down. And although making the bet may not be illegal in itself, the things you have to do to get someone to take the bet probably will be. Canary found mutual fund companies that were willing to permit fund timing and late trading in exchange for capital commitments and fees. In exchange for benefits for themselves, they were willing to assign some of their investors' profits to Canary. The relatively open manner in which these arrangements were negotiated, documented and communicated to senior managers (who seem not to have taken exception) suggests to me that the people involved were more stupid (and/or ethically tone-deaf) than they were larcenous.

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  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.

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.

© Oaktree Capital Management, L.P. All Rights Reserved UOften Wrong But Never In Doubt (or Hesitant to Share) The January 6 issue of “Pensions & Investments” contained its 2003 Investment Outlook. Twenty institutional money managers generously provided their views on what the coming year holds. They ranged from cautiously bullish to outright bullish. The headlines on the more restrained forecasts included: “‘Double-Dip’ a Possibility,” “Recovery with Headwinds,” “International Surprises Likely,” “Moving Sideways Toward a Bull Market,” “It Will Be a Stock-Selective Market,” and “Blame Iraq” The outright optimists said: “The Worst is Behind Us,” “Rocking and Rolling Before Long,” “Healing Process Is Already Well Along,” “Bullish on Credit,” “Crisis of Confidence Is Over,” “Bullish on Equities,” “We Are . . . in a Recovery,” and “Extraordinarily Bullish for 2003.” The most guarded forecaster said the market could be close to flat; nobody said “down.” One of my greatest complaints about forecasters is that they seem to ignore their own records. I’ve never heard one say, “I predict such-and-such will happen (and 7 out of my last 10 forecasts were off the mark)” or “I predict such-and-such will happen (and, by the way, I predicted the same thing last year and was wrong).” However, P&I did the unusual by critically reviewing the previous year’s forecasts.

© Oaktree Capital Management, L.P. All Rights Reserved The average “expert” added little in terms of predicting the future. It’s not that the forecasters were always wrong; when there was little change, they were often right. It’s just that in times of major changes (when accurate forecasts would have helped one make money or avoid a loss), the forecasters completely missed them. In the years reviewed, the expert consensus failed to predict all of the major developments. Where do these forecasts come from? The answer is simple: If you want to see a high correlation, take a look at the relationship between current levels and predicted future levels. . . In general we can say with certainty that these forecasters were much better at telling us where things stood than where they were going. Every six months, when the Journal reports on a new survey of forecasts, it takes the opportunity to cite the forecaster in the previous survey who came closest . . . And the truth is that the winner’s accuracy is often startling. . . . [However,] the important thing isn’t getting it right once. It’s doing so consistently. . . As the Journal itself pointed out, “ . . . by giving up the comfort of the consensus, those on the fringes of the economic prediction game often end up on the winning or losing end. . . the winners of six months and one year ago didn’t even get the direction of interest rates right this time.

© Oaktree Capital Management, L.P. All Rights Reserved  If you make a conventional, status quo-type forecast, you’re likely to be right most of the time.  But since the status quo usually is shared widely and factored into prices, a status quo forecast won’t help you beat the market or call its turns (even if it’s right).  The forecasts with real profit potential are the ones that correctly predict unusual events.  But idiosyncratic forecasts are wrong most of the time (and thereby unlikely to be profitable). So if (a) conventional forecasts are easy to make correctly but generally lack profit potential, and (b) unconventional forecasts have theoretical profit potential but are hard to make correctly, then (c) it should be clear that forecasts are unlikely to help you know enough about the future to beat the market. UDoes Anyone Point Out What The Consensus Doesn’t Know? I feel very strongly that the hundreds of economists and strategists with conventional forecasts add little to the equation. On the other hand, Byron Wein of Morgan Stanley is one of the small group who provide a very valuable service by consciously looking for surprises (and who knowingly accept the risk entailed in talking about things that probably won’t happen). At the beginning of each year Byron publishes a list of ten things that most people feel won’t happen but he thinks have a 50% or better chance of taking place.

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

© Oaktree Capital Management, L.P. All Rights Reserved  Don’t take credit for things that go right for the wrong reason.  Admit when things go wrong – without hiding behind excuses.  Communicate not just the facts, but also an honest interpretation. As you know, communicating both inside and outside Oaktree constitutes a major part of my job. It’s also the source of a great deal of my satisfaction. The most important thing is maintaining constructive personnel principles. Personnel turnover is endemic to the investment management industry and poses an enormous threat to long-term excellence. My career got its start at an institution where large numbers of raw recruits were trained each year, under the assumption that there would always be significant attrition. Because any greatness was expected to emanate more from the institution than from the individuals, however, people were considered fungible and turnover was accepted. But investing greatness, if it is to be attained, must come from people. Investing is an art, not a science, and few people can master that art. Superior investing is not democratic or egalitarian. If an organization is to be the best, it must find, train and retain the best. Not only does turnover drain off your best people, but it also takes their institutional memory and leaves you bogged down in hiring and training their replacements.

© Oaktree Capital Management, L.P. All Rights Reserved UI Know a Good Thing When I See It In “Lessons from Distressed Debt” I referred to Warren Buffett’s observation that, in the short run, the market’s a popularity contest. And since anyone can tell a good company from a bad one, it should be easy to predict the winners of the popularity contest and rack up above average gains. The CFA Digest is a publication of the Association for Investment Management and Research that provides two-page summaries of scholarly articles, and one-paragraph summaries of the two-page summaries (making it very useful for busy people). The November 2002 issue reviewed an article from the Journal of Financial Research entitled “Are the Best Small Companies the Best Investments?” It cited eleven annual surveys of the “best” small companies that ran in Business Week from 1985 to 1995. As the article shows, these surveys were of absolutely no value – check that; negative value – in the search for stock market profits. Whereas the stocks of the chosen companies had far outperformed a couple of stock indices in the three years prior to the surveys, they underperformed in the three years following publication. In sum, the authors show that investing in stocks subsequent to their appearance in Business Week’s “100 Best Small Companies,” on average, provides negative excess returns relative to the benchmarks.

I can honestly say that all of Oaktree’s leaders subscribe equally to the principles on which our firm operates. Second, a partnership is problematic if partners don’t respect each other’s contribution. “I can handle all I do and all of what he does” is a statement with dire portent. In contrast, our interaction at Oaktree is highly symbiotic, and we’re fortunate enough to appreciate that fact. I know my partners do a better job of portfolio management than I ever did. And they’re glad to have me out visiting our clients, so they can stay back and manage their portfolios. Last, any partnership can be imperiled by the wrong kind of partner. There are a lot of people in the investment business about whom we might say, “He’s a jerk, but he can make you a lot of money.” And those people tend to get hired, because the profits they’ll make are so tempting. But the only way to avoid rancor, strife and divisive debate is to work with people you respect and like (and vice versa), and who value working together in harmony above making the most money and winning every argument. So the recipe’s simple: shared values and complimentary skills; mutual respect and an appreciation for each other’s contribution; and people with whom you enjoy associating.

It was when commissions became negotiable and payments for research dried up that the firms started thinking less about their brokerage customers and more about investment banking. What’s changed? UHow Might the Regulators Help? There are numerous obstacles to equipping retail investors with the tools they need to invest safely and well. I feel most strongly that the answer doesn’t lie in giving them “independent research” that has been blessed and thus is likely to once again be overly depended on and just a new source of pain. Instead, the regulators should make sure investors are educated as to (a) the requirements for successful investing and (b) the severe limitations on forecasts and recommendations. Brokerage firms are aided when investing is made to look easy and safe, but their customers certainly are not. On December 21, The New York Times carried an article about Jack Grubman, who seems to be the poster boy for analyst malfeasance. What caught my eye, however, was the quote from Henry Hochman, 88, who lost almost $10.7 million on WorldCom. “I’m broke. I have to start saving pennies now. I can’t live the way I was accustomed to living. It has affected my health. Smith Barney told me this was the best of the telecom companies. Whatever Grubman wrote sounded very good.” Of course, Grubman and Smith Barney are far from without fault in this matter, but Mr. Hochman made his own mistake (although likely not unaided). From the fact that he had $10.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Etorre's Wisdom My memos evoke a wide variety of reactions. One I hear most often is "where do these ideas come from?" This memo will serve as a good example: it was inspired by a ride I took this summer with my son Andrew. That, in turn, reminded me of a clipping that's been sitting in my files since the early 1970s. The newspaper article, entitled "The laws that rule frustrating lives," enumerates a dozen principles that we suspect are at work on our bad days. Here are a few examples:  Everyone knows the first, Murphy's Law: If anything can go wrong, it will.  Fewer people, however, are conversant with O'Toole's Commentary: Murphy was an optimist.  There's a lot of truth in The Unspeakable Law: As soon as you mention something, if it's good, it goes away; if it's bad, it happens.  Every parent of a toddler has seen The Law of Selective Gravity in action: An object will fall so as to do the most damage.  But the one that's least controvertible is Etorre's Observation: The other line moves faster. While I was driving with Andrew he asked, as fifteen-year-olds are prone to, "Dad, why do you always have to drive in the slow lane? Why don't you switch to that one; it's moving faster?" As I wound up for a lengthy explanation, I recognized in his comment the greatest imaginable metaphor for investor behavior. What is it like to drive on our crowded highways?

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Quo Vadis? Leon Uris turned the question "Quo Vadis?" into a book title. Everyone wants to know. Where do we go from here? What's in store for the market? . . . for all the drama, yesterday's seesaw trading failed again to give investors the one thing they needed most: a clear picture of where the stock market is headed. Many on Wall Street had been hoping for some kind of resolution yesterday – either a significant drop that would wash out the selling, or a significant recovery. Instead, stocks bounced in both directions, as optimists battled the pessimists. (Wall Street Journal, July 24, 2002) I include this paragraph because it communicates a great deal in just a few words. It makes clear how much investors hunger for an indication of what lies ahead. It shows how inconclusive anyone day's evidence can be. And, most importantly, to me it hints at the sheer folly of this quest for an omen. There's no such thing as a conclusive sign, and there never will be. The future will always remain a mystery – and this is even more true for short-term fluctuations than for long-term trends. Nothing in the market's movement one day tells us anything about what it'll do the next. Most of the time people will conclude that they have no idea what lies ahead. And once in a while they'll feel they do (as in 1999) and likely be wrong.

These are people who believe they can discern what the future holds, and in their world investing is a simple matter:  First you decide what the economy is going to do in the period under consideration.  Then you figure out what the impact will be on interest rates.  From this you infer how the securities markets will perform.  You choose the industries that will do best in that environment.  You make judgments about how the industries' companies will fare in terms of profits.  Based on all of this information, you pick stocks that are bound to appreciate. End of story. Of course, the usefulness of this approach depends entirely on people's ability to make these decisions correctly. What if you're wrong about the economy? What if you're right about the economy but wrong about its impact on a company's profits? Or what if you're right about profits but the valuation parameters contract, and thus the price? The bottom line is that the members of this school think these things are knowable. I know lots of people who are perpetually and constitutionally optimistic about both the long-term future for stocks UandU their ability to make these judgments correctly.

© 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 On the other hand, I and most of the investors with whom I feel an affinity belong to the "I don't know" school. In short, (1) we feel it's impossible for anyone to know much about a vast number of things, (2) we consider it especially difficult to outperform by guessing right about the direction of the economy and the markets, (3) we spend our time trying to know more than the next person about specific micro situations, and (4) we think more about what can go wrong than about what can go right. In contrast to the "I know" school, people in this group are more cautious and feel a strong need for downside protection. Sticking to this approach requires some solid building blocks. One of those is contrarianism. Basically that means leaning away from the direction chosen by most others. Sell when they're euphoric, and buy when they're afraid. Sell what they love, and buy what they hate. In general, I think you'll find few bargains among the investments that everyone knows about, understands, feels comfortable with, is impressed by and is eager to own. Instead, the best bargains usually lie among the things people aren't aware of, don't fully understand, or consider arcane, unseemly or risky. Closely related to contrarianism is skepticism. It's a simple concept, but it has great potential for keeping investors out of trouble: If it sounds too good to be true, it probably is.

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

That means worrying about what one may not know, about what can go wrong, and about losing money. If you're worried, you'll tend to build in greater margin for error. Worriers gain less when everything goes right, but they also lose less – and stay in the game – when things return to earth. All of Oaktree' s activities are guided more by one principle than any other: if we avoid the losers, the winners will take care of themselves.about

© Oaktree Capital Management, L.P. All Rights Reserved That sounds like a loan to me. However, Enron's balance sheet told a different story. Because the derivatives related to commodities, the receipts usually were shown as "assets from price risk management" and the payments that it was obliged to make as "liabilities from price risk management." No loan transaction; just money in Enron's till and an obligation to make payments that amounted to interest and principal. There's nothing wrong per se with off-balance sheet partnerships, mark-to-market accounting or swap transactions, or with the standard methods of accounting for them. They're engaged in many times a day, and almost always benignly. The problem arises when these transactions are entered into and accounted for so as to fool, misrepresent and obscure. Among the common threads running through Enron's financial practices is the fact that (1) they had been designed for uses other than those to which Enron put them, and (2) Enron's accounting for them provided a distorted picture of what was actually going on. U What Was Wrong With Enron's Accounting? The principal problem was that the transactions represented an effort to use accounting as a weapon against investors, rating agencies, counterparties and regulators. Although the opponents of gun control like to say that "guns don't kill people; people kill people," I think it's people misusing guns who kill people.

© Oaktree Capital Management, L.P. All Rights Reserved maintaining a lofty stock price became a challenging obsession, the people who mattered most either engaged in corrupt practices or failed to blow the whistle on them. UCorporate Rot Can Spread From the Executive Suite In fact, Enron's culture in recent years seems to have encouraged doing the wrong thing. Certainly, the jury is still out regarding Ken Lay. Was he the oblivious dreamer who couldn't understand the details, trusted the wrong people and was duped? Or was he the manipulative master criminal we've heard vilified in Congress? Whichever was the case, right now we only know the results. It certainly appears that Enron was a company where:  hubris was encouraged,  schemers rose to the top,  people were rewarded for ends, not means, and  no one ever asked "but is it right?" Whistleblower Sherron Watkins has said that questioning CEO Jeff Skilling about the propriety of the partnerships would have been "job suicide." CFO Andrew Fastow is said to have cursed at the Enron representatives who negotiated against the partnerships he ran and to have tried to get one fired. Lawyers will argue the specifics, and judges and juries will decide, but it seems clear that there were bad guys at Enron, and that nothing in the climate there encouraged doing the right thing. And encouraging moral behavior, perhaps above all else, is the responsibility of top management.

© Oaktree Capital Management, L.P. All Rights Reserved When I think about whether the brouhaha over corporate misdeeds will soon die down, I worry about the following:  When the replacement auditors show up at each former Arthur Andersen client, they'll be bringing their fine-tooth combs. They'll have every incentive to find something wrong in the previous accounting and absolutely no incentive to say, "Everything was just fine."  With or without suggestions from new auditors, every management team will be motivated to amend its accounting. First, they'll want to join the holier-than-thou parade. Second, they know choosing a more aggressive accounting treatment will leave them open to criticism or worse. Last, they are likely to engage in the usual deck clearing to put costs and restatements behind them, prodded, in particular, by the requirement that they certify financial statements starting in mid-August. The sum of this may result in months of additional disclosures and restatements.  More virtuous accounting practices, including specifics like the expensing of option grants, are sure to mean lower reported profits than otherwise would have been reported. You might say investors will look beyond these numbers and perceive the lower quantity of earnings to be offset by the higher quality. I doubt it. I think the first-year shift to this new regime could make companies seem generally less profitable.

It's really an organized way to think about the question, "how much of the return comes from what the environment provides, and how much from the manager's value added?" When one considers these things, some relevant inquiries are:  Where did the return come from in the past?  Where is the return expected to come from in the future?  How exposed is a given strategy (or my overall portfolio) to market movement or dependence on claims of alpha? How much of my future return am I betting on the direction of the market, and how much on manager skill?  What assumptions am I willing to make about the outlook for those two things? A lot is written about the tyranny of benchmarks. Excessive benchmarking (and an overemphasis on minimizing tracking error) can force managers to migrate toward benchmark asset weightings in order to reduce their risk of negative performance comparisons. Clearly, if a manager has real skill, this process can suppress it. However, there are very valid roles for benchmarking. Perhaps the best is in helping to attribute performance between market impact and the manager's value added. In fact, this can't be done without reference to an effective benchmark.20

Nassim Nicholas Taleb’s views, expressed in Fooled by Randomness, connect up with Dimson’s. The world is an uncertain, even random, place. What “should happen” might be totally clear, meaning we know what the future should hold. But the things that should happen may not happen – and other things may happen instead – for any of a variety of reasons, many of them extraneous, unpredictable and even nonsensical. Those things can be described as random: the result of luck, either good or bad. The point is that we assemble our portfolios, and future events determine whether our performance will be rewarded or punished. People whose expectations are borne out generally make money, and those whose aren’t lose. That process sounds very fact-based, meritocratic and luck-free, and thus dependable. But that’s only the case on average and in the longest-term sense.  Sometimes, even though an investor’s projections may be far too optimistic relative to what he should have expected – a.k.a. “wrong” – the investor is bailed out by unforeseeable positive developments, or even by non-fundamentally based price appreciation. Either way, the stock rises and the investor is applauded. I’d say he was “right for the wrong reason” (or “lucky”).  Alternatively, a prudent, skillful investor may formulate a reasonable view of the future, only to see the world go off the rails and his investments fail. He might be described as “wrong for the wrong reason” (or “unlucky”).

 An investor may take an appropriately cautious stance – let’s say toward tech stocks in 1997 or residential mortgage backed securities in 2005 – only to see an irrationally overpriced market become more so, as prices soar for years. He looks terrible, a victim of the old adage that “being too far ahead of your time is indistinguishable from being wrong.”  Further, in a special case of being wrong as to timing although perhaps not fundamentals, an investor may take a concentrated position in a laughably underpriced stock, using a huge amount of borrowed money. But before the expected appreciation can take place, a market crash brings on a margin call, and he’s wiped out. As John Maynard Keynes said, “The market can remain irrational longer than you can remain solvent.”  Last year marked the passing of Joe Granville, a technical analyst whose warning in 1976 was followed by a 26% two-year decline, winning him respect and fame. But his next accurate call wouldn’t come for 24 years, when he told people to sell tech stocks in 2000. Was it skill back in 1976, or a lucky call that turned out right when events went his way? Regardless, he became one of many in the investment business who get famous for having been “right once in a row.” © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Remember what Lord Keynes said about the ability of markets to remain irrational for long periods of time. And remember that it's possible for you to be forced to sell at the bottom – by emotions, competitive pressure or the need for liquidity – turning temporary volatility (the theoretical definition of risk) into very real permanent loss. In order to get more out of the ups of stocks and try to lessen the pain of the downs, most people turn to active management via market timing, group rotation, industry emphasis and stock selection. But it's just not that easy. The American Way – earnestly applying elbow grease – doesn't often payoff. For a model, don't think about the diligent paperboy on his route; think about trying to profit from flipping a coin. I say that because I believe most markets are relatively "efficient," and that certainly includes the mainstream stock market. Where large numbers of investors are aware of an asset's existence, have roughly equal access to information and are diligently working to evaluate it, the market operates to incorporate their collective interpretation of the information into a market price. While that price is often wrong, very few investors are capable of consistently knowing when it is, and by how much, and in which direction. The evidence is clear: most investors underperform the market.

In other words, the academics say market prices are right, while I say they may be wrong but can’t consistently be improved upon (and the errors taken advantage of) by any individual. A market may not be efficient in the sense that prices are “right,” but it can be efficient in that it swiftly incorporates new information. The resulting prices may not be equal to the value, but they reflect everyone’s best collective thinking at a point in time. The result is the same: no one can beat the market. I think of the test for market efficiency as being twofold: if markets are efficient, (a) one market’s risk- adjusted return can’t be better or worse than any other market and (b) no investor in the market can outperform the rest in risk-adjusted terms. In other words, there can’t be opportunities for outperformance . . . either through skill or luck. In an efficient market – as with a Swiss watch (or, as Taleb would say, in dentistry) – luck plays no part. Are Markets Efficient? Is the Hypothesis Relevant? Let me say up front that I have always considered the reasoning behind the efficient market hypothesis absolutely sound and compelling, and it has greatly influenced my thinking. In well-followed markets, thousands of people are looking for superior investments and trying to avoid inferior ones. If they find information indicating something’s a bargain, they buy it, driving up the price and eliminating the potential for an excess return.

That's because it's unusual for portfolio returns to be entirely divorced from their environment. "Zero correlation" with the market is rarely attainable; "low correlation" may have to suffice.  Money flows will play a big role. In general, the good records have been built on small amounts of money. And those records will attract large amounts of money. There are several consequences. First, records simply may not be capable of extrapolation. To handle more money, a manager may have to invest faster, reduce selectivity, put more dollars into each position, put on a larger number of positions, broaden the fund's range of activities, and/or add new staff members. All of these can have negative implications for returns. Second, many of the best managers with skill UandU discipline are already closed to new money, or will reach the point when they are. Thus in the extreme, as Groucho Marx would have put it, "I would never invest my money with anyone who'd take it." And third, when there's too much money in an area, even funds that are closed can be affected. Long-Term Capital Management found others emulating its trades and eventually lost its opportunity because too much money had piled into its niches.  The wrong people will get money. The rush to invest in an area gives money to managers who shouldn't get it. When the best are closed, the rest will be funded.

© Oaktree Capital Management, L.P. All Rights Reserved. it’s one of the SEC’s missions to make sure that’s the case). I had markets like that in mind in 1978 when, on going into portfolio management, my rule was, “I’ll do anything but spend the rest of my life choosing between Merck and Lilly.” But I also believe some markets are less efficient than others. Not everyone knows about them or understands them. They may be controversial, making people hesitant to invest. They may appear too risky for some. They may be hard to invest in, illiquid, or accessible only through locked-up vehicles in which some people can’t or don’t want to participate. Some market participants may have better information than others . . . legally. Thus, in an inefficient market there can be mastery and/or luck, since market prices are often wrong, enabling some investors to do better than others. (Time for an aside: the fact that a market is inefficient doesn’t mean everyone in it gets rich. It simply means there are overpricings and underpricings, to profit from or fall victim to. Thus there can be winners and losers. Even in an inefficient market, not everyone can be above average.) Ultimately, there’s one reason why I think no markets are perfectly efficient. Remember the assumptions underlying market efficiency: the participants have to be objective and unemotional. Regardless of the market, few investors pass that test.

© Oaktree Capital Management, L.P. All Rights Reserved looking like a genius. But we should recognize that it happened because of luck and boldness, not skill. In the short run, a great deal of investment success can result from just being in the right place at the right time. I always say the keys to profit are aggressiveness, timing and skill, and if you have enough aggressiveness at the right time, you don't need that much skill. My image is of a blindfolded dart thrower. He heaves it wildly just as someone knocks over the target. His dart finds the bulls-eye and he's proclaimed the champ. . . . at a given time in the markets, the most profitable traders are likely to be those that are best fit to the latest cycle. This does not happen too often with dentists or pianists – because of the nature of randomness. (p.74) The easy way to see this is that in boom times, the highest returns often go to those who take the most risk. That doesn't say anything about their being the best investors. Warren Buffett's appendix to the fourth revised edition of "The Intelligent Investor" describes a contest in which each of the 225 million Americans starts with $1 and flips a coin once a day. The people who get it right on day one collect a dollar from those who were wrong and go on to flip again on day two, and so forth. Ten days later, 220,000 people have called it right ten times in a row and won $1,000.

© Oaktree Capital Management, L.P. All Rights Reserved I also want to touch on the issue of stock sales by executives. Perhaps because it's an issue with so much visceral appeal, the headlines are full of "Executives Sold While Company Crumbled; Employees and Small Investors Lost Everything." But I don't think there's anything inherently wrong with executives selling stock. They buy it to profit, and they should be expected to reap that profit at some point in time. If the company and the stock do well, appreciation can create a position too large to hold prudently. So selling's okay; the issue is when. Clearly, managers mustn't sell when they know things others don't. When that's true is a tough question and often a matter of degree; no shareholder can ever know as much as the CEO does. Selling while saying "the company's doing great" probably isn't a terrific idea – especially if it's not. And the number of shares it's proper to sell probably is a function of the absolute dollar amounts involved and the number of shares retained. One last note: I have absolutely no sympathy for managers who are renegades, like Enron's seem to have been, but they're not the only ones at fault here. Every investor who's complaining about the stock sales made by Enron executives could have learned about most of them from government filings and sold alongside. In fact, the onus is on investors who hold or buy while insiders are announcing massive sales.

Investors must accept responsibility for their actions; Enron's faulty transactions might have been covert, but most of the stock sales took place in plain sight. U Where Does the Buck Stop? While we're on the subject of responsibility, who else should accept it in the case of Enron? (So far I haven't seen many hands going up.) The little guys are employing the Nuremberg defense: "I only did what I was told." And they're right most of the time. It's true they could have objected to what they saw, but that would be asking a lot. The combination of certitude, principles, career alternatives and/or financial resources needed to create a whistleblower occurs only rarely. Sherron Watkins might be the closest thing thus far, and she certainly did raise red flags in her memo of August. She was brave and stepped forward when few others did, but I'm not ready to canonize her yet. Before I do so, I'll have to get over the large number of references in her memo not to what was right or wrong, but to what might be found out.gun,

© Oaktree Capital Management, L.P. All Rights Reserved Randomness Determinism Probability Certainty Belief, conjecture Knowledge, certitude Theory Reality Anecdote, coincidence Causality, law Survivorship bias Market outperformance Lucky idiot Skilled investor The table reminds me of a key difference between the "I know" and "I don't know" schools. "I don't know" investors are acutely conscious of the things in the first column; "I know" investors routinely mistake them for things in the second. I think Taleb's dichotomization is sheer brilliance. We all know that when things go right, luck looks like skill. Coincidence looks like causality. A "lucky idiot" looks like a skilled investor. Of course, knowing that randomness can have this effect doesn't make it easy to distinguish between lucky investors and skillful investors. But we must keep trying. I find that I agree with essentially all of Taleb's important points.  Investors are right (and wrong) all the time for the "wrong reason." Someone buys a stock because he expects a certain development; it doesn't occur; the market takes the stock up anyway; he looks good (and invariably accepts credit).  The correctness of a decision can't be judged from the outcome. Nevertheless, that's how people assess them. A good decision is one that's optimal at the time it's made, when the future is by definition unknown. Thus correct decisions are often unsuccessful, and vice versa.

© Oaktree Capital Management, L.P. All Rights Reserved  we do not have a fact pattern that would look good to the SEC or investors, and  best case: clean up quietly if possible. These quotations certainly suggest a preoccupation with perception. Did Watkins truly worry about right and wrong and choose her mode of expression to make an impact on Lay and company? Did she write to complain about wrongdoing or just to push for damage control? And are they two different things or the same? Unlike the little guys, the top execs are employing what I call the Geneva defense: "I was in Switzerland during the war." Nobody ordered the misdeeds or even knew about them. Either they were out of the room or the lights went off. Control freaks with great memories left things to others or can't remember what happened. And, ultimately, they claim the directors and auditors approved everything. UThe Role of the Auditors Why do companies have auditors? So the owners can be sure that (1) they know what management is doing and (2) the financial statements accurately reflect what's going on. As such, auditors play an absolutely essential role in the corporate governance process. In addition to checking the numbers and opining on the reasonableness of the financial statements, it's their job to tell directors, through the audit committee, when something's amiss. Every audit committee meeting should include some time when no management representatives are present.

This is the auditors' chance to tell the directors about things they feel are wrong. Did Arthur Andersen fulfill its responsibilities at Enron? They say yes and management says no. Surprise!! Certainly, at minimum, the picture is less than ideal.  First, there's no getting around the fact that Andersen certified financial statements about which no one has a kind word to say. If they had misgivings, they weren't sufficient to make Andersen send up a red flag. We haven't seen any record of Andersen expressing misgiving to the audit committee.  Andersen received $52 million in fees from Enron in 2000, less than half of which was for auditing. Auditors' compensation can be so great that keeping the job becomes too high a priority.  Roughly $5 million of the total was for Andersen's help in structuring some of the complained-of transactions. When management says, "we'll pay you to think of a creative solution to our problem," there's a lot of incentive to come up with something that accomplishes the company's objectives in terms of effect UandU optics. And there's little likelihood that the same firm will disapprove it on audit. It's kind of like paying your IRS agent to design a tax shelter.

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  As Enron's complex, questionable transactions indicate, the people looking for holes in the rules are often highly motivated, well financed and well advised. Those whose job it is to plug the loopholes are often over-matched, and their efforts to do so usually amount to a holding action. The furor over Enron's accounting shows that we need the ability to insist on adherence to general principles and punish those who violate them.  Security analysis and knowledgeable investing aren't easy. Investors must be alert for fuzzy or incomplete information, and for companies that don't put their interests first. They must invest only when they know what they don't know, and they must insist on sufficient margin for error owing to any shortcomings.  We all must watch out for unintended consequences, and that's especially true when promulgating regulations. Accounting rules and option programs were created with the best of intentions, but in the extreme they led to Enron's noxious transactions and counterproductive incentives. It'll be no less true the next time around. I apologize for the length of this memo, but the Enron matter is so sweeping and multi- faceted that I found it inescapable. It is my aim here to shed light, not to recount events. I hope you'll find it interesting and of use. March 14, 2002

UMarket efficiencyU – A great deal of how one views the investment world depends on one's position on the subject of market efficiency. Rather than reinvent my own wheel, I'll lift parts of my memo "Irrational Exuberance" from May 2000. (Thankfully, when you copy from yourself it's not plagiarism.) First, I'll provide my take on the efficient marketeers' view. Then, I'll describe my own version of market efficiency. I'll admit again that academicians don't share my view and theory says I'm wrong. But my approach works for me, and I'll restate it below. While at Chicago, one of the first things I studied was the Efficient Market Hypothesis, which states:  There are many participants in the markets, and they share roughly equal access to all relevant information. They are intelligent, highly motivated and hard working. Their analytical models are widely known and employed.  Because of the collective efforts of these participants, information is reflected fully and immediately in the market price of each asset.

© Oaktree Capital Management, L.P. All Rights Reserved  Thus, market prices provide accurate estimates of assets' intrinsic value, and no participant can consistently identify and profit from instances when they are wrong.  Assets therefore sell at prices from which they can be expected to deliver risk- adjusted returns that are "fair" relative to other assets. Riskier assets must offer higher returns in order to attract buyers. The market will set prices so that appears to be the case, but it won't provide a "free lunch." That is, there will be no incremental return that is not related to (and compensatory for) incremental risk. I believe strongly that some markets are quite efficient, including those for the world's leading stocks and bonds. Take international fixed income, for instance. Here, people try to decide whether British, French or German government bonds are the cheapest at a given time and establish portfolio weightings accordingly. The primary differences between these bonds, it seems to me, relate to their issuing countries' rates of economic growth and inflation. But it's to make allowance for those differences that there exist differential interest rates and floating exchange rates. And aren't those some of the world's most closely watched phenomena, with hundreds of sophisticated financial institutions on both sides of every question? Can any one participant realistically expect to be able to do a superior job in such a market?

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

© Oaktree Capital Management, L.P. All Rights Reserved collective interpretation of the information into a market price. While that price is often wrong, very few investors can consistently know when it is, and by how much, and in which direction. The evidence is clear: most investors underperform the market. They (a) can't see the future, (b) make mistakes that keep them at a disadvantage, (c) accept high risk in their effort to distinguish themselves, and (d) spend money trying (in the form of market impact and transaction costs). Of course, there are individuals who beat the market by substantial margins, and they become famous. The mere fact that they attract so much attention proves how rare they are. (That's the meaning of the adage "it's the exception that proves the rule.") Adding to return without adding commensurately to risk requires rare understanding – of how money is made and what constitutes value – and far more managers promise it than have it. I was recently on a panel that was asked what gave our firms their edge. One panelist responded "we have 160 analysts around the world." To me, that response demonstrated a total lack of insight. Unless those 160 analysts are more astute than the average investor, they'll contribute nothing. Certainly another 160 wouldn't double the manager's ability to add value. (If they could, everyone would be an analyst.)

This last point is very important in terms of what it does and does not mean. Inefficient markets do not necessarily give their participants generous returns. Rather, it's my view that they provide the raw material – mispricings – that can allow some people to win Uand others to loseU on the basis of differential skill. If prices can be very wrong, that means it's possible to find bargains or overpay. For every person who gets a good buy in an inefficient market, someone else sells too cheap. One of the great sayings about poker is that, "In every game there's a fish. If you've played for 45 minutes and haven't figured out who the fish is, then it's you." The same is certainly true of inefficient market investing. In inefficient markets, then, it's essential that a manager have superior personal skill, or "alpha" (see below). It's actually far more important than in efficient markets, where prices are so well aligned that it's hard to perform far off the average. Good evidence on this subject is found in the table on the next page, from "Pioneering Portfolio Management" by David Swenson of Yale.

But as the groups most heavily represented in the S&P did best, indexation was in fact looked at as an offensive weapon. As the tech stock boom reached its apex in 1999, even the keepers of the S&P 500 succumbed to the trend. In order to stay "modern" and "representative," they threw out low-priced Old Economy stocks that had lagged and substituted hot tech names such as Yahoo!, Broadcom, JDS Uniphase and Palm. The effect – the error – was classic.

At the same time, members of an outraged populace pursue vigilante justice against Middle Easterners, and the President sends in the army, led by an all-business general. He declares martial law, suspends civil liberties and rounds up New Yorkers based on ethnicity. It's not a great movie, but it is as relevant as "Wag the Dog" was to Bill Clinton's impeachment-eve bombing raids. You'll be glad to know it ends with the threat defused and American ideals preserved. There will be – already has been – violence against Americans of Middle Eastern origin. But know this: People say that if we let stocks fall, if we don't rebuild the Towers, or if we don't return to normalcy, then our enemies will have won. All of this is true, but if the events of the week are able to turn Americans against Americans and erode the values that have made this country great, they also will have won. UHysteria and MiscommunicationU – I witnessed, first-hand, the ability of emotion and fragmentary information to combine for error. On Thursday afternoon, I heard that three or four men in pilots' uniforms had been stopped trying to board planes. By early evening it had grown to seven. But on Friday it turned out to have been one.

It can best be described as "degree of responsiveness" to the market, or "relative volatility." An S&P index fund will have a beta of 1.0 relative to the S&P 500 (that is, it will go up and down at the same rate as the S&P). An S&P index fund leveraged two to one would have a beta of 2.0 (i.e., it will have twice the response). A portfolio consisting of half S&P index fund and half cash will have a beta of .5. A defensive equity portfolio might be expected to have a beta of .7. Turning up your beta, whether through the use of leverage or by emphasizing more volatile holdings, is certainly one way to try to add to your return. Under investment theory it's the only way, since "beta x the market's return" is the only non-zero term in the above equation (more on this later). The trouble with relying on a high beta to enhance your return is that it's entirely symmetrical. It cuts both ways, subtracting as much when it's wrong as it adds when it's right, which means that it does nothing to increase your expected return unless the underlying decisions are right.Vegas

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

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

Even the "I know" investors, who buy on the assumption they're right, insist on liquidity – because they know there's a good chance they'll be wrong and need to beat a retreat. But the more you can see the future, the less likely you'll be wrong, and the less risk there is that exiting could be difficult. In reality, then, not just investment theory, but also a great deal of everyday practice, is built around the acknowledgement that alpha – skill and foresight – is a scarce commodity. URiskU – It's essential that investors consider risk. In the time since I entered the investment field, return has increasingly come to be evaluated in risk-adjusted terms. Everyone knows that if two portfolios return 8% a year for five years, the two managers didn't necessarily do an equally good job of investing. If one did it with T-bills and the other with emerging market stocks, the first manager almost certainly did a better job – since he earned the same return with far less risk. That's real added value, just like earning more return with the same or less risk. To know how good a job a manager did, then, you have to have a good idea how much risk he took. Yet I think risk may be the area where both theory and many aspects of practice are furthest from right. The first thing you learn in investment theory, and one of the most widely agreed-on assumptions in practice, is that "volatility equals risk."

If we then based our investment process on that assumption, we would hold cash and make very few commitments. I call this "single scenario investing." The problem, obviously, is that arranging our portfolio so that it will succeed under a scenario as negative as that means setting it up to fail under most others. We do not believe in basing our actions on macro-forecasts, as you know, and we certainly don't think we could ever be that right. Thus Oaktree will continue to invest under the assumption that tomorrow will look a lot like yesterday – an assumption that to date has always proved correct. At the same time, we will continue to insist on an investment process that anticipates things not always going as planned, and on selections that can succeed under a wide variety of scenarios. As long-term clients know, this part of the story never changes. In the current environment, we will allow a very substantial margin for error. We will continue to work only in inefficient markets, because we feel it's there that low risk needn't mean low returns, and upside potential can coexist with downside protection. And we will continue to strive for healthy returns in good markets and superior returns in bad markets. We do not promise to beat the markets when they do well, but we also don't think that's an essential part of excellence in investing. UWill I Ever Drop My Cautionary Stance?one

© Oaktree Capital Management, L.P. All Rights Reserved overall) under the title "A Bear's Eye View." Because I wasn't crazy about that title, I was glad soon thereafter to receive the following e-mail from my partner Steve Kaplan: I have never viewed you as, nor do I believe you are, a pessimist. To the contrary, I think you have an optimistic view when it comes to things you believe you can control. . . . Your caution revolves around the uncontrollable, for which you recognize that a lot of the judgments of the so-called experts are in large part pure guesswork. I greatly appreciate Steve's comments, and I think – and hope – he got it right. I have no interest in being a pessimist or a bear, and I don't like to think of myself that way. I just may be more impressed by the unknowability of the future than most people. When I reflect on all of the mottoes I use, it seems half of them relate to how little we can know about what lies ahead. Am I right or wrong in being this cautious? No one can say. Does my mindset, and Oaktree's resultant approach to investing, cost us profits in good years? Probably. Are we well prepared for bad times and untoward developments, and are we happy with that? Absolutely. If we insist on a degree of defensiveness that turns out to be excessive, the worst consequence should be that your profits will be a little lower than they otherwise might have been. I don't think that's the worst thing in the world.

© Oaktree Capital Management, L.P. All Rights Reserved Most pension funds have a very long time horizon, and for a university endowment it's theoretically infinite. Volatile quarterly returns wouldn't be a meaningful source of risk for them as they would be for a retiree scraping by. But once you say a given portfolio is risky for one investor but not another, there ceases to be a unique number that measures its absolute riskiness. In that case, how can you talk about its risk, or its risk-adjusted return? UCorrelationU – The final analytical element to be considered when assembling securities into portfolios is their degree of connectedness, or correlation. As discussed above, a one-asset portfolio would be optimal for someone who can see the future. The main reason for holding more than one asset is diversification. But the principal virtue of diversification, protection from catastrophic error, is wiped out if the underlying assets will react the same to environmental change and move together. Thus it's not enough to be able to estimate return and risk in isolation; we must understand correlation. Even if we can estimate the separate potential of two assets, we cannot know how a portfolio combining them will behave unless we know how they will move relative to each other. Two stocks in the same industry may be highly correlated, but two companies whose products compete directly may not (that is, whichever one wins, the other is likely to lose).

Let's say there are two assets with high prospective return and risk. A portfolio consisting of the two can have high risk if they are correlated but low risk if they are not. Thus adding an uncorrelated, high-risk asset can reduce the overall riskiness of a portfolio. This understanding revolutionized investing by enabling risk-averse investors to hold high-return, high-risk assets as long as they are uncorrelated with the rest of their portfolio. Certainly Oaktree owes much of its very existence to the understanding of how assets behave in combination. Tracking error, which lately has been of increased interest, refers to a specific type of connectedness: that between a portfolio and a benchmark. More and more, clients are asking about managers' tracking error in the past and monitoring it after hiring them. A client hires managers to play specific roles in its portfolio, and it wants to be sure they will do so. In considering whether to include high yield bonds in its portfolio, for example, the client may model the performance of the portfolio incorporating the Salomon Cash-Pay Index as a proxy for the high yield bond component. Then if the client hires a manager, it wants to be sure the manager will track the Salomon Index closely (of course while outperforming!) Thus clients have reason to want low tracking error.

But if you think about it, the two principal sources of tracking error are (a) over- and under-weightings of the securities in the index and (b) inclusion of off-index securities. So it's obviously possible for tracking error to be too low; an index fund would have zero tracking error, but that's not what clients hire active managers to create. Thus we have a client who monitors our tracking error and complains when it's too low, because they want to see active bets being made.

© Oaktree Capital Management, L.P. All Rights Reserved and/or reduce selectivity. All of these can have negative implications. George Soras and Julian Robertson had terrific records, but they eventually reached $20 billion and lost their specialness. Second, many of the best managers with alpha and discipline are already closed to new money, or will reach the point when they are. Thus in the extreme, as Groucho Marx would have put it, "I would never invest my money with anyone who'd take it." And third, when there's too much money in an area, even funds that are closed can be affected. Long-Term Capital found others emulating its trades and eventually lost its opportunity because too much money had piled into its niches.  The wrong people will get money. The rush to invest in an area gives money to managers who shouldn't get it. When the best are closed, the rest will be funded. Second-string managers will split off from established groups and get money based on their old fund's record (regardless of how much of it was theirs). Thus, as the amount of money in the area rises, the average quality of the managers may fall.  Fees can eat up alpha. When the demand for funds outstrips supply, fund managers have the ability to raise fees and thereby appropriate for themselves a larger portion of their funds' returns.  Disappointments will be many. Due to the factors enumerated above, the next few years will see many investors fail to get what they hoped for . . . as usual.

UCycles and How To Live With Them No one knew when the tech bubble would burst, and no one knew what the extent of the correction could be or how long it would last. But it wasn't impossible to get a sense that the market was euphoric and investors were behaving in an unquestioning, giddy manner. That was all it would have taken to avoid a great deal of the carnage. Having said that, I want to point out emphatically that many of those who complained about the excessive market valuations – including me – started to do so years too soon. And for a long time, another of my old standards was proved true: "being too far ahead of your time is indistinguishable from being wrong." Some of the cautious investors ran out of staying power, losing their jobs or their clients because of having missed the gains. Some capitulated and, having missed the gains, jumped in just in time to participate in the losses. So I'm not trying to give the impression that coping with cycles is easy. But I do think it's a necessary effort. We may never know where we're going, or when the tide will turn, but we had better have a good idea where we are.2001

The father's dumbfounded silence clearly reflected his sudden realization that he knew less than he had thought. Obviously, in 2000, millions of investors across the board realized that they knew less than they thought they did, and that lots of what they had been sure of was wrong. * * * A year ago, I wrote in "bubble. com" that tech stocks had benefited in 1999 from a boom of colossal proportions. They exhibited all of the elements of a market bubble, with an attractive story providing the foundation for a gravity-defying escalation of prices far beyond reason, and for manic behavior on the part of investors.assets

“As Edward Ward observed in his poem ‘A South Sea Ballad’: Few Men who follow Reason's Rules, Grow fat with South-Sea Diet, Young Rattles and unthinking Fools Are those that flourish by it.” [The profits went to those unrestrained by reason or experience.] Robert Digby wrote “The South Sea Company is continually a source of wonderment. The sole topic of conversation in England revolves around the shares of the Company, which have produced vast fortunes for many people in such a short space of time. Moreover it is to be noted that trade has completely slowed down, that more than one hundred ships moored along the river Thames are for sale, and that the owners of capital prefer to speculate on shares than to work at their normal business.” [The name of the company was on everyone's lips, the fortunes it created were front-page news, and the average Joe was willing to give up his day job to participate ... sound familiar?] * * * I will devote the rest of this memo to what certainly seems to me to be another market bubble. Before doing so, however, I must point out a few things: First, as usual, little that I will write will be original; instead, I hope to add value by pulling together ideas from a number of sources. Second, a single word suffices to describe my recent caution regarding the stock market: wrong.and

© Oaktree Capital Management, L.P. All Rights Reserved In a supreme irony, the April week in which Robertson announced his departure turned out to be one of the best of his career, but the damage had already been done. I often think about the corrosive effect of being on the wrong side of a market judgment for prolonged periods, and the phenomenon through which those who resist trends the longest can finally capitulate at just the wrong time. Robertson, 67, had an approach that failed to work for two painful years and enough wealth to allow him to say “why put up with this?” The pressure to quit obviously hit its apex just as his timing in quitting was at its worst. Last week saw a pullback from risk on the part of George Soros, head of the remarkable Quantum Fund (up 32%/year after fees for 30 years), and the resignation of Stanley Druckenmiller, its portfolio manager since 1989. Why? Druckenmiller had resisted tech stocks until mid-1999, but then he invested and made a bundle in the second half. When he held on to most of them in 2000, they brought him heavy losses. The New York Times reported, “... he had known by December that the explosion in technology stock prices had gone beyond reason. But he expected it would go longer than it did ... ‘We thought it was the eighth inning, but it was the ninth.’” Or as Soros admitted, “Maybe I don't understand the market. Maybe the music has stopped but people are still dancing.

© Oaktree Capital Management, L.P. All Rights Reserved Having reviewed the historic data, what can we say about the future? Certainly, the venture capital funds are "where it's at": the toll bridge through which world-changing companies are likely to pass. Does that mean they're a good investment today? I feel strongly that no investment opportunity is so good that it can't be screwed up by the wrong relationship between supply and demand. Too much money for too few ideas can mean ruinous terms and purchase prices that are too high. To my mind, the immediate outlook for venture capital is called into question by: - the ardor that has been ignited by recent “headline” returns, - thus the huge amount of money looking for a home in ventures, - the expanded amounts that v.c. firms are accepting in their new funds, - the strengthened negotiating position of entrepreneurs relative to venture capitalists, - thus the need among v.c. firms to compete in haste to make investments, - the ease with which junior members can leave v.c. firms to start their own funds, - the strengthened negotiating position of venture capitalists relative to their investors, and - thus the ability of v.c. firms to raise their incentive fee percentage. In my experience, the big, low-risk profits have usually come from investments made at those times when recent results have been poor, capital is scarce, investors are reticent and everyone says “no way!

On August 25, 2000, a false press release was picked up on the Internet, taking Emulex stock from $103 to $45 within twenty minutes. After a few-hour trading halt, corrected information took it back above $100. Glassman's term for the markets: “dazzling in their efficiency.” He finds comfort in the fact that both the falsified data and the correction were disseminated so quickly. I feel the rapid and universal distribution of information - often at speeds and in amounts that make it impossible to verify, distill and understand - does nothing to make the markets safer per se. For proof, look at the trend in volatility. It seems inescapable that media hype and other short-term oriented developments have made the markets more treacherous. Looking at today' s mass market and the associated flood of information, my partner Sheldon Stone sees investors as passengers on a boat, running back and forth en masse -to one side in response to new information, and then back to the other. That makes for a rocky crossing. Where does Glassman go wrong? To me, his error is obvious in the following sentence: Markets know so much more about companies, and know it so quickly, that their assessments of worth have an up-to-the-minute efficiency and accuracy.

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

© Oaktree Capital Management, L.P. All Rights Reserved is $328 today, bringing its market capitalization to $29 billion. (By the way, in the first nine months of 1999, Akamai lost $28 million on $1.3 million of sales.) The ability to participate in IPOs has become a major perk. Investment banks compete with other money managers by promising wealthy individuals allocations in their IPOs. Technology companies allocate IPO shares to their customers as a way to cement business relationships. As usual, I don't think investors are thinking this through. The Akamai IPO was priced at 18% of the first day's closing price. So either (a) the founding entrepreneurs and investors sold it 82% below its fair price (and who would know better than they would?) or (b) the market's wrong. It may well be that issuers intentionally underprice their offerings so that the first day's rise will create the "buzz" that will enable (1) the companies to finance their losses and their expansion through additional stock issuance and (2) the founders to sell their remaining shares. I'm sure some of that is at work here, but how much? If the closing price of $145 was "right," Akamai left almost $1 billion on the table in the IPO by selling eight million shares at $26. Further, how much due diligence is being done on each new issue? How experienced are the people doing it? How strict are the valuation parameters they're using?

About under-researched companies and securities, we think it's possible to get an edge through hard work and skill. Finally, we believe in investing defensively. That means worrying about what we may not know, about what can go wrong, and about losing money. If you're worried, you'll tend to build in more margin for error.return

© 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.

© Oaktree Capital Management, L.P. All Rights Reserved Barton Biggs, Chairman of Morgan Stanley Dean Witter Asset Management, is a well- respected observer who has been somewhat cautionary to date (and wrong). His November 29 strategy piece was without equivocation. I'll let him sum up. The technology, Internet and telecommunication craze has gone parabolic in what is one of the great, if not the greatest, manias of all time ... The history of manias is that they have almost always been solidly based on revolutionary developments that eventually change the world. Without fail, the bubble stage of these crazes ends in tears and massive wealth destruction ... Many of the professional investors involved in these areas know that what is going on today is madness. However, they argue that the right tactic is to stay invested as long as the price momentum is up. When momentum begins to ebb, they will sell their positions and escape the carnage. Since they have very large positions and since they all follow the same momentum, I suspect they are deluded in thinking they will be able to get out in time, because all other momentum investors will be doing the same thing. (Emphasis added) * * * I am convinced that a few essential lessons are involved here. 1. The positives behind stocks can be genuine and still produce losses if you overpay for them. 2.

And a lot of money being made, but most of it by the few most optimistic and aggressive investors. The "rational" value investors have been decrying the excesses of the market for years – myself included. I've never felt more strongly the truth of the saying I picked up in the 1970s: "being too far ahead of your time is indistinguishable from being wrong." But as they say, "that's my story and I'm stickin' with it."1999

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients and Friends From: Howard Marks Re: Genius Isn't Enough (and Other Lessons from Long-Term Capital Management) On September 24, The Wall Street Journal carried an excellent front-page article regarding the inability of the "crack team" of economic policy makers led by Messrs. Rubin and Summers to halt the slide of the emerging markets' economies and currencies. Heading the column was a quotation from David Halberstam's account of the U.S. involvement in Vietnam, The Best and The Brightest: If there was ever anything that bound men ... together, it was the belief that sheer intelligence and rationality could answer and solve everything. Across the page -- just a few columns away -- was another excellent article, this time on the subject of Long-Term Capital Management. I think the Halberstam quotation is just as relevant to this one. The saga of Long-Term Capital is well known by now. My purpose here is not to discuss the facts, although I'll do so briefly, but rather the lessons to be learned. Long-Term was the creation of former Salomon Brothers vice chairman John Meriwether, along with several other well-respected ex-Salomon Partners, a former vice chairman of the Federal Reserve, and a pair of Nobel prize winners. It was formed to engage in bond arbitrage, the systematic exploitation of bond mispricings.

Assumedly, Long-Term used models to assess the probability of history reasserting itself and the risk to the overall portfolio of individual relationships going the wrong way. Thus would they determine the amount of risk and leverage that could safely be taken on. In his wonderful book, Against the Gods, Peter Bernstein shows how development of the study of probability made possible both informed gambling and informed investing (along with other forms of decision making concerning the future). But the products of this pursuit remain mere probabilities, or reasonable expectations. Likely events sometimes fail to occur, and unlikely events sometimes do. Or, as my friend Bruce Newberg says when I get the one improbable roll of the dice needed to beat him in backgammon, “there can be a big difference between probability and outcome.” If you are conscious of the difference between a likely outcome and a certain one, you may not want to bet the ranch. The same is true in the world of investments; put simply, relationships that are supposed to hold sometimes fail to do so.

© Oaktree Capital Management, L.P. All Rights Reserved 2) Hedge funds offer no magic per se. As we described in our April piece on alternative investments, hedge funds carry only two common threads: private partnership status and a fee mechanism through which general partners share in net gains. The hedge fund investor's birthright certainly does not include either high returns or low risk. But the hedge fund structure can have ramifications which investors (such as Long-Term's) seem to recognize only after problems arise. Our memo entitled "Risk In Today's Markets" (February 17, 1994) asked the following about 'til-then successful hedge funds: With the average stock or bond returning 10-15% last year, how did some hedge funds make 70% or more? It was through bold and heavily-leveraged plays ...What would have happened if the managers' calculations had proved wrong? ... Do the hedge fund aficionados know how much risk they are taking? For how long are they tying up their money? How much do they know about the strategies being employed? We never hope that our warnings will turn out to be needed, but we usually feel it is inevitable. The case of Long-Term demonstrates that hedge funds represent no panacea and often hold significant drawbacks. The c1osed-end structure should be entered into only after the underlying strategy has been reviewed in depth and confidence in the managers has been fully justified. 3) “If it seems too good to be true, it probably is."

Warren Buffet, with his insistence on "margin for error," would never make such a bet (although he was willing in the hours just before the restructuring to join Goldman Sachs and AIG in a low-ball bid of $250 million for Long-Term at a time when its net worth is thought to have been $600 million).

© Oaktree Capital Management, L.P. All Rights Reserved In “Are You an Investor or a Speculator” (September 3, 1997), we wrote: What could cause a market decline? A drop in investor confidence -- perhaps the commodity that's most freely available today -- would likely be the key, but the reason is hard to foresee. “We're not expecting any surprises,” people say, and that has become our new favorite oxymoron. Surprises are never expected -- by definition -- and yet they're what move the market….The next surprise could be geo-political (oil embargo, war in Korea), economic (tight money, slowing profit growth), or internal to the market (competition from bonds at higher interest rates, discovery of a fraud), but it's most likely to be something that no one has anticipated -- including us. When I was a kid, my dad used to joke about the habitual gambler who finally heard about a race with only one horse in it. He bet the rent money on it, but he lost when the horse jumped over the fence and ran away. There is no sure thing, only better and worse bets, and anyone who invests without expecting something to go wrong is playing the most dangerous game around. 5) “Never confuse brains with a bull market.” When the 1990s began, the economy and the stock market were at very low levels. As a result, success came easily, risk-bearing paid off and the highest returns often went to those who took the most risk. They and their strategies were accepted as the best.

Something always goes wrong eventually. Those who see high returns often mistake risk bearing for genius. The swings of the credit cycle can overwhelm all other factors. Every boom carries within itself the seeds of decline (just as every bust lays the groundwork for recovery). Forget forecasting -- you'll be well ahead if you simply bear in mind the lessons of the past. We've all heard George Santayana's famous observation that "Those who cannot remember the past are condemned to repeat it." And yet, how many of today's mistakes are just replays of the past? Thirty years ago, the stocks of "the best companies" reached P/Es of fifty and more from which they eventually collapsed. Ten years ago, highly leveraged investments were financed with bridge loans which investment bankers were stuck with when the financing window closed. Five years ago, banks got into big trouble with derivatives. All of these are causing problems again in 1998 for those who forgot history or rationalized its irrelevance in the "new paradigm." I've previously recommended John Kenneth Galbraith's excellent little book, A Short History of Financial Euphoria. Although I don't appreciate its swipes at high yield bonds, I consider it must reading for anyone who wants to think and invest against the grain. Galbraith says: 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.

© Oaktree Capital Management, L.P. All Rights Reserved 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. [Emphasis added] Amen. People who acknowledge no limits on their ability to know and control the future have no need to study history. For the rest of us, it's one of the best tools we've got. * * * Inability to remember that you can't know what the future holds is a common failing and the cause of some of the biggest financial difficulties. It's one of the greatest contributors to hubris -- the over-estimation of what you can know and do. General Motors's Charles Froland says the people of Long- Term Credit developed "too much conviction." Henry Kaufman was recently quoted on the subject as saying "there are two kinds of people who lose money: those who know nothing and those who know everything." Dirty Harry weighed in, saying "a man has to know his limitations." I actually think my mother had it best: "He who knows not and knows not he knows not is a fool; shun him." Oaktree is built on the following axioms (among many others): -- We can't know everything about the future, and the “bigger picture” the question, the less we can know the answer. -- We must always expect that something will go wrong and build in margin for error.

+1 June '96 Actual --0-- +100 b.p. +7 As the table shows, it's not that the forecasters were always wrong; when there was little change, they were often right. It's just that in times of major changes, (when accurate forecasts would've helped one make money or avoid a loss), the forecasters completely missed them. In the years reviewed, the expert consensus failed to predict all of the major developments. Included here are interest rate increases of 1994 and 1996, the rate decline of 1995, and the massive gyrations of the dollar/yen relationship. In summary, there simply hasn't been much correlation between predicted changes and actual changes.

On the one occasion, in 1994, when the consensus of forecasters was bold enough to venture a prediction for short rates which differed substantially from the then-current levels, they got even the direction of the subsequent change wrong. The problem is that, rather than extrapolate the year-end 1994 level, they extrapolated the 1994 trend, which reversed in 1995. In general, we can say with certainty that these forecasters were much better at telling us where things stood than where they were going. This bears out the old adage that "it's difficult to make accurate predictions, especially with regard to the future." The corollary is also true: predicting the past is a snap. And using the prevailing levels to predict the future would have been just about as effective as the average forecast. The prevailing levels differed from the future levels by 16% on average, while the consensus prediction erred by 15%.

© Oaktree Capital Management, L.P. All Rights Reserved on the bandwagon. Given years of above-average performance by stocks, many investors are now increasing their commitments to equities. A few weeks ago, we learned of an extreme example, a foundation whose long-term 80% allocation to bonds had been shown to be sorely out of step, so it threw in the towel and went 100% to equities. Capitulation like this adds to the strength of the trend (for a while), but it also increases the level of danger. First, it indicates the advanced age of the cycle; second, it can cause investors to take positions for which they are unsuited; and third, when the last investor has taken his or her maximum equity position, who's left to power a subsequent rise? As you know, we don't consider ourselves good macro-forecasters (or even people who believe in forecasting). So we certainly are in no position to say when the recession or market pullback will start, how bad it will be...or even that there definitely will be one. But we think we're unlikely to be proved wrong if we say cyclicality is not at an end but rather is endemic to all markets, and that every up leg will be followed by a down leg. In 1988, when we marketed our first distressed debt fund, the greatest obstacle we faced was a somewhat widespread belief that there would be no recession and we'd have nothing to do.

First, they generally failed to make accurate predictions in surveys other than the one they won (shown in bold). And second, in the surveys they didn't win, their forecasts were much more wrong than even the inaccurate consensus half the time. UDecember 1994 UJune 1995 UDecember 1995 Susan Sterne 6.80% 6.00% 5.00% James Smith 7.40 6.05 5.55 Michael Cosgrove 7.50 7.70 6.90 Consensus Prediction 7.92 6.60 6.00 Subsequent Actual 6.62 5.94 6.89 As the Journal itself pointed out in reviewing the results of the December 1995 survey: . . .by giving up the comfort of the consensus, those on the fringes of the economic prediction game often end up on the winning or losing end. James Smith of the University of North Carolina and Susan Sterne of Economic Analysis Associates, the winners six months and one year ago, respectively, didn't even get the direction of interest rates right this time.to

© Oaktree Capital Management, L.P. All Rights Reserved * * * In the interest of full disclosure, I want to mention here that I've been contemplating the possibility that my views on these matters are too cautious and short-sighted. My conclusion is that I am a product of my experience. Many of us were raised by parents whose views were heavily influenced by living through the Depression. Likewise, I was baptized under fire during my first five years in the investment industry, when the shares of the best companies in America -- the "nifty-fifty" -- dropped 70% to 90% in the early 1970s and then the entire market lost roughly half its value in 1973-74. You have to be more than forty-five years old to have been in the business during that last real bear market in 1973-74. I've heard it said that today "everyone over forty is terrified by the market, but most of the people running money are under forty." There's a lot of truth to this, and it's interesting to note that relatively few of today's investment professionals are in their mid-to- late forties, a scarcity caused by the tough times in the industry in the 1970s and the resultant lack of hiring. Maybe I spend too much of my time worrying about the next bear market; I've been conditioned to do that. And maybe I'm wrong. But Oaktree's clients needn't worry that we'll manage their portfolios based on the assumption that a correction is imminent.

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

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients and Friends From: Howard Marks Re: How the Game Should Be Played One of the questions asked most often in connection with our leaving to form Oaktree - - perhaps second only to "where'd the name come from?" -- is “why did you do it?" The answer is that we concluded we had an opportunity to create our own investment management firm, all of which would run our way, according to our philosophies, beliefs and standards. But what do we mean when we say "our way?" Well, an article about sports in the April 2 New York Times Sunday Magazine provided an excellent metaphor through which to illustrate the point. In it, the author wrote of Babe Ruth that he represented . . . The Credo of the Home Run: A man can never be faulted, even if he's wrong, for the bold, aggressive action in pursuit of victory; a real man must be willing to strike out, to go down swinging. I believe this is the way much of the investment world thinks, but it's Uthe opposite of what we believe in.U In fact, I wrote a memo in 1990 to take issue with a money manager who justified his poor recent performance by saying "If you want to be in the top 5% of money managers, you have to be willing to be in the bottom 5%, too." "Our way" is UneverU to tolerate poor performance, and certainly not to consider it an acceptable side-effect of swinging for the fences.

© Oaktree Capital Management, L.P. All Rights Reserved That's the way we think it should be done: by consistently finishing in the money, but with no need for headline-grabbing victories. What we think matters isn't whether you hit a home run or win the Masters on any given day, but rather what your long- term batting average is. Many money managers, it appears, believe either (a) that they really can predict what's in store for the markets and which issues will do best, or (b) that their clients expect them to be able to, and to act as if they can. Thus they swing for the fences each year with a portfolio which will earn big rewards if their forecasts are right ... and vice versa. The record suggests very few managers truly know what the future will bring, and yet many keep trying to make money through stock picking and market timing in even the most efficient markets. When their holdings appreciate, they recount their insights and take credit, never admitting when they've been right for unforeseen reasons. When they're wrong, they complain about the circumstances that conspired against them and explain that they were fundamentally right but just off in terms of timing or betrayed by chance. Then they go on espousing new predictions without ever publishing a scorecard from which to judge their record as forecasters. Our response on this subject is simple: (1) We accept that we're among the many who do not know what the big-picture future holds.

© Oaktree Capital Management, L.P. All Rights Reserved URandom Thoughts on the Identification of Investment Opportunities Howard S. Marks -- January 24, 1994 1. No group or sector in the investment world enjoys as its birthright the promise of consistent high returns. There is no asset class that will do well simply because of what it is. An example of this is real estate. People said, "You should buy real estate because it's a hedge against inflation," and "You should buy real estate because they're not making any more." But done at the wrong time, real estate investing didn't work. 2. What matters most is not what you invest in, but when and at what price. There is no such thing as a good or bad investment idea per se. For example, the selection of good companies is certainly not enough to assure good results -- see Xerox, Avon, Merck and the rest of the "nifty fifty" in 1974. Any investment can be good or bad depending on when it's made and what price is paid. It's been said that "any bond can be triple-A at a price." There is no security that is so good that it can't be overpriced, or so bad that it can't be underpriced. 3. The discipline which is most important in investing is not accounting or economics, but psychology. The key is who likes the investment now and who doesn't. Future prices changes will be determined by whether it comes to be liked by more people or fewer people in the future.

Although there were good days for a while as well as bad, the bond market never did recover its equilibrium once the rate rise had begun. The yield on the 30-year Treasury bond rose from 6.21% on January 28 to 7.40% on April 4, with its price falling 14%, from 100.41 to 86.22. The decline spread quickly to other asset classes, and many investors in riskier strategies suffered harsh consequences. Some observers protest that economic and industry fundamentals continue to be favorable. But those positive developments had come to be valued too highly, and the resulting correction of valuations has been painful. UIt's important to note the first lesson, then: successful investing has at least as much to do with what you pay for an asset as it does with what that asset's fundamentals areU. But why did the Fed's half-point bump up in short rates cause such devastation? First, of course, even a small step in terms of policy-related tightening implies there may be much more to come. More importantly though, the move suddenly took a big bite out of investors' optimism and reawakened their fear. Through January, investors acted as if nothing could go wrong. That first rate rise served to remind them that something could go wrong -- and had. Thus there has been a swing back from a euphoric extreme.and

© Oaktree Capital Management, L.P. All Rights Reserved uncertainty over Whitewater. At the same time, Mexico's stock market had its own correction, in reaction to the assassination of the leading presidential candidate. The important lesson to be learned here is that whenever market participants act as if nothing can go wrong (or right), that represents an extreme swing of psychology -- of the pendulum we wrote about in April 1991 -- that must be recognized for what it is and acted on. As Roseanne Rozanadana used to say on Saturday Night Live, "it's always something." UInvestment actions predicated on everything continuing to go well are bound to failU. If the spark that set off the decline in bond prices was the rate increase, why did the slump spread to so many other markets, including equities, foreign bonds, and commodities? Where were the benefits of strategic diversification? I would respond citing the following factors: - First, interest rates affect the value of everything. Investing consists of putting out money today in order to get more back at a later date. The "discounted present value" of the projected future proceeds varies inversely with the current level of interest rates. Simply put, when rates rise, the present value of a future dollar declines. - Another reason the impact of rates is broad stems from the fact that, as I was once told by sid Cottle (of Graham, Dodd and Cottle fame), "Investing is the discipline of relative selection."

I think it's important to remember, though, the symmetrical nature of most investments: almost every sword is two-edged, and he who lives by a risky strategy may die by it. Investments which will make you a great deal of money when things go well but not lose you a lot when things go poorly are very rare, and their existence must presuppose extremely inefficient markets. With the average stock or bond returning 10-15% last year, how did some hedge funds make 70% or more? It was through bold and heavily- leveraged plays on macro-developments such as currency movements. What would have happened if the managers' calculations had proved wrong? The hedge fund manager I know with the best performance last year, up more than 100%, is said twice in his life to have lost 30% in one day! Do the hedge fund aficionados know how much risk they are taking? For how long are they tying up their money? How much do they know about the strategies being employed? As the Forbes article pointed out, the sum of the "information" most hedge fund investors receive is a quarterly paragraph reporting the rate of return. I am not complaining about the fact that there are hedge funds, or about their popularity. My point is simply that the level of risk borne by investors is being systematically raised, often unknowingly and at a time when many valuations are quite high.

It is my view that, first, few of the trends being pursued are at their beginnings; money has been flowing to today's popular sectors for at least a year or two. Second, while some may argue that prices are not forbiddingly high, it's almost impossible to argue that they're very low (or that the easy money hasn't already been made). Third, it seems to me that investors are accepting higher levels of risk throughout the system. Here's one illustration: Our cautious high yield investing saved clients a lot of money and heartache in 1989 and 1990. Because we apply in-depth, downside-conscious credit analysis to the high yield segment of the bond market, and define it narrowly, investors who were chastened by the last decline and don't want to bear the full brunt of the next one have hired us repeatedly in the years since. Now, however, we detect increased interest in more "eclectic" managers who will buy cash-paying or non-cash-paying bonds, going concerns or bankruptcies, convertible or straight bonds, and U.S. or foreign debt. This is just one example, near to us, of the new acceptability of risk -- at what just might be the wrong time. Too-low interest rates and too-high prices may prove at some point to have set the stage for a correction. If so, many of the riskier tactics to which recent trends are pushing investors will increase the extent to which that correction is felt. What course of action, then, would we argue for? We do not preach risk-avoidance.

© Oaktree Capital Management, L.P. All Rights Reserved Inefficient markets must by definition entail illiquidity and occasional volatility, but we feel unleveraged and expert investment in them offers investors with staying power the best route to high returns without commensurately high risk. And we also feel investors who are capable of observing clinically can learn some valuable lessons from the current episode. We look forward to learning along with you. April 11, 1994

Other earnings doublings don't even cause a ripple -- or they prompt a decline. The key question is not "What was the change?" but rather "Was it anticipated?" Was the change accurately predicted by the consensus and thus factored into the stock price? If so, the announcement should cause little reaction. If not, the announcement should cause the stock price to rise if the surprise is pleasant or fall if it is not. This raises an important Catch 22. Everyone's forecasts are, on average, consensus forecasts. If your prediction is consensus too, it won't produce above-average performance even if it’s right. Superior performance comes from Uaccurate non- consensusU forecasts. But because most forecasters aren't terrible, the actual results fall near the consensus most of the time -- and non-consensus forecasts are usually wrong. The payoff table in terms of performance looks like this: Forecast Consensus Non-Consensus Yes Average Above Average Accurate?Average

© Oaktree Capital Management, L.P. All Rights Reserved The problem is that extraordinary performance comes only from correct non- consensus forecasts, but Unon-consensus forecasts are hard to make, hard to make correctly and hard to act onU. When interest rates stood at 8% in 1978, most people thought they'd stay there. The interest rate bears predicted 9%, and the bulls predicted 7%. Most of the time, rates would have been in that range, and no one would have made much money. The big profits went to those who predicted 15% long bond yields. But where were those people? Extreme predictions are rarely right, but they're the ones that make you big money. UMost Forecasts are Extrapolations The fact is, most forecasters predict a future quite like the recent past. One reason is that things generally continue as they have been; major changes don't occur very often. Another is that most people don't do "zero-based" forecasting, but start with the current observation or normal range and then add or subtract a bit as they think is appropriate. Lastly, real "sea changes" are extremely difficult to foretell. That's why some of the best-remembered forecasts are the ones that extrapolated current conditions or trends but were wrong. Business Week may never live down "The Death of Equities" and "The Death of Bonds." At the mid-1990 lows, the press suggested that no one would ever buy a high yield bond again.

© Oaktree Capital Management, L.P. All Rights Reserved UForecasters are Usually Most Wrong at the Extremes It's at just such times --- such inflection points -- when accurate forecasts of change would be the most valuable but are the hardest to make. Take high yield bonds, for instance. In 1989 and 1990 they absorbed a continual beating as a series of negative developments came together. There was the recession, the failure of a number of the leveraged buyouts of the 1980s, enactment of excessively stringent regulation and the collapse of Drexel Burnham, Columbia Savings and Executive Life. All of this was tied together -- and accentuated -- by lots of overly negative publicity. Each development was another drip of "Chinese water torture." Each one put an end to some investor's ability to remain optimistic. And so each one eliminated a potential buyer, created a seller and moved prices lower. And after all, what is a market bottom? It's that moment when the last holder who will become a seller actually does so -- and thus the moment when prices hit levels that will prove to have been the lows. From that point on, with no one left to turn negative, a few pieces of good news or the arrival of a few buyers with belief in values are enough to turn a market. So you can see that the crescendo of negativism, the lowest prices and the greatest difficulty in predicting a rise all occur simultaneously. No wonder it's hard to profit from forecasting.

© Oaktree Capital Management, L.P. All Rights Reserved UYou Have to Be Right About Timing Too Not only must a profitable forecast have the event or direction right, but it must be correct as too timing as well. Let's say you accepted the forecast that the Big Three would come to again own 100% of the U.S. market, and you bought the stocks in response. What if a year later their share was lower (and their stocks too)? Could you continue to hold out for the long term, or would your resolve weaken? What if their shares (and stocks) were unchanged five years later? Wouldn't you give up? And wouldn't that be just in time to see the prediction come true? In poker, "scared money never wins." In investing, it's hard to hold fast to an improbable, non-consensus forecast and do the right thing…especially if the clock is telling you the forecast is off base. As I was told years ago, "being too far ahead of your time is indistinguishable from being wrong." UIncorrect Forecasts Can Cost You Money As you know, we run our portfolios without reference to what we think the broad markets will do. An observer might think such behavior exposes us unduly to the fluctuations of the markets, and that to protect our clients we should actively go in and out of the markets based on what we think will happen. But remember, that will work only if our forecasts are right (and right more often than the consensus is right). I would argue that because forecasting is uncertain, it's safer not to try.

© Oaktree Capital Management, L.P. All Rights Reserved forecasts are implemented through transactions which cost money. If you're right half the time and spend money to try, your performance will fall further below buy-and- hold results the more trading you do. UFew People Revisit Their Forecasts We always read "I think the stock market's going to go up." We never read "I think the stock market's going to go up, (and 8 out of my last 30 predictions were right)" or "I think the stock market's going to go up (and by the way I said the same thing last year and was wrong)." Can you imagine deciding which baseball players to hire without knowing their batting averages? When did you ever see a market forecaster's track record? UMost Forecasts Don't Allow for Alternative Outcomes I imagine that for most money managers, the process goes like this: "I predict the economy will do A. If A happens, interest rates should do B. With interest rates of B, the stock market should do C. Under that environment, the best performing sector should be D, and stock E should rise the most." The portfolio expected to do best under that scenario is then assembled. But how likely is E anyway? Remember that E is conditioned on A, B, C and D. Being right two-thirds of time would be a great accomplishment in the world of forecasting. But if each of the five predictions has a 67% chance of being right, then there is a 13% probability that all will be correct and the portfolio will perform as expected.

With investors worrying less about default rates and forced selling, our high yield bonds returned more than at any time since the second quarter of 1980. The rebirth of interest in smaller and second-tier stocks produced a quarterly return for our convertibles above any since the fourth quarter of 1982. Lastly, suspension of "end-of-the-world" thinking and an increased willingness to envision possible solutions caused our distressed-debt Special Credits portfolios to gain even more than either high yield bonds or convertibles. It would be wonderful to be able to successfully predict the swings of the pendulum and always move in the appropriate direction, but this is certainly an unrealistic expectation. We consider it far more reasonable to try to (1) stay alert for occasions when a market has reached an extreme, (2) adjust our behavior slightly in response and, (3) most importantly, refuse to fall into line with the herd behavior which renders so many investors dead wrong at tops and bottoms.

© Oaktree Capital Management, L.P. All Rights Reserved Addendum to Third Quarter Client Letter From: Howard S. Marks Re: The Route to Performance We all seek investment performance which is above average, but how to achieve it remains a major question. My views on the subject have come increasingly into focus as the years have gone by, and two events in late September -- and especially their juxtaposition -- made it even clearer how (and how not) to best pursue those superior results. First, there was an article in the Wall Street Journal about a prominent money management firm's lagging performance. Its equity results were 1,840 basis points behind the S&P 500 for the twelve months through August, and as a result its five-year performance had fallen behind the S&P as well. The president of the firm explained that its bold over- and under-weightings weren't wrong, just too early. Here is his explanation, with which I strongly disagree: If you want to be in the top 5% of money managers, you have to be willing to be in the bottom 5%, too. The above calls to mind a convertible mutual fund I discussed in my second quarter 1988 letter to convertible clients. The fund held large amounts of common stock in the first eight months of 1987 and cash after that. As a result, its return was more than 1,600 basis points better than the average convertible fund for the year, and 945 b.p. ahead of the second-place fund. In the next half year, its tactics were equally divergent ...

but wrong this time, producing performance which was far enough behind to negate the majority of its 1987 achievement and pull its 18-month results well back into the pack. My observation at that time mirrored the fund manager quoted above, but from a negative viewpoint: . . . in order to strive for performance which is far different from the norm and better, you must do things which expose you to the possibility of being far different from the norm and worse. These cases illustrate that bold steps taken in pursuit of great performance can just as easily be wrong as right. Even worse, a combination of far above-average and far below- average years can lead to a long-term record which is characterized by volatility UandU mediocrity. As an alternative, I would like to cite the approach of a major mid-West pension plan whose director I spoke with last month.last