Howard Marks on Economic Moats

They concluded that companies with market-leading positions in essential software that was unlikely to be replaced would (a) enjoy the recurring subscription-based cash flows that can make a company bankable and (b) benefit from sustainable moats surrounding their businesses. Private equity funds began to buy software companies, and credit investors began to lend money for that purpose. In my experience, the limiting factor in the credit markets is never borrowers’ appetite for capital, but rather lenders’ willingness to supply it. To paraphrase Kevin Costner’s character in the movie Field of Dreams, “If you provide capital, they’ll borrow and put it to work.” Thus, the makeup of the credit market was greatly influenced by the growth of private equity, the boom in capital available for direct lending, and both parties’ agreement that software companies were good candidates for investment.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: An aside regarding the valuation of the S&P 500: A bit over half of its jaw-dropping 58% two-year total return in 2023-24 was attributable to the spectacular performance of just seven stocks, those of the so- called “Magnificent Seven” – Apple, Microsoft, Alphabet (parent company of Google), Amazon, Meta Platforms (parent company of Facebook), Nvidia, and Tesla. These are great companies – some are the best companies ever – and these seven stocks have grown to represent a startling one-third of the total market value of the 500-stock index. (Please bear in mind that I don’t claim to be an expert on stocks in general or tech stocks in particular.) Because of these companies’ greatness, their stocks are highly valued, and there’s a popular perception that their elevated valuations are responsible for the S&P 500’s unusually high average p/e ratio. The fact is their p/e ratios average out to roughly 33. This is certainly an above average figure, but I don’t find it unreasonable when viewed against what I believe to be the companies’ exceptional products, significant market shares, high incremental profit margins, and strong competitive moats. (A lot of the Nifty-Fifty stocks First National City Bank owned when I got there in 1969 were selling at p/e ratios between 60 and 90. Now that’s high!)

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.

Words like “stable,” “defensive” and “moat” will be less relevant in the future. Much of investing will require more technological expertise than it did in the past. And investments made on the assumptions that tomorrow will look like yesterday must be subject to vastly increased scrutiny. The Changing Nature of Business Increasingly, U.S. business is virtual, digital and information-oriented, no longer devoted to agriculture or to manufacturing physical products. Even those companies that do produce physical goods or services increasingly employ information products and other aspects of technology. These elements will have a profound impact on which legacy businesses will survive, which moats will hold up, and which newcomers will supplant the incumbents, as well as what our world will look like ten or twenty years from now. © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: I began to form my investment philosophy in the 1960s. Investment thought was much less developed at that time, and what did exist was heavily dominated by the philosophy espoused by Ben Graham. Buffett was still searching for his last puff of “cigar butts” and had yet to coin the term “moat” in reference to the lasting competitive advantages that sustain high-quality businesses. My philosophy was informed by the fact that I started working in 1969, during the “Nifty Fifty” bubble, which I watched crash around me. It was further shaped by my transition in 1978 from equities to fixed income investments in the form of convertible and high yield bonds. Importantly, Graham and his less famous co-author, David Dodd, characterized bond management as a “negative art.” What did they mean? In general, bond investors’ return is capped at a yield that stems from the promised interest payments and payoff at par upon maturity; that’s why it’s called “fixed income.” The upshot is that all bonds bought at a 6% yield will return 6% when held to maturity if they pay. Bonds that don’t pay, on the other hand, will produce losses of varying magnitudes. Thus, oversimplifying, you improve your performance in bonds not through which paying bonds you buy (since all 6% bonds that pay will have the same return), but through what you exclude (that is, whether you’re able to avoid the ones that don’t pay).

One still had to mail away for annual reports as recently as the 1990s, and while more people may have known how to find pure balance sheet arbitrages like Graham practiced in the 1950s and ’60s, seemingly basic analytical concepts like return on invested capital, competitive moats and the importance of free cash flow (rather than GAAP earnings) were not widely appreciated. And certainly, most people didn’t understand the dynamics around what are called “special situations,” which become available when complex corporate actions create investment opportunities by giving rise to significant mispricings. There was still the opportunity to find bargains in plain sight, albeit perhaps with an extra level of sophistication required. Fast forward to today, and everything has changed. The investment industry is wildly competitive, with tens of thousands of funds managing trillions of dollars. Investment management is one of the most desirable careers, prompting complaints about “brain drain” as intellectual prodigies eschew careers as world-changing scientists or inventors in exchange for jobs on Wall Street. Warren Buffett has evolved from a man buying cheap stocks in his home office to an international celebrity, with 50,000 investors from around the world making the pilgrimage to Omaha each year for the Berkshire Hathaway annual meeting.

It also stands to reason that in a time when readily discernable quantitative data is unlikely to produce high-profit opportunities: • if something carries a low valuation, there’s probably a good reason, and • successful investing has to be more about superior judgments concerning (a) qualitative, non-computable factors and (b) how things are likely to unfold in the future. Not Your Grandfather’s Market Not only are the traditional staples of classic value investing (readily discernable quantitative measures of cheapness in the here-and-now) no longer likely to produce a sustainable edge on their own, but the world has gotten more complex, with many more dynamics that can drive a decoupling of near-term metrics from valuation, both to the positive and negative. Back in the old days, Warren Buffett could find businesses that clearly were likely to remain dominant for long periods of time and perform relatively straightforward analysis to assess their valuation. For instance, he could look at something like the Washington Post, which essentially became the monopoly newspaper in a major city, and invest on the basis of reasonable, consistent assumptions regarding a few variables like circulation, subscription prices and ad rates. It was a foregone conclusion that the paper would remain dominant because of its strong moat, and thus that the past would look very much like the future.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • Because the friction and marginal cost of scaling over the Internet can be so low, businesses can grow much more rapidly than ever before. • It has never been more acceptable for public companies to lose money in the pursuit of a large prize down the road. This in turn leads to obfuscation of the real potential economics of winners and makes differentiating between winners and losers difficult without great, insightful effort to peel back the onion. • As developing and scaling new products is much easier in the digital world (often requiring little more than engineers and code), it’s never been more possible for companies to develop completely new avenues of growth, further extending their runways (Amazon’s AWS and Square’s Cash App are two notable examples). This gives real value to intangibles such as exceptional management, engineering talent and strategic positioning with customers. • The moats protecting today’s winners have never been stronger, and as Brian Arthur pointed out in “Increasing Returns and the New World of Business,” his amazing piece of almost 25 years ago, the winners often get stronger and more effective as they get bigger, rather than bloated and inefficient. • Conversely, the onslaught of startups with readily available capital and minimal barriers to scaling means that the durability of legacy businesses has never been more vulnerable or uncertain.

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

Thus 62% of the world’s population carries a computer with Internet connectivity in his or her pocket. • Finally, it’s easier than ever to scale these businesses. In the past, one would have to go to a dealer to buy software on a disc, take it home and install it. Now we download apps from the web in seconds. For these reasons, a large differential in terms of p/e ratios is warranted. Second, these groups will not merely coexist and perform differently. Rather, the tech companies have the potential to negatively impact some of the non-tech companies. The common term for this phenomenon is “disruption.” Amazon has endangered brick-and-mortar retailers. Netflix has challenged the traditional TV and movie ecosystem. Facebook has cut into newspapers and other traditional media – industries thought to be protected by moats and thus “defensive.” Tesla has revolutionized the auto industry and outperformed the incumbents in developing electric vehicles. The list of industries immune to technological change – in terms of profitability if not their essential nature – is limited. Finally, it’s argued that the leading tech companies of today are stronger than the Nifty Fifty of the late 1960s.

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: are less likely to be the fast growers of the future or benefit as much from the “moats” that protected them in the past. It may also be true that given the ease today of searching the universe of securities, it may be harder than it used to be to find “value” companies with current assets or earning power that are broadly unrecognized and thus underpriced. Since the best returns come from buying things whose merits others aren’t aware of, it’s certainly possible that easy, widespread access to data is making it harder for value investors to excel. On the other hand, companies that do have better technology, better earnings prospects and the ability to be disrupters rather than disrupted still aren’t worth infinity. Thus it’s possible for them to become overpriced and dangerous as investments, even as they succeed as businesses (this was often the case with the Nifty-Fifty in 1968-73). And I continue to believe that eventually, after the modern winners have been lauded (and bid up) to excess, there will come a time when companies lacking the same advantages will be so relatively cheap that they can represent better investments (see value versus growth in 2000-02). Understandably, the stocks of companies with bright futures are likely to be outperformers in times of economic growth and optimism, when investors are happy to pay up for potential.

© Oaktree Capital Management, L.P. All Rights Reserved As usual, Buffet puts it as succinctly as anyone could: “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.” (Emphasis added) (Three years ago, everyone wanted to be Warren Buffet, or at least read books about him. Now, appearing to have missed out on the technology movement, he and his investment approach are dismissed as passe by the dot-com gang.)  Altered lives -- During the South Sea bubble, as described above, boats were put up for sale and people with capital shifted from being workers to being investors. In a striking parallel, the Internet-commerce revolution is also changing lives. Of course, we know that thousands of Americans have become on-line traders either full- or part-time. Articles describe people who are trying to "ride the trend" of hot stocks and benefit from their momentum, but there's little indication that they have any idea what makes companies do well or stocks go up (or even what some of their companies do).