Howard Marks on Quality Businesses

Here I say with conviction that it’s a very real thing, with the potential to vastly alter the business world and change much of life as we know it. • Is application of the technology a distant dream? Clearly, the technology is already in demand and being applied on a large scale. Since AI seems amorphous and little understood, I think its potential is more likely to be underestimated today than exaggerated. • Are the people building AI infrastructure behaving unwisely? As I pointed out in December, in every example of sweeping technological innovation, the headlong rush to build infrastructure has vastly accelerated the adoption of the innovation and caused a lot of capital to be “malinvested” and destroyed. There’s no reason to assume this time will be different. • Will the investment in AI infrastructure produce an adequate return? Since we don’t have full knowledge of AI’s business potential or its impact on profitability, this question can’t be answered. As I wrote in my December memo, there’s certainly great enthusiasm for AI businesses. We’ll know in 10 years whether the resulting profits justified it. • Are the valuations assigned to AI businesses irrational? The so-called hyperscalers, for whom AI is one important part of a great business, may be overvalued or undervalued, but it’s unlikely that today’s prices for enormously profitable companies like Microsoft, Amazon, and Google are going to turn out to have been ruinously excessive.

They pay depositors (or the Fed) a low rate of interest to borrow the funds they need to operate, and they lend or invest those funds at slightly higher rates, earning a modest spread. But they literally make it up on volume. They employ heavy leverage, meaning they can do a lot of business based on little equity capital, thereby translating a low return on assets into a high return on equity. However, having a high ratio of total assets to equity capital means a modest decline in asset prices can wipe out a bank’s equity, rendering it insolvent. There’s no source of meltdown – in any sector – as potentially toxic as the combination of high leverage and an asset/liability mismatch. Banks have them both. © 2023 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

In the current iteration, these attributes are being applied to a small group of tech-based companies, which are typified by “the FAANGs”: Facebook, Amazon, Apple, Netflix and Google (now renamed Alphabet). They all sport great business models and unchallenged leadership in their markets. Most importantly, they’re viewed as having captured the future and thus as sure to be winners in the years to come. True as far as it goes . . . just as it appeared to be true of the Nifty-Fifty in the 1960s, oil stocks in the ’70s, disk drive companies in the ’80s, and tech/media/telecom in the late ’90s. But in each of those cases:  the environment changed in unforeseen ways,  it turned out that the newness of the business model had hidden its flaws,  competition arose,  excellence in the concept gave rise to weaknesses in execution, and/or  it was shown that even great fundamentals can become overpriced and thus give way to massive losses. The FAANGs are truly great companies, growing rapidly and trouncing the competition (where it exists). But some are doing so without much profitability, and for others profits are growing slower © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Finally, inflation often presupposes pricing power on the part of manufacturers, which I also don’t see. Those are the factors that argue against an increase in inflation. However, because of other forces – primarily financial and international – it could take increasing numbers of dollars to buy a given quantity of the imported goods on which we’ve become so dependent (a.k.a. inflation).  As I mentioned earlier, debtors want there to be inflation so they can repay their debts with currency that’s worth less. To accomplish this, debtor nations have the ability to debase their currencies by printing more of it. For the clearest example, see “The Limits to Negativism” (October 15, 2008) on the subject of the Weimar Republic. Post-World War I Germany was assessed war reparations it couldn’t afford, so it simply over-stamped its 1,000 mark notes “1 million marks.” All of a sudden it had created enough marks to pay its debt to the world . . . and destroyed the purchasing power of its currency.  A dollar weakened by reduced demand for it (e.g., as a vehicle for the investment of China’s reserves) would, likewise, equate to more dollars per item bought from abroad.  Finally, “stores of value” like gold hold value only because people agree they will. The same goes for currencies. Profligate spending, runaway deficits and declining world position could reduce the role of the dollar as a reserve currency, again cutting into its purchasing power.