Howard Marks on Second-Level Thinking

They do this without knowledge of what the future will bring or concern about whether the price they’re paying can possibly be expected to produce a reasonable return with a tolerable amount of risk. The end result for investors is inevitably painful in the short to medium term, although it’s possible to end up ahead after enough years have passed. I’ve lived through several bubbles and read about others, and they’ve all hewed to this description. One might think the losses experienced when past bubbles popped would discourage the next one from forming. But that hasn’t happened yet, and I’m sure it never will. Memories are short, and prudence and natural risk aversion are no match for the dream of getting rich on the back of a revolutionary technology that “everyone knows” will change the world. I took the quote that opens this memo from Derek Thompson’s November 4 newsletter entitled “AI Could Be the Railroad of the 21 st Century. Brace Yourself,” about parallels between what’s going on today in AI and the railroad boom of the 1860s. Its word-for-word applicability to both shows clearly what’s meant by the phrase widely attributed to Mark Twain: “history rhymes.” Understanding Bubbles Before diving into the subject at hand – and having read a great deal about it in preparation – I want to start with a point of clarification. Everyone asks, “Is there a bubble in AI?” I think there’s ambiguity even in the question.

What’s been behind these returns, and where do they leave the credit sector? Background As everyone knows, promised yields on credit instruments were meager in the low-interest-rate period I’ve discussed so much: 2009-21. At the beginning of 2022, before the Fed embarked on its program of interest rate hikes, high yield bonds yielded in the 4% range, with issuance taking place in the 3s and one bond issued in the 2s! I described Oaktree’s challenge at that time as “investing in a low-return world.” The ultra-low bond yields were unhelpful for most institutional investors, and many got out of the habit of investing in fixed income. There was, however, good interest in private credit, where yields in the area of 6% were being levered up to 9% or so. In 2022, investors who feared the Fed’s rate increases would bring on a recession caused the average high yield bond price to incorporate risk protection in the form of a yield spread of more than 4%, taking the overall yield to roughly 9½%. I argued at the time that these promised returns were (a) high in the absolute, (b) relatively safe because of their contractual nature, and (c) well in excess of the returns most institutions targeted. For these reasons, I urged that credit should be weighted significantly in portfolios. These high-single-digit yields alone would have given holders healthy returns.

Second-level thinking in the spring of 2025 required asking not just whether the tariff news was bad, but what was already in the price. Markets had moved sharply in response to the announcement, but the move was based on the immediate read of the policy text rather than on the eventual implementation. The gap between announcement and implementation is the gap in which second-level thinking operates. The market's initial response to a shock is typically a price action that reflects forced selling, mechanical de-risking, and the closure of crowded positions. That first move is rarely the right move to extrapolate. The second move — once the policy detail becomes clear and the structural positioning has been adjusted — is the move that more accurately reflects the fundamental impact. Investors who react to the first move as if it were the final word tend to sell at the worst prices and buy back at the worst prices. The psychology of a sudden regime announcement is a textbook illustration of recency bias. The market prices the new regime as if it will persist indefinitely, then prices the reversal as if the original regime is gone for good. Both impulses are usually wrong. The investor who can hold both possibilities in mind — that the new regime may persist or that it may be reversed — is better positioned than the one who commits fully to either narrative.

I’ve written so much about this that I’m not going to belabor it further (see my memo Ruminating on Asset Allocation, October 2024), but I’m always available to talk. (Before the bond pros jump down my throat, I’ll admit that the foregoing is less than 100% accurate. There are three components in bond returns, not two. Everyone knows about the interest payments and the movement of price to par at maturity. But there’s a third: the interest earned from reinvesting the annual interest payments, better known as “interest on interest,” and thanks to the power of long-term compounding, this is a major matter on 20- or 30-year bonds. The standard yield-to-maturity calculation assumes interest receipts are reinvested at the yield in effect at time the calculation is performed (for example, at purchase), but that’s a simplifying assumption, and the reality may well be different. No one wants to see the price of a bond one owns decline. But the truth is that if the bond price declines, the yield rises, meaning interest payments received can be reinvested at a higher rate than was anticipated. Thus, surprisingly, interim price declines can raise the overall return earned from holding a bond to maturity.) What About Private Credit? This is today’s other FAQ, along with the one about spreads. A lot of people have questions about private credit, which makes one wonder how the sector can be seeing such strong capital inflows.

That’s an inevitable part of life when your business consists of knowingly bearing credit risk for profit. But these caveats don’t keep the First Brands case from proving a valuable opportunity for learning. What are the key takeaways? • Defaults are a normal part of life in sub-investment grade investing. • However, bullish conditions in good times usually lead to a lowering of lending standards, giving rise to elevated defaults and an occasional fraud. • It’s absolutely essential to always balance the desire to put money to work with the need for prudence. • Superior credit analysis is a matter of second-level thinking – thinking that’s different from that of others and better – based on a mosaic of information and inferences. • In detecting credit defects, the big payoff is for being early. If you reach a negative conclusion at the same time as everyone else, the price you’ll get for your holdings is likely to be marked down to fully reflect the negatives – that’s market efficiency. • It’s important to note that whereas private credit has been the rage of late, all else being equal, it’s great to hold public debt that can be exited more readily if you sour on the credit. We’ve lived through generally good times in the last 16 years. The coming period is likely to be more “interesting,” as errors that were made in those good times come to light. On the other hand, the frauds described above have probably chastened lenders and investors, putting them on alert.

The effects of low interest rates are multi-faceted and ubiquitous, yet frequently overlooked. I became more conscious of them as I read The Price of Time, and I want to catalog them here: i. Low interest rates stimulate the economy Everyone knows that when central banks want to stimulate their countries’ economies, they cut interest rates. Lower rates reduce costs for businesses and put money into the hands of consumers. For example, since most people buy cars on credit or lease them, lower interest rates make cars more affordable, increasing demand. The result is typically good for automakers, their suppliers, and their workers, and thus for the economy in general. It’s important to realize that easy money keeps the economy aloft, at least temporarily. But low interest rates can make the economy grow too fast, bringing on higher inflation and increasing the probability that rates will have to be raised to fight it, discouraging further economic activity. This oscillation of interest rates between extremes can have effects and encourage behavior that natural/neutral rates (see p. 13) would be less likely to induce. ii. Low interest rates reduce perceived opportunity costs Opportunity cost is a major consideration in most financial decisions. But in low-interest-rate environments, the rate earned on cash balances is minimal.

The response to my Sea Change memo was considerable, and a fair share of it was critical. Critics pointed out that I have sounded cautious before — too early, by their measure — and that the business of forecasting regime shifts is a low-batting-average endeavor. I concede both points. The decision to publish the memo was not a forecast that the world would end but a reminder that the assumptions embedded in prices had changed in ways that warranted re-examination. What struck me in the pushback was how often it rested on the belief that the prior regime was the natural state of things. A skeptic might reasonably ask why anyone should believe a particular market configuration — one that prevailed for roughly forty years out of several centuries of financial history — is the default to which we will inevitably return. The contrarian posture here is not to predict doom but to resist the gravitational pull of recent experience. If the regime has in fact changed, the burden of proof should fall on those who argue for reversion to the prior mean, not on those who argue for adaptation. That is the inversion Sea Change proposed and that this follow-up defends. The longer central banks remain constrained by inflation fighting, the more reasonable the adaptation hypothesis becomes.

Second-level thinking in a regime-shifted environment is uncomfortable because it requires questioning what worked. Many investment processes were optimized for the prior regime — the spread compression trade, the multiple-expansion trade, the duration trade, the illiquidity premium trade. Each of these worked not because of skill but because the macro wind was at the back of anyone who applied them. Now that the wind has shifted, processes need to be re-examined. Patience is the virtue most needed at moments like this. The temptation is to act decisively — to declare the bottom is in or that the bear market has only just begun. Both impulses are usually wrong. The prudent posture is to deploy gradually, retain optionality, and resist the urge to commit capital in size until prices reflect the new regime's risk premium. I am often asked whether I think we are in a new bull or bear market. My honest answer is that I do not know, and that the question is less important than the question of whether current prices compensate for the risks that are now visible. If they do, deploy gradually; if they do not, wait. Sea Change is not a forecast of direction; it is a framework for asking better questions.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: In other words, poor performance had led to investor disinterest, and disinterest had perpetuated the poor performance, creating one of the supposedly unstoppable vicious cycles we see in the markets from time to time. In the author’s view, this negative state was likely to prevail for years. Like many arguments in the world of investing, the assertions in “The Death of Equities” may have seemed sensible on the surface. But if you drilled down a bit – and, in particular, if you thought like a contrarian – the logical flaws became readily apparent. What if the lows in optimism and enthusiasm for equities meant things couldn’t get any worse? Wouldn’t that mean they could only get better? And in that case, wouldn’t it be reasonable to assume that low stock prices presaged future gains, not continued stagnation? The above paragraph captures in brief the difference between the thinking of the average investor and what I call “second-level thinking.” The latter doesn’t rely on first impressions; rather, it’s deeper, more complex, and more nuanced. In particular, second-level thinkers understand that the convictions of the masses shape the market, but if those convictions are based on emotion instead of sober analysis, they should often be bet against, not backed. Here’s how I put it in Déjà Vu All Over Again: The negative factors are clear to the average investor. And from there he draws negative conclusions.

Superior investing requires being different from the consensus. That statement is so widely accepted as to have become a cliché, but the practice of it remains rare. The reason it is rare is that being different is uncomfortable — being different means being wrong some of the time, and being wrong in front of an audience that has the comfort of consensus is a special form of professional pain. Second-level thinking is the discipline of asking what the consensus believes and whether the consensus is right. The first-level thinker asks whether a company is good; the second-level thinker asks whether the consensus's view of the company's goodness is correct. The first-level thinker asks whether the news is good or bad; the second-level thinker asks whether the news is better or worse than what is already in the price. The two thinkers arrive at very different decisions from the same facts. The difficulty is that second-level thinking cannot be reduced to a formula. It requires judgment, context, and a willingness to disagree with people who are smarter than you in some respects. The case for being different is not that you are smarter than the consensus; it is that the consensus has under-weighted a consideration that you have weighed more carefully. The disagreement is about emphasis, not about information.

The second-level thinker always asks what is already in the price. When interest rates were collapsing for forty years, virtually every long-duration asset repriced higher in concert — bonds, equities, real estate, fine art. The rising tide lifted all boats and made asset selection look less important than it actually was. Now that the tide has turned, the cost of being wrong about an asset's quality or durability has risen substantially. I have been frank that the era of free money distorted the relationship between price and value. Capital flowed to strategies that promised growth at any price, to private structures that offered illiquidity premiums whether they were earned or not, and to fee structures that rewarded asset gathering more than return generation. The opportunity cost of staying in those arrangements is now visible: capital tied up in below-market illiquid commitments cannot be redeployed into the dislocations that follow a credit tightening. The discipline that matters now is the one Oaktree was built around — patient, credit-anchored, second-level thinking that asks not just whether an asset is good but whether it is cheap given what the consensus already believes. In a world of repriced risk, the answers tend to be more selective and more time-sensitive than the previous decade accustomed us to.

In response to the first tremors of the Global Financial Crisis, the Federal Reserve began to cut the fed funds rate in 3Q2007. They then lowered it to zero around the end of 2008 and left it there for seven years. In late 2015, virtually the only question I got was “When will the first rate increase occur?” My answer was always the same: “Why do you care? If I say ‘February,’ what will you do? And if I later change my mind and say ‘May,’ what will you do differently? If everyone knows rates are about to rise, what difference does it make which month the process starts?” No one ever offered a convincing answer. Investors probably think asking such questions is part of behaving professionally, but I doubt they could explain why. The vast majority of investors can’t know for sure what macro events lie just ahead or how the markets will react to the things that do happen. In The Illusion of Knowledge, I wrote at length about the way unforeseen events make a hash of economic and market forecasts. In summary, most forecasts are extrapolations, and most of the time things don’t change, so extrapolations are usually correct, but not particularly profitable. On the other hand, accurate forecasts of deviations from trend can be very profitable, but they’re hard to make and hard to act on. These are some of the reasons why most people can’t predict the future well enough to repeatably produce superior performance. Why is doing this so hard?

The psychology of selling is dominated by the fear of giving back gains and the fear of realizing losses. Both fears are present in every investor, and both fears lead to systematic errors. The investor who sells winners too early and holds losers too long is not making a series of independent mistakes; he is making the same mistake in two different forms — the mistake of letting tax and behavioral considerations override the underlying investment case. Second-level thinking on the sell side requires asking what the next owner of the asset will pay and why. If the answer is that the next owner will pay more because the consensus view is improving, the case for holding is strong. If the answer is that the next owner will pay more only because the price is rising, the case for selling into strength is strong. Distinguishing between these is the work. The simplest rule I can offer is to sell when the investment case has changed — when the price has risen to reflect the value you originally identified, when the fundamentals have deteriorated beyond what you underwrote, or when you have found a meaningfully better alternative. To sell for any other reason is to substitute activity for judgment, and activity is no substitute for judgment.

The psychology that produces extreme pendulum swings is itself fascinating. The same investors who were cautious at the bottom become aggressive at the top, and the same investors who were aggressive at the top become cautious at the bottom. The reason is that the recent past is the most salient evidence in any investor's mind, and the recent past at the top is gains, while the recent past at the bottom is losses. The temptation to extrapolate the recent past is the engine of the pendulum. The second-level thinker recognizes this pattern and uses it. At the top, when the consensus believes the recent gains will continue, the second-level thinker asks what is already in the price and what would have to be true for the gains to continue. At the bottom, when the consensus believes the recent losses will continue, the second-level thinker asks the same questions in reverse. The work is symmetric; the emotional discipline required is not. I beg to differ with the consensus not because I am smarter but because I have spent a career studying how consensus views form and dissolve. The consensus at any moment is the product of recent experience, and recent experience is not a sound basis for forecasting the future. The investor who can step outside the consensus frame and ask whether the consensus itself is built on solid assumptions has a structural edge. The edge is not in information; it is in the discipline of asking better questions.

© 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.

That description became the book’s first chapter, addressing one of its most important topics: second-level thinking. It’s certainly the concept from the book that people ask me about most often. The idea of second-level thinking builds on what I wrote in Dare to Be Great. First, I repeated my view that success in investing means doing better than others. All active investors (and certainly money managers hoping to earn a living) are driven by the pursuit of superior returns. But that universality also makes beating the market a difficult task. Millions of people are competing for each dollar of investment gain. Who’ll get it? The person who’s a step ahead. In some pursuits, getting up to the front of the pack means more schooling, more time in the gym or the library, better nutrition, more perspiration, greater stamina or better equipment. But in investing, where these things count for less, it calls for more perceptive thinking . . . at what I call the second level. The basic idea behind second-level thinking is easily summarized: In order to outperform, your thinking has to be different and better. Remember, your goal in investing isn’t to earn average returns; you want to do better than average. Thus, your thinking has to be better than that of others – both more powerful and at a higher level. Since other investors may be smart, well informed and highly computerized, you must find an edge they don’t have.

In fact, just as continued buying of appreciated assets can eventually turn a bull market into a bubble, widespread selling of things that are down has the potential to turn market declines into crashes. Bubbles and crashes do occur, proving that investors contribute to excesses in both directions. In a movie that plays in my head, the typical investor buys something at $100. If it goes to $120, he says, “I think I’m onto something – I should add,” and if it reaches $150, he says, “Now I’m highly confident – I’m going to double up.” On the other hand, if it falls to $90, he says, “I’m going to think about increasing my position to reduce my average cost,” but at $75, he concludes he should reconfirm his thesis before averaging down further. At $50, he says, “I’d better wait for the dust to settle before buying more.” And at $20 he says, “It feels like it’s going to zero; get me out!” Just like those who are afraid of surrendering gains, many investors worry about letting losses compound. They might fear their clients will say (or they’ll say to themselves), “What kind of a lame- brain continues to hold a security after it’s gone from $100 to $50? Everyone knows a decline like that can foreshadow further declines. And look – it happened.” Do investors really make behavioral errors such as those I’ve described? There’s plenty of anecdotal evidence. For example, studies have shown that the average mutual fund investor performs worse than the average mutual fund.

• They reduce the prospective returns investors demand from investments they’re considering, thereby increasing the prices they’ll pay. This can be seen most directly in the bond market – everyone knows it’s “rates down; prices up” – but it works throughout the investment world. • By lifting asset prices, they create a “wealth effect” that makes people feel richer and thus more willing to spend. • Finally, by simultaneously increasing asset values and reducing borrowing costs, they produce a bonanza for those who buy assets using leverage. I want to spend more time on that last point. Think about a buyer who employs leverage in a declining- rate environment: • He analyzes a company, concludes that he can make 10% a year on it, and decides to buy it. • Then he asks his head of capital markets how much it would cost to borrow 75% of the money. When he’s told it’s 8%, it’s full speed ahead. Earning 10% on three-quarters of the capital that’s borrowed at 8% would lever up the return on the other one-quarter (his equity) to 16%. • Banks compete to make the loan, and the result is an interest rate of 7% instead of 8%, making the investment even more profitable (a 19% levered return). • The interest cost on his floating-rate debt declines over time, and when his fixed-rate debt matures, he finds he can roll it over at 5%. Now the deal is a home run (a 25% levered return, all else being equal).

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Having made the case, I went on to distinguish second-level thinkers from those who operate at the first level: First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in “The outlook for the company is favorable, meaning the stock will go up.” Second-level thinking is deep, complex, and convoluted. The second-level thinker takes a great many things into account: • What is the range of likely future outcomes? • What outcome do I think will occur? • What’s the probability I’m right? • What does the consensus think? • How does my expectation differ from the consensus? • How does the current price for the asset comport with the consensus view of the future, and with mine? • Is the consensus psychology that’s incorporated in the price too bullish or bearish? • What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right? The difference in workload between first-level and second-level thinking is clearly massive, and the number of people capable of the latter is tiny compared to the number capable of the former. First-level thinkers look for simple formulas and easy answers. Second-level thinkers know that success in investing is the antithesis of simple.

History amply demonstrates that when (a) markets exhibit bullish behavior, (b) valuations become excessive, and (c) the latest thing is accepted without hesitation, the consequences are often very painful. Everyone knows – or should know – that parabolic stock market advances are generally followed by declines of 20-50%. Yet those advances occur and recur, abetted by what I learned in high school English class to call “the willing suspension of disbelief.” Here’s another of my very favorite quotes: 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. 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.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: meaning even after allowing for some defaults, they’re likely to deliver equity-like returns, sourced from contractual cash flows on public securities. Credit instruments of all kinds are potentially poised to deliver performance that can help investors accomplish their goals. The Outlook Inflation and interest rates are highly likely to remain the dominant considerations influencing the investment environment for the next several years. While history shows that no one can predict inflation, it seems likely to remain higher than what we became used to after the GFC, at least for a while. The course of interest rates will largely be determined by the Fed’s progress in bringing inflation under control. If rates go much higher in that process, they’re likely to come back down afterward, but no one can predict the timing or the extent of the decrease. While everyone knows how little I think of macro forecasts, a number of clients have asked recently about my views regarding the future of interest rates. Thus, I’ll provide a brief overview. (Oaktree’s investment philosophy doesn’t prohibit having opinions, just acting as if they’re right.)

Finally among the positives, I believe U.S. political uncertainty has declined somewhat, truncating the extreme tails of the distribution of possible events. With a center-left president and tiny Democratic majorities in both houses of Congress, I believe radical legislation is unlikely to be enacted. Arrayed against the optimistic outlook regarding the two most important things, the economy and the fight against the pandemic, are a number of concerns. The shortest-term risk is the possibility of unimpressive first quarter GDP data. The latest severe wave of the virus, which took daily cases in the U.S. to record levels, may have slowed current economic activity (so far, the economic data are very mixed). But everyone knows this, and investors have been willing to “look across the valley” for the past eleven months and are unlikely to stop now, when strong growth is right around the corner. The biggest risk of all is the possibility of rising interest rates. Rates have declined quite steadily for the last 40 years. This has been a huge tailwind for investors, since a declining-rate environment lowers the demanded returns on assets, making for higher asset prices. The linkage between falling interest rates and rising asset valuations is a good part of the reason why p/e ratios on stocks are above average and bond yields are the lowest we’ve ever seen (which is the same as saying bond prices are the highest).

They are locked into a politics of denial, distraction, and self-indulgence that can only be overcome if readers like you take back this country from the ideologues and spin doctors of both the left and the right. . . . With faith-driven catechisms that are largely impervious to analysis or evidence, and that seem removed from any kind of serious political morality, both political parties have formed an unholy alliance – an undeclared war on the future. An undeclared war, that is, on our children. From neither party do we hear anything about sacrificing today for a better tomorrow. In some ways, our most formidable challenge may be our leaders’ baffling indifference to our fiscal metastasis. (Emphasis added) The good news is that we’ve muddled through and enjoyed a good measure of prosperity despite the existence of these issues. The bad news is that little or nothing has been done about them. The Role of the Fed I won’t spend a great deal of time on this subject since everyone knows the story. But it has to be part of a memo that purports to discuss important changes that are underway. Historically, the job of central banks has been to control the level of inflation and make sure the economy grows fast enough to create “full employment.” In recent years, however, the Fed seems to have taken on the additional task of keeping the securities markets on an upward trajectory.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: Uncertainty I wrote a memo a week for six weeks starting on March 3, but I’ve skipped the last three weeks. First, the string had to end sometime. And second, I try to adhere to the principle that if I don’t have anything additive to say, I don’t write. Hopefully you’ll find this one worth reading. Our inability to know the future is a theme I’ve touched on repeatedly over the years, but now I’ve decided to devote an entire memo to it. Being at home for nearly two months means I’ve had a lot of time on my hands, like everyone else. And it’s a good thing, because getting philosophical musings down on paper is a lot harder than writing about current events and what to do about them. And while I’m explaining myself, I’ll apologize up front for the number of citations and their length – but there’s so much wisdom I want to share. All We Don’t Know As everyone knows, today we’re experiencing unprecedented (or at least highly exceptional) developments in four areas: the pandemic, the economic contraction, the oil price collapse and the Fed/government response. Thus a number of considerations make the future particularly unpredictable these days: • The field of economics is muddled and imprecise, and there’s good reason it’s called “the dismal science.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Forecasts create the mirage that the future is knowable. Peter Bernstein I never think of the future – it comes soon enough. Albert Einstein The future you shall know when it has come; before then forget it. Aeschylus Forecasts usually tell us more of the forecaster than of the future. Warren Buffett I think you get the point. I seem to be in good company in my belief that the future is unknowable. Having made that assertion, I’ll admit that it’s an extreme oversimplification and not entirely correct. There actually are things we know about the macro future. The trouble is that, mostly, they’re things everyone knows. Examples include the fact that U.S. GDP grows about 2% per year on average; heating oil consumption increases in winter; and a great deal of shopping is moving on-line. But since everyone knows these things, they’re unlikely to be much help in the pursuit of above average returns. As I’ve described before, the things most people expect to happen – consensus forecasts – are by definition incorporated into asset prices at any point in time. Since the future is usually a lot like the past, most forecasts – and especially macro forecasts – are extrapolations of recent trends and current levels, and they’re built into prices. Since extrapolation is appropriate most of the time, most people’s forecasts are roughly correct.

But as everyone knows, the Treasury and Fed announced rescue programs in mid-March and an enlarged Fed program during the week of March 23: zero interest rates, bond buying, grants, loans and significantly enhanced unemployment payments. The total ran to multiple trillions of dollars. And the authorities made it clear that there was more behind that: that the available resources were unlimited. • People accepted that the recession would end and a recovery take its place in short order. • With short-term interest rates near zero, investors lined up to buy bonds in the quest for return. Thus rather than a credit crunch, there’s been record amounts of capital available. • Even though the rescue provided “liquidity but not solvency,” whole industries (like the airlines) were saved from sure bankruptcy. • There were none of the spectacular implosions that mark most crises. • Ditto for panic selling. • Pessimism was replaced by willingness to think about better times ahead. • With interest rates at zero, investors couldn’t afford to be risk averse. They had to embrace risk assets in order to have a shot at returns above the low single digits. • Thus asset prices recovered. To illustrate the effect, since April 1, investors in distressed debt have had opportunities to make large rescue loans to companies or entities needing a quick response to problems related to illiquidity or pending debt maturities, and there’s still a good pipeline.

To that end, good play isn’t just a function of relying on the expected value of your holdings and pure math, but also of thinking broadly about risk. Would you bet all your money on an 80/20 favorite?  Adjusting your play based on the environment – In poker, if your competition is weak, you may decide to play more hands regardless of their strength and bet more aggressively, while against strong players you may tighten up and only play premium hands.  Overcoming emotion and biases – Human failings can cause gamblers to “chase” in poker (overstay in a hand in the hope of getting a lucky card), play loose (bet too much) when they’re “steaming” (smarting from losses and thus driven by heated emotion), and take bad doubles in backgammon. Hope, emotion and optimism are the gambler’s enemies.  Second-level thinking – It’s not just how good your hand is. There’s much more. How good does your opponent think your hand is? How good do you think your opponent’s hand is? How good does he think you think his is? How is that motivating his actions? The consistent winner has to be able to think at a higher, more complex level than the rest. All the ideas discussed above are important in investing, just as they are in gambling. In both pursuits, it all comes down to Jack Grayson’s title: Decisions Under Uncertainty.

© 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.

Senator who now leads a policy think tank describe as “fake news” a Congressional Budget Office report with which his organization takes issue. If the non-partisan CBO isn’t accepted as objective and truthful, who will be? In a time of raging partisanship, disrespect for experts, and drastically debased standards for discourse, is there such a thing as a fact? Can there be no distinction between opinion, fact and fake fact? Can there be a figure everyone trusts, another Edward R. Murrow? Can any statement be safe from disparagement even though it’s not 100% measurable and provable? Is history subject to unlimited revision if there are no video images? What will our grandchildren be taught is the meaning of the word “true”? What authorities will they trust? We certainly live in interesting times. Macro Investor Performance The acid test of an investment strategy is whether it produces good results. So here we are: first, “everyone knows” macro is a key determinant of investor performance these days, and second, there have been a lot of significant macro developments of late, providing opportunities for those with foresight to apply their predictive powers. Thus the ingredients have been in place for significant gains on the part of macro-oriented investors.

It’s a standard cycle: cautious investing produces good performance in a salutary environment . . . which leads to a reduction of caution . . . which leads to bad performance when the environment turns less favorable. This is part of the race to the bottom I wrote about in 2008. Emerging Market Debt The emerging markets are another place where investor opinion fluctuates wildly and visibly. “Everyone knows” the emerging markets have more growth potential than the developed world, but attitudes regarding the realizability of that potential – and thus the price one should pay for it – gyrate wildly over time. I described the phenomenon in “The Role of Confidence” (August 2013). When confidence is running high, the emerging markets are viewed as being just like developed markets, only faster- growing, meaning it’s reasonable for their securities to sell at yields and p/e ratios like those in the developed world. But when confidence declines, it becomes clear that there are risks that don’t exist in the developed world – like coups, institutionalized corruption, maxi-devaluation and debt repudiation – and thus significant valuation discounts are in order. Again, as with corporate credit, which is this? Are investors appropriately sensitive to the risks and imposing reasonable discounts, or are they ignoring the risks and happily paying up? That’s a lot of what you have to know. To answer the question, I’ll make reference to $2.

Our unlimited wants are continually colliding with the limits of our resources, forcing us to pick some activities and to reject others. Scarcity is the condition of having to choose among alternatives. (Macroeconomics Principles, Libby Rittenberg and Tim Tregarthen. Emphasis added) Because of the above, we make economic choices every day. Everyone knows choices like these are inescapable. Everyone, that is, except for politicians. The politician promises better grades and more leisure time. A cleaner environment and faster economic growth. That’s what caused me to write the memo: in politics and government – unlike the real world – the word “or” often goes out the window, replaced by “and.” No choices are necessary. A few months ago I saw a cartoon featuring caricatures of two primary opponents. Under one it said “bulls**t” and under the other it said “free s**t.” There’s bound to be a lot of the former in any election season, but economics tells us the latter is unrealistic. I wrote this memo to help readers understand why. * * * © 2016 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: What Does a Falling Market Say About Value? What do big price declines mean? They mean market participants sense fundamental deterioration. But what price declines say is reflective, not predictive. They tell you about the events that have occurred, and how investors have reacted to them. They don’t tell you anything that the average investor doesn’t know about future events. And, again, I’m firmly convinced (a) the average investor doesn’t know much, and (b) following average opinion won’t help you attain above average results. Most of my readers want to perform better than the average investor. As I’ve set out in “Dare to Be Great II” (April 2014) and in the discussion of “second level thinking” in my book The Most Important Thing, to accomplish that, you have to invest differently than the average investor. To do that, you have to think differently than the average investor. And to do that, you have to consider different inputs than the average investor, or consider inputs differently. You simply can’t follow the signals their behavior provides. It’s a matter of logic: if price movements reflect average opinion, following their supposed advice can’t help you perform above average. Now let’s think about the question of whether to sell. Here are some possible reasons to do so:  Belief that the price is high relative to the fundamentals.

© Oaktree Capital Management, L.P. All Rights Reserved Second-Level Thinking I always thought that when I retired, I would write a book pulling together the elements of investment philosophy discussed in my memos. But in 2009, I got an email from Warren Buffett saying that if I’d write a book, he’d give me a blurb for the jacket. It didn’t take me long to move up my timing. Columbia Business School Publishing had been talking to me about a book, and when I told them I was ready, they asked to see a sample chapter. For some reason, I was able to sit down – without previously having given the topic any organized thought – and knock out a chapter about the importance of something I labeled “second-level thinking.” This is a crucial subject that has to be understood by everyone who aspires to be a superior investor. And yet I’ve never covered it explicitly for the readers of my memos. I want to correct that now. In what ended up being the book’s first chapter, I introduced the subject as follows: Remember your goal in investing isn’t to earn average returns; you want to do better than average. Thus your thinking has to be better than that of others – both more powerful and at a higher level. Since others may be smart, well-informed and highly computerized, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss, or bring insight they don’t possess. You have to react differently and behave differently.

In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others . . . which by definition means your thinking has to be different. . . . For your performance to diverge from the norm, your expectations – and thus your portfolio – have to diverge from the norm, and you have to be more right than the consensus. Different and better: that’s a pretty good description of second-level thinking. Second-level thinking is what immediately pops into my mind when I think about Charlie’s observation. And it’s a good general heading under which to discuss the great many things that make superior investing a challenge. In short, to borrow from Charlie, anyone who thinks it’s easy must be a first- level thinker. Let me use some simple examples from the book to illustrate the difference.  First-level thinking says, “It’s a good company; let’s buy the stock.” Second-level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.”  First-level thinking says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-level thinking says, “The outlook stinks, but everyone else is selling in panic. Buy!”  First-level thinking says, “I think the company’s earnings will fall; sell.

” Second- level thinking says, “I think the company’s earnings will fall far less than people expect, and the pleasant surprise will lift the stock; buy.” First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in, “The outlook for the company is favorable, meaning the stock will go up.” © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved Second-level thinking is deep, complex and convoluted. The second-level thinker takes many things into account:  What is the range of likely future outcomes?  Which outcome do I think will occur?  What’s the probability I’m right?  What does the consensus think?  How does my expectation differ from the consensus?  How does the current price for the asset comport with the consensus view of the future, and with mine?  Is the consensus psychology that’s incorporated in the price too bullish or bearish?  What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right? The bottom line is that first-level thinkers see what’s on the surface, react to it simplistically, and buy or sell on the basis of their reactions. They don’t understand their setting as a marketplace where asset prices reflect and depend on the expectations of the participants. They ignore the part that others play in how prices change. And they fail to understand the implications of all this for the route to success. For example, when I lived in Los Angeles, a stockbroker often spoke on the radio station I listened to while driving to work. His advice was simple: “If there’s a company whose product you like, buy the stock.” That’s first-level thinking. How seductively easy.

© 2015 Oaktree Capital Management, L.P. All Rights Reserved Things often fail to work the way investment theory says they should. Markets are supposed to be efficient, with no underpricings to find or overpricings to avoid, making it impossible to outperform. But exceptions arise all the time, and they’re usually attributable more to human failings than to math mistakes or overlooked data. And that leads me to one of the most thought-provoking Yogi-isms, concerning his choice of restaurant: “Nobody goes there anymore because it’s too crowded.” What could be more nonsensical? If nobody goes there, how can it be crowded? And if it’s crowded, how can you say nobody goes there? But as I wrote last month in “It’s Not Easy,” a lot of accepted investment wisdom makes similarly little sense. And perhaps the greatest – and most injurious – of all is the near-unanimous enthusiasm that’s behind most bubbles. “Everyone knows it’s a great buy,” they say. That, too, makes no sense. If everyone believes it’s a bargain, how can it not have been bought up by the crowd and had its price lifted to non-bargain status as a result? You and I know the things all investors find desirable are unlikely to represent good investment opportunities. But aren’t most bubbles driven by the belief that they do?  In 1968, everyone knew the Nifty Fifty stocks of the best companies in America represented compelling value, even after their p/e ratios had reached 80 or 90. That belief kept them there . . .

for a while.  In 2000, everyone thought tech investing was infallible and tech stocks could only rise. And they were sure the Internet would change the world and the stocks of Internet companies were good buys at any price. That’s what took the TMT boom to its zenith.  And here in 2015, everyone knows social media companies will own the future. But will their valuations turn out to be warranted? Logically speaking, the bargains that everyone has come to believe in can’t still be bargains . . . but that doesn’t stop people from falling in love with them nevertheless. Yogi was right in indirectly highlighting the illogicality of “common knowledge.” As long as people’s reactions to things fail to be reasonable and measured, the spoils will go to those who are able to recognize this contradiction. Looking for Lance Dunbar There may be a few folks in America who, like the rest of the world’s population, are unaware of the growing popularity of daily fantasy football. In this on-line game, contestants assemble imaginary football teams staffed by real professional players. When that week’s actual football games are played, the participants receive “fantasy points” based on their players’ real-world accomplishments, and the participants with the most points win cash prizes. (Why is it okay to engage in interstate betting on fantasy football but not on football itself?

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 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.

Only an understanding that risk was high could have discouraged that behavior and rendered the world safe. I call this “the perversity of risk.” For most people it’s hard to grasp that a perception of safety brings on risk, and a perception of risk can lead to safety. But it’s clear for the deeper second-level thinker. This is just another example of the fact that what “everyone knows” is what shapes the environment, bringing high prices when things are perceived to be good, and vice versa. A perception that fundamental risk is low and the future is positive causes investors to be optimistic. This, in turn, causes asset prices to rise, and thus investment risk to be high. The problem that befalls most people – the first-level thinkers – is that they fail to distinguish between fundamental risk and investment risk. What has to be remembered is the defining role of price. Regardless of whether the fundamental outlook is positive or negative, the level of investment risk is determined largely by the relationship between the price of an asset and its intrinsic value. There is no asset so good that it can’t become overpriced and thus risky, and few so bad that there’s no price at which they’re a buy (and safe). This is one of the greatest examples of counterintuitiveness. Only those who are able to see its logic can hope to be superior investors. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved What Else? I’ve covered a few of the most important topics under the headings of complexity and counter- intuitiveness:  the importance of second-level thinking,  the lack of identity between “good company” and “good investment,”  the unhelpfulness of the things everyone knows, and  the perversity of risk. I see, however, that I’ve already filled seven pages. So rather than continue to provide a full treatment of all the topics I want to cover, let’s conduct an exercise. I’ll list below a number of elements of time- honored investment wisdom. See if you can tell which are helpful and which aren’t:  The market is “efficient,” meaning asset prices reflect all available information and thus provide accurate estimates of intrinsic value.  Because people are risk-averse, risky deals are discouraged and the market awards appropriate risk premiums as compensation for incremental risk.  Risky investments produce high returns.  Adding risky assets to a portfolio makes it riskier.  It’s desirable that everything in a well-diversified portfolio performs well.  Understanding the science of economics will enable you to safely harness the macro future.  Sometimes the outlook is clear, and sometimes it’s complicated and unpredictable. You have to be careful when it’s the latter.  Correct forecasts lead to investment gains.  A forecast has to be correct in order to be profitable.

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.

oil- independent, making it a net exporter of oil and giving it a cost advantage in energy – based on cheap production from fracking and shale – and thus a cost advantage in manufacturing. Now, the availability of cheap oil all around the world threatens those advantages. So much for macro forecasting!  There’s a great deal to be said about the price change itself. A well-known quote from economist Rudiger Dornbusch goes as follows: “In economics things take longer to happen than you think they will, and then they happen faster than you thought they could.” I don’t know if many people were thinking about whether the price of oil would change, but the decline of 40%- plus must have happened much faster than anyone thought possible.  “Everyone knows” (now!) that the demand for oil turned soft (due to sluggish economic growth, increased fuel efficiency and the emergence of alternatives) at the same time that the supply was © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

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

It wouldn’t make sense to voluntarily bear incremental credit risk if either of these two beliefs were lacking.  Another way to access attractive returns in today’s low-rate environment is to bear illiquidity risk in order to take advantage of investors’ normal dislike for illiquidity (superior returns often follow from investor aversion). Institutions that held a lot of illiquid assets suffered considerably in the crisis of 2008, when they couldn’t sell them; thus many developed a strong aversion to them and in some cases imposed limitations on their representation in portfolios. Additionally, today the flow of retail money is playing a big part in driving up asset prices and driving down returns. Since retail money has a harder time making its way to illiquid assets, this has made the returns on the latter appear more attractive. It’s noteworthy that there aren’t mutual funds or ETFs for many of the things we’re investing in.  Some strategies introduce it voluntarily and some can’t get away from it: concentration risk. “Everyone knows” diversification is a good thing, since it reduces the impact on results of a negative development. But some people eschew the safety that comes with diversification in favor of concentrating their investments in assets or with managers they expect to outperform. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

, unlike the general future, credit risk can be gauged by experts (like us) and reduced through credit selection. It wouldn’t make sense to voluntarily bear incremental credit risk if either of these two beliefs were lacking.  Another way to access attractive returns in today’s low-rate environment is to bear illiquidity risk in order to take advantage of investors’ normal dislike for illiquidity (superior returns often follow from investor aversion). Institutions that held a lot of illiquid assets suffered considerably in the crisis of 2008, when they couldn’t sell them; thus many developed a strong aversion to them and in some cases imposed limitations on their representation in portfolios. Additionally, today the flow of retail money is playing a big part in driving up asset prices and driving down returns. Since retail money has a harder time making its way to illiquid assets, this has made the returns on the latter appear more attractive. It’s noteworthy that there aren’t mutual funds or ETFs for many of the things we’re investing in.  Some strategies introduce it voluntarily and some can’t get away from it: concentration risk. “Everyone knows” diversification is a good thing, since it reduces the impact on results of a negative development. But some people eschew the safety that comes with diversification in favor of concentrating their investments in assets or with managers they expect to outperform.

© Oaktree Capital Management, L.P. All Rights Reserved. Where are we today? The p/e ratio on the S&P 500 is back to about 16, meaning the earnings yield is 6.25% once again. I‟ll use a 30-day T-bill rate of 1.00% (it‟s actually closer to zero, but a yield ratio approaching infinity wouldn‟t be meaningful). That gives us a yield differential of 5.25% (6.25% minus 1.00%), or 525 basis points, and a yield ratio of 6.25%/1.00%, or 6.25x. So let‟s recap: Post-WWII Norm 2000 Today Yield differential 325 b.p. 112 b.p. 525 b.p. Yield Ratio 2.08x 1.56x 6.25x Certainly the yield comparison is highly favorable for stocks today. In fact it‟s one of the best in the last century (probably barring only the early 1980s, when the p/e ratio on the S&P 500 fell to mid-single digits). Is that the whole story? It never is; nothing‟s that simple, especially in the world of investing. The problem with basing a pro-equities argument on the yield comparison is that most of equities’ current attraction on that basis comes from the lowness of interest rates. Just about everyone knows (a) interest rates are artificially low because of central banks’ efforts at stimulus and (b) rates will be considerably higher at some point in the intermediate term. In that case, rising rates would render stocks less attractive (all other things being equal, but they‟re not – see below). The Other Pros and Cons of Equities There are many ways to view valuation, and many elements in the current debate over equities.

© Oaktree Capital Management, L.P. All Rights Reserved. long – and the level of disinterest was so high – that only a few investors thought equities could ever catch on again. Those low expectations, when combined with modest fundamental and psychological improvement, gave the S&P 500 a return of about 13% over the year since that memo was written. So now we have a somewhat improved fundamental environment, a generally more optimistic group of investors, and stock prices that are a fair bit higher. No one should say the likelihood of improvement is entirely unrecognized today, as would have to be the case for this to still be stage one. I think the existence of improvement is generally accepted, but that acceptance is neither extremely widespread nor terribly overdone. Thus I’d say we’re somewhere in the first half of stage two. Pessimists no longer control market prices, but certainly neither have carefree optimists taken over. * * * A great rotation? Maybe . . . or maybe not. Nowadays pundits and the media are quick to come up with cute labels – usually just the right size for a headline or sound bite – to describe things that are taking place or that “everyone knows” are just around the corner. I don’t know whether it’s going to be great. Heck, I don’t even know if it’ll happen. But I like to enumerate the pros and cons and try to put them in perspective, as much as I like skewering excessive generalizations and pat pronouncements. Of course, doing that isn‟t enough.

(This is a good time for my typical reminder that I am not an economist, and far from all of my observations would be supported by that fraternity. And please note that one of the key tenets of Oaktree’s investment philosophy dictates that our investing will not be governed by macro forecasts. We say it’s one thing to have an opinion on the macro, but something very different to act as if it’s correct. I urge you to consider adopting a similar attitude toward all macro forecasts, especially mine.) Around 2008 or ’09, I had a visit from a senator looking – surprise! – for a campaign contribution. I suppose to make conversation, he asked if I could assure him we were headed for a vigorous recovery. “Forget vigorous,” I told him. “I’m hoping for lackluster.” I haven’t changed my tune. There’s a very human tendency to think things will stay as they are, and if they change, that they’ll revert to what we’re used to. Most people think of economic growth as the norm; after all, that’s been the general rule during our lifetimes. In fact, the global economy has grown nicely for hundreds of years. That’s something “everyone knows.” But how many people think about where economic growth comes from, and whether it’s naturally occurring and inevitable? © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. “Everyone knows XYZ is underpriced.” If everyone knows it‟s underpriced, why haven‟t they bought it and forced up its price? “Nobody will touch ABC; it‟s too risky.” If they know it‟s risky – presumably because its price is too high – and are shunning it or selling, why hasn‟t its price settled down to a level where it‟s safe? The writer continued: Indeed, the average stock price is now about 60% of the replacement value of the underlying assets . . . . . . companies have jumped on low stock prices to set off the biggest takeover binge in history . . . . . . buying at these prices is cheaper than building. The writer would look smarter today if he had recognized the implications of the fact that stocks were selling for less than their underlying asset value, and that companies were buying up other companies for that reason. But he didn‟t. He also didn‟t ask why, if it was smart for companies to buy other companies‟ shares, it didn‟t make sense for investors to buy those same shares. (Note: it was largely the ability to buy companies cheaper in the stock market than you could build them that gave pioneers of leveraged buyouts such as KKR, Apax and Warburg Pincus the great returns on their purchases in the 1970s.) It would take a sustained bull market for a couple of years to attract broad-based investor interest and restore confidence.

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

is threatened by our deteriorating infrastructure in areas like education, healthcare and transportation (as well as trends that are enabling other nations to catch up to us in these regards). These are things that made America great following World War II, but there seems to be little will (or money) to restore them to previous levels.  In my view, growing income inequality is a significant problem. The difference in incomes between those at the top and those at the bottom has risen dramatically, and the ability of those at the bottom to move up the chain has declined. Tax rates applied to income on capital (capital gains and dividends) have been cut relative to those on labor. Finally, everyone knows more than ever about how well the people at the top are doing. A lot of America’s economic success has stemmed from the fact that people in the lower income brackets felt the system would allow them to move up through hard work. To the extent that becomes less true – and the outlook today is guarded, especially given the low quality of public education – there can be negative ramifications for society overall.  The world of today seems full of intractable challenges. Think about the list of actual and potential problem areas: Iraq, Afghanistan, Iran, Israel/Palestine, Syria, Pakistan, North Korea, and occasional flare-ups in former Soviet republics.

” Similarly, the macro future seems far more uncertain today than at any time in my experience, but there’s a good chance it was never as certain as people thought. In the 1980s and ’90s, everything went right. Economic growth was strong. Companies thrived. There were great gains in productivity and technology. Profits rose dramatically. Interest rates declined. Inflation was quiescent. Equities soared. Houses and 401k accounts appreciated, producing a positive “wealth effect.” The world was largely at peace. All of this contributed to positive psychology, feeding back to further spur economic strength in a classic virtuous circle. Was this a period in which favorable outcomes were entirely dependable, or just one in which the underlying processes met up with good luck, producing favorable outcomes? And if the latter, were the results better than people should have expected to continue? Regardless, people did extrapolate them. When stocks returned 20% a year in the 1990s, rather than the normal 10%, investors ratcheted up their return expectations for the subsequent years, and with them their allocations to equities. Everyone knows that if you reach into a bag containing both black and white balls and pull out ten white ones in a row, the probability has increased that the next one will be black. But in the investment world, events like that serve to convince people that there are only white balls – favorable outcomes – in the bag.

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.

Why These Developments? As with any economic event, there are numerous explanations for these things. But the one I want to concentrate on is government stimulus. In the depths of the credit crisis, governments around the world took steps to deal with the liquidity contraction, economic slowdown and banks’ depleted capital accounts. These included reductions of interest rates to record lows. The motivations and effects are many and varied. First, everyone knows it’s the primary goal of rate cuts to stimulate economic activity by making it cheaper and thus more attractive for businesses to borrow money with which to invest in factories, capital good and inventories. Retail credit should be cheaper, too, encouraging consumers to borrow and buy. Second, providing low cost borrowings is a way to rebuild the health of financial institutions. If a bank can borrow $100 million from the central bank at 1% and lend it out at 6%, it’s as though the government gave it $5 million per year (assuming the loans turn out to be money-good). Thus, in addition to enhancing banks’ profitability and equity, in principle this should lead to increased lending. To date, the results in these areas have been mixed. Economic activity is still muted and lending is slow. But another by-product has become particularly pronounced: encouragement to take risk.

First, let’s consider financial institutions and the housing market. In recent years, as everyone knows, the former combined with the latter to create a bubble based on the combination of leverage, innovative structuring and heedless buying. Institutions and housing have been gravely hurt, and they’re likely to bring harm to additional sectors of the economy. For their downward spiral to be arrested, I see four things that have to happen:  Home prices have to stop going down.  Home mortgages have to be made available.  Financial institutions have to stop experiencing incremental write-offs.  Financial institutions have to be able to raise additional capital with which to rebuild their balance sheets. The problem I see is that each of these four things is dependent on the occurrence of another – a classic chicken-or-the-egg problem. Write-offs won’t stop until home prices stop going down. Prices won’t stop going down until mortgages become available. Mortgages won’t become available until lenders can raise capital. And capital won’t be freely available until write-offs stop coming. Which will happen first, facilitating the others? What will cause it to happen? When? These things will happen, of course. Maybe for reasons we can’t foresee. Maybe for no apparent reason. And maybe just because things got so bad they couldn’t get any worse. I go through this only to show why I don’t see an easy or quick solution. But then I’m rarely an unbridled optimist.

From neither party do we hear anything about sacrificing today for a better tomorrow. In some ways, our most formidable challenge may be our leaders’ baffling indifference to our fiscal metastasis. As former Treasury Secretary Larry Summers puts it, “The only thing we have to fear is the lack of fear itself.” (Emphasis added) It doesn’t require higher math to see that we face serious problems in areas such as Federal deficits, the balance of payments, international competitiveness, energy, Social Security, Medicare and education. Certainly those problems won’t solve themselves. But when did you last hear of any serious debate on them? Take the Social Security system. There are only four possibilities: (1) higher taxes, (2) lower benefits, (3) privatization, or (4) dealing with the system’s insolvency when it occurs. But the first two are unpopular, and the third is politically contentious, given that it’s inherently less egalitarian than the current system and could result in the government being on the hook as the payer of last resort. So that leaves the fourth . . . which is where we stay. This just is not an acceptable approach to problem solving. Likewise, everyone knows the tax code is overly complex, indecipherable and larded with provisions benefiting special interests. It desperately needs reworking from the ground up, but no one considers that politically doable.

© 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).

Usually, when either set of polar extremes is in the ascendancy, that fact is readily observable, and thus the implications for investors should be obvious to objective observers. But of course, the swing of the market pendulum to one set of extremes or the other occurs for the simple reason that the psyches of most market participants are moving in the same direction in a herd-like fashion. Few of the people involved actually are objective. To continue a thread from my last memo, “Everyone Knows,” expecting widespread clinical observation during a market mania makes about as much sense as saying “everyone knows the market has gone too far.” If many people recognized that it had gone too far, it wouldn’t be there. Between the two sets of cyclical extremes, I have no doubt that the environment of the last few years has been marked by the elements listed first above, not second: euphoria, greed, optimism, risk tolerance and credence; not depression, fear, pessimism, risk aversion and skepticism. Certainly it’s been the recent consensus of investors that, “It’s all good.”

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

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

© Oaktree Capital Management, L.P. All Rights Reserved The Unhelpful Consensus The bottom line is that what “everyone knows” isn’t at all helpful in investing. What everyone knows is bound to already be reflected in the price, meaning a buyer is paying for whatever it is that everyone thinks they know. Thus, if the consensus view is right, it’s likely to produce an average return. And if the consensus turns out to be too rosy, everyone’s likely to suffer together. That’s why I remind people that merely being right doesn’t lead to superior investment results. If you’re right and the consensus is right, your return won’t be anything to write home about. To be superior, you have to be more right than the average investor. Let me give you an outstanding example of a dangerous consensus. Historic data, buttressed by two decades of good returns, produced near unanimity in the late 1990s regarding future equity returns. Ask 100 institutional investors and consultants in 1999, and virtually 100 would say “about 11%.” There was little serious dissent. As a result, equity allocations were ratcheted up. Those who’d fallen behind because they were underweighted in equities earlier in the decade capitulated and bought more. Where did the support for that 11% number come from? It’s simple: recent results.

© Oaktree Capital Management, L.P. All Rights Reserved below 9%, making the company more productive, or selling it at an increased valuation. But the ability to do these things is either highly dependent on market conditions (leveraging cheap or selling dear) or skill-based. The wide disparity among private equity results for any given period of time shows how much they are a function of the skill of the general partners, and thus that most of the return on private equity is far from intrinsic to the asset class. Everyone Knows Two years ago, the herd knew residential real estate was a can’t-miss way to build wealth. “You can live in it,” “it’s a hedge against inflation,” and “they’re not making any more land” were oft- recited mantras . . . just as they had been in the mid-1980s (See “There They Go Again,” April 2005). After ten years of rapid appreciation, owners of condos felt they had it made, and non- owners felt they were on the outside looking in. People lined up to put down deposits on condos that hadn’t been built yet, and many assembled portfolios that way. No one talks that way anymore. The air came out of the condo balloon fast once prices stopped going up, putting the virtuous circle into a stall. The cheap financing that appeared to provide a ticket to financial security is now seen to have lured many buyers into water over their heads.

But I’m not sure that’s the model today. Few companies are languishing on the bargain counter, and everyone knows that if buyout funds bid for a company, the shareholders had better take a good look at what they’re giving up. Likewise, buyout funds are buying well into a period of economic expansion, and the scope for improvement in operations may be limited. No, the model today seems different: pay premiums to open-market prices for prominent, multi- billion dollar companies, sometimes after the boards, shareholders or other bidders have forced prices higher. Borrow large sums to finance the deals. Generate whatever fundamental improvement you can. Hope the market will provide a highly leveraged payoff. And, given the enormity of the scale, get rich off management fees, ancillary fees and the profits from the ones that work. In other words, it seems that, relative to the past, the thought process in mega-private equity is based on the combination of (1) ultra-cheap financing, (2) high fees, (3) quick withdrawal of equity capital and (4) a lower batting average but big payouts on the winners. The optionality is certainly on the GPs’ side. Let’s hope it works for the LPs as well. UIf the Lender’s a Sap, Is the Borrower a Genius? I have a lot of experience looking at leveraged transactions from the standpoint of the lender, but less experience as a borrower.

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.

© Oaktree Capital Management, L.P. All Rights Reserved If USC had made the two yards they needed on that fourth down play, it’s extremely likely they would have won the game. And if they’d won the game, they doubtless would be described today as the best college football team in history. But it didn’t happen that way, and no one talks anymore about their being the best, or even the second best. Now they’re considered just another great team. What this shows is how tenuous the connection can be between outcomes (which most people take for reality) and the real, underlying reality. What do I mean by that distinction? Consider this: What’s the probability that if USC had made the needed two yards – and today was considered the best team ever – they really would be the best team ever? Certainly not 100%. And just as interestingly (or to me maybe more so), what’s the probability that, even though they didn’t make the two yards, they actually are the best team that ever played? Certainly not zero. But since USC lost that game, most people would find nonsensical a suggestion that they’re the best team in history. To contemplate that possibility, they would have to consider an alternative history in which USC made those two yards. Can the result of one play really decide the issue? That’s the one thing we all can probably agree shouldn’t be the case. “Everyone knows” that the score of a game doesn’t necessarily tell you which is the better team.

© Oaktree Capital Management, L.P. All Rights Reserved dependent on it for their continued existence, he clearly had no way to realize them. My father used to tell a joke about the guy who insisted that his hamster was worth thousands more than he had paid for it. “Then you should sell it,” his friend urged. “Yeah,” he responded, “but to whom?”  Being seduced by loss limitation. Hunter is said to have liked buying deep-out-of-the- money options, and everyone knows that one great thing about buying options is that in exchange for a small option premium you receive the right to benefit from price movements on lots of assets. You can only lose 100% of the amount you put up . . . and in deep-out-of- the-money options people do just that all the time.  Misjudging liquidity. People often ask me whether a given market is liquid or not. My answer is usually, “that depends on which side you’re on.” Markets are usually liquid in one direction or the other but not necessarily both. When everyone is selling, a buyer’s liquidity is great, but a seller will find the going difficult. When sellers’ urgency increases, they’re likely to have to give on price in order to achieve the “immediacy” they crave (see my memo “Investment Miscellany,” November 16, 2000). If their desire for immediacy is extreme, the bids they see might be absurdly low. Thus markets can’t be counted on to accommodate a seller’s need to realize fair value.  Ignoring the impact of others.

Everyone knows there’s too much money looking for a home in buyouts, venture capital, distressed debt, hedge funds, real estate, and on and on. But that isn’t keeping more from flowing there. I love that terrific Yogi-ism: No one goes there anymore; it’s too crowded. But the corollary is appropriate for the alternative investing world of today: Because it’s so crowded, everyone wants to go there. Buyouts represent a great case in point today. It’s a simple business (execution aside). You buy a company with a little equity and a lot of debt. If you buy it right, if you can make it a better company, and if you run into an environment characterized by a strong economy, freely available capital and rising asset prices, you’ll be able to sell it for more than you paid for it, pay off the debt and enjoy a leveraged return. The theory is clear, but (like everything else in the investment world) it doesn’t always work. It worked very well from its inception around 1973 to roughly 1985, a period in which it was cheaper to buy a company through the stock market than start it and no one had ever heard of Henry Kravis. Then LBOs became enormously popular in the late 1980s, and companies were bought at ever-higher prices and ever-higher leverage ratios. Many of those went bankrupt in 1990 (causing a boom for distressed debt investors, but that’s another story). That’s what we call a full cycle.

© Oaktree Capital Management, L.P. All Rights Reserved “Everyone knows” it’s better to make tax-deductible mortgage payments than to pay rent. But the beauty of financial puzzles is that there’s no answer that’s always correct regardless of the circumstances. I’d rather pay a low rent I’ll be able to afford even if things get a little worse than a high and possibly rising mortgage payment, on the continuation of which my home ownership is riding. The old goal was to have the house paid off by retirement, so you could live in it when your paycheck stopped. Now, thanks to the magic of minimal down payments, minimal amortization and adjustable interest rates (starting from historically low levels), payments may well be higher in retirement than during the owners’ working years. How will people – possibly with little or no savings – hold onto their properties when their paychecks stop? We never hear anymore about people “saving for a rainy day” or “saving for their old age.” If you do those things, it may be harder to get the house of your dreams . . . but you’ll never go broke. I wonder how many of today’s home buyers will learn this lesson through painful experience. USelling Money If a seller wants to move more of his product, what does he do? Well, that depends on whether the product is capable of being differentiated from its competitors. If it is, he can try making it better, advertising it more or improving distribution.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Whad’Ya Know? I always ask Nancy to read my memos before I send them out. She seems to think being my wife gives her license to be brutally frank. “They’re all the same,” she says, “like your ties. They all talk about the importance of a high batting average, the need to avoid losers, and how much there is that no one can know.” Well, I guess I do tend to go on about everything that investors would like to know but is unknowable . . . and about all the people who claim to know it. But I’ve saved up some good stuff for a “rant” regarding the “I know” school people who think they know but don’t. So here I go again (with apologies for the length). UThe “Jumbo Shrimp” of Investing One of my favorite oxymorons is “common knowledge.” Knowledge just isn’t that common, and that which is common often contains little knowledge. On February 4, USA Today cited a strategist as saying “there might be a silver lining to the current investor backlash, because a lot of cash is piling up on the sidelines, and the heavy selling has wrung out most of the downside.” Everyone knows the stock market can’t stop sliding and begin a new bull phase rally until some cash has piled up on the sidelines. And thus everyone wants to see selling exceed buying. That seems eminently reasonable. And that’s what makes it one of my greatest pet peeves.

© Oaktree Capital Management, L.P. All Rights Reserved investable cash must come from sources that are exogenous to the market, such as household income, savings, tax refunds, and cash contributions to pension funds or endowments. The bottom line: there’s often no wisdom in the stuff that “everyone knows.” And nowhere is that more true than in investing. 4BUToward Understanding Market Movements One day in early 1995, the dollar made a big move against the yen. On my way to work, my radio station’s Tokyo correspondent reported that the Nikkei average of Japanese stocks had been off big that day. He was glad to explain why: investors were worried about the weakness of the yen. On my way home, the same station reported that the U.S. stock market also had declined a lot. The explanation given: investors were concerned about the strength of the dollar. Well that just can’t be. If one currency moves relative to another, how can companies in both countries be worse off than they were the day before? I think this episode illustrates a few themes. First, the general understanding of economic events and their implications is very poor. Second, everyone wants to explain the movements of the markets, and they’ll grasp at any straw with which to do so. Third, much of their commentary is useless. And, of course fourth, markets often do things that defy logical explanation – but people keep explaining them anyway.

© Oaktree Capital Management, L.P. All Rights Reserved Okay, that makes sense. Everyone knows stocks usually do well in January. But since it’s no secret, by now people should have learned to buy stocks ahead of the phenomenon, and that should have negated it. As I wrote in “Etorre’s Wisdom,” if everyone moves into the fast lane, it’ll stop being the fast lane. But let’s say there is a January effect. My favorite part of the Journal article was where it suggested that in 2002 people should wait until the end of December to buy, rather than entering the market sooner. The reason: while December’s usually a strong month, in 2002 a “statistical wrinkle” had the potential to make it a weak month instead. “In more than half the 21 instances since 1897 when the Dow Jones Industrial Average fell by 10% or more in the first 11 months of the year – it was down 11.2% this year – December was a weak month.” Sounds astute, right? But wait. First, the data reaches back to 1897, and I’m not sure 100-year-old observations are relevant today. Second, this set of facts has applied only 21 times in history, and that’s not much of a sample. Third, what’s the significance of “more than half”? If I told you a roulette wheel had come up black in 12 or 13 out of 21 spins, would that make you bet the ranch on black? I doubt it. If I told you it was 20 out of 21, that might make you consider it.

And if it had been black 60,000 times out of 100,000 spins, you might race to the table (and find me there). So what did happen to the January effect that “everyone knows about”? On February 3 the Wall Street Journal reported: . . . The Dow Jones Industrial Average finished [January] with a 3.5% drop. That is an inauspicious beginning to the year, doubly so because it follows a 6% decline during December. Historically, December has been the strongest month for stocks, with the industrial average rising in 72% of the Decembers since 1900. A back-to-back December-January decline is rare; it has happened only 9 times since 1900. In five of those nine years, the market fell after the January fizzle. So now the bullish January effect is discarded, and the bearish December-January effect demands our consideration. What has the Journal proved? That we can no longer count on the January effect? That it’s bad to hold stocks when both December and January show declines? Neither of these, I think. What’s been proved is that more data doesn’t necessarily mean more information. The Journal suggests the December-January rule as a guideline for managing money, but I wouldn’t bet a penny on something because it happened five times out of nine. (After all, if you flip a coin nine times, it has to come up at least five times on one side or the other.) For another example, my attention was drawn to the graphic accompanying the Journal story, titled “What Happens to Stocks When the U.S.

© 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 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.

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

And we do things that others find perilous, but we approach them in ways that cut the risk – like investing in emerging markets without making sink-or-swim bets on the direction of individual countries' economies and stock markets. I continue to believe there are ways to earn superior returns without commensurate risk, but they're usually found outside the mainstream. UA shortcut that everyone knows about is an absolute oxymoronU, as is one that's found where the roads are well marked and mapped. The route that's little known, unattractive or out of favor may not be the one that's most popular or least controversial. But it's the one that's most likely to help you come out ahead.2002

© 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. for everyone else to fail to notice that investor’s success, fail to emulate his methods, and thus allow the bargain to persist. Usually a free-lunch counter should be expected to be picked clean. The Current State of Market Efficiency Let’s compare the current environment for efficiency with that of the past.  Data on all forms of investing is freely available in vast quantities.  Every investor has extensive computing power. In contrast, there were essentially no PCs or even four-function calculators before 1970, and no laptops before 1980.  “Hedge fund,” “alternative investing,” “distressed debt,” “high yield bond,” “private equity,” “mortgage backed security” and “emerging market” are all household words today. Thirty years ago they were non-existent, little known or poorly understood. Today, as I say about the impact of the browsers on our mobile phones, “everyone knows everything.”  Nowadays few people make moral judgments about investments. There aren’t many instances of investors turning down an investment just because it’s controversial or unseemly. In contrast, most will do anything to make a buck.  There are about 8,000 hedge funds in the world, many of which have wide-open charters and pride themselves on being infinitely flexible. It’s hard to prove efficiency or inefficiency.

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.

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."

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: How's the Market? April 5 was just another ordinary day in the market, with big gains achieved and records broken. The Wall Street Journal article about it on April 6 was ordinary too, like hundreds that have been written in this bull market. I was struck, though, by the way it told in just a few paragraphs the whole story of what's been going on. UJust another dayU - On the surface, the aggregate stock market numbers continued to be very positive, with the Dow up 175 points, or 1.8%, to a new record. The S&P 500 was up 2.1% and the Nasdaq Composite Index was up 2.7%. Even on this day of huge aggregate gains, however, participation was still relatively narrow. Almost as many stocks were down (1,318) as up (1,695). Moreover, more stocks set new 52-week lows (81) than set new highs (73). This reminded me about the reliance of the market on just a few issues: In the first quarter of this year, 18 stocks accounted for Uall Uof the 5% rise in the S&P 500, (that's right, the other 482 stocks averaged a zero return). 55% of the stocks in the S&P lost money, and the Russell 2000 index of second tier stocks Udeclined U5.4%. UFollow the leaderU -- So the leadership continued to be concentrated, as everyone knows, in just a few stocks. Yahoo gained 22% on the day, and Amazon.com was up 9%.

In short, we believe (and have witnessed many times over) that the easiest way to make unusually high risk-adjusted returns is to buy from depressed sellers and sell to euphoric buyers...thus to buy when assets are underpriced and sell when they're overpriced. The opposite is a nightmare. The greatest extremes in our experience include 1970, when the New York banks believed the Nifty- Fifty companies were so good that it essentially didn't matter what price you paid for their stocks (subsequent declines of 70% to 90% soon became common among the stocks of America's greatest companies), and 1990, when investors acted as if any company experiencing an iota of difficulty was practically worthless (the distressed debt funds we created that year returned about 50% per annum). John Maynard Keynes said (roughly) that "a speculator is someone who takes risks of which he is aware, and an investor is someone who takes risks of which he is unaware." We think speculating, according to this definition, is more prudent than investing. It makes a lot of sense to purchase unpopular assets that promise excessive compensation for knowingly bearing risk. Buying high- priced, popular assets which "everyone knows have no risk" often proves terribly dangerous. Here's a case in point: © 1997 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved An investment that "everyone" knows to be undervalued is an oxymoron. If everyone knows it's undervalued, why haven't they bought it and driven up its price? And if they have bought, how can the price still be low? Yogi Berra said, "nobody goes to that restaurant; it's too popular." The equally oxy-moronic investment version is "Everybody likes that security because it's so cheap." 5. Book the bet that no one else will. If everyone likes the favorite in a football game and wants to bet on it, the point spread will grow so wide that the team -- as good as it is -- is unlikely to be able to cover the spread. Take the other side of the bet -- on the underdog. Likewise, if everyone is too scared of junk bonds to buy them, it will become possible for you to buy them at a yield spread which not only overcompensates for the actual credit risk, but sets the stage for their being the best performing fixed income sector in the world. That was the case in late 1990. The bottom line is that one must try to be on the other side of the question from everyone else. If everyone likes it, sell; if no one likes it, buy. 6. As Warren Buffet said, “the less care with which others conduct their affairs, the more care with which you should conduct yours." When others are afraid, you needn't be; when others are unafraid, you'd better be. It is usually said that the market runs on fear and greed.