Howard Marks on Shareholder Orientation

In my view, a bubble not only reflects a rapid rise in stock prices, but it is a temporary mania characterized by – or, perhaps better, resulting from – the following: • highly irrational exuberance (to borrow a term from former Federal Reserve Chair Alan Greenspan), • outright adoration of the subject companies or assets, and a belief that they can’t miss, • massive fear of being left behind if one fails to participate (‘‘FOMO’’), and • resulting conviction that, for these stocks, “there’s no price too high.” “No price too high” stands out to me in particular. When you can’t imagine any flaws in the argument and are terrified that your officemate/golf partner/brother-in-law/competitor will own the asset in question and you won’t, it’s hard to conclude there’s a price at which you shouldn’t buy. (As Charles Kindleberger and Robert Aliber observed in the fifth edition of Manias, Panics, and Crashes: A History of Financial Crises, “there is nothing so disturbing to one’s well-being and judgment as to see a friend get rich.”) So, to discern a bubble, you can look at valuation parameters, but I’ve long believed a psychological diagnosis is more effective. Whenever I hear “there’s no price too high” or one of its variants – a more disciplined investor might say, “of course there’s a price that’s too high, but we’re not there yet” – I consider it a sure sign that a bubble is brewing. Roughly fifty years ago, an elder gave me the gift of one of my favorite maxims.

Often, as Kindleberger indicates, it can be inferred from widespread participation in the investment fad of the moment, especially among non- financial types. Legend has it that J.P. Morgan knew there was a problem when the person shining his shoes started giving him stock tips. My partner John Frank says he saw it in 2000, when he heard the dads at his son’s soccer game bragging about the tech stocks they owned, and again in 2006, when a Las Vegas cab driver told him about the three condos he’d purchased. When Mark Twain purportedly said, “history doesn’t repeat itself, but it often rhymes,” it’s this kind of thing he was talking about. The New, New Thing If bubble thinking is irrational, what is it that permits investors to get away from rational thinking, like the thrust of a rocket ship that breaks free of the limits imposed by gravity and attains escape velocity? There’s a simple answer: newness. This phenomenon relies on another time-honored investment phrase, “this time is different.” Bubbles are invariably associated with new developments. There were bubbles in the Nifty Fifty stocks in the 1960s (more on them just below), disc drive companies in the 1980s, TMT/internet stocks in the late 1990s, and sub-prime mortgage-backed securities in 2004-06.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: not yet having materialized. In short, the tariff picture thus far is less bad than was feared at the time of the original announcements. It’s also possible that investors are encouraged by expectations of rising earnings; the tax and spending bill that was passed, with its favorable treatment of corporations; the pledges to invest in the U.S. that a number of foreign countries have made as part of trade deals; and even the potential of artificial intelligence to add to companies’ earning power. What can we say about the price/value calculus today? • The S&P 500 was highly valued at the end of 2024 and also just before the tariff announcement. • The economic possibilities – and likely multi-year earning power for companies – are probably less positive on balance than they were before the tariff announcement, albeit not as bad as initially feared. Rising inflation is still a concern. • The threat of higher inflation has reduced the likelihood of the early, stimulative interest rate cuts investors had hoped for. • The trade and tariff agreements the administration sought are being extracted, but the U.S. seems to be viewed around the world as a less-dependable ally and partner, and some investors may conclude they should be less heavily weighted toward U.S. assets. Implementation of this view could cause net selling and/or reduce the future demand for these assets. • The U.S.

That’s the question we must answer before the market does. (Emphasis added) Azhar references the use of off-balance sheet financing via special-purpose vehicles, or SPVs, which were among the biggest contributors to Enron’s precariousness and eventual collapse. A company and its partners set up an SPV for some specific purpose(s) and supply the equity capital. The parent company may have operating control, but because it doesn’t have majority ownership, it doesn’t consolidate the SPV on its financial statements. The SPV takes on debt, but that debt doesn’t appear on the parent’s books. The parent may be an investment grade borrower, but likewise, the debt isn’t an obligation of the parent or guaranteed by it. Today’s debt may be backed by promised rent from a data center tenant – sometimes an equity partner – but the debt isn’t a direct obligation of the equity partner either. Essentially, an SPV is a way to make it look like a company isn’t doing the things the SPV is doing and doesn’t have the debt the SPV does. (Private equity funds and private credit funds are highly likely to be found among the partners and lenders in these entities.) As I quoted earlier, according to Perez (who wrote on the heels of the dot-com bubble), “what enabled the deployment period were the money-losing investments.” Early investment is lost in the “Minsky moment,” in which unwise commitments made in an extended up-cycle encounters value destruction in a correction.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: The Impact of Debt My partner Bruce Karsh recently supplied me with a newspaper article about chess that inspired me to write a brief memo called The Indispensability of Risk. The response to the memo was favorable, hopefully because people found the content valuable, but quite possibly because it was only three pages long versus the usual ten to twelve. Thus encouraged, I’m following up with another short memo. One of my more interesting sources for readings on practical philosophy – including investment philosophy – is the blog from the Collaborative Fund to which Morgan Housel, a fund partner, is a regular contributor. As I read Housel’s musings, I often find myself saying, “that’s right in line with what I think.” And at other times, I say, as I hope others say after reading my memos, “I never thought of it that way.” I found Housel’s April 30 article, entitled “How I Think About Debt,” particularly interesting. The subject is the impact of debt on longevity, and it really boils down to a discussion of risk, one of my favorite topics. Housel starts by discussing the 140 businesses in Japan that are still operating more than 500 years after they were founded and the few that are purportedly more than 1,000 years old.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: The Indispensability of Risk Oftentimes, we’re best able to understand something we’re interested in through analogies that clarify the matter by establishing connections between it and other parts of life. That’s why I’ve written a memo comparing investing to sports in each of the four decades I’ve been writing memos and one connecting investing and card playing in 2020. The motivation for this memo comes from an article in The Wall Street Journal of April 12 that my partner Bruce Karsh sent me entitled “Chess Teaches the Power of Sacrifice” by Maurice Ashley, a chess grandmaster who has been inducted into the U.S. Chess Hall of Fame. Few people know that Bruce is a chess player, and I hadn’t thought about this fact for years, but the article provided a good reminder and moved me to dash off this memo. As is obvious from the article’s title, the piece is mostly about the role of sacrifice. Ashley says, “Many positions cannot be won or saved without something of value being given away, from a lowly pawn all the way up to the mighty queen.” Intentionally losing a piece as part of one’s gameplan is the sacrifice that Ashley is referencing. • He describes some sacrifices as “shams,” (a term coined by chess master Rudolf Spielmann in his book The Art of Sacrifice in Chess) where “. . .

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: What this means is that in good times, investors obsess about the positives, ignore the negatives, and interpret things favorably. Then, when the pendulum swings, they do the opposite, with dramatic effects. One important idea underpinning economics is the theory of rational expectations, described by Investopedia as follows: The rational expectations theory . . . posits that individuals base their decisions on three primary factors: their human rationality, the information available to them, and their past experiences. If security prices were really the result of the rational, dispassionate evaluation of data, presumably one piece of negative information would move the market down a little, and the next such piece would move it down a bit more, and so forth. But instead, we see that an optimistic market is capable of ignoring individual pieces of bad news until a critical mass of bad news builds up, at which time a tipping point is reached, the optimists surrender, and a rout begins. Rudiger Dornbush’s great quote about economics is highly applicable here: “. . . things take longer to happen than you think they will, and then they happen faster than you thought they could.” Or as my partner Sheldon Stone says, “The air goes out of the balloon much faster than it went in.” The non-linear nature of this process suggests something very different from rationality is at work.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Another classic cartoon sums up this ambiguity in fewer words. It’s highly applicable to the market tremor that inspired this memo. One more source of miscalculation is investors’ tendency toward optimism and wishful thinking. Investors in general – and equity investors in particular – must, by definition, be optimists. Who other than people with positive expectations (and/or a strong desire for increased wealth) would be willing to part with money today based on the possibility of getting back more in the future? Charlie Munger, Warren Buffett’s late partner, routinely quoted the ancient Greek statesman Demosthenes, who said, “Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.” One great example is “Goldilocks thinking”: the belief that the economy will be neither strong enough to bring on inflation nor weak enough to lapse into recession. Things sometimes work out that way – as may be the case right now – but not nearly as often as investors posit. Expectations that incline toward the positive encourage aggressive behavior on the part of investors. And if this behavior is rewarded in good times, still more aggressiveness usually ensues. Rarely do investors realize that (a) there can be a limit to the run of good news or (b) an upswing can be so strong as to be excessive, rendering a downswing inevitable.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Finally, the investment world might be less unstable if there were immutable rules – like the one governing gravity – that could be counted on to always produce the same results. But there are no such rules, since markets aren’t built on natural laws, but rather the shifting sands of investor psychology. For example, there’s a long-running adage that says we should “buy on rumor and sell on news.” That is, the introduction of favorable expectations is a buy signal, because expectations often continue to rise. That ends when the news arrives, however, because the impetus for gains has been realized and no further good news remains to take the market higher. But in the carefree environment of a month ago, I told my partner Bruce Karsh that maybe the prevailing attitude had become “buy on rumor and buy on news.” In other words, investors were acting as though it was always a good time to buy. Rationally, one shouldn’t price in the possibility of a favorable event twice: both when the possibility of the event is introduced and when the event occurs. But euphoria can get the better of people. Another example of the absence of meaningful guidelines can be seen in this excerpt from one of the oldest clippings in my file: A continuing pattern of consolidation and group rotation suggests that increasing emphasis should be placed on buying stocks on relative weakness and selling them on relative strength.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: It’s important to note that, as my partner John Frank points out, in comparison to the total number who own each company, it takes relatively few people to drive prices up during bubbles or down during crashes. When shares in a company that was worth $10 billion a month ago trade at prices implying a valuation of $12 billion or $8 billion, it doesn’t mean the whole company would change hands at these prices; just a tiny sliver. Regardless, a few emotional investors can move prices much more than should be the case. The worst thing you can do is join in when other investors go off on these irrational jags. It’s far better to watch with bemusement from the sidelines, buttressed by an understanding of how markets work. But better still to see Mr. Market’s overreactions for what they are and accommodate him, selling to him when he’s eager to buy regardless of how high the price is, and buying from him when he desperately wants out. Here’s how Ben Graham followed the introduction of Mr. Market that I included on page 1: If you are a prudent investor or a sensible businessman will you let Mr. Market’s daily communication determine your view of the value of your $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low.

” For investors, cycles, along with their causes and effects, are among the influential matters that invariably rhyme from one period to the next. Roughly 30 years ago – largely thanks to my involvement with my partner Bruce Karsh and his distressed debt funds – I became much more conscious of the importance of fluctuations in the availability and cost of money. Thus, I wrote as follows in my memo You Can’t Predict. You Can Prepare. (November 2002): The longer I’m involved in investing, the more impressed I am by the power of the credit cycle. It takes only a small fluctuation in the economy to produce a large fluctuation in the availability of credit, with great impact on asset prices and back on the economy itself. I reused that paragraph in my 2018 book Mastering the Market Cycle: Getting the Odds on Your Side, adding this: . . . the credit cycle can be easily understood through the metaphor of a window. In short, sometimes it’s open and sometimes it’s closed. And, in fact, people in the financial world make frequent reference to just that: “the credit window,” as in “the place you go to borrow money.” When the window is open, financing is plentiful and easily obtained, and when it’s closed, financing is scarce and hard to get. . . . © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: portfolios that contain only winners. The question isn’t whether you’re going to have losers, but rather how many and how bad relative to your winners. Warren Buffett – arguably the investor with the best long-term record (and certainly the longest long-term record) – is widely described as having had only twelve great winners in his career. His partner Charlie Munger told me the vast majority of his own wealth came not from twelve winners, but only four. I believe the ingredients of Warren’s and Charlie’s great performance are simple: (a) a lot of investments in which they did decently, (b) a relatively small number of big winners that they invested in heavily and held for decades, and (c) relatively few big losers. No one should expect to have – or expect their money managers to have – all big winners and no losers. In fact, not having any losers isn’t a useful goal. The only sure way to achieve that is by not taking any risk. But, as I said earlier, risk avoidance is likely to result in return avoidance. There’s such a thing as the risk of taking too little risk. Most people understand this intellectually, but human nature makes it hard for many to accept the idea that the willingness to live with some losses is an essential ingredient in investment success. Having watched some great tennis this summer – right through the U.S.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: About twenty years ago, my partner Sheldon Stone shared an interesting parable: Imagine you’re on a boat crossing Lake Erie. The captain comes on the loudspeaker and says, “Everyone run to the left side of the boat.” A minute later he says, “Everyone run to the right side.” And a minute after that he says, “Run back to the left.” It would make for an unusually rocky crossing. Today the internet and social media are the loudspeaker, which almost anyone can take over, disseminating any message they choose. This “digital herding,” as Gillian Tett of The Financial Times has labeled it, can have a huge impact in many fields, particularly those that run on information and trust. Was SVB’s Collapse Inevitable? To close the loop, I’m going to recap the interrelated factors that caused SVB to fail: • If the bank had made more loans relative to the size of its deposit base, it wouldn’t have bought as many potentially volatile bonds. • If the bonds the bank bought hadn’t had such long maturities, it wouldn’t have been as exposed to price declines. • If the Fed hadn’t raised interest rates as much as it did, the bonds wouldn’t have lost so much value. • If the depositors hadn’t exited en masse, the bank wouldn’t have had to sell bonds and realize the losses.

Open this past weekend – I’ll recycle a tennis analogy I first suggested in my memo Dare to Be Great II (April 2014). What if I went out to play tennis and said, “Today, I’m not going to commit any service faults”? My serves would have to be so meek that my opponent would likely destroy them. Tennis players have to take some risk if they hope to succeed (see below). If none of your serves fall outside the service box, you’re probably serving too cautiously to win. The same is true of investing. As my long-time partner Sheldon Stone puts it, “If you don’t experience any defaults, you’re probably not taking enough credit risk.” Winners’ Stats Looking back, it turns out I devoted an entire memo to analogies between investing and sports once per decade in the 1990s, the 2000s, and the 2010s. This time, in my fourth decade of memo-writing, I’m going to devote a few more paragraphs to tennis. As mentioned above, tennis makes for very apt comparisons to investing. Hit safely and get blasted? Or try for shots you can’t make consistently and beat yourself? Charles D. Ellis’s article “The Loser’s Game” (The Financial Analysts Journal, July/August 1975) was truly seminal in my development as an investor. He pointed out that there are two kinds of tennis players . . . actually, two different types of tennis games. Professionals play a winner’s game: They win by hitting winners (in tennis, that means shots the opponent can’t return).

So, in other words, for that person, there was no limit to negativism. And when I conclude that the other people in the market, the people setting the market prices, are excessively negative and excessively risk averse, then I – an inherently conservative person – and my partner, Bruce Karsh, who runs our distressed debt funds – also an inherently conservative person – we go crazy spending money when we conclude there’s excessive pessimism, fear, and risk aversion incorporated in asset prices [meaning they’re lower than they should be]. So it’s not just the mechanical aspects that determine market prices – it’s psychology. It’s mass hysteria, which comes in waves from time to time, that leads to market cycles that prove excessive. PS: Before I go to my next question, I’d like to come back to your point where you say it’s hard to quantify mood. But perhaps that’s exactly the problem: that we’re trying to capture it with analytical tools like Excel and MATHLAB. Or it is when, for example, you talk about, we need to measure the temperature of the market, and when we’re perceptive, we can gauge it. And it seems to me almost like when you’re trying to assess a mood in a restaurant, it’s a qualitative aspect.

Buffett, the patron saint of value investors, also practiced cigar butt investing with great success in the first decades of his career, until his partner, Charlie Munger, convinced him to broaden his definition of “value” and shift his focus to “great businesses at fair prices,” in particular because doing so would enable him to deploy much more capital at high returns. This led Buffett to invest in growing companies – such as Coca-Cola, GEICO and the Washington Post – that he could purchase at valuations that were not particularly low in the absolute, but that he found attractive given his understanding of their competitive advantages and future earnings potential. While Buffett has long understood that a company’s prospects are an enormous component of its value, his general avoidance of technology stocks throughout his career may have unintentionally caused most value investors to boycott those stocks. Intriguingly, Buffett allows that his recent investment in Apple has been one of his most successful. © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: of 2020, which “no one” thought made sense when it began. The markets certainly did a much better job of recognizing the potential impact of the Fed/Treasury actions than did most commentators.) What Do the Forecasters Know? Although it’s on the subject of stock market returns rather than inflation, I can’t fail to share some data regarding forecasts supplied by Sheldon Stone, my longest-running partner (we just passed 38 years working together). Last December, he shared a New York Times article by Jeff Sommer entitled “Clueless About 2020, Wall Street Forecasters Are at It Again for 2021” (December 18, 2020). According to the article: In December 2019, the median forecast on Wall Street held that the S&P 500 would rise 2.7% in 2020. Since the actual return on the index was 18.4%, that forecast was too low by 16 percentage points. But in April 2020, after the pandemic had taken hold (and after the initial actions on the part of the Fed, Treasury and Congress had been announced and initiated), the consensus forecast return was revised downward to negative 11% – almost 30 percentage points below the eventual outcome. Obviously, nobody could have been expected to have predicted the pandemic. Ditto for the full success of the policy response or the timing and extent of the consequent market bounce.

Calculation of Assets Under Management References to total "assets under management" or "AUM" represent assets managed by Oaktree and a proportionate amount of the AUM reported by DoubleLine Capital LP ("DoubleLine Capital"), in which Oaktree owns a 20% minority interest. Oaktree's methodology for calculating AUM includes (i) the net asset value (NAV) of assets managed directly by Oaktree, (ii) the leverage on which management fees are charged, (iii) undrawn capital that Oaktree is entitled to call from investors in Oaktree funds pursuant to their capital commitments, (iv) for collateralized loan obligation vehicles ("CLOs"), the aggregate par value of collateral assets and principal cash, (v) for publicly-traded business development companies, gross assets (including assets acquired with leverage), net of cash, and (vi) Oaktree's pro rata portion (20%) of the AUM reported by DoubleLine Capital. This calculation of AUM is not based on the © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

We saw numerous records smashed in the 11-week recovery of the stock market from its March 23 low. To sum up and over-simplify, as my partner Bruce Karsh asks in his role as devil’s advocate: can the Fed keep buying debt forever, and can its doing so keep asset prices up forever? In short, many investors appeared to conclude that it could. © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

There may be a painful correction, or in theory the markets could simply drift down to more reasonable levels – or stay flat as earnings increase – over a long period (although most of the time, as my partner Sheldon Stone says, “the air goes out of the balloon much faster than it went in”). Investing in a Low-Return World A lot of the questions I’ve gotten on the memo are one form or another of “So what should I do?” Thus I’ve realized the memo was diagnostic but not sufficiently prescriptive. I should have spent more time on the subject of what behavior is right for the environment I think we’re in. © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

As my partner Sheldon Stone puts it, “If you don’t have any defaults, you’re taking too little risk.” When I first went to work at Citibank in 1968, they had a slogan that “scared money never wins.” It’s important to play judiciously, to have more successes than failures, and to make more on your successes than you lose on your failures. But it’s crippling to have to avoid all failures, and insisting on doing so can’t be a winning strategy. It may guarantee you against losses, but it’s likely to guarantee you against gains as well. Here’s some helpful wisdom on the subject from Wayne Gretzky, considered by many to be the greatest hockey player who ever lived: “You miss 100% of the shots you don’t take.” There is no formulaic approach to investing that can be depended on to produce superior risk- adjusted returns. There can’t be. In a relatively fair or “efficient” market – and the concerted efforts of investors to find underpriced assets tend to make most markets quite fair – asymmetry is reduced, and a formula that everyone can access can’t possibly work. As John Kenneth Galbraith said, “There is nothing reliable to be learned about making money. If there were, study would be intense and everyone with a positive IQ would be rich.” If merely applying a formula that’s available to everyone could be counted on to provide easy profits, where would those profits come from? Who would be the losers in those transactions? Why wouldn’t those people study and apply the formula also?

© Oaktree Capital Management, L.P. All Rights Reserved. when it was published on July 16, I changed the title to “It’s All Good.” In the memo I complained that every asset class, every asset and every region was appreciating. In terms of amplitude, breadth and potential ramifications, I consider it the strongest, most heated upswing I’ve witnessed. A lot of this is because people seem to think everything’s good and likely to stay that way. As I saw it, overconfident investors were ignoring the possibility of things going down as well as up, swallowing promises of limitless potential, suspending disbelief, accepting financial innovation as sure to work, and embracing the trend toward increased leverage. Of course, this house of cards fell apart in short order. Thus that memo was followed by “It’s All Good . . . Really?” two weeks later, on July 30, and then by “Now It’s All Bad?” on September 10. In just eight weeks, confidence had evaporated and been replaced by widespread pessimism. And just a year after that, we witnessed the bankruptcy of Lehman Brothers and the onset of the worst financial crisis in 80 years. What this reminds us is how dangerous the world can be when confidence is too high and people are too comfortable. Also, the speed with which things can reverse demonstrates, as my partner Sheldon Stone says, that the air goes out of the balloon much faster than it goes in.

© Oaktree Capital Management, L.P. All Rights Reserved. I find it remarkable that the average high yield bond offers only about 6% today. Daily I see my partner Sheldon Stone selling callable bonds at prices of 110 and 115 because their yields to call or yields to worst start with numbers – “handles” – of 3 or 4 percent. The yields are down to those levels because of strong demand for short paper with prospective returns in that range. I’ve never seen anything like it.  As was the case in the years leading up to the onset of the crisis, the ability to execute aggressive transactions indicates the presence of risk tolerance in the markets. Triple-C bonds can be issued readily. Companies can borrow money for the purpose of paying dividends to their shareholders. And CLOs are again being formed to buy leveraged loans with heavy leverage.  The amount of leverage being applied in today’s private equity deals also indicates a return to risk taking. As The Wall Street Journal reported on December 17: Since the beginning of 2008, private-equity firms have paid an average of 42% of the cost of large buyouts with their own money, also known as “equity,” while borrowing the rest. In the past six months, the percentage has fallen to 33%, according to Thomson Reuters, close to the 31% average in 2006 and the 30% average in 2007. . . . Other measures also suggest that debt loads are hovering around pre-crisis levels.

We were even lucky enough to see the collapse of our great enemy, the USSR, and to live in a world that was generally at peace. It was a period in which the markets benefited from positive developments and overwhelmingly bullish attitudes. As my partner David Kirchheimer points out, the favorable underlying trends constituted a rising tide in the Buffett sense, meaning for a long time we didn’t get a chance to see which borrowers, risk takers and financial innovators were swimming unclothed. The picture has become less alluring with the tides less favorable, and I expect only moderate improvement in that regard. David adds that “it took many years, trillions of dollars in credit extension, and countless well-intentioned but misguided policies to get us into this mess, so it’s likely that under the best of circumstances it will take many years for the economy – and standards of living – to reach a new equilibrium, and for the financial markets to acclimate to a ‘new normal’ of possibly lower returns without the artificial effect of record government stimulus.” I feel the prosperity we enjoyed in the final decades of the twentieth century was considerably better than “normal,” and better than we’re likely to see up ahead. I’m not implying a world without growth or otherwise permanently negative. Just one without the prosperity, dynamism or positive feelings of past decades.

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

© Oaktree Capital Management, L.P. All Rights Reserved  UBelief in market efficiencyU – Although academics say the actions of intelligent investors cause assets to be priced right, I often find prices screwy. Rather than increasing market efficiency, improvements in computer and communications technology may have made the markets even more unstable. As my partner Sheldon Stone says, it’s like a cruise ship where everyone is told to stand on the port side. Then everyone simultaneously gets a message telling them to run to starboard. It makes for a rocky crossing. The New York Times wrote on August 17 that “Information may arrive instantly, but insight takes longer.” Certainly the cycles don’t seem any less volatile than they used to be, or the extremes any less irrational. In fact, in recent years, over-reliance on market efficiency may have kept people from questioning asset prices.  UInefficacy of modelsU – Quant funds invest according to models that extrapolate past patterns, operated by people who know computers and probabilities, not investment fundamentals. But models can’t tell you when past market behavior has been irrational (and thus unreliable), and they can’t predict when those patterns will change. They lead to investments that “would have worked almost all the time in the past,” but it’s amazing how often we see them derailed by once-in-a-lifetime events.

Before proceeding, it’s important to note that there is considerable unevenness in the way profitability ratios are calculated. Some people don’t look at the ratio of ending value to committed capital, but rather at the ratio of ending value to contributed capital or invested cost, sometimes called a “multiple of cost.” I consider this highly inappropriate, as it tells you how much was earned on the capital that was invested but does not deal at all with the fact that capital went undrawn (and as such it shares IRR’s great shortcoming). Certainly managers should be held responsible if they fail to promptly invest the capital commitments they accept. Multiples based on investment rather than commitment don’t accomplish this. Let’s calculate the multiple of cost – the ratio of ending value to contributed capital – to the data for Funds X and Y shown on page 4. Fund X’s ratio is 1.78 ($1,784 divided by $1,000). So is Fund Y’s ($178 divided by $100). But who doesn’t think Fund X did the better job? As opposed to a fund that calls down 10% of its committed capital and achieves a high IRR and multiple of cost, a limited partner would probably prefer a fund that draws down all of its capital and earns even a somewhat lower IRR and multiple of cost. Of course, this ultimately depends on how the limited partner feels about having capital uncalled, and on what he does with it while it is uncalled.

Only when it’s applied to a material amount of invested capital for a significant period of time does IRR produce wealth – something which is often (but not always) signified by a high TCR. Investors evaluating fund performance should look at both IRR and TCR . . . and beyond. USo, Bottom Line: Good or Bad? – Real-Life Example #3 Just as this memo was about to go to print, a friend showed me the 2005 report of a fund of funds and asked what I thought of its performance. Here are the facts: The fund was formed in mid- 2001 to buy secondary partnership interests (that is, interests in funds that limited partners want to get rid of). My friend committed $750,000. Given the carnage earlier this decade in buyout funds and, especially, venture capital funds, he felt (and still feels) his timing was quite good. The fund’s report consists of financial statements only, without any discussion to help a reader understand the implications or limitations of the figures. As concerns performance, the fund reports a since-inception internal rate of return of 27.1% and a “multiple of cost” of 1.45. So far, pretty good. But let’s go behind the numbers.  The first thing worth noting is that only $600,000 of my friend’s $750,000 capital commitment has been drawn down. He doesn’t understand why, given the dislocation of the early 2000s, all of his money hasn’t been put to work. He suspects the General Partner may have taken too much in the way of capital commitments.

© Oaktree Capital Management, L.P. All Rights Reserved Last month I was privileged to celebrate the twentieth anniversary of my partnership with Sheldon Stone, who joined me as an analyst at Citibank, moved with me to TCW, and has run our high yield bond portfolios since 1985. I found a quote from Andrew Kilpatrick’s “Of Permanent Value” with which to mark that occasion, and Shel and I agree it’s a pretty good formula for a successful partnership. I think you’ll probably start looking for the person that you can always depend on; the person whose ego does not get in his way; the person who’s perfectly willing to let someone else take credit for an idea as long as it works; the person who essentially wouldn’t let you down; who thought straight as opposed to brilliantly. Our success in retaining 100% of our senior partners since 1983, and in maintaining harmony, is something I think about a lot. In doing so, I’ve identified some of the major impediments to a smooth-running partnership. First, conflicts of demeanor or style can have a very negative effect on cohesiveness. In the bull market, the aggressive partner says, “That wet blanket’s holding us back.” In the bear market, the cautious partner says, “That animal’s getting us killed.” Many of Wall Street’s greatest flare-ups have been attributed to “culture clashes,” such as the mid-1980s battle between traders and investment bankers that brought Lehman Brothers’ independence to an end.

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

Pull out a few of the steps on this progression, and where would I be today? Here’s one more: Of all the jobs I applied for when leaving Chicago in 1969, I wanted one much more than the rest but didn’t get it. A few years ago, the company’s campus recruiter told me I had been chosen, but on the relevant morning the partner in charge came in hung over and failed to call me with the positive message he was supposed to deliver. Just think: but for that bit of “bad luck” I could have spent the next 39 years at Lehman Brothers! I know how lucky I’ve been. I find it incredibly uplifting and the source of great optimism regarding the future to know and appreciate my good fortune. Rather than detract from my satisfaction over the success I’ve enjoyed – because of having to admit it wasn’t all my own doing – this realization makes me feel fortunate to have been born when and where I was and to have benefitted from the developments that came along. I revel in my good luck. And what about the things I may have brought to my career: perhaps intelligence, insight and a talent for writing? Isn’t having these things a form of luck? Intelligent and innately talented people didn’t do anything to earn their gifts. No one can take credit for them as “something I did” or “something that was within my control.” These things, too, are luck, and something for which we should give thanks rather than take credit.

© Oaktree Capital Management, L.P. All Rights Reserved  Finally, Andersen served Enron for nineteen years, and maybe things got too comfortable. While SEC rules require that the audit partner be rotated, they don't limit the tenure of the firm. On the other hand, in Andersen's defense:  It's hard for auditors to know more than management will tell them. (It is their job, however, to tell the audit committee when they don't feel they're getting complete information and to check matters independently where they can.) There's just too much evidence to the contrary for anyone to believe that honest auditors will always sniff out dishonest management.  All of the details of the financial statements Andersen certified, and of their engagement at Enron, may have met the letter – if not the spirit – of the rules.  As in any other field, the rotten apple - the dishonest auditor, or even the incompetent one – can do a lot of damage. We don't know yet what the real role of Andersen's David Duncan was in the Enron debacle, but we may find out if he receives immunity as seems to be under discussion. Auditors are one of the shareholders' last bastions of protection. The Enron example shows us two things: their essential nature and their fallibility. We still need more help. USo Who's Left? The shareholders' ultimate protection comes from the board of directors. The directors are the representatives of the shareholders and the bosses of the CEO.

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

On November 30, a Wall Street Journal article about defections of buyout specialists to venture capital firms cited a KKR partner who had resigned to do just that. Venture capitalists and technologists, in turn, are moving to Internet firms. As a sign that it's even becoming hard for more mature technology firms to hold onto people, the CFO of Microsoft recently quit to join a fiber-optic company. Remember, Microsoft has already been public 17 years; the gold-rush is over at the established firms, and the overnight fortunes have been made. Even investment bankers are in transit; on December 14, a New York Times article on the subject was headlined “Wall St. Is Flush With Cash But Also Green With Envy.Business

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