Howard Marks on Valuation

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

But since investors’ actions toward one group of assets and the resulting price movements influence other assets and other markets – and since they ensue largely from investor psychology, which is highly contagious – I think my comments are probably applicable to other asset classes, to private assets as well as public ones, and possibly to markets outside the U.S. I’ll start by laying out where I think investment value comes from and how it should be assessed. I don’t think I’ve ever done this before in this form. It’s a big topic, but I’ll try to cover it briefly. Value Investment assets – things such as stocks, bonds, companies, and buildings – have a value, which is sometimes referred to as their “intrinsic value”: what the asset is “worth” at a point in time. This value is subjective. It can’t definitively be found anywhere – not even by AI, as far as I know – and opinions will differ as to what it is. In my parlance, the value of an asset is derived from its “fundamentals.” The fundamentals of a company, for example, encompass a great many things. These include its current earnings, its earning power in the future, the steadiness or variability of its future earnings, the market value of its component assets, the skill of management, its potential to develop new products, the competitive landscape, the strength of its balance sheet, and the myriad additional factors that will influence the company’s future.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The main job of an investment analyst – especially in the so-called “value” school to which I subscribe – is to (a) study companies and other assets and assess the level of and outlook for their intrinsic value and (b) make investment decisions on the basis of that value. Most of the change the analyst encounters in the short to medium term surrounds the asset’s price and its relationship to underlying value. That relationship, in turn, is essentially the result of investor psychology. Market bubbles aren’t caused directly by technological or financial developments. Rather, they result from the application of excessive optimism to those developments. As I wrote in my January memo On Bubble Watch, bubbles are temporary manias in which developments in those areas become the subject of what former U.S. Federal Reserve Chairman Alan Greenspan called “irrational exuberance.’’ Bubbles usually coalesce around new financial developments (e.g., the South Sea Company of the early 1700s or sub-prime residential mortgage-backed securities in 2005-06) or technological progress (optical fiber in the late 1990s and the internet in 1998-2000). Newness plays a huge part in this. Because there’s no history to restrain the imagination, the future can appear limitless for the new thing.

Assets can be tangible or intangible, and an asset’s earning power can produce earnings today and also in the future in amounts that might be higher or lower than today. Together, an asset’s current earnings, plus its power to produce earnings in the future, constitute its key fundamentals. Some investors emphasize paying a reasonable price for today’s earning power, and others are willing to bet on what they see as potential growth in earning power. Regardless, I think prudent investing has to be based on judgments regarding an asset’s present and future earning power. Once an investor has determined an asset’s intrinsic value in this way, he will have a basis for establishing a “right” price that will allow for good returns in the future. Price While value can seem theoretical and ephemeral, price is concrete. It’s the amount you pay to obtain something. Ultimately, as indicated above, doing a good job of investing comes down to estimating value appropriately and purchasing that value at a reasonable price. As mentioned above, there are a great many things that combine to make up an asset’s fundamentals. Ultimately, they can be boiled down to its earning power, and it’s from earnings that value is derived.In

The chapter I didn’t plan to write – and the one that became the most important chapter in the book and one of the longest – was the one titled “The Cycle in Attitudes Toward Risk.” Security prices fluctuate much more than do the intrinsic value and prospects of the underlying companies, and the main reason for this is the extreme volatility in the way people feel about risk. When the economy is humming, companies are reporting growing earnings, security prices are rising, and profits are piling up, people say things like: “Risk is my friend. The more risk I take, the more money I make. And anyway, I don’t see anything to worry about.are

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.

And sometimes the mood is negative and marked by pessimism, skepticism, fear of loss, and excessive risk aversion. Whereas in real life things fluctuate between pretty good and not so hot, in the minds of investors things can go from flawless to hopeless and back. When the majority of investors are optimistic, they cause price to rise and potentially exceed value. And when the pessimists reign, they cause price to decline and potentially fall short of value. Thus, a preponderance of investor psychology on one side or the other – in lieu of the rationality and objectivity on which the Efficient Market Hypothesis is predicated – can create the bargains or over-pricings the hypothesis says can’t exist. Investors should be on the lookout for them. The price of an asset means nothing in isolation. You can’t tell whether a car is good buy at $40,000 unless you know about the things that determine its market value: its make, model, age, mileage and condition. It’s the same in investing; what matters is the relationship between an asset’s price and its value. Investors call that relationship the asset’s “valuation.”

This is so because an asset’s price at any given point in time is mostly determined by investor psychology, which can be irrational and unpredictable. Thus, while the current relationship of price to underlying value should move in the expected direction, it can only be counted on to do so in the long run at best. “More likely to be” is the key phrase in the above paragraph. An undervalued asset can remain cheap – or even get cheaper – for a long time, just as an overvalued asset can become more overvalued, and then extremely overvalued, and then crazily overvalued. It’s the ability of price to go to crazy extremes that causes bubbles and crashes. If price always stopped going up when it began to exceed value, we wouldn’t have extended bull markets and bubbles (and the ensuing crashes), and vice versa. People who bet heavily that price will move in the direction of value – which we call “converging” – can be carried out if they don’t have sufficient staying power. That’s why John Maynard Keynes said, “The market can remain irrational longer than you can remain solvent.” It’s intellectually sound to expect price to move toward value rather than diverge further from it, and even to bet that it will happen, but it’s unwise and potentially dangerous to bet heavily that it’ll happen soon. As Benjamin Graham said, in the short run the market functions like a voting machine, reflecting assets’ popularity. But in the long run, it’s a weighing machine, assessing assets’ value.

Thus, we can think in terms of a “calculus of value” that I find entirely logical and almost mathematical . . . except for the fact that it’s applied by people who aren’t: • Value is what you get when you make an investment, and price is what you pay for it. • A good investment is one in which the price is right for what the value turns out to be. • Due to the volatile nature of investor psychology, asset prices fluctuate much more than fundamental value. • Thus, most price changes reflect changes in investor psychology rather than changes in fundamental value. • Because of the key role psychology plays in setting asset prices, in order to have a sense for where price stands relative to value, investors should try to gauge prevailing psychology, not just quantitative valuation parameters.

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

Morgan published a graph showing that if you bought the S&P 500 index at 23 times the coming year’s earnings per share in the period 1987-2014 (the only period for which there’s data on forward-looking p/e ratios and resulting ten-year returns), your average annual return over the subsequent ten years was between plus 2% and minus 2% every time. To the extent this p/e ratio history is relevant, it bodes pretty poorly for the S&P 500. • I concluded in my January memo that this was troublesome but not threatening, again mostly because the temporary mania or “irrational exuberance” that I believe accompanies – or gives rise to – most bubbles wasn’t present. That was then. What has happened since? The U.S. stock markets saw declines of up to 10% in the first quarter of this year, with the tech-heavy Nasdaq Composite falling the most. This was primarily the result of unspectacular economic and corporate performance, moderate but still higher-than-desired inflation, and possibly worries about valuation levels and whether the U.S. would retain its position as the world’s investment destination of choice. Then, on April 2, President Trump announced tariffs on imported goods that were much higher and much more sweeping than had been anticipated. Investors promptly concluded the tariffs were likely to cause inflation to accelerate, economic growth to slow, and the U.S. to be viewed less favorably by nations and investors around the world.

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

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Going all the way back to World War II and longer, the U.S. has been “holding the cards.” Trump believes in the strength of the U.S. and in cashing in on it. That’s what his moves on tariffs amount to: no longer “throwing the party” for the rest of the world. No longer generosity in the hope of long-term benefits, but rather transactions in which we extract fair value. I’ve received a lot of kind responses to Friday’s appearance on Bloomberg TV, and I’m going to use a comment from a viewer to bring us to a conclusion on this subject: In the 1980s, people like [current Trump economic advisor] Peter Navarro decided that Japan pulling ahead of the US in autos threatened the future of the U.S. Japan did indeed pull ahead and never looked back. The U.S. economy has more than doubled in size relative to Japan since then. It has doubled even after allowing for population changes and currency strength. It doubled in spite of losing the lead in autos, or is it that it doubled partly because of it? The margins on computer software and jet engines are probably a good deal higher than on mass-market automobiles. (Emphasis added) Japan exploited its advantages in producing autos, and the U.S. moved on to things in which it could achieve an advantage of its own. Isn’t that exactly the way things should work in dynamic economies?

Amid all these uncertainties, investors must ask whether the assumption of continued success incorporated in the prices they’re paying is fully warranted. Is exuberance leading to speculative behavior? For an extreme example, I’ll cite the trend toward venture capital investments in startups via $1 billion “seed rounds.” Here’s one vignette: Thinking Machines, an AI startup helmed by former Open AI executive Mira Murati, just raised the largest seed round in history: $2 billion in funding at a $10 billion valuation. The company has not released a product and has refused to tell investors what they’re even trying to build. “It was the most absurd pitch meeting,” one investor who met with Murati said.but

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

The cautionary signs today include these: • the optimism that has prevailed in the markets since late 2022, • the above average valuation on the S&P 500, and the fact that its stocks in most industrial groups sell at higher multiples than stocks in those industries in the rest of the world, • the enthusiasm that is being applied to the new thing of AI, and perhaps the extension of that positive psychology to other high-tech areas, • the implicit presumption that the top seven companies will continue to be successful, and • the possibility that some of the appreciation of the S&P has stemmed from automated buying of these stocks by index investors, without regard for their intrinsic value. Finally, while I’m at it, although it’s not directly related to stocks, I have to mention Bitcoin. Regardless of its merit, the fact that its price rose 465% in the last two years doesn’t suggest an overabundance of caution. I often find that, just as I’m about to release a memo for publication, something comes along that demands inclusion, and it has happened again.description:

Rather, I think it’s the average p/e ratio of 22 on the 493 non-Magnificent companies in the index – well above the mid-teens average historical p/e for the S&P 500 – that renders the index’s overall valuation so high and possibly worrisome. Why are asset prices so strong in the face of what I view as net negative developments? How can the S&P 500 have risen 14% in the four-plus months since April 1, the day before the tariffs were announced, given that most observers believe the tariffs will add to inflation, weigh on economic growth, and reduce the perception of the U.S. as the premiere investment destination? Here’s my explanation: • Investors are by nature optimistic. You must be an optimist to hand over your money to someone else in the hope of getting more back later. This is especially true of equity investors, and I think their optimism dies hard. • When they’re in an optimistic mood, investors have the ability to interpret ambiguous developments positively and overlook negatives. • The last sustained market correction ended in early 2009, meaning it’s been over 16 years since risk bearing was seriously punished and “buying the dips” wasn’t rewarded. That means no one under 35 or so – professional and amateur investors alike – has ever experienced a prolonged bear market. Older investors have experienced one or more, but, with the passage of such a long time, some may have been lulled into a false sense of security. • Although the U.S.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: we can’t answer any questions.’ ” (“This Is How the AI Bubble Will Pop,” Derek Thompson Substack, October 2) But that’s ancient history. . . already two months old. Here’s an update: Thinking Machines Lab, the artificial intelligence startup founded by former Open AI executive Mira Murati, is in early talks to raise a new funding round at a roughly $50 billion valuation, Bloomberg News reported on Thursday. The startup was last valued at $12 billion in July, after it raised about $2 billion. (Reuters, November 13) And Thinking Machines Lab isn’t alone: In one of the boldest bets yet in the AI arms race, Safe Superintelligence (SSI), the stealth startup founded by former OpenAI chief scientist Ilya Sutskever, has raised $2 billion in a round that values the company at $32 billion – despite having no publicly released product or service. (CTech by Calcalist, April 13) What’s the end state? Part of the issue with AI includes the unusual nature of this newest thing. This isn’t like a business that designs and sells a product, making money if the selling price exceeds the cost of the inputs. Rather, it’s companies building an airplane while it’s in flight, and once it’s built, they’ll know what it can do and whether anyone will pay for its services.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The graph, from J.P. Morgan Asset Management, has a square for each month from 1988 through late 2014, meaning there are just short of 324 monthly observations (27 years x 12). Each square shows the forward p/e ratio on the S&P 500 at the time and the annualized return over the subsequent ten years. The graph gives rise to some important observations: • There’s a strong relationship between starting valuations and subsequent annualized ten-year returns. Higher starting valuations consistently lead to lower returns, and vice versa. There are minor variations in the observations, but no serious exceptions. • Today’s p/e ratio is clearly well into the top decile of observations. • In that 27-year period, when people bought the S&P at p/e ratios in line with today’s multiple of 22, they always earned ten-year returns between plus 2% and minus 2%. In November, a couple of leading banks came out with projected ten-year returns for the S&P 500 in the low- to mid-single digits. The above relationship is the reason. It shouldn’t come as a surprise that the return on an investment is significantly a function of the price paid for it. For that reason, investors clearly shouldn’t be indifferent to today’s market valuation.

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • the positive psychology and “wealth effect” resulting from recent gains in markets, high-end real estate, and crypto, • the belief that, for most investors, there really is no alternative to the U.S. markets, and • the excitement surrounding today’s new, new thing: AI. These are the kinds of things that have the ability to fire investor imaginations and contribute to bull markets, and they certainly seem to be doing so now. * * * I came across a great quote last year from John Stuart Mill (1859): “He who knows only his own side of the case knows little of that.” In other words, if you’re not conversant with the arguments of those who oppose your position, you really can’t assess its validity. Thus, I can’t responsibly advance my view without giving the other side of the issue. In every strongly rising market, there has to be a justification for the extended valuations: the “bull case.” If it didn’t exist, asset prices couldn’t be where they are. It’s usually some variation on “it’s different this time.” Here’s how it goes today: A p/e ratio is basically the result of applying a discounted cash flow calculation to a stream of earnings, as described above. The main inputs for performing such a calculation and assigning a valuation are assumptions regarding the earnings’ growth rate, durability, and return on invested capital.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: Mr. Market Miscalculates In his book The Intelligent Investor, first published in 1949, Benjamin Graham, who was Warren Buffett’s teacher at Columbia Business School, introduced a fellow he called Mr. Market: Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. Of course, Graham intended Mr. Market as a metaphor for the market as a whole. Given Mr. Market’s inconsistent behavior, the prices he assigns to stocks each day can diverge – sometimes wildly – from their fair value. When he’s overenthusiastic, you can sell to him at prices that are intrinsically too high. And when he’s overly fearful, you can buy from him at prices that are fundamentally too low. Thus, his miscalculations provide profit opportunities to investors interested in taking advantage of them.

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

© 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.

But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position. In other words, it’s the primary job of the investor to take note when prices stray from intrinsic value and figure out how to act in response. Emotion? No. Analysis? Yes. August 22, 2024 © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: As the above graphs indicate, a high-risk approach introduces the potential for huge returns . . . as well as the possibility of loss. So, where’s the right place to be on this spectrum? Where can one find the best risk/return bargains? The short answer is that, according to investment theory – particularly the Efficient Market Hypothesis – there are no better (or worse) places to be. The EMH says markets price securities such that (a) their price equals their intrinsic value and (b) bearing incremental risk is rewarded fairly. Thus, bargains and over-pricings can’t exist. This is why, according to the theory, “you can’t beat the market.” The theory also suggests that if a market is at “equilibrium,” each change in prospective return is fair relative to the change in risk borne, such that all positions on the curve are equivalent in attractiveness. Move to the left, and you avoid some risk, but your prospective return drops. Move to the right, and your prospective return increases, but so does your risk. No position on the spectrum is superior to any other. It’s like a coin toss (which the EMH suggests active investing is): Neither heads nor tails is the smarter call. What About in Practice? One of my favorite quotes is attributed to Albert Einstein and Yogi Berra, among others: “In theory, there is no difference between theory and practice. In practice, there is.

And yet, when I was about two-thirds of the way through writing that book, a question dawned on me that I hadn’t considered before: Why do we have cycles? For example, if the S&P 500 has returned just over 10% a year on average over the 65 years since it assumed its present form in 1957, why doesn’t it just return 10% every year? And updating a question I asked in my memo The Happy Medium (July 2004), why has its annual return been between 8% and 12% just six times during this period? Why is it so far from the mean 90% of the time? After pondering this question for a while, I landed on what I consider the explanation: excesses and corrections. If the stock market was a machine, it might be reasonable to expect it to perform consistently over time. Instead, I think the substantial influence of psychology on investors’ decision-making largely explains the market’s gyrations. When investors turn highly bullish, they tend to conclude that (a) everything’s going to go up forever and (b) regardless of what they pay for an asset, someone else will come along to buy it from them for more (the “greater-fool theory”). Because of the high level of optimism: • Stock prices rise faster than company profits, soaring well above fair value (excess to the upside). • Eventually, conditions in the investment environment disappoint, and/or the folly of the elevated prices becomes clear, and they fall back toward fair value (correction) and then through it.

• The price declines generate further pessimism, and this process eventually causes prices to far understate the value of stocks (excess to the downside). • Resultant buying on the part of bargain-hunters causes the depressed prices to recover toward fair value (correction). The excess to the upside makes for a period of above average returns, and the swing toward excess on the downside makes for a period of below average returns. There can be many other factors at work, of course, but in my view, “excesses and corrections” covers most of the ground. We saw a number of excesses to the upside in 2020-21, and now we’re seeing corrections thereof. © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: In the 1970s, I had a loan from a Chicago bank, with an interest rate of “three-quarters over prime.” (We don’t hear much about the prime rate anymore, but it was the benchmark interest rate – the predecessor of LIBOR – at which the money-center banks would lend to their best customers.) I received a notice from the bank each time my rate changed, and I framed the one that marked the high point in December 1980: It told me the interest rate on my loan had risen to 22.25%! Four decades later, I was able to borrow at just 2.25%, fixed for 10 years. This represented a decline of 2,000 basis points. Miraculous! What are the effects of declining interest rates? • They accelerate the growth of the economy by making it cheaper for consumers to buy on credit and for companies to invest in facilities, equipment, and inventory. • They provide a subsidy to borrowers (at the expense of lenders and savers). • They reduce businesses’ cost of capital and thus increase their profitability. • They increase the fair value of assets. (The theoretical value of an asset is defined as the discounted present value of its future cash flows. The lower the discount rate, the higher the present value.) Thus, as interest rates fall, valuation parameters such as p/e ratios and enterprise values rise, and cap rates on real estate decline.

• Strong economic growth and lower interest costs added to corporate profits. • Valuation parameters rose, as described above, lifting asset prices. Stocks increased non-stop for more than ten years, except for a handful of downdrafts that each lasted a few months. From a low of 667 in March 2009, the S&P 500 reached a high of 3,386 in February 2020, for a compound return of 16% per year. • The markets’ strength encouraged investors to drop their crisis-inspired risk aversion and return to risk taking much sooner than expected. It also made FOMO – the fear of missing out – the prevalent emotion among investors. Buyers were eager to buy, and holders weren’t motivated to sell. • Investors’ revived desire to buy caused the capital markets to reopen, making it cheap and easy for companies to obtain financing. Lenders’ eagerness to put money to work enabled borrowers to pay low interest rates under less-restrictive documentation that reduced lender protections. • The paltry yields on safe investments drove investors to buy riskier assets. • Thanks to economic growth and plentiful liquidity, there were few defaults and bankruptcies. • The main exogenous influences were increasing globalization and the limited extent of armed conflict around the world. Both influences were clearly salutary. As a result, in this period, the U.S. enjoyed its longest economic recovery in history (albeit also one of its slowest) and its longest bull market, exceeding ten years in both cases.

Are you tempted to take some profits? Andrew: Dad, I’ve told you I’m not a seller. Why would I sell? H: Well, you might sell some here because (a) you’re up so much; (b) you want to put some of the gain “in the books” to make sure you don’t give it all back; and (c) at that valuation, it might be overvalued and precarious. And, of course, (d) no one ever went broke taking a profit. A: Yeah, but on the other hand, (a) I’m a long-term investor, and I don’t think of shares as pieces of paper to trade, but as part ownership in a business; (b) the company still has enormous potential; and (c) I can live with a short-term downward fluctuation, the threat © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

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

• Bulletin boards like Reddit turned investing into a social activity for people shut in at home. • As a result, large numbers of novice retail investors were recruited online, many of whom lacked the experience needed to know what constitutes investment merit. • Newcomers were stirred by a popular cult figure who said, “stocks only go up.” • As a result, many tech and “meme stocks” soared. The final element worth discussing is cryptocurrency. Proponents of Bitcoin, for example, cite its variety of uses, as well as the limited supply relative to the potential demand. Skeptics, on the other hand, point to Bitcoin’s lack of cash flow and intrinsic value and thus the impossibility of assigning a fair price. Regardless of which side will turn out to be right, Bitcoin satisfies some characteristics of a bull market beneficiary: © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • a wave of IPOs from money-losing companies; • record issuance of sub-investment grade securities, including risky CCC-rated debt; • debt issuance from companies in volatile industries such as tech and software that lenders are likely to shun in more cautious times; • rising valuation multiples on acquisitions and buyouts; and • shrinking risk premiums. Favorable developments also encourage the increased use of leverage. Leverage magnifies gains and losses, but in bull markets, investors feel sure of gains and disregard the possibility of loss. Under such conditions, few can see a reason not to incur debt – with its piddling interest cost – to increase the payoff from their successes. But putting more debt on investments made at high prices late in the up-cycle is no formula for success. When times turn bad, leverage turns disadvantageous. And when investment banks issue late-cycle debt that they can’t place with buyers, they’re stuck with it. Debt “hung” on banks’ balance sheets is often a “canary in the coal mine” with regard to what’s in store. Since I’m relying on time-worn investment adages, it’s appropriate at this point to invoke the one I consider the greatest regarding investor behavior over cycles: “What the wise man does in the beginning, the fool does in the end.

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

These things are innovative; they’re the reflection of people’s minds as applied to financial problems. But the tendencies of the human mind itself tend to rhyme over the years. By the way, the first time I ever came across the saying you mentioned – “It’s different this time” – was October the 11th of 1987. There was an article in The New York Times entitled “Why This Market Cycle Isn’t Different.” It talked about the fact that people often say it’s different this time and that this saying is generally employed to explain why historical norms don’t apply anymore: norms of valuation and the rhymes that I was just talking about. Anise Wallace wrote that article – it made a big impression on me – and she said, “You know what? This time it’s no different; these things will eventually lead to the same outcomes as they always have.” [The assertion that things were different was being used at the time to justify the very high stock market valuations. As it happens, the article ran just eight days before “Black Monday,” on which the Dow Jones Industrial Average declined by 22.6% in a single day.] Wallace mentioned that Sir John Templeton said, “About 20% of the time, things actually do change.” I wrote another memo within the last two years in which I said that, given the ubiquity of technology and the high rate of innovation, I think things actually do change more than 20% of the time. So you shouldn’t bet your life on the fact that the world doesn’t change.

Investors should find a way to keep their hands off their portfolios most of the time. A Special Word in Closing: Asymmetry “Asymmetry” is a concept I’ve been conscious of for decades and consider more important with every passing year. It’s my word for the essence of investment excellence and a standard against which investors should be measured. First, some definitions: • I’m going to talk below about whether an investor has “alpha.” Alpha is technically defined as return in excess of the benchmark return, but I prefer to think of it as superior investing skill. It’s the ability to find and exploit inefficiencies when they’re present. • Inefficiencies – mispricings or mistakes – represent instances when an asset’s price diverges from its fair value. These divergences can show up as bargains or the opposite, over-pricings. • Bargains will dependably perform better than other investments over time after adjustment for their riskiness. Over-pricings will do the opposite. • “Beta” is an investor’s or a portfolio’s relative volatility, also described as relative sensitivity or systematic risk. People who believe in the efficient market hypothesis think of a portfolio’s return as the product of the market’s return multiplied by the portfolio’s beta. This is all it takes to explain results, since there are no mispricings to take advantage of in an efficient market (and so no such thing as alpha).

My extensive discussions with Andrew led me to conclude that the focus on value versus growth doesn’t serve investors well in the fast-changing world in which we live. I’ll start by describing value investing and how investors might think about value in 2021. What is Value Investing? Value investing is one of the key disciplines in the world of investing. It consists of quantifying what something is worth intrinsically, based primarily on its fundamental, cash flow-generating capabilities, and buying it if its price represents a meaningful discount from that value. Cash flows are estimated as far into the future as possible and discounted back to their present value using a discount rate made up of the prevailing risk-free rate (usually the yield on U.S. Treasurys) plus a premium to compensate for their uncertain nature. There are a lot of common valuation metrics, like the ratio of price to sales, or to earnings, but they’re largely subsumed by the discounted cash flow, or DCF, method. Now, determining this value in practice is quite challenging, and the key to success lies not in the ability to perform a mathematical calculation, but rather in making superior judgments regarding the relevant inputs. Simply put, the DCF method is the main tool of all value investors in their effort to make investment decisions based on companies’ long-term fundamentals.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: based on the manic-depressive ups and downs of a character Benjamin Graham called “Mr. Market.” On any given day, Mr. Market can be exuberant or despondent, and he quotes prices for securities based on how he feels. The value investor understands that – rather than informing us as to what a given asset’s value is – Mr. Market is there to serve us by offering up securities at prices, which can be meaningfully disconnected from the actual value of a stake or claim in the underlying business. In doing so, he sometimes gives us the opportunity to snatch up shares or bonds at a meaningful discount from their intrinsic value. This activity requires independent thought and a temperament that resists the emotional pull of the market cycle, making for decisions based solely on value. Thus, to me the essential underlying principles of value investing are these: • the understanding of securities as stakes in actual businesses, • the focus on true worth as opposed to price, • the use of fundamentals to calculate intrinsic value, • the recognition that attractive investments come when there is a wide divergence between the price at which something is offered in the market and the actual fundamental worth you’ve determined, and • the emotional discipline to act when such an opportunity is presented and not otherwise. Value vs.

Growth Over the last 80-90 years, two important developments occurred with regard to investing style. The first was the establishment of value investing, as described above. Next came “growth investing,” targeting a new breed of companies that were expected to grow rapidly and were accorded high valuation metrics in recognition of their exceptional long-term potential. It seems likely that the label “value” was applied to the value school because one of its greatest early popularizers, Ben Graham, practiced a low-valuation style. Deemed “cigar butt” investing by his protégé Warren Buffett, Graham’s style emphasized the search for pedestrian companies whose shares were selling at discounts from liquidation value based on the assets on their balance sheets, which Buffett likened to searching the street for used cigar butts that had one last puff left in them. It is this style that Graham preached in his Columbia Business School classes and his books, Security Analysis and The Intelligent Investor, which are considered the bibles of value investing. His investment style relied on fixed formulas to arrive at measures of statistical cheapness. Graham went on to achieve enviable investment performance although, funnily enough, he would later admit that he earned more on one long- term investment in a growth company, GEICO, than in all his other investments combined.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Over time, a subset of value investors adopted a harder-line approach, with a pronounced emphasis on low valuation metrics. Graham and Buffett’s cigar butts had featured low valuation metrics, and this no doubt caused some value investors to elevate this characteristic to be the core consideration in their investment process. It’s interesting to note that the methodology for populating the S&P 500 Value Index relies solely on finding the one-third of the S&P 500’s market capitalization with the highest ratio of Value Rank (based on the lowest average multiple of earnings, sales and book value) to Growth Rank (based on the highest three-year growth in sales and earnings and 12-month price change). In other words, the stocks in the Value Index are those that are most characterized by “low-valuation parameters” and least characterized by “growth.” But “carrying low valuation parameters” is far from synonymous with “underpriced.” It’s easy to be seduced by the former, but a stock with a low p/e ratio, for example, is likely to be a bargain only if its current earnings and recent earnings growth are indicative of the future. Just pursuing low valuation metrics can lead you to so-called “value traps”: things that look cheap on the numbers but aren’t, because they have operating weaknesses or because the sales and earnings creating those valuations can’t be replicated in the future.

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

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: allowed that 20 percent of the time they’re right. Given the rising impact of technology in the 21st century, I’d bet that percentage is a lot higher today. It’s also worth noting with regard to truly dominant companies that are able to achieve rapid, durable and highly profitable growth that it is very, very hard to overprice them based on near-term multiples. The basic equations of finance were not built to handle high-double-digit growth as far as the eye can see, making the valuation of rapid growers a complicated matter. As John Malone famously said, if your long-term growth rate exceeds your cost of capital, your present value is infinite. However, this is only true for truly special companies, which are few and far between and certainly not as ubiquitous as is generally implied by the market in times of ebullience.

It’s important to note, that when markets are at extreme levels of optimism, as we saw in both the Nifty Fifty and Dot Com bubbles, (a) every company in the affected field is treated as a long-term winner, (b) if bought in times of significant optimism and extreme valuations for growth, the stocks of even the greatest companies are likely to produce outcomes that are mediocre at best, and (c) in the crashes that follow most bubbles, enormous interim markdowns can befall good companies as well as bad, requiring sharp analysis to differentiate between them, and high conviction and an iron stomach to hold on. I want to make very clear that I do not intend this to imply an opinion about growth stocks’ valuations today. I’ve heard a variety of views, and while I have my own, I don’t want to make it the subject of this memo. In the spirit of seeking to understand this new world, market commentators (including me) would be well served to understand the fundamentals underpinning the small number of companies that currently drive a huge percentage of the market, instead of basing top-down conclusions on purely historical valuation comparisons. And it seems imprudent to opine on the level of the overall market without being fully informed regarding the tech companies that now account for so much of equity indices like the S&P 500.

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

The key, as always, is to understand how today’s market price relates to the company’s broadly defined intrinsic value, including its prospects. The Heart of the Problem Consider two companies. Company A is a respected long-term competitor selling a widely consumed, fairly prosaic product. It has built a decades-long record that shows modest but steady sales growth and healthy profit margins. It manufactures its product using heavy machinery located on its own premises. Its stock sells at a modest multiple of earnings per share. © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

What happens to parts of the country that are left out of the new economy? Finally, much of the worry about whether we’re in a bubble relates to valuations. For the S&P 500, for example, the current ratio of price to projected 2021 earnings is roughly 22 (depending on which earnings estimates you use). This seems expensive compared to the historic average in the range of 15- 16. But knee-jerk judgments based on the relationship between current valuations and historic averages are too simplistic to be dispositive. Before making a judgment about today’s valuation of the S&P 500, one must consider (a) the context in terms of interest rates, (b) the shift in its composition in favor of rapidly growing technology companies, with their higher valuations, (c) the valuations of the index’s individual components, including those tech companies, and (d) the outlook for the economy. With these factors in mind, I don’t think most of today’s asset valuations are crazy. Of course, a big correction in speculative stocks could have a negative impact on today’s bullish investor psychology. © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

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

This possibility means (a) bonds with maturities much above ten years are obvious candidates for underweighting and (b) inflation beneficiaries should be considered for overweighting, including floating-rate debt, real estate capable of seeing rent increases, and the stocks of companies with the power to pass on price increases and/or the potential for rapid earnings growth. When it comes to finding decent returns in this environment, the options are slim. Investors have plowed capital into the mainstream public “beta” markets. As a result, prospective returns have come down – fully reflecting the reduction in interest rates – and markets have become quite efficient. In most cases, price has converged with – if not run ahead of – intrinsic value. That means it’s harder than ever to outperform, other than by taking on additional risk and being lucky enough to do so in an environment where such action is rewarded. Although no markets are starved for capital these days, there may be alternative “alpha” markets where investment skill can add to returns, hopefully without a commensurate increase in overall risk. Some of this additional return is simply a premium for bearing illiquidity, and the pain suffered by some institutions during the 2008-09 crisis shows how important it is to correctly assess one’s ability to live with illiquidity.

What if he had scaled out early? Fortunately, (a) Oaktree’s business consists mostly of garnering valuation discrepancies; (b) because of their nature, our asset classes offer up relatively few opportunities to err by prematurely selling off potential mega-multiple winners; (c) Oaktree’s decentralized structure insulates our portfolio managers from the extremes of my caution; and (d) my colleagues do a better job of letting their winners run than I might have. We might have done more if I didn’t have my limitations. Maybe I could have remained in equities, or even become a venture capitalist and seeded Amazon. But I can’t complain – things couldn’t have turned out better. © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

The Oaktree Emerging Markets Equities performance results displayed herein represent the investment performance record for a composite of emerging markets long-only accounts managed by Oaktree. The Composite includes all fully discretionary accounts invested in the Emerging Markets Equity strategy. The performance information set forth herein contains valuations of investments in companies that have not been fully realized as of December 31, 2020, or as otherwise noted. Oaktree values its investments in accordance with U.S. GAAP. Information regarding the valuation procedures and policies for each Oaktree fund, account or strategy mentioned herein is available upon request. There can be no assurance that any of these valuations will be attained as actual realized returns will depend upon, among other factors, future operating results, the value of the assets and market conditions at the time of disposition, any related transaction costs and the timing and manner of sale, all of which may differ from the assumptions upon which the valuations contained herein are based. Consequently, the actual realized returns may differ materially from the current returns indicated in this communication. Nothing contained herein should be deemed to be a prediction or projection of future performance. For more information or a description of the benchmark presented, please contact your Oaktree representative.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: To end, I’ll pull together what I consider the key conclusions: • Value investing doesn’t have to be about low valuation metrics. Value can be found in many forms. The fact that a company grows rapidly, relies on intangibles such as technology for its success and/or has a high p/e ratio shouldn’t mean it can’t be invested in on the basis of intrinsic value. • Many sources of potential value can’t be reduced to a number. As Albert Einstein purportedly said, “Not everything that counts can be counted, and not everything that can be counted counts.” The fact that something can’t be predicted with precision doesn’t mean it isn’t real. • Since quantitative information regarding the present is so readily available, success in the highly competitive field of investing is more likely to be the result of superior judgments about qualitative factors and future events. • The fact that a company is expected to grow rapidly doesn’t mean it’s unpredictable, and the fact that another has a history of steady growth doesn’t mean it can’t run into trouble. • The fact that a security carries high valuation metrics doesn’t mean it’s overpriced, and the fact that another has low valuation metrics doesn’t mean it’s a bargain. • Not all companies that are expected to grow rapidly will do so. But it’s very hard to fully appreciate and fully value the ones that will.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Appendix: Dealing with Winners in Practice The conclusions described above regarding how to deal with winners shouldn’t be taken to mean it was easy for Andrew and me to reach agreement on this subject. The discussion here was our most spirited, and we returned to it many times. Our talks usually went something like this: Howard: Hey, I see XYZ is up xx% this year and selling at a p/e ratio of xx. Are you tempted to take some profits? Andrew: Dad, I’ve told you I’m not a seller. Why would I sell? H: Well, you might sell some here because (a) you’re up so much, (b) you want to put some of the gain “in the books” to make sure you don’t give it all back and (c) at that valuation, it might be overvalued and precarious. And, of course, (d) no one ever went broke taking a profit. A: Yeah, but on the other hand, (a) I’m a long-term investor, and I don’t think of shares as pieces of paper to trade, but as part ownership in a business, (b) the company still has enormous potential, and (c) I can live with a short-term downward fluctuation, the threat of which is part of what creates opportunities in stocks to begin with. Ultimately, it’s only the long term that matters. (There’s a lot of a-b-c in our house. I wonder where Andrew got that.) H: But if it’s potentially overvalued in the short term, shouldn’t you trim your holding and pocket some of the gain?

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

Coca-Cola reached 46x earnings at the height of the bubble in mid-1972 – 2.4x the p/e on the S&P 500. From there it fell 65% over the next year and a half. A: First, saying a high p/e alone shouldn’t stop you from owning something doesn’t mean there’s no price too high. It simply means that no single metric can hold the key to investment decisions, and the price of something should be weighed against its fundamental potential. Coke may have been overvalued in 1972 at its p/e of 46. In particular, since it dealt in a physical product and required incremental capital to grow, © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Intelligent investors concentrate portfolios and hold on to take advantage of what they know, but they diversify holdings and sell as things rise to limit the potential damage from what they don’t know. Hasn’t the growth in this position put our portfolio out of whack in that regard? A: Perhaps that’s true, depending on your goals. But trimming would mean selling something I feel immense comfort with based on my bottoms-up assessment and moving into something I feel less good about or know less well (or cash). To me, it’s far better to own a small number of things about which I feel strongly. I’ll only have a few good insights over my lifetime, so I have to maximize the few I have. H: Isn’t there any point where you’d begin to sell? A: In theory there is, but it largely depends on (a) whether the fundamentals are playing out as I hope and (b) how this opportunity compares to the others that are available, taking into account my high level of comfort with this one. H: If there’s a point at which you’d start to sell, what it is? Isn’t setting a target price based on intrinsic value an important part of value investing? A: This company can’t be valued with a single number – and it’s not a mature company with a fixed value I’m trying to capture – so I can’t tell you where I’d start to sell.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: One way to think about the balance between offense and defense is to consider the “twin risks” investors face every day: the risk of losing money and the risk of missing opportunity. At least in theory, you can eliminate either one but not both. Moreover, eliminating one exposes you entirely to the other. Thus we tend to compromise or balance the two risks, and every individual investor or institution should develop a view as to what their normal balance between the two should be. Next, investors might consider trying to calibrate their balance over time in response to conditions in the environment – thus the title of this memo: • The more propitious the environment – the more prudently other investors are behaving, the better the outlook for earnings, and the lower security prices are relative to intrinsic value or “fundamentals” – the more an investor might want to shift toward offense. • On the other hand, the more precarious the environment – the more others are embracing risk, the more headwinds to profits there are, and the higher valuations are – the more an investor might choose to emphasize defense. In recent years, it’s been my view that the investment world was marked by the following characteristics: • more uncertainty than usual, • extremely low prospective returns, • full to high asset prices, and • pro-risk behavior on the part of investors reaching for higher returns.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: every purchase, do you insist on being sure the thing in question will never be available lower? That is, that you’re buying at the bottom? I doubt it. You probably buy because you think you’re getting a good asset at an attractive price. Isn’t that enough? And I trust you sell because you think the selling price is adequate or more, not because you’re convinced the price can never go higher. To insist on buying only at bottoms and selling only at tops would be paralyzing. On the contrary, I gave this memo the title Calibrating because of my view that a portfolio’s positioning should change over time in response to what’s going on in the environment. As the environment becomes more precarious (with prices high, risk aversion low and fear lacking), a portfolio’s defensiveness should be increased. And as the environment becomes more propitious (with prices low, risk aversion high and fear prevalent), its aggressiveness should be ramped up. Clearly, this process is one of gradual readjustment, not a matter of all-or-nothing. It shouldn’t be the goal to do this only at bottoms and tops. So it’s my view that waiting for the bottom is folly. What, then, should be the investor’s criteria? The answer’s simple: if something’s cheap – based on the relationship between price and intrinsic value – you should buy, and if it cheapens further, you should buy more.

No, he said, it would only buy government and agency obligations. As mentioned above, a few weeks ago the Fed added investment grade corporates to its buying list, and last week it dropped down to include some high yield securities (BBBs downgraded to BB and some high yield ETFs). It also gave regulatory relief to business developments companies, or BDCs, which buy or make loans to mid-size businesses. In order to help them avoid tripping limits on their activities, the Fed said they can value the loans on their books at December 31 prices. “The SEC is primarily trying to address the issue that a temporary markdown in the fair value of BDC portfolio companies could increase leverage above the regulatory maximum, thus limiting further lending by a BDC. As such, © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • the third stage, when everyone concludes everything will get better forever. Looking back (which is the main way we know these things), the first stage began in mid-March and culminated on March 23. Certainly very few people were thinking about economic improvement or stock market gains around that time. Then we passed briefly through stage two and went straight to stage three. Certainly by the time the interim high was reached on June 8, it felt like the market was being valued in a way that focused on the positives, swallowed them whole, and overlooked the negatives. That’s nothing but a value judgment on my part. It’s just my opinion that the imbalance of attention to – and blanket acceptance of – the positives was overdone. I had good company in being skeptical of the May/June gains. On May 12, with the S&P 500 up a startling 28% from the March 23 low, Stan Druckenmiller, one of the greatest investors of all time, said, “The risk-reward for equity is maybe as bad as I’ve seen in my career.” The next day, David Tepper, another investing great, said it was “maybe the second-most overvalued stock market I’ve ever seen. I would say ’99 was more overvalued.

but likewise we have no basis on which to judge how actual developments will compare against the expectations investors already have factored into asset prices.) Instead, intelligent investing has to be based – as always – on the relationship between price and value. In other words, not “will the collapse go further?” But rather “has the collapse to date caused securities to be priced right; or are they overpriced given the fundamentals; or have they become cheap?” I have no doubt that assessing price relative to value remains the most reliable way to invest for the long term. (It is the thrust of the whole discussion just above that there’s nothing that provides reliable help in the short term.) I want to acknowledge up front that ascertaining intrinsic value is never a simple, cut-and-dried thing. Now – given the possibility that the virus will cause the world of the future to be very different from the world we knew – is value too unascertainable to be relied upon? In short, I don’t think so. What I think we do know is that the coronavirus is not a rerun of the Spanish flu pandemic of 1918, “which infected an estimated 500 million people worldwide – about one-third of the planet's population – and killed an estimated 20 million to 50 million victims, including some 675,000 Americans.” (history.com) Rather, it’s one more seasonal disease like the flu, something we’ve had for years, have developed vaccines for, and have learned to deal with.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The U.S. stock market’s down about 13% from the top. That’s a big decline. It would be a lot to accept that the U.S. business world – and the cash flows it will produce in the future – are worth 13% less today than they were on February 19. That sentence may make it sound like I think the market’s undervalued. But that’s not the proper interpretation. If it was overvalued on the 19th, rather than being undervalued today, after the decline, it could just be less overvalued. Or it could be fairly valued, or even undervalued, but it isn’t necessarily. I think the stock market was overvalued two weeks ago . . . somewhat. That means I think that today, even with the short-term prospects of business somewhat diminished, it’s closer to fairly valued, but not necessarily a giveaway. In the starkest numerical terms, before the rout, the p/e ratio on the S&P 500 was 19 or so, roughly 20% above the post-World War II average (and there are arguments on both sides regarding the current applicability of that average). Thus, after a 13% decline, you’d have to say the p/e ratio is pretty close to fair (unless earnings for the year will be very different from what they previously had been expected to be). Buy, sell or hold? I think it’s okay to do some buying, because things are cheaper. But there’s no logical argument for spending all your cash, given that we have no idea how negative future events will be.

Today’s leaders are often compared to the Nifty Fifty, but they’re much better companies: larger; faster growing with greater potential for prolonging that growth; capable of higher gross margins (since in many cases there’s no physical cost of production); more dominant in their respective markets (because of scale, greater technological superiority and “lock in,” or impediments to switching solutions); more able to grow without incremental investment (since they don’t require much in the way of factories or working capital to make their products); and possibly valued lower as a multiple of future profits. This argues for a bigger valuation gap and is perhaps the most provocative element in the pro-tech argument. Of course, many of the Nifty Fifty didn’t prove to be as powerful as had been thought. Xerox and IBM lost the lead in their markets and experienced financial difficulty; the markets for the products of Kodak and Polaroid disappeared, and they went bankrupt; AIG required a government bailout to avoid bankruptcy; and who’s heard from Simplicity Pattern lately? Today’s tech leaders appear much more powerful and unassailable. © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

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

Here’s what Barclays reported on October 7: Yesterday, US large-cap technology stocks (i.e. Facebook, Amazon, Google and Apple) came under pressure after the House antitrust subcommittee released a 449-page report proposing far-reaching antitrust reforms. Recommendations include structural separation, prohibiting a dominant platform from operating in competition with the firms dependent on it and line-of-business restrictions, limiting the markets in which a dominant firm can engage. There are two groups of stocks in the indices, and the representation of tech stocks is large and expanding. In the S&P 500, for example, roughly one-quarter by value consists of tech and software companies that are fast growing and have the ability to increase both revenues and profit margins, and the remaining three-quarters is slow growing and already enjoying maximum margins. Today’s tech leaders are more superior than ever to run-of-the-mill companies, rendering indices that include both types of company less relevant than ever. Or so it’s argued. Regardless of where you come out on that question, if an index consists 25% of great growth companies at high multiples (up roughly 30% this year as of the end of September) and 75% more pedestrian companies at low multiples (up 4%), the average figures in terms of growth, valuation and performance might not be meaningful enough to support conclusions about “the stock market.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • The same uncertainties exist as were present last year (except that the recession and ending of the bull market that were considered ultimately inevitable have come and gone). In addition, we have some new uncertainties. The full list includes the battle against Covid-19, the shape of the recovery, the implications of the election and whether it will go smoothly, worry about higher taxes and more redistribution, the divisiveness in our country, and the outlook for racial harmony. • If prospective returns were low in the last few years, they’re even lower today thanks to the reduction of interest rates. A near-zero return on cash, 2% on investment grade debt, 5% on high yield bonds, 5-6% expected from equities – at the same time as lots of capital is eager to be put to work. Adequate returns are likely to be hard to come by. • The stock market is back near the high reached in February and selling at an above average valuation (as described earlier). The only things that appear to be low-priced are the ones that appear fundamentally most risky, such as oil & gas, retailers and retail real estate, office buildings and hotels, and low-rated tranches of structured credit. As I said earlier, everything appears to be fairly priced relative to everything else, but nothing is cheap thanks to the low base interest rate. • Thus, after a brief foray into bargain-land in March, we’re back to a low-return world.

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: markets have penalized heavily levered companies and rewarded those that are cash-rich. But if having negative-yield debt outstanding becomes a source of income, will levered companies be considered more creditworthy? Conversely, how will the market value businesses that hold a lot of cash and thus have to pay banks to keep it on deposit?  Financial models and algorithms – which essentially are a matter of looking for and profiting from deviations from historic relationships – may not work as well as they did in the past, since history (all of which has been based on positive interest rates) may be out the window. Nobel prizes have been awarded to economists that developed concepts such as the efficient frontier, the Capital Asset Pricing Model and the Black- Scholes option pricing model. But when a negative value is assumed for the risk-free rate in these types of models, fair value results shoot off toward infinity. With trillions of securities and derivatives dependent on these models, valuation is critical. (Jim Bianco, op. cit.) The one thing we can’t be sure of is that negative rates increase economic growth (or produce more growth than is generated by low rates). First, this requires “what-if” analysis, which is one of the most difficult kinds: are Europe and Japan growing faster today than they would have if their rates weren’t negative?

” For example, the current recovery is one of the longest ever; the GDP growth rate is at the top of the range for the last decade; and profit margins are well above average. Things like these can continue or even get better, but the odds are against it. It feels as if we may get through the next 18 months without a recession, but if we do, that’ll make this the longest recovery since the 1850s. Certainly not impossible, but against the odds.  Most valuation parameters are either the richest ever (Buffett ratio of stock market capitalization to GDP, price-to-sales ratio, the VIX, bond yields, private equity transaction multiples, real estate capitalization ratios) or among the highest in history (p/e ratios, Shiller cycle-adjusted p/e ratio). In the past, levels like these were followed by downturns. Thus a decision to invest today has to rely on the belief that “it’s different this time.”  Prospective returns in the vast majority of asset classes are some of the lowest in history.  The need of investors to wring out good returns in this “low-return world” is causing them to engage in what I call pro-risk behavior. They’re paying high prices for assets and accepting risky and poorly structured propositions. In such a climate, it’s hard for “prudent” investors to insist on traditional levels of safety. Investors who don’t want to sign on for risk (that is, who “refuse to dance”) can be constrained to the sidelines. © 2018 OAKTREE CAPITAL MANAGEMENT, L.P.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us:  As a result, we see a lot of the reaction that greeted my July memo: “the market’s expensive, but I think it has further to go.” How healthy can it be when investors think an asset or market is rich but they’re holding anyway because they think it might go up some more? Fear of missing out (or “FOMO”) is one of the more powerful reasons for investor aggressiveness, and also one of the most dangerous.  Market behavior implies a level of equanimity on investors’ part that could prove unrealistic (and thus subject to reversal). For example, 2017 was the first year in history in which the S&P 500 didn’t decline from high to low by more than 3% at least once. Likewise, in a six-month period late in the year, the VIX (an indicator of the level of volatility implied by investors’ pricing of S&P 500 options) closed below a reading of ten more than 40 days; never before had it done so more than six times in a six-month period (The New York Times, January 14).  It appears many investment decisions are being made today on the basis of relative return, the unacceptability of the returns on cash and Treasurys, the belief that the overpriced market may have further to go, and FOMO. That is, they’re not being based on absolute returns or the fairness of price relative to intrinsic value. Thus, as my colleague Julio Herrera said the other day, “valuation is a lost art; today it’s all about momentum.

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

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The market seems extremely comfortable with the proposition that as long as the macro- environment remains benign, stocks prices can continue to appreciate at rates that far outstrip the growth of their issuers’ profits, and thus the growth of their intrinsic value. Few market participants seem concerned about appropriate valuation levels – the relationship between assets and their prices – and this is a condition that we think must eventually have negative consequences. . . . Today’s combination of a stable economy, low interest rates, enormous cash flows and strong investor optimism has created a climate in which capital is available for both good investments and bad, and in which risk is rarely seen as something to be shunned. I wrote that in 1997, in a clients-only memo entitled “Are You an Investor or a Speculator?” I was cautionary then, like I am now. And it took almost three years for that to turn out to be correct. That doesn’t mean it wasn’t correct when it was written . . . just early. Today there’s beginning to be talk of a possible late-bull-market melt-up, making investors more money but perhaps fulfilling the requirements for a full-fledged bubble. (This may be part of the usual pattern of capitulation that occurs when those who haven’t fully participated lose the will to keep abstaining after years of market gains.)

The basic themes supporting the “melt-up” theory include (a) the existence of the fundamental positives listed above and (b) the arrival of euphoric psychology, which has been absent to date. For me the key points regarding the general market outlook are as follows:  The absence of widespread euphoria certainly is an important flaw in any near-term bearish view.  Thus there’s no reason for confidence in the existence of a soon-to-burst bubble.  Investor psychology continues to grow more confident, however.  Asset prices are already unusually high.  Future events remain unpredictable, but today’s high prices mean the odds are against a significant long-term upward move from here.  No one can say what’s going to happen in the short term. Asset prices and valuation metrics are certainly worrisome, but psychology and its implications – as well as timing – are unpredictable. I think that’s about all we can know. Thus Oaktree will continue to invest on the basis of value and its relationship to price, and to refrain from trying to time markets based on predictions regarding economies, markets or psychology. The “melt-up” school says securities that already are highly priced may become more so. We’d never bet on whether they will or won’t. Our post-2011 mantra remains in force: we’re investing when we find reasonable propositions, albeit with caution.

That’s probably not enough; most money is still managed actively, meaning a lot of price discovery is still taking place. Certainly 100% passive investing would suffice: can you picture a world in which nobody’s studying companies or assessing their stocks’ fair value? I’d gladly be the only investor working in that world. But where between 40% and 100% will prices begin to diverge enough from intrinsic values for active investing to be worthwhile? That’s the question. I don’t know, but we may find out . . . to the benefit of active investing. The third key question is: “Does passive and index investing distort stock prices?” This is an interesting question, answerable on several levels. The first level concerns the relative prices of the stocks in a capitalization-weighted index. People often ask whether inflows of capital into index funds cause the prices of the heaviest-weighted stocks in the index to rise relative to the rest. I think the answer is “no.” Suppose the market capitalizations of the stocks in a given index total $1 trillion. Suppose further that the capitalization of one popular stock in the index – perhaps one of the FAANGs – is $80 billion (8% of the total) and that of a smaller, less-adored one is $10 billion (1%). That means for every $100,000 in an index fund, $8,000 is in the former stock and $1,000 is in the latter. It further means that for every additional $100 that’s invested in the index, $8 will go into the former and $1 into the latter.

One equity analyst says that’s a reasonable valuation, since it’s 5x estimated 2020 revenues. Another has a target price 25% below the current price, although to get to that valuation the analyst assumes the company will be able to expand its gross margin by 30% a year for the next 12 years and be valued at 6x EBITDA in 2030.  Over the last two years, company D has spent an amount on buybacks equal to 85% of a year’s EBITDA. In part because of the buybacks, the company now has much more debt than it did two years ago. In contrast to the last two years, we estimate that in the seven preceding years, it spent only one-tenth as much on buybacks as in the last two years, at an average purchase price 85% below the more recent average.  A buyout fund just bought company E, a terrific company, for 15x EBITDA, a very high “headline figure.” The price is based on adjusted EBITDA which is 125% of reported EBITDA; thus the transaction price equates to 19x reported EBITDA. Stated leverage is 7x adjusted EBITDA, meaning 9x reported EBITDA. “We aren’t saying this will wind up being a bad deal. Just saying that IF this ends up being a bad deal, no one will be surprised. Everyone will say, with the benefit of hindsight, ‘they paid way too much and put way too much debt on the balance sheet, and it was doomed out of the gate.’ ”  Company F earns substantial EBITDA, but 60% comes from a single unreliable customer, and its growth is constrained by geography.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: And as I told CNBC, what matters is “the level that securities are trading at and the emotion that is embodied in prices.” Investors’ actions should be governed by the relationship between each asset’s price and its intrinsic value. “It’s not what’s going on; it’s how it’s priced. . . . When we’re getting value cheap, we should be aggressive; when we’re getting value expensive, we should pull back.” Here’s how I summed up on Bloomberg: It’s all about investors’ willingness to take risk as opposed to insisting on safety. And when people are highly willing to take risk, and not concerned about safety, that’s when I get worried. If it’s true, as I believe, that (a) the easy money in this cycle has been made, (b) the world is a risky place, and (c) securities are priced high, then people should probably be taking less risk today than they did three, five or seven years ago. Not “out,” but “less risk” and “more caution.” And from my visit to CNBC: All I’m saying is that prices are elevated; prospective returns are low; risks are high; people are engaging in risky behavior. Now nobody disagrees with any of the four of those, and if not, then it seems to me that this is a time for increased caution. . . . It’s maybe “in, but maybe a little less than you used to be in.” Or maybe “in as much as you used to be in, but with less-risky securities.

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

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Before starting in, I want to apologize for the length of this memo, almost double the norm. First, the topic is wide-ranging – so much so that when I sat down to write, I found the task daunting. Second, my recent vacation gave me the luxury of time for writing. Believe it or not, I’ve cut what I could. I think what remains is essential. Today’s Investment Environment Because I don’t intend this to be a “macro memo,” incorporating a thorough review of the economic and market environment, I’ll merely reference what I think are the four most noteworthy components of current conditions:  The uncertainties are unusual in terms of number, scale and insolubility in areas including secular economic growth; the impact of central banks; interest rates and inflation; political dysfunction; geopolitical trouble spots; and the long-term impact of technology.  In the vast majority of asset classes, prospective returns are just about the lowest they’ve ever been.  Asset prices are high across the board. Almost nothing can be bought below its intrinsic value, and there are few bargains. In general the best we can do is look for things that are less over-priced than others.  Pro-risk behavior is commonplace, as the majority of investors embrace increased risk as the route to the returns they want or need. Ditto In January 2013, I wrote a memo entitled “Ditto.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: I feel strongly that it’s possible to improve investment results by adjusting your positioning to fit the market, and Oaktree was able to do so by turning highly cautious in 2005-06 and highly aggressive in 1990-91, 2001-02 and immediately after the Lehman bankruptcy filing in 2008. This was done on the basis of reasoned judgments concerning: • how markets have been acting, • the level of valuations, • the ease of executing risky financings, • the status of investor psychology and behavior, • the presence of greed versus fear, and • where the markets stand in their usual cycle. Is this effort in conflict with the tenet of Oaktree’s investment philosophy that says macro-forecasting isn’t key to our investing? My answer is an emphatic “no.” Importantly, assessing these things only requires observations regarding the present, not a single forecast. As I say regularly, “We may not know where we’re going, but we sure as heck ought to know where we stand.” Observations regarding valuation and investor behavior can’t tell you what’ll happen tomorrow, but they say a lot about where we stand today, and thus about the odds that will govern the intermediate term. They can tell you whether to be more aggressive or more defensive; they just can’t be expected to always be correct, and certainly not correct right away.

All of them together will deliver a boom or bubble:  A benign environment – good results lull investors into complacency, as they get used to having their positive expectations rewarded. Gains in the recent past encourage the heated pursuit of further gains in the future (rather than suggest that past gains might have borrowed from future gains).  A grain of truth – the story supporting a boom isn’t created out of whole cloth; it generally coalesces around something real. The seed usually isn’t imaginary, just eventually overblown.  Early success – the gains enjoyed by the “wise man in the beginning” – the first to seize upon the grain of truth – tends to attract “the fool in the end” who jumps in too late.  More money than ideas – when capital is in oversupply, it is inevitable that risk aversion dries up, gullibility expands, and investment standards are relaxed.  Willing suspension of disbelief – the quest for gain overcomes prudence and deference to history. Everyone concludes “this time it’s different.” No story is too good to be true.  Rejection of valuation norms – all we hear is, “the asset is so great: there’s no price too high.” Buying into a fad regardless of price is the absolute hallmark of a bubble.  The pursuit of the new – old timers fare worst in a boom, with the gains going disproportionately to those who are untrammeled by knowledge of the past and thus able to buy into an entirely new future.

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

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: it’s still worthwhile. Even though no one can ascertain when we’re at the exact top or bottom, a key to successful investing lies in selling – or lightening up – when we’re closer to the top, and buying – or, hopefully, loading up – when we’re closer to the bottom. FAANGs There’s been a lot of discussion regarding my comments on the FAANGs – Facebook, Amazon, Apple, Netflix and Google – and whether they’re a “sell.” Some of them are trading at p/e ratios that are just on the high side of average, while others, sporting triple-digit p/e’s, are clearly being valued more on hoped- for growth than on their current performance. But whether these stocks should be sold, held or bought was never my concern. As I said on Bloomberg: My point about the FAANGs was not that they are bad investments individually, or that they are overvalued. It was that the anointment of one group of super-stocks is indicative of a bull market. You can’t have a group treated like the FAANGs have been treated in a cautious, pessimistic, sober market. So that should not be read as a complaint about that group, but rather indicative [of the state of the market]. That’s everything I have to say on the subject. Bitcoin As I said earlier, there has been particularly spirited response to my comments on digital currencies.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Serious investing consists of buying things because the price is attractive relative to intrinsic value. Speculation, on the other hand, occurs when people buy something without any consideration of its underlying value or the appropriateness of its price, solely because they think others will pay more for it in the future. In the memo I talked about Bitcoin as an investment asset that should have a value that can be appraised. While its fans tell me this isn’t the right way to view it, I note that in their February “Bitcoin Review,” even Steven and Murray called it “a new asset class.” I think this is the weakest claim being made about Bitcoin. As I said in the memo, “it’s not real” – there is no intrinsic value behind it. What Bitcoin partisans have told me subsequently is that Bitcoin should be thought of as a currency – a medium of exchange – not an investment asset. Given that the evolution of Bitcoin is so topical, I think further discussion is in order. To start, I’m going to present the case for it as a currency. What are the characteristics of a currency?  Most importantly, it’s something that people agree can be used as legal tender (to buy things and pay debts), used as a store of value, and exchanged for other currencies.  Currencies generally are created by governments.

The source of the citation is Amazon’s 1997 annual report, and the bottom line is that the future is unpredictable, and nothing and no company is immune to glitches. The super-stocks that lead a bull market inevitably become priced for perfection. And in many cases the companies’ perfection turns out eventually to be either illusory or ephemeral. Some of the “can’t lose” companies of the Nifty-Fifty were ultimately crippled by massive changes in their markets, including Kodak, Polaroid, Xerox, Sears and Simplicity Pattern (do you see many people sewing their own clothes these days?) Not only did the perfection that investors had paid for evaporate, but even the successful companies’ stock prices reverted to more-normal valuation multiples, resulting in sub-par equity returns. The powerful multiple expansion that makes a small number of stocks the leaders in a bull market is often reversed in the correction that follows, saddling them with the biggest losses. But when the mood is positive and things are going well, the likelihood of such a development is easily overlooked. Finally, a rationale often arises to the effect that, thanks to market technicals, investors’ powerful buying of the leading stocks is sure to continue non-stop, meaning they can’t help but remain the best performers.

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.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Maybe I’m just a dinosaur, too technologically backward to appreciate the greatness of digital currency. But it is my firm view that the ability of these things to gain acceptance is just one more proof of the prevalence today of financial naiveté, willing risk-taking and wishful thinking. In my view, digital currencies are nothing but an unfounded fad (or perhaps even a pyramid scheme), based on a willingness to ascribe value to something that has little or none beyond what people will pay for it. But this isn’t the first time. The same description can be applied to the Tulip mania that peaked in 1637, the South Sea Bubble (1720) and the Internet Bubble (1999-2000). Serious investing consists of buying things because the price is attractive relative to intrinsic value. Speculation, on the other hand, occurs when people buy something without any consideration of its underlying value or the appropriateness of its price, solely because they think others will pay more for it in the future. It isn’t unreasonable for someone to use Bitcoin to pay for something – or for a seller to accept Bitcoin in payment – based on an agreement between the parties: barter takes place all the time. But does that make it “currency”? The price of Bitcoin has more than doubled since the start of the year.

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

What he meant by the latter reference was that in the short run, intrinsic value is often ignored and the stocks that do best are usually the ones capable of winning a popularity contest. I believe that, over time, elections have become more like popularity contests. The successful campaign speech isn’t one that does the best job of analyzing the challenges and supplying optimal solutions. It’s one that most provides what people want to hear. In business and investing, people invariably compare the benefits and costs of A against the benefits and costs of B. Then they select the alternative with the better expected net result (and hopefully one whose bad outcomes are survivable). A lot of mistakes may be made, and the process is sometimes misguided, but the effort to make good economic decisions is undeniably there. Decisions usually have clear consequences, and they are likely to become known before the people responsible depart. In contrast, politicians tend to believe the best decision is the one that is most likely to lead to election or reelection. Responsibility for outcomes is highly diffused, and the results may only become clear years – or decades – after the elections are held and the decisions are made. Few voters have the ability to assess the reasonableness of candidates’ promises, and – given the time lags mentioned just above – it can be difficult to judge candidates for reelection on the basis of their performance on the job.

 Belief that while the current price may not be high relative to the current fundamentals, the fundamentals will deteriorate in ways that aren’t anticipated by the price. (In other words, the price is high relative to how the fundamentals will come to be viewed.)  Belief that the price will fall regardless of the fundamentals, meaning that by selling today you can avert a loss and/or position yourself to profit by buying lower later. Do you agree that these are the main reasons to sell? Are there others? Are these all legitimate? For me the first two are compelling. This is what the skilled investor thinks about. Both of these decisions are made relative to something called “intrinsic value.” There’s only one intelligent form of investing: figure out what something's worth and see if you can buy it at or below that price. It’s all about value. But note that the third reason to sell shown above has nothing to do with value. The price may be high, low or fair relative to the fundamentals today or what they’re expected to be tomorrow. You just sell because you think the price will fall. First, does it make sense to sell something if the price is low relative to the fundamentals, just because you fear it may fall in the short run? A long-term value investor holds or buys when price is low relative to value. Low price relative to value is his dream. Why sell a low-priced asset just because you think it’s going to fall for a while?

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: All other things being equal, as something falls in price, you should want to own it more, not less. The buy-and-hold value investor is stalwart, ignoring price fluctuations. Even better, the contrarian moves opposite to the market, buying when the price falls and selling when it rises. Second, if not on the basis of fundamentals, how does one make the decision to sell for the third reason listed above? Essentially, two things give rise to changes in asset prices: changes in the outlook (macro or asset-specific) and changes in attitudes toward the asset. In other words, fundamentals and valuation. Fundamentals are dealt with above. If you’re going to try to benefit from changes in price that are unrelated to changes in fundamentals, you’re left having to predict investor psychology. If “On the Couch” wasn’t successful in convincing you this isn’t possible, this memo probably won’t be, either. My bottom line is that markets don’t assess intrinsic value from day to day, and certainly they don’t do a good job during crises. Thus market price movements don’t say much about fundamentals. Even in the best of times, when investors are driven by fundamentals rather than psychology, markets show what the participants think value is, rather than what value really is. Value is something the market doesn’t know any more about than the average investor.

It makes no sense to think it would be otherwise. And what about the next seven words: “Anyone who finds it easy is stupid”? It follows from the above that given how hard investors work to find special opportunities, and that their buying eliminates such prospects, people who think it can be easy overlook substantial nuance and complexity. Markets are meeting places where people come together (not necessarily physically) to exchange one thing (usually money) for another. Markets have a number of functions, one of which is to eliminate opportunities for excess returns. Ed calls me and bids $10,000 for my car. Then he offers to sell it to Bob for $20,000. If Ed’s lucky and we both say yes, he doubles his money overnight. To put it simply, anyone who expects to make money easily trading cars this way either thinks (a) Bob and I are idiots or (b) the market won’t function in a way that enables us to know about the fair value of my car. If these conditions were met, it would be an “inefficient market.” But if Bob and I have access to market data on used car pricing, Ed’s chances of pulling off this deal are greatly reduced. In most markets, transparency tends to reveal and thus preclude obvious mispricings. (Thanks to the incredible gains in access to data by way of the Internet, this is certainly more true today than ever before.)

The answer usually takes the form of a schedule that says: “We could sell off x% of the portfolio in a day, y% in a week, and z% in a month, etc.” But that’s a terribly simplistic answer. It doesn’t say anything about how the price received would compare with the last trade or the price at which the assets were carried on the previous valuation date. Or about how changing market conditions might make the answer different a month from now. Bottom line: to the statement “we could sell off z% in a month” one should add “but who knows what the price will be, or what effect changing market conditions might have on that percentage?” Anything else requires an assumption that the assets’ liquidity is constant. That’s often far from the case. Usually, just as a holder’s desire to sell an asset increases (because he has become afraid to hold it), his ability to sell it decreases (because everyone else has also become afraid to hold it). Thus (a) things tend to be liquid when you don’t need liquidity, and (b) just when you need liquidity most, it tends not to be there. (In the 2014 Berkshire Hathaway Annual Letter, released early this month, Warren Buffett expresses his dislike for “substitutes for cash that are claimed to deliver liquidity and actually do so, except when it is truly needed.”) The truth is, things often seem more liquid when you buy than when you go to sell.

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

ETF-like vehicles, sometimes known as “tracking shares,” began to appear in the early 1990s, and they proliferated significantly after 2000. According to Wikipedia, “As of January 2014, there were over 1,500 ETFs traded in the U.S., with over $1.7 trillion in assets.” (Several years ago I cited Wikipedia in a memo, and Oaktree co-founder Richard Masson – a stickler for correctness – told me in no uncertain terms that it wasn’t a respectable source. I think things have changed enough since then, Richard: I’m citing it!) ETF’s have become popular because they’re generally believed to be “better than mutual funds,” in that they’re traded all day. Thus an ETF investor can get in or out anytime during trading hours, whereas with mutual funds he has to wait for a pricing at the close of business. “If you’re considering investing,” the pitch goes, “why do so through a vehicle that can require you to wait hours to cash out?” But do the investors in ETFs wonder about the source of their liquidity? Here’s what Wikipedia has to say about the liquidity of ETFs: An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be bought or sold at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund, which trades throughout the trading day at prices that may be more or less than its net asset value. . . . Consider the possibility that many of the holders of an ETF become highly motivated to either buy or sell.

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.

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

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

© Oaktree Capital Management, L.P. All Rights Reserved  Assets with greater liquidity are safer – Greater liquidity generally means you can get out of an asset easier and closer to the price of the last trade. But first, liquidity can dry up when other investors change their mind about the asset. And second, the theoretical ability to get out when you want says nothing about fundamental safety and relatively little about investment safety in the long run. It’s much safer to be in well-analyzed assets with good fundamentals and attractive prices, in which case you can hold for a long time without needing to exit. The best defense against a lack of liquidity is arranging your affairs so there’s little need for it.  The level of risk in a portfolio can be kept low by applying a simple formulaic process – Rather, risk comes in many forms and they can be overlapping, contrasting and hard to manage. For example, as I said in “Risk Revisited,” efforts to reduce the risk of losing money invariably increase the risk of missing out on gains, and efforts to reduce fundamental risk by buying higher- quality assets often increase valuation risk, given that higher-quality assets often sell at elevated valuation metrics. What does the above consist of? It’s a collection of time-honored bromides that range from (a) only effective part of the time to (b) just plain wrong. These investment myths are pervasive but of little help.

© Oaktree Capital Management, L.P. All Rights Reserved Chinese investors who had bought stocks on margin and perhaps were experiencing their first serious market correction. Their selling prompted investors in the U.S. and elsewhere to sell also, believing that the market decline in China signaled serious implications for the Chinese economy and others. The analysis of fundamentals and valuation should dictate an investor’s behavior, not the actions of others. If you let the investing herd – which determines market movements – tell you what to do, how can you expect to outperform?  While China was the “proximate cause” of the volatility, other things often contribute, and last month was no exception. The word that always comes to mind for me is “confluence.” Investors can usually keep their heads in the face of one negative. But when they face more than one simultaneously, they often lose their cool. One additional negative last month was the glitch in Bank of New York Mellon’s SunGard software, and the bank’s consequent inability to price 1,200 mutual funds and ETFs that it administers. It was another dose of disillusionment: no one enjoys learning that the market mechanisms they need to work can’t be depended on.  In good times – perhaps emulating Warren Buffett – investors talk about how much they’d like to see the stocks they own decline in price, since it would allow them to add to positions at lower levels.

The future cash flows, in turn, will be a function of the fundamental performance of the company and the way its stock is priced given that performance. We invest on the basis of expectations regarding these things. It’s tautological to say that if the company’s earnings and the valuation of those earnings meet our targets, the return will be as expected. The risk in the investment therefore comes from the possibility that one or both will come in lower than we think. To oversimplify, investors in a given company may have an expectation that if A happens, that’ll make B happen, and if C and D also happen, then the result will be E. Factor A may be the pace at which a new product finds an audience. That will determine factor B, the growth of sales. If A is positive, B should be positive. Then if C (the cost of raw materials) is on target, earnings should grow as expected, and if D (investors’ valuation of the earnings) also meets expectations, the result should be a rising share price, giving us the return we seek (E). We may have a sense for the probability distributions governing future developments, and thus a feeling for the likely outcome regarding each of developments A through E. The problem is that for each of these, there can be lots of outcomes other than the ones we consider most likely. The possibility of less- good outcomes is the source of risk.

It’s tautological to say that if the company’s earnings and the valuation of those earnings meet our targets, the return will be as expected. The risk in the investment therefore comes from the possibility that one or both will come in lower than we think. To oversimplify, investors in a given company may have an expectation that if A happens, that’ll make B happen, and if C and D also happen, then the result will be E. Factor A may be the pace at which a new product finds an audience. That will determine factor B, the growth of sales. If A is positive, B should be positive. Then if C (the cost of raw materials) is on target, earnings should grow as expected, and if D (investors’ valuation of the earnings) also meets expectations, the result should be a rising share price, giving us the return we seek (E). We may have a sense for the probability distributions governing future developments, and thus a feeling for the likely outcome regarding each of developments A through E. The problem is that for each of these, there can be lots of outcomes other than the ones we consider most likely. The possibility of less- good outcomes is the source of risk. That leads me to key point number two, as expressed by Elroy Dimson, a professor at the London Business School: “Risk means more things can happen than will happen.” This brief, pithy sentence contains a great deal of wisdom.

© Oaktree Capital Management, L.P. All Rights Reserved you can’t be confident about what the right price is, then you can’t be definite about financial decisions regarding oil. In the last few years, as I said in The Role of Confidence (August 2013), investor sentiment has been riding high. Or, as Doug Kass pointed out this past summer, there’s been “a bull market in complacency.” Regardless, it seems that a market that was unconcerned about things like oil and its impact on economies and assets now has lost its composure. Especially given the pervasive role of energy in economic life, uncertainty about oil introduces uncertainty into many aspects of investing. “Value investing” – the form of investing Oaktree practices – is supposed to be about buying based on the present value of assets, rather than conjecture about profit growth in the far-off future. But you can’t assess present value without taking some position on what the future holds, even if it’s only assuming a continuation of present conditions or perhaps – for the sake of conservatism – a considerably lower level. Recent events cast doubt on the ability to safely take any position. One of the things that’s central to risk-conscious value investing is ascertaining the presence of a generous cushion in terms of “margin of safety.” This margin comes from conviction that conditions will be stable, financial performance is predictable, and/or an entry price is low relative to the asset’s intrinsic value.

When you’re under pressure, the distinction between “volatility” and “loss” can seem only semantic. Volatility is not “the” definition of investment risk, as I said earlier, but it isn’t irrelevant. One example of a risk connected with volatility – or the deviation of price from what might be intrinsic value – is basis risk. Arbitrageurs customarily set up positions where they’re long one asset and short a related asset. The two assets are expected to move roughly in parallel, except that the one that’s slightly cheaper should make more money for the investor in the long run than the other loses, producing a small net gain with little risk. Because these trades are considered so low in risk, they’re often levered up to the sky. But sometimes the prices of the two assets diverge to an unexpected extent, and the equity invested in the trade evaporates. That unexpected divergence is basis risk, and it’s what happened to Long-Term Capital Management in 1998, one of the most famous meltdowns of all time. As Long-Term’s chairman John Meriwether said at the time, “the Fund added to its positions in anticipation of convergence, yet . . . the trades diverged dramatically.” This benign-sounding explanation was behind a collapse some thought capable of bringing down the global financial system. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

The two main ones are fundamental risk (relating to how a company or asset performs in the real world) and valuation risk (relating to how the market prices that performance). For years investors, fiduciaries and rule-makers acted on the belief that it’s safe to buy high-quality assets and risky to buy low-quality assets. But between 1968 and 1973, many investors in the “Nifty Fifty” (the stocks of the fifty fastest-growing and best companies in America) lost 80-90% of their money. Attitudes have evolved since then, and today there’s less of an assumption that high quality prevents fundamental risk, and much less preoccupation with quality for its own sake. On the other hand, investors are more sensitive to the pivotal role played by price. At bottom, the riskiest thing is overpaying for an asset (regardless of its quality), and the best way to reduce risk is by paying a price that’s irrationally low (ditto). A low price provides a “margin of safety,” and that’s what risk-controlled investing is all about. Valuation risk should be easily combatted, since it’s largely within the investor’s control. All you have to do is refuse to buy if the price is too high given the fundamentals. “Who wouldn’t do that?” you might ask. Just think about the people who bought into the tech bubble. Fundamental risk and valuation risk bear on the risk of losing money in an individual security or asset, but that’s far from the whole story.

The fact that an investment is susceptible to a serious negative development that will occur only infrequently – what I call “the improbable disaster” – can make it appear safer than it really is. Thus after several years of a benign environment, a risky investment can easily pass for safe. That’s why Warren Buffett famously said, “. . . you only find out who’s swimming naked when the tide goes out.” Assembling a portfolio that incorporates risk control as well as the potential for gains is a great accomplishment. But it’s a hidden accomplishment most of the time, since risk only turns into loss occasionally . . . when the tide goes out. The fourth is that risk is multi-faceted and hard to deal with. In this memo I’ve mentioned 24 different forms of risk: the risk of losing money, the risk of falling short, the risk of missing opportunities, FOMO risk, credit risk, illiquidity risk, concentration risk, leverage risk, funding risk, manager risk, over- diversification risk, risk associated with volatility, basis risk, model risk, black swan risk, career risk, headline risk, event risk, fundamental risk, valuation risk, correlation risk, interest rate risk, purchasing power risk, and upside risk. And I’m sure I’ve omitted some. Many times these risks are overlapping, contrasting and hard to manage simultaneously. For example:  Efforts to reduce the risk of losing money invariably increase the risk of missing out.

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

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

Since corporate directors have a fiduciary responsibility to stockholders but not to bondholders, some think they can (and perhaps should) do anything that’s not explicitly prohibited to transfer value from bondholders to stockholders. Bondholders need covenants to shield them from this kind of pro- active plundering, but at times like today it can be hard to obtain strong protective covenants. There are many ways for an investment to be unsuccessful. The two main ones are fundamental risk (relating to how a company or asset performs in the real world) and valuation risk (relating to how the market prices that performance). For years investors, fiduciaries and rule-makers acted on the belief that it’s safe to buy high-quality assets and risky to buy low-quality assets. But between 1968 and 1973, many investors in the “Nifty Fifty” (the stocks of the fifty fastest-growing and best companies in America) lost 80-90% of their money. Attitudes have evolved since then, and today there’s less of an assumption that high quality prevents fundamental risk, and much less preoccupation with quality for its own sake. On the other hand, investors are more sensitive to the pivotal role played by price. At bottom, the riskiest thing is overpaying for an asset (regardless of its quality), and the best way to reduce risk is by paying a price that’s irrationally low (ditto). A low price provides a “margin of safety,” and that’s what risk-controlled investing is all about.

Valuation risk should be easily combatted, since it’s largely within the investor’s control. All you have to do is refuse to buy if the price is too high given the fundamentals. “Who wouldn’t do that?” you might ask. Just think about the people who bought into the tech bubble. Fundamental risk and valuation risk bear on the risk of losing money in an individual security or asset, but that’s far from the whole story. Correlation is the essential additional piece of the puzzle. Correlation is the degree to which an asset’s price will move in sympathy with the movements of others. The higher the correlation among its components, all other things being equal, the less effective diversification a portfolio has, and the more exposed it is to untoward developments. An asset doesn’t have “a correlation.” Rather, it has a different correlation with every other asset. A bond has a certain correlation with a stock. One stock has a certain correlation with another stock (and a different correlation with a third). Stocks of one type (such as emerging market, high-tech or large-cap) are likely to be highly correlated with others within their category, but they may be either high or low in correlation with those in other categories. Bottom line: it’s hard to estimate the riskiness of a given asset, but many times harder to estimate its correlation with all the other assets in a portfolio, and thus the impact on performance of adding it to the portfolio. This is a real art.

In this memo I’ve mentioned 24 different forms of risk: the risk of losing money, the risk of falling short, the risk of missing opportunities, FOMO risk, credit risk, illiquidity risk, concentration risk, leverage risk, funding risk, manager risk, over- diversification risk, risk associated with volatility, basis risk, model risk, black swan risk, career risk, headline risk, event risk, fundamental risk, valuation risk, correlation risk, interest rate risk, purchasing power risk, and upside risk. And I’m sure I’ve omitted some. Many times these risks are overlapping, contrasting and hard to manage simultaneously. For example:  Efforts to reduce the risk of losing money invariably increase the risk of missing out.  Efforts to reduce fundamental risk by buying higher-quality assets often increase valuation risk, given that higher-quality assets often sell at elevated valuation metrics. At bottom, it’s the inability to arrive at a single formula that simultaneously minimizes all the risks that makes investing the fascinating and challenging pursuit it is. The fifth is that the task of managing risk shouldn’t be left to designated risk managers. I’m convinced outsiders to the fundamental investment process can’t know enough about the subject assets to make appropriate decisions regarding each one. All they can do is apply statistical models and norms.

Moreover, a portfolio within one of the credit strategies may not be diversified among a wide range of issuers, industries and countries, making the portfolio subject to more rapid changes in value than would be the case if the portfolio was more diversified. Many factors affect the demand and supply of securities and instruments targeted by the strategies discussed herein and their valuation. Interest rates and general economic activity may affect the value and number of investments made by such strategies. Such strategies discussed herein may target investments in companies whose capital structures may have significant leverage. Such investments are inherently more sensitive than others to declines in revenues and to increases in expenses and interest rates. In addition, such strategies may involve the use of leverage. While leverage presents opportunities for increasing total return, it may increase losses as well. Accordingly, any event that adversely affects the value of an investment would be magnified to the extent leverage is used. Such strategies may also involve securities or obligations of non-U.S. companies which may involve certain special risks. These factors may increase the likelihood of potential losses being incurred in connection with such investments.

© Oaktree Capital Management, L.P. All Rights Reserved. a higher valuation parameter (e.g., a higher price/earnings ratio for a stock or a higher multiple of EBITDA for a buyout) or accepting a lower return (e.g., a lower yield for a bond or a lower capitalization rate for an office building). Further, rather than paying more for the asset purchased, there are other ways for an investor or lender to get less for his money. This can come through tolerating a weaker deal structure or through an increase in risk. It’s primarily these latter elements – rather than securities merely getting pricier – with which this memo is concerned. History Rhymes In the pre-crisis years, as described in the 2007 memo, the race to the bottom manifested itself in a number of ways:  There was widespread acceptance of financial engineering techniques, some newly minted, such as derivatives creation, securitization, tranching and selling onward. These innovations resulted in the creation of such things as highly levered mortgage-backed securities, CDOs and CLOs (structured credit instruments offering tiered debt levels of varying riskiness); credit default swaps (enabling investors to place bets regarding the creditworthiness of debtors); and SPACs (Special Purpose Acquisition Companies, or blind-pool acquisition vehicles).

© Oaktree Capital Management, L.P. All Rights Reserved. such securities. The limited liquidity of the market may also adversely affect the ability of investors to arrive at a fair value for certain lower-rated securities at certain times and could make it difficult to sell certain securities. It should be recognized that an economic downturn or increase in interest rates is likely to have a negative effect on the lower-rated bond market and on the value of the lower-rated securities as well as on the ability of the securities' issuers, especially highly leveraged issuers, to service principal and interest payment obligations to meet their projected business goals or to obtain additional financing. Moreover, the prices of lower-rated securities have been found to be less sensitive to changes in prevailing interest rates than higher-rated investments. If the issuer of a fixed-income security defaults, the holder may incur additional expenses to seek recovery and the possibility of any recovery can be subject to the expense and uncertainty of insolvency proceedings. This memorandum, including the information contained herein, may not be copied, reproduced, republished, posted, transmitted, distributed, disseminated or disclosed, in whole or in part, to any other person in any way without the prior written consent of Oaktree. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

 Twitter took the first steps in the pricing of its eagerly awaited initial public offering. . . . The social media darling disclosed that it planned to sell 70 million shares at $17 to $20 each. At the midpoint of that range, the offering would raise about $1.3 billion and would value Twitter at about $10 billion, excluding options. . . . Such a valuation would make Twitter more than three times as big as one of the first big Internet giants, AOL . . . (The New York Times Dealbook, October 24)  Twitter is feeling more optimistic about investor appetite for its imminent initial public offering. On Monday morning, the company raised the price range for its I.P.O. to $23 to $25, signaling a bullish outlook ahead of its trading debut this week. The new range increases Twitter’s potential market value by several billion dollars. If it prices at the high end, Twitter would be valued at $13.9 billion at the start of its first day of trading. (Dealbook, November 4)  [Twitter] priced its shares at $26 on Wednesday night, giving it a market value of $18.1 billion. On Thursday, Twitter closed at $44.90 a share, 73 percent above its initial public offering price. (Dealbook, November 7)  In a sign of the fervor once again rising around Internet startups, the 23-year-old CEO of [Snapchat] a two-year-old company with no revenue has rejected a $3 billion buyout offer.

Well, the answer to the first question lies in which definition you‟re following. Of course the data tells us what the relative performance was (and 2012 was a great year, for example, with the S&P 500 up roughly 16% while the risk-less rate was close to zero). An equity risk premium defined this way is certainly in the best part of the historic distribution. But it tells us little about investors‟ past or present demanded returns. And what does it say about the prospects for continued outperformance? To me, the answer is simple: the better returns have been, the less likely they are – all other things being equal – to be good in the future. Generally speaking, I view an asset as having a certain quantum of return potential over its lifetime. The foundation for its return comes from its ability to produce cash flow. To that base number we should add further return potential if the asset is undervalued and thus can be expected to appreciate to fair value, and we should reduce our view of its return potential if it is overvalued and thus can be expected to decline to fair value.

© Oaktree Capital Management, L.P. All Rights Reserved. fueled expansion, the profit potential of e-commerce companies, and the extent to which equity gains could be perpetuated). As a result, equity returns averaged 20% per year over the decade. What was investors’ response? They ratcheted up their expectations. I believe by 2000 the professional consensus for future equity returns had risen from the 9-10% range to 11%. A decade of the highest returns in history had convinced people that more good years lay ahead. Few people seemed concerned that the extraordinary returns of the 1990s might have borrowed from the 2000s (as certainly seems to have been the case in retrospect). As a result, just when stock prices were reaching levels they wouldn‟t see again for more than a decade, bonds were being dumped so that equity allocations could be expanded to all-time highs. When I look at the P&I article, I see a statement that the equity risk premium is on the rise, but not a lot of reason why equities will do better in the future than they have in the past (or even specific mention of which past they‟ll do better than). Extrapolation or analysis? They’re two very different things. Valuing Stocks Today The underlying reason it took so little from FierceFinance to get me going on this memo is that I had a lot of pent-up thoughts about equities and their current valuation. That‟s what the following pages will be spent on.

© Oaktree Capital Management, L.P. All Rights Reserved.  When things are going well, investors swing to excessive euphoria, under the assumption that everything’s good and can only get better.  And when things are bad, they swing toward depression and panic, viewing everything negatively and assuming it can only get worse.  When the outlook is good and their mood is ebullient, investors take security prices to levels that greatly overstate the positives, from which a correction is inevitable.  And when the outlook is bad and they’re depressed, investors reduce prices to levels that overstate the negatives, from which great gains are possible and the risk of further declines is limited. The excessive nature of these swings in psychology – and thus security prices – dependably creates opportunities of over- and under-valuation. In bad times securities can often be bought at prices that understate their merits. And in good times securities can be sold at prices that overstate their potential. And yet, most people are impelled to buy euphorically when the cycle drives prices up and to sell in panic when it drives prices down. “Buy and hold” used to be a popular approach among investors, and it performed admirably when the markets rose almost non-stop from 1960 to 1972 and from 1982 to 1999. But thanks to the lackluster results of the last thirteen years, it has nearly disappeared.

© 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.

Here are a few of them (I‟ll start by reiterating the above for the sake of completeness): The differential between the S&P earnings yield and the risk-free rate or the yields on bonds – and their ratio – makes stocks look extremely cheap. PRO The attractiveness of these relative valuation parameters is highly dependent on interest rates staying low. CON (or LESS PRO) Relative to normal post-WWII p/e ratios, stock prices are average to slightly low as a multiple of projected earnings for the year ahead. PRO Robert Schiller‟s cycle-adjusted p/e ratios are gaining increased attention, and they suggest full rather than fair valuations. CON Arguably earnings growth in the years ahead will be slower than that which prevailed in the decades following WWII. Thus the post-war valuation norms are too high under the changed circumstances and should be discounted. CON The outlook for earnings is restrained by the questionable macro environment, including the challenges in restarting growth and the dire prognosis for the federal deficit. These problems may not be easily solved. CON Among the things keeping earnings high – and thus making stocks seem attractive – are some of the highest profit margins in history. If profit margins were to move toward normal levels, this © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

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

The result is a more dangerous world where asset prices are higher, prospective returns are lower, risk is elevated, the quality and safety of new issues deteriorates, and the premium for bearing risk is insufficient. It’s one of my first principles that we never know where we’re going – given the unreliability of macro forecasting – but we ought to know where we are. “Where we are” means what the temperature of the market is: Are investors risk-averse or risk-tolerant? Are they behaving cautiously or aggressively? And thus is the market a safe place or a risky one? Certainly risk tolerance has been increasing of late; high returns on risky assets have encouraged more of the same; and the markets are becoming more heated. The bottom line varies from sector to sector, but I have no doubt that markets are riskier than at any other time since the depths of the crisis in late 2008 (for credit) or early 2009 (for equities), and they are becoming more so. Is This a Sell Signal? If Not, Then What? No, I don’t think it’s time to bail out of the markets. Prices and valuation parameters are higher than they were a few years ago, and riskier behavior is observed. But what matters is the degree, and I don’t think it has reached the danger zone yet. First, as mentioned above, the absolute quantum of risk doesn’t seem as high as in 2006-07. The modern miracles of finance aren’t seen as often (or touted as highly), and the use of leverage isn’t as high.

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

© OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED. CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. Rather, investors swing wildly from optimistic to pessimistic – and from over-confident to terrified – and as a result asset prices can lose all connection with intrinsic value. In addition, investors often fail to unearth all of the relevant information, analyze it systematically, and step forward to adopt unpopular positions. These are some of the elements that give rise to what are called “inefficiencies,” academics’ highfalutin word for “mistakes.” I absolutely believe that markets can be efficient – in the sense of “quick to incorporate information” – but certainly they aren’t sure to incorporate it correctly. Underpricings and overpricings arise all the time. However, the shortcomings described in the paragraph just above render those mispricings hard to profit from. While market prices are often far from “right,” it’s nearly impossible for most investors to detect instances when the consensus has done a faulty job of pricing assets, and to act on those errors. Thus theory is quite right when it says the market can’t be beat . . . certainly by the vast majority of investors. People should engage in active investing only if they’re convinced that (a) pricing mistakes occur in the market they’re considering and (b) they – or the managers they hire – are capable of identifying those mistakes and taking advantage of them.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. performance. While we can’t know these things with certainty, specialized expertise can help us do a better job of assessing prospects and estimating intrinsic value.  We can try to find bargains and avoid overpriced securities. By applying a disciplined approach to security selection, a manager should be able to judge the relationship between the price of each security and its intrinsic value. This can’t be done flawlessly, of course, and at any rate the impact of this relationship on performance is often outweighed in the short run by trends in investor psychology and perception. Thus, like everything else, this won’t work every time. But on balance the superior manager should be able to assemble portfolios whose holdings have a higher collective probability of moving in the right direction.  We can limit risk. The risk in investing increases along with the degree to which the future is unknowable. Recognizing this, managers who acknowledge the limits on their foresight tend to incorporate a good measure of risk control in their portfolios. They try to make fewer investments whose success is heavily dependent on knowing what the future holds, thereby creating an increased margin of safety. This approach to investing shouldn’t be expected to maximize return – especially in good times – but rather to maximize risk-adjusted return. This is a mission-critical part of the investment manager’s job.

But in 1978, most investors wouldn’t buy B-rated bonds – at any price – because doing so was considered speculative and imprudent. In 1999, most investors refused to buy value stocks – also at any price – because they were deemed to lack the world-changing potential of technology stocks. Prejudices like these prevent valuation disparities from being closed.  Capital rigidity – In theory, investors will move capital out of high-priced assets and into cheap ones. But sometimes, investors are condemned to buy in a market even though there are no bargains or to sell even at giveaway prices. In 2000, in venture capital, there was “too much money chasing too few deals.” In 2008, CLOs receiving margin calls had no choice but to sell loans at bankruptcy prices. Rigidities like these create mispricings.  Psychological excesses – In theory, investors will sell assets when they get too rich in a bubble or buy assets when they get cheap enough in a crash. But in practice, investors aren’t all that cold-blooded. They can fail to sell, for example, because of an unwarranted excess of optimism over skepticism, or an excess of greed over fear. Psychological forces like greed, fear, envy and hubris permit mispricings to go uncorrected . . . or become more so.  Herd behavior – In theory, market participants are willing to buy or sell an asset if its price gets out of line. But sometimes there are more buyers for something than sellers (or vice versa), regardless of price.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved.  The simplest signs surround valuation. What’s the yield spread between high yield bonds and Treasurys? And between single-B and triple-C? Where are the yields and premiums on convertibles? Are distressed senior loans selling at 60 cents on the dollar or 90? Is the S&P 500 selling at 30 times earnings or 12? These things tell us whether markets – and investor ardor – are overheated or ice cold.  We find nothing as terrifying as the ability to easily do dumb deals (see “The Race to the Bottom,” February 14, 2007). When large numbers of transactions occur that leave us shaking our heads, it’s a strong signal that the market is lacking in the risk aversion and skepticism that are needed to keep it safe and sane.  Equally worrisome is the presence of investor ebullience. When results are good and everyone’s certain that more of the same must lie ahead, the pendulum of investor psychology invariably swings to extremes of greed, optimism, confidence and credulousness – the raw material for bubbles and subsequent crashes. I constantly go back to Warren Buffett’s formulation: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.”  It’s also troubling if aggressive investment vehicles are popular and over-subscribed. For the value-conscious investor, the seven scariest words in the world are “too much money chasing too few deals.

executive: “Have you been to an American stockholders‟ meeting lately? They‟re all old fogeys. The stock market is just not where the action‟s at.” And what consistently provides the foundation for this insistence that the game has permanently changed? Four of the most dangerous words in the investment world: it’s different this time. When investors choose to believe that historic valuation standards have become irrelevant; that one industry or product can maintain superior growth and profitability in perpetuity; or that one asset or market can outperform all the others forever regardless of how high its price goes in the process – that is, that trees can grow to the sky – the bubble is invariably undergirded by a steadfast belief that it‟s different this time. Here‟s the support BusinessWeek advanced: Says Alan Coleman, dean of Southern Methodist University‟s business school, “We have entered a new financial age. The old rules no longer apply.” When you see or hear words like these, you should go on high alert. Sometimes the world changes and the past becomes irrelevant, but most of the time I‟ll take the other side of that bet. Getting to the Truth In some ways, understanding the market is like mathematics. You don‟t have to be knowledgeable regarding the specifics of the underlying subject matter to know whether a conclusion makes sense. You just have to be able to apply principles, tell logic from illogic, and exclude the deleterious effects of emotion and psychology.

 In addition, it’s always possible that earnings estimates are too high, meaning stocks aren’t as cheap as their p/e ratios suggest. The one thing I know for sure, however, is that U.S. stocks are cheap versus historic norms. Another example of cheapness can be seen in high yield bonds. In the 33 years since I organized Citibank’s first high yield bond fund, the normal yield spread between the high yield indices and comparable-duration Treasurys has been 300 to 550 basis points. Today the spread is closer to 700 b.p. History shows that if you invest in the high yield bond indices when spreads go above 550 b.p., you usually outperform Treasurys by a wide margin over the next few years. Thus it’s clear that with spreads at 700 b.p., they’re priced to outperform. High yield bonds – like stocks – could turn out not to have been cheap enough, but there’s no arguing with the fact that they (and senior leveraged loans) are relatively very cheap. (Of course you can’t eat relative performance, and the current attractiveness of high yield bonds is very much a function of how low Treasury yields are. Nevertheless, after staring at 2% yields on Treasurys for a few years, 8% seems like a lot.) So we have valuation on our side in today’s markets. What else? The other positive, in my view, relates to the “temperature” of the market. I’ve often written that the key to understanding what might lie ahead is a sense for what’s going on in the investment environment.

 Credit instruments were increasingly marked by few or no covenants to protect lenders from managements’ machinations, and by interest payments that could be made with debt rather than cash at the companies’ discretion.  Collateralized loan and debt obligations were accepted as being respectable instruments – with the risk made to vanish – despite the questionable underlying assets.  Buyouts of larger and larger companies were done at increasing valuation multiples, with rising debt ratios and shrinking equity contributions, and despite the fact that the target companies were increasingly cyclical. © Oaktree Capital Management, L.P.Reserved

” Buying at low prices relative to intrinsic value (rigorously and conservatively derived) holds the key to earning dependably high returns, limiting risk and minimizing losses. It’s not the only thing that matters – obviously – but it’s something for which there is no substitute. Without doing the above, “investing” moves closer to “speculating,” a much less dependable activity. When investors are serene or even euphoric, rather than discomforted, prices rise and we become less likely to find the bargains we want. So if you could ask just one question regarding an individual security, asset class or market, it should be “is it cheap?” Oaktree’s investment professionals try to ask it, in different ways, every day. And what makes for cheapness? In sum, the attitudes and behavior of others. I try to get away from it, but I can’t. The quote I return to most often in these memos, even 17 years after the first time, is another from Warren Buffett: “The less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs.” When others are paralyzed by fear, we can be aggressive. But when others are unafraid, we should tread with the utmost caution. Other people’s fearlessness invariably translates into inflated prices, depressed potential returns and elevated risk.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved Much of the money that normally would be invested in the giant Treasury market simply couldn’t stay there because the yields were so low. Thus large amounts flowed toward smaller markets where they were quite capable of lifting prices. Nothing can reduce returns, worsen terms or raise risk faster than “too much money chasing too few deals.” It’s disproportionate flows of capital into a market that give rise to the disastrous race to the bottom such as we saw in 2005-07. Greater sums are provided to weaker borrowers at lower interest rates and with looser terms. Higher prices are paid for assets: first less of a discount from intrinsic value, then the full intrinsic value, and eventually premiums above intrinsic value. These processes account for many of the trends decried here. In addition, I would point out that the pain of the crisis was surprisingly short-lived. The real panic began on September 15, 2008, the day Lehman Brothers filed for bankruptcy. Until then, the world seemed to be coping and investors retained their equanimity. But Lehman, Fannie Mae, Freddie Mac, Merrill Lynch, Washington Mutual and AIG fell like dominoes in short order, and in the last fifteen weeks of 2008 people were paralyzed by fear of a global financial meltdown. And then things turned in the first quarter of 2009, primarily, I think, because people were coerced to move further out on the risk curve as described above.

Memo to: Oaktree Clients From: Howard Marks Re: Hemlines While the details change, the pendulum-like fluctuation of investment styles is a constant. Fear versus greed, pursuit of safety versus aggressiveness, stocks versus bonds, and growth versus value are just a few examples of the areas in which we see this take place. In this way, the investment world proves the wisdom of Mark Twain’s observation that, “History doesn’t repeat itself, but it does rhyme.” The limits of the pendulum’s swing are fixed, and it tends to move back and forth over the territory between them. This occurs because (a) people tend to take trends to extremes, (b) neither extreme of the pendulum’s arc represents a perfect or permanent solution, and (c) there’s no place else to go in these regards. Thus the best way to view investment trends may be through an analogy to hemlines: all they can do is go up and down, and so they do. The style mavens call for short skirts, and people fall into line, raising hemlines until they’re as high as they can go. And then they drop (and so forth). The reasons behind the rise and fall of investment fashions rarely repeat exactly, in that the details, timing and effects vary from instance to instance. But the underlying process is a recurring one. For example:  An idea is born when an undervalued asset is discovered.  Its undervaluation attracts attention, as do pioneering investors’ early gains.

Well, that’s exactly the way I think it is with gold. Either you’re a believer or you’re not. My View In the past, the only thing I considered certain about gold was that I didn’t have to consider it. But in the last few years, I did think (and write) on a subject very germane to gold: the valuation of non-income-producing assets. Show me a company, security or property that produces a stream of cash, and I think I can value it reasonably accurately. P/E ratios, yields and capitalization rates give us a framework for valuing these things, and by comparing them to prevailing interest rates, to historic valuation parameters and to each other, we can assess whether an asset is dear or cheap. But there’s no analytical way, in my opinion, to value an asset that doesn’t produce cash flow . . . and especially one that doesn’t at least have the prospect of doing so. (What I mean by the latter is that it’s more challenging to value an empty building than a rented one; or an empty lot compared to one with an office building on it; or a young company relative to an established, profitable one. But at least you can attempt to value the former asset in each case on the basis of its potential to produce cash flow.) How do you put a value on an asset that will never throw off cash?

performance led to steady increases in the capital allocated to equities, and eventually to the tech stock bubble. It culminated in books such as the fact-based Stocks for the Long Run and the more fanciful Dow 36,000. If you asked institutional investors what return they expected from stocks going forward, I think just about all would have said 11%. An aside: investors consistently seize upon above average returns as an encouraging sign and extrapolate them, and the 17.6% compound return on the S&P 500 from 1979 through 1999 was certainly a case in point. But rarely do they ask what gave rise to those good returns, or what it implies for the future. In essence, stock ownership conveys the benefits of owning a corporation, and stock appreciation should be powered by increases in profits. Thus long-run returns should reflect corporate growth. But as Warren Buffett has pointed out, “. . . people get into trouble when they forget that in the long run, stocks won't appreciate faster than the growth in corporate profits.” Although that growth is the underlying source of equity profits, it is often overshadowed and obscured in the short run by trends in valuation. People took that 17.6% gain as an encouraging sign, overlooking the fact that it stemmed primarily from the rise of p/e ratios described above and thus was unlikely to continue unabated.

© Oaktree Capital Management, L.P. All Rights Reserved Will states and cities go bankrupt in coming years? What will be the effect on their bondholders, and on the municipal bond market as a whole? How will bankruptcy be reconciled with municipal bond issuers’ promises to dedicate their full faith and credit to paying interest and principal (and thus, implicitly, to raise taxes without limitation)? How will the federal government respond? If it opens its coffers to bail out profligate states, what will that say to states that were prudent enough to stay out of trouble? No answers here, but lots of trouble in sight. Our Dance with China Here are the facts:  China has vast resources, human and otherwise.  It produces goods cheaper than the developed countries.  China’s likely undervalued currency aids its competitiveness as an exporter.  The U.S. buys more from China than it sells to China.  That means dollars keep piling up in China.  The U.S. has to borrow back those dollars to fund its fiscal and trade deficits.  We’d prefer low interest rates in order to minimize our interest payments, and a weak dollar so we can repay our debts (as if!) in devalued currency.  China, with its reserves growing, has to invest large amounts of dollars.  China wants high rates and a strong dollar in order to maximize the value of our future payments to them.

Forty years ago, you could turn in paper money and get an ounce of gold for each $35. Then President Nixon ended the convertibility of gold in 1971 and that was no longer possible. Now there’s nothing behind the dollar but people’s belief in it. As an aside, when I was working on Wall Street for the first time in the summer of 1967, the government announced that it was going to terminate the convertibility of banknotes labeled “silver certificates.” So I found a dozen or so in my wallet and took them to the Federal Assay Office on a nearby street called Old Slip. The clerk counted them, put the equivalent weights on one side of a huge balance scale, poured granulated silver onto the other side from a bag, and handed the silver to me in an envelope. I’m very glad that I still have it today, plus a few silver certificates that I didn’t convert . . . plus the rest of my memories of those early days. Wikipedia defines “fiat currency” as “state-issued money which is neither legally convertible to any other thing, nor fixed in value in terms of any objective standard.” Today the non-convertible dollar (like most other currencies) is a fiat currency. Wikipedia goes on to say fiat currencies “lack intrinsic value.” So if I complain that gold lacks intrinsic value, perhaps my wariness should also make me question dollars (and euros, pound sterling and yen). If gold has the limitations I describe in this regard, what can we say about currencies?

(Bruce Karsh goes on to raise a further conundrum: we may prefer income-producing assets, with their intrinsic value, to fiat currency. But the income they produce is reckoned in currency, and thus their value is as well.“real”

This pile of cash adds greatly to companies’ financial security and to the potential for dividend increases or stock buybacks in the future.  Finally, those selling or shunning stocks today seem to be overlooking some very attractive valuation parameters. o Price/earnings ratios are lower than usual. “The S&P 500 trades at 14.4 times annual earnings, compared with an average of 16.5, according to data . . . that goes back to 1954.” Not giveaway levels, but 13% below the post-war average. o Annual free cash flow for American companies excluding banks is running at 6.8% of their market value. This “cash flow yield” is roughly capable of being compared against the yield on bonds. Although (unlike dividends or interest) the cash flow isn’t necessarily received by investors as it’s earned, it should contribute to stocks’ value one way or another. The bottom line is that, as bond prices rise (reducing yields) and p/e ratios fall, the chances increase that stocks will outperform bonds. Thus the benefits high grade bond investors feel they’re gaining through what they’re buying can be undone by what they’re paying. I’ll say it another way: the attractiveness of one investment relative to another doesn’t come from what it’s called or how it’s positioned in the capital structure, but largely from how it’s priced relative to the other. I’m impressed today by the ability to assemble a portfolio of iconic, high quality, large-cap U.S.

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

Then, in recent weeks, things began to be discussed daily in the media – such as Greece’s profligacy and the risks involved in admitting it to the European Union; Europe’s lack of an established mechanism for dealing with a problem of this nature; and its reliance on Germany to contribute voluntarily to a solution – that in hindsight it seems should have been obvious. This tells us a few important things about investing:  Investors generally overestimate their ability to see the future, and the worst of them act as if they know exactly what lies ahead.  It’s important to worry about what’s coming next. The fact that we don’t know what it is shouldn’t permit us to think there’s nothing to worry about.  Low asset prices allow us to invest aggressively, without much consideration given to worrisome fundamentals and the possibility of negative surprises. But as prices rise, so should our degree of concern over these things. The bottom line is this: the fact that we don’t know where trouble will come from shouldn’t allow us to feel comfortable in times when prices are full. The higher prices are relative to intrinsic value, the more we should allow for the unknown. The recovery of 2009 in the face of significant fundamental uncertainty meant that the markets were reincorporating optimism and thus vulnerable to surprise and disappointment. This in itself should be sufficient to induce caution. May 12, 2010 © Oaktree Capital Management, L.P.Reserved

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

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: The Long View Many of my memos over the last year and a half have touched on the developments in 2003-07 that brought on the current financial crisis. By now, everyone understands the role of innovation, risk tolerance and leverage in the boom that led to the bust, so I think it’s now time to look back considerably further. The Importance of Cycles In my opinion, there are two key concepts that investors must master: value and cycles. For each asset you’re considering, you must have a strongly held view of its intrinsic value. When its price is below that value, it’s generally a buy. When its price is higher, it’s a sell. In a nutshell, that’s value investing. But values aren’t fixed; they move in response to changes in the economic environment. Thus, cyclical considerations influence an asset’s current value. Value depends on earnings, for example, and earnings are shaped by the economic cycle and the price being charged for liquidity. Further, security prices are greatly affected by investor behavior; thus we can be aided in investing safely by understanding where we stand in terms of the market cycle. What’s going on in terms of investor psychology, and how does it tell us to act in the short run? We want to buy when prices seem attractive.

The only things we have to fall back on at this juncture are intrinsic value, company survival and our own staying power as investors. Of course, even these things mean we have to make judgments about what the future is likely to look like. That requirement, in turn, means nothing can be approached with complete safety or certainty. Nevertheless, we can take action if we think those three elements will be present under most circumstances. That’s the right mindset for today. Harder Than Sudoku The impossibility of reaching into the economic toolbox for that one perfect tool is easily illustrated with a list of some of the challenges present today. For a learning exercise, skip today’s Sudoku or crossword puzzle and take a crack at resolving these dilemmas:  Consumer confidence and spending are weak. We want to stimulate, but we don’t want to replace weakness with hyperinflation.  We’re willing to drop fiscal discipline in favor of stimulus through deficit spending, but we don’t want to scare away offshore investors from the Treasury securities we’ll issue to fund our deficits.  We’re willing to distribute stimulus checks, but we seem unable to make frightened individuals spend the money rather than save it.and

” The truth is, risk tolerance is antithetical to successful investing. When people aren’t afraid of risk, they’ll accept risk without being compensated for doing so . . . and risk compensation will disappear. This is a simple and inevitable relationship. When investors are unworried and risk-tolerant, they buy stocks at high p/e ratios and private companies at high EBITDA multiples, and they pile into bonds despite narrow yield spreads and into real estate at minimal “cap rates.” In the years leading up to the current crisis, it was “as plain as the nose on your face” that prospective returns were low and risk was high. In simple terms, there was too much money looking for a home, and too little risk aversion. Valuation parameters rose and prospective returns fell, and yet the amount of money available to managers grew steadily. Investors were attracted to risky deals, complex structures, innovative transactions and leveraged instruments. In each case, they seemed to accept the upside potential and ignore the downside. There are few things as risky as the widespread belief that there’s no risk, because it’s only when investors are suitably risk-averse that prospective returns will incorporate appropriate risk premiums. Hopefully in the future (a) investors will remember to fear risk and demand risk premiums and (b) we’ll continue to be alert for times when they don’t.

For example, as of the middle of 2008, the average $1 billion-plus endowment is said to have had investments in and undrawn commitments to the main illiquid asset classes (private equity, real estate and natural resources) equal to half its net worth. Some had close to 90%. The willingness to invest in locked-up private investment funds is based on a number of “shoulds.” Illiquid investments should deliver correspondingly higher returns. Closed-end investment funds should call down capital gradually. Cash distributions should be forthcoming from some funds, enabling investors to meet capital calls from others. And a secondary market should facilitate the sale of positions in illiquid funds, if needed, at moderate discounts from their fair value. But things that should happen often fail to happen. That’s why investors should view potential premium returns skeptically and limit the risk they bear, including illiquidity. Comfortable with Complexity Investors’ desire to earn money makes them willing to do things they haven’t done before, especially if those things seem modern and sophisticated. Technological complexity and higher math can be seductive in and of themselves. And good times and rising markets encourage experimentation and erase skepticism. These factors allow Wall Street to sell innovative products in bull markets (and only in bull markets). But these innovations can be tested only in bear markets . . . and invariably they are.

Until the 1950s, equities always provided higher current yields . . . for the simple reason that they had to. People invested primarily for yield, and riskier securities – stocks – would attract buyers only if they promised higher yields than bonds. This changed in the second half of the 20th century:  Common stock investing was popularized; I believe Charlie Merrill of Merrill Lynch deserves a lot of the credit for this.  Prior to some pioneering computer work at the University of Chicago in the 1960s, the historic returns on stocks had never been scientifically quantified. Then the Center for Research in Security Prices came up with the 9.2% compound annual return that fired many investors’ appetites.  The concept of growth-stock investing was popularized in the 1960s; I remember reading a broker’s brochure about companies with exciting earnings growth. This led to the “nifty-fifty” investing craze, in which investors (and especially bank trust departments) bought the stocks of fast-growing companies regardless of valuation. The equity boom burst in the 1970s.1973-74,

© Oaktree Capital Management, L.P. All Rights Reserved Investors pulled a record $72 billion from stock funds overall in October alone . . . . If history is any guide, they may not return quickly. I want to make a heretical assertion: that equities aren’t the greatest thing since sliced bread, but rather an asset class that can do well or poorly depending on how it’s priced. Investors fell into a trap at the 1999 peak because they were seduced by stocks’ long-term average return in addition to their recent gains. Rather than ask “What’s been the historic return on stocks?” they should have asked “What’s been the historic return on stocks if you bought them when the average p/e ratio was 29 (which it was at the time)?” Once again, investors came to believe in the magic asset class and forgot the importance of reasonable valuation. The truth is, rather than being superior, equities are an inferior asset class . . . structurally, that is. Unlike debt, they don’t promise annual interest or repayment at maturity, and they don’t carry a senior claim against the company’s assets in case of trouble. All they offer is an uncapped participation in profits. Debt promises a stream of contractual payments, and common stocks provide the residual that remains after those payments have been made. Thus equities’ higher historic average and potential future returns should be viewed as nothing more than compensation for their inferior status and greater volatility.

© Oaktree Capital Management, L.P. All Rights Reserved dance. We’re still dancing.” The implication’s clear: No worries; high prices. No risk aversion; no risk premiums. Certainly that describes the markets in 2003-07. In the fourth quarter of 2008, when asset prices were collapsing, I imagined a very different conversation from that of 2003-07, with most investors saying, “I don’t care if I never make another dollar in the market; I just don’t want to lose any more. Get me out!” Attitudes toward the two risks were still unbalanced, but in the opposite direction. Just as risk premiums disappear when risk is ignored, so can prospective returns soar when risk aversion is excessive. In late 2008, economic fundamentals were terrible; technical conditions consisted of forced selling and an absence of buyers; and market psychology melted down. Risk aversion predominated, and fear of missing out disappeared. These are the conditions under which assets are most likely to be available for purchase at prices way below their fair value. They’re also the conditions in which most people go on buying strikes. In the future, investors should do a better job of balancing the fear of losing money and the fear of missing out. My response is simple: Good luck with that. Pursuing Maximization When markets are rising and investors are obsessed with the fear of missing out, the desire is for maximum returns. Here’s the inner conversation I imagine: “I need a return of 8% a year.

(On June 23, talking about general resilience – not investor attitudes – President Obama said the American people “. . .are still more optimistic than the facts alone would justify.”) On the other hand, there’s good reason to believe that at their lows, security prices had understated the merits. So are prices ahead of fundamentals today, or have they merely recovered from “too low” to “in balance”? There’s no way to know for sure. Unlike the fourth quarter of last year – when assets were depressed by terrible fundamentals, technicals and psychology – they’re no longer at giveaway prices. Neither are they clearly overvalued. Maybe we should say “closer to fair.” With price and value in reasonable balance, the course of security prices will largely be determined by future economic developments that defy prediction. Thus I find it hard to be highly opinionated at this juncture. Few things are compelling sells here, but I wouldn’t be a pedal-to-the-metal buyer either. On balance, I think better buying opportunities lie ahead.2009

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

But if some counterparties are unable to pay, institutions that bought insurance from them (or from others that bought from those institutions) might fail to receive billions in payments. Consider it one big daisy chain. It’s probably because of its position as a counterparty that Bear Stearns wasn’t permitted to fail in March (while Lehman was cut adrift this month when its failure was judged to be bearable). Of course, these two developments have been complicated by (a) the fact that no one can reasonably say what the home underlying a mortgage is worth (the intrinsic value of a non-cash-producing asset is a useless concept in the short run), (b) the fact that no one knows how the credit swap market will function in a crisis, and (c) their own sheer magnitude. The sum of the foregoing has the potential to place in jeopardy any financial institution that lacks federal backing. It’s for this reason that the government has assumed the liabilities of Fannie Mae and Freddie Mac, lent money to AIG, accepted Goldman Sachs and Morgan Stanley as bank holding companies (with permanent access to Fed borrowings), backstopped money market funds, and now proposes to purchase $700 billion of mortgage securities. UDoes Ben Know Something We Don’t? I cited the above headline in “Now What?” last January. That’s what breakingviews.com asked about the Fed’s September 2007 decision to cut rates by 50 basis points rather than the expected 25.

© Oaktree Capital Management, L.P. All Rights Reserved  By July 2007, however, the defaults became serious and could no longer be ignored. This precipitated wholesale downgradings of CDO debt securities.  The defaults and downgrades led to price declines. This caused leveraged investment entities that held CDO debt to receive margin calls and capital withdrawals. When they went to the market to sell the debt to raise cash, they found either that it couldn’t be sold or that the bids were way below fair value. When some investors announced significant losses, the mark-to-model approach often used for pricing was questioned and then rejected in favor of market prices.  In times of crisis, you sell what you can sell, not what you want to sell. Many of the entities that held CDO debt also held leveraged loans (the new term for bank loans, since most banks no longer hold on to loans for long). Thus, when they couldn’t get fair prices for CDO debt, they sold leveraged loans, putting their prices under pressure as well. And when the creation of new Collateralized Loan Obligations slowed to a trickle, the decline in demand from CLOs removed an important prop from loan prices.  Some leveraged entities that couldn’t sell enough CDO debt (or other holdings) at fair prices suspended withdrawals. In extreme cases, they melted down and investors lost everything.

© Oaktree Capital Management, L.P. All Rights Reserved the things that will influence the price of oil, such as finite supply, growing demand, and the unreliability of some of the producing nations. But what do those factors make it worth? No one can convert these intangibles into a fair price. That’s why, a few months ago at $147, we were seeing predictions of $200 oil. And now, with the price down two-thirds, there’s talk of $25. The same is true of commodities, gold, currencies, art and diamonds. And houses. What’s a house worth? What it cost to build? What it would cost to replace today? What it last sold for? What the one next door sold for? The amount that was borrowed against it? (Certainly not.) Some multiple of what it could be rented for? What about when there are no renters? The answer is “none of these.” On a given day, houses – and all of the things listed just above – are worth only what someone will pay for them. Well, that’s true in the short run for corporate securities, too, as we’ve seen in the last few months. But in the long run, you can expect security prices to gravitate toward the discounted present value of their future cash flows. There’s no such lodestone for houses. Think about one of the biggest jokes, the home appraisal. If a house doesn’t have a “value,” what do mortgage appraisers do? They research recent sales of similar houses nearby and apply those values on a per-square-foot basis.

But such an appraisal obviously says nothing about what a house will bring after being repossessed a few years later. Nevertheless, in recent years, a purchase price of $X, supported by an appraisal of $X, was used to justify lending 95% of $X – or maybe 100% or 105% – when a home was bought or refinanced. No wonder homes valued in the biggest boom in history have turned out to be unreliable collateral. Second, these overrated mortgages were packaged into the most alchemical and fantastic leveraged structures. It is these, not mortgages themselves, that have jeopardized our institutions. There was a limited market for whole mortgage loans; they were considered a specialist market entailing risk and requiring expertise. But supposedly those worries would be obviated if one bought the debt of structured entities that invested in residential mortgage-backed securities (RMBS). First question: where did the risk go? We were told it disappeared thanks to the magic of structuring, tranching and diversifying, permitting vast amounts of leverage to be applied safely. Second question: how reliable was the diversification? Answer: again we were told, highly reliable; there had never been a national decline in home prices, so mortgages could be considered uncorrelated with each other. The performance of a mortgage on a house in Detroit would be unaffected by what went on in Florida or California. (Well, so much for what we were told.)

© Oaktree Capital Management, L.P. All Rights Reserved I want to take this opportunity to congratulate and thank my Oaktree colleagues for their ongoing steadfastness. There’s a simple formula for taking maximum advantage of opportunities in a collapsing market: (a) have a firm, well-reasoned estimate of an asset’s intrinsic value; (b) recognize when the asset’s price falls below its value, and buy; (c) average down if the price goes lower; and (d) be right about the value. Acumen and resolve are both essential. My colleagues continue to show both. In recent weeks our list of purchases has been long most days, and our list of sales almost non- existent. Where there’s cash we’ve put a lot to work, averaging down aggressively, in what we think are great buys. I also want to thank our clients for trusting us and sticking with us. As Bruce Karsh and I wrote ten days ago in a memo to investors in our Opportunities Funds for distressed debt, “. . . in a few years we’ll reminisce together about how easy it was to take advantage of the bargains of 2008-09.” Whether or not the worst of the crisis is now truly behind us, I continue to feel that way. October 15, 2008

Another chance for someone else to help me say it better, this time from 100-plus years ago: As a general rule, it is foolish to do just what other people are doing, because there are almost sure to be too many people doing the same thing. “Common Sense” and Other Oxymorons Take, for example, the investment that “everyone” believes to be a great idea. In my view by definition it simply cannot be so.  If everyone likes it, it’s probably because it has been doing well. Most people seem to think outstanding performance to date presages outstanding future performance. Actually, it’s more likely that outstanding performance to date has borrowed from the future and thus presages sub-par performance from here on out.  If everyone likes it, it’s likely the price has risen to reflect a level of adulation from which relatively little further appreciation is likely. (Sure it’s possible for something to move from “overvalued” to “more overvalued,” but I wouldn’t want to count on it happening.)  If everyone likes it, it’s likely the area has been mined too thoroughly – and has seen too much capital flow in – for many bargains to remain.

But when every Tom, Dick and Harriet joins the herd, after the merits of the situation have become obvious to all, they can’t expect a bargain; the merits must be reflected fully – or to excess – in the price. In fact, each of those latecomers bears the risk of being the last to jump on the bandwagon . . . just before it goes off the cliff. The Best Companies in America As readers of these memos know, I first worked in the Investment Research Department of First National City Bank (now Citibank) in 1968. Whereas common stocks traditionally were bought on the basis of their issuers’ current book value and earnings, “growth investing” recently had come into fashion. Under this new approach, buyers paid higher-than-usual valuation multiples for the stocks of “growth companies” in recognition of the above-average rates at which their earnings were projected to increase in the future. Growth investing reached its zenith in the pursuit of the “Nifty Fifty,” and that’s the style the bank pursued to the virtual exclusion of all others. It consisted of buying the stocks of the best, fastest-growing companies in America, companies like IBM, Xerox, Polaroid, Kodak, Hewlett Packard, Texas Instruments, Perkin Elmer, Merck, Lilly and Avon. Each one was a corporate icon, or what I call a “head nodder” – one person says “Xerox” and everyone else nods and says “great company.

© Oaktree Capital Management, L.P. All Rights Reserved UIt’s Different This Time My memos are full of quotations, adages and old saws. I’m attached to a few and tend to use them over and over. Why reinvent the wheel, especially if the old one can’t be improved upon? Hopefully the things I borrow contain enough wisdom to make them worth repeating. Equally worth repeating are the statements I cite as investor mistakes. They, too, are highly instructive . . . in the sense that they’re heard often and must be recognized for how potentially toxic they are. None is as dangerous as “it’s different this time.” Those four little words are always heard when the market swings to dangerously high levels. Like so many of the polar opposites enumerated above, it’s not just the sign of an absurd condition. It’s a prerequisite. I first came across the phrase in what for me was a seminal article, “Why This Market Cycle Isn’t Any Different,” by Anise C. Wallace (New York Times, October 11, 1987). The stock market’s rapid ascent at the time was being attributed to (or excused by), among other things, (1) the outlook for continued economic growth, given that the economy had learned how to correct itself painlessly, (2) the likelihood of continued buying of U.S. stocks by foreign investors piling up dollars with no better place to go, and (3) the fact that stocks weren’t overvalued compared to other assets, which had also appreciated. But Ms.

Wallace countered as follows: “No matter what brokers or money managers say, bull markets do not last forever. In general, investment professionals say, cycles and markets differ only by degree.” And of course, in the next eight days the Dow fell 30%. It wasn’t just 1987. People also came to believe the business cycle had been tamed in 1928 and in the late 1990s. And wouldn’t you know, I’m hearing it again today:  The Fed’s skillfully walking the tightrope between stimulus and restrictiveness. (A few years ago people felt Greenspan was indispensable; now there’s suddenly faith in Bernanke.)  A service economy is less volatile than a manufacturing-based economy.  As the Chinese and Indians get rich, their purchases from us will buoy our economy. The truth is, we couldn’t have great cyclical extremes if people didn’t occasionally fall for a justification that’s never held true before. How else might investors rationalize holding or buying despite highly elevated valuation parameters, low prospective returns and just-plain- wacky security structures? I still believe what I wrote in “The Happy Medium”: Cycles are inevitable. Every once in a while, an up- or down-leg goes on for a long time and/or to a great extreme and people start to say “this time it’s different.” They cite the changes in geopolitics, institutions, technology or behavior that have rendered the “old rules” obsolete. They make investment decisions that extrapolate the recent trend.

© Oaktree Capital Management, L.P. All Rights Reserved buyers of their stocks have already paid in full for greatness. Others will disappoint, and the stock of a disappointing company that’s been bought at a great-company price can be a disaster. By 1970, the scene had been set for just such a development by the Nifty Fifty investors’ attitude toward valuation: “These companies are so good, and growing so fast, that there’s no such thing as a price that’s too high. If the price seems excessive given this year’s earnings, just wait; the earnings will grow enough to justify the price.” Those who participated can say they cared about price, but I never heard of anyone refusing to hold those stocks just because they were priced too high. Such discipline is rarely seen during investment manias. The rest, as they say, is history. In the early and mid-70s, the wheels fell off. Common stock investing, which had become extremely popular, fell out of favor. Business Week ran its famous cover story, “The Death of Equities.” The economy became mired in stagflation. Great companies’ earnings failed to grow and sometimes contracted. Nifty Fifty stocks that had traded at p/e ratios of 80 and 90 fell to p/e ratios of 8 and 9 (really). And The Wall Street Journal eventually ran its customary listing of stocks that had lost 90% – a possible buy signal that depressed investors routinely ignore. So we had a quick lesson in the folly of buying on supposed merit alone, without regard to price.

© 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.

Long-Term Capital Management, the Granite Fund, Amaranth Advisors, the two Bear Stearns funds, Sowood Alpha Fund and Basis Yield Alpha Fund were all marked by “safe” positions leveraged to the sky. And they all melted down. In a number of ways, perpetuation of the market conditions of the last few years was dependent on several assumptions about liquidity:  that investors with liquidity would be eager to put it to work,  that providers of capital would make liquidity available, meaning that leveraged investors would be able to maintain their portfolio holdings and buy more,  that securities markets would remain liquid, such that holdings could always be sold at prices close to their intrinsic value, and  that funds would therefore be able to keep the promise of liquidity that they’d made to their investors. In short, it was assumed that liquidity would continue to flow in the direction of leveraged investment funds (in the form of financing and incremental capital commitments) rather than away (in the form of margin calls and investor withdrawals). Two or three months ago the world was described daily as “awash in liquidity.” Where is it now? Investments requiring nothing more than the perpetuation of favorable market conditions can be very seductive. And they work most of the time . . . until the pit has been dug deep enough, the branches have been spread, and everyone has forgotten about the existence of risk.

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

© 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.

For a final example, what about the asset-class return on private equity? This strikes me as an even more unreliable concept. The return on a private equity investment will come from the combination of (a) the potential of the underlying company and (b) the ability of the manager to identify the opportunity, buy the company at a good price, make it a better company, and sell it at higher valuation parameters than it was bought for. Certainly all of the elements included in “b” are highly dependent on the manager’s skill and have little or nothing to do with the fact that the investment belongs to a given asset class. UAbsolute-Return Investing My memos are often sparked by something I stumble on, and this one is no exception. The prompt came from “The Myth of the Absolute-Return Investor” by M. Barton Waring and Laurence B. Siegel (Financial Analysts Journal, March/April 2006). Many people talk today about absolute-return investing and say they want to put money with absolute-return funds and managers. But as Waring and Siegel indicate, there’s no broad agreement on what that means. They start their article by citing a few popular definitions for absolute-return investments, which seem to be distillable to investments possessing the potential for positive returns regardless of general market conditions. In my opinion, if you’re interested in absolute return investing, you should be looking for a steady outcome rather than responsiveness to market conditions.

© Oaktree Capital Management, L.P. All Rights Reserved willing to settle for less. To quote Peter Bernstein, “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.” My bottom line, as they might say in the self-help books: Listen to your inner Martian. What’s going on usually isn’t that big a mystery. An overheated environment doesn’t mean the market’s going down tomorrow, just as an excess of risk aversion doesn’t signal it’s the absolute bottom. But the circumstances should inform our behavior. Simply observing what’s going on around you and acting accordingly should improve your investment results. And the distinctions needn’t be cut too fine. There can be lots of room for argument between “undervalued” and “fairly valued,” or between “fairly valued” and “overvalued” – that’s where most of the uncertainty lies. But it’s unlikely that disciplined investors will find it hard to choose between overvalued and undervalued. In my opinion, if you’re wracking your brain trying to figure out whether something’s overvalued or fairly valued – that is, whether you should sell or continue to hold – it’s usually pretty clear that it’s not a buy. 1BUWhat Is Going On Around Us Today? No one I know thinks investors today are acting out of an excess of caution, and I agree.

© Oaktree Capital Management, L.P. All Rights Reserved But how do you determine the intrinsic value of a Euro, a bar of gold or a barrel of oil? You can talk about the positives and the negatives associated with these goods. But how do you convert those things into a price? For example, the factors that argue for high oil prices are obvious. “The supply is finite.” “We’re using it up at an accelerating rate.” “Environmental issues in the U.S. will constrain the domestic supply.” “Much of the foreign supply is in the hands of hostile or unpredictable governments: Iran’s a worry, Venezuela is turning anti-American, and Saudi Arabia is subject to instability.” Sure they make oil a valuable good, but how valuable? How do we know the current price doesn’t adequately reflect these things already? What’s the UrightU price for it? We had a particularly instructive lesson in July. The price of oil had been strong, and the outlook was for more of the same. With the price at $77 per barrel, it was reported that the Alaskan pipeline had to be shut down to repair damage. With domestic shipments restricted, the price had to rise; oil UhadU to be a buy. But the $77 price at which oil traded on the day of the announcement hasn’t been seen since. Within just four months, the price of oil fell to $55 (down 28%) – and the factors listed above were just as true at $55 as they were at $77.

© Oaktree Capital Management, L.P. All Rights Reserved USelling dearU – Of course, you can always hope to sell at valuation multiples higher than you paid, but it’s not reasonable to count on being able to do so all the time. Purchase multiples below the historic norms could buttress such an expectation, but we’re not there now. Today’s valuation multiples are being supported by low interest rates (prices of financial instrumen as demanded yields decline, and vice versa), and higher interest rates would be expected to reduce sale prices for companies. And as the subject companies get bigger and bigger, the number of possible buyers shrinks. For the $30 billion companies that are being talked about today, the stock market may be the only exit, and that’s something that can’t be counted on ye in and yea ts rise ar- r-out. So in contrast to the description of the golden days of buyouts on the previous page, today we have:  A buyout phenomenon that everyone’s aware of and eager to play.  A stock market that can’t be described as cheap.  Heavy competition to buy target companies.  Dependence on financial engineering based on low interest rates and generous capital markets that may not stay that way forever. We also see companies being sold from one buyout fund to another. What does that imply? In most transactions, one party’s right and the other’s wrong. Generally, the buyer can’t be getting a bargain unless the seller is accepting less than he should.

© 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.

© Oaktree Capital Management, L.P. All Rights Reserved In that vein, The Wall Street Journal of March 22 carried a story comparing the cost of buying and renting. A study of 21 markets by Torto Wheaton Research had found that rent on the average two-bedroom apartment was well below the mortgage payment on the median home. Now certainly the two may not be comparable, and the study ignored such factors as down payments, tax deductions, property taxes, maintenance costs and appreciation. But the most important observation is that, based on national averages, the relationship has changed substantially over the last four years: rent now averages 92% of mortgage payments, down from 102% in 2001. This relative increase in mortgage payments indicates that today, home prices are based on lower “cap rates.” The capitalization rate on a piece of real estate is the yield implicit in the sale price. Thus a cap rate is analogous to the earnings yield on a stock, which in turn is the reciprocal of its p/e ratio. Bottom line: home prices have risen substantially relative to the underlying (or implicit) cash flows. According to another study, by M/PF YieldStar, the price of the average home rose 16.4% in 2003-4, while the average rent was flat. Certainly real estate valuation ratios are up. Why are homebuyers paying these higher valuations? Here are some answers, in the form of statements quoted in the New York Times article cited above.

How many of the investor errors enumerated on pages 2-3 do you see below? It’s driven by the same forces [as drove the dot-com stocks]: that investments can’t go bad; that it has the potential to make you rich; that you’ll regret it if you don’t do it; that it looks expensive but really is not. . . . a limited supply of land coupled with demand from baby boomers and foreigners [will] prolong the boom indefinitely. I don’t think prices are going to fall, and I don’t think they’re even going to be flat. It really is a very hot real estate market, and I don’t know how long it’s going to continue. But in the short run, why not profit from it? I look at this as a short-term investment and plan to unload it as soon as things look dangerous. I’d bet none of the people quoted above lost money in the last real estate cycle or learned the lessons of the past. It’s for that reason that they’re prone to mistake the up-leg of yet another cycle for a new and permanent miracle. And so it goes. The commercial, retail and residential properties that professionals buy have escalated also – although not as crazily or with as much disregard for valuation. Nevertheless, cap rates are down in response to the general decline in interest rates, demanded returns and risk premiums. With returns on Treasury bonds at 4-5%, fully leased class “A” office buildings apparently look good at 6-7%.

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

” If the consensus of investors feels the same, that’s what the spread will be. What if we depart from investment grade bonds? “I’m not going to touch a high yield bond unless I get 600 over a Treasury note of comparable maturity.” So high yield bonds are required to yield 12%, for a spread of 6 percent over the Treasury note, if they’re going to attract buyers. Now let’s leave fixed income altogether. Things get tougher, because you can’t look anywhere to find the prospective return on investments like stocks (that’s because, simply put, their returns are conjectural, not “fixed”). But investors have a sense for these things. “Historically S&P stocks have returned 10%, and I’ll only buy them if I think they’re going to keep doing so.” So in theory, the common stock investor determines earnings per share, earnings growth rate and dividend payout ratio and inputs them into a valuation model to arrive at the price from which S&P stocks will return 10% (although I’m not sure the process is nearly that methodical in actuality). “And riskier stocks should return more; I won’t buy on the NASDAQ unless I think I’m going to get 13%.” From there it’s onward and upward. “If I can get 10% from stocks, I need 15% to accept the illiquidity and uncertainty associated with real estate. And 25% if I’m going to invest in buyouts . . . and 30% to induce me to go for venture capital, with its low success ratio.

Well that’s the way I’ve always thought of the investment world. Mainstream institutional investors emphasize the big asset classes and follow the big companies, creating a relatively efficient market and a context for relative valuation. But their attention wanes as the targets shrink, and their hands are tied by constraints on their behavior. Little guys such as hedge funds operate in the interstices. They take advantage of small inefficiencies and misvaluations that the big guys create, permit or ignore. They pursue things that are unseemly, esoteric or highly labor intensive. And they can employ tactics like leverage and shorting – and live with levels of portfolio concentration and illiquidity – that aren’t tolerated in the mainstream investment world. In other words they, too, benefit from the big guys’ leavings. The critical question is obvious: How many little fish can thrive in the shadow of each big fish? A hundred little fish trailing each big one all can do well. But those crumbs won’t feed five hundred. Not only will the crumbs be insufficient in number, but the crowd will fight over them in a way that’s unhealthy for everyone. Tortured enough? Maybe so, but I think the analogy holds. In my time in this business, the institutions have been the big fish of the investment world, and the hedge funds and alternative investment specialists have profited from their biases and limitations.

© Oaktree Capital Management, L.P. All Rights Reserved  How much of a bargain-priced security can be bought without the price being driven up?  How big an arbitrage position can be put on without the profit spread shrinking?  How many shares of an overvalued stock are available for short-sellers to borrow?  How much of something can the hedge funds collectively own without illiquidity closing their exit window? When there’s an increase in the amount of capital that investors want to put into an area, there’s no reason to expect a commensurate increase in the opportunities for good investment. So when the ratio of money to ideas increases, the implications for future performance can’t be good. Now it should be made clear that the venture capital boom, for one example, was based in a very narrow investment segment and dependent on the creation of new companies for the deployment of capital. Hedge funds, on the other hand, collectively are able to invest in any form of asset or security, in all of the world’s markets and employing a wide variety of investment techniques, and through shorting they have to ability to profit from “inefficiencies” in overvalued as well as undervalued assets. Thus the potential universe for hedge fund investments is enormous in the absolute.

When investors are in a pessimistic mood and can’t see more than a few years out, they can only think about the negative cash flows and are unable to imagine a time when the building will be rented and profitable. But when the mood turns up and interest in future potential runs high, investors envision it full of tenants, throwing off vast amounts of cash, and thus salable at a fancy price. Fluctuation in investors’ willingness to ascribe value to possible future developments represents a variation on the full-or-empty cycle. Its swings are enormously powerful and mustn’t be underestimated. UValue Investing vs. Growth Investing – (or Value Today vs. Value Tomorrow) Interest in “value investing” versus “growth investing” is another phenomenon that fluctuates over time, with the relative popularity of growth investing based heavily on investors’ willingness to value the future. It’s not just a random fad, but a reflection of a cycle in attitudes. In my view, all investors try to buy value – that is, to buy something for less than it’ll turn out to be worth. The difference between the two principal schools of investing can be boiled down to this: “Value investors” buy stocks (even those whose intrinsic value may show little growth in the future) out of conviction that the current value is high relative to the current price.

When you’re talking about a 10% 10- year bond, you can argue about whether the return over the next few years will be 15%, 10%, 5% or zero. But when you’re talking about a 5% bond, the range by definition has to be significantly lower.  Finally, stocks are well down from their highs; their valuations have been rendered less excessive by today’s generally higher corporate earnings; and they aren’t being borne aloft by capital inflows. On the other hand, absolute p/e ratios are still high, supported by the low level of interest rates, and there’s the risk of downward valuation when people realize that the long-term return on stocks is likely to be driven by profits growth in mid-single digits. Taking all of the above into consideration, I feel this is a time when the route to investment success may be via the “least bad” course of action. For over a year I’ve been telling the boards on which I serve that I view the solution as “special niches, special people.” Because the vast majority of asset classes are high priced and crowded, the key is to find those that are less so. Similarly, it’s important to choose managers with enough talent and discipline to make the most of the current situation. None of my observations is sure to be right, as always, but I want to share my thinking about what’s going on in the investment markets today.2004

Joining the herd and participating in the extremes of these cycles obviously can be dangerous to your financial health. The markets’ extreme highs are created when avid buyers are in control, pushing prices to levels that may never be seen again. The lows are created when panicky sellers predominate, willing to part with assets at prices that often turn out to have been grossly inadequate. “Buy low, sell high” is the time-honored dictum, but investors who are swept up in market cycles too often do just the opposite. The proper response lies in contrarian behavior: buy when they hate ‘em, and sell when they love ‘em. “Once-in-a-lifetime” market extremes seem to occur just once in a decade or so – not often enough to build an investment career around capitalizing on them. But attempting to do so should be an important component of any investor’s approach. Just don’t think it’ll be easy. You need the ability to detect instances in which prices have diverged significantly from intrinsic value. You have to have a strong-enough stomach to defy conventional wisdom (one of the greatest oxymorons) and resist the myth that the market’s always efficient, and thus right. You need experience on which to base this resolute behavior. And you must have the support of understanding, patient constituencies.

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

© Oaktree Capital Management, L.P. All Rights Reserved how to invest in today’s stock market. “Figure out which industries have been doing best, and pick out the leading companies in those industries. The professionals know which they are, so their stocks will sport P/E ratios that are higher than the rest. But that’s okay: do you want the best companies or the worst?” My answer’s simple: I want the best buys. The most important thing is a solidly based, strongly held estimate of intrinsic value. To value investors, an asset isn’t an ephemeral concept you invest in because you think it’s attractive (or think others will find it attractive). It’s a tangible object that should have an intrinsic value capable of being ascertained, and if it can be bought below its intrinsic value, you might consider doing so. Thus intelligent investing has to be built on estimates of intrinsic value. Those estimates must be derived rigorously, based on all of the available information. And the level of belief in estimates of intrinsic value has to be high. Only if the estimate is strongly held will a manager be able to do the right thing. If there’s no conviction, a drop in the price of a holding can weaken the investor’s faith in the estimate and make him fail to buy more, or maybe even sell, just when a lower price should lead him to increase his position.

Thus it's tempting to think that the moderation of expectations may have stemmed from the corrosive emotional effect of recent losses on investor psyches, not from new data or objective analysis.  In fact, it's comforting to note a hopeful analogy. In August 1979, after a harsh correction in 1973-74 followed by several sluggish years, the cover of Business Week proclaimed "The Death of Equities" . . . just prior to the ignition of the historic bull market that lasted through 1999. As in that case, with attitudes toward equities beaten down so universally, the contrarian position today might be to bet heavily on them. Sentiment toward equities can hardly get worse and, unimaginable as it seems, it just could get better. At the same time, there are negatives to be dealt with:  Even though stock prices have come down substantially, the average P/E ratio remains high – in the upper teens or low twenties, depending on whom you ask. In the last major cycle, which bottomed in the 1970s, P/E ratios reached levels like today's at the UhighU and fell to single digits when prices hit bottom. By that standard, today's valuations suggest a high, not a low.  One reason today's P/E ratios are high in the absolute is that interest rates are so low. Low interest rates justify a high valuation of future cash flows.what

© Oaktree Capital Management, L.P. All Rights Reserved Oaktree follows a clearly defined route that it trusts will bring investment success: If we avoid the losers, the winners will take care of themselves. We think the most dependable way for us to generate the performance our clients seek is by avoiding losing investments. We don’t claim that this is the only way to invest well; others may choose more aggressive approaches, and they may work for them. This is the way for us. Investing defensively can cause you to miss out on things that are hot and get hotter, and it can leave you with your bat on your shoulder in trip after trip to the plate. You may hit fewer home runs than another investor . . . but you’re also likely to have fewer strikeouts and fewer inning-ending double plays. The ingredients in defensive investing include (a) insistence on solid, identifiable value at a bargain price, (b) diversification rather than concentration, and (c) avoidance of reliance on macro-forecasts and market timing. Warren Buffett constantly stresses “margin of safety.” In other words, you shouldn’t pay prices so high that they presuppose (and are reliant on) things going right. Instead, prices should be so low that you can profit – or at least avoid loss – even if things go wrong. Purchase prices below intrinsic value will, in and of themselves, result in larger gains, smaller losses, and easier exits. “Defensive investing” sounds very erudite, but I can simplify it: Invest scared!

© Oaktree Capital Management, L.P. All Rights Reserved UWhere Were the Strategists? Another group that’s no longer riding quite as tall in the saddle are the brokerage house strategists. They attracted a lot of respect in the ‘90s, and some even attained “household name” status. But I don’t know of any who helped their clients avoid the pain of the last three years. I think the test is simple: Did they call the TMT bubble? It’s obvious in retrospect that many of the tech/media/telecom companies and their strategies were somewhere between fanciful and fictitious; the valuation multiples were ridiculous; investor behavior was nuts; and Wall Street had turned into a machine for short-term appreciation. If it’s so obvious in retrospect, lots of the strategists (whose sole job it is to figure out what’s going on and what it means for the future) should have had an inkling at the time. Since this was the most extreme event of our investment lifetime thus far, and since it built up in plain sight over a period of years (as opposed to being the result of a sudden and surprising exogenous influence), shouldn’t the strategists have seen it? The emperor was as naked as he’s ever been, but the brokerage strategists failed to point it out. Abby Joseph Cohen was the most prominent of the strategists, having made a real name for herself by correctly predicting stock price gains for a decade or more.

© Oaktree Capital Management, L.P. All Rights Reserved major gains if one is to achieve the absolute prerequisite for investment success: survival. The most important thing is being mindful of cycles (and where we stand in them). We must never forget about the inevitability of cycles. Economies and world affairs rise and fall in cycles. So does corporate performance. The reactions of market participants to these developments also fluctuate cyclically. Thus price swings usually overstate the swings in fundamentals. When developments are positive and corporate profits are high, investors feel good and often bid assets to prices that more than reflect their intrinsic value. When developments are negative, on the other hand, panicky investors are prone to sell them down to overly cheap levels. So prices sometimes represent high multiples of peak prospects (as they did with technology stocks in the ‘90s), and sometimes low multiples of trough prospects. Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do. People often act as if companies that are doing well will do well forever, and investments that are outperforming will outperform forever, and vice versa. Instead, it’s the opposite that’s more likely to be true. The most important thing is contrarian behavior.

© Oaktree Capital Management, L.P. All Rights Reserved Perhaps the website FierceFinance summed it up best that same day: “Now, Wall Street firms are pondering whether [star strategists] have become anachronisms. It reminds me of the perennial debate in Great Britain about the need for royalty in the modern era.” 6BUHow Do They Rate? While we’re on the subject of who knows what, we should consider the credit rating agencies. These organizations are dedicated to assessing the quality of debt securities. They’ve been around for scores of years and are viewed as objective. So highly are they thought of that their ratings are accepted as regulatory standards and incorporated into law; there’s even a special SEC label for them: “nationally recognized statistical rating organizations.” But do they do any good? I confess: I love the rating agencies! Oaktree would be lost without them. My whole career and many of Oaktree’s activities are based on opportunities created by credit ratings. First, a digression: In an efficient market, there’s no chance for superior returns through active management. Active managers need markets that are inefficient. What are inefficient markets? They’re markets where mistakes are made; where assets sell for prices different from their fair value and thus can be bought for less (or sold for more) than they’re worth.

© Oaktree Capital Management, L.P. All Rights Reserved billion dollars were withdrawn from stocks, the effect was moderate. But when those same refugee dollars sought deployment in our niche markets, the impact was dramatic. In the last few months, what had been a buyers' market has become a sellers' market. Last year, especially in distressed debt, it was "the more money, the better." Now it's the opposite. In the long run the return on an investment will follow the fundamentals, and in that sense I think of it as something approaching a fixed-sum proposition. But market fluctuations will render the receipt of that return highly uneven, as price moves above and then below intrinsic value. Thus, everything else being equal, a higher return to date means a lower return in the future. In this way the recent increase in bond prices implies lower bond returns in the future, and the narrowing of yield spreads implies lower relative returns for lower-rated bonds. A manager of lower-rated bonds hates to have to make these admissions, but refusing to make the admissions wouldn't make them any less true. UThe Cat, the Tree, the Carrot and the Stick I hope you'll forgive an incredible mixing of metaphors, but I can't resist using one to sum up on the subject of the current investment environment. As I think about situations like today's, (which, by the way, is not unprecedented), I visualize a cat in a tree.

Under these circumstances, assets can be mispriced relative to their intrinsic value, relative to their risk, and relative to each other. And discernible mispricings are a necessary condition for profitable active management. Only if mispricings exist such that they can be exploited by skillful managers can consistent outperformance be possible. Finance theory holds that because it takes higher prospective returns to induce investors to make riskier investments, risk and apparent prospective return must be correlated. It also holds that since investors can’t add to returns through active management, the only way to increase returns is by accepting more risk. This makes great sense with regard to markets that are efficient. And it highlights a final attraction of less efficient markets: that risk and return need not be so perfectly correlated. Thus, in inefficient markets, “low risk” doesn’t have to mean “low return.” In fact, I think our team’s greatest accomplishment is having demonstrated over a long period of time that low risk and high returns can go hand in hand (and, in fact, that low risk can lead to higher returns). Because of my views on market efficiency and its ramifications, I made a conscious decision 25 years ago to work exclusively in markets I believe are inefficient. It’s there that hard work and skill can pay off dependably.risk-

© Oaktree Capital Management, L.P. All Rights Reserved adjusted returns, it’s not likely to be by doing the same things everyone else is doing. The best and most safely earned profits are apt to be found outside the mainstream, not inside. The most important thing is being leery of leverage. The key elements in Oaktree’s investment approach include focusing on what’s out of favor; ascertaining intrinsic value and trying to buy for less; and adding value by working with assets once we own them. If done well, these things can simultaneously increase prospective return and reduce risk. Leverage, on the other hand, increases prospective return and UincreasesU risk. There’s nothing magic about leverage. It increases upside potential, but it also reduces or eliminates the margin of safety. Leverage is just an application of the Las Vegas maxim, “The more you bet, the more you win when you win.” But I think people tend to omit “. . . and the more you lose when you lose.” As Warren Buffett puts it, “It’s a very sad thing. You can have somebody whose aggregate performance is terrific, but they have a weakness – maybe it’s alcohol, maybe it’s susceptibility to taking a little easy money – it’s the weak link that snaps you. And frequently, in the financial markets, the weak link is borrowed money” (emphasis added).

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

Certainly investor behavior has turned bearish. Selling sometimes seems indiscriminate. Every better performing group gets its turn in the barrel. The value stocks that outperformed for the last two years are sharing the pain of the growth stocks. It seems there's no place to hide. Investors complain that they can't take it and have started to throw in the towel. Maximum panic usually coincides with minimum prices. Thus these may be signs that capitulation, the exhaustion of selling, and a bottom are near. UNegative Arguments On the other hand – as any good politician would say – there are counter-arguments to many of the above, and a large number of additional negatives to be considered. In my opinion, just as the strongest positive is seen in the failure of the market to reflect the ending of the recession, I think the counter to that – and the strongest negative – lies in the matter of valuation. In short, the fact that stocks are down since the end of the recession, and down a great deal from their peak, doesn't mean they're cheap. In fact, most rumination on the market's future direction touches on the correction, investor psychology and the economy, but not whether stocks are rich or cheap, always a difficult subject to plumb.

© Oaktree Capital Management, L.P. All Rights Reserved Governments at all levels also are likely to see their revenues decline. The Federal government will run deficits, (the end of which was one of the factors lifting the market in the late 1990s), and the states and cities will cut back on spending, with a retarding effect on the economy. If both individuals and institutions have less cash to invest and less willingness to part with it, our reliance on foreign capital is likely to become clearer. But with foreign investors no longer feeling they can count on the dollar to be worth ever-increasing amounts of yen or euros, inflows of those currencies for dollar investments are less dependable. The implications for security prices and capital formation are obviously negative. And questions about our system's integrity and transparency can't help. Beyond the fundamentals of economy and valuation, there are a vast number of psychological factors to be considered:  Of course, cynicism prompted by corporate misdeeds tops the list. Who'll invest in the face of the corruption at "all these companies"? How many investors realize that the dishonest acts have been limited to a handful of firms? Or that there is a difference between aggressive accounting and fraud? Who'll believe even the simplest of management's statements about cash in the bank or the next quarter's earnings? (By the way, I think the recent exposure itself can be counted on to produce better corporate behavior.

© Oaktree Capital Management, L.P. All Rights Reserved The need for time came into play in another way for the technology and telecommunications entrepreneurs. Many raised the money they needed for a year or two and proceeded to burn it up. They counted on being able to raise more later, but in 2000-02 capital has been denied even to worthwhile ideas. Lots of companies never got the chance to reach profitability. They simply ran out of time. UFifthU, you must never forget the key role played by valuation. Investment success doesn't come primarily from "buying good things," but rather from "buying things well" (and the difference isn't just grammatical). It's easy for most people to tell the difference between a good company and a bad one, but much harder for them to understand the difference between a cheap stock and an expensive one. Some of the biggest losses occur when people buy the stocks of great companies at too-high prices. In contrast, investing in terrible companies can produce huge profits if it's done at the right price. Over time, investors may shift their focus from dividend yield to p/e ratio, and they may stop looking at book value, but that doesn't mean valuation can be considered irrelevant. In the tech bubble, buyers didn't worry about whether a stock was priced too high because they were sure someone else would be willing to pay them more for it. Unfortunately, this "greater fool theory" only works until it doesn't.

When seeking appreciation, you can look for one or more of the following: 1 increases in an asset's intrinsic value (earnings or asset values), 2 movement of the asset's price from a discount toward its intrinsic value (that is, from undervaluation to fair value), and/or 3 movement of the price from intrinsic value toward a premium (that is, from fair value to overvaluation). In my opinion, superior returns come most dependably from buying things for less than they're worth and benefiting from the movement of price from discount to fair value. Making money this way doesn't require increases in intrinsic value, which are uncertain, or the attainment of prices above intrinsic value, which is irrational. The attractiveness of buying something for less than it's worth makes eminent sense. However, doing so requires cooperation from someone who's willing to sell it for less than it's worth. It's the SEC's goal to make sure that everyone has the same corporate information. So how is one to find bargains in efficient markets? You must bring exceptional analytical ability, insight or foresight. But because it's exceptional, few people have it. Once in a while someone will find an undervalued stock or guess right about the direction of the market, but very few people are able to do those things consistently over time.

They also thought the technological developments were so great that the companies' stocks could be bought regardless of price. In the end, though, when newness becomes old, flaws appear and investor ardor cools, the only thing that matters is the stock's price . . . and it's usually much lower. Most shortages – whether of commodities or securities – ease when high prices inevitably cause supply to rise and satisfy the demand. And no fad lasts forever. Thus valuation eventually comes into play, and those who are holding the bag when it does are forced to face the music. USixthU, beware the quest for the simple solution. Two important forces drive the search for investment options: the urge to make money and the desire for help in negotiating the uncertain future. When a market, an individual or an investment technique produces impressive returns for a while, it generally attracts excessive (and unquestioning) devotion. I call this solution-du-jour the "silver bullet." Investors are always looking for it. Call it the Holy Grail or the free lunch, but everyone wants a ticket to riches without risk. Few people question whether it can exist, or why it should be available to them. At the bottom line, hope springs eternal. Thus investors pursued Nifty-Fifty growth stock investing in the 1970s, portfolio insurance in the '80s, and the technology boom of the '90s.

© Oaktree Capital Management, L.P. All Rights Reserved. What about people – like those of us at Oaktree – who don’t consider themselves macro forecasters or market timers? Even the most devoted value investor acts on the basis of expectations: that an asset selling at x will turn out to be worth 2x, and that one of these days everyone else will recognize its value and bid it up. And the agnostic buy-and-hold equity investor operates under the assumption that the economy will expand, companies will increase their profits, and stock prices will rise as a result. Let’s say investors reach their conclusions about current intrinsic value or future earnings growth by applying skillful analysis to accurate data and reasonable assumptions. Let’s grant, in short, that their conclusions are “right” in some abstract sense. It still takes a great deal of luck for their version of future events to materialize. Elroy Dimson of the London Business School is responsible for one of the most trenchant observations: “Risk means more things can happen than will happen.” In other words, the future isn’t a predetermined scenario that’s sure to unfold, but rather a range of possibilities, any one of which may happen. Investors formulate opinions as to which of them will happen. Those opinions may be well-reasoned or dart throws. But even the most rigorously derived view of the future is far from sure to be right. Many other things may happen instead.

 Politicians will keep battling to show who's less tolerant of corruption. Democrats will pick on Republicans for their closeness to business, and Republicans will strive to show they're just as tough as Democrats. I think this is overwhelmingly likely to last through the November elections.  The media will throw gasoline on the fire as always, rising up in indignation whenever they detect a sensational story. The stories are too good, the targets are too rich and attractive, and the rewards for resisting sensationalism are few and far between. Reporters who were pro-investment and pro-free market just a few years ago now see the greatest gains in calling for scalps. And I can just hear the talking heads on CNN and MSNBC saying, "I never liked the stock market anyway." When I put it all together, I come down, as usual, on the cautious side. I'm not confident that the excesses of the bull market of 1982-1999 and the enormous tech bubble could have been corrected in just 28 months. Stocks' current swoon need not go on without end, but I see fundamental, valuation and psychological problems that will take time to fix. Maybe there'll be some lackluster years rather than a continuous collapse. It's said the investors who were burned in the excesses of the 1920s didn't return to the market until 1955 – or was it their kids?

We say about such investors, “it can’t be luck.” * * * Where Is It Easiest to Get Lucky? The second inspiration for this memo came from a report entitled Alpha and the Paradox of Skill by Michael Mauboussin of Credit Suisse. In it he talks about Jim Rutt, the CEO of Network Solutions. As a young man, Rutt wanted to become a better poker player, and to that end he worked hard to learn the odds regarding each hand and how to detect “tells” in other players that give away their position. Here’s the part that attracted my attention: At that point, an uncle pulled him aside and doled out some advice. “Jim, I wouldn’t spend my time getting better,” he advised, “I’d spend my time finding weak games.” Success in investing has two aspects. The first is skill, which requires you to be technically proficient. Technical skills include the ability to find mispriced securities (based on capabilities in modeling, financial statement analysis, competitive strategy analysis, and valuation all while sidestepping behavioral biases) and a good framework for portfolio construction. The second aspect is the game in which you choose to compete. (Emphasis added) Mauboussin goes on to talk primarily about changes in the relative importance of luck and skill. But for me, what his words keyed first and foremost were musings about market efficiency and inefficiency. What they highlighted is that the easiest way to win at poker is by playing in easy games in which other © OAKTREE CAPITAL MANAGEMENT, L.

© Oaktree Capital Management, L.P. All Rights Reserved. players make mistakes. Likewise, the easiest way to win at investing is by sticking to inefficient markets. Luck and Efficiency Here’s my take on the efficient market hypothesis: Thousands of intelligent, computer-literate, objective, unemotional, highly motivated and hard-working investors spend a great deal of time searching for information about assets and analyzing what it means for their value. For this reason, all available information is incorporated instantaneously in market prices. This causes the market price of every asset to accurately reflect its intrinsic value, such that an investor in the asset will enjoy a risk-adjusted return that is fair relative to the return on all other assets: no more and no less. Thus there are no “inefficiencies,” or instances where assets are priced incorrectly so as to provide an “excess return” or a “free lunch.” For this reason, no individuals are able to demonstrate superior investment skill (“alpha”). Even if some people were smart enough to take advantage of pricing errors, the market doesn’t present errors for them to take advantage of. As a result, nobody can beat the market. I have one main disagreement with the theory as presented above. Whereas the academics say in an efficient market the price of each asset accurately reflects its intrinsic value, I say the price set by the consensus does the best job of estimating the asset’s intrinsic value.

© Oaktree Capital Management, L.P. All Rights Reserved  attention to the cyclical nature of things  consciousness of timeframe  concentration on valuation  disdaining the hunt for the silver bullet  awareness of prevailing investor psychology You can go with opinions about the future. Everyone's got them, and what they call for in terms of investment behavior usually is obvious. In other words, the "I know" school makes investing sound easy – although in my opinion it's not often right. Or you can join me in the "I don't know" school, where you must:  face up to the uncertainty that surrounds the macro future;  concentrate on avoiding pitfalls;  invest in a few areas of specialization based on in-depth analysis, conservatively estimated tangible values and modest purchase prices; and  be prepared for returns that trail the risk-takers when markets are hot. This may be the less common path, and certainly the less rosy, but it's the one I'd much rather count on for success in the long run. May 31, 2002

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

© Oaktree Capital Management, L.P. All Rights Reserved Finance professors would say that these fluctuations reflect changes in the discount rate being applied to the cash flows or, in other words, changes in valuation parameters. Practitioners would agree that changes in p/e ratios are responsible, and we all know that p/e ratios fluctuate much more radically than do company fundamentals. The market has a mind of its own, and its changes in valuation parameters, caused primarily by changes in investor psychology (not changes in fundamentals), that account for most short-term changes in security prices. This psychology, too, moves in a highly cyclical manner. For decades – literally – I've been lugging around what I thought was a particularly apt enumeration of the three stages of a bull market:  the first, when a few forward-looking people begin to believe things will get better,  the second, when most investors realize improvement is actually underway, and  the third, when everyone concludes everything will get better forever. Why would anyone waste time trying for a better description? This one says it all. Stocks are cheapest when everything looks grim. The depressing outlook keeps them there, and only a few astute and daring bargain hunters are willing to take new positions. Maybe their buying attracts some attention, or maybe the outlook turns a little less depressing, but for one reason or another, the market starts moving up.

© Oaktree Capital Management, L.P. All Rights Reserved The success of South Sea spawned talk of any number of speculative schemes, some of which was probably apocryphal. “The most famous of the legendary bubble companies was that ‘for carrying on an undertaking of great advantage but no one to know what it is.’” [I can't understand what it does, but that's okay; just tell me the name, II. or maybe the symbol's enough.] Despite their lack of profits, companies like South Sea were able to finance their operations by issuing stock at higher and higher prices. “The circularity inherent in the scheme made a rational calculation of the shares' fair value difficult to compute. Some argued that the higher the shares rose, the more they were actually worth .... ‘Was there ever such a delusion from the beginning of the world ... according to this Way of Computing, no Person can Purchase at too high a Rate, since his Profit will increase in Proportion to the Price he gives.’” [There's no such thing as too high a price if the concept is right, and the ability to issue stock at rising prices will lead to profitability.] "Adam Anderson, a former cashier of the South Sea Company, later claimed that many purchasers of shares ... bought knowing that their long-term prospects were hopeless, since they aimed to get 'rid of them in the crowded alley to others more credulous than themselves.'" [The greater fool theory is nothing new.]

It's now clear the analysts added little insight in terms of either fundamentals or valuation. The December 18 Wall Street Journal revisited six price targets. On average, the analysts predicted a 64% gain, but the stocks UdeclinedU 88% instead. For me, the most telling thing was one analyst's alibi: "By setting [the target] only about 25% higher. . . we were indicating there was only a little more upside in the stock." I seem to remember when calling for a 25% gain was a bullish statement, not a warning. But then again, all kinds of nutty behavior typified this bubble. UOdds and ends at the extremeU - Numerous other elements, large and small, captured the excesses of the tech stock mania and their reversal.

© Oaktree Capital Management, L.P. All Rights Reserved stocks went up faster. Valuation didn't matter: if you bought a stock with a good enough “story,” someone else would pay you more for it. Third, the role of the brokerage house analyst changed. When I started doing equity research 31 years ago, the sell-side analyst tried to serve investors so as to attract trading and generate commissions. In the 1990s, with commission rates so low and the big money being made in investment banking, it became the sell-side analyst's job to generate capital market deal flow. The analyst tried to become influential with investors in order to endear himself to company management. Serious valuation work dwindled and “sell” recommendations became even more scarce: why antagonize a company whose investment banking business you're trying to attract? A recent Wall Street Journal quote from Morgan Stanley's Cisco analyst is emblematic of the analyst's new dog- chasing-its-own-tail role: We have to accept the facts of life. If investors want to buy these high growth companies, we are just trying to take what they are willing to pay and translate it into a target price and therefore a stock recommendation. In other words, it wasn't the analyst's job to throw cold water on the investor's party by pointing out that the target price had been reached or the price was too high. He just moved the target price up.

And investment newcomers, unaware of how superficial this all was, actually attached some importance to the target prices assigned by analysts. Fourth, with reason lacking, the retail investor's approach came to be based on extremely simplistic thought processes.  When momentum investing was working, the mantra was “buy stocks that have done well - they'll keep going up.”  When the inevitable pause in the rise swept the market - as it did in August 1998, when Long-Term Capital and the emerging markets stumbled - the cry of “buy the dips” took hold, and it worked every time.  On bad days recently, with the confidence behind the rise deflated (and with no reserve of reason there to back it up), I think it's been “sell before it goes down more.” Investors with no knowledge of (or concern for) profits, dividends, valuation or the conduct of business simply cannot possess the resolve needed to do the right thing at the right time. With everyone around them buying and making money, they can't know when a stock is too high and therefore resist joining in. And with a market in free fall, they can't possibly have the confidence needed to hold or buy at severely reduced prices.

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

© Oaktree Capital Management, L.P. All Rights Reserved That is, the market may often misvalue stocks, but it's not easy for anyone person - working with the same information as everyone else and subject to the same psychological influences - to consistently know when and in which direction. That's what makes the mainstream stock market awfully hard to beat - even if it isn't always right. * * * Lastly, I want to share what I told the board of a charity whose Investment Committee I chair. I listed some of the elements that have been at the foundation of prudent investing during my time in the business and more:  pursuing both appreciation and income,  balancing growth and value investments,  balancing the desire for gain and the fear of loss,  buying companies with a history of profitability,  caring about valuation parameters,  emphasizing cheap stocks,  taking profits and reallocating capital,  rotating industries, groups and themes,  diversifying,  hedging,  owning some bonds, and  holding some cash. How did this list do in 1999? It was a recipe for disaster! Every one of these elements would have caused you to underperform. What should you have done? Just two things:  bought growth and technology stocks that had already appreciated, and  held them as they rose further, refusing to sell at any price. Thus in one more way, wisdom was turned on its ear in this period.

© Oaktree Capital Management, L.P. All Rights Reserved UNever forget valuationU – The focus may shift from dividend yield to p/e ratio, and people may stop looking at book value, but that doesn't mean valuation is irrelevant. In the tech bubble, buyers didn't worry about whether a stock was priced too high because they were sure someone else would be willing to pay them more for it. Unfortunately, the "greater fool theory" only works until it doesn't. Valuation eventually comes into play, and those who are holding the bag when it does are forced to face the music. UBe conscious of investor psychologyU – I don't believe in the ability of forecasts or forecasters to tell us where prices are going, but I think an understanding of investor psychology can give us a hint. When investors are exuberant, as they were in 1999 and early 2000, it's dangerous. When the man on the street thinks stocks are a great idea and sure to produce profits, I'd watch out. When attitudes of this sort make for stock prices that assume the best and incorporate no fear, it's a formula for disaster. I find myself using one quote, from Warren Buffett, more often than any other: "The less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs." When others are euphoric, that puts us in danger. When others are terrified, the prices they set are low, and we can be aggressive.

An analysis by Sanford Bernstein shows that on September 30, you could have bought America Online and Microsoft for $625 billion and gotten $25 billion of sales and $7 billion of earnings. Alternatively, for $635 billion you could have bought 70 industrial, financial, transportation and utility companies including Bank of America, Chubb, Federated Department Stores, Litton, Philip Morris, Ryder and Whirlpool and gotten $747 billion of sales and $43 billion of earnings. The future certainly looks better for AOL and Microsoft than for those other companies, but does the differential warrant a p/e ratio 6 times as high (89 versus 15)? And that's for “established” companies. Because the price/earnings ratios of Internet companies are so outlandish - usually negative - one may be forced to look to the price/sales ratio in order to speak about valuation. Red Hat, for example, sells at about 1,000 times its annualized revenues in the August quarter. Many of the Internet and tech companies are just concepts, and their stocks have truly slipped the valuation moorings. Under these unusual circumstances, The Journal wrote on December 10, “stock valuations take on an unusually large importance in gauging a business's performance.” In other words, in the absence of other signs, people must look to the share price for an indication of how the company is doing. Isn't that backwards? In the old days, investors figured out how the business was doing and then set the share price.

In this valuation parameter vacuum, a “lottery ticket mentality” seems to govern the purchase decision. The model for investments in the tech and dot-com companies isn't the likelihood of a 20% or 30% annual return based on projected earnings and p/e ratios, but a shot at a 1,000% gain based on a concept. The pitch might be “We're looking for first-round financing for a company valued at $30 million that we think we can IPO in two years at $2 billion.” Or maybe it's “The IPO will be priced at $20.the

As Alan Abelson wrote when he ran the graph, “Our reservation here is that (a) technology, like everything else in life, is cyclical; and (b) there's something goofy about the price of a stock discounting as much as a century of earnings for a company in a field where change is the only constant and where the pace of change is constantly quickening.” (Emphasis added) In September Steve Ballmer, President of Microsoft, said he thought tech stocks were overvalued. The stocks are much higher today, and his own is up more than 20%. Whose opinion matters? Is there a price that's too high?

Those positives - and the massive profits that seemingly everyone else is enjoying - can eventually cause those who have resisted participating to capitulate. 3. A “top” in a stock, group or market occurs when the last holdout who will become a buyer does so. The timing is often unrelated to fundamental developments. 4. “Prices are too high” is far from synonymous with “the next move will be downward.” Things can be overpriced and stay that way for a long time ... or become far more so. 5. Eventually, though, valuation has to matter. To say technology, Internet and telecommunications stocks are too high and about to decline is comparable today to standing in front of a freight train. To say they have benefited from a boom of colossal proportions and should be examined very skeptically is something I feel I owe you.2000

Although IBM rose 4%, it was overshadowed by America Online, which gained 11% and became the more valuable of the two companies for the first time. Illustrating the mania for things Internet, an article in the next day's New York Times reported on . . . . . . last week's initial offering of Priceline.com, which allows customers to name their own price for airline tickets on the Web. After less than a year in business, during which it lost $114 million selling $35 million worth of tickets, Priceline.com is valued at $10 billion, more than the combined net worth of UAL's United Airlines, Northwest Airlines and Continental Airlines. UIndifference to valuationU - The entire bullish article - 22 column inches long - omitted all mention of valuation parameters such as P/E ratio, EBITDA multiple or dividend yield. The bottom line is that many of the investors setting the prices in today's market don't care about valuation.managers

By purchasing undervalued bonds and selling short overvalued bonds affected by similar factors, gains would be earned consistently and without exposure to market risk. The intellect and accomplishments of Long-Term's managers, and its strong annual returns, compelled investors to invest and freed them from feeling they had to understand exactly what the fund did. The fund's approach may not have been fully delineated to investors, its portfolio was never disclosed, and the managers' actions were not even reported after the fact; 40% annual returns were enough to keep investors satisfied. You've probably heard us say that bond investing is a game of inches. So then how was Long- Term able to earn returns of 40% or more most years? The answer was leverage: they borrowed enough money to buy bonds worth many times their equity. It is now known that Long-Term's general partners' cash equity was increased through borrowings to roughly $1.5 billion and paired with $3.1 billion of limited partners' capital. This $4.6 billion of equity was somehow sufficient to enable Long-Term to hold investments totaling about $150 billion and long and short positions in derivatives believed to have had an aggregate "notional value" of $1.25 trillion!

Bought when "riskless," this paper proved to be a disaster; purchased off the trash heap, we found it very attractive. That leads us to the $64,000 question (although many of you already know my answer): Where do we currently stand? What attitudes and behavior characterize today's investors? We think many "investors" have been buying with euphoria and belief rather than hesitance and skepticism. Many investors seem to be most afraid of being uninvested and missing out on the gains others are enjoying; that is, they're most worried about the risk of not taking enough risk. Although many valuation indicators are at all-time highs and price gains in July set record after record, investors are quite willing to accept platitudinous rationalizations like "technology has brought a new era," "globalization offers unlimited opportunities for growth" and "we have nothing to worry about from the business cycle." Some analyses suggest that prices are fair today, implying that future returns will be proportional to the risks involved; by many other standards, prices are too high. We find it very difficult, however, to conclude that stocks are underpriced, and thus that the potential exists for high and dependable returns from here. We find particularly troubling the oft-repeated mantra that "because the outlook continues to call for low inflation and stable interest rates, stocks can continue to rise."

This statement was made at 6,000 and 7,000 on the Dow, and it was made in July at 8,200. But it can't be right regardless of the level of stock prices. Inflation is important because it determines interest rates, and rates are important because they determine valuation multiples for stocks. Thus, for every level of inflation and interest rates, there's a "right" level for stocks. What's the right level for stocks given today's conditions? Might it be below the current level? © 1997 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

It's worth noting in this connection, thinking back fifteen or twenty years to ancient history, that this bull market got its start because companies could be bought cheaper through the stock market than they could be created -- this fact kicked off the LBO boom that powered the stock market throughout the 1980s. Today, many companies' stocks have reached prices that no value-conscious entrepreneur would pay for the entire company. The market seems extremely comfortable with the proposition that as long at the macro- environment remains benign, stocks prices can continue to appreciate at rates that far outstrip the growth of their issuers' profits, and thus the growth of their intrinsic value. Few market participants seem concerned about appropriate valuation levels -- the relationship between assets and their prices -- and this is a condition that we think must eventually have negative consequences. We are incredulous when, each day there's more news of economic equilibrium and stable rates, the market goes up another percent or so. We believe strongly that with corporate profits growing in the vicinity of their normal 10% or so, stable rates are not in themselves a reason why stock prices should rise at 20%-plus forever. Today's combination of a stable economy, low interest rates, enormous cash flows and strong investor optimism has created a climate in which capital is available for both good investments and bad, and in which risk is rarely seen as something to be shunned.

We see this in aggressive lending by banks; in the popularity of leveraged structures in many areas of investing; in the strong flow of equity IPOs (and their strong after-market performance); in the explosive issuance of high yield securities (including payment-in-kind preferreds and calamity-linked bonds); and in the massive amounts of capital available for every form of alternative investing. Each of these activities is appropriate at the right time and price, but each can be overdone. We feel the simplest adages remain the best, and few are better than "what the wise man does in the beginning, the fool does in the end." Every cycle eventually proves the wisdom of this old saw. Are we "ringing the bell" on this bull market? Absolutely not; we've learned the folly of attempting to do so. We are not calling for a market collapse, but we do want to recap a few things that we feel are obvious: The market may be either fairly- or over-valued, but it is not under-valued. The best most bulls can say is that the extent of the current over-valuation isn't extreme. With valuations having reached full levels, no one should expect stock prices to continue to out-pace company profits. It is certainly true that there are favorable developments in technology, productivity, taxation, inflation, monetary policy, geo-politics, demographics and labor tractability. These advances justify high multiples, but not ever-higher multiples.

Valuations shouldn't be expected to expand ad infinitum just because the environment is benign and cash is flowing in; at some point, valuation has to matter. In fact, as the above litany of favorable developments suggests, everything has gone about as well as it could over the last fifteen years, making for a most atypical period in the market. Unemployment and interest rates have halved, the index of consumer confidence has doubled, and the population of investors has exploded. But we think the © 1997 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients and Friends From: Howard Marks Re: Will It Be Different This Time? One of my favorite articles, "Why This Market Cycle Isn't Different" by Anise C. Wallace, appeared in the New York Times. It skeptically recounted the rationale being advanced why a traditional correction of the stock market's meteoric rise need not take place. Among the reasons cited were (1) the outlook for continued economic growth, given that the economy had learned how to correct itself painlessly, (2) hope for return to a gold standard, (3) optimism regarding world peace, (4) the likelihood of continued buying of U.S. stocks by foreign investors piling up dollars with no better place to go, and (5) the fact that stocks were not overvalued compared to other assets, which had also appreciated. This was the optimists' argument. But its flaws became apparent almost immediately after the article was published ... on October 11, 1987. By the close on October 19, the market had fallen by 30%. So much for the bulls' predictions!! And so much for predicting a future markedly different from the past. The article pointed out that some of the arguments did have some truth to them, but it also cited John Templeton's assessment that people who say things will be different are right only one time out of five. The hard part is knowing which times those are.

© Oaktree Capital Management, L.P. All Rights Reserved The article goes on to cite the arguments behind this year's version of "this time it'll be different." First, because the recovery has been wishy-washy to date, there is no "boom" to "bust." Second, today's enhanced pace of business has been accommodated more through flexibility and efficiency than through brick-and-mortar expansion and inventory building. Third, the service economy has largely supplanted the more cyclical manufacturing sector. Fourth, globalization of the economy will enhance geographic diversification and provide new sources of demand for goods. Similarly, we all hear lots of reasons why today's high stock market valuations aren't dangerous and no correction is required. These include the inevitability of 401(k) inflows; the steadfastness of mutual fund investors; the shortage of stocks which will result from corporate buybacks (in 1987, the shortage was going to result from the privatization of companies via leveraged buyouts); the vast opportunities presented by technology and the Internet; the improved profit stance of business after years of downsizing and cost-cutting; the fiscal responsibility imposed on government and the resulting favorable outlook for the deficit; and the irrelevance of dividend yield and other traditional valuation parameters. As always, the list appears to grow longer as higher levels are reached on the Dow.

But I recoil any time I hear a prediction that trees will grow to the sky, or that centuries of history are irrelevant. When I hear people say the valuation measures of the past no longer matter, I think John Kenneth Galbraith put it well, stating that in a speculative episode, 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. (UA Short History of Financial EuphoriaU, Viking, 1990) And I feel cyclicality is one of the few constants in the economy and markets. Cycles are the result of human behavior, herd instinct and the tendency to psychological excesses, and these things are unlikely to evaporate. Galbraith cites "the extreme brevity of the financial memory" in explaining why markets are able to move to extremes of euphoria and panic. And few adages have been borne out as often as "What the wise man does in the beginning, the fool does in the end." It is rare for trends to be curtailed at a reasonable point before swinging to the excesses from which they invariably correct. Today, there are some signs just as worrisome as the bullish arguments are constructive. We detect the decline of skepticism and discipline and the aggressive extension of credit which regularly precede corrections. Capacity expansion has been strong in some industries, and construction seems about to resume.

© 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.

© Oaktree Capital Management, L.P. All Rights Reserved Comparison against low interest rates makes low earnings yields and dividend yields seem tolerable. Likewise, low rates increase the discounted present value of companies' future earnings as calculated by valuation models. For these reasons and others, many valuation indicators are at levels today which have proved dangerous and unsustainable in the past. Just as today's low interest rates are pushing investors toward riskier securities all along the "food chain" described above, however, this sword can also cut the other way. Warren Buffet said, in one of my favorite adages, "The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs." Another adage I'm fond of is, "What the wise man does in the beginning, the fool does in the end." No course of investment action is either wise or foolish in and of itself. It all depends on the point in time at which it is undertaken, the price that is paid, and how others are conducting themselves at that moment. When everyone shrinks from a security because it's "too risky," the few who will buy it can do so with confidence, secure in the knowledge that the price has not been bid up, and in the likelihood that others will eventually outgrow their fear and jump on the bandwagon. Today, many prices have been bid up, and the bandwagon is already crowded with wild-eyed investors.

© Oaktree Capital Management, L.P. All Rights Reserved investments, and not to be among those who uncritically joined the trend toward risk. Whatever investment opportunities you decide on, we would encourage you to stress thorough appraisal of the risks entailed and cautious implementation. What is it that distinguishes the investment opportunities we’d suggest you pursue today? Not just the offer of high returns, but of returns which are more than proportionate to the risk entailed. The reason we champion inefficient markets (such as the high yield bonds, convertibles and distressed debt we're involved with) is that there exists by definition the potential, if exploited correctly, for an uncommonly favorable ratio of return to risk. Exploitation of opportunities in inefficient markets; insistence on preserving capital; refusal to pursue maximum return at the cost of maximum risk; specialization rather than dabbling; heavy emphasis on careful analysis; use of less-risky senior securities -- these themes have been the cornerstones of our approach over the years. They remain highly relevant and should continue to be pursued by all of us, especially at this point in the cycle. February 17, 1994

Thus when sales are forced in a chaotic market -- whether by margin calls, client withdrawals or cold feet -- they can have the effect of contributing to or exacerbating the decline. Often in this environment, the manager's choices for liquidation will be limited to his highest quality and most marketable holdings. In this way, forced sales can easily contribute to a deterioration of portfolio quality. When the Granite Fund received margin calls, its manager could only get reasonable bids for securities which perform well when rates rise. Selling them cost the fund its hedge. The prominent hedge funds that attracted the recent attention -- favorable in 1993 and less so this year -- are multi-billion-dollar entities which, because of their size, often invest not in the undervalued micro-situations on which their early records were built, but in macro-phenomena all around the world. Thus they provide an important object lesson to which we want to point. These funds are run by managers who pursue aggressive returns through the use of highly leveraged and thus volatile positions in large markets, some of which, such as Treasury bonds, are relatively efficient. In this sense, they represent the opposite of what we espouse. Our approach emphasizes the low-risk exploitation of inefficient markets, as opposed to aggressive investment in efficient ones. We restrict ourselves to markets where it is possible to know more than other investors.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Clients From: Howard Marks Trust Company of the West Re: First Quarter Performance The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum "on average," it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward an extreme itself that supplies the energy for the swing back. Investment markets make the same pendulum-like swing: - between euphoria and depression, - between celebrating positive developments and obsessing over negatives, and thus - between overpriced and underpriced. This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at a "happy medium." In late 1990, the securities markets were at a negative extreme as concerns about the economy and Iraq produced exaggerated risk aversion and thus drastic under-valuation of all securities considered to be of less than "gilt-edge" quality. The subsequent first quarter swing toward more reasonable valuations imparted to our portfolios some of the best quarterly performance in our history.