05-12-2010, 03:14 PM
Memo to: Oaktree Clients
From: Howard Marks
Re: Open and Shut
Mark Twain is described as having said, "History doesn't repeat itself, but it does rhyme."
Thanks to the tendency of investors to forget lessons and repeat behavior, it sometimes seems there's no longer a need for me to come up with new ideas for these memos.
Rather, all I have to do is recycle components from previous memos, like a builder reusing elements from old houses. I'm willing to try an experiment along those lines for this memo. Here are my building blocks:
From "First Quarter Performance" April 11, 1991:
From "The Happy Medium" July 21, 2004:
From "You Can't Predict. You Can Prepare." November 20, 2001:
From "Genius Isn't Enough" October 9, 1998:
The Credit Cycle at Work
Consider this: the ups and downs of economies are usually blamed for fluctuations in corporate profits, and fluctuations in profits for the rise and fall of securities markets.
However, in recessions and recoveries, economic growth usually deviates from its trendline rate by only a few percentage points. Why, then, do corporate profits increase and decrease so much more? The answer lies in things like financial leverage and operating leverage, which magnify the impact on profits of rising and falling revenues.
And if profits fluctuate this way , more than GDP, but still relatively moderately , why is it that securities markets soar and collapse so dramatically? I attribute this to fluctuations in psychology and, in particular, to the profound influence of psychology on the availability of capital.
In short, whereas economies fluctuate a little and profits a fair bit, the credit window opens wide and then slams shut . . . thus the title of this memo. I believe the credit cycle is the most volatile of the cycles and has the greatest impact. Thus it deserves a great deal of attention.
In "The Happy Medium" I discussed the workings of the credit cycle in creating market extremes:
Looking for the cause of a market extreme usually requires rewinding the
videotape of the credit cycle a few months or years. Most raging bull
markets are abetted by an upsurge in the willingness to provide capital,
usually imprudently. Likewise, most collapses are preceded by a
wholesale refusal to finance certain companies, industries, or the entire
gamut of would-be borrowers.
Then, in "You Can't Predict. You Can Prepare." I described this expand-and-contract process in detail, along with its ramifications:
1. The economy moves into a period of prosperity.
2. Providers of capital thrive, increasing their capital base.
3. Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk.
4. Risk averseness disappears.
5. Financial institutions move to expand their businesses , that is, to provide more capital.
6. They compete for share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction, and easing covenants.
When this point is reached, the up-leg described above is reversed.
1. Losses cause lenders to become discouraged and shy away.
2. Risk averseness rises, and with it, interest rates, credit restrictions and covenant requirements.
3. Less capital is made available , and at the trough of the cycle, only to the most qualified of borrowers, if anyone.
4. Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies.
5. This process contributes to and reinforces the economic contraction.
Of course, at the extreme the process is ready to be reversed again.
Because the competition to make loans or investments is low, high returns
can be demanded along with high creditworthiness. Contrarians who
commit capital at this point have a shot at high returns, and those tempting
potential returns begin to draw in capital. In this way, a recovery begins to
be fueled. . . .
Prosperity brings expanded lending, which leads to unwise lending,
which produces large losses, which makes lenders stop lending, which
ends prosperity, and on and on.
The bottom line is that the willingness of potential providers of capital to make it available on any given day fluctuates violently, with a profound impact on the economy and the markets. There's no doubt that the recent credit crisis was as bad as it was because the credit markets froze up and capital became unavailable other than from governments.
Interested ? Full pdf can be downloaded below.
From: Howard Marks
Re: Open and Shut
Mark Twain is described as having said, "History doesn't repeat itself, but it does rhyme."
Thanks to the tendency of investors to forget lessons and repeat behavior, it sometimes seems there's no longer a need for me to come up with new ideas for these memos.
Rather, all I have to do is recycle components from previous memos, like a builder reusing elements from old houses. I'm willing to try an experiment along those lines for this memo. Here are my building blocks:
From "First Quarter Performance" April 11, 1991:
Quote: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. . . . 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 the "happy medium."
From "The Happy Medium" July 21, 2004:
Quote:The capital market oscillates between wide open and slammed shut. It creates the potential for eventual bargain investments when it provides capital to companies that shouldn't get it, and it turns that potential into reality when it pulls the rug out from under those companies by refusing them further financing. It always has, and it always will.
From "You Can't Predict. You Can Prepare." November 20, 2001:
Quote: Overpermissive providers of capital frequently aid and abet financial bubbles. . . . In Field of Dreams, Kevin Costner was told, "if you build it, they will come." In the financial world, if you offer cheap money, they will borrow, buy and build , often without discipline, and with very negative consequences.
From "Genius Isn't Enough" October 9, 1998:
Quote: Look around the next time there's a crisis; you'll probably find a lender. The above citations provide the themes for this memo. I'll just update them, put them into the current context and discuss the ramifications for investing today. We'll see how it goes. If it works well this time, readers may conclude that in the future they can fashion their own memos from bits and pieces of my old ones.
The Credit Cycle at Work
Consider this: the ups and downs of economies are usually blamed for fluctuations in corporate profits, and fluctuations in profits for the rise and fall of securities markets.
However, in recessions and recoveries, economic growth usually deviates from its trendline rate by only a few percentage points. Why, then, do corporate profits increase and decrease so much more? The answer lies in things like financial leverage and operating leverage, which magnify the impact on profits of rising and falling revenues.
And if profits fluctuate this way , more than GDP, but still relatively moderately , why is it that securities markets soar and collapse so dramatically? I attribute this to fluctuations in psychology and, in particular, to the profound influence of psychology on the availability of capital.
In short, whereas economies fluctuate a little and profits a fair bit, the credit window opens wide and then slams shut . . . thus the title of this memo. I believe the credit cycle is the most volatile of the cycles and has the greatest impact. Thus it deserves a great deal of attention.
In "The Happy Medium" I discussed the workings of the credit cycle in creating market extremes:
Looking for the cause of a market extreme usually requires rewinding the
videotape of the credit cycle a few months or years. Most raging bull
markets are abetted by an upsurge in the willingness to provide capital,
usually imprudently. Likewise, most collapses are preceded by a
wholesale refusal to finance certain companies, industries, or the entire
gamut of would-be borrowers.
Then, in "You Can't Predict. You Can Prepare." I described this expand-and-contract process in detail, along with its ramifications:
1. The economy moves into a period of prosperity.
2. Providers of capital thrive, increasing their capital base.
3. Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk.
4. Risk averseness disappears.
5. Financial institutions move to expand their businesses , that is, to provide more capital.
6. They compete for share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction, and easing covenants.
When this point is reached, the up-leg described above is reversed.
1. Losses cause lenders to become discouraged and shy away.
2. Risk averseness rises, and with it, interest rates, credit restrictions and covenant requirements.
3. Less capital is made available , and at the trough of the cycle, only to the most qualified of borrowers, if anyone.
4. Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies.
5. This process contributes to and reinforces the economic contraction.
Of course, at the extreme the process is ready to be reversed again.
Because the competition to make loans or investments is low, high returns
can be demanded along with high creditworthiness. Contrarians who
commit capital at this point have a shot at high returns, and those tempting
potential returns begin to draw in capital. In this way, a recovery begins to
be fueled. . . .
Prosperity brings expanded lending, which leads to unwise lending,
which produces large losses, which makes lenders stop lending, which
ends prosperity, and on and on.
The bottom line is that the willingness of potential providers of capital to make it available on any given day fluctuates violently, with a profound impact on the economy and the markets. There's no doubt that the recent credit crisis was as bad as it was because the credit markets froze up and capital became unavailable other than from governments.
Interested ? Full pdf can be downloaded below.
