New Oaktree Capital Memo: The Race is On

I absolutely love reading Howard Marks Memos and he has released a new one. Here is the opening paragraphs with a link to the rest, his website is littered with additional memos and is a great resource. Also Check The 20 Most Important Things Proposed By Howard Marks (Part I Of IV) 

 Memo to: Oaktree Clients

By: Howard Marks

Title: The Race is On

I’ve written a lot of memos to clients over the last 24 years – well over a hundred. One I’m particularly proud of is The Race to the Bottom from February 2007. I think it provided a timely warning about the capital market behavior that ultimately led to the mortgage meltdown of 2007 and the crisis of 2008. I wasn’t aware and didn’t explicitly predict (in that memo or elsewhere) that the unwise lending practices that were exemplified in sub-prime mortgages would lead to a global financial crisis of multi-generational proportions. However, I did detect carelessness-induced behavior, and I considered it worrisome. 

As readers of my memos know, I believe strongly that (a) most of the key phenomena in the investment world are inherently cyclical, (b) these cycles repeat, reflecting consistent patterns of behavior, and (c) the results of that behavior are predictable. 

Of all the cycles I write about, I feel the capital market cycle is among the most volatile, prone to some of the greatest extremes. It is also one of the most impactful for investors. In short, sometimes the credit window is open to anyone in search of capital (meaning dumb deals get done), and sometimes it slams shut (meaning even deserving companies can’t raise money). This memo is about the cycle’s first half: the manic swing toward accommodativeness. 

An aside: I recently engaged in an exchange with a reader who took issue with my use of the word “cycle.” In his view, something is a cycle only if it’s so regular that the timing and extent of its ups and downs can be predicted with certainty. The cycles I describe aren’t predictable as to timing or extent. However, their fluctuations absolutely can be counted on to recur, and that’s what matters to me. I think it’s also what Mark Twain had in mind when he said “History doesn’t repeat itself, but it does rhyme.” The details don’t repeat, but the rhyming patterns are extremely reliable. 

Competing to Provide Capital 

When the economy is doing well and companies’ profits are rising, people become increasingly comfortable making loans and investing in equity. As the environment becomes more salutary, lenders and investors enjoy gains. This makes them want to do more; gives them the capital to do it with; and makes them more aggressive. Since this happens to all of them at the same time, the competition to lend and invest becomes increasingly heated. 

When investors and lenders want to make investments in greater quantity, I think it’s also inescapable that they become willing to accept lower quality. They don’t just provide more money on the same old terms; they also become willing – even eager – to do so on weaker terms. In fact, one way they strive to win the opportunity to put money to work is by doing increasingly dangerous things. 

This behavior was the subject of The Race to the Bottom. In it I said to buy a painting in an auction, you have to be willing to pay the highest price. To buy a company, a share of stock or a building – or to make a loan – you also have to pay the highest price. And when the competition is heated, the bidding goes higher. This doesn’t always – or exclusively – result in a higher explicit price; for example, bonds rarely come to market at prices above par. Instead, paying the highest price may take the form of accepting…. Article Continued Here

Warren Buffett on Value & Growth: The Two Approaches Are Joined At The Hip

“Learn from the mistakes of others, you can not live long enough to make them all yourself.” – Eleanor Roosevelt

In the Chairman’s Letter of 1992 from Warren Buffet I found this small excerpt on his view about value, growth and using discounted cash-flow analysis. I felt like the writing must have light shed on it and be shared with others as it resinated with me, as does most of Buffett’s writings and insight. I was not entirely sure how to paraphrase and interpret each paragraph as Warren does an amazing job teaching in a basic manner, so I decided to just share it all!

Warren Buffett:
But how, you will ask, does one decide what’s “attractive”? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

In addition, we think the very term “value investing” is redundant. What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labeled speculation (which is neither illegal, immoral nor – in our view – financially fattening).

Whether appropriate or not, the term “value investing” is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value” purchase.

Similarly, business growth, per se, tells us little about value. It’s true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.

In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here:

The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds. Even so, there is an important, and difficult to deal with, difference between the two: A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future “coupons.” Furthermore, the quality of management affects the bond coupon only rarely – chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity “coupons.”

The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find: Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.

Though the mathematical calculations required to evaluate equities are not difficult, an analyst – even one who is experienced and intelligent – can easily go wrong in estimating future “coupons.” At Berkshire, we attempt to deal with this problem in two ways. First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we’re not smart enough to predict future cash flows. Incidentally, that shortcoming doesn’t bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know. An investor needs to do very few things right as long as he or she avoids big mistakes.

Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.

1992 Chairman’s Letter

Warren Buffet Wisdom: Flash Back to the 80s

Over the recent weeks I have been re-reading the Berkshire Hathaway  Annual Reports & Shareholder letters from 1965 to 1990 (will continue to re-read the rest) looking for lessons and tidbits of knowledge from the “Oracle of Omaha”, continuously taking notes or as some call it “reading with a purpose.”

Some interesting, straightforward views are provided in various topics such as: convertible preferred shares, zero coupon bonds, EBDIT, capital outlays, commodity based businesses, and hiring management.

On Hiring Management: “If each of us hires people who are smaller than we are, we shall become a company of dwarfs.  But, if each of us hires people who are bigger than we are, we shall become a company of giants.” – 1986 Shareholder Letter 

The quote above provides insight how recruitment staff and human resource departments (especially small businesses) should be operating their businesses, actively looking for the best candidates, not worried about the potential to be out done or “shown up” by the new hires, young guns or more experienced, putting ego and superiority aside for the benefit of the business.

Why Investing is the Greatest Business, Warren Buffett 

On Skipping Capital Outlays: “Capital outlays at a business can be skipped, of course, in any given month, just as a human can skip a day or even a week of eating. But if the skipping becomes routine and is not made up, the body weakens and eventually dies. Furthermore, a start-and-stop feeding policy will over time produce a less healthy organism, human or corporate, than that produced by a steady diet.” – 1989 Shareholder Letter 

It does not take a businesses genius to figure out that a company’s depreciation rate exceeding that of the capital expenditures on a routine basis (in a free market unless it is a bridge or other business based on enormous one time costs) will be plagued by inefficiencies, and surely not thrive against competition. The most likely outcome being the business ultimately “cuts” to their own demise. Surely you would not eat the bare minimum acceptable to keep you alive?

On Convertible Preferred Shares: “The point you should keep in mind is that most of the value of our convertible preferred is derived from their fixed-income characteristics. That means the securities cannot be worth less than the value they would possess as non-convertible preferred and may be worth more because of their conversion options”

6 Quotes from Warren Buffet (1982 shareholder letter)

On Insurance (Commodity Based Businesses Engaging in Price Wars): “While the lamb may lie down with the lion, the lamb shouldn’t count on getting a whole lot of sleep.” – Woody Allen

Warren quotes Woody Allen frequently throughout his reports usually with intelligent punches at the perfect timing. This quote reflects the non-stop onslaught of competition in commodity based businesses (unless of course you enjoy being the low cost producer) and how it feels to be up against the low cost producer (the lion).

On EBDIT and investment bankers using it: “Our advice: Whenever an investment banker starts talking about EBDIT – or whenever someone creates a capital structure that does not allow all interest, both payable and accrued, to be comfortably met out of current cash flow net of ample capital expenditures – zip up your wallet. Turn the tables by suggesting that the promoter and his high-priced entourage accept zero-coupon fees, deferring their take until the zero-coupon bonds have been paid in full. See then how much enthusiasm for the deal endures.”

EBDIT stands for earnings before depreciation interest and tax, that is earnings before any deductions. Add in amortization and we have EBITDA. Now this can be beneficial to look at and is sometimes taken as a proxy for cash-flow. On the flip side EBDITA can be very misleading in general uses as high indebted companies may not be able to service their interest with working capital and cash-flow or a company may be profitable pre-tax and un-profitable afterwards. Further more tax rates may differ if companies being compared within the same industry are not within the same country, all the while EBITDA would paint a much rosier picture.

Times They Are A Changing

The market continues to further stretch to the upside with the S&P500 over the last 4 weeks running up 130 points and the DJIA rallying over 800 points in the same period. The rally this week was partly fueled by comments from David Tepper on CNBC, a hedge fund manager, suggesting that he remained bullish. Is it crazy to think “professional” money managers would buy on statements from another fund manager, legendary or not. Logic easily goes out the window when emotions are so high and can often evoke “irrational exuberance” or the twin brother discouragement when on the other end of the spectrum.

Many market participants who have been waiting for a market pullback have not had the chance in 2013 as we haven’t had 3 consecutive down days this far. Sidelined cash holders are no doubt in panic buying mode as the market seems to have left them behind. Short sellers have been handed their heads and completely eradicated for the time being stepping aside from the market.

It may seem like a perfect storm for Equities to run higher, but I have felt it is more likely a turning point in the markets in the coming days/weeks. It is very strange behaviour to see market cycles move in an almost straight line up or down.

We have had an enormous and quickly staged rally from the 1400 level in S&P with modest earnings and dividend growth and most of the companies 2013 earnings expectations loaded for the back half of the year.

The rally thus far has clearly been driven by global easing by almost all central bankers, Japan in particular with the Nikkei up over 43% YTD on a massive stimulus plan (same size as US). I do not see this type of move as anywhere near sustainable and have raised cash in the recent months, being selective of what I continue to hold, carefully scrutinizing my personal research thesis’s.

I am not calling a market top and as @ReformedBroker said on Twitter “I do not wait for market pullbacks, I wait for dividend payments, you can put that on my tombstone.”

With record low bond yields and so many sidelined managers waiting with piles of cash, this could just be the start to another leg in the 09-13 bull market. I don’t pretend to know where the market is heading in the short-term but one thing I know is it will be higher 30 years from now.

“In the short run, the market is like a voting machine, but in the long run, the market is a weighing machine.” – Benjamin Graham