"Too Much Money Chasing Too Few Deals," Warns Oaktree Capital's Howard Marks

In this segment from MarketFoolery, host Chris Hill and Foolish investor-at-large Tim Hansen consider the annual letter released last week by billionaire investing guru Howard Marks of Oaktree Capital (OAK). In it, he expressed concern about the number of questionable deals happening in this low interest rate environment, as an excess of optimism and high risk-tolerance send capital toward assets it should probably shun at current prices.

The two look at some of the low returns for risk in the emerging markets, a lack of enthusiasm for individual equities, the money flowing toward IPOs, and consider Marks' history of being right (albeit a bit early) in terms of seeing trouble on the horizon.

A full transcript follows the video.

This video was recorded on Sept. 27, 2018.

Chris Hill: Let's start with Howard Marks. When we talk about annual letters, Warren Buffett's rightly gets attention, Jeff Bezos is starting to get more attention. Howard Marks from Oaktree Capital, for as great an investor and as respected an investors Howard Marks is, his annual letter doesn't really get the same buzz as the others. But I know it is must-reading for you.

Tim Hanson: It's like the critically acclaimed independent record relative to the Warren Buffett pop single hit. The Howard Marks letters are routinely excellent. He had a new one out yesterday. He tends to be a little bit more measured in his observations of the world, which I think, at a time like this in the market cycle, 10 years of party times, it's a perspective worth considering and keeping in mind for people who are making asset allocation and capital allocation decisions.

Hill: In terms of highlights from the letter, it's nice that he basically said, as you said, the cautious optimism. He's basically like, "Yeah, there are some prices that are high. They're not bananas. Valuations across the board are not nuts."

Hanson: The message in the letter that I think people should be interested in is, what kind of decisions are you making about your amount of risk you're taking on in your portfolio? Are you being properly compensated for the risk you're taking? For example, they have a list of bullet points of questionable deals that they've seen done this year. That may point to the fact that, in a low-interest rate environment, people are stretching and aren't going to get the returns in the future that they expect. One of those, for example, this is near and dear to my heart, as a former emerging market stock analyst, is the fact that some pension fund manager somewhere made the decision to buy $10 billion of Turkish lira-denominated corporate bonds that yielded 6%. There's not a world where I would invest in lira-denominated anything for 6%, let alone, you've got the currency on top of, now not a sovereign debt, a corporate debt in Turkey! 6%!

Hill: What if we put a zero next to that? What if it was 60%?

Hanson: I mean, that's closer to what you would want to demand. I think people have seen the lira volatility this year. That trade has gotten crushed. It probably lost half its value at this point. I just started looking up some random sovereign debt rates this morning, as you do on a Thursday.

Hill: [laughs] Just another Thursday.

Hanson: [laughs] Bolivia has a five-year bond out there with a coupon of 4.7%. Bolivia!

Hill: How can you not jump at that?

Hanson: There was a time in 1999, not that this will ever happen again, but I think you could get Treasury inflation-protected securities --

Hill: TIPS.

Hanson: TIPS. In the U.S. We have our problems, still probably the world's No. 1 credit. I think the real yield was like 4.5%. You're locking in, at that point, an equity-like long-term return with very little risk. And now, Bolivia and Turkey, local currencies have the same yields. It's wild! It just goes to show that it's always worth taking a step back. Sometimes you should evaluate things on relative term. You can't get a great yield on a U.S. Treasury right now. But should you really reach for 6% on a Turkish lira-denominated corporate bond?

Hill: Well, do you think that's at least a little bit of what continues to drive the bull market here in the U.S.? That a lot of institutional investors, a lot of pension fund managers, hedge fund managers, are looking around the world, and they're not really seeing the types of opportunities, so they say, "It's not sexy, but yeah, I'm going to put some more money into the FAANG stocks."

Hanson: I think that's right. It's a little bit hackneyed to say people don't like this bull market. You see that from time to time, that it's the most hated bull market or whatever. But I do think one of the reasons why people haven't been super enthusiastic about this bull market to the extent they haven't been is because, yeah, as you suggest, it's a product of relativism rather than, "Man! I love that company at that valuation! This stock is going up!" It's more like "Well, that's better than that thing."

Hill: Yeah. Last thing on Howard Marks' letter. Was there anything that you read yesterday that made you rethink anything you're doing as an investor? Or made you feel better about yourself as an investor?

Hanson: I can say, personally, over the past year or so, I've been accumulating more cash, just because I haven't been finding absolute opportunities where I'm like, "Yes, I love that!" And I'm a little bit more cautious about saying, "I'll do it because it's better than doing nothing." I actually think there's a lot of value in doing nothing a lot of the time. [laughs] I wrote an article about that not long ago.

The idea that he was looking back -- there's a funny quote, which is like, "The market has 10-year cycles, but bankers only have five-year memories." That's amusing. He was saying, he started to get more cautious in 2006 and 2007 relative to what he was seeing in the marketplace, because he saw bad deals being made. And it took a few years before everything collapsed. But the trade-off between being wrong for a couple of years vs. being prepared when the opportunity's there, I think is a worthy one.

I think there's a lot of fear of missing out in the world today, both in the financial marketplace, but also in social circles, brought on by social media and what have you. I think that can be very dangerous force. If you can be comfortable doing nothing, or comfortable missing out, COMO, that might be a healthier way to look at the world.

Hill: When you look at, as was referred to, in the letter, too much money chasing bad deals --

Hanson: Too little return.

Hill: -- weak deals, I know the example you used was emerging markets. I'm wondering if you could also say the same about IPOs. Matt Koppenheffer was in here yesterday, and one of the things we were talking about was, essentially me scratching my head at things like Survey Monkey going public and the stock popping 70% at one point. Last week, Eventbrite. Not to hate on Survey Monkey or Eventbrite.

Hanson: Lovely people.

Hill: [laughs] Lovely people, and fine businesses. But not the type of businesses that you would think would warrant that sort of thing. You mentioned to me this morning an IPO coming next week that maybe seems like it's a little bit more tempered, but still possibly a solid business.

Hanson: We'll see what happens next week, but Upwork is coming public. Upwork, for people who don't know, is a platform where freelancers can connect with companies that need software development and other work done. It's one of those platforms that has real network effect possibilities. It's been around for a long time, almost 20 years at this point. The business has solid revenue streams. If it's not generating cash, it's almost generating cash. Not booking huge losses. It's going to have a solid cash position. And I think it's going to go public at $1.3 billion, which would be about 5X sales. That's not classically cheap, but on a relative basis, that is more interesting than some of the other businesses that are out there. Obviously, network effects can always be a very durable source of competitive advantage, and the gig economy is growing.

I think it's going to be an interesting one to look at. I never buy IPOs out of the gate. You always want to see how a company behaves as a public company before you get into it, particularly as a lot of companies are notorious for dressing themselves up before they initially public offer. We'll see how it behaves in its first couple of weeks as a public company.

As you said, I think there's a lot of speculative stuff coming public because it's a good time to cash in. But that doesn't mean that it's all speculative. We'll see.

Hill: It's a good reminder, and I think you were the one who first made this point on Market Foolery years ago. I don't even remember the company we were talking about that was going public. You hammered on the point that was essentially, "You have to remember, when a company is getting ready to go public, they're making their books look as good as they possibly can. They are pulling every lever they can to make that prospectus look great."

Hanson: Yeah. I think it was Arcos Dorados, the Latin American McDonald's franchise. I haven't looked at their books recently, but at least as of not too long ago, I think the best year in the company's history was the year before they went public.

Hill: [laughs] Well, and on the flip side, if someone's getting ready to go public, and you look at the prospectus and you're like, "Eh...," wow! That's a big red flag, if they can't make it look good then.

Hanson: [laughs] Yeah, that's true. Now, obviously, there are some businesses that do great things after they go public, or we wouldn't be talking about it.