Howard Marks on China, Risk, and Interest Rates

Howard Marks is co-founder and co-chairman of Oaktree Capital Management. In this podcast, Bill Mann, The Motley Fool's director of small-cap research, caught up with Marks to discuss:

• Why higher interest rates created a "sea change" for investors.
• China's economic miracle, and its impact on inflation.
• Lessons from the era of easy money.
• What life insurance companies can teach investors about risk. 

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Jan. 29, 2023. 

Howard Marks: People would say how can you invest in the debt of a company that's bankrupt? The answer is that even a bankrupt company has value. By the way, in the law, they call it the estate, like a dead person. The estate has value. When everybody is throwing the dead out as if it has no value, if you can buy it at a low price, maybe you can get a good return. 

Chris Hill: I'm Chris Hill and that's Howard Marks, co-founder and Co-Chairman of Oak Tree Capital Management, a leader in alternative investments, including the biggest distressed debt fund in the world. His memos are considered required reading by many investors. His latest one describes the widespread impacts of more normal interest rates. Bill Mann caught up with Howard Marks to talk about why he likes sectors that other people consider uninvestable. His views on inflation, as well as winners and losers from the era of easy money. 

Bill Mann: You put out a letter and investing luminaries, starting with Warren Buffett have said that when you put out a memo that he drops everything and reads it and I'm in the same boat. You put out a memo in December, it was called sea change. In sea change, you describe what you see in 53 years of investing only the dawn of the third era of investing. Now obviously in that period of time, we've seen lots of fads, we've seen lots of trends. But in this case we're talking about something that is a total transformation. We have felt it too, but I wanted to take the opportunity to ask you really in your own words to talk about what it is that you see that's happening and why you think it's happening now.

Howard Marks: I think Bill, that since the global financial crisis, which ended in '09, we've been living in a world which was engineered to be an easy world. Some of the manifestations may not have been intentional. But the point is that the Fed had to save the country and the world from the global financial crisis. It did so by drastically lowering interest rates and increasing liquidity through quantitative easy, the buying of bonds. Those two changes had many ramifications, and they made, I would say just for a summary, they made the world an easy place. It was an unusually, unnaturally easy place for the 13 years from the '09 through the end of '21.

What do I mean? Well, first of all, of course, it was very easy to borrow money and it was cheap to borrow money. Borrowers did not have to commit to extensive documentation or restrictions. What we call covenants, tended to disappear. Now the reason for this is largely because the reduction of interest rates reduced the returns on very safe instruments like cash, T-bills, high-grade bonds. To the point where people who investors, especially institutions that need six or seven or eight percent a year, couldn't use those things. They had to move out the risk curve in order to get the kinds of returns they needed. That made their capital readily available to riskier companies at low interest rates.

The accommodative monetary policy that I described supported the economy. We had the longest economic recovery in history. It's supported the markets. We had the longest bull market in history. Declining interest rates increased the value of all assets. The theoretician says that the value of an asset is the discounted present value of all the future cash flows. If you lowered the rate at which you do the discounting, the present value of future cash flows goes up. Assets became more valuable. It was very difficult to default or go bankrupt in this accommodative environment. The rate of defaults and bankruptcies was very low. In the prior crises, I had managed money in 1991, '01. '02, we had two years of double-digit defaults in the high-yield bond universe. In this case, we only had one. Again because of these accommodative policies.

Bill Mann: You can always go get more money.

Howard Marks: Exactly.

Bill Mann: Money was available.

Howard Marks: A zombie company which consumed money where the debt service requirements exceeded the cash flows, as you say burnt money every quarter, but it was very easy for them to get more money. So an easygoing environment and the main point of the memo sea change is that Number 1, obviously in 1980, I had a loan outstanding from a bank and I got a slip from the bank saying the rate on your loan is now 22.25.

Bill Mann: It seems like a lot?

Howard Marks: Forty years later I was able to borrow at two-and-a-quarter. I just think that interest rates don't have much further to go on the downside, so that phenomenon is largely over. I think for various reasons, the Fed is not going to go back to the ultra low interest rates over the last 13 years. I think that we're back more to in my opinion, a more normal environment where it's not easy to get finance. Some people can some can't, it's not as cheap. There may be some covenants involved. It's not so easy to avoid default and bankruptcy. It's not so easy to avoid recession. It's just going to be a little more challenging time. Now if people say, I want to go back to normal, let's go back to normal like 2015, 2016, 2017. That was not normal time.

Bill Mann: We are in normal. 

Howard Marks: This is normal. The new conditions that I describe our normal. The conditions of the last 13 years were abnormal.

Bill Mann: There was a brilliant chart and I should send it to you. It was provided to me. The Bank of Japan did it and it showed that the interest rates over the last 13 years worldwide were at 700 year lows. Probably longer than that. But they ran out of the capacity to track from the beginning of recorded history in which interest was a formalized thing. We're at a 700-year low. What's really interesting to me, so I got my start in investing in Japan and it was the early 1990s. It was a very, incredible time to be an investor. Japan never did learn that lesson or at least they have pushed it off. That the types of cleansing that you're talking about, bankruptcy is good. Bankruptcy it hurts and I think that it feels bad. But in some ways, our country works best because we are really good at rewarding well-invested capital and punishing poorly invested capital. In the last 13 years, that accommodative environment made that something that you could step through it.

Howard Marks: I said in one of my memos during the pandemic that fear of bankruptcy is to capitalism as fear of hell is to Catholicism. On the straight narrow, it's what makes us make prudent decisions. If you're not afraid of bankruptcy or default because the conditions are so benign and you believe that there's always a put from the Fed in which they'll bail you and the economy out, then you don't have to be so prudent. That's the downside, and that creates moral hazard and all those things.

Bill Mann: It also creates what I saw in Japan was a 30-year period in which you didn't get any return because there were so much poorly allocated capital that was not allowed to be siphoned down to the system?

Howard Marks: Yes.

Bill Mann: When we spoke in 2018, we were talking just after you had published your book. I describe your book, Mastering the Market Cycle as one of my old friends. It immediately went into the pantheon of books for me, along with Ralph Wanger's Zebra and Lion Country the Intelligent Investor, Peter Candel's book. It is a fabulous book.

Howard Marks: Thank you.

Bill Mann: But there's something I want to read from here because I think when we were talking about it in 2018 and when you were writing about it, on one hand, it felt like we might as well have been speaking in Albanian. As brisk attitude swing from high to low, so do opportunities for profit or loss. When everything is going well and asset prices are soaring, investors tend to view the future as rosy, risk as their friend, and profit as easily achieved. Everyone feels the same. Meaning little risk aversion is incorporated in prices and thus their precarious.

We had another year and a half to two years once you wrote this book, and it occurred to me later on seeing you, and it really occurred to me reading and see change that this was a period of time in which Oaktree Capital and your investment team pulled back and you described it as being a really difficult time for your firm. I wanted to ask really, how did you stay disciplined? What was it that you saw if you didn't see a date certain in which things would change, what were the characteristics that allowed you to remain counter to what was happening in the market?

Howard Marks: Well, look, everything we do starts off with wanting to do the right thing for the client. That means invest aggressively when there are excellent opportunities and cautiously when there aren't. From October of 2012 until February of 2020, the doorstep of the pandemic I used to give a speech entitled investing in a low-return world and for the credit investor, which is what we predominantly are, we were in a low-return world. When the Fed set the risk-free rate on Fed funds at zero, all returns scale from that. If you start here, they go like that but if you start here, they go like that.

Bill Mann: The curve is the same, it's just where it starts.

Howard Marks: We had a downward move. All assets offered prospectively low returns, just like your Japanese friends now, I wasn't around for the whole 700 years But these were some of the lowest prospective returns in history, especially on credit, which is, as I said, what we do. We had to acknowledge that. In that speech, in the low-return world, I said, how do you pursue return in low-return world? I listed six possibilities. One is that you invest as you always have and expected the returns you've always gotten but that was there as a red herring because that's really not true. If you do what you've always done, you have to expect much lower returns.

That was a fake. Number 2 was do what you've always done and except that the return will be lower than it used to be. Number 3, was reduce your risk because you think you're in precarious territory and accept that the return will be lower still. Number 4, go to cash because you think that the precarious conditions are going to produce a correction which will enable you to make great investments at the bottom, sit there in cash, but you better be right, and you better be right soon since cash yield zero in that environment. Number 5 was go the other way, take on a lot of incremental risk in pursuit of incremental return.

Then Number 6 was look for what I call special niches and special people in that difficult environment where you can still get a better deal than average. That was it. Basically, we calibrate our portfolio positions by manipulating our balance between aggressiveness and defensiveness and in that environment, we went pretty defensive. Now, we couldn't go hide under the bed and accept the zero return our clients give us money and they tell us what to invest in. Our job is to make the investments. We adopted a mantra called move forward but with caution. Try to be fully invested, but do it cautiously and we are in inherently cautious firm I think so when I say with caution, I mean more caution than usual. We were in a cautious mode in this period, we thought it would end and we had no idea when.

Bill Mann: There's two parts to this question. The first of which is how important having well-aligned shareholders were for you because obviously, as you said, you went defensive. You have investors who've given billions of dollars to you to manage in a certain way but there could possibly be a prudence versus expectation disconnect. How important is having well-aligned shareholders to you and what you do?

Howard Marks: It's the key. If we're acting for them. We can't have a successful relationship if we're not in agreement on how we're going to behave. In many forms of life, the key to happiness is low expectations But I would say that the key with somebody like an investment manager is realistic expectations. Now we have an investment philosophy. We are proud of it. We send it out. We talk about it all the time. Tenant number 1 is risk control. We hold ourselves out as the risk-controlled alternative in our niches. I can't imagine that there's a client out there who doesn't expect Oaktree to behave in a risk-controlled manner. Now, when they see that such and such a market is up 50 percent, they may say, gee, I wish wouldn't hired Oaktree, I wish I had hired somebody more aggressive.

Bill Mann: I hear what they say that they do, but maybe I want to be exposed a little bit less than what they do.

Howard Marks: But I don't think that any of them could say, "Oh Jesus, it came as quite a surprise to me that they acted in a risk-controlled manner." An agreement on expectations and clear communications are really fundamental in my opinion to a successful relationship in this business and I try to work hard on both. I think we have both and I think our clients come to us for our risk-controlled approach and where we have times when we do great and times when we do less great for that reason. But the point is, we moved forward. We stayed fully invested, but with great selectivity and an emphasis on caution and margin of safety and we produced respectable returns in that period given the environment and all you can do as an investor is produce returns that are reasonable given the environment.

But we raised small amounts of money. We stayed our assets under management remain fairly stable for most of that period when a lot of the public peers among alternative investment managers were doubling and tripling their assets and as I say, I think our returns were certainly respectable. We're certainly roughly in line with our benchmarks. Our closed-end funds produced, respectable, non-penalty, absolute returns. They just weren't up to what we had done in previous environments. By the way, I failed to say when we went on your first question, when you asked about the sea change. The real import of this is that in that climate of the last 13 years, it was great to be an asset owner, it was great to be a borrower.

It was not so great to be a lender or a saver and what the government really does, and I put the Fed in that category, is my position is that the government doesn't add the GDP and the Fed doesn't make anything. All it does is engage in policy decisions and what policy decisions do is they favor some groups over others. They direct assets and revenues toward some groups and away from others. This behavior on the part of the Fed for at least the last 13 years and maybe arguably since Greenspan came in 25 years ago, they penalized savers and lenders and that made it a tough period. But you asked before about and knowledge and misunderstandings. If it was a good period for owning assets and it was a good period for borrowing, what about somebody who owned assets using borrowed money? It's a double bonus and that is private equity.

As I said in the memo, you study a company, you conclude that the company overall will return 10 percent a year. Then you find out that you can borrow the money at eight percent, so you say this is great, we can borrow at eight, invest at 10, so you do it. Then when the debt matures and you go to renew it, they say, OK, now it's going to cost you five percent. You say, "Boy, I'm smart." Were you smart or were you the beneficiary of a downtrend in interest rates? Clearly the latter, but it feels like smart and the people who did it get their pictures in the paper. That's the nature of our business. That it's not necessarily the people who made the most best reasoned decisions, it's the people who did XYZ and were favored by the gods. If those were the factors that were rewarded in the certain environment, and if the environment is going to be quite different going forward, maybe different strategies will be rewarded in the coming environment and not necessarily a continuation of the same once.

Bill Mann: There is a word that you didn't write in sea change. But to me, it was in the background and the word is China. Because when you're talking about a 13-year period, I think you're generally talking about an interest rate environment. But the 40-year period you're talking about primarily the impacts of globalization and for a 40-year period, we had the capacity and the endless desire to exports inflation to China. Is that time over as well?

Howard Marks: Well, I would rephrase. I wouldn't say we exploited inflation. I'd say we exported a sourcing which had the effect of fighting inflation. I think there was a 25-year period there, maybe it was hold on, maybe it was something like 1990-2015 when consumer durables prices overall declined by 40 percent and it didn't happen because the OS production got cheaper, it happened because we imported more and more and more from Asia. When we're talking about durables, we're talking about appliances and things of that nature, TVs and the raise your hand if you have an American-made TV. 

Bill Mann: It's a coffee table, if you too. 

Howard Marks: By the way, this was the period that coincided with what I call China's economic miracle. I'm not going to put you on the spot, but do you know how much Chinese GDP is up in the last 42 years?

Bill Mann: You mean aggregate?

Howard Marks: No, what percentage or how many times? Has it doubled? Has it tripled?

Bill Mann: I think it's like eight times.

Howard Marks: It's 100 times.

Bill Mann: So I was really wrong.

Howard Marks: Really wrong.

Bill Mann: Thank you. You did put me on the spot by not putting that out. 

Howard Marks: But back in 1978, as I recall, Chinese GDP was $178 billion and most recently it was 17.8 trillion so that's 100x and our business made China rich and allowed them to move people from the farms to the cities and into manufacturing from agriculture and so forth. But it's largely over. Ironically, there are a lot of people who want to do outsourcing who say, now, China's too expensive. Because the Chinese miracle raised the per capita income and the wage in China and you can't get work done as cheaply over there anymore as you used to.

Bill Mann: On a yield basis, it doesn't really work out anymore.

Howard Marks: Exactly, so you have people going to countries other than China, Vietnam, or Bangladesh are examples. But then you have the fact that the pandemic demonstrated that we have to worry about sources of supply. There was a force going on now called deep globalization, which is a reversal of the sourcing abroad in some small ways, in some certain areas. But that will stop or undo the progress against inflation that globalization produced, so you can't have it both ways?

Bill Mann: It can't be both ways and you're exactly right that it was a continuum and if raising China's economic standards was a goal and from the outset, from both sides it was a goal. Richard Nixon looked at China and said, having a China in poverty, it's not helpful for anybody. It was absolutely a policy goal, but they've done it. You are at the point now where China is no longer competing on price.

Howard Marks: Now, if inflation average, I'm not 100 percent sure on this datum, but if it averaged two percent a year in this country for the last 30 years and that benefited from the process I described in which durables prices went down by 40 percent. What would inflation have been if durables prices hadn't gone down by 40 percent and if durables prices are not going to go down by 40 percent in the years ahead, what will inflation be? I think we may have a slightly higher normal rate of inflation than we did over this period.

Bill Mann: You do agree with me that we exported inflation. I'm still stinging from the fact that my guess that the exponents were, for how much China has grown was so far off, but it does so.

Howard Marks: Yeah.

Bill Mann: Even if you know your stuff, exponential math or exponential factors are really hard to contemplate. What you are suggesting and see change is that a lot of the things that have not worked for the last 13 years maybe are about to.

Howard Marks: It's not yes, no; black, white.

Bill Mann: Of course, it's not by them.

Howard Marks: The things that were penalized in that period will be less penalized or maybe benefited. Great example, high yield bonds. That's really where I started as a money manager in '78, and it's a big part of what we do here at Oaktree. About a year ago they yielded four or something and that was the low-return world. They were not useful to the institutional client trying to make 6, 7, or 8 who would invest in low-quality debt to make four or something. Well, today it yields about eight. That's a usable rate of return. That's just very simple example of what you're talking about. The availability of returns now that I would describe as helpful or ample they're not the highest I've ever seen. They're or not. I wouldn't describe them as the most generous, but at least they're usable.

Bill Mann: Right.

Howard Marks: Another example is one of the things we invest in here and are well known for is distressed debt. Well, guess what? There wasn't much distress.

Bill Mann: If you could just keep raising capital.

Howard Marks: Yes.

Bill Mann: Yeah.

Howard Marks: The default rate in my first 30 years in that position, the default rate averaged around four percent a year. In the last 13 years average something more like two, so very little default, not much for default distressed debt funds to do. We raised smallish funds, and they had moderate returns, not our dream environment.

Bill Mann: Yeah, it sounds to me, Howard, like you were describing a much better environment than we've had in a long time for pensions.

Howard Marks: Yes.

Bill Mann: For pooled money that they have struggled so much for the return for their current obligations. What are some of the other areas you think will benefit from the new world order?

Howard Marks: Well, it's basically everything on the lending side of the equation. That's one, so ranging from cash which now has a few percent positive return through treasuries, through high grades, through high yield. Private lending now yields low double digits, it used to be mid to high single digits, distressed debt funds should be able to make more money in a more target-rich environment, and then there's the one off here and there. If you want to look at the things that have been hurt, an example is the emerging markets. The emerging markets face significant challenges. They've incurred a lot of debt denominated in dollars, and they don't have that much access to dollars, but this low-return world, the hunt for return on investors part, allowed, made dollar capital available to the emerging markets through loans, which has not normally been the case. They'll struggle with paying off those loans.

But the securities are starting from a cheap place. Is it cheap enough, then they're going to go up? I'm not saying that, but there are two piles of securities or assets. There's one pile that everybody knows about, feels they understand, feels good about, feels are seemly and prudent and they're optimistic about. Then there's another pile of things that people don't know about, don't understand, don't feel good about, think are unseemly, and they're pessimistic about. Which pile contains the bargains? It's the latter. Now, I want to say very clearly for your viewers and listeners, that's not to say that everything on the latter pile is a bargain, but the bargains are in that pile. I've made a living for 50-odd years buying things on that pile, doing the things other people didn't want to do. You get to China. What's the word that people have been applying to China for the last year or so? Uninvestable.

Bill Mann: Yeah.

Howard Marks: I like to hear that.

Bill Mann: Okay. 

Howard Marks: I like to hear that. Because I say, OK, nobody else is willing to do it. That means there's not much optimism in the prices. That means the prices may be too low. Let's take a hard look.

Bill Mann: Yeah.

Howard Marks: That's how we think around here.

Bill Mann: It was an argument that I was making about oil and gas companies two years ago. When you were able to buy them at, they weren't profitable necessarily, but you're buying them at 0.1 asset value. That can work out OK.

Howard Marks: It's probably been the best-performing sector.

Bill Mann: Yes. Been quite satisfactory. We have about six minutes and I'm about to ask you a 55-minute question. How do you go about in a distressed market making a business case? Because to me, there's a contrarian element. But in order to be successfully contrarian you also have to be right. I mean, it's contrarian to go stand right next to the fireworks when they're going off but that's not.

Howard Marks: My first book most important thing there is a second edition, the illuminated edition and in the chapter on contrarianism, Joel Greenblatt, the great equity investor, says, "Just because five other people refused to stand in the path of an oncoming truck doesn't mean it's smart for you to do so." Contrarianism, for its own sake, is not a good idea. But the answer is, when we started this in '88, my partner Bruce Karsh and I, Bruce had the idea. He said, "You've owned all these high-yield bonds which went from par of 10-30. Why don't we just do the 10-30 part?" But people would say, "How can you invest in the debt of a company that's bankrupt?" The answer is, that even a bankrupt company has value. By the way, in law, they call it the estate, like a dead person. The estate has value. When everybody is throwing the debt out as if it has no value, if you can buy it at a low price, maybe you can get a good return.

Now, what's a low price? What Bruce and I did is we spec out the job of the analysts to ask three questions. Number 1, what will this estate be worth at the time that the bankruptcy restructuring is completed? Number 2, how will that value be divided up among the various claimants? Number 3, how long will it take? If you know that you're going to get a certain size pizza, you know how many pieces it's going to be cut into and you know how long it's going to take, then you know how much pizza you're going to get and when. The only question is, how much do you have to pay for it? You compare the terminal value with the current price and you say it's a buy or it's not a buy. This is not buy and pray. This is the same studious analysis that you engage in with Small Caps and Motley Fool does with all the things it does just in a different dimension.

Bill Mann: There is something that's very important about what you just said because what you're describing in high yield and distressed debt, I think if you were to throw it into a bucket, you would say is some of the highest risk components of the capital markets. But you're still dealing in is's not maybes. I'm so glad that you went through and describe that process because I think that the environment that we're moving into from my own perspective is it's going to be valuing is's more than it has been.

Howard Marks: Is's is value.

Bill Mann: Yeah.

Howard Marks: Not will be. Will be is growth, is is value.

Bill Mann: Yeah.

Howard Marks: We consider ourselves value investors like you.

Bill Mann: Yeah. I think a lot of people view value investing as being utilities.

Howard Marks: I'm going to use one of the remaining three minutes to talk about risk-bearing. I was asked in 1981 by the Financial News Network, one of the first cable shows, how can you invest in high-yield bonds when you know some of them are going to default? I said to them, the most conservative companies in America, are the life insurance companies. How can they ensure people's lives when they know they're all going to die? This is what I said. This is risk and return thinking. I'm going to describe to you the prudent bearing of risk for profit. The life insurance company knows everybody is going to die. It's not an unknown risk, it's a risk you can contemplate. Number 2, it's a risk you can study. When I got my first life insurance policy, they actually sent the doctor to my house to give me a physical.

Bill Mann: Yeah, same.

Howard Marks: You can assess the risk. Number 3, its risk you can diversify. No insurance company ensures just smokers or just skydivers or just people who live on the San Andreas Fault. You have a diversified portfolio by age, sex, occupation, location, etc. Number 4, it's risk you're well-paid to take.

Bill Mann: Yeah.

Howard Marks: They charge you a premium which is more than adequate to pay for the fact that yeah, you're going to die.

Bill Mann: Yeah.

Howard Marks: That's all we have to do. Risk awareness, risk assessment, diversification, pricing. My job, your job, and hopefully the job of those who are listening. 

Chris Hill: As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.