Howard Marks on Distressed Debt

Oaktree Capital's Howard Marks has been featured many times on the blog, especially in regards to his thoughts and takes on distressed debt. In his most recent memo (all of them can be found here: Howard Marks' memos), Marks expands on why distressed debt is such an "alpha" generating asset class as well as a few other salient points. In my estimation, it is one of the best memos in recent years. I have embedded it for you below. Here are some of my takeaways.

• Howard Marks starts out by discussing the concept of zero sum in investing. I.E. your gain is another person's loss. And that 'transaction' has to occur because one party has made a mistake in their analysis or they simply don't know what they are doing. If I had to go head to head with an investor in weather derivatives that specialize in weather risk management, I'd get my head blown off.
• "...in every investment transaction you're part of, it's likely that someone's making a mistake. The key to success is not have it be you." A concept I introduced early in the blog was that of the information disadvantage a new buyer has of an asset versus a long term holder (and now seller). You have to ask yourself WHY this person is selling. If its for uneconomic reasons (margin calls, downgrade, have to sell bankrupt assets), it could be a compelling buy. 
• Howard Marks notes he focuses on mistakes for three reasons: 1) mistakes are ever-present in the investment process 2) understanding why you are not the party making the mistake and 3) reducing the probability that you are the one making the mistake (better investment process?)
• Fantastic commentary on why the market efficiency hypothesis is wrong: "...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"
• Marks goes on to talk about the pendulum of optimism/pessimism that investors deal with on a daily basis. This creates a massive disconnect between asset's prices in the marketplace and their intrinsic value.
• Here are Mark's two rules for whether you should engage in active investing 1) pricing mistakes occur in the market they're considering and 2) they are capable of identifying those mistakes and taking advantage of them. 
• And a choice quote: "Active management has to be seen as the search for mistakes." You have to ask yourself: where is the consensus wrong? what is the market assuming that is blatantly wrong? An example I often point to in distressed is the valuation of Nortel's patents. The sell side, which I generally use as a proxy for market consensus because of buy side anchoring and frankly laziness, was well below the eventual sale price. And if you saw this mistake, you could have profitted handsomely
• Marks goes on to point out what would make a perfectly efficient market including market prices set by a thoroughly rational and unemotional being. As humans we are infallible to mental shortcuts and processes that we needed when we had to battle sabretooth tigers for our food. This is behavioral finance at its best. And what Marks points out that is most relevant: When investors fail at being rationale and unemotional, they all err in the same direction at the same time. Sounds like bubbles and crashes - some of the most profitable investment environments for contrarian.
• Why do people fail at investing, i.e. failure to buy cheap assets and sell expensive assets? 1) Biases (can't buy value stocks in the 1999 because everyone was buying tech), 2) Capital Rigidity 3) Psychological excesses (greed, envy, hubris) and 4) Herd behavior
• Another great quote: "In practice, there are numerous reasons why one asset can be priced wrong - in the absolute or relative to others - and stay that way for months or years. Those are mistakes, and superior investment records belong to investors who take advantage of them consistently."  What I think people will miss here is 'consistently'. As I've noted in the past investing is like a NASCAR race; you can only win if you make it to the finish line.
• The letter now turns to distressed debt as an example of an inefficient market. Oaktree's distressed team, led by Bruce Karsh, has returned 18% net for more than 23 years without the use of leverage. Amazing!
• This is probably the most interesting part of the letter: He notes that distressed debt isn't inefficient because people don't understand or play distressed, as there are MANY distressed debt funds. Instead it is because the usual mistakes an investor makes in investing are harder to make when investing in distressed.
• Bob O'Leary, a PM in Oaktree's distressed business says, distressed is "an examination of flawed underwriting assumptions." I.E. profiting from mistakes of par buyers and providers of capital that do not get it right when extending capital to leveraged borrowers. And when they do not get it right, these debt holders get too pessimistic in bad times = the most compelling risk/return environment for an enterprising investor. 
• What do we, as distressed debt investors do, that gives us an advantage over most? 1) We never invest in companies where things are going well and investors are enthralled = we buy at lower prices 2) We invest after problems have already emerged = less chance of getting sideswiped by a business failure, earnings miss, etc 3) We buy from motivated or forced sellers = we have an advantage over the seller in the "zero sum" analogy
• "It's not that distressed debt investors can't make mistakes; just that their likelihood of doing so is reduced by the very nature of their investment activity. Anything that decreases an investor's chance of erring - even an involuntary safety mechanism - works to his advantage" - great quote

And the final quote I think we should all remember: "Nothing is more likely to make as asset too cheap than excessively negative psychology." 

Fantastic read! Enjoy the entire document below.

It's All a Big Mistake_06_20_12