Howard Marks On Business Cycles And The Option Value Of Cash

by: Erik Kobayashi-Solomon

As I mentioned in my last article, I recently had the pleasure of attending MOI Global's Latticework 2018 Conference, at which legendary investor Howard Marks was one of the featured speakers.

Marks is co-chairman and co-founder of Oaktree Capital Management, a prominent investment firm managing over $120 billion in assets. In October, Houghton Mifflin Harcourt will publish Marks' newest book, Mastering the Market Cycle; Marks' Latticework appearance represented a sneak peek of the arguments presented in his new book.

Marks has been investing professionally for a long time, so his insight into market cycles and into the general state of the investing business is richer than most people alive today. After hearing Marks speak, I cannot wait to read his book.

Like other very experienced investors, he believes that it has become increasingly harder to run at the front of the investment pack. Information about public companies is ubiquitous and very nearly free, computing power is cheap, and tens of thousands of smart, well-paid people are fighting to find, exploit, and (once they are securely in their position) announce any information that might lead to a slight investing advantage.

In this environment, Marks believes that there are only three sources of an investing "edge." A person must be:

  1. Better at inferring the consequences implied by current company data,
  2. Better at managing the psychology of investing, or
  3. Better at assessing the present stage of the business/market cycle.

Marks' book and his Latticework presentation obviously addresses the third factor in developing an edge, but the topic is not without controversy. Value investors are sagely advised to avoid the evils of "market timing" and talking about market cycles is held as a taboo in some circles, especially in circles of buy-and-hold investors.

But Marks makes a strong point with his own experience that paying attention to market cycles can serve as a powerful boost to returns.

Oaktree is famous for having put an enormous amount of money to work - an average of $625 million per week - during the 2008-2009 financial crisis. Investing at the bottom is a clear path to success, but it is a method away from which most people self-select by not having cash to invest when cash is most needed.

After all, if you are fully invested in the stock market when the market takes a tumble, it does not matter how great your powers of equanimity and level-headedness are - you will be forced onto the sideline. The only choice available to a fully-invested investor is the choice to realize a loss in one position to initiate a potentially more profitable position in another asset.

Marks was able to invest aggressively at the bottom of the market because he had received prior commitments of capital from his clients and because he had the equanimity to make those capital calls during the darkest days of the crisis. According to his presentation, when Lehman Brothers announced its bankruptcy 10 years ago, he had called in only 12% of his clients' capital commitments. This left 88% of the commitments to be called in and deployed.

An individual investor has no mechanism for making a "capital call" from his or her clients. Instead, he or she must be far-sighted enough to hold cash in reserve, and to hold more cash in reserve the closer the economy and the market come to a downturn.

How does one know we are close to a downturn? Marks has his own rule of thumb for knowing when we are near the top of the cycle:

  1. There is too much optimism ("It's different this time" are the four most dangerous words in investing).
  2. There is too little risk aversion.
  3. There is too much liquidity (too many dollars chasing too few good deals).

In my view, each of these conditions hold today, and judging by Marks' own actions, he thinks so as well. Marks reported that he started soliciting capital commitments in 2015 and has so far deployed only a fraction of that money on deals.

Noah did not wait until the rain started to begin building his ark. Intelligent investors should not wait for a flood of bad news to start building a cash position.