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Takeaways from “Sea Change”

Takeaways from “Sea Change”

Howard Marks, a billionaire and founder of Oaktree Capital Management, is known to be a critical thinker and he shares his views openly in his memos.

He published his memo entitled “Sea Change” recently and here are my takeaways:

1) With higher interest rates, investors cannot afford to be complacent by investing in companies with weak balance sheets and a lack of profitability. In terms of our portfolio, we must make this shift ASAP. We cannot afford to invest in companies with “sexy” technology with zero profits. The new capital markets won’t be able to support such companies.

2) Without the tailwind from the interest rates, the source of prospective returns will come from a company’s profits and cash flow growth.

I’ll talk about why the fed fund rate was a tailwind in the past.

Supposedly, you’re seeking a 10% yearly return for buying biz.

Using the formula, $1 / 10% (expected return) = 10x

This means you’re willing to pay 10x for every dollar it produced.

What if u could borrow money at 2% because the Fed drops the interest rate? You might be happy with a 5% yearly return for buying a biz.

$1 / 5% (expected return) = 20x.

Compared with the previous example of 10x, you are now OK to pay 20x because of the cheaper money.

A company that is earning the same money is now worth 2x more without any real earnings growth. Now, interest rates are raising and they are not returning to 1-2% any time soon, the future returns are likely to come from the earnings growth of companies instead of interest rate changes.

3) While inflation seems to be a rearview mirror issue now, the recession might be looming ahead because a) some businesses with poor fundamentals are suffocating from high-interest rates will disappear b) consumers will spend lesser and contribute to lower corporate earnings c) defaults in risky debts may happen.


Full Notes:

  • In the past, investors would buy bonds only if they are investment grade. Today, bonds are acceptable as long as they offer high yields regardless of their quality. This means investors are more focused on potential returns without focusing on the potential huge downside. This gave rise to a new investor mentality which accepted concepts such as distressed debt, structured credit and private lending.
  • The OPEC oil embargo of 1973 supposedly caused the inflationary environment in the 1980s. It took a fed funds rate of 20% to get inflation under control.
  • Between August 1982 and the beginning of 2022, the S&P 500 index compounded over 10.3% per year due to four decades of a declining interest rate environment. There are other factors such as gains in technology, productivity, globalisation and economic growth.
  • Declining interest rates accelerate the growth of the economy, increase the fair value of assets, benefit those who buy assets using leverage, and increase risk appetite.
  • A big portion of the money that investors made over this period resulted from the tailwind generated by the massive drop in interest rates. Without it, those gains were impossible.
Chart 1: The history of Fed Fund Rate
  • From 2009 through 2021, it was a borrower’s market (due to low-interest rates) and an asset owner’s market. With interest rates near 0%, the fear of loss is absent.
  • Now, higher interest rates led to higher demanded returns, which will depress valuations. There is no more FOMO and everyone is now focused on risk. The fear of recession also created the fear of rising debt defaults.
  • The current S&P 500’s rally from the October low has been motivated by beliefs such as (a) inflation is easing (b) The Fed will soon pivot from restrictive policy back towards stimulative (c) interest rates will return to lower levels.
  • Howard Marks believes we won’t return to a stimulative monetary policy any time soon because it wants to drop inflation to near 2% + see the inflationary psychology vanish. Fed wants to maintain credibility.
  • Fed needs normal interest rates to be high enough to have some room to cut if it needs to stimulate the economy in the future. We might think interest rates are high now, but in the longer context of history, they are considered normal.
  • Do not expect interest rates to come down any time soon.
  • Things will be less rosy even after inflation is coming down as a recession is looming ahead. Along with corporate earnings and weakening investor psychology, it is possible for stock prices to stay flat or drop.
  • Now we might be returning to a normal full-return world, what worked in the last 13 years may not be the ones that outperform in the years ahead.