橡树资本客户与朋友

Memo to: From: Re:

Oaktree Clients and Friends Howard Marks How the Game Should Be Played

One of the questions asked most often in connection with our leaving to form Oaktree - perhaps second only to "where'd the name come from?" -- is “why did you do it?" The answer is that we concluded we had an opportunity to create our own investment management firm, all of which would run our way, according to our philosophies, beliefs and standards. But what do we mean when we say "our way?" Well, an article about sports in the April 2 New York Times Sunday Magazine provided an excellent metaphor through which to illustrate the point. In it, the author wrote of Babe Ruth that he represented . . . The Credo of the Home Run: A man can never be faulted, even if he's wrong, for the bold, aggressive action in pursuit of victory; a real man must be willing to strike out, to go down swinging. I believe this is the way much of the investment world thinks, but it's the opposite of what we believe in. In fact, I wrote a memo in 1990 to take issue with a money manager who justified his poor recent performance by saying "If you want to be in the top 5% of money managers, you have to be willing to be in the bottom 5%, too." U

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"Our way" is never to tolerate poor performance, and certainly not to consider it an acceptable side-effect of swinging for the fences. While we strive to be somewhat above average each year, our philosophy mandates that we put the greatest emphasis on trying to avoid losing our clients' money. U

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And that brings me to what I feel is a much more appealing sports metaphor, which I clipped from the Wall Street Journal in 1992 but never had occasion to cite until now: the story of golfer Tom Kite. The article was about Kite's having won a major tournament, but the part that interested me dealt with his record up to that time: The bespectacled 42-year-old had won ... over the past 20 seasons some $7.2 million in official prize money, more than any other golfer -- ever. But [he had never before won] one of the sport's "majors" (the U.S. and British Opens, Masters and PGA Championship).

1995 Oaktree Capital Management, L.P.

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That's the way we think it should be done: by consistently finishing in the money, but with no need for headline-grabbing victories. What we think matters isn't whether you hit a home run or win the Masters on any given day, but rather what your longterm batting average is. Many money managers, it appears, believe either (a) that they really can predict what's in store for the markets and which issues will do best, or (b) that their clients expect them to be able to, and to act as if they can. Thus they swing for the fences each year with a portfolio which will earn big rewards if their forecasts are right ... and vice versa. The record suggests very few managers truly know what the future will bring, and yet many keep trying to make money through stock picking and market timing in even the most efficient markets. When their holdings appreciate, they recount their insights and take credit, never admitting when they've been right for unforeseen reasons. When they're wrong, they complain about the circumstances that conspired against them and explain that they were fundamentally right but just off in terms of timing or betrayed by chance. Then they go on espousing new predictions without ever publishing a scorecard from which to judge their record as forecasters. Our response on this subject is simple: (1) We accept that we're among the many who do not know what the big-picture future holds. (2) It is for this reason that we choose to work in inefficient markets where specialization, skill and hard work can add value and lead to above-average performance over time. (3) Lastly, we feel that because we're not clairvoyant, it's important to acknowledge our limitations and put the highest priority on avoiding losses, not executing bold strategies. U

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I was raised on an adage which had good things to say for "he who knows and knows he knows" but warned about the danger of following "he who knows not but knows not he knows not.” Or, as expressed in my favorite quotation, from Stanford behaviorist Amos Tversky, . . . It's frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what's going on. We never forget how risky it is to join that group. Thus our "game plan" is directed at avoiding strikeouts and building a high batting average over time, not at hitting a home run each trip to the plate. May 26, 1995

1995 Oaktree Capital Management, L.P.

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Memo To:

Oaktree Clients

From:

Howard Marks

Re: Date:

The Value of Predictions II (or "Give That Man a Cigar") July 22, 1996

In a February 1993 memo entitled "The Value of Predictions," I expressed my negative opinion of attempts to predict the macro-future. Now, to follow up, I've examined a handful of semi-annual Wall Street Journal economic surveys I've been stashing away. Please note that this was not a scientific study; my sample was limited to the contents of my desk drawer. The conclusions are interesting nevertheless. First, can accurate forecasts be made? The record shows the predictions of the Journal's average "expert" to have added little value in terms of predicting the future. The table below shows the wide margin by which the consensus missed the mark. 90-day bill rate

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30-year bond rate

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Yen/$

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December '93 12-Month Prediction December '94 Actual

3.7% 5.7

6.4% 7.9

115 100

December '94 6-Month Prediction June '95 Actual

6.5 5.4

7.9 6.6

104 85

December '94 12-Month Prediction December '95 Actual

6.4 5.1

7.6 5.9

107 103

June '95 6-Month Prediction December '95 Actual

5.4 5.1

6.6 5.9

89 103

June '95 12-Month Prediction June '96 Actual

5.3 5.2

6.6 6.9

92 110

December '95 6-Month Prediction June '96 Actual

4.9 5.2

6.0 6.9

105 110

1996 Oaktree Capital Management, L.P.

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On average, these predictions were off by 15%. In the three sets of half-year data I had available, the average expert forecaster couldn't even get closer than 96 basis points when attempting to predict the level of long rates six months out! And missing long rates by 96 basis points implies missing the price of the $1000 long bond by $120. Second, are these forecasts of any value? My limited survey shows the average forecast published by the Journal has not been helpful. The key isn't whether the forecasters accurately predicted the level of the parameters but, (since you make money by anticipating change), whether they were right about the likelihood of significant change and its direction. That these forecasts weren't of value can be seen clearly in the following table, which looks at changes rather than levels. 90-day bill rate

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30-year bond rate

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Yen/$

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December '93 12-Month Predicted Change Actual Change

• 60 b.p.

+260 b.p.

• 10 b.p.

+160 b.p.

+3 -12

December '94 6-Month Predicted Change June '95 Actual

• 80 b.p.
• 30 b.p.

--0--130 b.p.

+4 -15

December '94 l2-Month Predicted Change December '95 Actual

• 70 b.p.
• 60 b.p.

• 30 b.p.

-200 b.p.

+7 +3

June '95 6-Month Predicted Change December '95 Actual

--0-- 30 b.p.

--0-- 70 b.p.

+4 +18

June '95 l2-Month Predicted Change June '96 Actual

• 10 b.p.
• 20 b.p.

--0-+ 30 b.p.

+7 +25

• 20 b.p.

--0--

• 10 b.p.

+100 b.p.

+1 +7

December '95 6-Month Predicted Change June '96 Actual

As the table shows, it's not that the forecasters were always wrong; when there was little change, they were often right. It's just that in times of major changes, (when accurate forecasts would've helped one make money or avoid a loss), the forecasters completely missed them. In the years reviewed, the expert consensus failed to predict all of the major developments. Included here are interest rate increases of 1994 and 1996, the rate decline of 1995, and the massive gyrations of the dollar/yen relationship. In summary, there simply hasn't been much correlation between predicted changes and actual changes.

1996 Oaktree Capital Management, L.P.

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Third, where do these forecasts come from? The answer is simple: If you want to see a high correlation, take a look at the relationship between current levels and predicted future levels. The table below, which does just that, shows a remarkably better "fit." 90-day bill rate

30-year bond rate

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Yen/$

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December '93 Actual 12-Month Prediction

3.1% 3.7

6.3% 6.4

112 115

December '94 Actual 6-Month Prediction

5.7 6.5

7.9 7.9

100 104

December '94 Actual 12-Month Prediction

5.7 6.4

7.9 7.6

100 107

June '95 Actual 6-Month Prediction

5.4 5.4

6.6 6.6

85 89

June '95 Actual l2-Month Prediction

5.4 5.3

6.6 6.6

85 92

December '95 Actual 6-Month Prediction

5.1 4.9

5.9 6.0

103 105

Now that's a correlation! On average, the predictions were within 5% of the levels which prevailed at the time they were made. When rates were low, the experts predicted that they would stay low; after rates rose, they were expected to stay high. High dollar/yen exchange rates brought high dollar/yen forecasts, and vice versa. There's no question about it: each consensus forecast represented a near-extrapolation of then-current levels. Like many forecasters, these economists were driving with their eyes firmly fixed on the rearview mirror. On the one occasion, in 1994, when the consensus of forecasters was bold enough to venture a prediction for short rates which differed substantially from the then-current levels, they got even the direction of the subsequent change wrong. The problem is that, rather than extrapolate the year-end 1994 level, they extrapolated the 1994 trend, which reversed in 1995. In general, we can say with certainty that these forecasters were much better at telling us where things stood than where they were going. This bears out the old adage that "it's difficult to make accurate predictions, especially with regard to the future." The corollary is also true: predicting the past is a snap. And using the prevailing levels to predict the future would have been just about as effective as the average forecast. The prevailing levels differed from the future levels by 16% on average, while the consensus prediction erred by 15%.

1996 Oaktree Capital Management, L.P.

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Fourth, can't anyone get it right? It is absolutely not true that nobody makes accurate forecasts. Every six months, when the Journal reports on a new survey of forecasts, it takes the opportunity to cite the forecaster in the previous survey who came closest to accurately predicting the three financial indicators shown above plus the change in GNP and CPI. It prints the winner's picture and lauds the unique insights which led to the accurate forecasts. And the truth is that the winner's accuracy is often startling, as shown in the following table with regard to what we consider the most important of the indicators, the interest rate on the 30-year Treasury bond. Each time, the winner's forecast was quite close to the actual and much more accurate than the consensus. Susan Sterne Economic Anal. Assoc. December 1994

James Smith Univ. of No. Caro. June 1995

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Michael Cosgrove The Econoclast December 1995

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Winner's Prediction

6.80%

6.05%

6.90%

Subsequent Actual

6.62

5.94

6.89

Consensus Prediction

7.92

6.60

6.00

Looking at the winning forecasters' results shown above, one might even be tempted to conclude that accurate predictions are in fact achievable. Fifth, then why do I remain so negative on forecasters' ability? The important thing isn't getting it right once. It's doing so consistently. The table below shows two things that might make you think twice about heeding the winners' forecasts. First, they generally failed to make accurate predictions in surveys other than the one they won (shown in bold). And second, in the surveys they didn't win, their forecasts were much more wrong than even the inaccurate consensus half the time. December 1994

June 1995

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Susan Sterne James Smith Michael Cosgrove Consensus Prediction Subsequent Actual

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6.00% 6.05 7.70 6.60 5.94

6.80% 7.40 7.50 7.92 6.62

December 1995

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5.00% 5.55 6.90 6.00 6.89

As the Journal itself pointed out in reviewing the results of the December 1995 survey: . . .by giving up the comfort of the consensus, those on the fringes of the economic prediction game often end up on the winning or losing end. James Smith of the University of North Carolina and Susan Sterne of Economic Analysis Associates, the winners six months and one year ago, respectively, didn't even get the direction of interest rates right this time. The same happened last year to

1996 Oaktree Capital Management, L.P.

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Wayne Angell of Bear, Stearns Securities Corp., the winner before them .... (Emphasis added) An interesting pattern emerges from the data shown above. In all three surveys, Ms. Sterne's prediction was the lowest of the three experts and Mr. Cosgrove's was the highest. One way to get to be right is to always be bullish or always be bearish -- if you hold a fixed view long enough, you may be right sooner or later. And if you're always an outlier, you're likely to eventually be applauded for an extremely unconventional forecast that correctly foresaw what no one else did. But that doesn't mean your forecasts are regularly of any value. A lot of adages fit this data. I've heard it said that "even a blind squirrel occasionally finds an acorn," "a stopped clock is right twice every day" and "if you put enough monkeys in a room with typewriters, eventually one of them will write the Bible." I feel the sum of this data shows that it's possible to be right about the macro-future once in a while, but not on a regular basis. It doesn't do any good to possess a survey of 64 forecasts that includes a few which are accurate; you have to know which ones they are. And if the accurate forecasts each six months are made by different economists, it's hard to believe there's much value in the collective forecasts. By the way, there's an important analogy to be drawn here: Efficient market advocates don't say it's impossible to beat the market; lots of people do it every year. (Remember, half the observations in any sample are above the median.) They only assert that no one can consistently do so in risk-adjusted terms. Finally, can macro-forecasts be used to gain an advantage? I pointed out in my 1993 memo that most of the time, you can't get superior results with inaccurate forecasts or with accurate forecasts that reflect the consensus. (This is because the consensus view of the future is already embedded in the price of an asset at the time you buy it). To bring above average profits, a forecast generally must be different from the consensus and accurate. But, as I described in 1993, it's difficult with regard to a non-consensus view of the future (1) to believe in it, (2) to act on it, (3) to stand by it if the early going suggests it's wrong, and (4) to be right. Those who invest based on fringe predictions are often wrong to an embarrassing and costly extent. At Oaktree, we don't spend our time attempting to guess at the future direction of economies, rates and markets, things about which no one seems to know more than anyone else. Rather, we devote ourselves to specialized research in market niches which others find uninteresting, unseemly, overly complicated, beyond their competence or not worth the effort and risk. These are the inefficient markets in which it is possible to gain a "knowledge advantage" through the expenditure of time and effort. They also happen to be markets in which micro factors relating to companies, assets and securities matter the most. This is where it's possible to find bargains, and only bargain purchases can be counted on to dependably lead to returns which are aboveaverage relative to the risk entailed. We say "we try to know the knowable" -- and that doesn't include the macro-future.

1996 Oaktree Capital Management, L.P.

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