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Thank you for joining us, Howard. [applause] So, we have a lot of students in the audience, and I was wondering if you could take us back to put yourself in their shoes. 18, 19 year old Howard. Is this the path you thought you would be on?
>> No, I I you know, I was Some people plan ahead and some don't. And I was in the latter category. Uh, you know, I was, uh, uh, very young when I went to college. I was 17 for my whole freshman year. Uh, but interestingly, I grew up in New York. I went to the public schools and and uh one of my buddies at some point in time said they're giving you a course in accounting and we should take it and I took it and I just really liked it and so I figured I'd become an accountant. I applied to Wharton. Uh the my guidance counselor told me I wouldn't get in. Uh but I I did get in uh to study accounting. Then when I ran into finance, I switched to finance as my major. Then after that I I took an MBA at University of Chicago where I did major in accounting. Um and then when I was coming to the end you know I didn't know what I wanted to do. So I I applied for six different jobs in six different fields. Uh and um and uh in the end I took the job at City Bank in investment research. I had had a summer job there the previous year and I liked it and I went back. It was it was kind of it wasn't a brilliant decision. was just a path of police resistance and and the and the familiar uh avenue.
Um and you started off as an equity research analyst following office equipment and then the you know and conglomerates which was a group that by the way I came out here on my first business trip which was in January of 1970 and fell in love with California and and and wanted to live out here and it took me 10 years to find a way because the the investment community in in LA was really tiny. Um but um uh you know my first break came well my first break was probably when I got into Wharton but then uh u you know there was an oil embargo in 1973 and um they asked me to start up research in oil and gas because the the banks were investors in the growth stocks and they and all the other coverage atroof feed and so I had to start coverage in oil and gas and then in the basic industries of paper, chemicals, steel steel and and uh forest products. Um and then uh I was associated with the investment in the growth stocks. I was called the nifty50. It was a total disaster. And uh so when that failed uh I was relegated to the bond department which was the equivalent of Siberia. Um and uh but uh interestingly when I at at 29 I became the bank's director of research for equities and I had 75 employees, a $5 million budget which was a lot of money then and I was on the five most senior investment committees. Then I got sent to the bond department. I had no employees, no budget, no committees. And I was ecstatic because all I had to do was follow 40 securities and know more about them than anybody else. And so it's really important. Everybody wants we used to kid it at the bank in those days. We everybody wanted BMR broad managerial responsibility. It's it's not for everybody and you know you shouldn't aspire to something just because it's a common aspiration. But when I when I got the chance to just study a few securities and and outperform other people, I found it much more interesting and rewarding. And then three months later, I got a call from the head of the bond department who said, "There's a guy in in California called Milin or something and he deals in something called high yield bonds. Do you think you can figure out what that means?" Because a client had asked for a high yield bond. I said, "I think I can." And of course, that was 78. That was the beginning of that world. If you've read Malcolm Gladwell Outliers, you know that it's great to be the first. And and I was. and and the fund I started at city in 78 was the first high yield bond fund from a mainstream financial institution and and and that's the root from which all of oak tree has grown. Uh so I I wouldn't describe it as uh I don't describe my process as intentional or focused. I kind of uh drifted along but got lucky.
>> Luck luck and skill often are intertwined. Um, so in terms of a differentiation, right? I mean, how do you think your studying of of past bubbles and investor psychology gave you an edge? I'm thinking more towards bubble.com in 2000.
>> Sure.
>> Well, one of the important sayings in life is that is experience is what you got when you didn't get what you wanted. And and if you think about it, if you bought the Nifty50 stocks the day I got to work in September of ' 69 and if you held them loyally and faithfully and diligently within five years, you lost 95% of your money and and and it turned out that it had been a bubble which and and the companies were many of the companies were overestimated and all of them were overpriced and and so that was very informative and It's very desirable to learn your lessons early and also preferable to learn your lessons when there's not a lot of money at stake which I did. And so now on the other hand in in many ways that scarring experience made me too conservative. Um, and you know, I've I've been I've been riskaverse all my life. Uh, and and given the, if you think about it, from 1980 when the when the inflation was solved, essentially to date, generally speaking, the more optimistic you were, the more money you made. So, so that was that was the downside of that. But what it taught me, what I I what I came out of uh that experience saying is that it's not what you buy, it's what you pay. And good investing is not just a function of buying good things, but of buying things well. And the difference is not just grammatical. and and and so you know when I had the chance to go into hyo bonds rather than an asset class that was beloved and on the pedestal of popularity and overpriced I got to go into an asset class that almost everybody else said I wouldn't touch that with a 10-ft pole and when you hear that you say oh maybe I can get that at a bargain price there is no such thing as as a bargainedpriced asset that everybody loves it's an oxymoron But if they say I would I hate it and you know people but in 78 you know it's almost 50 years ago people would say well young man I'm sure you could make money doing that but it wouldn't be right. Okay let's go. Sounds good to [laughter] me you know so that that was that was my process and uh I I as I say I I got some lucky opportunities.
>> Absolutely. So, you mentioned that you were kind of risk averse kind of after you were maybe snake bitten by by those losses.
>> Uh, can we do a little role playing? If I were interviewing for a job with Oak Tree and you asked me >> how risky is this investment and I said the volatility of this asset over the last 5 years has been 6%.
>> What would be your response to that?
>> Well, that's that's what you call a softball. [laughter] Um, so when I was getting out of Wharton, when I went into Wharton, I had no plans to get a graduate degree. And I thought a Wharton degree would be sufficient, but by the end of the four years, we had a little something going on called the Vietnam War. And if you came out of school, you were a good candidate, and I got my 1A classification, which I was not eager to seize on. So, but at that time, if you stayed in school, you you were deferred from the draft. So I said I'll get an MBA and and uh so I couldn't go to Wharton because that would be repetitive. Uh Harvard and Stanford turned me down and I went to University of Shuharo. Now uh um the Wharton education that I had this was pre- theory. I don't know what they're teaching here now, but this was before the the theory of investment had been developed at Chicago in the early 60s. But uh when I went to Wharton in the early 60s um it hadn't been developed. So my education was pragmatic and qualitative. Then I got to Chicago where the theory had been developed and implemented and my education was quantitative and theoretical. Either one of which would probably be a disaster but the combination of the two was very very uh very very helpful. And you know, I took a the final exam in my favorite investment course consisted of one question. How do you reconcile the theory you've learned here with with what you're going to do in the real world? And I've spent the last uh 56 years uh working on that question and and uh so just question about volatility. So at Chicago the the the the main thesis was that the main way you can enhance your returns is by accepting more risk. And even people in the investment business subscribe to that. Um and at the end of the process to see if you did a good job you would do compute something called the sharp ratio which is basically basically the ratio of your return to the risk. Well we know what the return was. you were up 14% last year or nine or 17 or whatever it was, but what's the risk? What's the what number do you use for risk? And they said, well, we'll use volatility. The the the the uh fluctuation of the value. The great thing about volatility is you can look at history and know what the volatility of an asset was. You can use that number to extrapolate into the future volatility. you can incorporate it in calculations to figure out what has the highest risk adjusted return. There's only one weakness. It's not risk. So, it's a number which serves as a proxy for something, but it is not an accurate proxy because, believe it me, investors don't care about volatility. I've never heard anybody say, "Oh, you know, I I don't think I'm going to invest in that because it could be volatile. They say I'm not going to invest because I could lose money. That's risk. Risk in my opinion and my my view has evolved. Uh risk is the probability of a negative outcome of an undesirable outcome. It is not the volatility of the stream. And Buffett uh said uh I would rather have a lumpy 15 than a smooth 12. And if you can survive long enough to enjoy the long-term benefit of the lumpy 15, it beats the hell out of the smooth 12. But you have to survive. And and so so volatility is relevant for some people, but volatility is not risk. And if I had that interview and somebody said the volatility is this, I would have to uh educate them. [laughter]
>> Feel like I got to keep my day job. Um, we actually have a slide. Uh, one of the first things that I encountered when I was reading uh some of your memos when I was in school at Pepperdine >> was a risk return chart. >> And we can put that. There you go. >> And this made so much sense to me. Now I'm looking at the audience and it may not make that much sense to everyone >> yet, but it will when I get done.
>> There you go. That's what I That's what I want to hear. So what they if you if you see the the vertical axis, the horizontal axis and the diagonal line. This was a graphic presentation that I virtually saw every day at University of Chicago for two years. And of course what you know the line slopes up and to the right that that means positive correlation. uh you have uh return on the vertical axis and risk on the horizontal axis and you go from left to right on the uh horizontal axis that is to say you take on more risk the line goes up be and you get more return positive correlation now and this is what I was taught at Chicago and if you say to most people even today even the people who haven't read the book what does that mean that relationship ignore the squiggles for now. Just focus on the diagonal line. They would say, "Well, what it means is the riskier assets have higher returns." And you'll get that nine times out of 10, >> right? Nothing could be more incorrect if you think about it. If a risky asset can be counted on to have a high return, then it's not risky. So, it can't be true. It's just it's just incorrect on its face. What the relationship means is that an asset that appears to be risky has to appear to offer a high return or else nobody will buy it. That makes perfect sense. If I off if I come in here with my oak tree sales kit and I say we have a treasury bill fund that will give you a return of six or we have a venture capital fund where we're going to invest in AI startups and if we choose the right ones we think we can make you six. Which will you take? You'll take the Treasury bill fund. You'll say, "Why would I possibly take the risk associated with doing startups if it doesn't offer a premium return?" That's the most intelligent thing you can say. It has to appear to offer a high return. But it doesn't have to deliver. That's where the risk lies. And so what I did in a memo in ' 06 called risk is I took these little bell-shaped probability distributions and I turned them on their side and I superimposed them on the line. So now as you go from left to right on the horizontal axis and you increase the risk, what happens? In the old graph, the return went up, the expected return. Now the expected return goes up but the range of possible outcomes becomes wider and the bad outcomes become worse. That's risk. Risk is the unpredictability and the possibility of a wider range of outcomes and the fact that some of them can be more negative. That's risk. And so when we uh select our investments, we have a trade-off to make. You can have a an a re an an investment you expect to have a low return dependably, confidently, maybe even contractually. Or you can have an investment with the with a high expected return upside beyond that but the chance of falling short and even losing money. That's the fundamental choice. Do you want certainty or do you want the possibility of a high return? You can't get both. There's no such thing as of the certainty of a high return. And and so this I think that this uh chart uh captures all of that and I I use pictures a lot because I do think that it that it's true what they say a picture is better than a thousand words.
>> I agree with that and this is one of the things that we we teach our interns day one >> good >> is it's not that easy. Now recent times uh I think the old chart seems to to ring a little more true as we've had a period of declining interest rates. I'm thinking back to C change.
>> Yeah.
>> Where you know you you mentioned you know two specific changes which was >> uh riskadjusted returns and then also a mentality of of that and then also a period of declining interest rates and how that's kind of shifted >> expectations. Can you talk a little bit about the interest rate environment?
>> Sure. Who in the audience can tell me >> what was the most important event in the financial and investment world in the last 50 years? Pardon me.
>> You're cheating. Who said that? [laughter]
>> Most people say Lehman Brothers, global financial crisis, tech bubble meltdown, uh, Black Monday in ' 87. Uh, but I believe that it was the decline in interest rates. And I, so I wrote this memo that Jeff's referring to called Ca Change in [cough] December of 22. By the way, I'm going to refer to memos. They're all available at the Oak Tree website, oakrecap.com, under the heading of in insights, and the price is right because they're free. And you can sign up for you can read all the old ones. The I've been writing them for 35 years. We just passed 35. And you can read the old ones or you can sign up for a subscription to the new ones. And and as I say, they're free. Uh, so um where was I going?
>> Uh interest rates.
>> Interest rates. So I wrote this memo called C Change in in December of 22 and I said that in 1980 I had a personal loan outstanding from the bank a and I got a slip of paper in the mail and it said the interest rate on your loan is now 22 and a quarter. And 40 years later in 2020, I was able to borrow at two and a quarter fixed for 15 years. So in other words, a decline of 20 percentage points or what we call in the business 2,000 basis points over 40 years. And this had a profound impact on the financial and investment world. How? Number one, when interest rates go down, investments become more valuable. And what? Well, what do I mean? Well, let's say you you you own a bond of mine. I've promised to pay you a bond uh pay you uh I've borrowed money from you. I promise to pay you money back at the end with 8% interest. That's worth, let's say, 100 cents on the dollar. But if the prevailing interest rate goes from 8 to six, a bond that promises eight is better than contemporary interest rates. It's worth more than 100 cents on the dollar and it'll go to 110. So, uh, my partner Sheldon Stone, who's been my partner since 83, my longest surviving partner, goes around doing this all day. Rates down, price up, rates up, price down. That's the way it works. And it works in all of the investment world because whatever the potential return is on an investment. It looks better when interest rates are lower, it looks relatively more attractive. And when interest rates are higher and you can get 14% on bonds, you you turn up your nose and so the price goes down. So declining interest rates are extremely beneficial for asset ownership and of course they're beneficial for people who borrow money uh because the cost of borrowing goes down. So what happens if your strategy is borrowing money to buy assets? You get a double bonanza when interest rates go down. the value of what you own goes up and the cost of financing it goes down and it turns into a real uh bonanza. And um and I I compared it in the memo to going out to the airport and getting on the moving walkway. And you know, you get on the walkway and you walk at your normal pace and you make great progress over the ground. Then you say, "Boy, I'm fit." But maybe it wasn't all you. And it's the same with levered strategies. When interest rates go down, the levered investor makes a lot of money, but maybe it wasn't all her.
Absolutely. I mean, so for what you're saying, you know, talking about the private equity industry or levered buyouts, >> right? Should would it be rational for us to expect those types of returns that they've experienced where um for the audience you know if I borrow money to acquire a company that already has a significant amount of debt and then sell it later that benefits tremendously from what you just described and we've seen superior returns at least higher returns over the past multiple decades right entire industries have been built on this entire frameworks for investing even endowments have revolved around this. going forward, would it be rational to expect that to continue?
>> Well, it would not be rational.
>> All right.
>> Thank you. Um, so you can go out and buy something and if it goes up, you'll make some money. Or you can go out and borrow some money and buy five of them and if they go up, you'll make five times as much money. if it goes up well declining interest rate make it go up and the cost of paying the money well the better example so you're sitting there and you find a company if you buy that company you think you can make 10% a year if you own it and you talk to your investment banker and they say well we can get money for you at 8% you say oh I can borrow at 8 and invest at 10 let's go so you go out and do it but then interest rates go down and rather than make 10 you make 12 >> right >> and rather than pay eight, you pay six and you you say I'm Bernard Baroo, you know, and and and so you have to, you know, we we we used to have a saying, don't never confuse brains in a bull market. And and and when you when you're lucky, when you when you happen upon a salutary environment, never think it was all you. And most people credit themselves with all their successes and blame others for their failures. Uh but private equity, which is borrowing companies using borrowed money, was enormously successful. It's not a coincidence. It was created in the early 80s at the beginning of this period that I mentioned to you. And it it shouldn't come as a surprise that it prospered. And in fact and and also of course this was a for since 1980 for the most part this was a great period in the economy great period to be a corporation in America. And if you could have lost money buying a an American company using borrowed money in a period of declining interest rates there's got to be something wrong with you.
>> It takes a skill if you will >> right.
>> Um so let's stay on the interest rate. I mean uh the Federal Reserve is in the in the news uh recently. Um, and I think Fed independence, is that something that is on your radar in terms of risk or did the Fed lose independence in 1987?
>> You know, um, uh, Jeff, it's it's it is on my radar. It's very worrisome. It's not something I can do anything about >> and it will affect everybody universally pretty much the same. So, it's not like if you say, well, let me think. uh you know, the Fed's going to lose its independence and the interest rate is going to be 3% next year. Not much I can do about that. And by the way, if they cut the long rate, which is what Trump wants, the the short rate, the long rate might may even go up because people get more worried about the long-term future of America. Uh but there are these things in the environment that we have to live with, and that's one of them. Uh but I think it's a very negative thing. I think that you know uh the interest rate is to the business community kind of like oxygen is to living uh organisms and it's the environment we live in. It's a necessary uh condition of doing business is is is is interest rates. And a lot of what we do is calibrated off of interest rates. And um uh we know that if the interest rate if the economy is languishing, if you cut interest rates, you stimulate business and it picks up because it's cheaper to build factories and cheaper to buy cars and everything. gets more vibrant. And if the economy is overheated and prices are going up too much uh and inflation is a worry, you raise interest rates and that cools it off for the for the inverse reason. And this is the the legitimate role of the Fed. And you know, but in my own view, I prefer a Fed chair who is not an activist, who is not an interventionist, and who leaves these things alone. Uh who says, you know, if the if the economy is producing jobs, which is a big part of the Fed job, you don't it doesn't need stimulus. And if it's uh not overheating and and high and inflation isn't rising, we don't need restriction. Just leave it alone. Don't mess with it. And I I think Powell is more in that category than some of the recent predecessors. Alan Greenspan, who took over in the mid '90s, was uh was something between an activist and a cheerleader. And he injected liquidity every time he he could think of any reason why liquidity might be needed. And you might remember why Y2K uh which was something that people were afraid of when the when we turned from the 20th century to 21st and the clocks changed. They were afraid that the computer mechanisms would all wouldn't know what year it is. Uh they would think that it would went back to 1900. And so so Greenspan injected liquidity to make sure that that wouldn't have a bad effect. Anyway, so I'd like a a non-interventionist uh Fed. Um, but uh I would say in general politicians want lower interest rates because the lower the rate, the more the economy is stimulated. The better the economy is, the the the more better it looks to the voters. Um and the other thing is we have this enormous $38 trillion debt. The lower the interest rate is, the the easier it is to service. So, no elected official wants wants higher interest rates, but sometimes you need them to fight inflation. And so, uh that's why we have an independent Fed uh to do the right thing with interest rates rather than pander to the voters by cutting rates. Uh you might say, "Well, Howard, why not cut rates? Uh you know, you you said it makes it easier to service the national debt and it stimulates the economy. Why not?" And the answer is number one, it stimulates inflation, which is bad for most people. People who who who most people in America spend every penny they make to live. And if the cost of goods go up and their wages don't go up, then they can't live as well. Uh so that's one reason. And then the other reason is because when interest rates are artificially low, uh people make dumb decisions in the business world, you know. And uh just think about this. You say to somebody, "Would you buy this bond that's a 4% bond?" No, I would never buy a bond that pays 4%. It's ridiculous. It's a low rate of return. The company is too risky. It doesn't deserve to be able to borrow money at 4%. It's absurd. I'll lend you the money at 2%. I'll take all I can get, you know, and so when interest rates are low, people engage in unwise decisions. And I wrote a memo in January of 23, I think, or or uh no, 24, entitled easy money. And and easy perpetually easy money is not a good thing. The the the Fed should not be in a perpetually stimulative position or a perpetually restricted position. And most of the time, they should let the interest rate. Who should determine interest rates? The Fed, the president, Congress? No. the borrower and the lender. You say, "I want to borrow money to build a building." The lender says, "I'll give you money at 8%." You say, "That's ridiculous. I'll pay seven." That's that's a naturally occurring interest rate. And there's such a thing as natural interest rates and that's where that's where the rate should be and not where most of the time not where somebody in Washington wants it to be.
>> Absolutely. Thank you. Let's keep going.
>> By the way, let me just add one thing. I imagine here at Pepperdine, you teach uh especially to business students, you teach the benefits of the capitalist system.
>> Yes.
>> And we believe I went to Chicago, Milton Friedman was the shining light there. Uh and and he was the you know the most outspoken defender of capitalism in the free markets and we we all concluded and I'm sure it's true that the free market is the best allocator of resources. That includes money. The free market sets the interest rate and it and money goes to the right purposes and if we mess with it and control the interest rate artificially too high or too low it it it warps that. So I would say hands off as much as possible. [clears throat]
>> I agree with that completely. Let's keep going with that. You know in terms of you know you said the the lender and the borrower set the interest rate. Um, you know, in 2007 you wrote a memo. I think it was Race to the Bottom, >> and that was talking Race to the Bottom, >> which I think was, you know, where you you viewed these lenders making deals and winning auctions, if you will.
>> Uh, can you talk a little bit about that? What what really raised your your awareness and your concern? U as we know 2008 was
>> Well, I wrote that memo at in February of 07 and at the very end of '04 I started to turn cautious too early um for the simple reason that I saw dumb deals getting done and I talk about easy money. So so you know I would go into my partner Bruce K on a daily basis with a page from the Wall Street Journal. I said, "Look at this piece of crap that got issued yesterday." And if the if the market is is being run by people who are diligent and prudent and cautious, this deal could not be done. So that means we have imprudence in the marketplace. And Buffett says the less prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own affairs. when other people are carefree and unw worried, it it warps the market. We should be terrified. It's only when people are terrified that we should turn aggressive and and that's a rule that we follow. Uh and so uh I thought that the market was not by the way this line remind me why does it slope up and to the right? Well, remind yourselves why does it slope up to the right? two words, risk aversion. We we we don't want to lose money. We don't like uncertainty. We prefer safety. So we we we are averse to incremental risk and demand compensation if we're going to take it. Risk aversion. And so when the when investors are behaving in a suitably riskaverse manner, the market is safe and sane. when they forget to be suitably riskaverse, the market becomes insane and unsafe. And that's what we thought was going on. So that was 05 06. And at the beginning of 07, I wrote this memo that Jeff sites called easy uh called the race to bottom. And what I said in there does is that the market for investments, the market for the opportunity to make loans, let's say somebody wants to build a building, Pepperdine wants to build a building. They go to five banks and they say, "We'd like to borrow money." It's an auction that takes place. Who who gets the opportunity to lend the money to Pepperdine? Who wins? The bank that will accept the lowest rate of interest and the least safety. So, when you go out and you're a lender and you you're looking for loans and somebody says, "Well, I I need money." And you say, "Well, I you're not that great a lender a risk. I need I need uh 8% interest and a full set of documents. And somebody else says, you know, I'll take 7%. I don't need that many documents. And then somebody else who's the boss has been beating up because they haven't been making enough loans and they've been losing market share. Somebody else says, I'll take 6%. I don't need any documents. So who gets the who gets to make the loan? The person who will accept the least return and the most risk. And when the when the marketplace is heated and people are behaving imprudently and when people have money that they have to put out and they're too eager to put it out, the person who wins the auction is actually the loser >> because they make an imprudent investment. And if the if the economy and the market stay good, maybe they get out of it. But if the if if they if they are tested by hostile conditions, the the flaw in the investment is exposed and they lose money. And that's why Buffett says it's all comes down to Buffett. He says it's only when the tide goes out that we find out who's swimming naked. It's when it's when conditions in the business world turn averse that we find out who made bad loans and bad investments.
>> Absolutely. And by so by the and and in my book uh which Jeff me meant to tell you to buy several copies of >> [laughter] >> u that was the next >> in in the in the section on risk I say that risk and loss are not the same. Risk is the possibility of loss. So the example I used because I wrote it in 2011 when I was in Los Angeles. I said, "You may have a house and it may have a construction flaw, but you don't find out until there's an earthquake." So risk is the potential for loss. The loss occurs when the tide goes out.
>> Absolutely. I think you mixed metaphors.
>> A saying about um you know the the worst loans are made in the best of times that >> that plays here.
>> Can you walk us through? So you you wrote that memo uh concern about these lending uh these loans that were being made and then after a few months >> tide went out.
>> The tide went out. We saw who was swimming without clothes.
>> Um, and then you went on I call it a war path >> but I believe you deployed $500 million a week for 13 weeks. Well, Oakri as a whole >> Oakri as a whole >> Oakri as a whole uh >> invested 650 a week on average for 15 weeks or 10 billion dollars in a quarter and and but see the leadup was that because we were worried in ' 05 and six we sold a lot of assets we liquidated a lot of funds we we if we raised funds we raised only small funds we increased our selectivity and then on the first day of 07 7 uh for our opportunities funds which which you might say distress debt funds uh we ran out to raise a new fund first day of '07 and the biggest fund in history uh was uh two and a half billion that was our 01 fund four and so uh we went out to raise uh three billion and within a month we had orders for And we said we can't take we can't do anything with $8 billion. So we'll take three and a half. We'll close that fund. That was fund seven. But we said but if you if you still want to invest, we'll take your additional uh interest in a standby fund and we'll collect commitments and we'll just put it on the self and if the if the stuff hits the fan, we'll invest it. If it doesn't hit the fan, that'll just be our next fund. And so by the time we were done marketing fund 7B, it was 11 billion in an area where the biggest fund in history was two and a half. And it was closed in March of 08. And then you had the bankruptcy of Bear Sterns, Meil Lynch, Lehman Brothers, AIG, Wovia Bank, Washington Mutual. And I'm just reading now the galls of Lloyd Blankfine's uh memoir uh former CEO of of uh Goldman Sachs and I just finished last yet last night reading the section on the global financial crisis and believe me we were on shaky ground and and we all knew that Morgan Stanley was next and and Morgan Stanley was like this and and he even Lloyd says that Goldman Sachs which was in a essentially strong position when confidence is withdrawn from the whole financial sector, anything can happen. Um and so but you know every nobody nobody wanted to buy anything. Everybody was selling everything. The prices were collapsing down every day. And so we we took the 11 billion off the shelf and started to invested. And Bruce K, my partner, uh you know, he's very brave and and I supported him. In that fund, he invested an average of 450 a week. Uh, and that's all you had to do. By the way, you didn't have to be selective, patient, disciplined, perspeacious, uh, any of those things. All you had to do was have money and they're willing to suspend it. And, you know, when the market is cascading down and nobody else will buy and and you're the only buyer, which we essentially were, great things happen.
>> Absolutely. And we benefited from those as Pepperdine Pepperdine's Endowment. Um, so you know, you have a book called Mastering the Market Cycle, and a lot of that's kind of pattern recognition.
>> Uh, where are we today?
>> The clock stopped.
>> Oh, no, that's the time. Yeah. Okay. Where are we today? [laughter] We're in the market cycle. Yeah. Well,
>> I believe, you see, we have this thing called intrinsic value. Every company has an intrinsic value. Every asset class has an intrinsic value. And it kind of goes like this. It meanders along and it tends to grow over time. Most companies become more profitable and more valuable over time. So intrinsic value grows like this. And it's not a straight line. It goes a little up and down depending on the economy and the and the decisions that management makes. But it's essentially up and to the right. But then if you look at the prices of assets, they go like this. They they c they carine like mad. What's the difference? If intrinsic value grows like this, why do asset prices grow like this? Who knows? Psychology. You know what I say is that in the real world, things fluctuate between pretty good and not so hot. But in the minds of investors, they go from flawless to hopeless. And so the prices are are fluctuate enormously around the intrinsic value. Um, and um remind me >> um basically just where we are in the market. Where are we today? So, so what matters if you want to make good investments and you want to know if this is a good time to to to make investments, you say, well, where is price relative to intrinsic value? When price is above intrinsic value, you're overpaying. When it's when it's uh below intrinsic value, you're getting a discount. When it's fair, you you you'll basically benefit from the progress of the intrinsic value. What determines the relationship between price and intrinsic value is emotion or psychology or we call it investor sentiment. And when people are optimistic, you get prices above intrinsic value. And when prices are when people are pessimistic, you get prices below intrinsic value. And that's why Buffett says you should be uh uh cautious when uh people are carefree and aggressive when people are terrified. It's called contrarianism. We try to practice that. But but um so so your question was where are we today? Well, what what uh psychology holds sway today? And the answer is that uh in uh 22 was the worst year in recent memory and it was the worst year for we in our business we talk about 6040 this hypothetical portfolio which is 60% stocks and 40% bonds. Nobody holds it anymore, but it's it's just a figure of speech. But it was the worst year in history in in all time history for the the 6040 portfolio because stocks have done worse in the past. But usually when stocks go down, bonds go up. And this time stocks and bonds both went down at the same time. And it was it was a rough year. Um, and at the beginning of 22, people said, "Well, we have uh inflation. That's that that's a bad thing." But then the Fed will probably raise rates to kill the inflation and that'll cause a recession and that's a bad thing. So in other words, it's all bad and that's why 22 was such a bad year because people were depressed. But then around the end of 22, they started to say, "Hey, wait a minute. uh the the inflation looks like it's subsiding and uh the higher rates haven't produced a recession and the Fed will still given that the inflation is subsiding the Fed will probably start to cut rates which will stimulate the economy. Oh yeah, now it's all good. So, so again remember flawless to hopeless and and now so the the sentiment fluctuated from hopeless to flawless and the mark stock market started to go up roughly I think November of 22 and here we are uh 39 months later and this has been one of the greatest markets in history and uh the S&P 500 stock index has been around for about a century there have 97 or 98 three-year periods by definition and there have been only six which were better than than than the last three years. So we've had a big swing from pessimism to optimism. We've had a rapid rise in prices. But now I don't think it can be argued that prices are below intrinsic value. I think they're above which means that the market is somewhat precarious and you should take uh an intelligently prudent uh approach to it.
>> Absolutely. >> I appreciate that. >> It's not terrible. You It's not time to hide under the mattress, but but you you should be careful.
>> I appreciate that, Howard. I want to make sure we have time for questions. So, if you guys have a QR code and a question you want to ask, um please pull that up and I will pass those over.
>> Oh, good. Um, who's got a question? Oh. Oh. Oh, you're they send them to you.
>> Yeah.
>> Okay, I'll have that.
>> Let's go.
>> All right. I'll try to answer give shortly short answers so we can get through more.
>> All right. What are your thoughts on AI?
>> AI? Well, you know, I wrote a memo on AI. Now, I say that all the time. My wife goes like this. She says, "You got to stop saying that." But the truth is by now I've written a memo on almost everything. And so I wrote a memo on AI and when did it come out? Uh early December I guess. Yes, early December.
>> And uh you know the question the title was is it a bubble? Now a bubble is irrational exuberance. When there is ir when there's irrational exuberance about something then you get prices that are not high relative to intrinsic value. They're crazy relative to intrinsic value and I've lived through a half a dozen bubbles and and learned from them. And as I said, the nifty50 was a bubble back in 69. Um, and and uh so there is certainly a great deal of enthusiasm around AI, but nobody can sit here today and tell you whether or not it's irrational because AI may revolutionize the world and you know and and and turn this place into the Garden of Eden. So uh but all I can tell you is there's a lot of enthusiasm, prices are high. The Nvidias of the world have done great uh and we have what the lawyers call indisia of bubble behavior. And I say in the memo, for example, that some woman left open AI, started a company called uh Thinking Machine Labs, went out to raise money, and she said, "We're going to this company's going to engage in AI, but I can't tell you what we're going to do. It's a secret." And people gave her $2 billion [laughter] for for a sixth of the company. That is to say, they valued the company with at at $12 billion. and they don't know what it's going to do. Now, that's the kind of thing that can only happen in a buoyant market and it's certainly not a an indicator of high prudence. And that was June or July and at the time I was writing the memo, she was out trying to raise more money at a $50 billion valuation for a company that wouldn't say what its product is. So like I said about the years leading up to the global financial crisis when when crazy deals can get done it's a worry worrisome sign and that's just one anecdote. It doesn't the whole world but it these these things are out there.
>> Absolutely. U let's try some rapid fire here. Um, for students that are looking at risk in the market cash often feels safe. Is that
>> again? I'm sorry.
>> For students uh looking at the market cash often feels safe. Is that something that you are a fan of or
>> Well, cash is cash is safe unarguably. The only thing that the risk that cash exposes you to is the risk of not making money. If you if you look at the chart that Jeff put up on the board, cash is zero risk. Guess what? If if if you get if you take zero risk, you get the lowest possible return. So, by the way, nobody holds cash. Nobody walks around with money in their pocket. When we say in our
Business, when we say cash, we meant T bills. So, you buy 30-day US T bills, which are you have no credit risk. I believe you have no interest rate risk because interest rates can't go up and and the value go down because the period to maturity is so short. Uh uh you have no purchasing power risk because there can't be much inflation over the next 30 days. And so it's absolutely riskless and it has the lowest possible rate and we call it the risk-free rate and it's today it's uh three-ish right so that's the trouble with cash uh and by the way if you take a job as an investor and you put the money in cash I promise you'll get fired [laughter] you know so I I'm not a big advocate of cash.
>> What are your thoughts on gold, Bitcoin, crypto?
>> Okay, well that's a great question. Uh gold/Bitcoin. So I wrote a memo, hey uh back in back in 2010 and the title was "All That Glitters." And I tried to put in everything I knew about gold. And and I said there are two kinds of assets in the world. There are assets that produce cash flow and assets that don't. The assets that produce cash flow are things like stocks, bonds, companies, and buildings. If you buy one of those, it gives you cash hopefully every year or month and you can value it. So, I have a building. It throws off a million dollars a year in profit. I want to sell it to Jeff. Jeff is open to buying a building and he says, "I'll give you $8 million for it because at $8 million I get a 12% return. One over eight is 12%." I say, "Jeff, that's not high enough. You have to give me $12 million because it's such a high quality asset that an 8% return, one over 12 is sufficient and in fact because it's so well-lo the income will probably go up and you'll get a return more than eight. We can value an asset that produces cash flow by having this kind of discussion."
But if you have an asset that doesn't produce cash flow, you can't have a discussion. What are some examples? Diamonds, paintings, furs, oil, gold, Bitcoin. They they they don't produce any cash. So, you can't say what the right price for a barrel of oil is or a bar of gold. And I remember that in July of '07, oil was selling at $147 a barrel. And if you said to me, said to people at at some brokerage firm, well, why is oil at $147? They would say, well, uh, it's a finite supply. We're using it up and much of the supply is in the hands of countries that are, uh, adverse to the United States. So, it's very valuable. Six months later, oil was selling at uh, I think $35 or maybe $47, something like that. If you said, well, but all the, and all those things were still true. So you take the fact that this finite supply is finite and the fact that we may not make it anymore and the fact that we're using it up and the fact that it's in hostile hands, but how do you turn those qualitative elements into a fair price? And the answer is there is no way. And that is true of gold and that is true of Bitcoin. So if I say to you, Jeff, because Jeff's a fan of gold, why do you like gold? He would say it's a store of value and in tough times, inflation or panic, uh, gold holds its value. Why does it hold its value?
>> It's a price the market.
>> Well, it always has.
>> Why has it? There's no linkage. There's no mechanism. There's nothing that makes gold a store of value other than the fact that people treat it as a store of value. And that leads us to Bitcoin. The value of Bitcoin has no value other than the the value that people accord it.
>> Perfect. Uh, what are you reading? What do you read daily and and weekly? How do you stay on top of this and and kind of filter out the noise?
>> Well, I mean, we all read this few newspapers, uh, you know, uh, Wall Street Journal, uh, FT, uh, Economist magazine. The FT and the Economist. Maybe it's because they're not American. They seem the most uh objective. Uh, and uh, and and I like both of those, you know, and then we all read read a lot of blogs or websites or whatever you call them and we we select we we should we should have broad exposure to a lot of ideas. The worst thing you can do is only read media that agrees with you. How are you going to grow? And and uh, who was it? Who was it? Well, I'm not going to try to remember. Uh, I think it was John Stewart Mill who said, "He who knows only his side of the argument knows little of that." Which is an interesting thing. I thought he was going to say, "He who knows only his side of the argument doesn't know the other side." No. He who knows only his side of the argument doesn't know much about his side because he hasn't seen it challenged. Ideas have to be challenged in order to get to the truth. So, I think we have to read a variety of sources.
>> I like that. Um, what are your feelings towards the Magnificent Seven versus the Magnificent Seven versus the rest of the S&P?
>> Well, we have these seven companies at the top of the S&P and they've been they're great companies. They've been outperforming and and and increasing in price and now they represent close to 40% of the S&P. Right.
>> Yes. Um, and and so people are worried that the S&P is not indicative and I agree. It is not indicative. It's if it's if they if it's dominated by seven companies, it's not typical of companies in general. Uh, now, but these companies have been done very well and they're very highly priced. Are they too expensive? Uh, six of them sell at multiples roughly in the 30s. 30 times earnings. We say multiples, price earnings multiple. So if a company makes $3 a share and it sells it at 30, it'll it'll sell at at $90 bucks a share. And the historical average multiple on the S&P for the last 80 years since World War II is 16. So these companies are selling to basically double the average uh PE ratio. It doesn't seem egregious to me. These are the great, some of these are the greatest companies I've ever seen. They are large, brilliant, dominant market share. They are protected by strong moats around their businesses. They're they're enormous profitability is enormous. When you're when your when your product is virtual and you want to you want you're selling one, you're making some money, you want to sell two, there's almost no cost in the second one. So the incremental profitability is enormous. And these are great companies. Microsoft, Amazon, Apple, uh, etc. Uh, Tesla is the exception. Tesla sells at much higher multiple, uh, and doesn't make much money. Um, uh, but the other six at multiples in the 30s, I I'm not troubled by. By the way, I mentioned that Nifty 50 that were uh, flying high when I came into the business uh, 56 years ago. Um, they were selling at multiples between 60 and 90 as I recall. So 30 looks like a bargain to me for a truly great company. And I'm I think they're probably okay. Uh, what I'm a little more troubled about the other 493 companies in the S&P 500 because they're selling on average at I think 18 or 19 times earnings. Why should why should the other 493 be selling at a higher multiple than than the average multiple of the S&P 500 including the best companies at that time? So I I think that's where the error lies and and I think it's because people have embraced indexation to the S&P as the default solution for equity investing and so people automatically put money into the S&P companies which I think causes a bunch of them to be selling at prices above what they're worth.
>> Definitely market cap weighting and passive investing has taken over. I want to take some creative license with this one. Um
>> Maybe this is the last one.
>> Yeah. Uh, so your memos are for free. You you make them available to everyone.
>> Um, you know, your your philanthropy is is tremendous. You're here tonight um without asking for any sort of compensation. Who or what drives your values and instills kind of your your ethics and values to make you act the way that you do?
>> Well, you know, I was just brought up that that you know, uh, there there's a a saying in the Talmud, great brilliant rabbi said, "If you're not for others, what are you? If you're not for yourself, who will be? If not now, then when?" And I think we all have a responsibility to to balance these things. And you know, I if you're if you're only for others and you're mother to racer, that's not very realistic. If you're only for yourself, that's antisocial and and so you know, I was brought up to balance those ideas. Uh, and I think those of us who are fortunate, you know, I I describe my my good luck. I wrote it, by the way, I wrote a memo which in January '14 called "Getting Lucky," not in the campus sense. And and uh, and uh, at that time or or until '21, it was the most popular of all the memos in terms of the response I got. And I describe how lucky I've been in my life. And if you've been lucky in life, you must pay it back. You must embrace you. A lot of people say, "Oh, I was never lucky. It was all hard work." BS. If you if you've been lucky and you grew up in the US in the 20th century in this environment, you had parents who got you in a good education, you went to the public schools, you did okay, went to Wharton and Chicago and had the jobs I did and met the partners I have and have clients like you, you should be jumping out of your skin and and you can't rest until you give it back.
>> Amen. Thank you, Howard. Thank you for taking the time. Thank you all.