Transcription
I always am honored to get to speak with. Howard was a deep thinker at a time where we need some deep thoughts. I want to start with your latest memo. You were talking about artificial intelligence and how it is definitely not a bubble as a technology. If anything, we might be underestimating its expectations. We'll get to that in a second. It's not the same thing to say about the actual investments in A.I., that they're not in a bubble.
We're all here because a lot of people are very concerned about private credit right now. Do you think the concerns are warranted about private credit? Yes. Well, I mean, you know, lending money to companies is is is a fundamentally sound activity. I've been engaged in lending money to subinvestment grade companies now for 48 years since I fortunately was asked by Citibank to start the high yield bond activity in '78, which was the beginning of that world. And, you know, our clients have done very well. I think it's 99% of the high yield bonds we bought paid off. So, you know, there's nothing wrong with it fundamentally, intrinsically. The problems arise when, from time to time, too many people want to do it. They're too eager to do it. They compete for deals that bid down interest rates, that bid down safety. And then once in a while, everything in the investment business gets sold to the wrong people who aren't prepared and are shocked when the when the works show up.
Do you think that the introduction of artificial intelligence and the displacement of certain corporate activities, the sort of a disintermediation, the idea that software might be rendered obsolete, do you think that that changes the story of how you invest in any way? Well, I think that the changes that are underway today and in particular the introduction of AI, render the world much less predictable than at any time, probably any time ever, and certainly any time in my lifetime. You know, most people in the investment business decide their course of action based on what they think is going to happen. I argue that that's not enough. You need two things. I wrote in, I wrote a book about cycles in '18 and I said, in there, you need two things. One is a view of what's going to happen, and the other is a view of the probability that you're right. Not all predictions have the same probability of working out. And I think that life under AI is one of the most unpredictable things I've ever contemplated. And we just don't know it. And by the way, the same power that gives it its importance gives it its unpredictability. You know, what will it do? What won't it do? To what extent will it take over from us? To what extent will it put people out of work? What will a society be like if large numbers of people are put out of work? We've never contemplated questions like these, which is a reason why I think people are concerned about the concentration of certain types of investments by private fund managers, that the lack of transparency is making people uneasy, a sense of they're not sure how those loans were made. Is there anything in the way in terms of the leverage or the covenants that were used, that that makes you think maybe we're getting to the end of a cycle or that feels a bit frothy and that people are right to say maybe there needs to be a wash out?
I've spent the last three days writing a memo that may not surprise you about private credit. You know, these days what I talk speak a lot at occasions like these and to our clients and and CFA groups and so forth and everybody has questions. But at any given point in time, the questions are usually the same for obvious reasons. And, you know, in the last few months or certainly the last six weeks, the main question has been, what about private credit? Well, a year ago I wrote a memo called Give Me Credit. And I said in there, the only question I was getting was, what about private credit? But in a good sense. What about private credit? Do we have enough? Should we put in more? You know, is it is it the key to riches without risk? And and today they're asking, what about private credit? But in a different vein. And, you know, I've been around long enough to have seen many cycles of boom, bust, not economic boom, bust, boom, bust of an idea. And, you know, something new comes along. It's invariably something new because then the new thing fires the imagination and is easily sold to people. And because it's new, there's never been a chance to see its flaws in action. So these things, I mean, I don't think they I don't think there's ever been a bubble in something prosaic. There was never a steel bubble, you know, or a hamburger bubble. But but it's it's new technologies or new financial innovations. And so people buy in, you know, on the basis of promise without an understanding of the downside. And then something happens which causes their expectations to be disappointed. And then they find out that they that they didn't know 100% of what they were doing, that they haven't hadn't understood the limitations. And, you know, they end up unhappy.
When you were writing Gimme Credit, there was a discussion about how maybe at that time public markets might be more valuable or more attractive because of the enthusiasm around private credit. Are we at a place where there is enough fear to find this moment attractive, or does there need to be even more fear? Are people still greedy? Is there still sort of enough heat in that system to be worked through? Yeah, I don't know. I don't know how the private credit is being priced today. Maybe Bob can tell us. You know, in 2011, when the banks, chastened and regulated because of the global financial crisis, pulled back from lending for buyouts, so-called non-bank lenders stepped in and started to engage in direct lending, lending for mid-sized buyouts. And, of course, since the since the demand for capital from the private equity industry was strong and the supply of capital from the non-bank lenders was limited, the non-bank lenders could demand high interest rates and good safety. But, you know, the greatest saying in our business is that the wise man does in the beginning, the fool does in the end. And what happens is the early success becomes visible. Other people emulate the entrants bid for the thing in question and the specialness goes away. So I think enough of that took place in private credit for the for the interest rates to be bid down and the safety will be down. And let's say, three months ago, two months ago, I would say that public credit was yielding about seven. And and direct lending was yielding about eight and a quarter. It struck me that 125 basis points for a liquidity premium was about fair. It was probably adequate, but certainly not lush. And so in my opinion, the specialness had gone away. It was adequate. Private was at equilibrium with public. It was a fair deal, but not more. And, you know, I said in the memo, everybody asked me, what about private credit? And I answered, What about credit? Now, of course, there's an activity in our world that's called talking your own book. And Oaktree has been in the public credit business for 48 years. So we want some attention paid to that. But, you know, I think that when when A and B are priced at equilibrium with each other, rather than putting all your money into one or the other, you might as well buy both.
One of the other problems that people have identified in the private credit space is that increasingly there is an effort to reach out to retail investors. There is an effort to bring in people who might want periodic liquidity on some level. Do you think that the transparency of some of the assets or the marks, the pricing, the values, needs to be more standardized in order to really make this worthwhile? Well, obviously, my guess would be that, well, first of all, certain parties of which we are not exempt, decided that they could do some business by selling private credit vehicles like BDC to retail investors or retirement investors. And and they did so and I'm going to venture a guess that not all of the buyers were fully informed or took to heart the ramifications of illiquidity and the absence of a market to market. And but they invested anyway, probably out of ignorance rather than knowing all about it and saying it wasn't a concern. And you know, I was thinking I was thinking about this yesterday to another group of investors, and I said it reminded me of Casablanca. Has everybody seen the movie Casablanca and the the gendarme goes into the bar that he's been taking bribes from for the last 20 years. And he says, I'm shocked, shocked to see that gambling is taking place. And, you know, the point is the things that investors have discovered and aren't happy about are nothing new. These vehicles were always illiquid. They were never priced mark to market, etc.. But, you know, things are overlooked in happy times when people are eager to invest that then are the source of consternation when this stuff hits the fan.
People have identified private credit, in part because what you can't see makes people nervous. There are, though, these sort of questions about the software industry or other industries that could be affected by artificial intelligence. Do you think that some of the stress that you're seeing in some of these private credit funds or even the discussion around it is representative of a larger stress that will percolate out in a bigger default cycle or something more significant throughout the credit market? Well, look, Lisa. There are credit cycles. There are times when everything's going well. It's really easy to borrow money. When things are going poorly, it's hard to borrow money. When it's easy to borrow money, people compete for the deals. And as I described before, the interest rates tend to contract. In the tough times, people aren't that eager to lend. So the few who will lend can demand higher interest rates. And this is this is the cycle that goes on. And, you know, back in the fall, when First Brands and Tricolor shocked everybody, shocked everybody with their with their bankruptcy and and their probable fraud. I wrote and Jamie Diamond said what he said about their, you know, usually not being just one cockroach. I wrote a memo entitled Cockroaches in the Coal Mine, mixing metaphors. And and I said, you know, when when the music's playing the music, the money's available freely. And that causes the lenders to compete for deals by lowering their standards. It creates a climate in which an undeserving credit or a can can get money and a fraud has a higher probability of being perpetuated. His wife. And one of the one of the long-standing sayings in the banking business is that the worst of loans are made in the best of times. And it's for this reason. And so we went through 17 years of good times. You know, the stock market bottomed, March, six, I think it was of 2009, 17 years ago this month. And there hasn't really been a tough time in the financial markets since then. Okay, 2015 wasn't great. We had three bad weeks in March of 2020 with the pandemic, and then '22 was a was a poor year. But, you know, since the roughly September 30th of '22, I would venture that the S&P has doubled. I mean, company values haven't doubled intrinsic values, but prices have doubled. So it's been a great time and and great times encourage the desire to put money to work and discourage analysis, discipline, high standards, skepticism. And and FOMO takes their place. And when FOMO is is ruling rather than skepticism, bad deals get done. And so this is nothing new. And we've had we've had, you know, we've had 17 years of low defaults. And, you know, the actions of the Fed made the global financial crisis, which was probably the most destructive environment I've ever lived through, have only one year of elevated defaults on high yield bonds rather than the normal two. In that instance, it was it was the worst incident and it had fewer defaults than any of the crises I had lived through. And then, of course, we had, you know, people were talking about 15% default rates in 2020, and I think it came in at five and a half. So people just have gotten used to the absence of defaults. Defaults are a normal thing, and especially after you go through a period in which credit is readily extended, then you go into a period where the where the tide discloses, you know, Buffett gets says everything the best. And he says it's only when the tide goes out that we find out who's swimming naked. It's only in tough economic times that we find out who lent money stupidly. And to whom. And that period lies ahead.
Is the corporate debt market more broadly pricing in an elevated default cycle in any way, shape or form? Well, as I said, I don't know. The we have a bench here of of one of the guys that could tell me what the rates are today. Okay. But but, you know, you would say not. I mean, what people mostly have been asking about is why are yield spreads on sub-investment grade credit at the at the low end of the normal range. So if if the yield spreads are at the low end of the normal range, you would have to say that that the fear of elevated defaults is not present. And, and, and compensation for an elevated default rate is not is not available.
We're talking about how AI and technology can transform some of our expectations just simply because it's so unpredictable. And as you were saying, it's the most unpredictable environment that you've been in. Does it make sense to you that Google, Microsoft, Amazon, behemoths, very strong companies are selling debt for 30, 4000 years at a time when we can't game out the next five? Well, I think that I think that is exemplary of what I'm talking about here. I mean, I don't think if you if you think about what Lisa just described and I think Google issued 100-year bonds paying 5.8%, I think you would have to say, you know, optimism, not pessimism, credulity and this not skepticism are in the ascendancy today. And and when when optimism and credulity are in the ascendancy, it gets hard to make return investments that will produce what we call excess returns. That is to say, returns which are more than commensurate with the risk.
How do you invest in a company that is tied to some of this new technology, given that it does have such promise? With any certainty, how do you select the companies that are going to benefit? Well, you know, first of all, many more companies will be affected than just the AI companies or just the technology companies. But, you know, what I said in the in the December 9th memo, I touched on the the wisdom of lending money for for for AI companies or tech companies to invest in AI. And basically, I quoted my colleague Bob O'Leary as saying that you probably shouldn't, you know, if you're going to put money into a company as opposed to AI, you should probably buy the stock. And and get the upside if it if it ensues. Rather than just lend the money and get a fixed return if they're successful. And and I think that, you know, I think that's right. You know, I mean, your expression was, you know, you're lending money to companies for 30 or 4000 years when we can't predict the next five. So if you're taking fundamental business model risk, shouldn't you get paid for it by being an owner rather than rather than a fixed income investor? Of course, it's going to affect every firm. Yeah, well, it is. It is. And and it is. The fact that it's going to have such a sweeping effect and its unpredictability that renders this a tougher world. I like the old world better. I don't know about you. Well, you know, when I was a kid, you went to school backwards with fair play. Well, nothing changed, you know, nothing changed from year to year. When I was a kid. And now things change every day. And that that imparts a certain dynamism. And certainly we live better than the world lived when I was a kid, in many ways. But but it it does mean that we can depend less on on our expectations.
How is AI transforming what you do at Oaktree? Is it is it affecting the number of people you hire or the number of people you employ? Is it something that everyone's using as sort of a tool? It has not affected our business model, the number of people we hire or how we do our work. But it's just an aid we're using as an aid to marshal data. And, you know, my experience with writing that memo, you know, so I wrote the memo, as Bob described, and I, I do these things with the help of my son, who is a great venture capitalist. And so when I got through writing it, I said, you know, do you want to see it? He says, No, send it to Claude. So to send it, you know, I wrote it on my on my desktop and to send it to Claude, I had to copy it, paste it to an email on my phone. Now paste it to an email, send the email to myself so that I could open it on my phone. Cut it. Copy it there and paste it into AI and send it off to Claude. So that took me 2 minutes to do that and I push send and scroll down to the bottom. And the answer was there already. It was remarkable. I mean, I was just blown away by this process. So, you know, I mean, I can do these things. It can it can it has read everything that's ever been written. It remembers everything it's read and it can find it again, which is different from us. Right. And and it can, you know, find the patterns that have led to success or failure in the past. And it can extrapolate those into the future. And it can probably do so without making arithmetic mistakes or logical mistakes. And it can do so without making emotional mistakes. It doesn't get too excited at the top or too depressed at the bottom. So. So these are this is a big improvement over what 80% of people can do. 90%? I don't know. I'm hoping it's not an improvement over 100% of people can do. I hope there are still things we can do, and I think there still are because and I in the in the February memo, there's a section called The Implications for Investing. And I said that I think there are things that AI can't do. I don't think it has intuition. You know, you read sometimes you read a prospectus and that. And as we say, the hairs on the back of your neck stand up. I don't think AI has hairs on its neck. We believe that we've saved our clients a lot of money by not investing with bad people. I think we're probably a better judge of bad people than AI is and and on and on like that. So I think that AI understands history, recognizes patterns, makes extrapolations. What AI basically does, I've come to realize is it makes predictions. It doesn't answer questions. It makes predictions. And if you want a great example, you take out your phone, you compose an email, and if you look at the bottom, it proposes the next word. It predicts what the next word in that sentence should be. I hope you will go with me to the party. It says it now. It could be ball game and maybe that's somewhere else down there. But. But it predicts the next word. And and it does so because it's read 10 million sentences to start with. I hope you will go with me to the. And 73.7% of the time the next word was party. So it can do that. And it gives us predictions, which I describe as hypotheses. But I'm not going to invest money for people on the basis of what it says. I think we still need humans to examine the hypotheses. But of course, that reintroduces human error. But I still think it's an essential thing, and we're not ready to turn the process over to AI, but we're glad to have its help.
Do you think that in a time of such unpredictability, it's important to have a greater degree of liquid assets or assets that can easily turn into capital that you can redeploy? Well, you know, when I started at Citibank in September '69, the bank and most of the money center banks, it's an old-fashioned expression, invested in what we called the Nifty 50. These are the 50 best, fastest growing companies in America where nothing could go wrong and there was no price too high. So if you bought the stocks today, I got there, I think it was September 22 of '69, if what I was saying, and if you held them tenaciously for five years, the greatest companies in America, you lost about 95% of your money. And then I was exiled to the Siberia of the bond department and asked to start a high yield bond fund, which was the luckiest thing in my life, or one of. And now making money steadily and safely in the worst public companies in America. So what it taught me is that there is no asset that is so good that it can't become overpriced and lethal. And there are very few things that are so bad that they can't get cheap enough to be attractive. So despite our worries about AI and despite the inability to have confidence in our judgments, I still believe that assets, certain assets have the potential to get cheap enough that they're a buy in that environment. Now, exactly how we feel when we when we come to that moment remains to be seen. It hasn't happened yet. You know, very few people are absolutely throwing things away, as we have seen in past crashes. But I think those things will happen. And I like to think that we will step up. We stepped up massively in September and October of '08, even though most people thought that the financial or acted as if the financial sector was going to meltdown.
Do you think that we're headed toward another event like that? I have a very profound answer. Who knows? I mean, you know, you know, Ben Graham said that in the long run, the market is a weighing machine. But in the short run, it's a voting machine. I don't know how people are going to vote next month. If they vote for crash, we'll have a crash. If they vote, if they regain their equanimity and they decide we're okay, we won't have a crash. It's as simple as that. And, you know, so, you know, I just think that that's unpredictable. But, you know, I'm not going to invest now in the belief that the crash isn't coming. So I'd better put my money to work. Now. I'm going to wait and see what happens. And if it comes, I think we'll become a we've become aggressive. But exactly when it is going to come, I don't know. And when it has arrived, you don't know. You never know when it's cheap enough. But you have a sense. By the way, I'm not sure that AI has that sense. And I don't. I don't. I think if you send it, put it in a thing for Claude and you say, Tell me when we've gotten to the buying point, I don't think he's going to have a good answer. So when you think about when you ask about the role of AI in the investment process, I think that is an example of what it's not going to be able to do.
Would you describe the way you're approaching markets right now as cautious? I'm always cautious until the time when I agree, I believe because I'm inherently cautious. And that caution has to be overcome. And by the way, a lender should be 80% caution. You know, being around cautious, aggressive investor is not a lender is not a great idea because lending only has downside. It doesn't have any upside. The upside is that the contract is kept, the promises. But, you know, so I think we'll remain cautious until we believe that that the disappointment and the declines have been profound enough to make it time to be aggressive. And then hopefully, as we have in past cycles, hopefully we'll be the best, most aggressive people on the planet. And, by the way, maybe the only aggressive people left on the planet.
We just have about a minute left. I'm curious, what do you think people are underestimating today? Well, I think most people are underestimating the impact of AI. And, you know, what was it, roughly 18 days ago on a Friday that a company called Block, which had 10,000 employees, announced that 4,000 were out. 40% of the workforce gone in one day because AI could do the work cheaper and faster. So you know, how many people in the world understand the potential import of that? That's what it is. Howard Marks, thank you so much. Well, Lisa, always one of the places, always a great interview.