Howard Marks and the economic cycle
This is a long excerpt from Howard Marks’ November 2001 Memo “You Can't Predict. You Can Prepare.” I think it is an important topic/mental model to keep in mind, both for today’s investing environment and for future ones. Especially since interest rates today are being kept artificially low, profit margins are still near all-time highs and Wall Street estimates for corporate earnings are based on, to quote John Hussman, the “assumption that profit margins will achieve and indefinitely sustain the highest profit margins observed in U.S. history.”
How can non-forecasters like Oaktree best cope with the ups and downs of the economic cycle? I think the answer lies in knowing where we are and leaning against the wind. For example, when the economy has fallen substantially, observers are depressed, capacity expansion has ceased and there begin to be signs of recovery, we are willing to invest in companies in cyclical industries. When growth is strong, capacity is being brought on stream to keep up with soaring demand and the market forgets these are cyclical companies whose peak earnings deserve trough valuations, we trim our holdings aggressively. We certainly might do so too early, but that beats the heck out of doing it too late.
The Credit Cycle
The longer I'm involved in investing, the more impressed I am by the power of the credit cycle. It takes only a small fluctuation in the economy to produce a large fluctuation in the availability of credit, with great impact on asset prices and back on the economy itself.
The process is simple:
- The economy moves into a period of prosperity.
- Providers of capital thrive, increasing their capital base.
- Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk.
- Risk averseness disappears.
- Financial institutions move to expand their businesses – that is, to provide more capital.
- They compete for market share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction, and easing covenants.
At the extreme, providers of capital finance borrowers and projects that aren't worthy of being financed. As The Economist said earlier this year, "the worst loans are made at the best of times." This leads to capital destruction – that is, to investment of capital in projects where the cost of capital exceeds the return on capital, and eventually to cases where there is no return of capital.
When this point is reached, the up-leg described above is reversed.
- Losses cause lenders to become discouraged and shy away.
- Risk averseness rises, and along with it, interest rates, credit restrictions and covenant requirements.
- Less capital is made available – and at the trough of the cycle, only to the most qualified of borrowers.
- Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies.
- This process contributes to and reinforces the economic contraction.
Of course, at the extreme the process is ready to be reversed again. Because the competition to make loans or investments is low, high returns can be demanded along with high creditworthiness. Contrarians who commit capital at this point have a shot at high returns, and those tempting potential returns begin to draw in capital. In this way, a recovery begins to be fueled.
I stated earlier that cycles are self-correcting. The credit cycle corrects itself through the processes described above, and it represents one of the factors driving the fluctuations of the economic cycle. Prosperity brings expanded lending, which leads to unwise lending, which produces large losses, which makes lenders stop lending, which ends prosperity, and on and on.
In "Genius Isn't Enough" on the subject of Long-Term Capital Management, I wrote "Look around the next time there's a crisis; you'll probably find a lender." Overpermissive providers of capital frequently aid and abet financial bubbles. There have been numerous recent examples where loose credit contributed to booms that were followed by famous collapses: real estate in 1989-92; emerging markets in 1994-98; Long-Term Capital in 1998; the movie exhibition industry in 1999-2000; venture capital funds and telecommunications companies in 2000-01. In each case, lenders and investors provided too much cheap money and the result was over-expansion and dramatic losses. In "Fields of Dreams" Kevin Costner was told, "if you build it, they will come." In the financial world, if you offer cheap money, they will borrow, buy and build – often without discipline, and with very negative consequences.
The credit cycle contributed tremendously to the tech bubble. Money from venture capital funds caused far too many companies to be created, often with little in terms of business justification or profit prospects. Wild demand for IPOs caused their hot stocks to rise meteorically, enabling venture funds to report triple-digit returns and attract still more capital requiring speedy deployment. The generosity of the capital markets let companies sign on for huge capital projects that were only partially financed, secure in the knowledge that more financing would be available later, at higher p/e's and lower interest rates as the projects were further along. This ease caused far more capacity to be built than was needed, a lot of which is sitting idle. Much of the investment that went into it may never be recovered. Once again, easy money has led to capital destruction.
In making investments, it has become my habit to worry less about the economic future – which I'm sure I can't know much about – than I do about the supply/demand picture relating to capital. Being positioned to make investments in an uncrowded arena conveys vast advantages. Participating in a field that everyone's throwing money at is a formula for disaster.
We have lived through a long period in which cash acted like ballast, retarding your progress. Now I think we're going into an environment where cash will be king. If you went to a leading venture capital fund in 1999 and said, "I'd like to invest $10 million with you," they'd say, "Lots of people want to give us their cash. What else can you offer? Do you have contacts? Strategic insights?" I think the answer today would be different.
One of the critical elements in business or investment success is staying power. I often speak of the six-foot-tall man who drowned crossing the stream that was five feet deep on average. Companies have to be able to get through the tough times, and cash is one of the things that can make the difference. Thus all of the investments we're making today assume we'll be going into the difficult part of the credit cycle, and we're looking for companies that will be able to stay the course.
The Corporate Life Cycle
As indicated above, business firms have to live through ups and downs. They're organic entities, and they have life cycles of their own.
Most companies are born in an entrepreneurial mode, starting with dreams, limited capital and the need to be frugal. `Success comes to some. They enjoy profitability, growth and expanded resources, but they also must cope with increasing bureaucracy and managerial challenges. The lucky few become world-class organizations, but eventually most are confronted with challenges relating to hubris; extreme size; the difficulty of controlling far-flung operations; and perhaps ossification and an unwillingness to innovate and take risks. Some stagnate in maturity, and some fail under aging products or excessive debt loads and move into distress and bankruptcy. The reason I say failure carries within itself the seeds of success is that bankruptcy then permits some of them to shed debt and onerous contracts and emerge with a reborn emphasis on frugality and profitability. And the cycle resumes . . . as ever.
The biggest mistakes I have witnessed in my investing career came when people ignored the limitations imposed by the corporate life cycle. In short, investors did assume trees could grow to the sky.
- More From Ed Chancellor On Focusing On Industry Supply...
From his introduction to Capital Returns: Investing Through the Capital Cycle: A Money Manager's Reports 2002-15: FOCUS ON SUPPLY RATHER THAN DEMAND Given that the future is uncertain, why should Marathon’s approach fare any better? The answer...
- Ed Chancellor On The Capital Cycle...
From his introduction to Capital Returns: Investing Through the Capital Cycle: A Money Manager's Reports 2002-15, which was released in hardcover today: Typically, capital is attracted into high-return businesses and leaves when returns fall...
- What Distinguishes A First-class Business From An Ordinary Business?
From Deep Value: In a cruel irony, most good businesses earning high returns on invested capital can’t absorb much incremental capital without reducing those high returns, while most bad businesses earning low returns on invested capital require all...
- Hussman Weekly Market Comment: Restoring The "virtuous Cycle" Of Economic Growth
Link to: Restoring the "Virtuous Cycle" of Economic GrowthIn a healthy economy, the productive activity of one sector opens a vent for the productive activity of other sectors of the economy. The useful allocation of resources in one area of the...
- A Template For Understanding What’s Going On - By Ray Dalio
I provided a link to this in a previous post, but I thought I’d also give it its own post as I believe this paper from Ray Dalio is one of the most important things I’ve read all year. As Dalio mentions, there is a big difference between a normal...