Howard Marks: Debt, investing and how caution “may save your financial life”

The Oaktree Capital founder's latest memo begins by considering an article by one of his fund partners Morgan Housel. This looked at the more than 140 companies in Japan still operating more than 500 years after they were created.

“These ultra-durable businesses are called “shinise,” and studies of them show they tend to share a common characteristic: they hold tonnes of cash and no debt. That’s part of how they endure centuries of constant calamities,” Marks writes.

Noting that “all else being equal,” indebted people and companies that are more likely to run into trouble than those that aren’t, Marks stops short of concluding debt is necessarily a bad thing.

“Rather, it’s a matter of whether the amount of debt is appropriate relative to (a) the size of the overall enterprise and (b) the potential for fluctuations in the enterprise’s profitability and asset value,” Marks writes.

Why investors take on debt

The answer is simply “to increase capital efficiency,” because in many cases the cost of debt is cheaper than the “expected returns that motivate equity investments and thus relative to the imputed cost of equity capital.”

Marks recalls hearing casino pit bosses motivating gamblers with the line: “The more you bet, the more you win when you win.”

Likewise, he notes a) the more debt capital an investor can use to buy assets, the more assets they own and b) the more assets, the greater the profits.”

“But few people talk about the downside. The pit boss never says, “. . . and the more you lose when you lose.” Likewise, when your assets decline in value, the more leverage you’ve employed, the more equity loss you’ll suffer.”

A key caveat: “When things go well”

Marks also makes the point that investors usually base their decision on how much leverage to take on “normal levels of volatility” – those seen regularly and documented in historical statistics.

“The problem is that extreme volatility and loss surface only infrequently. And as time passes without that happening, it appears more and more likely that it’ll never happen,” writes Marks.

“In all aspects of our lives, we base our decisions on what we think probably will happen. And, in turn, we base that to a great extent on what usually happened in the past.”

The role of investor psychology

Investor psychology has a dominant influence on the market in the short run, and the attitudes that motivate investment decisions are often cyclical, “driving markets to irrational extremes and then correcting…to the opposite extreme.”

Marks cites the following cycle of events spurred by investor behaviour and attitudes to risk.

• Favourable aspects of leverage become well-recognised,
• Negative potential is overlooked,
• Investors become interested in employing more leverage,
• Lenders become willing to provide more, and
• Regulations and attitudes governing the use of leverage tend to become more permissive.

Using debt sensibly

Marks wryly observes that success bias leads some investors to conclude the right amount of leverage is “all you can get”. Instead, he says successful use of investment leverage considers a) Debt’s magnifying effect when losses are made, and b) “The risk of ruin” if extreme negative circumstances occur.

Marks refers to an earlier memo from December 2008, Volatility + Leverage = Dynamite, which reflected on the cause of the GFC. Emphasising leverage should only be used with caution:

“If you’re doing something novel, unproven, risky, volatile, or potentially life-threatening, you shouldn’t seek to maximise returns. Instead, err on the side of caution,” he writes.

Conservative assumptions on debt may “save your financial life”

Marks also invokes a pet topic of the great value investor Warren Buffett, “[who] constantly harps on margin of safety.

“The key to survival lies in what Warren Buffett constantly harps on: margin of safety. Using 100% of the leverage one’s assets might justify is often incompatible with assuring survival when adverse outcomes materialise,” writes Marks.

The riskier the underlying assets, the less leverage should be used to buy them. Conservative assumptions on this subject will keep you from maximizing gains but possibly save your financial life in bad times.

Read the full memo: You can read Howard Marks' full Impact of Debt memo by downloading the attached PDF.