Howard Marks Sees ‘Sea Change’

During the pandemic, I stopped covering Howard Marks’s memos. For a time, I even stopped reading them.

Marks is a good writer, and a fine thinker as far as legendary investors go. The problem: That doesn’t actually go very far.

If the literary yardstick is Warren Buffett, then sure, Marks is a veritable John Steinbeck. If philosophical prowess is measured against Ray Dalio’s LinkedIn posts, then yeah, Howard is Marcus Aurelius. But prose isn’t what I need from my capitalists, and with apologies, I certainly don’t need any implicit life advice from them.

While acknowledging that the first several months of the pandemic were a time for deep reflection, Marks’s memos during that period felt, to me anyway, like overwrought pretensions to a kind of profundity that he simply has no claim on. Not everyone agreed with that assessment, but my criticism was constructive and, more importantly, totally harmless: It wasn’t personal, Howard surely didn’t notice and, even if he had, he surely wouldn’t have cared.

More than two years later, I find myself compelled to highlight a few passages from Marks’s latest memo because, in the most straightforward terms I can conjure, it’s good. Happily, it also aligns with my “Great Immoderation” thesis, at least in part.

Marks on Tuesday described the “incredible tailwind” from declining interest rates over the past four decades. The effects of lower rates are familiar to every undergraduate business student (e.g., higher growth via credit-fueled spending, more capex, lower cost of capital, lower hurdle rates, a mechanical increase in the fair value of assets and the wealth effect from higher asset prices), but Marks spent some time editorializing around the implications for investors who employ leverage. He set out a hypothetical and walked through the evolution of a trade (or deal). To wit:

He analyzes a company, concludes that he can make 10% a year on it, and decides to buy it. Then he asks his head of capital markets how much it would cost to borrow 75% of the money. When he’s told it’s 8%, it’s full speed ahead. Earning 10% on three-quarters of the capital that’s borrowed at 8% would lever up the return on the other one-quarter (his equity) to 16%. Banks compete to make the loan, and the result is an interest rate of 7% instead of 8%, making the investment even more profitable (a 19% levered return). The interest cost on his floating-rate debt declines over time, and when his fixed-rate debt matures, he finds he can roll it over at 5% Now the deal is a home run (a 25% levered return, all else being equal).

And that’s not even the whole story. If rates fall over the course of that investment (as Marks assumes they do in the hypothetical), the underlying business, assuming it’s viable and management is any semblance of competent, will surely benefit from the same secular decline in rates as the investor, both in terms of the company’s market value and its profitability.

Marks likened that to walking on a conveyor belt. “At some airports, there’s a moving walkway, and standing on it makes life easier for the weary traveler, but if rather than stand still on it, you walk at your normal pace, you move ahead rapidly,” he wrote. “That’s because your rate of travel over the ground is the sum of the speed at which you’re walking plus the speed at which the walkway is moving.”

That, he said, is why investors have done so well over the past four decades — so, during The Great Moderation. He doubts most investors appreciate that, and to the extent he’s right, it means many market participants likely don’t appreciate how challenging life could be if we have, in fact, transitioned to a new macro regime.

“It seems to me that a significant portion of all the money investors made over this period resulted from the tailwind generated by the massive drop in interest rates,” he said. “The results have been great, but I doubt many people fully understand where they came from.”

Marks then walked through a lot of recent history with which any engaged investor is intimately familiar. His overarching message was that “the base interest rate over the next several years is more likely to average 2-4% than 0-2%,” for a variety of reasons including, but not limited to, a still tight labor market, the trend towards less globalization and the Fed’s desire to see a positive real funds rate, as well as an inclination on the part of policymakers to preserve some countercyclical ammunition to use during the next downturn.

“The bottom line for me is that, in many ways, conditions at this moment are overwhelmingly different from — and mostly less favorable than — those of the post-GFC climate,” Marks went on to say. “These changes may be long-lasting, or they may wear off over time, but in my view, we’re unlikely to quickly see the same optimism and ease that marked the post-GFC period.”

Ultimately, Marks doesn’t think a return to highly stimulative rates is likely in the near-term, and maybe not in the medium-term either, unless there’s a severe recession which, of course, would give rise to another set of problems for investors.

He took note of the recency bias I frequently reference in these pages while discussing not just the macro (i.e., The Great Moderation), and not just markets (i.e., the post-GFC era), but also geopolitics (i.e., Pax Americana).

“People who came into the business world after 2008 — or veteran investors with short memories — might think of today’s interest rates as elevated,” he wrote. “But they’re not in the longer sweep of history, meaning there’s no obvious reason why they should be lower.”

The title of Marks’s latest memo was “Sea Change.”

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