Risk in Today's Markets

The ability of the stock market to react so harshly on February 4 to a small, Fedmandated rise in
interest rates, pushing the Dow down 9 points, suggests a lack of
preparedness for negati!e de!elopments" Thisprompts me to write to you about certain
risks # feel may be present in the markets today"
There are plenty of bullish arguments to be made about the prospects for the economy
and corporate profits, and pundits to make them" $hile # will not de!ote space or time to
them, # don't pretend they are none%istent" &nd # won't deny the possibility that as an
inherently cautious in!estor, # sometimes tend too!erstate the negati!es" $hat # want to
do, howe!er, is point out the degree to which # feel in!estors are beha!ing in a risktolerant
manner today, and the implications for all of us"
Two !ery powerful trends are at work, and ha!e been for the last few years" The first is
the decline in interest rates, which has carried rates to the lowest le!els of the last thirty
years and brought on great dissatisfaction with the returns a!ailable from low'risk fi%ed
income in!estments" The second is the fabulous performance which was produced by
!irtually all in!estments in securities from (99( to (99)" This was a period in which
risk'taking was rewarded, and almost withoute%ception !ery high returns went to those
who took great risk"
*ut these two phenomena together and what do you ha!e+ # think the answer is an
en!ironment in which risk'taking is greatly encouraged"
#t is often said that the market runs on fearand greed, but # belie!e it usually runs on fear
or greed, that is, at most points in time,one or the other predominates" Right now,
because of the two trends cited abo!e, greed is greatly ele!ated and, perhaps more
importantly, fear is in short supply" Thus,
' the money market in!estor, not content toearn )- per year, .a negati!e return
after ta%es and inflation/, turns to notes and bonds,
' the bond in!estor, unhappy with returns at the shorter .read 0low'risk0/ end of
the cur!e, e%tends maturities,
' the high grade bond in!estor drops down in 1uality,
' the fi%ed income in!estor turns to e1uities,
' the e1uity in!estor 2oins a hedge fund,
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' the domestic in!estor looks o!erseas,
' the international in!estor emphasi7es emerging markets, and
' the traditional bond'and'stock in!estor searches for 0alternati!e in!estments0
likely to repeat the success of the 684 and bankruptcy funds"
&nd why shouldn't they+ The 0stick0 is the low prospecti!e return offered in each
in!estor's traditional bailiwick, and the 0carrot0is the high returns earned recently in the
riskier sectors" #n brief, 0why should # settlefor )- in T'bills when # can get double'digit
returns in stocks+0
There are numerous signs of infatuation with '' or non'1uestioning acceptance of '' the
pursuit of high returns" The torrential inflow of dollars to mutual funds is one, # recently
attended a conference at which a fund group representati!e said theywere taking in 9(::
million a day, 9:- of it for foreign funds" The rising le!el of margin debt is another"
8ooks on in!esting are reaching the best'sellers list" The names of hedge fund managers
are almost household words"
&nd that brings me, for purposes of illustration, to the sub2ect of hedge funds" $hen #
first got to know the money management community twenty years ago, only a handful of
managers were good enough to command a share of the profits as compensation" Today,
according to a recent article in Forbes, there are ;:: hedge funds, and some people think
being accepted by one of the big names is the chance of a lifetime"
# think it's important to remember, though, the symmetrical nature ofmost in!estments<
almost e!ery sword is two'edged, and he who li!es by a risky strategy may die by it"
#n!estments which will make you a great deal of money when things go well but not lose
you a lot when things go poorly are !ery rare, and their e%istence must presuppose
e%tremely inefficient markets" $ith the a!erage stock or bond returning (:'(=- last
year, how did some hedge funds make >:- or more+ #t was through bold and hea!ilyle!eraged
plays on macro'de!elopments such as currency mo!ements" $hat would ha!e
happened if the managers' calculations had pro!ed wrong+ The hedge fund manager #
know with the best performance last year, up more than (::-, is said twice in his life to
ha!e lost ):- in one day? Do the hedge fund aficionados know how much risk they are
taking+ For how long are they tying up their money+ @ow much do they know about the
strategies being employed+ &s the Forbes article pointed out, the sum of the
0information0 most hedge fund in!estors recei!e is a 1uarterly paragraph reporting the
rate of return"
# am not complaining about the fact that there are hedge funds, or about their popularity"
My point is simply that the le!el of risk borne by in!estors is being systematically raised,
often unknowingly and at a time when many !aluations are 1uite high"
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5omparison against low interest rates makes low earnings yields and di!idend yields
seem tolerable" 6ikewise, low rates increase the discounted present !alue of companies'
future earnings as calculated by !aluation models" For these reasons and others, many
!aluation indicators are at le!els today which ha!e pro!ed dangerous and unsustainable
in the past" Aust as today's low interestrates are pushing in!estors toward riskier
securities all along the 0food chain0 described abo!e, howe!er, this sword can also cut
the other way"
$arren 8uffet said, in one ofmy fa!orite adages, 0The less prudence with which others
conduct their affairs, the greater the prudence with which we should conduct our own
affairs"0 &nother adage #'m fond of is, 0$hat the wise man does in the beginning, the
fool does in the end"0 Bo course of in!estmentaction is either wise or foolish in and of
itself" #t all depends on the point in time atwhich it is undertaken, the price that is paid,
and how others are conducting themsel!es at that moment"
$hen e!eryone shrinks from a security because it's 0too risky,0 the few who will buy it
can do so with confidence, secure in the knowledge that the price has not been bid up,
and in the likelihood that others will e!entually outgrow their fear and 2ump on the
bandwagon" Today, many prices ha!e been bid up, and the bandwagon is already
crowded with wild'eyed in!estors"
#t is my !iew that, first, few of the trendsbeing pursued are at their beginnings, money
has been flowing to today's popular sectors for at least a year or two" Cecond, while some
may argue that prices are not forbiddingly high, it's almost impossible to argue that
they're !ery low .or that the easy money hasn'talready been made/" Third, it seems to me
that in!estors are accepting higher le!els of risk throughout the system"
@ere's one illustration< 4ur cautious high yield in!esting sa!ed clients a lot of money
and heartache in (9;9 and (99:" 8ecause we apply in'depth, downside'conscious credit
analysis to the high yield segment of the bond market, and define it narrowly, in!estors
who were chastened by the last decline and don't want to bear the full brunt of the ne%t
one ha!e hired us repeatedly in the years since" Bow, howe!er, we detect increased
interest in more 0eclectic0 managers who will buy cash'paying or non'cash'paying bonds,
going concerns or bankruptcies, con!ertible or straight bonds, and D"C" or foreign debt"
This is 2ust one e%ample, near to us, of the new acceptability of risk '' at what 2ust might
be the wrong time"
Too'low interest rates and too'high prices may pro!e at some point to ha!e set the stage
for a correction" #f so, many of the riskier tactics to which recent trends are pushing
in!estors will increase the e%tent to which thatcorrection is felt" $hat course of action,
then, would we argue for+
$e do not preach risk'a!oidance" #n fact, the knowing acceptance of risk for profit is
at the core of much of what we do, and we feel there is an important role today for
in!esting which is creati!e and adaptable" 8ut we would take thisopportunity to e%hort
you to re!iew most critically the risk associated with your current and contemplated
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in!estments, and not to be among those who uncritically 2oined the trend toward risk"
$hate!er in!estment opportunities you decideon, we would encourage you to stress
thorough appraisal of the risks entailed and cautious implementation"
$hat is it that distinguishes the in!estment opportunities weEd suggest you pursue
today+ Bot 2ust the offer of high returns, but of returns which are more than
proportionate to the risk entailed" The reason we champion inefficient markets .such
as the high yield bonds, con!ertibles and distressed debt we're in!ol!ed with/ is that there
e%ists by definition the potential, if e%ploited correctly, for an uncommonly fa!orable
ratio of return to risk"
F%ploitation of opportunities in inefficient markets, insistence on preser!ing capital,
refusal to pursue ma%imum return at the cost of ma%imum risk, speciali7ation
rather than dabbling, hea!y emphasis on careful analysis, use of less'risky senior
securities '' these themes ha!e been the cornerstones of our approach o!er the years"
They remain highly rele!ant and should continue to be pursued by all of us,
especially at this point in the cycle"
February (>, (994
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6egal #nformation and Disclosures
This memorandum e%presses the !iews of the author as of the date indicated and such !iews
are
sub2ect to change without notice" 4aktree has no duty or obligation to update the information
contained herein" Further, 4aktree makes no representation, and it should not be assumed, that
past in!estment performance is an indication of future results" Moreo!er, where!er there is the
potential for profit there is also the possibility of loss"
This memorandum is being made a!ailable for educational purposes only and should not be
used
for any other purpose" The information contained herein does not constitute and should not be
construed as an offering of ad!isory ser!ices or an offer to sell or solicitation to buy any
securities or related financial instruments in any 2urisdiction" 5ertain information contained
herein concerning economic trends and performance is based on or deri!ed from information
pro!ided by independent third'party sources" 4aktree 5apital Management, 6"*" .G4aktreeH/
belie!es that the sources from which such information has been obtained are reliable, howe!er,
it
cannot guarantee the accuracy of such information and has not independently !erified the
accuracy or completeness of suchinformation or the assumptionson which such information is
based"
This memorandum, including the information contained herein, may not be copied, reproduced,
republished, or posted in whole or in part, inany form without the prior written consent of
4aktree"