The IPO Frenzy Has Begun — ft. Howard Marks

29:33You know, the non-Shiller PE ratio is about 23 or so today. The 80-year average is 16. So we're roughly 50 % higher today. But in 2000, I think it was 32. When I started in this business as a young man, 1969, in the research department at Citibank, The bank and most of the banks invested in what were called the nifty 50, which were considered to be the best and fastest growing companies in America. Xerox, IBM, Kodak, Polaroid, Merck, Lilly, Texas Instruments, Hewlett, Packard, Coca-Cola, Avon, et cetera. And most of those stocks were selling at P-E ratios between 60 and 90. So to look at the Max 7 takeout Tesla, they're selling at P ratios in the 30s.

30:31Doesn't sound so expensive to me. And that's just P.E. But you can't just depend on P.E. That's too simplistic. The companies are different. Their capital intensiveness is lower. Their marginal profitability is higher. Since the product is an intellectual product rather than a piece of metal, it doesn't cost much to make the next one. So their incremental profitability is much higher. And then another thing is we've never, ever seen companies growing at the rates of today. You know, and I don't know the specifics, so I don't want to go there. But, you know, you hear about companies that are growing 50 % a month or 100 % a year or whatever it might be.

31:21You've never seen that before. And, you know, you look at AI and the progress that it has made in the last four years. You know, three years ago, you know, you talk about moats, you talk about impregnability. Three years ago, most people thought software was a great industry to invest in because everybody who used computers, which was everybody, needed software. And if you had a software system that served your company and industry, it would be expensive to change. And for the most part, it was hard to figure out a reason to change. So that's a pretty good moat. And more recently, people are wondering whether the whole software industry is going to go out of business because nobody writes software anymore.

32:16AI writes its own software for itself. People have to tell it what to write, but it can write it without any help. So now people have, in that world, there's something called SAS, software as a service. and around February 1st, we had something called the Cesspocalypse where the great AI companies announced some coding models and everybody said, that's it. The whole software industry has gone out of business. Now, that's probably an exaggeration.

32:57But it's very hard to figure out these things. By the way, I want to come back to something. that you asked me a long time ago, and I didn't answer, and I don't want to leave it unanswered. How do you invest in this, given all these uncertainties that I'm talking about? And what history has shown is that one of the greatest mistakes you can make is being not optimistic enough. And another mistake you can make is to say, the future is unclear, so I can't invest. Those two things don't necessarily go together. The future is always unclear. Maybe it's more unclear than ever, but that's not a reason not to invest.

33:40You just have to invest carefully, knowingly. You have to be aware of the risks you're taking. So how to invest in AI? Like anything else, there's a spectrum. And at one end of the spectrum, we have ultra high possible returns with great uncertainty. and at the other end of the spectrum, maybe we have somewhat lower possible returns with less uncertainty. Now, all of this is more uncertain than ever, but that spectrum still exists. And so you can choose a point on that spectrum. Let me give you a couple of examples. You can invest in what we call the hyperscalers, Amazon, Google, Meta, Microsoft, for example.

34:33They have established businesses with moats, enormous operating cash flow. They want to get into AI. They maybe feel that they have to compete vigorously in this winner-take-all battle. but still with established businesses and cash flow and some diversity of business these are as i said before without naming names some of the greatest companies i've ever seen so so you would think that investing in them would be maybe the low risk way to invest in ai But if AI booms and takes off and octuples in the next three years, since they have other businesses holding back their growth rate, they're not going to be the maximum profit winners.

35:29Then you have established companies. As you said before, we don't know their profitability, their finances, and maybe they're one product companies in the sense that they're all AI. So maybe it's harder to specify their future, but Anthropic and OpenAI, for example, NVIDIA, have a very high probability, I think, not being an expert, a high probability of still being successful five or 10 years from now. Now, they may not be the number one they are today, but they're unlikely, I think, to be obsoleted. So depending on the price you pay and its fairness, they may be riskier than the hyperscalers, but they're not make it or break it.

36:29They're already up and running. And then you have startups. You have startups where you don't know, where they may not have revenues. They may have revenues, but no profits. You may not even know what the product will be. But if you can get in at something called, you know, ground level, and they turn, and one of them turns into be a big winner, you can make an incalculable amount of money. And I described this in a recent memo as a lottery ticket. And so at the riskiest end of the spectrum, you have lottery behavior. And if you think about the lottery, most people who buy lottery tickets lose all their money.

37:21A few people become incredibly rich. So that's probably the profile of performance at the riskiest end of the spectrum. You can pick where to play on the spectrum. You can mix positions on the spectrum. And then you can decide how much should all of these companies on the spectrum be of your total portfolio. I guess the problem just on that point is that it seems that we are muddying what the spectrum actually is, and we're almost rebranding lottery tickets as certain safe investments. I think the best example would probably be SpaceX, whose losses grew 700 % year over year. It's an incredibly unprofitable business, especially the AI business.

38:12Anthropic is also unprofitable, though maybe we're starting to see, although we haven't seen the financials, if that's starting to change. OpenAI is certainly very unprofitable. But a lot of times when you say this, people will say, but the revenue is growing spectacularly. It grew, as you say, like 50 % month over month, crazy revenue growth. And that's sort of the justification as to why it isn't a lottery ticket. Don't worry about the profitability. The top line's growing really fast. And I'm actually not sure what to make of that argument. Part of me wants to say, no, it's still losing a ton of money, still a lottery ticket.

38:46But as someone who's looked at so many companies over the years, I mean, what do you make of that argument? What do you make of subsidizing these losses to the tune of literally hundreds of billions of dollars? This seems like we're entering a new era. It seems as though profitability isn't really a thing anymore, at least I guess it's not a problem and they can come on these valuations. And so I guess I ask that to you, knowing that you're not a VC, but you're someone who's seen so many cycles, you've experienced investments work and not work. Conceptually, what do you make of it? In the heat of the moment, in the exuberance, people say things like, profits don't matter.

39:35What matters is in the future. You know, we used to value stocks on earnings. Then when we started investing in companies with no earnings, we talked about investing on the basis of sales, ratio of sales. Then when we talked about companies that had no sales, people back in 1999, 2000, people said, well, what's how much per per eyeball, how much per click? And people put values on on Internet stocks based on how many people were going to their site, even though they were going there free. But I believe ultimately it always comes down to value. Ultimately at some time in the future, profitability will matter.

40:19And if you find a company that's a great tech leader today, and it looks like it has an unlimited technological franchise and great expertise. And if you tell me that 20 years from now, it still won't be making money, my guess is that the price paid today by an exuberant investor will turn out, will turn, will produce disappointment. When exuberance is replaced by sobriety, people say, well, of course profits matter. We invest in companies which we think will make money and their profits will give, will make money for us. So it's silly to disregard completely the possibility of profits. And by the way, Warren Buffett said in connection with the internet in, I think, 2000, he said, there's no doubt about the fact that the internet will add to efficiency, but that's not the same as adding to profitability.

41:30And that's relevant today also. So, you know, AI is going to change the world. I have no doubt about that. Who will it make money for? You know, I mean, if it's a, if, if, if all the hyperscalers plus the Anthropics and, and open AIs of the world and Tesla and some of the startups, if they all engage in battle and compete against each other at enormous costs, how profitable will they be? Who will make the money? And if AI is primarily a labor saving device, which I think might be an accurate description, who gets the benefit of the labor savings? Maybe the customer, the shipping company or the retail company or the warehouse company, benefits from a price war among AI providers such that the user adds to his or her profits.

42:40But the purveyor of AI services doesn't do that great. You know, these things can't be specified now. We'll be right back. And for even more markets content, sign up for our newsletter at ProfGMarkets.com.

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46:52We're back with Prof G Markets.

46:54Scott Galloway:I want to ask a question about your business. Obviously, I've been in your business nearly as long as you, but I've been around it. And I remember when I first moved to New York, I was in San Francisco in the 90s and then New York from 2000 on, And I just knew a ton of people making a great living in your business. Now I know a small number of people making an astronomical living and the rest are gone. The rest, it feels like there's been just an incredible consolidation in your business where you're either a Leviathan or you're a no man's land. I would just love to get your take on your business as a business and how you've seen it change and where you think it's headed.

47:32Scott Galloway:How long do you have? I mean, that's a pretty broad question. Sure. First of all, you know, I'm pretty sure I'd predate you. When I attended the University of Chicago in 1968, the professor pointed out that the average mutual fund did worse than the S &P before fees and then charged a high fee. And so he says, why don't they just buy one share of each stock in the S &P? There were no index funds or no concept of indexation, but it came along and it, you know, today the majority of mutual fund equity capital is managed by indexation or passive investment. That's one reason why a lot of people have disappeared.

48:23The consumer was not well informed and paid a high fee for a defective product, which is not a great business model. On the other hand, in the last, well, let's say 40 years, which is maybe a little more or less, there have been all these innovations. We lived 40 plus years in a period of declining interest rates, which made a lot of things very successful. and a lot of people cashed in and built very, very profitable businesses investing in what are called alternative investments, private equity, private credit, and things like that. And they found an environment which was perfect for them. And especially since March of 2009, which was the low point of the global financial crisis, things have been rosy for over 17 years.

49:17and so a lot of people have made a lot of money. This tends to get sorted out in the bad times. In the good times, the great investors do great, the bad investors do good. In the bad times, it gets sorted out. There may be rougher times ahead for some of these new, new things in the investment business and some of it may get sorted out. By the way, let me just close this to home for Oak Tree. In the last 15 years, they developed a business called private credit, which is really the broader term for what we call direct lending, which is private loans for midsize buyouts. and I'm informed on good authority that, so this case, this didn't exist in 2010 and it's$1.7 trillion today.

50:15And I'm told that there are roughly 700 direct lending managers. And so the, the, the, the availability of that$1.7 trillion put a lot of people into business and made a lot of people extremely successful, along with a very favorable economy and with low or generally low or generally declining interest rates, which are salutary. So this has been an ideal environment. And we have 700 managers making money in this industry today. what will it look like five or ten years from now? We'll find out. But I'm told that of the 700, roughly 3 % were in business before the global financial crisis. So we don't know how many of them had what it takes to deal with a harsh environment.

51:19Making money in a salutary environment proves almost nothing. To make money in a sanitary investment environment, you can do it on the basis of good judgment and hard work and skill, or you can do it on aggressiveness and getting lucky. It doesn't get sorted in the good times. As Buffett says, it's only when the tide goes out that we find out who's been swimming naked. So this period that you describe, and particularly the period 09 to date, this has been salad days, halcyon days. And nobody should look at those 17 years and say, oh, that's a long period, so that's probably normalcy. This was the greatest period imaginable for the investment industry and especially for the alternative investment industry.

52:17And one day, I think, the tide will go out and one day some of this will be sorted.

52:24Scott Galloway:Just a quick question to wrap up here. We didn't touch on private credit. There's a lot of fear and a lot of concern around private credit right now. Do you think those fears are overblown, underblown? What is your view on the private credit market right now? And I realize that's an awfully big market, but it's getting a lot of attention right now. I think it's overblown. These were managers who collected money from clients and gave loans for midsize buyouts. and some of them will be unsuccessful, but probably not a large percentage. I mean, this activity has been around under different guises since 78 or 77.

53:11I was lucky to be asked to start Citibank's HIO bond activity in 78. And we've been making loans to companies of moderate credit worthiness and doing well for 48 years. People who don't do it as well will not have great results, but most of the loans will pay. And the people who are throwing up their hands are probably exaggerating the difficulty and extrapolating the fears in software, which are probably overblown. Having said that, retail investors or individual investors bought these products and these are private loans. There's no market for them. You can't get out of them at the drop of a hat.

54:07And so a lot of the, I think most of the unease concerning what you call private credit, what I call direct lending is around the fact that people have said, okay, you know what? I'm not that happy. I'd like to get my money back. And if you went into a non-traded BDC, which is what we call these things you're talking about, the people said, well, we can only let out 5 % of the investors per quarter. And other people said, you know what I mean? I put money in, I can't get it out. Well, that was always the terms. If you read the prospectus, which admittedly very few people do, It was there. None of this is a surprise, but people do things in the good times when they're feeling no pain, sometimes without adequate care or research or prudence, and they tend to regret them in the bad times.

55:03Some of that is going on, but I don't think there was a misrepresentation. People should not be surprised that they can't get all their money out every quarter. But one of the most powerful forces in the investment business is disillusionment. And people went from being unworried to now thinking that this ship is sinking, and that's very painful. The unworried feeling was mistaken, and now the feeling that the ship is hopelessly sinking is also probably mistaken. Howard, you've been incredibly successful on Wall Street. You started one of the most successful asset management firms in the world.

55:50A lot of young people listen to this podcast, starting their careers, who want to build economic security, who want to be successful. What advice would you give to those people who are just starting out in their careers right now? I've enjoyed a great career, and I don't consider it over. investing is a fascinating field. I mean, just think about this podcast and think about the number of times I said, I don't know, or something's unpredictable or inestimable or incalculable. So what we do every day is we peel an onion and we deal with uncertainty and we make judgments. We make the best judgments we can in an uncertain world.

56:36In his book, Fooled by Randomness, Nassim Taleb talked about, made comparison between investing in dentistry. And he said, if you go to dental school and you learn how to fill a cavity and you fill the cavity that way every time, you'll be successful every time. That's not true of investing. So if you're the kind of person who wants to be successful every time, don't become an investor, become a dentist or an engineer or something where you have physical rules in play that are reliable. There are no physical rules in investing that will make you successful all the time. Warren Buffett, the most successful investor of all times, attributes his success to 12 investments over the last 60, 70 years.

57:26Now, he didn't have that many abject failures, but many, many, many investments that he made were only moderately successful. He did 12 great ones. So do you like dealing with uncertainty and ambiguity? Can you live with a batting average which is far from 1 ,000? The only thing I would emphasize is that investing has been enormously profitable industry for those of us participating in it in the last 50 years. You shouldn't become an investor just because it's a high-paid industry. But if you meet the description that I just laid out, I think it's a great thing to do. It's exciting. It's intellectually challenging.

58:21You never reach a point where you say, well, I got this figured out, and I find that to be a wonderful attribute. I wish we could keep going for hours, but alas, we cannot. Howard Marks is the co-founder and co-chairman of Oaktree Capital Management. Prior to co-founder Oaktree, Marks led the groups at the TCW Group that were responsible for investments in distressed debt, high-yield bonds, and convertible securities. He was also chief investment officer for domestic fixed income at TCW. Previously, Marks was with Citicorp Investment Management for 16 years. Howard has published three books on investing, including The Most Important Thing, Uncommon Sense for the Thoughtful Investor, and Mastering the Market Cycle, Getting the Odds on Your Side.

59:02Howard, we really appreciate your time. Thank you so much. Thank you, Howard. Thank you, fellas, for your great questions. It's been a pleasure. This episode was produced by Claire Miller and Alison Weiss and engineered by Benjamin Spencer. Our video editor is Jorge Carty. Our research team is Dan Jelan, Isabella Kinsel, Chris Nodonoghue, and Mia Silverio. Jake McPherson is our social producer. Drew Burrows is our technical director. And Catherine Dillon is our executive producer. Thank you for listening to Prof G Markets from Prof G Media. If you liked what you heard, give us a follow and join us for a fresh take on markets on Monday.

59:43Lifetimes

59:49You have me

59:53In kind reunion

1:00:00As the world turns

1:00:05And the dove flies In love

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