[Investor Letters] Howard Marks on Liquidity
Like Warren Buffett, Howard Marks is a master craftsman of memos on the state of the market, investment psychology, and investment philosophy. In January of 2016 as capital seemed to be pouring out of public and private equity markets – at the time of his post, the S&P was down almost 9% from where it ended 2015 – and liquidity was on the minds of many investors and operators.
For people building companies (as opposed to investment firms), his notes on liquidity provide ample learning opportunities to help effectively navigate periods of exuberance and tightening that inevitably occur.
Marks framed his thoughts on liquidity well at the beginning of this Bloomberg interview where he states: “The best defense against liquidity is not needing it. It is buying things you can hold for a long period of time.”
We have pulled out our favorite sections and added our thoughts below. The full investor letter (pdf) can be found at the bottom of this post. All of the charts, images, quotes, and emphasis below were added by us.
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Oaktree’s Howard Marks on Liquidity
Sometimes people think of liquidity as the quality of something being readily saleable or marketable. For this, the key question is whether it’s registered, publicly listed and legal for sale to the public.
“Marketable securities” are liquid in this sense; you can buy or sell them in the public markets. “Nonmarketable” securities include things like private placements and interests in private partnerships, whose salability is restricted and can require the qualification of buyers, documentation, and perhaps a time delay.
But the more important definition of liquidity is this one from Investopedia: “The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price.” Thus the key criterion isn’t “can you sell it?” It’s “can you sell it at a price equal or close to the last price?” Most liquid assets are registered and/or listed; that can be a necessary but not sufficient condition. For them to be truly liquid in this latter sense, one has to be able to move them promptly and without the imposition of a material discount.
Much ink has been spilled in recent periods about the lack of liquidity – using the definition Marks’ favors – in the private markets. Companies of all stages are struggling to raise fresh capital without taking a haircut (selling an asset below the last price) and the IPO window is firmly closed.
I often say many of the important things in investing are counter-intuitive. Liquidity is one of them. In particular, it’s probably more wrong than right to say without qualification that something is or isn’t “liquid.”
If when people ask whether a given asset is liquid they mean “marketable” (in the sense of “listed” or “registered”), then that’s an entirely appropriate question, and answering it is straightforward. Either something can be sold freely to the public or it can’t.
But if what they want to know is how hard it will be to get rid of it if they change their mind or want to take a profit or avoid a possible loss – how long it will take to sell it, or how much of a markdown they’ll have to take from the last price – that’s probably not an entirely legitimate question.
It’s often a mistake to say a particular asset is either liquid or illiquid. Usually an asset isn’t “liquid” or “illiquid” by its nature. Liquidity is ephemeral: it can come and go. An asset’s liquidity can increase or decrease with what’s going on in the market. One day it can be easy to sell, and the next day hard. Or one day it can be easy to sell but hard to buy, and the next day easy to buy but hard to sell.
In other words, the liquidity of an asset often depends on which way you want to go . . . and which way everyone else wants to go. If you want to sell when everyone else wants to buy, you’re likely to find your position is highly liquid: you can sell it quickly, and at a price equal to or above the last transaction. But if you want to sell when everyone else wants to sell, you may find your position is totally illiquid: selling may take a long time, or require accepting a big discount, or both. If that’s the case – and I’m sure it is – then the asset can’t be described as being either liquid or illiquid. It’s entirely situational.
There’s usually plenty of liquidity for those who want to sell things that are rising in price or buy things that are falling. That’s great news, since much of the time those are the right actions to take. But why is the liquidity plentiful? For the simple reason that most investors want to do just the opposite. The crowd takes great pleasure from buying things whose prices are rising, and they often become highly motivated to sell things that are falling . . . notwithstanding that those may be exactly the wrong things to do.
Specific investor actions can have a dramatic impact in illiquid markets For example, the price of an illiquid asset can rise simply because one buyer is buying, in which case selling the asset becomes very easy. When that buyer stops buying, however, the market can quickly reset to much lower levels in terms of both price and the liquidity enjoyed by sellers (and it can overshoot in the other direction if the buyer decides to sell what he bought.
People have pointed out that the slowdown in VC funding (to whatever extent it has or will happen) has been largely a VC conspiracy and it is tough to write this off entirely — although I am sure that in this imagined world of VC “conspiracies” a yoga studio or vest-shopping excursion replaces the dark, smoke-filled rooms of old-timey conspiracy theories.
The reality is that the venture market is small and quite illiquid, so when a few major firms decide to focus more on their existing portfolios or non-traditional players like mutual funds decide to slow down, liquidity begins to trickle out of the market.
And in an already illiquid market, change can happen fast. In describing current market conditions, Mark Suster of Upfront Ventures noted the following:
If you want to see what was on my mind – I started foreshadowing change publicly in October 2015 with a forecast of what I expected in 2016 VC funding markets at a presentation I gave at the annual Cendana VC/LP conference hosted by Michael Kim. Word travels at light speed amongst this small network of people who all know each other and even though they’re rivals they also sit on boards together and many probably went to business school together.
So when something in changing those at ground zero, in my word, “get the memo.” Of course it’s not literally a memo but that’s a metaphor for knowing that things have dramatically changed. If you’re not in this closed group of VCs you will eventually figure out the new game but the memo arrives more slowly. Many of the industry’s top thinkers were at Cendana’s annual meeting and panel after panel privately debated what they were seeing.
On the other hand, at the right time, investors can make tremendous amounts of money simply by being willing to supply liquidity (are accept illiquidity). When everyone else is selling in panic or sitting frozen on the sideline, refusing to buy, cash can be king. Often when a crash follows a bubble driven run-up, most people are short of cash (and/or the willingness to spend it).
A few paragraphs before this passage, Marks touches on the need to think about liquidity levels carrying over from one asset or market to another. This was the case in 2008 and 2009, when it seemed people in all markets were content to sit on the sidelines and reserve cash. During that time, investors who were unwilling to spend their cash (supplying liquidity) in the early stage private markets would have missed out on investing in generation-defining companies like Uber, Slack, and Airbnb.
The bottom line is unambiguous. Liquidity can be transient and paradoxical. It’s plentiful when you don’t care about it and scarce when you need it most. Given the way it waxes and wanes, it’s dangerous to assume the liquidity that’s available in good times will be there when the tide goes out.
What can an investor do about this unreliability? The best preparation for bouts of illiquidity is:
- Buying assets, hopefully at prices below durable intrinsic values, that can be held for a long time – in the case of debt, to its maturity – even if prices fall or price discovery ceases to take place, and
- Making sure that investment vehicle structures, leverage arrangements (if any), manager/client relationships and performance expectations will permit a long-term approach to investing.
These are the things we try to do.
In the section above, Marks is talking about the Oaktree approach to building their firm and later notes two benefits to their approach:
- We aren’t highly reliant on liquidity for success, and
- Rather than be weakened in times of illiquidity, we can profit from crises by investing more – at lower prices – when liquidity is scarce.
Rephrased for someone building a company and not an investment firm, the benefits to this type of strategy would be:
1. We aren’t highly reliant on another round of funding for success
2. Rather than be weakened when the funding market pendulum swings, we can profit from downturns by investing more – at lower prices – in things like talent and customer acquisition
This mirrors the approach of Slack’s Stewart Butterfield who has tried to take advantage of a period of high liquidity to protect his company (financially and psychologically) from a market downturn.
“And really the thing we get out of having the cash in the bank at this point is options. We’re in a really good position where when opportunities arise that we want to take advantage of, we can just do them. Whether that’s acquisitions, international expansion, advertising — whatever it is that comes up that feels like the best move for the business, we will take advantage of. Having the freedom to pursue opportunities without the constraint of capital enables all kinds of things which otherwise wouldn’t have been possible.” – Stewart Butterfield, Business Insider Interview