CG - Billionaire Howard Marks Says Sell Stocks Buy Credit: Our Top Picks

2023-10-16 07:30:00 ET

Summary

• Howard Marks' recent memo highlighted a potentially pivotal shift in the investment landscape and the necessity of reevaluating traditional investment strategies.
• Marks suggests reallocating capital into credit securities in this new environment.
• We offer our take on his latest memo and also discuss two of our favorite credit-like investments right now.

Howard Marks' latest memo - "Further Thoughts on Sea Change" - provides a comprehensive analysis of the current macroeconomic environment and emphasizes a potentially pivotal shift in the investment landscape. In it, he underscores the necessity of reevaluating traditional investment strategies, particularly in the context of the stock market, and advocates potentially reallocating capital into credit securities in light of recent economic and financial developments. In this article, we will explore his memo further and then share some of our top picks of the moment in light of his commentary.

The Marks Memo: Rethinking The Investment Landscape

In his memo, Mr. Marks begins by reflecting on the adage "this time it's different," cautioning investors against the perils of rationalizing high valuations, while also acknowledging that on rare occasions, fundamental shifts in markets do indeed occur that warrant a reevaluation of investment strategies. He goes on to make the case that the current investment environment might be one of those rare instances where things genuinely have changed in a significant and lasting manner, thereby necessitating a change in investment strategies.

While the Federal Reserve's decision to lower the fed funds rate to zero in late 2008 and the ensuing 13-year period of accommodative policies and low interest rates benefited asset owners and borrowers, they also fostered complacency among asset owners and eagerness among potential buyers. Moreover, the subsequent Covid-19 relief measures - coupled with supply-chain disruptions - led to a classic inflationary scenario of too much money chasing too few goods. This produced persistent inflation in 2021 and 2022, forcing the Fed to abandon its accommodative stance and raise interest rates dramatically while ending its quantitative easing ((QE)) program to the point where it is now actually engaging in quantitative tightening by letting assets roll off of its balance sheet as they mature.

Perhaps the most gripping part of Marks' memo to me was his mention of the 2,000-basis-point decline in interest rates between 1980 and 2020, which he believes was largely responsible for the majority of investment profits during that period. Long-term macro trends, such as this four-decade long decline in interest rates, can go unnoticed yet have a profound impact on investment outcomes. Moreover, it is important to keep in mind that most investors alive today have only witnessed declining or ultra-low interest rates, and even those who were in the markets during the high interest rates and high inflation of the 1970s have been out of it for so long that it is likely that they have fallen into a bit of complacency about low interest rates as well. As a result, it is quite possible that the market's perception of what is considered a "normal" interest rate is heavily skewed towards lower levels than what has typically occurred over the course of history.

As a result, Marks is skeptical - as should we all - that we are going to soon return to near zero percent interest rates, and also believes that the outcome of a higher interest rate range moving forward may slow economic growth, erode profit margins, lead to higher business bankruptcy rates, and result in less reliable asset appreciation in both the public and private markets.

As a result, assumptions that investment strategies and asset classes that have boomed over the past decade or even longer may turn out to be misguided.

Marks: Why You Should Sell Equities And Buy Credit

Marks also devotes considerable space in his memo to making the case for why credit securities are likely a much better risk-adjusted investment than equities at the moment. As a result, he believes that it may be prudent for investors to reallocate their capital accordingly, particularly into high-yield bonds.

While the preceding 13 years presented a bleak scenario for credit investors, characterized by the lowest prospective returns across various asset classes, the present environment promises higher prospective returns given that high-yield bonds now yield over 8%. As a result, the expected pre-tax yields from non-investment grade debt investments now approach or even surpass the historical returns from equity, with the added advantage of being contractual returns and in some cases even secured by underlying businesses and/or hard assets, providing a measure of predictability and security.

Moreover, given that there is considerable uncertainty about the future direction of the economy, it is important to note that credit investments - unlike equities - are not dependent on market behaviors and are not as sensitive to economic growth for generating total returns. While every investment comes with its risks - which include borrower defaults and lack of appreciation potential in the case of sub investment grade credit - the stability and promising yields of credit securities, especially amidst the aforementioned potential sea change in the investment environment, make them an increasingly attractive candidate for inclusion in investment portfolios.

Our Top Picks

Given that the stock market's major indexes such as the S&P 500 ( SPY )( VOO ) and the Nasdaq ( QQQ ) are significantly overvalued based on just about every major valuation metric out there - even as interest rates are at levels not seen in a long time - we have to agree that the relative value proposition between most stocks and most bonds has changed fundamentally. For example, the U.S. 10-Year Treasury yield is at levels not seen since mid 2007, yet SPY's P/E ratio is ~30% higher today than it was when interest rates were last where they are today:

Of course, what happened to stocks in the months that followed was one of the worst market crashes in history and the economy was plunged into the "Great Recession." While no one knows for sure what will happen this time, the odds definitely seem to be increasingly leaning in favor of credit securities.

With that said, what are we buying right now? While investment grade bond yields ( CORP ) are up significantly and stand far higher than they ever have over the past decade, they are still less than impressive from a total return standpoint:

However, high yield bonds ( SPHY ) are offering yields of around 7.5%, which puts them in close range of the historical average return of stocks. Given that stocks are so overvalued right now, it is entirely possible - if not likely - that high yield bonds could deliver a total return on par with - or even superior to - stocks over the next 5-10 years:

While high yield/non-investment grade bond ETFs are not bad ways for total return-oriented investors to take advantage of the elevated interest rates available right now, we think there are two even better ways for total return-oriented active investors to take advantage of the rise in interest rates and the relative attractiveness of credit compared to stocks at the moment:

• Buy BDCs ( BIZD )
• Buy triple net lease REITs ( VNQ )

Why do I think this? First of all, BDCs are really nothing more than actively managed diversified portfolios of sub investment grade credit securities. In fact, in many cases, I would argue that BDC portfolios offer much more attractive risk-adjusted returns than investing in a high yield bond ETF, because:

1. The vast majority of the credit securities in BDC portfolios are senior secured (typically with a 1st lien). This is often not the case with high yield corporate bonds.
2. These portfolios are actively managed by large and very experienced teams at some of the world's leading alternative asset managers like Blackstone ( BX ), Oaktree/Brookfield ( BN )( BAM ), Ares ( ARES ), Carlyle ( CG ), KKR ( KKR ), and Blue Owl Capital ( OWL ).
3. BDCs often trade at a discount to the value of their underlying net assets, making them a better value in many cases than buying high yield bonds directly or through an ETF.
4. They apply a reasonable amount of cheap and long-dated leverage to their portfolios, to enhance returns on equity from the high single-digits that you can currently get on high yield bonds to the low to mid-teens, making them very comparable to equity in terms of ROE.
5. They also typically invest in floating rate debt securities, which are much harder to access in such large numbers on the open bond market. As a result, they can double as a great portfolio diversifier for stocks, which typically suffer from rising interest rates.
6. Since stocks are generally much more volatile than bonds and the stock market views BDCs as stocks, BDC management teams can (and often do) exploit the much greater volatility of their stock price relative to the value of their underlying loans by issuing stock whenever it trades at a premium to NAV in order to grow book value and earnings per share and then even buy it back when it trades at a discount to NAV in order to once again grow book value and earnings per share. Ares Capital ( ARCC ) and Main Street Capital ( MAIN ) are two BDCs that have issued equity at a premium to NAV quite effectively over the years, while Blackstone Secured Lending ( BXSL ) and FS KKR Capital Corp ( FSK ) have both been buying back stock recently to exploit discounts to their underlying NAV.

We recently shared five high quality BDCs that offer well-covered (and in many cases growing) yields of 7-13%, which you can look at more closely here .

The other option - buying triple net lease REITs like Realty Income ( O ), W.P. Carey ( WPC ), and NNN REIT ( NNN ) - is also a great way to exploit the increased attractiveness of credit vs. stocks because triple net leases are often viewed as financial instruments akin to credit. This is because businesses often turn to triple net sale leasebacks with these REITs as an alternative means of raising capital instead of going to a BDC or other lender. Moreover, the structure of these leases - long-dated, contractual, with low expenses and risks for the landlord, and regular fixed or indexed rent bumps - makes them very much like a debt instrument substitute. As a result, the stock market has sold off these REITs quite aggressively in order to push up their yields in line with the rise in interest rates.

Today, you can buy them at dividend yields ranging from 6-8% (making them akin to high yield bonds) and cash flow yields of 8-10%, while also buying them at equity valuations that are considerably less than the underlying private market value of their real estate. Moreover, they also offer a low to mid-single digit annualized growth rate to their high yields and these REITs almost all have strong investment grade balance sheets and business models that have held up extremely well through multiple recessions and other macro crises. They therefore make great credit-like investments that could very possibly - and in fact likely - outperform the major equity indexes on a risk-adjusted basis for years to come.

Investor Takeaway

We believe that Howard Marks is correct: a massive shift has taken place in markets in recent years as interest rates have risen rapidly, yet the major indexes remain near all-time highs and trade at very elevated valuations. As a result, we think it is prudent for investors to buy credit-like securities hand-over-fist right now. In particular, we find triple net lease REITs and high quality BDCs to be particularly attractive places to allocate capital at the moment.

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