Beutel Goodman Speaker Series…Featuring Bruce Flatt, CEO of Brookfield Asset Management

Beutel Goodman Speaker Series…Featuring Bruce Flatt, CEO of Brookfield Asset Management

On September 10, 2019, James Black, Vice President, Canadian Equities led a fire-side chat with Bruce Flatt, Chief Executive Officer at Brookfield Asset Management for the latest event in our Beutel Goodman Speaker Series. Bruce joined Brookfield in 1990 and was named CEO in 2002. Under his leadership, the company has developed a global operating presence in over 30 countries, giving him unique insight into many of the issues facing the world today.

Brookfield Asset Management, a company with over US$350 billion in assets under management and investments in real estate, infrastructure, renewable power and private equity, has been an investment in our Canadian Equity strategies for several years. What follows is an edited transcript of a highly insightful exchange that covers everything from the origins of the company to recent acquisitions to Bruce’s outlook for the global economy.

James Black…

Thanks very much and welcome everybody. We are thrilled to have you join us today, Bruce. Full disclosure: in addition to Beutel Goodman having owned the stock since 2014, I was an employee at Brookfield Asset Management for about two and a half years, around 12 years ago. Brookfield has been a substantial contributor to the investment performance of our funds, and most importantly, to the capital appreciation of clients’ portfolios. So Bruce, on behalf of all of us, thank you. I was hoping we could start by stepping back in history a bit and talking about the origins of Brookfield to help people who are less familiar frame how the company has evolved from an owner of assets across a number of asset classes to both an owner and an asset manager.

Bruce Flatt…

Thanks James, and I’ll just start off by saying thank you everyone for coming. I am proud that Beutel Goodman is an investor in Brookfield.

As to the origins of Brookfield, here’s what I would start with: sometimes you get lucky in business. One of our people came upon a very interesting idea 25 years ago, and we invested into all of the things we do today at that point in time. At that time we were also invested in a lot of other assets, but we disposed of them because they were commodity-related, highly volatile businesses and although they tended to do really well if you picked the right timing, they did poorly over long cycles. If you invested in them on a cost-of-capital basis, it was very tough to make a return over a long period of time as a permanent investor.

Instead, we decided to focus on core businesses that we still have today: real estate, infrastructure, renewable power and our industrial business, which we call our private equity business. At that time, we concluded that the only legitimate way that we could expand the business and get to the scale we needed was to find capital to invest beside us. We thought about different ways we could do this and came upon the idea that if we could provide these products to institutional clients, they would place them into their portfolios and we could earn them a reasonable return. At that point in time, some competing funds were investing directly in real estate, but nobody did infrastructure or renewables, and private equity was just starting out as an allocation in U.S. plans via some of the big private equity players.

I’d say this is where luck played into it: over the last 25 years, institutional pools of money grew exponentially, while interest rates declined from 8.5%-9% to 1-2%. This combination of events meant that our first institutional investors did very well with us and with others who provided the same types of alternative products. It gave them the confidence to continue to invest, but more importantly—and this is the luck—some of the institutional funds are so large now that they almost have no other choice than to put money into alternatives. When you get to a point where you can’t roll a 2% coupon over in a fund; when those coupons are now negative, you just can’t legitimately invest in fixed income when rates are negative. Every Japanese client we have, every Korean client we have, every European client we have is in this situation.

We experienced this for 10 years in Japan and it’s starting in Europe today, so the wall of money is pushing somewhere else. I’m not a macro-economist and I don’t try to be, but I think the enormous pressure on the U.S. Treasury at 30 years and 10 years is because of these institutional clients with massive rollovers of capital and nowhere else to go. There really are only three places in the world where all of that money can go: equity markets, alternatives, and U.S. treasuries. U.S. treasuries are at least positive today, but it’s scary to buy them at 1%—at best you’re going to earn 1% for 30 years, and they [rates] might go up to 2% and you’d lose a lot of money.

We got really lucky. We executed and took a business that was largely investing for our own balance sheet—and we still do that—but now we’re investing on behalf of an enormous client base. With every transaction, about 20% of the money is sourced from one of the discretionary balance sheets we have control over and 80% from institutional clients. That has been a big change in the business and we’ve had a great ride. We’ve compounded at 17%, 18% for 20 years. But I really think the wall of money is only starting.

James Black…

In addition to the private funds and the institutional clients, you have a second source of third-party capital—your listed investments in your four major asset category partners: Brookfield Property Partners, Brookfield Infrastructure Partners, Brookfield Renewable Energy Partners, and Brookfield Business Partners, your private equity listed fund. What roles do they fill in your asset-management strategy?

Bruce Flatt…

Fifteen to twenty years ago, we thought what we needed was broad access to liquidity, because the things we buy, own, build and run have enormous asset values. The one tower at Brookfield Place – which we are looking out at—alone, for instance, is worth $1.6 billion to $1.7 billion. We looked at master limited partnerships in the United States and thought, “How can we adapt those models to benefit our investors?”

We created all four of our partnerships listed on the New York and Toronto stock exchanges through spin outs. Brookfield Asset Management kept 30%-40% and gave the balance of the shares of the spinoffs to existing shareholders, thus creating the permanent partnerships that invest beside our institutional clients. The way we think of them is we provide our institutional clients real estate expertise, infrastructure expertise, power expertise, or private equity expertise and we provide the same thing to retail investors in the stock market by having these listed vehicles. We have discretion over the investments just like we have with our institutional clients, and it just gives us a different source of capital, which allows us to do things that most other investment managers we compete with can’t do. These permanent capital vehicles give us access to the capital markets and they help us build the business significantly. They participate in exactly the same areas our institutional clients participate in.

James Black…

Can you talk a bit about Brookfield’s investment strategy?

Bruce Flatt…

Our view is that capital in a business should either have a strategic advantage when invested or it should be given back to shareholders and somebody else should take that capital and invest it where there is strategic advantage. We care a lot about capital allocation and organically over the last 25 years, we’ve come upon three things that give our capital an advantage:

1. Because of our institutional clients, our partnerships and our own balance sheets, we have access to more money than most people in the world, so a $100-million transaction may have 35 investors who can bid for it; a $1-billion transaction may have 8; and a $5-billion transaction may have 3—and once in a while, there may only be 1 or 2 people who can bid for it. That is an enormous advantage, so we try to use that as a strategic advantage and we’ve gotten to a point where most things we do have a scale.

2. We have people in 30 countries around the world who ensure that when we make mistakes, we can dig our way out. We know how to get money into and out of a country. We know the rule of law and whether or not a nation respects capital. We only go to places that adhere to our strict criteria. Most importantly, we are value investors, and the only way we felt we could continue to be value investors was to be diversified not just across industries but also across countries, because countries don’t all act the same way at the same time. This allows us to move money to the places that require capital, and therefore the large sums of money on the margin are always being allocated to these value-based places.

3. The value of having strategic partners is the 100,000 people who work for Brookfield. They work for those partnerships; they stay within those businesses; they are permanent to us. This gives us an enormous differentiation of the capital that we have.

James Black…

What we find attractive about Brookfield as an investment is that in many ways, your approach is valuebased, long-term—you buy stuff that in most cases you can own forever. That’s very much how we look at investments. We have a minimum three-year time horizon and we want a 15% annual return over that time horizon with new investments. Brookfield has a similar approach, depending on the asset class, but would look for a mid-double-digit return on assets over time. So this is a very easy company for us to own because we understand the basis on which the investment decisions are being made. I’d love to hear a couple of war stories when it comes to investments. Maybe one that worked out better than you thought it would and one that didn’t, and what you took away from those.

Bruce Flatt…

Well James, in a record that is pretty good over a long period of time, I can tell you that we’ve made a lot of mistakes. Maybe the most important thing we’ve found about making mistakes is never bet the franchise on anything, and if you do bet, be very aware of the mistakes you make and learn from them instead of letting them destroy the franchise.

The biggest thing for us is going into new industries or new businesses or new countries – and I’ll say this about Canadian companies – about 30 years ago I started going to the U.S. and trying to build the business. The horror stories you’d hear about Canadian companies going to the United States and getting their feet blown off was just tragic. It destroyed a lot of management teams’ incentive to build their businesses in the U.S. We did it slowly and I think that was really important because if you blow your feet off in an investment, even if it doesn’t harm the company irreparably financially, what it does is take away the confidence of the management team or the board, and it takes years or decades to reverse that in a corporate culture. So for us it’s really important that we don’t make any really large mistakes, although we have made lots of small ones.

One mistake that may be relevant to some of you is investing in foreign places, even if that is just buying stocks outside of your native currency. Often people don’t think about currency; they think they’re a genius to have bought something that has gone up 40%, until they figure out that 40% after a 40%-decline in the currency is actually a loss.

We had been in Brazil for a long time, just due to some of the history of the company. We sold a lot of assets back in 2005-2007, but then the financial crisis arrived there and we doubled down, tripled down. We bought some amazing assets—in fact, we bought a lot of these assets, I would say, at 25 cents on the dollar. But the currency declines took an amazing turn and made it just okay. I’m not sure that the risk we took was compensated by the return we got after the currency loss. We kept investing and kept doubling down, which I would say is an important tenet of value investing, and because of that some of the returns we had were stunning. So we did fine overall, but the point is, when investing in international markets, paying attention to currency is really important.

By and large, we hedge – even though it costs us – in most currencies back to U.S. dollar if we can. The sums of money we deal in are very large and posting collateral with currency hedging is in itself risky, so most people don’t pay attention to that. We spend a lot of time thinking about it and we’ve learned a lot over the years through mistakes in that area.

James Black…

Building on that, one thing that Brookfield has been able to do very well is take advantage of dislocations at different points in time and make transformational deals that either establish you in a new asset class or help you build critical mass. A couple that spring to mind are the World Financial Centre in the early nineties and Babcock & Brown post-financial crisis on the infrastructure side. Do you think we might see that kind of dislocation again, where Brookfield can step into the void?

Bruce Flatt…

Our view is always informed by what we see within our business. Overall, we see nothing that really says there is going to be a total meltdown in the economic situation of any country, particularly in the United States, which continues to do pretty well even though some people quote technical problems. In general, the global economy is operating quite well.

Despite that, we’re worried that we’re 11 years into an economic recovery, stock markets are at highs, bond markets are at highs and politics are crazy everywhere. I have the benefit of travelling country to country to talk to our people, and every one of them is focused on their own politics. If you just go through the list it’s very worrying, but while we’re cautiously investing in more defensive areas than we would have five years ago, it’s not because we see anything out there. It’s because our business is about ensuring we earn a reasonable return over the long term, and the enormous amounts of money are prepared so that we have capital when others don’t. To give you an indication of what we’re doing, we have more cash on the balance sheet than we ever have before and more capital available for institutional clients than ever before. We also bought Oaktree, which is a credit manager, and we partnered with the founders of it because we think at some point in time our balance sheet and relationships, combined with the capital behind their franchise, will allow us to do extremely well coming out of a market downturn.

JamesBlack…

Culture in successful companies is extremely important, and Brookfield has always had a culture of ownership among its employees, meaningfully investing in the stock of the company alongside shareholders. My view is that this differentiates you from other asset managers where staff is more transitory in nature and more focused on short-term compensation than long-term. As you’ve grown, how have you been able to retain that same culture that was in place when I was there, and how do you integrate—or not integrate—a new investment, a new asset class like Oaktree, into that culture?

Bruce Flatt…

It’s more difficult as you get larger for any organization to ensure that the culture stays the same. Despite that, I think the advantages of scale we have in place outweigh the disadvantages that come with the issues of size. We’ve tried to keep our principles, which are pretty simple: eat your own cooking, be invested alongside everyone that is there, and make money for your clients. The one thing I learned in life is that if you make money for your clients, they will come back for more. If we didn’t make money for you, James probably wouldn’t have invited me here. We’ve tried to keep it simple. People can make a lot of money with us over a long period of time if the company does really well.

With respect to Oaktree, it’s run by a man named Howard Marks—he’s what I’d call a legend in distressed investing. He and Bruce Karsh started the firm 24 years ago and still run it, and their record is exceptional. We visited them and said ‘we’d like to take the public out of the company and become your partner’. They looked at me and said ‘it’s the wrong time to sell, we don’t want to sell’. And we said ‘no, no. You’re not selling, you’re actually staying in. If you’re selling were not buying.

So we’re buying the public out, in a half cash, half Brookfield Asset Management shares deal, which we very seldom do. So they are coming along with us, the public market investors, and Howard, Bruce and their management team will own 40% of the franchise after the deal closes, so they will remain highly incentivized alongside of us to continue to build the business. Simply stated, our machine behind them should allow them to do more with what they have than what they could do on their own.

James Black…

… and will they give you some interesting client relationships as well that you don’t have access to today?

Bruce Flatt…

I think it will be additive both ways. We have an amazingly strong franchise for fundraising in the Middle East. For unusual reasons, we invest capital for virtually every sovereign plan and institutional client in every country in the Middle East. And they have, I’m quite sure, fewer relationships there than we have, and therefore we will be very helpful to them in that market. Howard’s been raising money in the U.S. for a long time and has an amazing track record, and I think his shine on us will help us a lot. So I think it will be additive both ways, and I think we can help them scale up their business in ways that they otherwise would not be able to do.

Website,

https://www.beutelgoodman.com/assets/searchable/In-Conversation-with-Bruce-Flatt-Brookfield.pdf

Do not follow fashion, follow value for big returns in long run, says Bruce Flatt

Do not follow fashion, follow value for big returns in long run, says Bruce Flatt

Another good article about Bruce Flatt and his investment philosophy...

Bruce Flatt, CEO of Brookfield Asset Management, says going against the crowd and maintaining a contrarian approach is often a very lucrative strategy in investing, if accomplished.

He also says companies should seek profitability rather than growth, because growth does not necessarily add value.

Brookfield Asset management is a leading global alternative asset management firm with a focus on real asset sectors of real estate, renewable power and infrastructure.

Flatt says while most investors follow fashion, those who do not follow fashion but follow value tend to earn much greater returns in the long run.

He says there was never a secret recipe or a particular strategy that his firm followed over the years to become successful in real asset investing. It was based more on a value thesis, where his company tried to learn and develop a strategy that worked for it.

“The number one thing that I would say to anyone is that there’s never a right strategy in investing. It’s whatever strategy fits you and what you want to do. For us, though, we generally have always operated with a methodology where we try to walk away from the cliff. One should always look for opportunity away from where the crowd is going, and not go with the crowd. In real asset investing, that’s a very important lesson to learn,” he said in a presentation made at the Talk @ Google, whose video is available on YouTube.

Talking about the investment guidelines that his company developed and followed over the years, Flatt says it is important to identify places where companies have a competitive advantage and invest in those areas.

“It is best to always invest on a value basis with a goal of maximising return on capital and look to buy assets or find assets that have cash flow inherent in them or can be built within the business,” says he.

Measure success to know where you stand

Flatt says it is absolutely essential to measure success to know where you stand against competition. There are four things that can be looked at to evaluate this.

First, companies should measure success based on total return on capital over the long term, which would prevent them from making the mistake of looking at short-term objectives within the business.

Next, companies should try to encourage its people to take calculated risks, which should be compared with the return that one might get out of the investment.

To be successful, it is also important to sacrifice short-term profit, if necessary, to achieve long-term capital appreciation.

And lastly, companies should seek profitability rather than growth, because growth does not necessarily add value.

Follow this business philosophy to become successful

Sharing his views on the business philosophy that one should follow, Flatt says it is important to build a business and all relationships based on integrity as running a business for the long term needs strong relationships, both outside the company and with the people within the business.

It is also important to attract and retain high-calibre individuals who can grow with the company over the long term and ensure that these individuals think and act like owners in all their decisions.

It is necessary to treat the client and shareholder money like it’s their own before making a business decision.

Keep business model very simple

Flatt feels it is crucial to keep the business model very simple.

Referring to his own company’s business model, he says they try to utilise their global reach to identify and acquire high-quality real assets on a value basis and finance them on a long-term, low-risk basis.

Further, they enhance cash flows and value of these assets through their leading operating platforms and source equity from clients seeking exposure to property and infrastructure returns. This strategy, Flatt says, should be repeated over and over with assets with similar cash flow characteristics.

Competitive advantage key to remain ahead

Revealing why they have been better than competitors, Flatt says it has been because they use competitive advantages in everything they do.

Although size of a company does not necessarily generate profitability, given the scale of their company, they have been able to use size as a differentiator.

The global businesses they have built over the years have enabled them to move capital to locations where it is scarce and allowed them to take ideas and turn them into actionable opportunities, Flatt says.

They have also been able to use global unrestricted funds, which have allowed them the freedom to seek value where available.

Also, people-enabled execution capabilities have given them a strategic advantage to be able to run the businesses and operate them efficiently.

“Often our investments are longer term and are more illiquid than others. So, our advantage is that we’re willing to be longer-term investors, and we’re willing to have something that’s illiquid versus what others might accept. Often they’re larger in size, and that’s not attainable by others. And most of the time, when we’re making investments, it’s not fashionable. Most investors follow fashion. If you cannot follow fashion and follow value, the returns will be much greater over the longer term,” he says.

Invest in real assets to generate strong returns

Flatt says real assets have a strong return profile to invest into, as they earn good cash-on-cash yields and can be contracted for longer durations. Also, cash flows adjust with inflation or by other means and assets are scarce and often appreciate in value.

The private nature of these assets ensures low volatility and the returns are far greater than other options available to institutions, he says.

Flatt feels it is a very good time to be a real estate investor, as institutional capital is growing exponentially and increasing percentages are being allocated to real assets due to the returns they offer.

“The most important things that are happening is that the institutional plans are putting more money into real assets. And if you look back to 2000, the percentage in their portfolios in general was 5%. Today, it's 25%. And we think that number will be 40% by 2030. And what's happening with that there's this therefore an exponential increase of money being taken out of equities and bonds going into these type of real assets as they can offer 6% to 20% returns,” he says.

Things to watch out for before investing in real assets

Flatt offers some guiding principles which he says should be kept in mind before investing in real assets.

He believes investors should buy great quality assets even if one has to pay a little more for it.

Next, he suggests investing in assets assuming they will be owned forever, an approach that would enable investors to look at them with the long-term fundamentals involved.

Also, he feels while buying a real asset it is essential to buy it at less than the replacement cost. “It most often indicates value because the competitive product that will ultimately compete against you will cost more than what you paid. So you should be able to either earn a higher return or out price your competition during the investment. And that's probably the number one thing, which is why in our business what you're always trying to do is to move your capital to the places where others are not,” he says.

Flatt also warns investors to avoid misfinancing their assets as it is of utmost important to ensure surviving the market downturns.

While looking for investment opportunities investors should look to acquire assets where capital is scarce as it is the best indicator of the right time.

“In 2016, we bought a graphite electrode company in the United States out of bankruptcy. And at that time, the steel market was incredibly under stress. But we were able to purchase it and it was really only because there was nobody else in the market that would put capital into the steel industry at that point in time. We've now taken it public at eight times the price that we paid,” he says.

Flatt advises investors to keep a balance between being too positive or too negative while investing in real assets. He also feels investors have a tendency of getting too influenced with news media and stories which needs to be kept in check.

Flatt believes real estate businesses are difficult to operate but hard work and smooth execution can be a key to earning decent returns.

Avoid these mistakes while investing

Flatt thinks making mistakes is a very common thing in investment and it is important to learn quickly from them to avoid huge losses.

“It's not possible in investing not to make mistakes. So we try to limit the number of mistakes and try to limit their effect,” he says.

Flatt lists out some of the common mistakes that investors generally make.

According to Flatt, investors get attracted towards a bad business believing that it will be okay if acquired cheaply.

Also, often investors start too large in a new business or a market leading to losses later.

There are times when investors get the compensation incentive plans wrong and occasionally they are not as strict on the financial covenants in an up market as they should be.

There are also times when investors take on an undue development risk in unstable or new jurisdictions.

 
Various investment opportunities lie ahead

Flatt believes that the world around us is constantly changing and is continuously growing and evolving which has opened up various opportunities for investors.

There are significant retail real estate opportunities and the integration with retail and the internet will bring significant opportunities over the next 10, 15 years, he believes.

Secondly, there is a great opportunity in the renewable power industry as it has changed dramatically over the past 10 years.

Flatt also feels that natural gas revolution particularly in North America has resulted in changes across industries which is going to continue globally.

And also there are a number of real asset technologies that can be deployed to make operational improvements and enhancements within the businesses, says he.

Buy great investments and leave the rest to the power of compounding

Flatt concludes by saying that the most amazing thing that the investment world has is the compounding of return.

“The wealth that can be generated through compounding of returns is significant. It's amazing what it accomplishes if you don’t make too many mistakes or lose capital on the way through and you just keep compounding a return. And it really is an amazing concept in the world of investing,” he says.

Flatt finally advises investors to continue buying great investments and holding them for compounding returns.

“Don't pay taxes by selling them. And don't look for fashion when you make them,” he says.

Anupam Nagur, ETMarkets.com, April 17, 2019

https://economictimes.indiatimes.com/markets/stocks/news/do-not-follow-fashion-follow-value-for-big-returns-in-long-run-says-bruce-flatt/articleshow/68921712.cms

Portfolio Postioning, Excerpt from Howard Marks latest Memo, April 6, 2020

Portfolio Positioning

 Solid advice from Howard Marks as always concerning how to position and adjust one's investment portfolio in lieu of the current market environment. The object of this exercise is to expunge your emotions from the investment process and take a longer term view as to where the market is in its cyclic process...

 One of the benefits I derive from writing my memos is that the more I work on a memo about something, the more it comes into focus.  Thus the four March memos gave me a great opportunity to ponder what the events imply for investment behavior.  I’m glad to say I’ve reached a conclusion on that subject.  I feel strongly that it’s right . . . and I fully expect to amend it in the future.  (To set the scene, the next few paragraphs will be repeat things I’ve said in the past.) 

 In recent years I’ve become more and more convinced that the fund manager’s most important job for the intermediate term isn’t to decide the allocation of capital between stocks versus bonds; U.S. versus foreign; developed markets versus emerging; large-cap versus small-cap; high-quality versus low-quality; or growth versus value.  And it isn’t choosing among strategies, funds and managers.  The most important job is to strike the appropriate balance between offense and defense.  Those other things won’t help much if you get offense/defense wrong.  And if you get offense/ defense right, those other things will take care of themselves.

 One way to think about the balance between offense and defense is to consider the “twin risks” investors face every day: the risk of losing money and the risk of missing opportunity.  At least in theory, you can eliminate either one but not both.  Moreover, eliminating one exposes you entirely to the other.  Thus we tend to compromise or balance the two risks, and every individual investor or institution should develop a view as to what their normal balance between the two should be. 

 Next, investors might consider trying to calibrate their balance over time in response to conditions in the environment – thus the title of this memo:

 The more propitious the environment – the more prudently other investors are behaving, the better the outlook for earnings, and the lower security prices are relative to intrinsic value or “fundamentals” – the more an investor might want to shift toward offense.

• On the other hand, the more precarious the environment – the more others are embracing risk, the more headwinds to profits there are, and the higher valuations are – the more an investor might choose to emphasize defense.

 In recent years, it’s been my view that the investment world was marked by the following characteristics:

• more uncertainty than usual,
• extremely low prospective returns,
• full to high asset prices, and
• pro-risk behavior on the part of investors reaching for higher returns.

 These things told me the world was a risky, low-return place, and for that reason Oaktree’s mantra has been “move forward, but with caution.”  We’ve generally been fully invested, but with even more than our usual caution.  We made a decision to overweight defense, and there were years in which higher risk produced higher returns, and we paid a price for being cautious.  We had no idea what the catalyst would be that turned the risk into loss, and there were no obvious candidates.  But we felt the world was a risky place, exposed to negative developments.  Now we know the catalyst, and now portfolio risk has produced loss.  That’s the background.

 As described above, I felt the uncertain, low-return environment called for defense to be over-weighted relative to offense.  Now, however, as opposed to the conditions of 2, 6, 12 or 24 months ago:

• the risks in the environment are recognized and largely understood,
• prospective returns have turned from paltry to attractive (for example, the average yield on high yield bonds ex. energy has gone from 3½% to almost 9%),
• security prices have declined, and
• investors have been chastened, causing risk-taking to dry up.

 Given these new conditions, I no longer feel defense should be favored.  Yes, the fundamentals have deteriorated and may deteriorate further, and the disease makes for risk (remember, I’m the one who leans toward the negative case).  But there’s a big difference between a market where no one can find a flaw and one where people have given up on risk-taking.  And there’s a big difference between one that’s priced for perfection and one that allows for bad outcomes.

 Cautious positioning in recent years has served its purpose.  Investors who favored defense over offense have experienced smaller losses this year, have the satisfaction that comes from relative outperformance, and are able to spend more of their time looking for bargains than dealing with legacy problems.  Thus, I feel it’s a time when previously cautious investors can reduce their overemphasis on defense and begin to move toward a more neutral position or even toward offense (depending on how sure they want to be of grasping early opportunities). 

 I’m not saying the outlook is positive.  I’m saying conditions have changed such that caution is no longer as imperative.  With part of the crisis-related losses having already taken place, I’m somewhat less worried about losing money and somewhat more interested in making sure our clients participate in gains.  My 2018 book, Mastering the Market Cycle, carries the subtitle Getting the Odds on Your Side.  In that vein, I now feel the odds are more in investors’ favor or, at a minimum, somewhat less against them.  Portfolios should be calibrated accordingly.

Looking for the Bottom

 Before I close, just a word on market bottoms.  Some of the most interesting questions in investing are especially appropriate today: “Since you expect more bad news and feel the markets may fall further, isn’t it premature to do any buying?  Shouldn’t you wait for the bottom?”  

 To me, the answer clearly is “no.”  As mentioned earlier, we never know when we’re at the bottom.  A bottom can only be recognized in retrospect: it was the day before the market started to go up.  By definition, we can’t know today whether it’s been reached, since that’s a function of what will happen tomorrow.  Thus, “I’m going to wait for the bottom” is an irrational statement. 

 If you want, you might choose to say, “I’m going to wait until the bottom has been passed and the market has started upward.”  That’s more rational.  However, number one, you’re saying you’re willing to miss the bottom.  And number two, one of the reasons for a market to start to rise is that the sellers’ sense of urgency has abated, and along with it the selling pressure.  That, in turn, means (a) the supply for sale shrinks and (b) the buyers’ very buying forces the market upward, as it’s now they who are highly motivated.  These are the things that make markets rise.  So if investors want to buy, they should buy on the way down.  That’s when the sellers are feeling the most urgency and the buyers’ buying won’t arrest the downward cascade of security prices.

 Back in 2008, on the heels of Lehman Brothers’ September 15 bankruptcy filing, Bruce Karsh and his team embarked on an unprecedented program to buy the debt of companies in distress.  They invested an average of roughly $450 million per week over the last 15 weeks of the year, for a total of nearly $7 billion.  Debt prices collapsed throughout that period, and they continued to fall in the first quarter of 2009 (along with the stock market).  But because the hedge funds facing withdrawals had been gated – and because the leveraged, securitized vehicles that would melt down had all been liquidated – large amounts ceased to be for sale after year-end.  In short, if we hadn’t bought in the fourth quarter, we would have missed our chance.

 The old saying goes, “The perfect is the enemy of the good.”  Likewise, waiting for the bottom can keep investors from making good purchases.  The investor’s goal should be to make a large number of good buys, not just a few perfect ones.  Think about your normal behavior.  Before every purchase, do you insist on being sure the thing in question will never be available lower?  That is, that you’re buying at the bottom?  I doubt it.  You probably buy because you think you’re getting a good asset at an attractive price.  Isn’t that enough?  And I trust you sell because you think the selling price is adequate or more, not because you’re convinced the price can never go higher.  To insist on buying only at bottoms and selling only at tops would be paralyzing.  

 On the contrary, I gave this memo the title Calibrating because of my view that a portfolio’s positioning should change over time in response to what’s going on in the environment.  As the environment becomes more precarious (with prices high, risk aversion low and fear lacking), a portfolio’s defensiveness should be increased.  And as the environment becomes more propitious (with prices low, risk aversion high and fear prevalent), its aggressiveness should be ramped up.  Clearly, this process is one of gradual readjustment, not a matter of all-or-nothing.  It shouldn’t be the goal to do this only at bottoms and tops.

 So it’s my view that waiting for the bottom is folly.  What, then, should be the investor’s criteria?  The answer’s simple: if something’s cheap – based on the relationship between price and intrinsic value – you should buy, and if it cheapens further, you should buy more. 

 I don’t want to give the impression that it’s easy to buy while prices are tumbling.  It isn’t, and in 2008, Bruce and I spent a lot of time supporting each other and debating whether we were buying too fast (or too slow).  The news was terrible, and for a good while it seemed as if the vicious circle of financial institution meltdowns would continue unchecked.  Terrible news makes it hard to buy and causes many people to say, “I’m not going to try to catch a falling knife.”  But it’s also what pushes prices to absurdly low levels.  That’s why I so like the headline from Doug Kass that I referred to above: “When the Time Comes to Buy, You Won’t Want To.”  It’s not easy to buy when the news is terrible, prices are collapsing and it’s impossible to have an idea where the bottom lies.  But doing so should be the investor’s greatest aspiration.

As for the current episode, here’s some data from Gavekal Research’s Monthly Strategy piece for April, bearing on the question of whether the bottom was passed in March:

. . . markets rarely clear after one massive decline.  In 15 bear markets since 1950, only one did not see the initial major low tested within three months . . .  In all other cases, the bottom has been tested once or twice.  Since news-flow in this crisis will likely worsen before it improves, a repeat seems likely.

And here’s some data from my son Andrew regarding the movements of the S&P 500 index around the time of the last two big crises.  The first and second declines were followed by substantial rallies . . . which then gave way to even bigger declines:

9/1/00 - 4/4/01	-27%
4/4/01 - 5/21/01	+19%
5/21/01 - 9/21/01	-26%
9/21/01 - 3/19/02	+22%
3/19/02 - 10/9/02	-33%
10/9/07 - 3/10/08	-18%
3/10/08 - 5/19/08	+12%
5/19/08 - 11/20/08	-47%
11/20/08 - 1/6/09	+25%
1/6/09 - 3/9/09	-27%

 Gavekal’s and Andrew’s data tell us markets rarely rally in a straight line.  Rather, their movements represent a continuous tug-of-war between the bulls and the bears, and the result rarely goes in just one direction.  After the optimistic buyers of the initial dips have responded to the low prices and bought, the pessimists find the new, higher prices unsustainable and engage in another round of selling.  And so it goes for a while.  Thus, as Oaktree’s Wayne Dahl points out, it took until mid-May 2007, or almost seven years, for the stock market to regain the September 2000 highs, and it took until mid-March 2013, or five and a half years, to regain the highs of October 2007.

The bottom line for me is that I’m not at all troubled saying (a) markets may well be considerably lower sometime in the coming months and (b) we’re buying today when we find good value.  I don’t find these statements inconsistent. 

Howard Marks, Excerpt from latest Memo, April 6, 2020

Update for Brookfield Shareholders as of 03/23/2020

Update for Brookfield Shareholders as of 03/23/2020

Dear Shareholders,

Given all the market volatility of the last few weeks, we thought it would be helpful to provide an update on where we stand as a company. No one is immune to the issues we are all dealing with, but as you know from our letters over the years, we have been expecting a recession and market washout for some time. Nobody could have predicted that the coronavirus would be the cause, but the markets sure turned over the last month.

As to our positioning and readiness for this, we believe we are in very good shape. We think it is important for you to know a few points:

• We have approximately $12 billion of bank lines in BAM and our four listed affiliates, all of which are very long-term, and importantly are all virtually 100% undrawn with global financial partners who we trust.

• We have approximately $5 billion of financial and non-core assets that can be liquidated with relative ease (even in today’s markets) should we so choose, to fund strategic investments or take care of issues. Many of these are hedged with index hedges so even if markets are down, this should offset marks that may come about due to the environment.

• We have only $7 billion of corporate debt (against an equity market cap of $40 to $60 billion – depending on the day) and none of that debt is coming due for many years. Similarly, in our private funds and listed affiliates, we have very little debt coming due over the next few years. To the extent that we have debt due, they are financings and mortgages secured by individual assets (which confines any impact to the asset). However, even in 2008/09 we were able to roll those over.

• We have no ‘hung purchases’. In fact, it’s the opposite – one way or another, every contested deal we tried to do over the past five months, we lost. We remained disciplined, which meant that we did not buy a number of businesses as their price rose. In hindsight, this was good.

• We just finished raising our latest funds and co-investments, totaling over $50 billion. These are only 40% invested, so we have a lot of capital to put to work in this environment. We also have the support of many leading sovereign and institutional investors in the world to augment these resources.

• We partnered with Oaktree last year in anticipation of the debt markets unwinding. Now it’s taking place. The team at Oaktree is accelerating the pace of deployment of their current distressed debt fund and preparing to launch their next fund, which we think could significantly exceed the size of their last. If this turns out to be the case, the addition of this business to ours will be very additive for us and our clients.

• Most of our businesses are very resilient, and we therefore don’t foresee major issues. Of course, with people staying home, business is slowing everywhere. In our operations, for example, our malls will be operating at a significantly reduced rate for a while (but this is a second derivative exposure as we collect rent, not run the stores, and our financing structures are in good shape), and fewer ships will travel to our ports. The bottom line is that while there are certain to be issues across our portfolio, our businesses are diversified, our financing structures are time-tested, and our resources significant to deal with this.

• Much of what we own around the world is critical infrastructure – across our property, infrastructure, renewable power and industrial businesses. We are working with governments and our employees to ensure that these facilities remain operational through this period. While many are at home now, people and companies still need corporate premises, infrastructure, power, broadband, utilities and many other critical services that form the backbone of the global economy, and that Brookfield’s businesses provide. Our teams are doing their best to ensure uninterrupted delivery of these services for our customers, while operating under difficult circumstances.

As to what we do now, here is how we are approaching this market volatility and uncertainty:

• Most importantly, we are staying calm and ensuring our people are safe. For us, compared to the direct hit we took on 9/11, this uncertainty and volatility feels manageable. In 2008, with the banking system failing, real asset owners didn’t know if many lenders were going to exist in the future. Today, the banking system is in far better shape. It never feels very good to have this degree of chaos, but this will pass.

• We are being vigilant and will continue to be disciplined. We will maintain capital for our worst-case scenarios. This is always very important, but even more so now.

• We have switched our focus for investments to the listed stock markets, and through our Oaktree franchise, the traded debt market. There are some stocks and debt starting to trade at a large discount to intrinsic value and we are focused on these. We are also starting to receive calls from companies in need of capital, and we look forward to being helpful to companies in need, where we can.

• Our shares have sold off along with everything else. We have been acquiring, and will continue to acquire our own shares for value when it makes sense – and in time, we are certain they will recover.

• Interest rates are now 100 basis points lower than they were a month ago. The value of many real assets is therefore higher, and our clients’ need for our offerings even greater. In time, this will all flow through to our assets and the valuations of our business.

Finally, a reminder regarding investing in times like these: the underlying value of a business that trades in the public market does not change on an hourly basis. Despite the fluctuations, you own a part of an actual business, not a piece of paper or electronic symbol that adjusts on a minute-by-minute basis.

Acknowledging that the value of some businesses has changed, at least in the short term (airlines being the most extreme example at the moment), the long-term value of many companies – i.e., the discounted stream of cash flows based on an estimate of growth and durability into the future – has not changed substantially over the past few months. The proviso is that a company must be able to pay its liabilities when due (stay solvent), which of course will be an issue for numerous companies in the absence of government assistance. Our focus has always been on structuring our affairs to ensure we can survive all environments, and we are confident we are in this position today.

Most of our cash flow streams are of very long duration with long-term property leases, long-term power sale contracts, and long-term regulated utility rates that provide durable business revenues with strong counterparties. As a result, the change in value of our businesses in the stock market over a few months has very little to do with the underlying businesses that you, as a shareholder, own. Please remember that you each own a portion of the investment management fees our business generates, as well as a portion of each of the durable businesses and assets we own.

It would be less distracting if we all owned this business together privately. That way you could read our materials, look at how each of our businesses is doing, observe the cash flows projected for many years, and not worry about how the stock market, with its short-term focus, values this information. We publish our views of how we value this business, and we encourage you to focus on these values over time (adjusted upward or downward as you see fit) and not on the stock price when volatility is at an extreme. In fact, the main reason to consider the stock price at moments like these is that it allows you to acquire a portion of our business at a large discount from its real value.

It is very easy to invest in the markets when times are good, but it is in times of market decline that following the tenets of value investing matters most. We encourage you to follow them. We know this is a very stressful time for everyone. Please know that we are watching out for your capital.

Be safe and please wash your hands,

Bruce Flatt

Chief Executive Officer

March 23, 2020

Coronavirus May Light Fuse on ‘Unexploded Bomb’ of Corporate Debt

Coronavirus May Light Fuse on ‘Unexploded Bomb’ of Corporate Debt

‘The corporate credit markets also are performing well, but we believe this is where the great value will be found in the next downturn. We are positioning ourselves to capitalize on this – both through our Brookfield funds, and through Oaktree.'

Bruce Flatt, CEO of Brookfield Asset Mangement, Feb 13, 2020

LONDON — To grasp why the most important central banks — from the Fed to the Bank of England to the Bank of Japan — are now leaping into action as if the world were on fire, it helps to examine the subject of corporate debt.

For years, wonks bearing spreadsheets have warned that corporations around the planet were developing a dangerous addiction to debt. Interest rates were so low that borrowing money was essentially free, enticing companies to avail themselves with abandon. Something bad was bound to happen eventually, leaving borrowers struggling to make their debt payments. Lenders would grow agitated, tightening credit for everyone. The world would confront a fresh crisis.

Something bad is now happening. As the coronavirus outbreak spreads, halting factories from China to Italy, sending stock markets plunging and prompting fears of a worldwide recession, historic levels of corporate debt threaten to intensify the economic damage. Companies facing grave debt burdens may be forced to cut costs, laying off workers and scrapping investments, as they seek to avoid default.

“We have been always saying that we are sitting on top of an unexploded bomb, but we don’t know what is going to trigger it,” said Emre Tiftik, director of Research for Global Policy Initiatives at the Institute of International Finance, a Washington-based financial industry trade group. “Can the coronavirus be a trigger? We don’t know. Maybe.”

By the end of 2019, total outstanding debt among corporations other than financial institutions had surged to a record $13.5 trillion worldwide, according to a recent report by Serdar Çelik and Mats Isaksson for the Organization for Economic Cooperation and Development, the Paris-based research institution. That number has swelled as many companies have sold riskier bonds to finance expansions.

Worries about corporate debt appear to be enhancing the panic that has captured world markets, as investors have dumped riskier assets like stocks in favor of safer holdings like United States government bonds.

This was especially vivid on Monday, as markets plunged in reaction to word that Saudi Arabia was driving oil prices lower. Many energy companies are dependent on riskier bonds. For them, lower oil prices translate into lower earnings. They may be forced to cut costs through layoffs or diminished investments to find cash to make their debt payments.

Concern about corporate borrowing also helps explain why the U.S. Federal Reserve last week opted to drop interest rates, and why the European Central Bank is expected to follow suit on Thursday. Lower interest rates limit debt payments for companies that might otherwise fall into trouble.

The concern about the magnitude of corporate debt is an outgrowth of how the world reacted to the financial crisis in 2008. Central banks from the United States to Europe to Japan pushed interest rates to zero and below, spurring companies to borrow and invest.

That approach ended the emergency, but also removed a source of market discipline: It diminished the risk of relying on debt.

Since 2008, corporations worldwide have issued about $1.8 trillion in new bonds each year, a pace roughly double the previous seven years, according to the O.E.C.D. Bond sales slowed in the latter half of 2018, as central banks lifted rates. But as central banks last year lowered rates anew, the debt binge resumed.

The International Monetary Fund last year examined the situation in eight countries including the United States, Japan, China and several European nations. It warned that a shock only half as severe as the global financial crisis would put nearly 40 percent of total corporate debt at risk, meaning that companies would not be able cover their payments with earnings alone.

Not everyone is sounding the alarm. “The prophets of doom who thought that more debt was more risk have generally been wrong for the last 12 years,” said Nicolas Véron, a senior fellow at the Peterson Institute for International Economics in Washington. “More debt has enabled more growth, and even if you have a bit more volatility, it’s still net positive for the economy.”

In contrast to the financial crisis of 2008, few today are worried about the banking system, which holds capital to cover bad loans. The best-financed companies like Apple, Google and Facebook have hundreds of billions of dollars in cash, making them essentially immune to whatever reckoning may lie ahead.

But even some who praise central banks for rescuing the world from catastrophe argue that easy money has outlived its usefulness. Years of loose credit have enabled weak companies to stave off extinction.

“There are whole sectors that survived that should have gone into restructuring,” said Alberto Gallo, head of macro strategies at Algebris Investments, an asset management firm in London. “Retailers in a world of online retail, energy companies with high production costs, small banks in Europe that are not efficient. The availability of funding at very cheap rates has kept zombie companies alive. This means we have an accumulated level of fragility in the economy which can be exposed very easily to real shocks.”

As the coronavirus has spread from Asia to Europe to North America, it has threatened the earnings of companies that have financed their businesses by selling riskier bonds.

The world of bonds can be roughly divided into two realms — those that gain the stamp of approval from credit rating agencies as investment grade, and those deemed to be less secure, bearing so-called junk status. Since 2010, about one-fifth of new corporate bond issuances have been below investment grade, according to the O.E.C.D. Last year, that proportion grew to one-fourth. “Default rates in a future downturn are likely to be higher than in previous credit cycles,” the report said.

Even within the sturdier category, bond markets have taken a pronounced turn toward risk: Last year, 51 percent of all outstanding investment-grade bonds were rated at BBB, the lowest level to qualify for that status, according to the O.E.C.D. That was up from 39 percent before the financial crisis.

That trend is troubling to financial experts because it leaves companies — and the world economy — especially vulnerable to a change in fortunes.

The world’s largest pools of money — asset managers that control pension funds, mutual fund operators, and insurance companies — are typically restricted in where they can invest. Many are obligated to hold the safest bonds.

When corporate bottom lines are threatened, credit ratings can be downgraded. Given that more than half of all investment-grade bonds now occupy the lowest rung of that classification, downgrades could render trillions of dollars’ worth of such holdings effectively radioactive. Money managers would be forced to unload them while buying safer assets. That would make credit tighter for many companies, threatening some with insolvency and constraining economic growth.

This was the situation before the coronavirus began its lethal, wealth-destroying wander around the globe. The widespread disruption to factories across Asia and in Europe, the effective quarantining of all of Italy, and the spread of the outbreak to the United States have threatened the earnings of thousands of companies.

Last month, Kraft Heinz, the maker of ketchup and other processed foods, had its debt slashed to junk status. Macy’s, the department store giant, as well as the carmakers Ford and Renault, have also suffered downgrades.

Fitch Ratings, the credit rating agency, last week said that one-fourth of the corporate bonds it tracks in Europe have been issued by companies impeded by government actions meant to limit the spread of the virus, like travel restrictions and bans on public gatherings.

Companies dependent on Italy appear especially vulnerable.

Poste Italiana oversees mail delivery while also selling financial, insurance and telecommunications services. The company’s debt is rated BBB. No great powers of imagination are required to grasp that the sequestration of the nation is going to stop customers from reaching post offices.

“We’re going to look at all cost-reduction measures,” the company’s chief executive, Matteo Del Fante, said in a recent presentation to analysts.

Before the outbreak arrived in Europe, CNH Industrial, which makes machinery for construction and agriculture, was cutting expectations for earnings, citing weak demand in North and South America. As of the end of 2019, it carried debt of nearly $25 billion. Its bonds are mostly rated BBB, and Italy is the source of one-tenth of it sales. Those facts seemed unlikely to bolster confidence.

History shows that perilous pressures can build for years inside major economies without disaster unfolding. Danger signs frequently turn out to be benign. Perhaps the wave of corporate borrowing will subside without a traumatic event to right the balance.

But if a nasty reassessment of risk lies ahead, bringing an economic crisis, the coronavirus outbreak could be the event that sets it in motion.

“This is exactly the type of thing that can trigger a chain reaction,” said Sonja Gibbs, managing director of Global Policy Initiatives at the Institute of International Finance. “The vulnerability in the corporate debt market has been building up for a very long time.”

Peter S. Goodman, The New York Times, reporting from London, England

Peter S. Goodman is a London-based European economics correspondent. He was previously a national economic correspondent in New York. He has also worked at The Washington Post as a China correspondent, and was global editor in chief of the International Business Times. @petersgoodman

Website

https://www.nytimes.com/2020/03/11/business/coronavirus-corporate-debt.html

Buying the Apocalypse

Buying the Apocalypse

Remember the Speculator’s Edge…to demand supply and supply demand. Doing your job as a speculator sometimes requires buying when there’s blood in the streets or under other circumstances when all but the bravest are selling. Indeed, the best trade (investment) imaginable would be buying stocks at the Apocalypse. You’d get them while their worth less than their intrinsic value (value of future cash flows discounted back to the present). The discount rate is the yield on the ten year bill (the risk-free rate) which is now under one percent…Therefore those future cash flows will be discounted by very little...In other words think long term where there is less competition for the information that really matters. And remember at times of emotional extremes, be contrary. Don't be part of the herd...stand apart!

A few reassuring words from Bruce Flatt from his latest letter to the shareholders…

While we manage our underlying business for the long term, we realize that you are also interested in our stock performance. Its 50% increase in 2019 was an anomaly; at the same time, the previous year the share price was down, which we also viewed as an anomaly. We estimate that we earned approximately 20% annual returns on our intrinsic value over the two years. As a result, over the two years combined, our stock had a return that was about the same as what we generated in the business.

In short what is now happening in the stock market is an anomaly. The run-up up to the current sell-off was an anomaly…Focus on long term values…hold your nose and buy or just hold on to what what you have. Stocks that have a history of raising their dividends will beat the hell out of the returns one can get from putting his money into the ten year bill where your return will be currently less than one percent for the next ten years...think about it.

Investing Ideas, Stephen Takacsy, BNN-Bloomberg’s Market Call, Feb 24, 2020

Investing Ideas, Stephen Takacsy, BNN-Bloomberg’s Market Call, Feb 24, 2020

Investment is a process in time,
Hyam Minsky

CENTRIC HEALTH (CHH TSX)

Centric is one of Canada’s largest distributors of medication to senior care facilities. The stock is down because they recently sold their surgery clinics at a lower price than the market expected and did a large equity financing at $0.12 to pay down debt. David Murphy, the new CEO from Cardinal Health, is now focused only on the core drug distribution business and has done a great job cutting costs and improving margins. We see significant organic growth opportunities to grow their customer base. Centric also now has the balance sheet to make accretive acquisitions to consolidate the institutional drug distribution space. The shares have the potential to triple through organic growth and acquisitions, plus an eventual sale to a larger player as has been the trend in the U.S. We bought a large block of shares in December to average down.

MEDIAGRIF (MDF TSX)

Quebec-based Mediagrif sells software solutions and owns valuable business-to-business (B2B) e-commerce platforms enabling buyers and sellers to do business on-line. Examples include suppliers bidding on government contracts, corporations interacting with their suppliers and customers and digital marketplaces. The stock is down because the company took large write-offs in its business-to-consumer segment (classified ads, jobs and dating sites) which are being sold, and eliminated its dividend to redeploy cash to grow its B2B platforms.

The company’s new CEO just announced his first acquisition and is focused on providing end-to-end e-commerce solutions to small and medium businesses like Shopify. He has a very successful track record of creating shareholder value in the tech space, having sold businesses to large corporations such as OpenText.

The B2B business generate recurring revenues and high gross margins. The company is now investing in IT and salespeople, so EBITDA margin is coming down at the expense of top line growth. Mediagrif is likely worth $9 to $10 per share based on a modest two times revenues. It’s a great time to buy the stock as the company is in transition and most investors haven’t bothered to look at its new B2B strategy.

ANDREW PELLER (ADW/A TSX)

Andrew Peller is Canada’s second-largest wine producer and distributor. The stock is down 45 per cent from its highs as top line revenue has slowed, but the company has been pruning lower margin brands and focusing on premium products to gross margins. Gretzky brands (wine, whisky and beer) are doing very well. Earnings per share continue to grow as they control selling, general and administrative costs and are now buying back shares. The valuation is now at a huge discount to international brands like Constellation and Diageo. It’s an excellent time to buy shares in a high-quality and well-managed company.

Stephen Takacsy,
Lester Asset Management