Howard Marks, the billionaire founder and chairman of Oaktree Capital, sends out his “Memos” several times a year. His December issue, titled Sea Change, offers food for thought about successful investment strategies to use in the new year.

Let’s take a look, and see how we can earn some nice cash returns next year with less risk…

Marks’ December memo opens with this:

sea change (idiom): a complete transformation, a radical change of direction in attitude, goals…(Grammarist)

In my 53 years in the investment world, I’ve seen a number of economic cycles, pendulum swings, manias and panics, bubbles and crashes, but I remember only two real sea changes. I think we may be in the midst of a third one today.”

The first sea change Marks is referring to occurred in the mid-1970s when it became acceptable for corporations to issue non-investment grade bonds as a way to raise capital. Prior to that, there was no market for bonds that didn’t have an investment-grade credit rating. Non-investment grade or high-yield bonds opened up the potential for companies to issue this type of debt to fund growth or make acquisitions.

Marks, who made his fortune investing in high-yield securities, explains:

…The most important aspect of this change didn’t relate to high yield bonds, or to private equity, but rather to the adoption of a new investor mentality. Now risk wasn’t necessarily avoided, but rather considered relative to return and hopefully borne intelligently. This new risk/return mindset was critical in the development of many new types of investment, such as distressed debt, mortgage-backed securities, structured credit, and private lending.

The second sea change started when, in 1980, Fed Chairman Paul Volker ratcheted the federal funds rate up to 20% to kill the high inflation that had persisted since 1974. The move succeeded and ushered in four decades of falling interest rates, which were tremendously positive for investing and the economy. Bond prices go up when interest rates fall. As a result, bond funds posted year after year of positive returns.

Falling rates also fueled corporate investments that led to massive economic growth. Low interest rates reduce the cost of capital for businesses and increase the fair value of assets.

Per Marks:

It seems to me that a significant portion of all the money investors made over this period resulted from the tailwind generated by the massive drop in interest rates. I consider it nearly impossible to overstate the influence of declining rates over the last four decades.

The third sea change, now underway, is that inflation and high interest rates have produced investor uncertainty and pessimism. These are valid concerns, as growth-focused companies can no longer count on cheap money to fund their growth.

Marks closes the memo with this:

We’ve gone from the low-return world of 2009-21 to a full-return world, and it may become more so in the near term. Investors can now potentially get solid returns from credit instruments, meaning they no longer have to rely as heavily on riskier investments to achieve their overall return targets. Lenders and bargain hunters face much better prospects in this changed environment than they did in 2009-21… if you grant that the environment is and may continue to be very different from what it was over the last 13 years—and most of the last 40 years—it should follow that the investment strategies that worked best over those periods may not be the ones that outperform in the years ahead.

I have already started making changes to my Dividend Hunter recommendations that should let subscribers earn attractive cash returns with less risk. Now in its ninth year, my strategy has continuously evolved, and the recommended strategy and investments will do very well in the new “sea-changed” world.

— Tim Plaehn

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Source: Investors Alley