Oaktree's decision to sell itself does a disservice to minority shareholders.

I generally endeavour to follow Mr. Buffet's recommendation that we "praise by name, and criticise by category". However, in this post I shall knowingly disregard this advice. This is because I feel  particularly strongly about this matter.

I have been a shareholder in Oaktree Capital Management for over a year now. There were a few reasons I chose to make an investment in the company. The most important ones are outlined below:

A. I thought Oaktree was a good quality business:

1. Good quality, trustworthy management with long-term orientation.
2. Good investment return track-record and cautious approach to investing.
3. Serious focus on its philosophy and fiduciary responsibility.
4. 1, 2, and 3 make it a leader in distressed debt investing. 
5. 'Firms', 'Capital', and 'Credit' will always exist in some form.

B. I thought Oaktree was undervalued:

In recent years, as the financial markets have rebounded after the Great Financial Crisis, and achieved new highs, Oaktree has been able to exit positions and 'book' returns. However, as optimism has increased, the number of bargains has fallen. Hence, Oaktree has been unable to redeploy all of this capital. Consequently, they have returned money to some investors in the funds, or have chosen not to raise capital. The 'reduced' AUM, and unavailability of bargains has resulted in lower management - and performance fees. Consequently, earnings of the management company have been low.  

As and when the next crisis occurs, Oaktree's reputation will enable it to raise capital, and the circumstances will present bargains. Thus, as the markets recover, Oaktree would - again -  be able to deliver strong financial performance to its investors. This in turn would enable Oaktree - the management company - to generate greater profits. At least, that is the business story Mr. Marks and his firm have long presented.

As of today, my thesis for Oaktree Capital Management remains largely unchanged. Thus, I am confused by Oaktree's sudden decision to sell itself. Firstly, I fail to understand why you would sell the company at a time when earnings are lower than they will likely be in the future. Oaktree itself says that "[its IPO] has not been a great success. Maybe [we] are not suited for public ownership." It is difficult for me to swallow that a firm full of long-term value investors has chosen to judge how much the market likes asset management firms within a six-year 'long' time period since its IPO. Furthermore, it is my view that the firm should not sell itself simply because the stock has not performed well. Moreover, this statement by Oaktree's management, that Oaktree is undervalued provides proof that the 'premium' to market value paid by Brookfield is meaningless. Also, in selling itself to Brookfield, which is itself listed, Oaktree doesn't necessarily resolve this issue; perhaps Oaktree is simply hunting for excuses for selling itself. Secondly, I feel cheated by the fact that Oaktree's management will continue to own and operate the company independently. When I initially purchased my stake, internal ownership gave me confidence that I was in the same position as Mr. Marks. Now I find that is not quite true. I am able to understand why Brookfield may insist on the managers' owning a stake in Oaktree. However, this raises concerns over the conflict of interest facing Oaktree's executives: by selling the public's shares at a discount to fair value, Oaktree could secure a better price for its managers in the future. This would directly place management's interests before those of the minority public unitholders. 

I am sure that Oaktree has the legal grounds for their actions. Yet, Mr. Marks and his team are wrong to sell. They were certainly not capable of negotiating the best possible deal to benefit minority public unitholders, who do not have significant voting rights.  I have suffered a great personal loss - lost a role-model - if Mr. Marks has chosen to place his personal interest above what is morally right. Thus, I should be delighted if Mr. Marks were to directly address these concerns in an explicit manner. Perhaps he could start by publicising the terms of his future liquidation. Otherwise, people should take note; if Mr. Marks' firm is willing to put itself above minority shareholders, someday Oaktree will be willing to place itself above investors too.

A reflection on the importance of probability, outcome, and expected return.

Why probability alone is useless, the challenges posed by tail outcomes, and our inability to determine distributions.

It’s All About Expected Return

I am currently reading Nassim Taleb’s Fooled By Randomness. Early on, Taleb makes an important distinction between probabilities, and expected returns. This is particularly key when there is an asymmetric distribution of outcomes. 

Here is a brief summary of Taleb’s example. Taleb considers the stock market. For the purposes of the example, say there is a 70% chance the market (index) will go up, and a 30% chance the market will go down. Using these probabilities - without considering the outcomes - we would arrive at the conclusion that one ought to invest in the index. Now let us take the same odds, and attach outcomes to each probability; there is a 70% probability that the market will go up by 1, and a 30% probability that the market will go down by 10. In the following table, expected return is calculated:

Probability	Outcome	Expected returns
70%	1	0.7
30%	-10	-3
	Total expected return:	-2.3

The expected return is -2.3, suggesting that it would be wiser to short the index. This is because if I were to make this decision - in the same theoretical conditions - an infinite number of times, I would only be able to generate a positive return by doing this.

Low Probabilities and Finite Deaths

Whilst I have just used Taleb’s example to show that expected return is a more useful metric than probability, I must strike a cautionary note. This is because in reality, we do not always have the ability to repeatedly make the low probability bet in this example. In effect, it is possible for you to make decisions that are correct on an “expected return” basis and still suffer an “unacceptable outcome”. This is because we can only make a finite number of ‘bets’. If the more likely outcome were to occur in each of your ‘bets' you could lose all capital. This would be a finite death. Thus, perhaps it is best to invest only when the probability and expected return are both in your favour.

We have now discussed how investing solely in low probability events that can be justified on an expected return basis could result in an indigestible outcome. However, it must be said that ignoring tail risks (of very low P) that have a great magnitude could have equally - if not more - devastating consequences. In my post about Confidence Game, I distinguish between improbability and impossibility. This is an important distinction, because events with very low probabilities can produce unacceptable outcomes when they do occur. 

Effectively, it is important to consider low probability events in a careful, balanced manner as they may be associated with unacceptable outcomes.

Imagining Odds and Outcomes

In the example Taleb refers to, there are two definite probabilities, and two specific outcomes. This serves the purpose of illustration; however, assuming that things are as easily predicted in reality, would be a grave mistake. 

In reality, we must begin by coming up with a range of outcomes. This itself is very challenging. Now, after we have determined a range of outcomes, it is important to attach a probability to each outcome. It is very difficult to attach accurate probabilities. People normally overestimate the amount by which things will change in a year, and underestimate the magnitude of change that can be achieved through slow, steady progress in a decade. This is just one systematic error we are prone to making. 

Imagining the outcomes, and then attaching probabilities to these outcomes is an art form. It must be undertaken with diligence, caution, and an awareness of the difficulty of the task. Investing does not reward ‘accuracy’ - indeed some say this is impossible. Instead, it pays you for (i) being right about the ‘story’ of a business, and (ii) seeking a margin of safety.

Value vs. Growth

Investing is often divided into value investing and growth investing. This is wrong.

Value investors “believe” in buying assets for less than they are worth today. Growth investors “believe” that investing in fast-growing companies is more important than investing in companies at a discount to real value.

Both schools of thought have some merit; you must own businesses which are trading below what they are worth to be able to generate any return. It is also important to own businesses which will, at the very least, exist in the future, if not grow, if you want to be able to generate returns over long time-periods. 

Indeed, as Howard Marks says, ‘All investors try to buy value – that is, to buy something for less than it’ll turn out to be worth’. One might say that Value investors are focussed on the present and can’t help having to deal with the future, whereas Growth investors are focussed on the future, and are compelled to consider the present. Marks believes that the choice isn’t one of value vs. growth but one of “value today” vs. “value tomorrow”.