Investing in high-yield and distressed debt securities carries inherent risks due to the nature of the underlying companies.

These types of companies often have financial instability and various management issues. Leading to a higher likelihood of default in exchange for a higher return.

Howard Marks and his fund Oaktree Capital Management is one of the leading firms in these strategies. Let’s remember how they became so successful in this challenging space and the strategies they employ from the original article we wrote back in June 2020.

High praise from one of the greatest, if not the greatest investors we’ve ever seen. There are few people that the Oracle of Omaha himself would listen to with bated breath, and Howard Marks, one of the founders of Oaktree Capital Management, can consider himself one of those people.

Marks has commanded this level of respect, not just from Buffett, for decades.

In 1995, after success at Citibank, and then at Trust Company of the West (TCW), Marks decided it was time to strike out on his own.

He and his group at TCW were frustrated, feeling as if they were subsidizing poor performers at TCW, and not being compensated for the massive returns they were bringing to the firm. When he finally decided to leave and start Oaktree, the respect he commanded allowed him to bring along some of the most distinguished members of the then-TCW team, including multiple managing directors.

This “brain drain” at TCW was just the beginning.

Almost immediately after Oaktree was formed, a number of major TCW clients moved over $1.5 billion from TCW to Oaktree. These clients were investing in the team, not the brand, and Marks and his team were who investors wanted to be with.

To mitigate their losses, TCW eventually came back to Marks with its tail between its legs, and worked out a deal with Marks and Oaktree. The latter would manage roughly $2.6 billion that had been managed by TCW’s former managing directors.

With assets under management, a quality team, and a reputation that preceded them, Oaktree immediately became a success. It has only built on that over the last twenty-five years.

Today, Oaktree runs over $100 billion.

Yet, while some equity investors know of Marks’ memos, and read them for their general outlook, most knew very little about his stock-picking ability.

That is because he isn’t a stock-picker.

Today, $7 billion of Oaktree’s assets under management (AUM) is in equities, which makes up around 4% of its total AUM.

It’s a tiny exposure in the fund’s portfolio but Oaktree’s niche is in credit. The firm is focused on high yields, convertible debt, and distressed securities.

Its strategy relies on finding cheap, generally senior, safer credit, in which they have a “knowledge advantage.”

That being said, we can still take a look at Oaktree’s equity portfolio, using its most recent 13-F, to provide a window into the firm’s overall philosophy.

To find companies that can deliver alpha beyond the market, just finding companies where as-reported metrics misrepresent a company’s real profitability is insufficient.

To really generate alpha, any investor also needs to identify where the market is significantly undervaluing the company’s potential.

These dislocations demonstrate that most of these firms are in a different financial position than GAAP may make their books appear. But there is another crucial step in the search for alpha. Investors need to also find companies that are performing better than their valuations imply.

Valens has built a systematic process called Embedded Expectations Analysis to help investors get a sense of the future performance already baked into a company’s current stock price. Take a look: