Sea Change

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.

As I’ve recounted many times in my memos, when I joined the investment management industry in 1969, many banks – like the one I worked for at the time – focused their equity portfolios on the so-called “Nifty Fifty.” The Nifty Fifty comprised the stocks of companies that were considered the best and fastest-growing – so good that nothing bad could ever happen to them. For these stocks, everyone was sure there was “no price too high.” But if you bought the Nifty Fifty when I started at the bank and held them until 1974, you were sitting on losses of more than 90% . . . from owning pieces of the best companies in America. Perceived quality, it turned out, wasn’t synonymous with safety or with successful investment.

Meanwhile, over in bond-land, a security with a rating of single-B was described by Moody’s as “failing to possess the characteristics of a desirable investment.” Non-investment grade bonds – those rated double-B and below – were off-limits to fiduciaries, since proper financial behavior mandated the avoidance of risk. For this reason, what soon became known as high yield bonds couldn’t be sold as new issues. But in the mid-1970s, Michael Milken and a few others had the idea that it should be possible to issue non-investment grade bonds – and to invest in them prudently – if the bonds offered enough interest to compensate for the risk of default. In 1978, I started investing in these securities – the bonds of perhaps America’s riskiest public companies – and I was making money steadily and safely.

In other words, whereas prudent bond investing had previously consisted of buying only presumedly safe investment grade bonds, investment managers could now prudently buy bonds of almost any quality as long as they were adequately compensated for the attendant risk. The U.S. high yield bond universe amounted to about $2 billion when I first got involved, and today it stands at roughly $1.2 trillion.

This clearly represented a major change in direction for the business of investing. But that’s not the end of it. Prior to the inception of high yield bond issuance, companies could only be acquired by larger firms – those that were able to pay with cash on hand or borrow large amounts of money and still retain their investment grade ratings. But with the ability to issue high yield bonds, smaller firms could now acquire larger ones by using heavy leverage, since there was no longer a need to possess or maintain an investment grade rating. This change permitted, in particular, the growth of leveraged buyouts and what’s now called the private equity industry.

However, 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. It’s no exaggeration to say today’s investment world bears almost no resemblance to that of 50 years ago. Young people joining the industry today would likely be shocked to learn that, back then, investors didn’t think in risk/return terms. Now that’s all we do. Ergo, a sea change.