In This Episode

In a week of the debut of Elon Musk’s underground tunnel, a #MeToo outcry against “Baby, It’s Cold Outside,” and a British currency crash in the wake of a delayed Brexit vote in Parliament, there’s a lot for Dan Ferris and Buck to unpack this week.
Most significant for investors – and surely on a lot of minds – is JPMorgan’s warning that a 70% likelihood of a recession is looming. Dan explains why the projection is utterly irresponsible – and why, instead of predicting recession, value investors can prepare for one regardless.
Of course, even if a recession isn’t imminent, it always makes sense to hold onto a bit of cash – the question is how much.
That’s where Adam Schwarts, this week’s podcast guest, comes in.
Adam is the Chief Investment Officer at Black Bear Value Partners who has 16 years of buy-side investment experience in a variety of themes including equities, structured products, corporate credit and capital structure arbitrage. Prior to founding the Investment Manager, Adam served as a Director and senior member of the investment team at Fir Tree Partners, a $13BB peak-AUM multi-strategy investment manager.
His ”concentrated portfolio” strategy allows investors to focus only on their best ideas – and like Dan, he’s got his own portfolio composed to a surprising degree of cash.
And just like Porter, he’s been closely watching the corporate bond crisis that could be on the horizon. Whether it comes in JPMorgan’s predicted time frame or not, you’ll want to prepare.


Featured Guests

Adam Schwartz
Adam Schwartz
Adam Schwartz is the Chief Investment Officer at Black Bear Value Partners who has 16 years of buy-side investment experience in a variety of themes including equities, structured products, corporate credit and capital structure arbitrage. Prior to founding the Investment Manager, Adam served as a Director and senior member of the investment team at Fir Tree Partners, a $13BB peak-AUM multi-strategy investment manager (2007-2015). Prior to joining Fir Tree, Adam was an Investment Analyst at LibertyView Capital Management, a multi-strategy investment fund within Lehman Brothers, as well as at Kore Advisors, an investment fund seeded by Paloma Partners. Adam received his BS and MS with a concentration in Accounting from Washington University in St. Louis in 2001/2002.
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Episode Extras

NOTES AND LINKS

To see more of Dan’s work in Extreme Value – Click Here

SHOW HIGHLIGHTS

3:06: Buck and Dan discuss Elon Musk’s latest headline-grabber: the tunnel beneath LA set to open in a few days that will transport people at speeds of up to 150 miles per hour. “I don’t see this changing the future of human transportation.”

7:29: Buck asks Dan about JPMorgan’s warning that there’s a 70% risk of recession within the next two years, and Dan invokes the words of economist Paul Samuelson: “The stock market predicted nine of the last five recessions.”

13:50: Buck breaks down Theresa May’s decision to delay the Brexit vote in Parliament, and the uproar it’s causing among Britain’s political establishment while the sterling tumbles to a 20-month low.

22:28: Adam Schwartz, this week’s podcast guest, comes onto the air. Adam is the Chief Investment Officer at Black Bear Value Partners who has 16 years of buy-side investment experience in a variety of themes including equities, structured products, corporate credit and capital structure arbitrage. Prior to founding the Investment Manager, Adam served as a Director and senior member of the investment team at Fir Tree Partners, a $13BB peak-AUM multi-strategy investment manager.

24:20: Dan observes that Adam’s fund runs a concentrated portfolio. “Can you talk about that – why you do it, and what it looks like?” Adam explains how concentration allows people to focus only on their best ideas.

34:28: Concentrated portfolio investing is nowhere near mainstream – in fact, it’s the opposite of conventional wisdom “diversification” so Dan asks Adam how he first convinced investors to trust him. “After trusting someone to watch your kids… trusting someone to watch your capital is the next biggest thing.”

39:19: Dan says one of the things that shows a manager is serious about his view is his willingness to hold cash – and Adam agrees. And Adam is holding “a good amount of cash” – but not for the reason most investors would.

41:44: Adam’s name has been stuck in Dan’s head for a few months, thanks to a presentation he gave last summer in the Rockies. “Normally the presentations were about long stock picks – but yours was about shorting credit ETFs.” Adam explains how to exploit a financial house of cards.

47:44: With corporate profit margins near all-time highs, Adam explains why some companies just can’t seem to stop issuing debt. “They assume tomorrow’s gonna be a sunny day. And if it’s a cloudy day…”


Transcript

Announcer: Broadcasting from Baltimore, Maryland and New York City, you're listening to the Stansberry Investor Hour.

[Music plays]

Tune in each Thursday on iTunes for the latest episode of the Stansberry Investor Hour. Sign up for the free show archive at InvestorHour.com. Here are the hosts of your show, Buck Sexton and Porter Stansberry.

Buck Sexton: Hello, everybody. Welcome back another episode of the Stansberry Investor Hour. I'm radio host Buck Sexton. With me, the long-time editor of Extreme Value and Stansberry member Dan Ferris is gonna be covering and carrying the intellectual load here on the show this week. Mr. Ferris, great to have you, sir.

Dan Ferris: Yeah. It's great to be here once again. I'm really enjoying this every week with you, Buck.

Buck Sexton: Yeah. It's good times. I get to learn a lot. So hopefully the folks listening get to learn a lot too.

Dan Ferris: As do I.

Buck Sexton: We got some big topics. I wanna try a quick run-through. We got Elon Musk's tunnel under LA, Apple having trouble after China bans the sale of some iPhones, Elon Musk talking some smack on 60 Minutes, a jailed Huawei – did I get that right? – executive in China getting angry about that, soft banks, mobile IPO, and then whatever else we throw into the mix here. So we got a lotta show to cover today. Let's start with the – actually, Dan, your choice. 'Cause you're lead. I'm riding shotgun on this one. You wanna do Elon Musk's tunnel, tell us what's going on there?

Dan Ferris: You know, I actually – I don't know a lot about the tunnel. But it scares me. It scares me because there's something about being whisked – they talk about being whisked from place to place and up to 150 miles an hour. And I get on the freeway and pass somebody going 80 and my blood pressure heads up a little bit [laughs]. So I'm not sure about this.

Buck Sexton: So you may know about the electric scooter phenomenon. Just by way of a little bit of context here for our discussion, Dan, DC, where I am, just passed an ordinance that the scooters can no longer go 15 miles an hour, only 10 miles an hour. So there you go.

Dan Ferris: Well, I don't know. Are the scooter drivers all like 80 years old or something? I don't quite get that.

Buck Sexton: No. These aren't like Rascal scooters where you sit down. That's a whole different kinda scooter. These are the hipster scooters that you do – like Uber share with them and they leave – they don't have these in your town? They leave these in the streets all over DC, LA. They're coming to New York. They're in Baltimore. They were in St. Louis, Missouri when I was there. They're all over the country now.

Dan Ferris: Right. Yeah. You just seem 'em kind of left by the sidewalk there. And there's now a speed limit on them. Great [laughs]. I'd like to see them enforce that.

Buck Sexton: If you're going ten miles an hour on anything that's electric-powered, you could actually get passed by some of the older folks riding the scooter.

Dan Ferris: Yeah [laughs].

Buck Sexton: The 150-mile-an-hour tunnel thing – I just feel like this is, I don't know, one of those news stories the press loves to talk about. But I don't see this changing the future of human transportation anytime soon.

Dan Ferris: Ditto. Let's move on [laughs].

Buck Sexton: All righty. Well, Dan, what is the biggest thing for you this week? Let's start with that.

Dan Ferris: Well, it's not the biggest thing but I did wanna get to this business of: it's Christmastime again and so now, this season, we learn that the song, which actually won an Oscar¸ "Baby It's Cold Outside," is problematic. They're calling it a date rape anthem because the gist of the song of course is: "Baby, it's cold outside. Stay in here with me tonight." Et cetera. And I just – I don't know if I'm guilty of spending too much time thinking about this stuff as well as those who have the energy and time to criticize it. But it just strikes me as a little ridiculous that someone is talking about men trying to romance women as being anything but as old as humanity itself. It's ridiculous. There's no rape or date rape implication of any kind whatsoever anywhere near that song. I mean, it's as absurd as talking about "Rudolph the Red-Nosed Reindeer" as a homophobic, bigoted piece.

Buck Sexton: Do you know that that's happened too in the last few weeks, right?

Dan Ferris: Yeah, of course.

Buck Sexton: That Rudolph's now under fire. Okay.

Dan Ferris: And it's all ridiculous.

Buck Sexton: Rudolph is – he's being otherized – and for those who don't know this that're listening at home, the problem with "Rudolph the Red-Nosed Reindeer," according to the social-justice-warrior Left, is that Rudolph's otherness is only acceptable when it has utility for those who are part of the dominant paradigm, which is a fancy way of saying it's useful to the Man. The Man, in this case, being Santa Clause. The red nose. And that's what makes it okay. But difference should not have to be useful to those in the power structure. That's what people say. It's crazy.

Dan Ferris: Yeah. It is a little crazy. Look, we all know what the moral of that story is: Rudolph is different, Hermey the dentist elf is different, and they pick up a few different other friends along the way, and they're kind of outcast, and then in the end everybody comes together and realizes that their differences aren't that bad. You know, they aren't any reason to cast people out. And if you see this any other way, I'm sorry, but I really think you have too much time on your hands. That's what I have to come away with. Because otherwise I go down this dark place where society is headed in a bad direction and people are becoming too intolerant, and I don't wanna go there. So I'm just gonna say that these people have too much time on their hands [laughing] and leave it at that.

Buck Sexton: Yeah. Also the classic – by DJ Khaled – "[Beep] & Bottles," which our friend, Left Lane, who is there in the control room in Baltimore, can probably weigh in on how popular the song is – that will not be kicked off the airwaves any time soon. I can assure you of that. You've probably never even heard of that. That is a song. That is a real song.

Dan Ferris: Right. The songs, like mostly I guess rap music and other heavy metal stuff that involves actual sexual violence towards anyone, women or anyone else – that stuff isn't getting thrown off of the air. "Baby It's Cold Outside" is getting delisted from the [laughs] radio playlists. It's a little bit crazy. I'm sorry.

Buck Sexton: This is where I have a perfect opportunity to ask you: what is your favorite – in the Ferris household, what is the number-one Christmas movie of choice?

Dan Ferris: I don't know that there's consensus on this. I think – I know my wife really likes Meet Me in St. Louis, which I do too. I think we both like that one. And I think we both like Holiday Inn quite a bit. We like the old movies.

Buck Sexton: It would be Die Hard in my household. 'Cause there are three guys that're all – my brothers and I watch Die Hard a lot. Which is technically a Christmas movie. It all occurs on Christmas Eve.

Dan Ferris: It does. Yes. I am aware that that is a Christmas movie. And when I was younger and at home with my father and my three brothers, we'd watch stuff like The Godfather and The Right Stuff and Dr. Strangelove and all kinds of things on Christmas [laughs]. So there's quite a wide variety to choose from on Christmas.

All right. What else we got here?

Buck Sexton: I was just gonna say: can I press upon you for some financial expertise for all of our folks listening who are probably wondering – I saw this thing today about how I think Morgan Stanley is putting out that there's a 70-percent risk of recession in the next two years. People are worried about stuff. What did we see this week? Big swings, markets looking volatile. What did you take away from things?

Dan Ferris: I took away what the economist, Paul Samuelson, once took away, which is that the stock market predicted nine of the last five recessions [laughs]. Look, I'm not saying there won't be a recession. But I'm telling you that you're not gonna hear me forecasting one. They happen when they happen and the idea is not to predict them; it's to have a portfolio that's prepared for one.

And this may sound like a broken record to you because you probably heard me say it five or six times by now but I think the best way to prepare for a recession is to be a value investor. Because you're not gonna be buying overvalued stocks at the top; you're gonna be avoiding them and selling them. And you're not gonna be able to find anything much to buy so you're gonna be holding plenty of cash. And when there's a downturn, and equities become attractively priced again, you will be ready to exploit the opportunity, unlike lots of folks who are holding all the wrong stuff and will continue to hold it all the way down.

And as far as predicting a recession, who the heck knows? They say the risk of recession is now between 20 and 37 percent. That is really to me very irresponsible of JP Morgan to put specific numbers out there like that. Because we human beings – this gray thing between our ears, this mushy gray thing: it loves that kind of precision. Unfortunately, that kind of precision is simply unavailable to us. It's crazy. Even though you may know – I can look at those numbers – odds of recession now, risk of recession now between 20 and 37 percent – I know it's baloney but my – how does one say? – mammalian brain still latches onto that. And it's insidious.

If the financial world were responsible, they'd say, "Look, we have no idea what the odds of a recession are. We can't really calculate that. We just can't calculate the odds of something happening in the future like that, something which hardly ever happens." And then they'd be honest. But then they'd have to start saying all the other things they don't know and they wouldn't be able to sell you anything. So I guess that wouldn't go over on Wall Street very well. But that's really all I have to say about that.

Buck Sexton: And I don't mean to take us down a pathway that wasn't planned, here, but there's a lotta talk recently about climate change. In fact, because of the gilets jaunes – it's fun to say – because of the yellow vest protests, there's also an understanding now that the size of the state can be a problem for the middle class that the state is claiming to help, and especially when the state begins to institute taxes that are specifically to address the issue of climate change. I see all these economists.

And I pay more attention in the last couple of years since I started working at Stansberry I ever did before about who goes on TV to talk about the markets. And I'm amazed because there're all these people that go on TV and they say the things that I would go on TV, if I was asked to talk about markets, as a non-market, non-finance expert, that I would say. They find some shiny object and they attach it to – and what you find out is that a lotta these economists and other people that're making these predictions: they're wrong a lotta the time. Nobody seems to really care. And even the really good ones can't tell you what's gonna happen with any precision, to your point, that far out.

Meanwhile, we're supposed to believe, from the most recent climate change report that came out from the US government, actually, from the agencies that handle this, that they can tell what the temperature's gonna be in 2090 to within one degree of accuracy. That's a farce. And people get very mad at me when I say that. But they just simply do not know. There's no way.

Dan Ferris: Well, as far as I know, they don't know what it's gonna be 24 hours from now.

Buck Sexton: Well, there's that too.

Dan Ferris: [Laughs]. With any degree of accuracy. They could be off 10 or maybe 20 degrees.

Buck Sexton: I always like this about Michael Crichton: he says that in his whole career – the Jurassic Park author, who people think of as a sci-fi pop guy, and also the writer and producer of ER – I think he's one of the only guys to have ever had the number-one book, the number-one movie, and the number-one TV show at once ever. It was ER and Jurassic Park. And he used to say that in his – he was a Harvard-trained MD. He kinda reminds me of the kinda guy that would be like one of the Stansberry analysts. 'Cause you don't even realize that he's got a Harvard MD because he's so busy writing all these bestselling books. But he would just say that the one thing that he's sure of is that nobody can predict the future. It kinda reminds me of a Dan Ferris thing to say actually. Nobody can predict the future. You can try to prepare. You can try to make smart decisions. But anyone who says they know doesn't know.

Dan Ferris: Well, people have been saying this stuff for thousands of years: the only permanence is change and you don't know what's coming next.

Buck Sexton: Yeah. That's true. Can you tell me about the – well, actually I wanted to ask you about Brexit. That was what I was thinking about with the people going on TV. I turn on CNBC; they're like, "Oh, Brexit fear is driving the market." And then the market rebounds. I'm like: did the Brexit fears go away? Was this just somebody that had something to say – had to go on TV and say something about something? I mean, the sterling fell to a 20-month low after this decision to delay the vote on Brexit. The political establishment got all upset about it. And now Theresa May is going back to Europe to try to get the withdrawal agreement amended. What did you make of this?

In general, too, Dan, when there's a big drop in the market one day and people are all attributing it to a political event, among many others, do we have any sense of whether this is accurate or not? Do you buy into Brexit driving the market as a primary factor?

Dan Ferris: Certainly psychologically. This is one of those things that everybody thinks that they need to be thinking about that I think they probably don't need to think much about. And in the end, Buck, I am a very bad talking head on things like this because I'm totally content to say I don't know, which I wish people in the finance world said more often. I don't know what sterling – that is, the British pound – I don't know what sterling will look like in – it fell to a 20-month low recently and I don't know what it'll look like 20 months from now. And I'm perfectly content to wait.

I'm perfectly content with the notion that all of the companies that I spend my days and some nights examining and considering to write about in Extreme Value – I think most of them will continue to show up for work in the morning and do what they do and not be very influenced by this. That's one of the messages we've tried to get across to people.

And I'm only human. I make the same mistakes as everybody else. But at least I understand that politics and political developments and paying a lot of attention, especially for an equity investor to pay a lot of attention to political developments – who's elected president and what's happening with Brexit – paying a lot of attention to that and taking a lot of action in your portfolio is generally gonna be a mistake. So if I sound like I don't know what's going on and I'm gonna keep my – I'm not keeping my head in the sand. I'm open to the idea that this could be very important to me. But so far I don't see it, and in general I'm skeptical about – even the smartest equity investors – people like Warren Buffett don't worry about things like this. So I don't think you and I really, as equity investors, which is primarily what I am, need to worry much about this stuff.

Buck Sexton: I used to tell people that were starting out in the punditry game, so to speak, that especially on certain – there're certain issues where if you just more or less memorize a script and change some basic words – after a terrorist attack, all these people go on TV – and I was one of them for years – and people want answers. Well, the real answers are: "Terrible attack. Thoughts and prayers to people affected by this. Authorities are on it. Investigators gonna be looking at the digital footprint online. They're going to be working with our allies and working through law enforcement," depending if it's overseas. But it's the same thing people say every time.

And now that I pay more attention to these prognosticator finance types on TV, I feel like it's be kind of a fun game to just give somebody who knows nothing about the markets or finance the basics of what they're supposed to say and just see how long they could get away with it. You know, they go on TV: "Uncertainty about the markets and who knows what's gonna happen with the dollar? And the Fed's probably not gonna raise rates in 2019. Right now there's a selloff 'cause people are concerned about the debt." It just kinda sounds like speculation dressed up as analysis a lotta the time.

Dan Ferris: It is.

Buck Sexton: I mean, that's just from an untrained ear. But that's what it sounds like.

Dan Ferris: It is. It's baloney. It's noise. It's not signal. And the trouble is: trying to be signal and not noise often leaves you saying things like, "I don't know," and "This may be an exciting thing to talk about but it's really not that important to you as an investor." So signal is what it is. The truth is what it is, as I say it. And it may not be sexy, but I think over time it has teeth.

But you remind me, Buck, of something – you know, the story about Max Planck and his chauffeur. Do you know that story? The physicist, Max Planck, he had this chauffeur who was driving him around to speak about physics here and there, and he'd stand in the back of the hall while Max was up there talking. And after a while he said, "You know, Mr. Planck, I've heard you give this speech so many times I think I could do it." And so Planck says, "Okay, next time you'll give the speech and I'll sit in the back." And he gives this speech and it's all very compelling, and at the end of course he takes questions, and the first guy asks this kind of long-winded, complicated question, and the chauffeur's up there pretending to be Max Planck, and he says, "Oh, sir, that question is so simple-minded. I'm going to let my chauffeur answer it" [laughs].

It's a corny old joke, but that's what you're talking about it. And it's the difference between – so there's Max Planck knowledge and there's chauffeur knowledge. And what you're talking about, what I'm talking about when I call it noise is: the world is filled with these chauffeurs who just wanna get on TV and talk and maybe don't have any particularly valuable insight to add. They're just kind of making noise and being a little entertaining and gesturing with their hands and speaking in an animated way and using all the right phrases. But they're unwilling to say, "You know something? I don't know and I don't think it's very important." That won't get you on TV, will it, Buck?

Buck Sexton: It will not. It will not with anything. But I think there's also – from my side, looking from the outside, as somebody who does a lotta political analysis on TV at the financial analysis side of the house – again, televised, not actually people that necessarily know what they're talking about – finance is one of those, or the markets, investing – it's one of those areas where you actually have a scoreboard, which is very rare.

DC is littered with political consultants who run failing campaigns all the time. No one seems to pay attention or notice. Tons of people that have lost this or that race, and then a lot of other people that're just offering commentary. And commentary, the beautiful thing about it for so many of us, is that by the time you're wrong, most people never really find out, and they don't care. That's the other side of it. I can make whatever prediction I want about who's gonna win the 2020 election today; if I do it in a way that's exciting and interesting to people, they'll listen and I get what I want, which is attention and interest now. By the time the election happens, no one's digging back into the podcast.

But if I went on this podcast and I said, "You know what, everybody?" – I know this is a horrifying thought – "I've got this one stock; everybody should pile" – I don't know anything and I'm not even allowed to give stock advice – "everybody should pile their money in this one stock," and for some reason someone listened to me and they lost all their money, which is probably what would happen, they would care [laughs]. They would remember. That would be an issue. So it's interesting to me that there doesn't seem to be – in the sphere of television commentary on these subjects, that line doesn't seem to matter all that much between actual accountability for what you say or what you publish or what you do in finance and investing versus politics, where it's just basically all of us throwing stuff at the wall.

Dan Ferris: Yeah. So Nassim Taleb, the author of The Black Swan and Fooled by Randomness says, "All you have to do is read newspapers a week after the stories come out and you'll stop reading them." 'Cause everything they said last week – it's either genuinely changed and they were stupid to even talk about it, or they were completely wrong. They speculated and they guessed and were completely wrong. But as you say, nobody's going back. Nobody's reading the newspapers a week late. So, yeah, I hear you. I hear you loud and clear.

[Music plays]

Buck Sexton: Our guest this week, everybody, is Adam Schwartz. He's the chief investment officer at Black Bear Value Partners, who has 16 years of buy-side investment experience in a variety of things including equities, structured products, corporate credit, and capital structure arbitrage. Prior to founding the Investment Manager, Adam served as a director and senior member of the investment team at Fir Tree Partners, a $13-billion peak AUM multi-strategy investment manager from 2007 to 2015. Prior to joining Fir Tree, Adam was an investment analyst at LibertyView Capital Management, a multi-strategy investment fund within Lehman Brothers, as well as Kore Advisors, an investment fund seeded by Paloma Partners. Adam received his BS and MS with a concentration in Accounting from Washington University in St. Louis in 2001/2002.

Please welcome to the Stansberry Investor Hour Mr. Adam Schwartz.

Adam Schwartz: Thank you very much. It's great to be on the show. I appreciate you having me.

Dan Ferris: All right, Adam, it's Dan. I'm really excited to have you on. And just for our listeners' sake, I got to know Adam a little bit this past summer. We attend an event up in the Rocky Mountains every summer which is a little invitation-only kind of conference of value investors. And Adam and I both fall into that category. And I can't get his presentation this year out of my head. He did a wonderful presentation, and that's really mostly what I'd like to talk about. But before we get to that, Adam, I noticed that your fund – it runs a concentrated portfolio. Can you talk about that a little bit? And, first of all, why do you do it? And, second of all, what does it look like? What's the makeup of the portfolio?

Adam Schwartz: Sure. So, thanks again for having me, Dan. I've enjoyed our conversations at the conference and I'm pleased to be here to join you today. The idea of a concentrated portfolio's really just to focus on our best ideas. So if you think about the investment universe, there's just thousands and thousands of companies and opportunities that're out there. And on the one extreme you have the idea of just an index which is, depending in how it's weighted, an exposure to all the different companies and all different types of ideas. And as an investment professional, my goal is to outperform the various indices over a period of time. And the way that you can do that the best is by having concentration and focusing on your best ideas.

And as a team of one, I wanna have a few ideas – my best ideas – to have most of my money in them. I'm the largest LP of my partnership. And this is kind of the vehicle that I'm using to grow my capital, my LP's capital. And I just wanna focus on our best ideas and grow it that way. So I don't think there are that many great ideas in any one given time. So the idea is sort of to find the best stuff and kind of seldom bet, but when you bet, bet kinda big.

Dan Ferris: Wow. That sounds gutsy [laughs].

Adam Schwartz: You know, it is and it isn't. Because if you think about it, if you take your time and you know that you're not gonna make that many bets, that many investments, you're gonna be very cautious and prudent with the decisions that you make. And so it sort of forces a lot of discipline because you're just not gonna turn the portfolio over very often. You're gonna be making bets in companies, in management teams that you're willing to take on for a longer period of time. And so it creates sort of a cautious approach.

But when you like something and you know you like it, why wouldn't you wanna own a lot of it? And if it goes down more, unless your thesis' imperiter is wrong, which happens to everyone, assuming that nothing's changed but the emotions of other investors and they just decide they wanna sell 'cause they're pessimistic, that's a great opportunity. If you know it well and your horizon is longer than others, it's a great opportunity to buy more of things. So it's tough. It's not easy. It can be quite painful at times. But it's a great opportunity, if you know something and understand it, to concentrate in it and to grow it.

So, you know, we have a handful of themes in the portfolio. But right now we have 11 names on the long side, and the top 5 or 6 comprise probably about 60 percent of our portfolio. So it's a pretty concentrated philosophy.

And, by the way, I'm not the one who's created this template. So you look at all the great investors – plagiarism is the best form of flattery. And I've studied a lot of the best investors and I've said, "What can I do like them to try and have returns that're similar to theirs?" And a theme along most of them, if not all, is putting most of their capital in their best ideas. And so it can lead to a little bit rockier times month to month, but I'm thinking about 10 years out, 20 years out, in terms of where I'd like to have our capital be. And if you take a longer-term view, it's a great way to make money.

Dan Ferris: Right. So it's one thing for a money manager to take the long-term view and have the wherewithal to – just the emotional makeup to ride out drawdowns and tough times. But it's another thing entirely, isn't it, to find clients, investors, limited partners who will go along with you on that ride? So I assume you've been able to do that. That's a difficult thing, isn't it?

Adam Schwartz: Yeah. I mean, it's tricky. I started Black Bear with the idea – I was a little bit different than how most fund managers start, but I started the fund with the idea that I was gonna raise no money for a fairly long period of time. And the reason why was because – and the way we've done that is: keep our expenses very low, at a fund level, and then for our investors, we run – our management fees and everything are very low.

And why did I do that? And it's pretty simple. I wanted to find LPs that were taking a longer-term view and that I wanted to make sure that we had the right types of partners. And so having the right LP base is critical to pursuing any sort of long-term strategy. If you have the wrong LP base, if you rush into the business and just raise money from the easiest pockets, you're setting yourself up for a lot of problems down the road if the market doesn't work with your ideas in the short run. I wanted to take that risk off the table.

So I basically started it with my own money and then slowly have been growing the investor base, much of it through word of mouth. Some of my investors I've never met – they read my letters and they subscribe to sort of the concept of long-term compounding. And I've told people that I don't want their two-year money or their three-year money. I want their 10-year money, they're 20-year money. I want the capital that's gonna sit that we can just grow it together, and that they're gonna invest with me. So if they're ever worried that I'm doing something crazy or it may appear crazy, understand that I have the lion's share of my net worth in it and we're gonna grow it together.

That message resonates with some. It doesn't resonate with all. And, frankly, it doesn't resonate with most because most want short-term liquidity and they want kinda the best of both worlds: they want long-term views – I was saying to a friend the other day: everyone is extremely patient with their investment so long as it happens quickly [laughs]. You wanna find the right LP base. And it takes time to cultivate it and to find partners in your business. So it's growing but it's important to be as prudent with your business as you are with your investments.

Dan Ferris: So, in other words, you started out with this. You weren't desperate to grow a business. You were desperate to do things right and to take your time. That's also a theme of great investors. You know, Buffett, the most obvious example, was able to grow Berkshire Hathaway because when he actually took over Berkshire and decided to stop doing the partnership thing, he was rich. He wasn't desperate for money so he could take his time. And it sounds like you were in a similar position, which – it's funny because that's probably one of the best ways – it's so hard for investors to really assess managers, and even to assess people like me who just write newsletters.

And I still firmly believe that my willingness not to recommend stocks – which, in the newsletter business is tough, but I go sometimes a month or two or three or whatever – one year I only recommended two stocks all year. And publishers hate it. But readers who are gonna be with you for a long time love it. And it sounds like your investors – you've found investors who love that too.

Adam Schwartz: Yeah. Look, I wouldn't put myself in the category of Warrant Buffett on pretty much any metric –

Dan Ferris: Well, sure.

Adam Schwartz: – other than maybe I'm trying to replicate aspects of what's made him successful and apply them to my life in kind of how I run my business. And there's a lot of other people too. But I think the way that you write your newsletter and being selective: it's hard. It's not easy to not always have something to talk about, to say, "I don't know." That's a really tough thing. And when you're in the business – when you run a fund, you're investing but you're also sorta selling yourself and selling your ideas.

To an extent, what I'm trying to sell is more of a philosophy and a vision of where the hedge fund industry should be going versus where it is. And where it is is fairly high fees and lousy performance and not the most aligned structure between the managers and the LPs. And I think it needs to go to more of a business where you don't get – Buffett said you don't get paid to breathe. I think that's very important. Managers should feel an incentive to want to grow the capital in a sensible way. But when you're printing humungous management fees it's very hard to feel that incentive. You don't wanna lose the capital because it's paying you so much.

So creating that structure's really important. But there's nothing easy about it. There's nothing easy about being different or cultivating long-term relationships and being patient, letting people get to know you, not rushing people. Obviously I'd like to grow my business. But I want people to feel super comfortable. Other than asking someone to watch your kids, probably the next thing is to watch your capital, which provides for your family or for your endowment for your university or for – whatever it is, it's a sacred thing for someone to give you their money and for you to be responsible for it. And I think that as a manager, you wanna be very careful to take the right types of partners on and for people to know who you are and kinda the values that you stand for.

I happen to be blessed with an amazing LP base. It's small and growing. But we've had three or four turbulent months in the market in the last two years and I've received zero phone calls from my partners asking how we're doing or what's going on or what's going on with the portfolio. They let me do my job. And that, to me, is a testament of how a business is set up: how it operates when kinda the waters get a little rocky. Are my passengers, effectively my partners – are they letting me fly the plane? Are they letting me steer the ship? That to me is –

Dan Ferris: That's super important.

Adam Schwartz: Yeah.

Dan Ferris: Super important. There's a story of Buffett cashing a guy out because he showed up at the office. I don't know if you ever heard that.

Adam Schwartz: I have, yeah.

Dan Ferris: He told his investors – yeah.

Buck Sexton: I don't know the story. What's the story?

Dan Ferris: Well, Buffett told his investors – he said, "Don't show up. Don't come to the office to visit me. Just let me do my job." And a guy showed up. And his secretary said, "There's this guy here to see you. He's one of your investors." And Buffett's response was, "Cash that guy out." In other words, "Give him his money back; he's outta the fund." "Told you not to come in; told you not to see me." And that's kind of a abrupt way to exit the fund. But the point is well-made.

Adam Schwartz: I haven't done anything quite that draconian.

Dan Ferris: I didn't think so [laughs].

Adam Schwartz: But, look, I think that the fact is: you wanna make sure that you're as selective – a lot of managers, because they're in such a rush to raise capital, they don't vet their investors. They let the investors vet them. But it's a two-way street. And I think as a manager, you need to be very careful about the kinds of investors that you have and that there's mutual expectations that you're both – you understand kind of what you're signing up for. Because if someone's going to get nervous and worried and bother you, or bother me, that's not productive for anybody. And so I exercise caution to people who invest with me and I ask them: have they read my letters? Do they understand what we're doing? What're their goals? Here's our goals. Et cetera. And I sort of force them to take their time and to just make sure that this is the right fit for them.

Because, frankly, out of self-preservation – I have a lot of my own money in this vehicle – I don't wanna be focused on hand-holding during tough times. I wanna be able to be analyzing and making quality decisions. So I've been just super lucky. My investors are a great group. And the band keeps getting a little bit bigger. But slowly. But they're all – each one is terrific and patient and I'm very lucky for that.

Dan Ferris: Well, that's quite an achievement. So one of the things that kind of identifies a manager who's kind of willing to put his money where his mouth is with his long-term perspective is the willingness to hold cash. Do you agree?

Adam Schwartz: I do.

Dan Ferris: So do you find yourself – you're a value-oriented guy. Now, I know you have this kind of multi-asset – you're agnostic, it seems, about assets and size and market cap, industry, all these things. But do you find yourself holding plenty of cash right now?

Adam Schwartz: Yeah. I have a good amount of cash. I have an idea that sort of actually – I'm not gonna disclose the name but it just kinda came to fruition today. It was a special situation that was actually over 20 percent of our fund which was quasi-cash 'cause it was a merger-related kind of deal. And if you sorta think of that as quasi-cash, we have a good chunk of kinda dry powder available. But I don't let cash – cash is sort of the result of the opportunity set. It's not really the determining factor in terms of – I don't go into the day saying, "I wanna have X percentage of cash." Maybe to some extent I do, and say, look, I like having five, six, seven percent cash sitting around as a baseline," and then in a market that's a little bit frothy or maybe I'm not finding as many opportunities, I like having the dry powder.

But, listen, it's very hard to be patient. I think that it's not even cash so much. I think it's just very hard for people to do nothing.

Dan Ferris: I agree. I've had the same experience. If I don't pick a stock, readers write in and say, "What the hell are you doing?" And what you just said – I want the listeners to know: what you just said is something I hear from all of the best value investor. Cash as a residual. Like you said, you don't sit around saying, "I wanna have X percent in cash." You just wind up with a lot of it at certain times because there may not be a lot to do. I think that's kind of an important point.

Adam Schwartz: That's right. And, look, I think that most value investors usually, absent a few times in my career, always think that things may get a little worse before they get better. So I would say value investors generally speaking always have a little bit more cash than the average investor because they like the ability – most of us are buying securities even if the markets are frothy. We may be buying securities and industries that are a little bit more distressed or depressed.

And so pessimism – just because you're buying a stock doesn't mean it knows you own it. And so it can go down the next day and the next day and the next day. And sometimes when you're buying something, pessimism begets more pessimism until it doesn't. And so I like to always – I'll buy a position but usually they go down more often after I buy them than go up. But that's kind of the nature of the beast. So, as a result, I probably have more cash than average, in order to be able to sort of leg into a position over time.

Dan Ferris: I see. All right, Adam. I'd like to kind of get to the reason why your name has stuck in my head for months, which is the presentation you gave this summer up in the Rocky Mountains. And the idea was just – it was a little bit different. Normally the presentations are about long stock picks. But yours was about shorting credit ETFs. And I wonder if you could just – the way you drilled down into it I thought was – it was kind of beautiful, actually, if you're into this stuff.

Adam Schwartz: Than you.

Dan Ferris: Because you told me exactly what I was wondering about: what is inside of a junk bond ETF and how does it get in there? And, more importantly for your thesis, how does it get out when people are selling these things? So I wonder if you could just kind of tell us about this thesis of yours and tell us about this idea. I find it absolutely fascinating.

Adam Schwartz: Sure. Well, I appreciate the kind sentiments. It's very nice of you to say. Whenever I give – I'm sure others feel the same: whenever you give a presentation or an idea – I assume you feel the same way sending your newsletter out – it's always a little bit like revealing artwork. And people can boo it and not like it, and sometimes it gets a little nerve-wracking. So getting positive feedback is always nice. So thank you.

Dan Ferris: You're quite welcome.

Adam Schwartz: So the basic idea with the credit ETFs is that – and there's kind of two things going on. The first side is kind of the fundamental view, which is: is credit cheap? Is credit expensive? And this applies to high-yield; this applies to investment grade. And we'll talk about investment grade a little bit in a second as well, 'cause I think that's actually pretty compelling. So on the one hand you have this question of credit – cheap, expensive. And then the second part is this idea of this liquid-versus-illiquid argument.

So let's talk about fundamentals first. Fundamentally, rates have been very low for a very long period of time, since the financial crisis. And you have these securities, these bonds, that're issued by companies. And, for your listeners, a bond – people know what bonds are, but basically it's a promise where you lend your money and you get an interest rate and you hopefully get your money back. And there's a bunch of rules that kind govern how that bond is supposed to work. Particularly I think of the rules and the covenants as almost like a prenuptial agreement. It's the agreement between the lender and the borrower of what we're gonna do if things don't necessarily go to plan.

And so what you see fundamentally is: a lot of debt's been issued and there have been almost no losses outside of some small energy names and maybe some retail. And that's because anyone and everyone who has problems has been able to refinance their debt. 'Cause rates are low. So that's created this strange dynamic where there's record levels of debt and virtually no defaults. And then additionally, the yield spread that the borrowers are asking for is very tight. And so there's more debt; there's lower interest rates. And then you would hope that the promises, the covenants that're made between the borrower and the lender are strong so at the very least if things were to go bad you'd be protected. But those are at all-time terrible levels where you really don't have that many protections and assets are able to be moved from a security out of the security so you really don't have that much asset coverage at the bond level.

And when you look at the rates that you're getting paid as the lender, in the high-yield market right now, it's about a seven-percent yield on a gross basis, and people say, "That's great. I can't make seven percent anywhere." But the reality is that's a gross basis, and there's losses. And so if you look at a historical loss rate on high-yield, it's about 2, 2.5 percent. So your real yield is – let's call it five. But there's been no losses for the last five or six years. And so if you think about all those sick companies that've sort of been the living dead, if you will, if those start reverting to the mean, you could see losses that are more on like kinda the three-to-four-percent net range. And you could be buying a high-yield bond at treasuries minus a spread. And so you've got that dynamic.

On the investment-grade side, what's kind of interesting is on the ETFs – and, by the way, I think this is kind of by design, but if you were to click on an investment-grade ETF overview on their website, you have this very bifurcated sort of portfolio where half the portfolio are names like Apple and Microsoft, Bank of America, names that wouldn't cause you much concern. But the other half is triple-B. So they've managed to get a bond that has long duration, about eight years investment grade, and a four-percent coupon, but it's really two camps. And what people hopefully learned in the financial crisis is you're really only as strong as your weakest link. And when half of your portfolio is quasi-junk that's sorta one hiccup away from being downgraded, it can get pretty tricky in the investment grade, and you're paying a very tight spread to that, to treasuries.

So, fundamentally, I think credit is really expensive. On a loss-adjusted basis, you're probably getting something equivalent or worse than treasuries. And people's expectations for it are that it'll continue to perform as it has. But rates have been going up and margins are at all-time peaks. What happens if that starts compressing? There's all sorts of reasons why, fundamentally, things can get a little bit tricky.

I'll pause there. The second part is the liquidity/illiquidity. But before I get there, I'll pause. I don't know if you had any questions on that.

Dan Ferris: You know, I think I follow you. When you say margins – you just mentioned margins. In other words, corporate profit margins are near all-time peaks.

Adam Schwartz: Yeah.

Dan Ferris: And if they compress as – it's one of the most mean-reverting data series in the whole financial world. And if it reverts to the mean, they have less ability to support debt and it could create a huge problem is what I took from that.

Adam Schwartz: Yeah. Exactly. That's at a 50-year high in terms of company – I mean, if you're a company, why would you issue equity in the last five, six, seven years? You'd issue debt. Because rates were really low. And so it makes all the sense in the world that if people are gonna lend to companies at three, four, or five percent, why wouldn't you borrow the money there if you're a proven capital allocator? But we all know that there's some companies that're proven capital allocators and there's others that just can't stop issuing debt and they just perpetually do it over and over again, and they assume that tomorrow's gonna be a sunny day. And if it becomes a cloudy day, it can get pretty challenging.

And as an investor in debt securities, you need to be extremely prudent about who you lend to, why you lend to them, and your expectations of being paid back. And you need to make sure that in the event that maybe you lack prudence on the lending, at least you're prudent on the rules that make sure that your assets are – that there's coverage of your securities by the assets. And that's just not happening on any front. So when investors are lacking prudence and lending sort of at any terms, it can be pretty scary when things aren't met. Because you're taking equity-like risk in some of these securities and you're getting a very lousy return, fundamentally.

Dan Ferris: Yeah. I also think you make an interesting point about the bifurcated portfolio. You have a much higher-quality piece and then a piece that is just on the cusp of junk. It's one downgrade away from junk, one or two.

Adam Schwartz: That's right. Back in the mortgage crisis, there was this product that was created called Alt-A. And what Alt-A was was they were not subprime, but they weren't good enough to be prime. They were sort of in the middle. And so these triple-Bs remind me a lot of that Alt-A, which is: they're not subprime but they're like one layoff away from not being able to pay their mortgage; they're one life hiccup away from falling into that subprime category. And they're very far away from ever getting into prime. So that's what these remind me of.

These are companies that are doing okay today at peak margins and in an economy that's sorta rumbling along. But if the economy stops running along or you have wage inflation, cost inflation, anything that starts impacting their margins, and if they don't have pricing power, their margins get squeezed, cash flow comes down, and then their leverage ratios all tick up. And then when that happens – I mean, look at General Electric. You plummet through the ratings pretty quickly. So I think investment grade is a little bit – frankly, it's scarier to me in a sense than junk because people think it's investment-grade and it's really sorta two securities. In its math.

[Crosstalk]

Because when you look at it, it looks very safe at the first glance.

Dan Ferris: Right. This is a point that I've made a few times on the podcast. I think that there's greater potential for people to get harmed – or there's a great potential, an unappreciated potential for people to get harmed really badly financially in those instruments perceived as the safest.

Adam Schwartz: That's right.

Dan Ferris: Sovereign debt is supposed to be this safe thing but the stuff is negative yielding, some of it. And that turns it into toxic waste. And we turned mortgages into toxic waste. The 30-year mortgage, the glory of the world, the US 30-year mortgage was turned into toxic waste in the financial crisis. And at the peak of a good equity bubble, the very best businesses become toxic. Cisco was a great business in 2000.

Adam Schwartz: The price you pay is what's gonna determine the safety of the investment.

Dan Ferris: Exactly.

Adam Schwartz: There are amazing companies in the Nifty 50 that were terrific companies that people were overpaying for, and they were great businesses many of them, and they didn't earn their – the growth that was priced in was tremendous and didn't come to be, and the stock prices went down a lot. So nirvana is finding a great business at a cheap price. That's hard to do. But if you're not finding that, you wanna just make sure that the price you're paying – you feel comfortable with the downside and how much you think you can lose over the fullness of time. That's gonna determine a lot.

Dan Ferris: Okay. So, Adam, I wanna sorta close the loop here on this credit idea.

Adam Schwartz: Sure.

Dan Ferris: The final piece of this was the one that really kind of stuck in my head: when you talked about what happens when funds are falling and ETFs have to sell bonds. So they buy bonds and they stick 'em in this ETF. But what happens when they have to sell?

Adam Schwartz: Yeah, look, the answer is: I don't know. You know, markets function most of the time, right? And so I would caution everyone here: I'm not predicting the demise of the ETF. I'm just saying that there are a lot of things that can happen, and the way that people take sorta the truth and the assumption that it will work, they're taking for granted. And if it doesn't work, it could get pretty ugly.

The basic idea is that you've got a structure, in ETF, that promises effectively minute-by-minute liquidity but underneath it are assets that aren't that liquid. I don't know how one can exist while the other exists. So I don't know how you can have a liquid instrument backed by illiquid securities. It just doesn't make logical sense to me.

The way that it's been explained to me, and if you read the indentures, they have these market makers called associated persons. And their role is basically to act as an arbitrageur where they're gonna buy if it ever trades – so for your listeners, if you think about it, let's say that there's a $100.00 worth of bonds out there that they're valued at $100.00 and there's a lotta people rushing to sell.

The market maker's role is to come in – and let's say they bid 98 percent, 98 cents on the dollar, and they go in and they buy that ETF from whoever's selling it, and then they go into JP Morgan or BlackRock or State Street and they effectively retire the shares. They give them $100.00 worth of bonds that they bought at $98.00 and they're supposed to get $100.00 worth of cash bonds that they then go sell at a price higher than $98.00. And if they do that enough, the gap between the NAV – the $100.00 – and the price they paid – the $98.00 – should close.

But when I see something like – that's assumed to work because it always has. And we've talked about in housing: everyone assumed housing would always go up and never goes down. People assume this will always work because it never has not worked. I don't take that for granted. And I don't know who they're gonna sell the cash bonds to. And I don't know why people are so comfortable making that assumption. And what I worry about is: people may get that liquidity that they think they signed up for but it may come at a tremendous discount to the NAV.

So the cycle that I get worried about is: if an investor believes that bonds don't lose money and they have minute-by-minute liquidity, that when they go to sell it and they're quoted a price that's ten percent below where it closed the day before, or five percent below, whatever it is, then that's gonna create quasi-pandemonium among investors and then the APs are gonna be coming in and they're not gonna know how many redemptions they need to fulfill with the issuer. And they don't know how many cash bonds they're gonna have to sell. So they're gonna be bidding lower and lower and bigger and bigger discounts to the NAV.

And it becomes this sort of circular problem, which will eventually probably solve for itself, but it could be quite painful getting to that point. And then it will sort of be discovered that you cannot create liquidity out of thin air. _____ _____ _____ _____ _____ _____.

[Crosstalk]

Dan Ferris: Right. This reminds me of the failed asset-backed securities auctions during the financial crisis.

Adam Schwartz: You know, muni auction rates were an example that failed. CDO liquidations. There's just a lot of concepts of – you just can't insert someone and say, "Because there's a market maker there, that's liquidity." If securities are illiquid, they're illiquid. It's just the way it is. And I think that a lot of the ETFs that were created serve a great purpose. In equity markets, and maybe even in some bond markets for more liquid securities. But for illiquid securities, I think it's gonna be pretty painful for people if things get bad. If things stay okay, it's probably – it may not be as big of an issue. But eventually – nothing lasts forever. And I think if things start to get a little bit weaker, this could be a very vulnerable instrument.

Dan Ferris: All right, Adam. We have actually run outta time. And I think that's okay. Because I think that leaves us at a perfect place, with ETFs possibly being very vulnerable.

Adam Schwartz: Perfect.

Dan Ferris: Yeah. Thank you so much for coming on and explaining this to us. I really appreciate it.

Adam Schwartz: My pleasure. Thanks for having me.

Dan Ferris: Yeah. You bet. So, you know, maybe we'll have you back sometime in the future and see how all this worked out [laughs].

Adam Schwartz: Awesome.

Buck Sexton: Thank you so much.

Dan Ferris: Okay, Adam. Bye-bye. Thank you.

Adam Schwartz: Thanks so much.

[Music plays]

Buck Sexton: All right. So, mail bag this week. We only got one up for you before we have our last show of the year I think next week. But [email protected] We read all the stuff. We try to respond to every one, even the ones that make us sad on the inside. Although Dan is not quite the bomb thrower that some others on the podcast have been. We don't get a lot of mean ones. That's nice.

Let's get e-mail number one in the mix. David S. writes, "I was listening to episode 79. You were talking to your guest, Mattie Duppler. You were responding to her comment about labor." This is all meant for Dan. "You stated that labor is an expense. Ideally you would not like to pay more for labor. To pay more, and to make it worth more to pay more, sounds like you were telling me that there are massively new and higher-margin opportunities that did not exist before this once-in-a-generation change. I partially get your statement and partially do not get it.

"Here is the part that I get: labor is an expense. I understand you wanna keep labor costs low. However, there comes a time when cutting labor may be shooting yourself in the foot. You may be overlooking the interdependence between labor costs and revenues. If people do not get the money to buy things from their paycheck, how are they going to pay for their services your company provides? Additionally, they will seek to get it, money, by other means.

"Responsible companies should pay their workers well. They should make products and provide services that benefit people. They should train their workers to make the products safe and effective. They should provide wages and salaries their employees can go home and raise their families on. This is the true value investment. Profits should be the natural consequences of a well-run business. Look forward to your response. David S to Dan." Dan, your move, sir.

Dan Ferris: Hm. You know, I think I probably was caught up in the moment there with Mattie and let you believe that I don't agree with what you said here, which is true. Responsible companies should pay their workers well. And, more to the point, they should pay their workers exactly what they're worth. And we were discussing – Mattie was more in the political side of things, as podcast guests go. So we were talking about labor laws, as I recall, and whether or not you should force people to pay minimum wages and things like that. And so I hear you. And I agree with you. And I hope you didn't misconstrue any of my comments to mean that – I want the picture you're painting here. I want a competitive marketplace where companies have to pay to compete to get the good workers. That is exactly what I want.

My fear is that you distort things by having governments control the price of anything, including the price of labor. So if everybody gets $15.00 an hour, it's harder to figure out – it's harder for the market to figure out who's doing a good job and who isn't. And it's harder to be a responsible company, frankly, if you have to pay everybody well, including the people who aren't doing such a great job. So I agree with the gist of this and I hope that we're kind of on the same page now. And thank you for writing in, David S.

Buck Sexton: That's gonna be it for this episode of the Investor Hour, folks. Thank you for hanging out with us. Please do let us know your thoughts: [email protected] And obviously you can get show transcripts and all kinds of other goodies at the website, InvestorHour.com. Love us or hate us, just don't ignore us.

Mr. Dan Ferris, thank you for your expertise, my friend.

Dan Ferris: All right, Buck. It was very enjoyable, once again, and I look forward to the next one.

Buck Sexton: Talk to you soon, everybody. Later.

Dan Ferris: Thank you, everyone.

[Music plays]

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