In This Episode

We’ve covered mental models in previous episodes – the unique patterns of thought that open up opportunities – and reveal pitfalls – that the vast majority of more conventional minds don’t see, or even understand.

Dan gets into a new mental model in this week’s episode, describing second-level thinking. “This one is very important for investors – it’s no coincidence that the first chapter of Howard Marx’s book is all about second-level thinking.”

It touches every investing activity, from passive index funds to actively managing your own portfolio. “It’s impossible to have consistent long-term success as an investor without mastering the art of second-level thinking.”

Dan then runs through a flurry of news items, from the under-reported “end of an era” at Apple, to the latest Tesla news, before getting to this week’s guest, Chris Pavese.

Chris is the President and Chief Investment Officer of Broyhill Asset Management and Vice President and Chief Investment Officer of BMC Fund, a registered investment company. He is a CFA Charterholder, past President of the Board of the CFA Institute’s North Carolina Society, and has some sweet moves on the dance floor.

Even more interesting, his firm has the stated goal of maintaining clients’ wealth for generations, for families, shielding family wealth from the epic disruptions that come with each wave of creative disruption. We think you’ll find what strategies and insights he can reveal, all the way to a disruption in the car dealership industry he’s poised to pounce on.  

Featured Guests

Chris Pavese
Chris Pavese
Chris is the President and Chief Investment Officer of Broyhill Asset Management and Vice President and Chief Investment Officer of BMC Fund, a registered investment company. He is a CFA Charterholder, Past President of the Board of the CFA Institute’s North Carolina Society.

Episode Extras


  • You can learn more about Dan’s Extreme Value service and get the details on a special market situation he’s closely monitoring by clicking here.
  • To check out Chris’s frim Broyhill Asset Management, click here.


2:44: Dan explains second-level thinking by first explaining what it ISN’T – shallow and superficial, the kind of thinking almost everyone does, all the time. “First-level thinkers all tend to be on the same page about an investment.”

5:45: There’s a two-word question that immediately transitions you from first-level to second-level thinking when it comes to a stock – here’s what to ask yourself after every headline you see.

13:44: As you know, Dan doesn’t normally get into politics – but when it’s impacting the stock market, like this week’s G-20 meeting and the trade war denouement, he has to give his two cents.

17:09: Dan makes note of gold’s reaction to the G-20 inspired stock surge: “That’s gold for you.”

20:01: The Chief Design officer of Apple is leaving the company after a 27-year tenure, and Dan calls it “an end of an era” for two-thirds of Apple’s yearly revenue. “Apple’s the one with the biggest question mark over it to me, since it’s a one-product company – it needs to do something about that.”

26:00: Dan introduces this week’s podcast guest, Chris Pavese. Chris is the President and Chief Investment Officer of Broyhill Asset Management and Vice President and Chief Investment Officer of BMC Fund, a registered investment company. He is a CFA Charterholder, past President of the Board of the CFA Institute’s North Carolina Society, and has some sweet moves on the dance floor.

27:11: Chris explains how he got into finance from his dreams of being an architect. “Somewhere along the line I realized I could graduate with two different degrees in the same seven years.”

34:50: Chris details the era in which he joined Wall Street, when JPMorgan, hiring him straight out of college, had just 10,000 employees. “A much different institution than it is today.”

37:10: Dan asks Chris about Broyhill Asset Management, and Chris explains how this “private endowment for family members” came to be, based on the goal of maintaining family wealth over generations if not centuries.

43:00: Chris reveals the two businesses with overlooked spinoff opportunities his firm has taken stakes in. “The fact that management was staying with the used car option… we thought was a very important signal.”

59:45: In the mailbag, Scott S. from Texas lists several fundamental metrics he follows, and asks if he’s doing enough fundamental analysis.  Dan’s reply goes a level deeper and gets beyond the metrics.  


Announcer:                 Broadcasting from Baltimore, Maryland all around the world, you're listening to the Stansberry Investor Hour.

[Music plays]

Tune in each Thursday on iTunes for the latest episodes of the Stansberry Investor Hour. Sign up for the free show archive at Here is your host, Dan Ferris.

Dan Ferris:                 Hello and welcome to another episode of the Stansberry Investor Hour. I'm your host, Dan Ferris. I'm also the editor of Extreme Value, a value-investing service published by Stansberry Research. All right. Let's do this thing.

Now, in episode 103, I talked about mental models. Mental models are simply different perspectives on reality. They're ways of understanding reality that can help you frame a particular situation and understand different situations. They're tools. They're thinking tools. Most mental models are designed to help you avoid trouble before it arrives. A lot of them are. And we specifically addressed the circle-of-competence mental model in episode 103.

You remember circle of competence? It works like this. You draw a large circle on a sheet of paper. Inside that large circle you draw a smaller circle. Maybe a lot smaller [laughs]. And the large circle represents everything you think you know but don't really know so well, and the smaller circle represents what you really know well enough to even claim that you know it. That's your circle of competence. And the idea is to focus your efforts in investing and business within your circle of competence, right? So a doctor might have a real big advantage over the rest of us when it comes to analyzing health care companies, for example. So they should really use that to their advantage. That's their circle of competence.

This week we'll talk about a different mental model. This one is called second-level thinking. This one is very important for investors, very important. It's no coincidence that the first chapter of investor-author Howard Marks' book The Most Important Thing is all about second-level thinking. Investing in individual stocks and bonds instead of just buying an index fund – actually managing your own account actively – is, at its core, an exercise in second-level thinking. Whether you realize it or not, it is. It's impossible to have consistent long-term success as an investor without mastering the art of second-level thinking. So a good question to ask at this point might be, oh, I don't know, "What the heck is second-level thinking?"

Now, long-time listeners know negative definitions often come first around here, right? This is no exception. The most important thing second-level thinking is not is first-level thinking. First-level thinking is shallow and superficial. Anybody can do it. Everybody does it all the time. Every time the stock market goes up because people think the Fed is going to cut interest rates, that's the most superficial first-level thinking.

If you say something like, "Company XYZ is firing on all cylinders and they just had a good earnings report and they're expected to keep doing well; therefore the stock will continue to rise," you're probably engaging is first-level thinking. But if you say, "This is a good company and it's doing well but everybody and his brother thinks it's the greatest company in the world and I don't think it's the greatest company in the world; I just think it's OK, so I'm going to avoid owning it," then if you say things like that and think that way, then you're starting to engage in second-level thinking.

Howard Marks says, "Second-level thinking is deep, complex, and convoluted." First-level thinking was shallow and superficial. Second-level thinking is deep and complex. The first-level thinker doesn't ask many questions. The second-level thinker rarely stops asking questions about his investment. First-level thinkers are looking for simple tricks and tips and easy things that are – they're looking at charts and trying to figure out what the magic point is that means the stock is just going to go up and make them a lot of  money real fast.

Second-level thinkers are trying to develop a robust process for finding and making new investments and eliminating bad ones too. First-level thinkers all tend to be on the same page about a particular investment. They all hate it or they all love it because they're all just taking whatever the commonly-known facts are and assuming that's the whole story and that's all there is to it.

"Tesla's got a great product," for example. I'll pick on Tesla. "Tesla's got a great product and they're changing the world and Elon Musk is a genius. Therefore it's going to go up forever." Second-level thinkers are all over the map, though. They have a wide variety of very thoughtful, nuanced views because they've all done their own homework and lots of it. First-level thinkers usually assume the obvious, intuitive cause-and-effect relationships, right? Earnings are going up; stock's going to go up. Second-level thinkers consider the effects of the effects. Maybe they'll say, "The earnings are going up; the stock's going up; it's getting too expensive; I'm out." Something like that.

If you want an easy way to shift into second-level thinking, just remember a simple two-word question: "Then what?" No matter what you hear about a company, you always want to a say, "Then what?" "The earnings are going up this quarter? Well, then what?" "The earnings are going up next year? Then what?" Whatever it is, you keep asking, "Then what?" Because you want to know the effects of the effects of the effects. No matter what happens, the second-level thinker's always trying to think ahead beyond the immediate cause-and-effect relationships. So, for example, a first-level thinker might look at rising home prices and run out and buy homes for investments. A second-level thinker would look at how much the supply's increased versus the demand and what the pricing trends are. And probably among many other variables. And they'll likely come to a completely different, far more nuanced and insightful conclusion than the first-level thinker.

First-level thinker might've looked at Walmart in early 2008 and thought, "Oh, jeez. If housing and related industries continue to struggle, Walmart's average customer will struggle, and they'll have a lot less money to spend if a full-blown financial crisis develops. I better sell Walmart shares." The second-level thinker might've said, "We've just been through an enormous boom in housing and banking and it's clearly coming to an end. People are going out of work. Home builders are struggling. A lot of  folks who think they're too rich to shop at Walmart today will very likely end up shopping there in the future. Better buy some Walmart." Second-level thinking can help you identify bargains when others are terrified.

In the spring of 2009, a lot of investors were looking at a little company called Prestige Brands Holdings, which had $378 million in debt and a $322-million market cap, so more debt than market cap. Banks look at that and bond investors look at that and they say, "Oh, boy. The equity is worth less than the debt," and it scares them away. And back then, investors assumed every company with a lot of debt was super risky. But I thought it was a fantastic business. It didn't do manufacturing and distribution. It just owned these popular, over-the-counter products like Compound W wart remover and Spic and Span cleanser. And it just owned the brands and controlled the marketing.

It was like a royalty. It was really cool. And the products had huge market shares. They were sold in 50, 60, in some cases 90%of all the places where similar products were sold. So it was hard to avoid them. It's hard to avoid buying something, maybe that's a good business. Prestige Brands Holdings' stock eventually rose more than 400%. It was one of the biggest winners in Stansberry history and one of the biggest winners we've ever had in Extreme Value.

Second-level thinking can help you avoid problems other investors don't see. When everybody thinks a particular stock is a no-brainer – everybody has to own it – it's probably more like: nobody should own it because it's toxic waste. And even if it's a great business. And the example I keep returning to is Cisco Systems in early 2000. This is the internet plumbing company. And everybody thought it was the no-brainer: no matter what happens, this company's going to keep growing and it's the greatest business in the world, greatest management in the world, blah blah blah. It fell 90%from its March 2000 peak and still hasn't returned to that high price. It was $80.00 a share. It's never seen $80.00 a share again. And it'll probably be a while before it does.

To make better-than-average returns in the stock market means, by definition, that you have to think better than average. You can't do that with first-level thinking. You can't do that with simple, cause-and-effect, reactionary-type thinking. Only the consistent application of asking, "What's next?" and getting deeper, engaging in second-level thinking will get you there.

Second-level thinking in the stock market clearly involves a healthy dose of psychology. Because once you consider if a particular investment is too popular, you realize you're actually thinking about whether or not others are thinking it's too popular. You get it? So Howard Marks tells the story – he wrote about second-level thinking, by the way, also in his e-mails to investors. There's one from September 2015 on this topic that has some different material that's not in the book.

And so he tells this story about John Maynard Keynes, the economist. And Keynes made up this hypothetical newspaper contest. He said, "What if we held this newspaper contest" – and this was back in 1936, so you could talk about stuff like this [laughing]. He says, "What if we held this newspaper contest for readers to vote on the prettiest girls, the six prettiest girls out of 100?" So readers would look at 100 pictures of pretty girls, and the contest was to pick the six prettiest, and the reader who successfully picked the six girls who got the most votes would win a prize. You can already see the analogy, right? So most people don't even see the difference between the prettiest and most popular. They're sitting here going, "I don't understand the difference."

But it's really very different, isn't it? Because the job isn't to pick the prettiest girls at all; it's to successfully anticipate which six girls would be chosen by most other readers. And first-level thinkers – they don't even recognize the distinction. They'll just pick the six girls they think are prettiest, not realizing that "prettiest" is a subjective judgment influenced by cultural differences or some other mostly idiosyncratic preferences. Probably it depends on which city this thing is held in, let alone what country. If the contest is held in a town where there are more red-headed women, for example, it's likely to have a different outcome than if the contest were held in a town populated exclusively by blonde-haired people.

And I can't say which way it'll go. What if you put a bunch of brunettes in the town where there's blonde-haired people? Will they pick them because they're different or will they pick them because they're too unfamiliar? It's hard to think about this. There's no obvious immediate cause-and-effect relationship. And second-level thinking always involves that extra layer or two or three or four of complexity. There's always something the first-level thinkers are missing in the stock market. I'll tell you something: you better know that before you invest.

Howard Marks mentions the difference in the workloads of first and second-level thinkers. The second-level thinkers obviously do a lot more work than the first level. When you get into something up to your eyeballs and do a lot of work, you think about it a lot differently than if you just take a cursory glance at the headlines and accept the prevailing attitudes. You tend to arrive at conclusions that are very different than the ones the first-level thinkers come up with.

So a first-level thinker might hear Elon Musk say production for a particular quarter will be so many thousands of cars and they'll think, "The stock will rise and they'll hit that production number and everything will be great." Second-level thinker will wonder if Musk is exaggerating or lying on purpose or whatever else he might be doing. They just go behind the obvious. First-level thinkers tend to do less work because they think it's easy. They think it should be easy, anyway. First-level thinkers tend to be naïve. They're just trying to follow what's popular and they want to think what everybody else is thinking, whether they even realize they do or not.

Second-level thinkers know investing is hard, really hard. They know they're competing with lots of people with more money and bigger, faster computers, and advanced degrees in finance and everything else. To do better, you need to think at a different, higher level than what most people are thinking. You need to think at the second level. OK?

That's the rant for this week. Write in to us at [email protected] and let me know what you think. All right. Let's talk about what's new.

[Music plays]

All right, folks. Let's talk about what's new in the world. Now, as you know, I don't normally talk about political stuff. But every now and then something appears to be impacting the stock market so much that I feel like I can't not at least mention it. I have to at least mention it. So the G20 meeting – what does that mean for the stock market? And the main thing that came out of that was that President Trump and President Xi from China agreed to take a step back from the trade war, apparently, and continue the negotiations. And Trump says that there will be no new tariffs on Chinese goods while they continue trade talks. And the market kind of loved – the market loved that, OK [laughing]? The market went straight to a new high, first thing Monday morning after it heard that news.

So this reminds me of something. Of course everybody's wondering now: how will G20 talks affect markets going forward? Or what's going to happen from now on as a result of that? And the new highs – that was the result. But this reminds me of something [laughing]. I don't know if you ever watched the very popular television show called Friends. I actually did not watch it. I have not watched it very much. But way back in the day I was working with some folks who, every time I came to work, everybody would sort of gather around and say, "Did you see Friends? Did you see Friends?"

But there is this one recurring thing that was kinda funny: apparently two of the characters had a relationship. They were dating. And then they weren't dating very briefly and the guy went out with another girl or something. Then they got back together. And from that point forward, there was this running gag I think – I think it's a running gag – where the guy says, "We were on a break!" The girl accuses him of cheating and other people accuse him of cheating and he says, "But we were on a break! We were on a break!"

And I feel like when Trump says no new tariffs on Chinese goods while they continue the trade talks, it has that flavor of "We're on a break" kind of a thing. Because it's a thing you say – it's an excuse. It's just something you throw out there when maybe you know you've done something wrong or maybe you know you're going to behave in a certain way or you have behaved in a certain way. And maybe the tie isn't crystal clear to you, but it just feels the same. It feels like the same kind of BS. It feels like the same kind of storytelling.

If he says there's going to be no new tariffs, he could easily come back and say, "Well, we're technically not in trade talks this week. We're on a break. So I'm going to do some new tariffs." You see what I'm saying? It's just – I don't know. It's hard to believe anything politicians say. For me it is anyway. And I'm always trying to look behind it to find things like this that might reflect what I think would be a more realistic outcome.

And so gold prices are down. The stock market went straight to new highs and gold actually dipped back below $1,400, after hitting $1,430-something or $1,440. And that's gold for you. Gold is volatile. And the move from $1,440 back to I think it was like in the $1,380s, and as I talk to you, maybe mid-$1,390s. That doesn't mean anything to me. It doesn't mean, "Oh, it's a fake move and it's not for real." Because if it weren't for real it would've headed back to the low $1,300s, right? It would've headed back below $1,350. So I think the move is still intact. And I think we'll look back in a year or two or three or five or however long it takes, and we'll say, "Oh yeah. That was when gold got moving."

Of course that's a guess about the future. But I think it's also a general guess about where we are in the cycle. That's the important part for me. I think we're still closer to the bottom than the top and I think the top will take us well past the old high of $1,900 an ounce for gold. How long that will take, who knows? Five, 10 years? I don't know. But you don't want to wait too long to see how it unfolds. You want to be early in the trend and hold on throughout the trend, right?

Speaking of things hitting new highs, McDonald's hit all-time highs recently for the 18th time in 2019. And if it's up in the month of July, it'll be like the seventh straight month in the black. And when I think about – Walmart has also done well. It hit new highs fairly recently. Maybe not as recently as McDonald's, but these two stocks – they're kind of stuck in my head from the financial crisis. Because in 2008, Walmart was up 20 or 21%I think including dividends. And I think McDonald's was up six or eight percent or something like that, including dividends.

And obviously the play was, as I alluded to in today's rant: if you really thought about it, of course these stocks should do well when others aren't doing well because more people you would think would shop at a place like Walmart when times are tough and more people would eat at a place like McDonald's when times are tough. Just kind of common sense. But I realize [laughing] common sense doesn't always work in the stock market. But I think that's what's going on here. People are just wanting to own the defensive names. So that's the kind of action you get with McDonald's and Walmart doing really well.

And of course, another thing I feel like I can't not at least mention to you is that Jony Ive, the chief design officer of Apple, is leaving the company. He's been there for like 27 years? He's been there since 1992. And of course, the combination of Jony Ive and Steve Jobs – it came together to create these really incredible products: the iPod, the iPhone, the iPad, all this stuff. And if you read the Walter Isaacson biography of Steve Jobs, there's quite a discussion of Ive's and Jobs' involvement with each other in there. And it was a big deal. They created these iconic products. The look and the feel of them. And also it was different just to have a designer just be so well-known and so high up in the company and so influential.

But nothing lasts forever. And he's moving on to create an independent company. He says he'll still be involved with Apple. I don't know what that means though. And it's the end of an era, isn't it? You wonder. Apple makes two thirds of its revenue off of the iPhone, this iconic product that would not exist in its present form – anything like its present form – without Jony Ive. And what's next for Apple? Of all the big tech names – Facebook, Google, Apple, Amazon – Apple's the one with the biggest question mark over it to me. Because it's effectively a one-product company. And it needs to do something about that.

And you could argue, "Google and Facebook are effectively one-service-type companies." But I feel like their moats are wider. They're more deeply embedded in our lives. And if people choose to buy other devices – if the iPhone turns out to be less popular in the next 10, 15 years than it has been in the last 10 – what are we going to see in terms of a financial performance from Apple? I don't know.

All right. And I can't not talk about Tesla because it's just so darn much fun. Couple of things. One report suggested that – a UBS report came out and suggested – they lowered their price target. They didn't suggest anything. They lowered their price target from $200 to $160. And they projected that Tesla would deliver between 90,000 and 100,000 cars in the quarter. This quarter. They believe that meeting that delivery is unlikely. When Tesla projects 90,000 to 100,000 a quarter, UBS says, "No, we think that's unlikely. It's more like 84,000 units." And they'd lowered that projection from the UBS projection before of 88,000. So, you know, not great stuff about Tesla.

And I think that's really it for what's new. I mean, there's a lot of stuff going on. There's two big deals. Brookfield Infrastructure bought the Genesee & Wyoming railroad. This is just a typical Brookfield thing. $8-billion deal. Not small. And Anheuser is going to do almost a $10-billion IPO for their Asian unit, their Asia-Pacific business. They're going to list that. And it's called Budweiser Brewing Company APAC. And they're selling 1.6 billion worth of primary shares between $5.00 and $6.00 a share approximately, according to term sheets that were seen by a Reuters reporter. Great business. People are never going to stop drinking beer. Not a lot to see here. It's just: end of the cycle, there's always giant deals of one kind or another.

And I'll leave you with one thing though. There was this guy who I've never heard of – apparently he's some kind of management guru at Yale. His name is Jeffrey Sonnenfeld. And he made these kind of sharp comments about Elon Musk from Tesla. And he says, "Elon Musk – obviously he's a genius and this is a board" – the board of directors – "that considers him to be a genius. Yet we see he's disappointing on so many fronts." And the guy accused Elon Musk of using "diversionary moves," he says, "to distract investors away from disappointing" – one disappointment after another, frankly. So, to me, when I hear a voice from academia making those kind of statements about Tesla and a well-liked genius like Elon Musk, I don't know. It just catches my attention.

I really think that Whitney Tilson is right when he says that this is it for Tesla, or the stock's going to be below $100 by the end of the year, and it's kinda the beginning of the end of the Tesla bubble. And this is just like another piece of that puzzle falling into place. When an academic feels safe to just go out and bash someone like that – of course bashing in the business world I guess [laughing] is OK for an academic, right? Anyway, just wanted to leave you with that from what's new. And it's time for the interview.

[Music plays]

It's time for our interview. I think this one's going to be a lot of fun, frankly. I've been looking forward to this. Our interview today is with Chris Pavese. Chris is the President and Chief Investment Officer of Broyhill Asset Management, and Vice President and Chief Investment Officer of BMC Fund, a registered investment company. He is a CFA Charterholder, past president of the board of the CFA Institute's North Carolina Society, and has some sweet moves on the dance floor. Chris, welcome to the show.

Chris Pavese:             Hey, Dan. Thanks for having me.

Dan Ferris:                 You bet. So, Chris, I usually start these things out – especially when I have somebody who manages money for a living, I always ask them how old they were when they first got into investing and what was so interesting about it that got them interested; what happened? Was there an event or an idea or something? How did you get started?

Chris Pavese:             Yeah. I think most folks I would imagine probably can tell you specifically when they got interested in investing and started investing in common stocks as a child or a great background story like that. My story's not quite as interesting. As a kid I grew up dreaming of becoming an architect. Had a drafting table in middle school, took drafting classes through high school, actually went to undergrad as an architecture major for at least year one. And somewhere along the way I've realized that – let's see. So, architecture at the time, undergrad was a five-year program. Master's was an additional two years. So it would've been seven years of schooling.

Somewhere along the line I had the bright idea that I could still do the same seven years of school, but rather than spend all seven as an architecture major, I could do four with a business degree and then go back for three with an architecture degree, and graduate with two degrees in the same seven years. That was during the mid-'90s. And somewhere along the lines of that roaring bull market in tech is when my interest in investing developed. Graduated in '98, which was sorta the high time for finance, and never really looked back.

Dan Ferris:                 So you are a – how does one say? – a Frank Lloyd Wright fan. You were very into him, weren't you, when you were –?

Chris Pavese:             I was. We had chatted about this a bit earlier. So Frank Lloyd Wright's – the concept of organic architecture and how he thought about design integrated with landscape and surroundings just always really appealed to me. I actually interned at a Frank Lloyd Wright home, one of four in New Jersey, during one of the summers I was home from college. And there's so much to – a few years ago I wrote a paper comparing the investment process to the architectural design process. Surprisingly, there's a good bit of overlap there that most folks wouldn't ordinarily think of. But I think just the combination of creativity and problem-solving, intersection of art and science or art and engineering, and just the ability to sort of see the big picture and think broadly I think is a skill set that often goes overlooked in the industry but I think has wide applications across the investment business.

Dan Ferris:                 So I have a bone to pick about Frank Lloyd Wright. Now, I was an enthusiast of him. I read The Fountainhead, that Ayn Rand book, and the hero in there is sort of – he's an architect and the style that she describes is somewhat in the spirit of Frank Lloyd Wright. I love looking at pictures of the stuff. But then I visited the Kaufmann house, Fallingwater house in Pennsylvania.

Chris Pavese:             Sure.

Dan Ferris:                 And I thought to myself: the setting was beautiful, and from the outside it just – that cantilevered porch and everything – it's just gorgeous. It's absolutely gorgeous. But then I went inside and the bedroom is tiny and the floor is like this rough, hard rock. I couldn't imagine waking up in this tiny little bedroom, stepping on this hard floor first thing in the morning. It really kind of deflated me with Frank Lloyd Wright. I don't know. Have you been in a lot of his – you worked in that one house. You've been in a lot of Frank Lloyd Wright buildings I assume.

Chris Pavese:             I have. One of the things that stands out – and you sort of alluded to it, Dan – when you walk through a Frank Lloyd Wright home, is just how he thinks about and manipulates your experience, and your experience with space as you're walking through the home. So you'll go through doorways that're intentionally smaller that'll open up in to a wide open space. And I think that also ties very well with this concept of sort of relative value in the markets, where you can be – your experience is heavily influenced by how you arrive to it, right?

So if you're walking through a very small, very closed hallway, and walk through the doorway into a opened-up massive space, it amplifies the effect of that space. Similar to living in the past 10 years of a bull market where 20 times EBITDA is now just sort of a normal valuation for a tech company and you're comparing that to companies that – 18 times EBITDA, that may seem cheap. Or 25 times EBITDA, that may seem a little bit more expensive. But it's very hard to look back and imagine that those same businesses may've been trading at single-digit multiples 10-plus years ago and could very well go back there at some point. So I think our experiences both in the physical world and in the investment world can be heavily biased by what we've grown accustomed to.

Dan Ferris:                 Well-put. I would never have thought about that. The parallels between architecture and investing. So, one more architecture question. What's your involvement today? Any? Are you just an enthusiast? You just like to look at buildings, or what? Anything?

Chris Pavese:             No involvement whatsoever. I guess my only involvement left behind came along with – our youngest is six years old and very into building and constructing with LEGOs. And LEGO has this wonderful series called the LEGO Architecture set where they actually have Frank Lloyd Wright's Fallingwater, and the Guggenheim Museum is another. Around my home office you will see the office scattered with LEGO models of famous architectural buildings. Other than that, just: I still tend to be old-fashioned. We've got thousands and thousands of notes online in the cloud that are shared across the team, but generally folks that know me well and have sat in a meeting with me will know that more often than not when I'm taking notes it's with a pad and pencil and I'm sketching and outlining ideas. I tend to be a very visual thinker.

Dan Ferris:                 I see. Makes sense. So, when was the first gig? When was the first finance gig for you?

Chris Pavese:             Yeah. Also a little bit unusual. I guess I've only had really two jobs in this business. So I graduated Penn State in 1998, went right to work for JP Morgan at the old JPM headquarters at 60 Wall Street. At the time I think JPM had maybe 10,000 employees. So it was a much different institution than it is today. But still had a storied history and a prestigious investment banking culture. I grew up on the investment management side of that business, worked my way through their ranks, and in '05 had an opportunity to join a small family office in North Carolina, where I was assisting in managing their internal equity portfolio.

And I am still at that family office over a decade later. So it's been enjoying life in the Southeast and in North Carolina. Still get up to New York a good bit to visit friends and family and obviously for work and meetings. But there's a lot to be said to have the distance and perspective away from the crowd.

Dan Ferris:                 Yeah. It must be cool being down south instead of in Chicago or New York or someplace. So, talk about this firm, Broyhill Asset Management. As little or as much as you want to. But I'm just curious: who founded it? And when and why? And under what circumstances did you get involved?

Chris Pavese:             Sure. So, the family office was initially established in 1980 when the Broyhill family sold the furniture business. Broyhill Furniture, the name and brand, is still alive and well today. Although it's been bought and sold several times over since then and the family does not really have any involvement in it today, nor have they in quite some time. So in 1980 they essentially went overnight from the furniture business to managing the family's wealth. And did that themselves with a small team over a quarter century before I came on board.

I came on board in '05, as I said, to start to assist in managing one of the family's internal equity portfolios. That portfolio – you mentioned BMC Fund at the intro – is really a closed-end SEC-registered mutual fund, for all intents and purposes. But it's not publicly traded. It's not open to the public. I guess the best analogy is it's sort of like a private endowment for family members where the thinking and aim is for that money to live in perpetuity and be available for several generations of Broyhill family members.

One of the things that really excited me about the opportunity to join Broyhill back 10-plus years ago, in addition to just helping the family run their own money, was the potential to leverage that infrastructure to begin to offer individual investors, likeminded investors, the same research-intensive investment process in constructing individual portfolios. And really that has been the genesis of Broyhill Asset Management, the registered investment advisory firm, and where we've been increasingly focused for the last several years.

Dan Ferris:                 OK. So give us an example of – go ahead.

Chris Pavese:             Was just going to add: so that firm – most of what we're doing today is focused on finding attractive investment opportunities and running concentrated portfolios of equity investment when and if we see things worthy of putting capital at risk. Similar to the earlier comment, the value in being away from the big city, in the value in being located in the foothills of the Blue Ridge Mountains, is that we don't get caught up in the groupthink and the noise and the quarter-to-quarter, and the ability to sort of think with a rational objective long-term perspective outside of the fray and away from the noise – I think that really is and truly is a competitive advantage of the firm.

Dan Ferris:                 Yeah. And just for the listener, I get to see at least one Chris Pavese presentation each year when we attend the VALUEx Vail conference. And I have to tell you all: Chris' presentations are different than everybody else. You can tell that he's taken a lot of care with the ideas and the order in which they're presented. And there's always plenty of good humor in them. And it seems like a very careful, thoughtful process. It's of a different character than most of the other presentations. So maybe you could just talk us through a typical example of a company that you would invest in at Broyhill.

Chris Pavese:             Sure. Well, first of all, thank you, Dan. I very much appreciate that. The VALUEx conferences are always a great set of presentations and certainly a good group of talented managers. So very much appreciate that.

To your point, I think one of the things we try to do is take any idea and bring it down to its essence and try to make it as simple as possible. We also try to have fun doing what we do, right? A lot of folks in the industry I think come off as overly serious or overly quantitative. And we don't see a very strong correlation between the appearance of being serious and actually being good at your job. I think the more fun you can have day to day, the more passion you bring with it. So we try to bring that with us in presentations and the material we put together as well.

I think a good example of that is just: the most recent presentation we gave just a few weeks ago at VALUEx was our investment thesis on KAR Auction Services, which was a relatively new position for us this year. If we back up for a second, the majority of our investments over time have generally fallen into one of two categories. It is either a value-driven investment with a particular catalyst for realizing that value or it is another investment that for one of many reasons is temporarily out of favor or there's been a dislocation where the market has taken a short-term data point and extrapolated it well into the future and we're just betting on a reversion to the mean.

What's interesting about KAR is that we've sort of had both dynamics at work. We think the business is undervalued, and we can get into that in a moment, get into the numbers if you'd like. What attracted to us to the situation was: about a year ago, without being prompted at all, management announced that they were splitting off one of the two businesses that they owned. And we thought that that would be the catalyst for value creation. The temporary dislocation actually happened in February of this year, about a year after they announced the spin-off, when, on a recent earnings call, management fumbled a bit responding to analysts' questions about the timing of the spin-off.

The quick knee-jerk reaction from most of the sales side was that they did not believe that the spin-off – well, let's just say that the risks to the spin-off actually happening were greatly increased. So all of a sudden the market went from valuing these two businesses independently on the sum-of-their-parts business to just knocking it down and not giving them credit for the highly valuable salvage business that was about to be spun off.

Long story short, stock dropped 20%in a day, which was that temporary dislocation we were looking for. When we dug in, we didn't really reach the same conclusion that the rest of the market did. It seemed that the response to the question regarding the spin was just sort of boilerplate legalese. So we took a position. And within a few weeks, management clarified the situation and stock came back to where it was. So that was the sort of first phase of the move in the stock.

The second phase we see in value creation is them spinning off the salvage business. So KAR basically runs a duopoly in two similar but different businesses. One of their businesses is in whole-car auction services. So another way of saying that is they run auctions on used cars for dealerships where dealerships will go to these large physical auctions and bid on cars either coming off lease or through other dealerships. But it's a relatively large market, with KAR being one of two major players that control 70 to 80%of the market. Great returns on capital, high margins, strong recurring cash flow.

The second business is also an auction business. And that is the salvage business, which was being spun off. And actually that spin-off was effective this week. So now that business is trading as an independent entity. We thought that business was clearly and obviously undervalued inside of KAR pre-spin. Reason being is: we had a clear publicly-traded peer in Copart. That traded at 2 times the valuation of KAR. So the first part of the thesis was that basically in the short term, once IAA was spun off from KAR, IAA being the salvage business, that business would almost immediately be re-rated to a valuation more in line with Copart. And we are already seeing that this week in just how quickly IAA is being re-valued.

The second part of the business which we think is still being overlooked – and actually there was a downgrade on the street today on the remaining business – is, we thought it was really interesting: if you look and think about the incentives of a spin-off – and I'm sure your readers are probably already aware of why spin-offs in general are attractive areas for investment, just because smaller companies go undercapitalized or under-management or underappreciated inside of a much larger business. When they're spun off, for a number of reasons, they tend to do well as smaller independent entities.

In this case we thought it was really interesting that management was not moving over to the spun-out business, IAA, which everyone realized was clearly undervalued, and we believed, and most of the street believed, would immediately re-rate higher. The fact that management was staying with the remain co, ADESA, which is the used-car auction, we thought was a very important signal. I mean, ADESA is a more cyclical business. There's more structural threats in terms of online competition. And there's no clear comps because their biggest competitor is privately held. So why would you stay with that business if you're management, rather than go to this smaller, spun-off entity that is very clearly likely to re-rate almost immediately? As management, your stock options are very likely to appreciate significantly in the near term.

So the fact that they were staying with the remain co led us to believe that there was probably a good reason for them doing so. And let's just say we think the long-term upside in remain co, the remaining KAR services business, is significant and still misunderstood.

Dan Ferris:                 Before we go further, in the regular remain co, the regular whole-car-auction business, who's doing the selling? You said the dealerships are buying. Who's doing the selling?

Chris Pavese:             One of the biggest drivers of that business in the last few years has been the volume of off-lease vehicles that are coming into the market. So there's a lot of auto bears out there for several years. And that's actually, if we rewind for a sec, Dan. We have been studying the auto industry and have been involved in various parts of the supply chain for several years. We think a recurring theme we've seen in the markets for the last five-plus years has been accelerating change across industries driven by new technologies. Oftentimes those new technologies represent great investments, although most of the times they're not realized by value investors.

But more generally when there is a worry of some sort of secular change or a disconnect in the industry or a sort of misunderstanding of what direction the industry is going – media is another great example, just being disrupted by Netflix and over-the-top, versus traditional cable. You can sometimes find really interesting, heavily discounted investment because there's not certainty, or a greater amount of uncertainty around those investments. So auto I think for a number of reasons has been in that – could be very well-defined, along the same lines, which is why we've been so interested in the space.

So, not only have the bears been concerned about the quantity of new vehicle sales over the last few years, with annual car sales at $60 and $70 million, up significantly from the crisis lows, but there's also this technological threat in terms of Tesla and electric vehicles, in addition to self-driving and autonomous vehicles, that is severely weighing on a number of the auto businesses up and down the supply chain. The used-car-auction market is one of those.

One of the bearish arguments for the auto OEMs, the manufacturers, is that, one, subprime lending has been an issue and juiced new vehicle sales. And in addition to subprime lending, people have been stretching and buying more car than they would otherwise afford because they've been leasing cars rather than financing them. And so leasing allows them to make smaller payments, and they're basically budgeting based on the monthly payment rather than the overall value or the overall cost. So you've seen this tremendous spike in leased vehicles as a percentage of the total over the last three to five years.

KAR has actually been a big beneficiary of that. Because as those cars come off lease, which you're starting to see now, or have seen in the last year or two, you've got this big wave of vehicles that need to be resold. So, more often than not, they're pushed onto an auction either held by Manheim or KAR, and auctioned off to various dealers across the state. So that has been a big source of supply.

Another source of supply that is underappreciated – and this ties back to subprime – is repossessions. So if you think about the percentage of subprime loans and loan quality deteriorating as well as loan terms being extended and the maturity of those loans being extended, you've started to see losses pile up at some of the finance companies. And this was more so a couple years ago when I think subprime really go to the more worrying levels than it was today. The market has tightened up a bit since then. But as repossessions spike, those cars also go to auction. And that's also a nice offset to the more cyclical parts of KAR's business, in that repossessions should act more as a countercyclical element of their business.

Dan Ferris:                 Wow. That was a great answer. And I just want to point out for our listener: I asked Chris a very simple straight question. He did not give me the first-level thinker's answer. He gave me the second-level thinker, the deep, nuanced answer. This is the sound of a second-level thinker at work, OK?

I could sit here and listen to you talk about KAR all day. It sounds like a great idea. But moving on, I guess maybe we have about five or 10 minutes here. We read a lot of the same books and you post a lot of your reading on your website, on the Broyhill Asset Management website, which I encourage people to go to. It's a great source of information and insight. And a great list of books. I guess the real question I want to know is: what have you read lately, or even in the past year, that's just changed your life? If anything.

Chris Pavese:             If it's OK, I may reword that question a bit. Rather than something that changed my mind, a couple books that had a significant influence or resonated with us significantly over the last few years.

Dan Ferris:                 OK.

Chris Pavese:             So I'll give you a couple examples. One that had the biggest impact on me personally was a book titled Why We Sleep by a neurologist by the name of Dr. Matthew Walker. For 10 years prior I have been just a worrisome insomniac. This book just really opened up my eyes to the importance of sleep, both from a mental and physical standpoint, and just all of the benefits – both the benefits of a full eight hours of sleep, and also the risks of not getting that sleep. So I would highly encourage folks and yourself, Dan, if you haven't given it a read, to take the time to read that.

Something perhaps a little bit more in line with what we've been talking about today – I think last year on the book club I highlighted da Vinci's biography by Walter Isaacson, and mentioned earlier just the sort of intersection of science and art. And I don't think there's a better example in history of that level of thinking. Dan, you mentioned second-level thinking, which I think the term was popularized by Howard Marks at Oak Tree. But just da Vinci's curiosity, his childlike sense of wonder, and just seeking knowledge for the sake of knowledge is just fascinating. There were examples in the book where the guy was literally sketching the tongue of a woodpecker because he was curious about how the tongue retracted and how that would work with the bird slamming its head into a tree.

He's got other examples in his notebook where there's almost 200 attempts of him trying to square a circle, just drawing it out over and over. He's got 730 other sketches of different varying flows of water. And 67 different words for describing how water generally moves. He was also a very visual thinker. His to-do lists in notebooks may be one of the greatest testaments to curiosity that we have ever seen.

And one more example which I can tie back to Frank Lloyd Wright as well. He was a daydreamer. And he had a reputation as such. It took him – a lot of people probably don't realize it took him six years to complete the Mona Lisa. While painting The Last Supper, for example, he would sometimes stare at it for an hour, make one small stroke, and then go home for the day.

And this goes back and ties well to a story I've heard about Frank Lloyd Wright and how he designed Fallingwater. It was designed for the Kaufmann family, who loved the site and commissioned him to design something amazing on that property. And Wright basically did nothing for over a year. And at some point on a Sunday morning Kaufmann called him up and said, "I'm coming up for lunch and I'd love to see what you've done in terms of the design of the place." And in the time that it took Kaufmann to drive up to Frank Lloyd Wright's office, between when he was eating breakfast and when they met for lunch, Frank Lloyd Wright basically drew the design for Fallingwater, after a year of doing nothing.

So I think the lesson there – and that also ties back to the benefits of being away from the street and away from the noise – is: there is so much value in distraction or procrastination or just being able to schedule time to think, right? Doing nothing isn't always a bad thing. Because doing nothing allows information to filter in through our subconscious. Not unlike a dreaming state does when we're sleeping. So I think we just become better at seeing associations that we wouldn't otherwise see if we were constantly bombarded with information.

So like: finding the time to step away, take a walk, go up to the mountains, take a walk in the woods, go for a hike – Amos Tversky, who was Kahneman's partner – Kahneman being the behavioral economist that wrote Thinking Fast and Slow that has been very much popularized over the last few years – has a great quote on this. And I'll wrap up here. He said, "The secret to doing good research is always to be a little underemployed. You waste years by not being able to waste hours."

Dan Ferris:                 Brilliant. That's a brilliant quote. And I read that book too, the da Vinci book. In fact, I read all four of those genius biographies by Isaacson, and they're incredible. Einstein, Steve Jobs, Benjamin Franklin. But I agree: the da Vinci book is just off-the-charts incredible. He goes deep into what made that guy what he was. And there's a whole list of stuff at the end of the book. There's like 10 things that made him incredible. You almost might want to start there if you're going to read it.

Chris Pavese:             Yeah. Agree.

Dan Ferris:                 But, Chris, we have a few minutes here. If I could ask you, as I do with many of my guests, if you had just one thought that you'd want to leave our listeners with, what would it be?

Chris Pavese:             I would say, more than anything –

Dan Ferris:                 Not an easy question, is it?

Chris Pavese:             No, it's not an easy question. Maybe just going back to this idea of curiosity and the importance of curiosity. I think a lot of times in this industry people have a tendency and a habit to favor and hire for intellect and intelligence or hire for skills. In our opinion, skills can be learned, right? That childlike curiosity cannot. And over the years we've learned that effort – I guess, simply stated, effort is greater than intelligence. You can't teach that curiosity. You can't teach that motivation. And I think ultimately that persistence, that drive is what differentiates the successful from everyone else.

Dan Ferris:                 Good answer. Listen, Chris, thanks for being here. I really appreciate it. I've been looking forward to it. And, as I knew you would not, you did not disappoint. And I hope you'll be able to join us again sometime.

Chris Pavese:             Will look forward to it. Thanks, Dan. Appreciate it.

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Dan Ferris:                 All right. It's time for the mailbag. This is a very important part of the show, folks. This is where we talk to each other. This is where you talk back to me after I've been talking at you for an hour. So write in to us. Talk to us. Write in to [email protected] with comments, questions, politely-worded criticisms, anything that's on your mind, OK?

I've got one here from Scott S. He writes in. He says, "This is Scott S. from Texas." All right, Scott. I hear you. From Texas. And Scott says, "Speaking of fundamentals" – he actually wrote a longer e-mail I think and I just cut out this section. "Speaking of fundamentals, sometimes I feel a bit lazy when it comes to fundamentals, compared to people who log many hours of research into a single position before they plunk down a single penny toward the first share. What do you think about my approach to fundamentals, which is only to look at statistics on Yahoo Finance? Just kidding.

"OK. Seriously, then," he says, "I do look at certain metrics of course: price-to-book, price-to-sales, return on equity compared to competitors, free cash flow year over year versus revenue year over year, insider share ownership, level of debt versus market cap and free cash flow, et cetera. And I read as many articles and Stansberry e-mails, for example, about a company and its sector as a readily available, paying particular attention to a relatively small number of advisors and thinkers like yourself and Porter," Porter Stansberry, "and Steve Sjuggerud, Mark Yusko, Jesse Felder," who we both had on the program, "and Jim Rogers, and subscribe to a couple investing services I greatly respect. Reading and listening to all of that, listening carefully when the track records or decisions of company CEOs and founders are discussed.

"So, Dan, is that enough fundamental analysis? Because I'm probably not going to be making batches of phone calls to various current or former employees of a company whose stock I'm considering buying or shorting. I won't be flying to China or India or LA or Timbuktu to meet with CEOs and company founders in person. I mean, it's why we spend money on solid financial advisers and subscriptions, right? If you actually read all this you're a good bloke, Mr. Ferris. You're a good man even if you don't. Scott S. from Texas."

OK, Scott. Couple of things. All you've told me is what you read and what you look at. You haven't told me really what you do with it. That is the key piece. All you've told me is what your inputs are. And your inputs seem pretty good to me. But, for example, you told me you look at price-to-book, price-to-sales, ROE, free cash flow. What do these things mean to you? And there was one little phrase that kind of set me off a little bit. You said, "Read many articles about a company and its sector as is readily available." Look, the second-level thinker – he doesn't care what's readily available. He finds out what he needs to find out in order to see if he can get the odds in his favor or not. So I don't really know if your process results in getting the odds in your favor. But this is just my reaction to what you've written here and your question about doing enough fundamental analysis.

Technically speaking, only you can really answer that. And really, technically speaking, only the market and time can answer that, really. That's who can answer that for you. But, sure, those inputs sound great. But it's what you do with them and how you think about them. And if you want to know what I mean by how you think, read that book I mentioned at the opening, The Most Important Thing by Howard Marks. Good question. Thank you, Scott.

Number two. "Hi, Dan." This is from Brendan K. "Hi, Dan. I love the show. Thank you for all the knowledge and wisdom you share with us each week. I listened to episode 106 and took your advice about using discounted free cash flow to value a business. I used Phillips 66, ticker symbol PSX, to do this analysis. I know in the podcast you mentioned you found that Starbucks was priced for little to no growth when the stock was between $40 and $50 but didn't quite go into the details other than stating that you take the current stock price and back-calculate the growth rate that's priced into the stock at its current price.

"After watching Investopedia's video about how to use discounted free cash flow analysis, I didn't know what an accurate exit price for the investment price was so I assumed a very conservative two-percent growth in free cash flow over five years and an exit price of $50 billion, which seemed pretty reasonable. With that, I found that the discounted free cash flow price is $106.51, while the stock closed the day at $94.06 on July 1, signaling the stock is undervalued. Did I perform this analysis correctly? Were my assumptions valid? Thanks again, and I hope you answer my question. Best regards, Brendan K."

Well, yeah – he sent me a spreadsheet too. And everything looked fine. But of course this suffers from the problem I was talking about with discounted free cash flow. When you said you didn't quite know what the terminal value – I think you called it the exit price. Because the typical thing is to discount five or 10 or 20 or 30 or however many years, and then at the end of that, you assume that you sell the investment, and you're basically saying all the cash flows after that are going to be worth X. And that's your terminal value.

So, we haven't really dealt with the problem of discounted free cash flow. Yes, you're doing it right. But my question is: how much is it worth? Also you said the stock was $94 and it closed at $106 so it was undervalued. Actually what's that? Within like 10 or 12%or something? That's not enough. I would need a discount of 20 or 30 or more percent. Because a 10% fluctuation like that in a discounted free cash flow – all you have to do is change a few variables a little bit and you'll get a 10 or 12% fluctuation. So I disagree that it shows that the stock is undervalued at that price because you can't pinpoint these things. We made some guesses about the future and did some math. We didn't really figure out what's going to happen in the future.

And I think I'll leave it there. Because, as you see, the problem is not whether or not you did this right; it's: what's it worth if you do it right? And I think it's not worth a lot. I like what we do better where we figure out what's baked into the current share price. And if it's extreme enough pessimism, then we go for it. But good question. And I have to say, Brendan K., you're my dream listener. You went and – I did a show on – or rant, a brief rant on a very simple idea about free cash flow analysis and you went and did it. So, good on you, Brendan K. Thank you for listening. You're awesome.

Number three. "Thank you for the podcast, Dan." This is from Mike G. "Thank you for the podcast, Dan. I would like to hear more of the thought processes you had before putting on a specific trade. I'm not asking for your current trades. I think the listening audience would be very happy to hear about what you were thinking as you put on trades in the past and maybe why or why they didn't work out. For example, I loved when you talked about your thought process regarding Altius Minerals. You have previously talked about buying put options for protection and would love to hear your inner mindset before putting on a trade like that. I think it would help us all expand our creative thinking. P.S.: tell Porter to get out of Baltimore while he still can. Mike G."

Oh, Baltimore's not that bad, Mike. I was born and raised there. Anyway. Thank you, Mike. So, the best – look, I hate to do this but it's the truth. The best way to get my thought process is to read Extreme Value, OK? And if you go to, you'll have our latest offer. But you mentioned the put options for protection and you wanted to hear my inner mindset. My inner mindset is: when I did it, a couple of times, we were at the most extreme valuations ever seen in the stock market in history, higher than 1929, higher than March of 2000. And I thought, "Well, I want a little bit of protection here because you don't know what's going to happen. And I want to hold stocks. I don't want to pretend I know the future so I want some insurance." And insurance was cheap.

If you look at just the basics, like look at where the VIX is compared to where it's been, or look at where the SKEW index, the 30-day, look at tail risk hedging. When I've put on puts, these things were scraping the bottom. And I don't know all the complicated math that people use to trade options like every day. I'm not one of those guys. But it was an insurance play for me. Hope that helps. Thank you, Mike G.

I'm going to leave you with one more very short e-mail. You remember I talked about whether or not I should call the opening rant a rant at all. And one of our readers was a neurosurgeon. He said, "You should call it a perturbation" [laughs]. And I just thought that was funny because it's obviously a very unwieldy term and we would never do that. But one reader, Gary S., wrote in and says he loves it. "Long live the perturbation." Which I think is hilarious. So, thank you, Gary S. And thank you also to Andrew L., Lance K., Jeff D., Chris H., David W., Bruce S., Jeeparj Wan, and Dan T., and Lorraine F. for writing in this week. Because there were a lot of great comments in there and I wanted to include more but then we'll be doing an hour of comments.

So, look, write in to us at [email protected] And that's another episode. And it's my privilege to come to you every week. I really enjoy doing this. And I'm moved at the thousands of people that download us every week. Thank you so much. Keep downloading. Keep listening. Keep writing in. Keep this thing alive. I think we all appear to be getting something out of it, you and me both. So, just go to and you can sign up. You can put your e-mail in there. You get all the updates. You can go there. You can see any episode we've ever done from the very beginning in 2017, all the way back. And we have transcripts for each show that you can look at. And that's all that same website:

Thank you so much once again. I will talk to you next week. Bye-bye.

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