Episodes

Recorded Voice:         Broadcasting from Baltimore, Maryland and all around the world, you're listening to the Stansberry Investor Hour. [Music playing] Tune in each Thursday on iTunes for the latest episodes of the Stansberry Investor Hour. Sign up for the free show archive at investorhour.com. Here's your host, Dan Ferris.

Dan Ferris:                 Hello, and welcome to the Stansberry Investor Hour. I'm your host, Dan Ferris. I'm also the editor of Extreme Value published by Stansberry Research. I can't wait to get to our interview today, I must say. We'll talk with Dan Rasmussen from Verdad Capital. They have a really cool strategy. I just happened to go onto their website one day. And I read about it, and I thought, "Wow. Listeners will love to hear about this." And he was thrilled to come on the program. So he'll be here in a little bit. But first, a few thoughts. As long-time listeners know, I'm still bearish on U.S. stocks, and actually bonds globally don't look that great to me.

And I have also discussed private equity and venture capital more as signs of the top, you know... signs of the end of the cycle and those other things. And Venture Capital is just an out-and-out bubble that appears to be bursting right now. And I re-iterated all this last week. So it kind of begs the question or ought to beg the question, "What should I do now that I've expressed this viewpoint and I'm holding this viewpoint?" Well, I'll tell you what I should do. I should run around looking for ways that it can be wrong. I should get plenty of competing viewpoints in my head and think, "Hmm. Do I have this part right? Do I have that part right?"

That's what you should do. You know? You should punch holes... it's a weird thing, investing. Because most people, they don't hold long enough – meaning they overreact to headlines that really don’t affect the business. But they don't think enough about the actual business itself. So now that I've thought about the overall market, I should think about, you know, reasons why I'm wrong about it. You know, which way could I be wrong about this? So let's talk about this guy who came out in the past week and says, "There's no risk in stocks right now." Right? He's like the anti-Dan. He's the opposite of me. And he's not kidding.

So let me establish a little context here, right? Goldman Sachs says it's 10.7 years since the last 20% correction – the longest run in more than 120 years of U.S. stock data. Right? Now bull markets don't die of old age, but this particular epic run is accompanied by record valuations as I've discussed more than once. In other words, the stock market has moved up higher and for longer than any time in more than 120 years. You know, it's more expensive, it's moved higher, longer... so it's an extreme moment here. And of course last week, I went through my whole bearish position again. This week, I turn your attention to Mister Chris Rupkey, Chief Financial Economist at MUFG – the massive Japanese financial corporation. Mitsubishi, you know, UFJ something or something like that.

And the ticker symbol's MUFG. You know, it's got a long name and it's a big corporation. Whatever. [Laughs] The point is, last week this guy who worked for this massive corporation that most, you know... they must manage tens and tens of billions if not hundreds of billions of other people's money. And he sent the firm's clients a note that says – among other things – quote, "Back up the truck and buy, buy, buy. Buy it all," he says. And he also said, "Take risk off the table as a concern to be hedged. There is no risk. Bet on it." His phrasing is awkward. "Take the risk off the table as a concern to be hedged."

You know, he's basically saying don't worry about risk. Right? There is no risk, he said. Bet on it, he says. There is no risk? I mean, this guy represents an enormous financial institution. And he's telling his clients who've invested billions and billions and billions with them that there's no risk whatsoever in an asset that even the least responsible people on Wall Street generically refer to as what? [They] refer to them as risk assets. [Laughs] So this guy says there's no risk in risk. It is like the Orwellian moment in finance. You know, in a year when people are paying $120,000 for a piece of art that is a banana duct-taped to the wall, this guy is going in the Orwellian. You know, those guys are going in the bizarro direction. This guy's going in the Orwellian direction.

There's no risk in risk. Right? You remember 1984 by George Orwell? "War is peace, freedom is slavery, ignorance is strength." You know, it was this dystopian – one of the classic dystopian-future novels. And this guy says there’s no risk in risk assets. It took me aback. I stared at the article for several minutes. I was like, "He's serious. He's saying this with a straight face." And it's insane. But this is what you get in a world where so-called passive-investing accounts for 50% of all the managed assets. You know? People just put money into a passive fund, and it just buys. There's no criteria. It's just, money comes in, they buy. They just buy no matter what. Right? They're price and value and sensitive buyers. Just buy, buy, buy.

And that's his message – buy, buy, buy. So he's right in-tune with the passive investing zeitgeist. Weird thing is – and this is more to my point about finding competing viewpoints and things I could be wrong about... weird thing is, he could wind up being right. And I must admit it. So I'm not changing my bearish stance. But as you know, I have to entertain these points of view. I could probably get famous if I yelled like a lunatic and said the same one-sided view a million times every week. But I'd be an idiot. And though you might disagree about whether I've achieved my goal, I'm trying not to do that.

And the competing point-of-view here is basically that, you know, the constant move into passive mostly market cap-weighted vehicles – mutual funds, ETF's, et cetera – it'll keep a bid under the market for longer than a bearish like me could ever figure. If you think about it, you hear all the time about the “Algo's” – meaning algorithmic traders, who figure out some pattern of price, volume, and time or whatever. Then they program a computer to buy and sell based on the algorithm. And people refer to them as the Algo's. And an algorithm is just a recipe, right? So they figure out this recipe of price, volume, time, whatever, and they trade and program the computer to trade that way. Well the simplest algorithm of all is the passive funds. The index and passive funds. The algorithm is, "Receive a dollar of capital, buy the index." That's it. [Laughs]

And the only slight complication is, you know, they put more of that dollar into the largest-cap stocks and less into the smallest. That's what the market cap-weighting means. More of your money goes into the biggest, and less goes into the smallest. And it's no surprise that our interview guest today, Dan Rasmussen of Verdad Capital recently reported that market cap-weighting in general has vastly outperformed small-cap value this year. And it's like, you know, small-cap value's done diddly squat, zero... slightly negative, I think.

And market cap-weighting in general is up 20% or so. Now if I'm wrong about this being a great time to be a value investor, that dynamic of money just chasing after market cap-weighting like that, no matter what the valuation – and then money is basically avoiding the smaller-cap value stuff. No matter how cheap it gets, that'd probably be one of the bigger culprits that makes my bearishness wrong. In fact, I really do believe that has the potential to be a much bigger culprit to make me look wrong in the next couple years than say something like technological innovation or some consumer trend in the market. And this is an answer – this I was prompted to sort of think about this by a question sent in by listener Peter G – who is a long-time listener, very good correspondent, very thoughtful fellow. Okay, Peter.

So I think innovation and consumer trends are big and important. But if I'm wrong and you're asking me how I can be wrong... if I'm wrong about this moment being one where you avoid buying these expensive, huge-cap stocks, I think it'll be because too many dollars are headed to passive vehicles where they buy completely indiscriminately with no reference whatsoever to any kind of fundamental. And just whether or not the stock is in the index. And that's it. That's the only thing. So that's the full, passive algorithm. Right? Get a dollar from an investor, buy stocks in the index in proportion of the market cap. Most money into the biggest, least money into the smallest… and I still think cycles happen.

And you have to understand that there's a flip-side to that algorithm of getting a dollar in and just buying indiscriminately. Because when that investor wants a dollar of cash – and he will. They always do eventually – then the passive mutual fund or ETF must sell. And the biggest part of the dollar coming out will come out of those big-cap stocks. Right? It's where the biggest part of the dollar went in. And on the way back out, it comes out of there in proportion. And the smallest part of the dollar comes from the small-cap stocks in the passive, you know, index, ETF's and mutual funds. And none of those dollars come from selling stocks that aren't index components.

So today, you can go around looking for non-index stocks – stocks that aren't in an index and aren't getting a passive bid under them. And you can buy them, but you'd have to understand as cheap and wonderful as they may look to you, you have to understand you'll underperform as long as this passive bid is under the market. You know, you'll outperform once the passive ask becomes the bigger component. Right? Once they start selling. But of course, I have no idea when anything will happen. So I can't say when all this turns. So what do I do? I revert to my long-term experience to guide me, and I wind up diversified in some proportion in cash stocks and precious metal as I've advised consistently for the last two-and-a-half years.

So just a different slant on my bearish rant form last week. A competing point-of-view. And my answer to it, you know, "What can happen on the other side of it as an analyst?” Right? That's what I just gave you. Now before we move onto Dan Rasmussen, I do want to talk about a new story that was sent in by listener Wesley O. Thanks, Wesley. It was a Bloomberg article titled – it was dated on December 10th titled, A 5,000-Year-Old Plan to Erase Debts is Now a Hot Topic in America. The story is about the idea of a debt Jubilee. And as the article points out, quote, "In ancient Babylon, a newly-enthroned kind would declare a jubilee wiping out the population's debts." End quote. You recognize this idea, right? Porter Stansberry wrote a book called American Jubilee – what, it must be a couple of years ago now – all about how he expects to see a new debt jubilee by some, you know...I'm thinking probably Democratic Presidential candidate.

But apparently, there's this book that the article quoted. It's called, And Forgive Them Their Debts, by an economist named Michael Hudson. And he describes the ancient roots of the practice of debt jubilees. I mean, it's a whole book about it. You know, it must be a big, complicated thing. But apparently, the jubilees, they were kind of about competition. That's my interpretation. The article didn't say that, but... So the ancient rulers would wipe out the debts of the people so that they would have enough money to contribute to public projects and wouldn’t be prevented from contributing to the public projects because they had this burden of debt payments.

And like I said. This idea's alive and well in the politics of at least two Democratic Presidential candidates that I know of. Maybe more. I don't know. Elizabeth Warren and Bernie Sanders have both floated this idea of a debt jubilee at least for student loan debt. Because they think, you know – they think student loan debt should just be wiped out. It's a fairly insane idea, as far as I can tell. And maybe I'm going a little too far here. But it's the rough equivalent of the government sort of burning your house down under the belief that the money you spend maintaining it would be better spent by paying higher taxes maybe. Something like that as an analog to the ancient justification for it. You know, those loans that they want to wipe out – there's some lender asset.

And I know like three quarters of them are owned by the government. So don't write in to remind me of that. But, you know, that money is owed to – the other 25% – to some lender. And just saying one day, "It doesn’t exist," is a little silly. Because obviously, the student's benefit is the lender's total loss. And moral hazard is a real problem here. If you cancel the debts, it automatically creates an incentive to do what? Go out and take on more debt of some other kind. That's how people really behave. You know? Like mortgage debt, credit card debt, what have you. If you don't require people to pay back the money they borrow and don't give lenders some legal recourse, don't you just create a society full of dead-beats? Doesn't this send the wrong message?

Now I agree all day long that college is a huge scam from the inflated tuition prices caused in large part by the government getting in the business of guaranteeing student loan programs, you know, all the way to the textbooks – which they require a new addition every year and they charge you $2- or $300 bucks for it. You know, it's a big scam. And the textbooks are, you know... the ones in the humanities are garbage. They were at least when I was in school.

And they're far inferior to, you know, ancient books. Books that have been around for a long time that are much more valuable and cost a lot less to buy and that you'll revisit for your whole life. You know, I wish I had back all the money I spent on textbooks. Could've saved it and bought a couple more guitars or bought some other really good books. You know? Some Marcus Aurelius or Epictetus or Aristotle or something.

Anyway. You know, Porter wrote this book, American Jubilee, and this whole thing reminded me of it. And I thought it was worth mentioning when I saw the Bloomberg article, Debt Jubilee. [Laughs] Remember that idea? And if it happens, you heard it from Porter first and you heard it from me again today. So that's it. Let's talk to Dan Rasmussen now. This is going to be a good conversation.

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Dan Ferris:                 Okay. I'm looking forward to this interview. Our guest today is Dan Rasmussen. Dan is the founder of Verdad Capital. Before starting Verdad, Dan worked at Bane Capital and Bridgewater Associates. Wow. Impressive stuff there, Dan. Dan earned an AB from Harvard College, summa cum laude and Phi Beta Kappa and an MBA from Stanford Graduate School of Business. He is the New York Times bestselling author of American Uprising: The Untold Story of America's Largest Slave Revolt. In 2017, he was named to the Forbes 30-under-30 list. Please welcome the very impressive Mister Dan Rasmussen. Dan, welcome to the program.

Dan Rasmussen:         Thanks so much for having me on.

Dan Ferris:                 So Dan. My first question. I would guess that a guy like you with credentials like that was thinking about finance before college. Am I right in that guess?

Dan Rasmussen:         [Laughs] Yeah. Not exactly, actually. I spent college studying the history and literature of the 19th century American South and had virtually no interest or inclination towards finance until about my Junior year when my dad – who's a lawyer – you know, said, "Dan, you've got to start figuring out what to do after college. And you shouldn't do law, because it's awful and nobody likes it." And my dad was funny guy, said, "You know, I went to my – in my law school class, the bottom half of the class went into business and they ended up making about 10 times more money and retiring earlier and working fewer hours than the top-half of the class. So my instinct is that, you know, I was in the top of my class at law school. You're doing well academically. Why don't you go into business? It seems like a much easier path."

Dan Ferris:                 Okay. So wrong guess, but wow. Really cool. And this book, American Uprising: The Untold Story of America's largest Slave Revolt. You know, if you had to guess the kind of thing that an investment guy would write, that doesn't come to the top of the list. But that's... and I'm sorry that I haven't read it. It sounds really interesting.

Dan Rasmussen:         Well I highly recommend it. It was my Senior thesis in college. And, actually, there was just a re-enactment of the revolt about a month ago in New Orleans. An artist called Dred Scott got together with – oh, I think almost 500 people – just outside of New Orleans. They did a huge re-enactment of it. So it's really taken on... that book has had a nice impact and sort of lives on a life of its own even though I'm working obviously with the hedge fund... so [I’m on] a bit of a different career track than writing early American History. But it's something I was really passionate about and really love doing.

Dan Ferris:                 That is so cool. And believe me. I will be on Amazon clicking on that thing as soon as we get done talking. Tell me about Bane Capital. And Bane and Bridgewater. That's pretty impressive stuff. I mean, you were on the inside at Bridgewater. You saw the model that is now much more famous happen before your very eyes. What was that like

Dan Rasmussen:         Yeah. You know, I was only there for a summer. So, you know, it wasn't the longest, most in-depth experience. But it was enough to get a sense of it. And very different to Bridgewater and Bane Capital... very different approaches to investing, I think. On the one extreme, I think Bridgewater has a very crude sketch of their investment strategies to say, 'Let's look for things that are logically related." You know? " And second, that are evidenced over long periods of time across multiple markets. So if you can come up with a logical argument that essentially back-tests well across long periods of market data, you've got a good investment strategy."

And so, a lot of that thinking is very rigorous, very logical and very – it's at a very high level. Right? You're not thinking, "Should I buy the pound today?" You're thinking, "When over the long stretch of history has been a good time to own the pound relative to other currencies, and why? And what's the logic behind that?” And then on the other hand, Bane Capital was... you know, they were really experts in analyzing individual companies.

So the level of analysis was very, very detailed about individual companies. "What's their competitive advantage? What's their growth rate? You know, how are their cost structures evolving?" So very, very micro-oriented perspective on investing. And I like to think of what I do now as, in some sense, a fusion of those two. Although probably, you know, more on the side of Bridgewater than Bane Capital.

Dan Ferris:                 Well more on the side of Bridgewater, only because you are focused on public companies and you're not a private equity firm, but you have fused – as you've said, you've got that... I mean, is the main component from the private equity world in your fund just the leverage that you use?

Dan Rasmussen:         Yeah. So when you think about private equity – and it's a really hot topic right now, because private equity is the hottest, sexiest asset class. Everybody wants in. Everybody's increasing their allocation. 94% of institutional allocators believe private equity will outperform public markets. And if you look at it, private equity did really outperform public markets for really almost 30 years. 25, 30 years. That hasn't been true really since 2006. But prior to 2006, private equity was thumping the private markets. And so, the question is: Why? You know, what drove that historical outperformance?

And it's actually quite simple. So if you compare private equity to public markets, private equity is comprised primarily of three things. So first, you're buying small companies. Really micro-cap companies. The average market cap of a private equity deal is less than $200 million. Right? The large end of the micro-cap index is $400 million. Right? These are micro-cap companies. Second, they're bought with leverage. So generally about 65% and add that to enterprise-value debt on the balance sheet... versus about 10% for the Russell 2000. So these are much smaller, much more-levered companies.

And then third. And what's really interesting is that, during the period that private equity was really outperforming public markets, private equity investors were buying these companies with 30- to 40% discount where public markets traded. So if you think about the brilliance of that... right? The early PE investors were going and buying these small companies. They were buying them really cheap. You know? Six, seven times Ebitda when the public markets are trading at 11 times Ebitda. And then, they were adding professional management, and then they were selling them. And they were either... you know, if they grew it enough they could IPO it. And since public markets trade at a premium valuation – and are much, much bigger than private markets – you made a huge, multiple appreciation. You multiply that by the leverage you're really gaining. Or you could sell to a strategic. Right? So publicly-traded strategic could just buy your small, little company as a Bolton. So there were multiple exit opportunities where those exit opportunities traded at much higher multiples, and you were able to purchase things in private markets. So it's this tremendous arbitrage between private, illiquid markets and public, liquid markets that closed – really starting in '06, it closed. And now, private equity firms pay higher prices than public markets. You know, I think – although WeWork was a ___   – you know, you saw it with WeWork. Right? The valuations in private markets were way higher than what we would have gotten in public markets.

And that's true at large. You know, the average private equity deal is done at about 12 times adjusted Ebitda which is probably about 16, 15 times gap Ebitda. And the S&P trends at about 12 times gap Ebitda. So you're paying higher multiples for private deals than public deals. Which doesn’t make a lot of sense. And what I think that investors should do – the lesson to learn from private equity is to buy small, cheap things with debt... is a very good idea. Not private markets are always superior to public markets, even if you pay more and put crazy amounts of leverage on.

Dan Ferris:                 Yeah. I think another lesson is that these people are as human as anyone else, and they go all in at the top. And they do it with leverage.

Dan Rasmussen:         That's right. And I think the other really important thing is, you have to think about – private equity leverage as so essential to it. Right? It's a two-headed hydra. Now at least, it's the private credit markets and the private equity markets, and they're linked. And if you think about it, you know, let's say you think a company is worth 8 times Ebitda. And you're at an auction, and some private credit firm is willing to offer somebody 8 times debt-to-Ebitda. And so, they say, "Well if they're – if I can get 8 turns of debt, surely I can pay 10 times or 9 times or 8-and-a-half times" – right? So the level of leverage that's willing to be offered by the credit markets is something that drives valuations higher.

And simultaneously, right, the credit guys are saying, "Well, you know, if we're putting in $100 million of debt, as long as – if the private equity guys are putting in $100 million and that's subordinated to us, that's a lot of cushion that we'd have to run through. So if they're willing to put that equity in, of course we're willing to lend. Because they're smart guys, and that's a cushion for us." And so, you see these two markets working together to drive leverage levels and purchase prices ever-higher, ever-higher.

And what you then see and what's really interesting is, because so much of the lending is shifted from public debt or bank balance sheets to private credit and CLO's – and private credit and CLO's are heavily-negotiated asset classes. They're private, they're negotiated – you see, essentially, the ability of these private credit firms to basically cause a dramatic reduction in the default rates. Because instead of forcing private equity deals to go default and go bankrupt, they just renegotiate new terms. And then, neither the private credit firm nor the private equity firm has to acknowledge that they've got egg on their face. They just say, "Oh. We re-negotiated." And so, you see that diminution of the potential default risk through negotiations – even adding more fuel to this kind of heated frenzy to do bigger, more-levered, more expensive deals.

Dan Ferris:                 Right. And that justifies the deterioration in terms. Investor protection, some people call them. But terms.

Dan Rasmussen:         That's right. You know, private equity guys are known for two things. They love debt, and they're good negotiators. So you fuse those things together with the private credit market – which is a negotiated lending – and what do you see? You see spiking leverage levels. You see, you know, sharply-deteriorating covenant protections. You see a rise in Ebitda adjustments, phony earnings projections that end up being wildly off. You know? Basically all of these horrible things. And, you know, it's... but again. You can negotiate, extend and pretend your way out of it on both the equity and the debt side.

Dan Ferris:                 Right. And this whole dynamic that you describe – actually, you know, Dan. As you describe it, I think, "Okay. You know, maybe some of this is justified. And I can see if you can negotiate and avoid a big write-down or something, that's real. That's something that actually takes place in the market. And okay. I get it." But the dynamic is still the same, isn't it? Because the equity and the subordinated provides this cushion. And so, people look at it and they say, "Oh. Well if that's there, then we can do even more. You know, we can borrow even more." Or lend even more, really. I'm looking at from the lender's point-of-view. But you and I know, that cushion is not – it can go away, simply put.

Dan Rasmussen:         Exactly. It's not real. It's driven by the same assumptions that drive... right? It's all driven by assumptions. And I think, you know, that at the end of the day a company is a company, and debt is debt and equity is equity. And equity and debt both depend on the cashflow of the business. And so, you know, at some point there's just a maximum limit to what you can earn in private credit. And there's some, you know... all this stuff at some point has to adhere to the economic rules of reality. Right? You can't just negotiate away and default permanently. Right? You can extend it and pretend it and push it. But eventually, what you create is essentially zombie companies. And investors get their capital trapped, and maybe they don't realize they had losses. But, you know, when it's 15 years and they haven't gotten their money back, you know, they start to figure out that maybe default would've been better. Because they could've taken losses earlier.

Dan Ferris:                 Right. And as you point out, you know, the basis of all that is really the cashflow of the company. But as you pointed out – I want to say a year-and-a-half ago – in an article about private equity, they're not really as good at operating businesses as they want to represent. And what they're really good is levering them up. So this idea that it's all justified – that all that leverage is justified in the viewpoint about the, you know, equity and subordinated cushion as justified is kind of... it's not real, at least anymore.

Dan Rasmussen:         That's right. I mean, I'm very skeptical of the idea that somehow, you know, private equity folks are materially better operators of companies than public markets. You know? And I think if you look at what's going on with the credit quality, there's massive downgrades going on. And the credit ratings are, you know, massively downgrading private equity back to companies. So, you know if the operations are improving so much, you know, why is the credit all getting downgraded? And when you actually look at what's going on in these companies, you know, it's exactly what you'd expect. There's no way to grow a company without investing. Right? Companies don't grow without investment.

And if you're siphoning all your cash to pay interest and taxes, all that interest expense eats away at your ability to invests which slows your growth rate. Right? This is just sort of obvious financial theory. Right? And so, what happens with these companies when they get over-levered is that, they get on this treadmill that they're never able to get out of. Because they can't grow Ebitda without investing, and they can't invest because all the cash is going to interest. And so, they're sort of trapped by debt. And I think that's a really scary thing. And that's what creates these zombies or it creates defaults. And both of them are bad.

Dan Ferris:                 Bad is an understatement. You know, when you consider some of these outcomes. But let's turn to what you do, Dan, which I found fascinating. That's really why I wanted to get you on the program, because I read the overview of your strategy on your website. And, you know, you talked about the innovation of private equity by Kravis. And then the innovation of indexing by John Bogle. Right? And you guys sort of fused these two things together. And I was like, "Oh, wow." You know? "First of all, these people have balls." [Laughs] That's the first thing I thought. But as you represented it, and obviously you're a very smart guy who's been around the block a little bit. And, you know, young as you still are. But as you represented it, you have a really – sounds like you have a really deep process that vets the companies well and that you have a discipline about not making the mistake of modern-private equity and not overpaying and not over-levering.

Dan Rasmussen:         So that's exactly right. Well I hope. It's nice of you to say. But I think what we're trying to do... so I think first of all, we're standing on the shoulders of giants. Right? We're not doing anything new. We're just taking the lessons that have been learned from the past. And I think there's a few intellectual streams that we're drawing from. I think the first is really the small value – you know, the discoveries of Fama and French and all the research that's been done on the small value premium. Right?

So it is true that smaller, cheaper stocks have historically done much better than larger, more expensive stocks. Now let's carve out the last five years in the U.S. when that hasn't been true [laughs] – or even, I guess, the last decade really. But broadly over market history, multiple countries, multiple regions, multiple decades… small, cheap stocks do really, really well. Now private equity, right, was buying... used to be buying small, cheap stocks.

So you can think about that as being, you know, a sort of subset or an even smaller, even cheaper version of small value for many years. But what private equity was adding to that – they weren't just buying small, cheap companies. They were using leverage. Right. So that was and is a crucial part of private equity. And now, it happens that value and leverage are really interrelated. Right? Because leverage is a double-edged sword. On the one hand, if you put leverage on a company that you bought cheaply and then you sell it for more than you bought it for – right – that leverage multiplies your return. So that type of leverage is very beneficial. On the other hand, leverage increases default rates.

So the more leverage you put on a company, the more risky it gets and the higher the risk of default. Now if you're buying cheap companies, you get the benefits. And up to a certain point... right? So let's say you pay 6 times Ebitda for a company, you put 3 turns of debt on it. Right? 3 turns of debt is sort of a double-B type range that has historically a 7% or so default rate. Right? It's not that risky. On the other hand, you pay 12 times and you put 7 turns of debt, you've created a triple-C bond. And triple-C's have a 30-plus percent default rate. So you've massively increased your risk of default by adding leverage. So leverage, clearly bad there. And that leverage is clearly going to interfere with the operations of the business.

So they have to take so much out to pay interest – versus the, you know, 6 times you put 3 turns. Right? Where, you know, that amount of debt's totally manageable. That amount of interest is totally manageable. It's fine. And I think what I would argue, right, is that what you want to do is buy small value with leverage – but where that leverage is not interfering with the operations of the business – where it's manageable. It's going to enhance your returns and it's not going to cause the company to go bankrupt. So I think that where we sort of focus and where our investment strategy is focusing... let's focus on small, cheap, levered companies. And one of the great benefits of the small, cheap levered company – right – is that the payoff of the debt as the company – a cheap company – generates cash and they pay the debt down, that naturally accretes to the equity holders and it reduces the bankruptcy risk of the company. So it's a wonderful use of capital. It's a wonderful capital allocation strategy.

And it's sort of an in-built catalyst. And so, you think about what we do and what we focus on – right – it's these small, cheap, levered companies that are not going to go bankrupt and that are going to pay off their debt. It's that intersection where we think you can maximize the returns within small value. And we think that the lessons of the private equity industry over the phenomenal returns in the '80s, '90s, and early thousands are really a testament to the fact that this works. And it's logical. And it builds on, you know, simple financial-theory building blocks. And the best part of it is that public markets hate levered firms. So, [laughs] you know, you're able to get these levered companies quite cheaply. And then as they pay off debt, they get more richly valued by the market.

Dan Ferris:                 So I just want to make something clear, Dan. You are talking about the companies themselves being levered. You're not talking about – are you talking about your fund also being levered or no?

Dan Rasmussen:         No. And I think that's – you know, putting leverage on stocks, back-leverage, I think is too risky. You know, stocks are so followed. And the volatility of stocks is something like 20 times the volatility of their underlying earnings. Right? So you're much better having the debt tied to the earnings of the company and the debt tied to the market price. So when we think about – we call ourselves leveraged small-value investors – we're talking about companies down on the balance sheet just like private equity. Right? That's debt's non-recourse to us. It’s not marked to market. It doesn’t depend on the equity value. It's all on the balance sheet of the companies.

Dan Ferris:                 I see. And tell me about... you have a little paragraph here. It's just two sentences titled "risk exposures." And my main take away from that is, you seem like a group of investors that pay a lot of attention to the high-yield bond market. What kind of attention do you pay?

Dan Rasmussen:         So most of our companies are issuers of high-yield. We also invest in high-yield bonds. So we have Greg Obenshain who's at Verdad – came to us from Apollo. You know, he focuses on credit. So we're very interlinked. Right? Most of our companies are issuers in the high-yield market. We're very alert to looking at what the market is telling you. Debt market signals are valuable to equity markets. Right? So if a credit's getting downgraded, you probably don't want to own the equity. Right? If credit's going to get upgraded, you probably do want to own the equity. Right? These things are very interconnected. There are signals in the bottom market that are very helpful to the equity market.

And I think another thing to understand that's really important – to small-cap investing broadly, but especially small value and especially levered small value – is the relationship between the high-yield market and small value stocks. So high-yield market, right, is the small value of bonds. These are generally much smaller companies, and are obviously at a high-yield. So it's meeting both of those criteria. But what you see is that every three to five years, there are these sorts of high-yield crises. Right? High-yield spreads blow out, liquidity dries up, there's no new financing. During those times, a couple things happen. Right? One, private equity firms can't do deals. Right? There's no new issuance of bonds at those times.

So no private equity deals. The second is that symptomatic of withdrawal of new financing. Right? And so, all of the companies are dependent on financing – which most small levered, cheap companies are – sell off dramatically. Right? And so, you see that withdrawal of liquidity in the bond market and there's a withdrawal and liquidity in the equity market too. It doesn’t affect a Microsoft or an Amazon, right? But it affects, you know, a tiny, little company with $300 million in market cap a lot. And so, you see all of these companies sell off – I think irrationally. And then the minute that liquidity flows back into the market, they rebound. I think perfectly rationally. And so, when you think about investing in small value or levered small value, you've got to be cognizant of its cyclicality. And you have to solve for that cyclicality.

And I think there are a few ways to solve for it. One is, you got to say, "I know this is going to happen." Right? "I know that sometime when I own these things, they're all going to sell off and it's going to be painful. So I've got to have a horizon that looks past that." And then second, you've got to also try to think about being counter-cyclical. Right? So if small value is 8% of the... small cap is 8% of the market, small value is 4% of the market. Right? Your allocation to small value – even if you're 2 times overweight – it's 10% of your equity exposure.

And I think the logic should be, you know, when high-yield spreads are wide, that's a really good time to maybe double or triple your exposure to small value. And then when things normalize, go back to normal... but these are exceptional times within small value just like there are exceptional times in high-yield. The time to buy high-yield is really when high-yield spread are wide. The time to buy a small value stock's when high-yield spreads are wide. Right? This is, I think, a lesson from the macro economy – it's more of a Bridgewater type of thinking, but a really good indicator for thinking about how to time your exposure to small value.

Dan Ferris:                 Got you. Okay. I want to focus on a couple of sentences from the overview of your business on the website. Because it's an interesting topic to me, because I know so little about it. But if I could just read these two... it says, "We run every stock through a Bayesian model developed through machine learning analysis that predicts which companies are most likely to pay down debt. We submit these short lists of stocks for fundamental analysis using Monte Carlo models to understand the distribution of potential outcomes and weighting our portfolio towards stocks with the greatest asymmetry." Lot of weighty ideas there. Maybe you could talk us through Bayesian, Monte Carlo and this idea of the greatest asymmetry.

Dan Rasmussen:         Sure. So I think where perhaps we differ from...you know, a lot of fundamental investors have a price target. Right? And they're saying, you know, "We've done the work. We think this company is worth" – I don’t know, "10 dollars a share. It trades at $5 a share, so we're going to hold it till we hit $5." We view the market and stocks in a different way. Right? We say there's a distribution of potential outcomes. Right? And we believe in base rates. So Phil Tetlock who is a scholar at the University of Pennsylvania says that the best way to forecast is to look at base rates.

And base rates are just the historical probabilities of things happening. Right? So if you said, "What's the probability that this stock is going to double?" Right? The first way you could say is, "Well what percent of stocks over the past 100 years have doubled?" Right? And let's say you came up with a number that said it's something like, 10% double in a year. And so, you say, "Well the chances that this doubles in a year" – the chance that it goes from $5 to my $10 price target – "is roughly 10% according to base rates." Right? That's a good use of the base rates.

But then, you might want to say, "Well are there characteristics that meaningfully increase the probability that I'm going to double my money?" And what you'd find by doing some level of statistical research is that, you know, cheapness, size, low bankruptcy risk... you know, some of those things actually do meaningfully impact it. And maybe you go from 10% to 15- or 20% chance of doubling your money. But you're never going, [laughs] you know, from 10% to 100% like these sort of simple DCF models or the fundamental price targets are. Right? You're going from a realistic set of probabilities based on historical outcomes. And then, you're conditioning that based on factors that matter. Right? So we would say that what we try to then think about is applying base rates in a systematic way and using quantitative tools that have, in the past, had meaningful impact on predicting outcomes. Right?

So we do a few things. Right? One, we think that within levered equities, paying off debt is really important. Right? So we looked at 60 years of debt pay-down and what predicted, in year 1, that paydown in year 0. Turns out, it's a lot of simple things like profitability, cashflow generation, historical track record of paying down debt – right? And we built a machine-learning model to essentially probabilistically say, "Which companies were most likely and least likely to pay down debt?" We think with that model, we can get to 65- to 70% accuracy. Right? So again. These models are giving you a probability distribution.

So we apply that, and we found that things that are likely to pay down debt do end up going to pay down debt. Right? Our live results are pretty similar to the historical machine-learning back-tests. And firms that don't pay off debt that are small, cheap, and levered don't tend to be that great as equity investments. But again. We don't know better than a 65% chance if we're right or not. Right? So if you think about taking that more probabilistic view of the world, what you'd then find is that often the things – the highest chance of success. Right? The things that are most likely to be a 2 times return in a year are also some of the riskiest. Right? This sort of makes intuitive sense.

Right? The things that might be twice as likely to be a 2 times might be also twice as likely to be a 0. And so, when we think about a Monte Carlo simulation, right, we're trying to say, “Let's assume Y distribution of potential outcomes" – for say, revenue growth or margin change or where this company is valued by the market – and try to graph – try to graph or think about what that distribution of outcomes will be. And what you find with the Monte Carlo is that, as your volatility of potential outcomes goes up, right, your expected return on the stock goes up. And so, one way to think about that is that, if you buy a stock, the worst outcome is 0 and the best outcome is you make 7 times your money or something. Right? Over a two or three-year period.

And so, what you're trying to do is look for the things that have the chance to hit a 7 times over the course of three years. Because, you know, that's the stuff that's really going to drive exceptional outcomes for your portfolio. And then again. You know, when you turn to say, "Okay. Well what does predict that extreme distribution of outcomes? What does increase the volatility and the distribution" – right, of course leverage does. Right? A more-levered company obviously has a higher chance of bankruptcy but also a higher chance of earning multiples of money. Value is intuitive. Right? Like it's possible to go from 4 times EBITDA to 25 times EBITDA.

It's pretty hard to go from trading at 25 times EBITDA to trading at 1,000 times EBITDA or 200 times EBITDA. Right? This is just, you know, base rates. Right? We know a certain percentage of companies trade at certain levels. So the probability is higher. And then of course, you know, for you to see multiple chances of this, right, the company has to not go bankrupt. Right? Buy small and cheap. But if it goes bankrupt, you don't get a chance to roll the dice again. Right? Your seat at the poker table has been removed. So you've got to buy the smallest, cheapest, most-levered firms that aren't going to go bankrupt.

Dan Ferris:                 Wow, Dan. Thank you for that. I feel like you've given us so much. And I hope our listeners will listen twice, go to verdadcap.com and read about all this. But if I could talk about one more topic before we go... What about your portfolio? You've told us about, you know, philosophical considerations and security selection and things. But what about – you know, like how many stocks are we talking about? A small-cap portfolio, I usually assume that that's going to be a lot of positions. How man positions are we talking about?

Dan Rasmussen:         So we think that, you know, your sort of optimal outcome comes right around 40 securities. So you're essentially weighing things. Right? So on the one hand, right, everybody has a rank – whether you're a fundamental or whether you're a quantitative investor, you have some sort of ranking system. Right? You have the best ideas, sort of the highest expected return model. And then, you go down that list. And I think when you're a more quantitatively-oriented investor, then you're thinking about it in terms of base rates.

So you know you need to hit a certain number of companies to make sure you're going to get the actual probability distribution you're looking for. That's probably right around 30 or 40 when you start to achieve the full benefits of diversification. And then, we find that... and what we do is very, very volatile obviously. We end up having a, you now, certain number of small positions that we're buying to learn about. You know, they're new. They're interesting but we having seen enough time to know. Or conversely, we're exiting things and we're exiting them slowly. So, you know, sometime right around 40. A little over, a little under... that ends up being right where our portfolio sizing is.

Dan Ferris:                 Yeah. That makes good sense. So if I could ask you then, Dan, to just – if you had one idea to leave our listeners with... you've given us a lot of really interesting ideas. But if I asked you, you know, "Could you just leave our listener with one sort of nugget, one sort of valuable idea – and it could only be one – which one would it be?

Dan Rasmussen:         Yeah. So I would say that I think the most broadly-applicable thing as a value investor...right? I think there are a few things that you want to look for as a value investor. Right? I think as a value investor, you want to look for cheapness. Right? And if you look, "Where is the world cheap today," the world is not cheap in the United States. It's cheap outside the United States – much cheaper outside the United States. And then second, you want to say, generally a country needs to climb a sort of a wall of worry, right, for the equity markets to get better. Right?

So where do we see people worried about the economy and where those worries could potentially subside?" And again. The United States, people are very confident about the economy. Very confident about the prospects of our companies. However you go outside the U.S. – I would say if you look at specifically Japan and Europe... In Europe, you've got the Brexit concerns. You've got, really, concerns with the economy in Italy and Portugal and Spain. If you consider Russia part of Europe, you've got a lot of concerns about Russia. Japan, you've got all the normal litany of problems. And I think my one advice to investors today – especially U.S. investors – is to go abroad. If you're a value investor, go abroad. Go to find cheaper companies abroad and economies that are not doing as well as the United States where the rebound on the economy could drive your value stock portfolio up.

Dan Ferris:                 Excellent. I think I'm going to take you up on that "go abroad" thing. I consider myself – I've been a value investor for many years. I haven't gone abroad enough, and I think I'm going to take your cue. And thanks for being here, Dan. I mean, this [laughs] has been really great for me, really educational. And I hope that you will come back and talk with us again sometime.

Dan Rasmussen:         I'd love that. This has been a lot of fun.

Dan Ferris:                 Yeah. All right, Dan. Thanks very much. And, you know, we'll talk to you next time whenever that may be.

Dan Rasmussen:         Excellent. I look forward to it. Thank you.

Dan Ferris:                 Okay. Bye-bye. Wow. That guy, he reminds me of – do you remember when we interviewed a fellow named Nitin Sacheti? Nitin packed a big punch. Dan Rasmussen packs a big intellectual punch. Listen to this thing twice. Listen to this interview twice, because there's a lot in there. And it's valuable. And maybe start by going to the website, verdadcap.com. There's a lot of good things there. They have an overview, and then they have several press pieces. You know, and Dan's written a bunch of good stuff that's been published here and there. Wow. All right. Now it's time for the mail bag.

Dan Ferris: Hey, guys. Really quick. I just want to tell you something. As host of the Stansberry Investor Hour podcast, I also enjoy listening to other podcasts. It helps me figure out ways to make the Stansberry Investor Hour a better experience for you. One podcast I really like is called We Study Billionaires, hosted by Preston Pysh and Stig Broderson of theinvestorspodcast.com. It's the biggest investor podcast on the planet enjoyed by thousands of listeners every week. Preston and Stig interview legendary billionaires like Jack Dorsi, founder and CEO of Twitter and payments company Square, and billion investor Howard Marks – whose book, The Most Important Thing, I've recommended dozens of times.

Sometimes Preston and Stig spend a whole episode reviewing lessons learned from billionaires they've studied like Dell-Computer Founder Michael Dell, tech-industry maverick Peter Teal and macro-trader Stanley Druckenmiller. Before starting the We Study Billionaires podcast, Preston went to West Point and John's Hopkins, found an investment company... and his finance videos have been viewed by millions. Stig went to Harvard and worked for a leading European-energy trading firm. They're smart, experienced investors who know the wealth-building secrets of billionaires better than anyone. And their listeners love it. And I'm one of those listeners. Head over to theinvestorspodcast.com and check out We Study Billionaires with Preston Pysh and Stig Broderson. Theinvestorspodcast.com. Check it out.

All right. The mail bag, of course, is where we get to have a nice conversation with each other, each week. You write into feedback and investorhour.com with questions, comments, and politely-worded criticisms, and I read every single one and every single word of every single one – even the ones that are kind of a little bit too long. And I respond to as many as I can each week. And we get to have a nice, frank, open conversation about investing which hopefully makes you and I better investors. [email protected].

First one this week is from Kate. Don't have a last initial. Just Kate. And Kate says, "Hey, Dan. Do we think that U.S. corporate bonds are headed for trouble? For the past eight months, everyone's been talking about the bond bubble and also negative interest rates in Europe and fearing they're coming to the U.S. What would need to happen to make negative interest rates happen here? -Kate."

Well thanks, Kate. The answer to the first question, "Do we think U.S. corporate bonds are headed for trouble," we don't even have to go that far.

All we have to do is say that most bonds are just priced for really paltry, little returns. So why would you want to own them anyway? Unless you were just kind of preserving capital and you wanted to keep some money in like a safe, short-term treasury bond or treasury ETF that yields something like, you know, 1- or 2- or 3% or something. Otherwise, you really can look at the overall top-down picture. But you can also buy individual bonds from the bottom up. And that's the way I think you should do everything. And yes, it's true. Interest rates are low. The bond market has been a crazy bubble. At times, really crazy on and off over the past couple of years.

But you can still buy bonds bottom-up, one at a time. It's probably harder. There's probably a lot fewer that you'll even want to go near. But you can do it. So unless you have, let's say some kind of a bond ETF that's got a lot of really long-dated stuff with really tiny yields – that's where you get into the biggest trouble. You know, you buy a 30-year bond that yields 2- or 3%, you know, the volatility on that thing will [laughs] potentially disappoint you quite a bit.

The second question you ask… "What would need to happen to make negative interest rates happen here?" Well why'd they happen in Europe? They happened in Europe and Japan because the central banks pushed interest rates down so far trying to stimulate the economy. So maybe that's how it could happen in the United States.

And of course, we covered other reasons why people buy them after they turn negative – because maybe they want to hold a certain currency rather than a certain other currency. So if you're going to lose 1% or something or .2% a year for a few years, and it's okay with you because maybe you think you're going to lose 30% if you hold the wrong currency. So you're going to make 30% by holding the negative interest-rate bond. You see? So there are reasons to hold these things, when people are holding them. But your question, "What would need to make them happen here" – probably the same thing that happened in Japan and Europe is the answer. And it's a good question. We should be asking it.

Next. This is a good story by Stevie T. And Stevie T says, "Funny story. I work at a fancy fine dining establishment in a city with a ton of money. We were hosting an annual holiday party for a major multi-national investment firm. These are great people. Solid professionals. It's a tradition to have a few speakers from other major multi-national investment firms come up and give us a synopsis of how the year in the market went. They gave a reasonably optimistic view on the market. And one in particular made a point of how inflation was consistently under the Fed's target of 2% (1.8% in particular) and how employment is so solid and how this is a sign that the media-feeding doom and gloom is just a bunch of noise and equities are solid since the numbers are fundamentally sound. Everyone agrees, and it was an awesome party. The funny part was that, at the end of the night, the bill arrived and the host was shocked at the price. [Laughs] he throws this party every year, and he can usually anticipate the cost. This year was quite a bit more. Oh well." Then he says, "Put it on this card, and that – great party." Not sure what that means. "I remember you or someone on your show mentioning that paying too much attention to numbers and backwards-looking indicators can cause even the most savviest investor to not see what's right in front of them. The price of food and wine simply went up. Not 1.8%, but a lot more." Okay. Then he talks about a few other things in that same vein. He says, "Keep up the good work. Stevie T." Thank you, Stevie T. I completely agree with the insight here.

And I have said many times in different contexts – not just inflation data, but in different context. Even with the financials of a given company. Any data you're looking at is... if it's a fact, it is necessarily historical. Right? It's backward-looking. It's what's happened up to this moment. That doesn’t necessarily tell you what's going to happen in the next moment. In fact, the next moment can be quite different. And as you imply also, Stevie T, not a lot of people think inflation is a big, hairy risk. Even though people are paying a lot more for stuff all over the place, as you point out. That's a great e-mail. Thank you.

The next one is from Christopher A. And Christopher A says, "Dan. Capitalism isn't broken. It's working as it always has to increase the wealth of the few at the expense of the many. What is broken is the American way of dividing power between labor unions, central government and entrepreneurs. The wealthy have increasingly bought" – he says, "pelicans." I think he means politicians. [Laughs] "The wealthy have increasingly bought politicians who have passed laws favorable to businesses, which in turn uses the extra wealth to buy more politicians so the labor unions and central government have been weakened greatly, thus returning this country to the capitalism of the 1890's and the Robber Baron situation. Historically, this situation's been resolved by violent revolutions which target all rich people regardless of their value to society as a whole, and which makes the lives of the poor much worse. But hey. Who pays attention to history these days? Hope this helps. Best, Christopher A."

Christopher, I disagree that capitalism has always increased the wealth of the few at the expense of the many. History is the exact opposite. If you read history, you can't conclude what you just said. History is simply that capitalism is the only system which has lifted great numbers of poor people out of poverty, period. The end. Done, historical fact. As far as the Robber Baron, that's a misnomer. They weren't robbers. They were great entrepreneurs. They created enormous sums of wealth. They didn't rob anything. It was a stupid idea then, it's a stupid idea now. Otherwise, you're spot-on. Big companies buy people in government right and left and have way too much influence and get way too much benefit. A whole lot more benefit than the rest of us.

So you're spot-on with that. I think you're wrong about the rest of it. The violent revolution thing? You know, I can't disagree with you there. Right? When a lot of people who think they're left out of the system – and we have that, I think, growing nowadays... When there are a lot of people who think they're left out of the system, they can take to the streets and get very violent. And hopefully, it'll just be like these little episodes and it won't develop into a full-blown revolution. Because I think what we have here is still pretty special and pretty good. So, you know, I agree with maybe half of your ideas, and I disagree totally with the other half. And that's a good thing, right? We all want to agree and disagree and exchange viewpoints. Okay.

Next one is from Bill. No last initial, just Bill. Bill says, "Hey, Dan. That was a fun podcast. Your first story about the banana taped to the wall was great. [Laughs] When you got to the point where another artist ate the banana, it reminded me of the Monty Python skit about defending yourself against an attacker armed with a ripe banana. I guess in today's crazy world, Monty Python is social commentary. -Bill." Thank you, Bill. I'm going to let that stand on its own. It's awesome. [Laughs]

Okay. I have one more here from Daniel H. Daniel H says, "Dan, awesome podcast as usual. I agree with the high valuations giving big warning signs of tops. My retirement account got clipped to the tune of 68% in '08 and '09. And that was with a money manager. It's like, 'Dude, you never heard of stop losses?' Yes, I fired him. Thought about hunting him down, but I had to repent. That started my total disdain for money managers, investment advisors, et cetera. Then I found Stansberry – a total breath of fresh air. Telling others what they would want to hear if positions were reversed. An awesome concept. My faith in humanity restored a little. Dan, I listen to and heed your advice on the valuation excess warnings. But I stay in the market by selling all stocks, then I use stock replacement strategy by buying deep-in-the-money options that would equate to the same stock position size. That way, I am holding more cash. Then I just roll options using delta levels or theta levels, increasing into expirations. It is more managing, but max loss reduced to option price. I sleep better considering your podcast. And info below. Cheers, Daniel H."

And then, he gives some info below. He just lists a bunch of little data points like, for example, total value of corporate equities as a percentage of GDP is now 145%. The dot-com top was 161%. That's the old Ben Graham and Warren Buffett measure of the overall stock market, which for years Buffett said was the best way to think about the overall valuation. And now, you know, it's pretty high. It's really high now. And then, he gives a bunch of other similar data points showing the same conclusion – things are over-valued. So the only thing I would say is, yeah. That thing you're doing with options is a lot more managing. That is not my style.

And, you know, the tax consequences are going to be different, too... is the only thing I would add to that. Otherwise, hey. If it works for you, it works for you. And thanks for sharing.

So that's it. That's it for another episode of the Stansberry Investor Hour. It's my privilege to come to you this week and every week. And by all means, write to us at [email protected] with comments, criticisms and politely-worded... politely-worded [laughs] criticisms. Comments, questions as well.

Tell you what I want you to do. I want you to go to www.investorhour.com any time you feel like it, and you can look at any one of all the episodes we've ever done since the beginning, and we have a transcript for every single episode that we've ever done since the beginning. People ask about this all the time. They're there. Every episode. It might take a day or two to get the latest episode transcript, but they're all there. And I go back and read them sometimes.

Tell you what else you do – go to iTunes. Subscribe to the Stansberry Investor Hour podcast and hit Like. That'll push us up in the rankings, get more eyes on us, get more listeners and get more of those comments and questions and politely-worded criticisms that make this conversation we have every week about investing even better. Okay? So do that. iTunes. Subscribe, Like. Thanks a lot, folks. I really enjoyed doing this this week, just like I do every week. [Music playing] I will talk to you guys next week. Bye-bye for now.

Recorded Voice:         Thank you for listening to the Stansberry Investor Hour. To access today's notes and receive notice of upcoming episodes, go to investorhour.com and enter your e-mail. Have a question for Dan? Send him an e-mail at [email protected]. This broadcast is provided for entertainment purposes only and should not be considered personalized investment advice. Trading stocks and all other financial instruments involves risk. You should not make any investment decision based solely on what you hear. Stansberry Investor Hour is produced by Stansberry Research and is copyrighted by the Stansberry Radio Network.

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