The S&A Digest: Correction Opportunity Report II

Stansberry & Associates Top 10 Open Recommendations
(Top 10 highest-returning open positions across all S&A portfolios)

As of 06/27/2013

Correction Opportunity Report II... Feeling Moody?... O'Rourke on politicians... Capitalism and morality... Blackstone's tax bill...

It was unnerving watching how quickly American Home Mortgage went bankrupt... and watching dozens of financial companies – even those without any exposure to mortgages – get smacked by the market. But then... we looked around. Wait a minute... all of that company's mortgages are guaranteed by the government... This finance firm doesn't even own mortgages at all... Last week, Billy Joel began to play in the background for securities analysts and long-term investors... These are the days to remember, for they will not last forever...

Our first targets were the low-hanging fruit: financial firms whose asset values were firm (and knowable) and whose operations wouldn't suffer any permanent damage from the tumult. We chose four we were familiar with last Friday. Their shares, as you can see, have mostly gone up, with only one exception.

This week, we've followed up on a subscriber's idea: Moody's (NYSE: MCO, $46.00). The 107-year-old company provides ratings on fixed-income securities, debt instruments, and counterparties – corporations. In all, it covers 12,000 corporate issuers of debt and about 96,000 structured financial obligations, including things like mortgage-backed securities. It has offices in 22 countries and employs more than 3,000 people worldwide.

There are two keys to understanding this business. First, it's essentially impossible to issue debt without a rating from Moody's, and the issuer must pay for the rating. As a result, Moody's makes money both by selling information to subscribers and by selling ratings to debt issuers. Second, Moody's has a very wide economic moat because of its sterling reputation and because the government regulates these firms – the so-called Nationally Recognized Statistical Rating Organizations. Moody's and Standard & Poor's are widely considering the leading firms. Following behind them are Fitch, A.M. Best, and Dominion Bond Rating Service of Canada.

The market has sold the stock strongly since July 10. It has fallen nearly 40% from $76 to $46. This is the biggest decline in share price in its entire trading history. (Moody's was spun off of Dun and Bradstreet in 2000). The market obviously believes that Moody's business will slow as the issuance of mortgage-backed securities declines. It also fears that regulators will lay some of the blame for mortgage-security defaults at the feet of Moody's and Standard & Poor's.

We believe both fears are overblown – especially the threat to Moody's reputation. Berkshire Hathaway (Warren Buffett's holding company) has established a huge position in the stock – 48 million shares, 18% of the company. Buffett has proven time and time again that he can manage reputation risk. Just look at his large investments in American Express after the salad oil scandal and his ownership of Salomon Brothers during the Treasury bond scandal.

In regard to the economic risks, Moody's has proven very resistant to economic cycles. In good times and bad, companies issue debt. For example, during the last bear market in 2002, Moody's revenues were more than $1 billion – up considerably from the boom year of 2000 ($602.3 million). In 2006, Moody's had its best year ever, with revenues topping $2 billion. It earned $750 million in net income and produced an incredible 51% return on assets. It rewarded shareholders, too. Moody's purchased nearly $1 billion worth of its own shares.

We don't expect Moody's to produce these kinds of blockbuster numbers every year. But even if Moody's results are only average for the next several years, we think long-term investors will be rewarded buying the stock at current prices. Over the last 10 years, in good times and bad, Moody's has averaged $400 million per year in free cash flow.

Currently, Moody's market capitalization is $12.5 billion. That's about 15 times the company's peak earnings and about 30 times average 10-year free cash flow. On a current basis, the stock is trading for 17 times free cash flow – an anomaly.

We don't think you have to worry about rushing into this stock, though. I expect the company to weather a lot of bad press over the next year, which should provide you with future opportunities, perhaps at even better prices. But this is a name you should watch and strongly consider buying. Moody's is a top-tier operating company – the kind of stock that could be a legacy for your family. Given the long-term quality of this business, the value in the stock, and the likelihood of a depressed price for the next 12-18 months, Moody's seems like a good opportunity for covered call writing, too – if you're familiar with how to execute the strategy.

We'll continue to publish our Friday Correction Opportunity Report ideas, and we encourage you to participate by sending us suggestions at: feedback@stansberryresearch.com.

We also thought it would be beneficial to offer a special package (and special pricing) on three of our best newsletters for long-term investing – Extreme Value, Sjuggerud Confidential, and the S&A Gold Report. Our offer is unique: You'll get all three publications for about the price of one, and your subscriptions will last until the S&P 500 hits a new high... in other words, as long as the correction lasts. That might be only a few months... or it could be more than a year. (Don't worry we won't cheat you: If the correction ends quickly, you'll get all three pubs for at least one year.)

So, for as long as stocks look cheap and attractive to us, you'll be getting some of our best, premium advice. Hopefully this helps you build a high-quality portfolio for the long run.

Dan Ferris passed this P.J. O'Rourke quote around the office... we thought you'd like it: "Politicians are foxes. But we insist on believing that some are guard dogs. We elect them to watch the hen house, and on the first Wednesday in November there's nothing left but feathers."

Bond King Bill Gross, manager of the world's largest bond fund, said he's buying the debt of financial companies, which are now yielding an average of 6.1%. Gross bought bonds from Goldman Sachs, Deutsche Bank, Inside Strategist pick American Express, Bank of America, and Merrill Lynch. The risk of holding bonds of these companies increased the most since at least October 2004, with the yields now 60 basis points above Treasuries.

More bullish signs for financials... David Williams, manager of the Excelsior Value & Restructuring Fund, is placing heavy bets on financials. Williams placed one quarter of his $8.9 billion fund in shares of Morgan Stanley, JPMorgan Chase, and Lehman Brothers, thinking the stocks are inexpensive relative to earnings. "I've never seen them so cheap in my life," said Williams.

Extreme Value pick Home Depot (HD), which was set to accept a $10.3 billion private-equity bid for its supply unit, may end up selling for a bit less. Shares of the home-supply store have been battered in recent months, falling 15% amid the subprime scare. Now the bidding consortium wants a $1.2 billion discount. However, the deal may not close before the Thursday deadline with the financiers – JPMorgan, Merrill Lynch, and Lehman Brothers – balking at the financing. In a bullish sign, shares of Home Depot were up more than 2% this morning.

Blackstone, the world's largest private-equity group, claims that its tax bill would triple to $525 million under proposed U.S. legislation. In a five-page letter to Sen. John Kerry (D-Mass.), Blackstone argues the Baucus-Grassley bill, which seeks out higher taxes from public hedge funds and private-equity firms, would lead to a net loss in tax collections, as many groups would be dissuaded from going public. The private-equity giant goes on to say that the new bill could erase as much as $10.5 billion of the firm's $25 billion market cap.

More details on yesterday's BAC purchase of Countrywide... BAC has the right to match any buyout offer for the mortgage lender, although BAC cannot buy additional shares or buy the company outright unless it is in response to a competing offer. BAC also has the right to name two directors to Countrywide's board if the company fails to pay dividends on the preferred shares for six quarters.

China's stock market closed above 5,000 for the first time yesterday. The Shanghai Composite index rose 1% to close at 5,032.5, continuing an 88% rally this year. The seemingly unaffected market rose 12.6% in August alone, as opposed to the S&P 500's 0.2% loss.

No new highs. It's a correction... a time to buy stocks, not sell them.

In the mailbag... we're going to keep it short. We've noticed that our answers get testier the more mail we respond to. So... we're going to trim the mailbag down... and try harder to mind our manners. Send comments and criticism here: feedback@stansberryresearch.com.

"You don't get 'old and slow,' rather you become more 'experienced and deliberate.' As I become more 'experienced,' I find relevance in your, 'But here's what I tell my parents...' advice. Could you elaborate on 'You should have at least half of your savings in very safe fixed-income investments.' Don't see much in the newsletters about fixed-income investments. What are your thoughts on fixed annuities?" – Paid-up subscriber Vane

Porter comment: Currently, we don't offer advice on fixed income. We're looking to change that by launching a new publication: True Income. Unfortunately, we've had a very hard time finding the right fixed-income analyst. If you're a fixed-income pro and you'd like to write a newsletter, please get in touch.

"I'm not trying in this note to change Porter's atheism, but I do want to know if he can justify capitalism on moral grounds other than mere prosperity for most people if not all (a dubious conclusion without the necessary premises), when he apparently doesn't agree that we should not steal, make false representations, murder, cheat, and be greedy (the last 5 Commandments from the Bible or the Torah)." – Paid-up subscriber Sam Campbell

Porter comment: I wonder why you assume I'm an atheist? In regard to the moral foundations of capitalism, I wouldn't look for them in the Bible or the Torah or the Koran. I'd look at the real world. Capitalism is merely one expression of liberty. I ought to have the freedom to sell my labor and exchange freely with my neighbor, as I see fit. Likewise, in a civil (moral) society, I should not have to fear the loss of my possessions and property through plunder. Capitalism is the only moral and civil way to organize an economy, simply because it does not require coercion or plunder. (By the way, I've noticed that most people who point their finger and say "greed" are the exact same people who think it's just fine to point a gun at their neighbor to collect taxes.)

"I enjoy reading all the Alliance letters and The Digest. They have made me much money and given me interesting and entertaining reading. But Jeff Clark – you are the savior of my sanity during market upheaval. In 2002, I thought there was no end to the bad news and sold lots of stocks on the LAST DAY of the correction. Everyone at Stansberry does a great job of analysis month by month, but I really appreciate Jeff Clark's day by day explanation of what the heck is going on, even when he throws up his hands and says 'Turn off your computer and go to the beach!' Getting the 'backstory' on market moves really helps me make informed choices. Porter... it's like the difference between CHOOSING a golf shot and seeing it happen, and walking up to your ball just hoping you can make contact, taking a swing, and then wondering, 'What the hell just happened there?!' Thank you! All of you!" – Paid-up subscriber Sally E.

Regards,

Porter Stansberry

August 24, 2007

Baltimore, Maryland

Stansberry & Associates Top 10 Open Recommendations

Stansberry & Associates Hall of Fame