The S&A Digest: Buy senior debt

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

As of 06/26/2013

Buy senior debt... Venezuela teeters... Capitalism at work... A Soviet Encyclopedia stock pick... Another BBQ recipe... Thank God for "freedom"...

"EXTREMELY SERIOUS WARNING: Unless you are smart as Johann Karl Friedrich Gauss, savvy as a half-blind Calcutta bootblack, tough as General William Tecumseh Sherman, rich as the Queen of England, emotionally resilient as a Red Sox fan, and as generally able to take care of yourself as the average nuclear missile submarine commander, you should never have been allowed near this document. Please dispose of it as you would any piece of high-level radioactive waste and then arrange with a qualified surgeon to amputate your arms at the elbows and gouge your eyes from their sockets. This warning is necessary because once, a hundred years ago, a little old lady in Kentucky put a hundred dollars into a dry goods company which went belly-up and only returned her ninety-nine dollars. Ever since then the government has been on our asses. If you ignore this warning, read on at your peril – you are dead certain to lose everything you've got and live out your final decades beating back waves of termites in a Mississippi Delta leper colony. Still reading? Great. Now that we've scared off the lightweights, let's get down to business."

The above disclaimer comes from the prospectus of a fictional start-up company in the novel Cryptonomicon by Neal Stephenson. It is also appropriate for readers of investment newsletters.

According to the Mortgage Bankers Association, the number of Americans who may lose their homes to foreclosure rose to a record high 0.65% in the second quarter. Now one out of every seven subprime borrowers is making late payments. It's hard to imagine that so many people losing their homes won't impair retail spending and curtail credit growth in our economy. But who knows... maybe folks will spend more now that they're not making their mortgage payments...

Sjuggerud's latest Confidential report analyzes the entire senior secured lending market... and suggests buying. Several closed-end funds that specialize in this type of lending are trading at discounts to NAV that imply annual returns of 20% or so, assuming liquidity (and confidence) eventually returns to the market. Sjug's not the only one who sees the opportunity: Private-equity groups are scrambling to raise funds to buy these leveraged loans in the belief that banks will have to sell $250 billion of forthcoming senior debt on the cheap.

At least it's not as bad as in Venezuela... While LIBOR is rising, we've got a long way to go to catch up with the land of Hugo Chavez. Venezuela's interbank overnight lending rate jumped to as high as 90% after the central bank suspended short-term lending to banks. We've been expecting a currency crisis in Venezuela.

Capitalism at work. Extreme Value pick H&R Block (HRB) has underperformed the S&P 500 by 92% over the past five years. Now investors are working to get the board of directors replaced and get the company turned around. Breeden Partners, Richard Breeden's activist hedge fund, took a 1.8% stake in the company and is seeking three board seats. A majority of proxy advisors and institutional shareholders support Breeden. With any luck at all, H&R Block will soon focus on preparing taxes and returning capital to shareholders. That's how capitalism should work... and it's one of the reasons value-investing strategies do work.

New highs: none.

In the mailbag... More mea culpa. Once again, we take the blame for our ill-timed recommendations in the mortgage sector. The good thing about reading the mailbag early in the morning is that, after the 'bag, my day can only get better. We read your criticisms. We appreciate your suggestions. And we enjoy your quips. Send your note here: feedback@stansberryresearch.com.

"My wife and I have dropped a considerable amount of money (for us) on Thornburg Mortgage. I was expecting some kind of discussion of this debacle by Mr. Dyson in the current 12% Letter. Instead, TMA disappeared like a recently dead communist official from the Soviet Encyclopedia. I admire courage and candor, I despise cowardice." – Paid-up subscriber Jim

Porter comment: I know exactly how you feel. I was an investor in Thornburg, too. You probably saw the same things we did in this opportunity: The cumulative total loan loss in Thornburg's 10-year history of making residential mortgage loans was only $174,000... on a loan portfolio of $14 billion. This was the blue-chip mortgage company. But the severity of the credit crunch in August destroyed the company's ability to finance its portfolio, and it had to sell $20 billion worth of the highest quality mortgages in the country – at a loss of close to $1 billion. Worse, the speed of the crisis resulted in an almost overnight collapse in shareprice. In little more than a week, Thornburg went from $25 per share (August 2) to less than $10 a share (August 14). Tom didn't expect this kind of volatility from the highest-quality mortgage lender in the United States.

In fairness to Tom, Thornburg had historically taken advantage of these kinds of situations... and we thought it would be able to do so again. In any case, in accordance with our risk-management strategy, we had to sell when the shares fell by more than 25%. Selling in the midst of the panic cost us dearly, too. It was a very unfortunate situation: We ended up taking a big loss on a stock we didn't think was risky at all.

I can certainly understand your frustration and the pain of your loss. But I can't agree with your wonderful analogy – the Soviet Encyclopedia entry. We've written extensively about our bad calls in the sector – including my own recommendation, American Home Mortgage, which, unlike Thornburg, went bankrupt. As for Tom, he sent an urgent update to all subscribers on August 13, alerting readers to the sudden fall in share price and reminding them that our stop loss had been triggered. (You will find a copy of the e-mail on our website, just search for "Thornburg," or go to our site's 12% Letter page and click on "E-mail updates.")

As hopefully all subscribers realize, some of our recommendations are going to "tax" you. Losses can occur even in situations where we have great confidence. That's why we stress the importance of diversification. It's what you don't know, what you can't know, that will hurt you. The only way to temper those risks is by keeping your position sizes small (4%-6% of your total portfolio, maximum).

"Porter, you should apply your brisket recipe to a whole sirloin (with a couple of minor alterations). Apply the rub 24 hours in advance of smoking. Reduce the cooking time to about 9 hours for a 13 lb. sirloin (the better cut of meat requires less time to reach the proper consistency). Begin the application of the mop sauce at about 5 hours and apply every 30 through 7 hours of cooking, then add the rest of the sauce and seal per the original recipe. After it has rested and is ready to slice, you will not believe the perfect texture of the meat. Thanks for the recipe." – Paid-up subscriber Ken McGaha

Porter comment: That's a great idea... I'll try it this weekend.

"You are granted the privilege of criticizing the government ONLY by the willingness of better men and women than you to die and fight so that you can enjoy this country. Don't you EVER forget that. You need to thank God for those people. Otherwise you would have no market to comment on and enjoy your way of life. You guys want to be smart patriots and get rid of the 'standing military', fine. How do you propose we defend ourselves? Are you such an idiot that you think we will just say 'boo' and they go away? Damn."

– Paid-up subscriber Carl Monson

Porter comment: Ha, ha, ha... That's what we've been fighting for, huh, the right to free speech and national security? That's why we station troops in 120 different nations? That's why we have invaded Nicaragua 26 times in the last 100 years? That's why we occupied Haiti from 1915 through 1934? That's why we invaded Panama and threw Noriega in jail? That's why our Marines died guarding an airport in Lebanon? In Somalia? In Bosnia? That's why the CIA launched coup d'etats in Guatemala, Chile, Iran, etc.? That's why we prop up violent dictators around the world – and especially in the Middle East? Ha, ha, ha... The fighting isn't about security, the fight is about "freedom" – don't you remember? You're forgetting all the key slogans... We care so much about "freedom" that we're the world's only major country that imposes worldwide taxation on its citizens... America, the land of the free... Ha, ha, ha...

"In Wednesday's Digest concerning LIBOR, you stated, 'It is the annualized rate of interest that banks charge each other to borrow money for extremely short durations. The rate is set by a bank trade association in London...' The bank trade association to which you refer is the British Bankers' Association (BBA). While what you said is true, your phrasing perhaps leaves the uninformed with an impression that the BBA might set the rates arbitrarily. This is not the case and LIBOR does reflect the free market rate at which major international banks lend to each other. There are sixteen international banks that make up a panel for determining the daily US dollar LIBOR. At 11:00 a.m. (Greenwich time) each of the sixteen banks' London offices submits a rate at which they would 'offer' to lend to other similar banks. The highest four rates are dropped, the lowest four rates are dropped and the middle 8 rates are averaged to determine LIBOR. This calculated LIBOR is then immediately broadcast on all major financial information networks (Reuters, Bloomberg, etc.) and the whole process is quite transparent. LIBOR is the rate at which real international interbank borrowings are occurring on a daily basis and it is not like the discount rate or the prime rate which stay the same for lengthy periods. In addition to the USD, LIBOR is calculated for the following currencies: GBP, CAD, EUR, AUD, YEN, CHF, NZD, SEK and DKK." – Paid-up subscriber Brian Clark

Regards,

Porter Stansberry

Baltimore, Maryland

September 6, 2007

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