The S&A Digest: NEW: The Correction Opportunity Report

NEW: The Correction Opportunity Report… Icahn doubles down… Housing hits new low… Earnings growth stalls…

In today's Digest, we've decided to offer some timely (and hopefully profitable) advice… for free. Yes, really.

We've put together a select group (only four names) of very safe financial firms whose shares have been hammered… but whose operations have absolutely nothing to do with mortgages. As the credit markets "unlock" thanks to the Fed, these stocks will all rebound. We're calling this part of The Digest the Correction Opportunity Report. Don't miss it, below.

As I'm sure you know, the Federal Reserve stepped up to the plate this morning and "unlocked" the credit markets by providing financing for AAA-rated bonds at a discount for member banks. This does three things. First, it assures banks that they will have access to funding for solid assets. Second, it reassures the stock market that the Fed isn't going to ignore the financial sector's woes. And third, it will allow hedge funds and other highly margined investors to reduce leverage and save themselves.

What does this mean for your investments? Probably not too much. The credit bubble that has been built with mortgages – particularly subprime mortgages – must be unwound. (Moody's downgraded another 691 subprime bonds yesterday.) Interest rates will have to rise. Mortgages will be harder to get and more expensive to refinance. Folks who shouldn't have borrowed so much in the first place will lose their homes. All of this will depress spending and slow the economy. The Fed will respond by cutting the Fed funds rate. We'll probably see inflation rise a bit and the price of gold and other precious metals move higher. Firms that sell consumer cyclical items (refrigerators, cars, etc.) will probably do poorly. We might enter a recession in 2008. We'd urge you to be cautious with your investments, stick to the high-quality names and buy only great value.

What would we buy now? We went looking for financial stocks that have been caught in the crossfire of the mortgage mess – firms that have nothing to do with mortgages but have seen their stocks get crushed regardless. We think, with the Fed on the move, you should consider buying several of these companies. We call the list our Correction Opportunity Report. We'll update this list for you on Fridays for the next several months. And we'll add names to the list as we find them. Stay tuned…

In order of safest to riskier:

1. The Van Kampen Senior Income Trust (NYSE: VVR): Now yielding 10%, this fund holds hundreds of different senior corporate notes – 90-day loans to corporations. Each loan is tied to specific collateral and is senior to any other debt. Because of this collateral, these notes carry essentially zero risk of default. Prior to the debacle in the credit markets, the loans VVR carried had a net asset value of $8.60 per share. However, SEC rules require the trust to get a live "bid" on its portfolio daily. As the credit markets shut down, getting a live bid became impossible at any reasonable price. The bid doesn't really matter, because the trust (as a closed-end fund) has no desire to sell and no need to raise cash for redemptions. But it must report its "bid" NAV had declined. As a result, some investors panicked and sold, for as little as $6.80 per share. As I type the fund is trading for $7.40, a 14% discount from NAV. The fund historically trades right around NAV. Thus, we expect, over the next year, you'll make back this discount (14%) plus the 10% yield, for a total return in excess of 20% in a nearly risk-free vehicle. This is as easy and simple as it gets.

2. Quest Capital (AMEX: QCC): Similar to the Van Kampen Senior Income Trust, Quest Capital provides short-term loans to corporations with assets to put up as collateral. It specializes in loans to the resource sector, and its management team is very experienced, operating successfully since 1984. The stock fell from $2.90 to where it's trading now around $2.20, a decline of almost 25%. It's now trading near book value and yielding 4%. Here again, we would expect to see total returns of more than 20% in the next year, as investors again recognize safe financial stocks such as Quest.

3. MFA Mortgage Investments (NYSE: MFA): Now… I know what you're thinking – this company has "mortgage" in its name. It must be a mortgage broker, right? No. It borrows money at short-term rates in order to fund a portfolio of AAA-rated mortgages. Fannie Mae or Freddie Mac guarantees more than 90% of MFA's mortgages – meaning this company has essentially no credit risk. MFA earns the spread between its funding costs and its mostly guaranteed mortgage notes. The stock has been crushed because anything associated with mortgages has been sold. MFA fell from around $8 to below $6.75 and now trades for 75% of book value. The company earns a 70-basis point spread on its portfolio and pays a 6% dividend. At the very least, we would expect this stock to return to book value ($8.50), earning investors a capital gain of 23%. We also believe the dividend will increase because, as the Fed cuts interest rates, MFA's funding costs will decrease. Thus, we believe this is an excellent time to establish a 2-3 year position in MFA Mortgage.

4. Asset Acceptance Capital Corp. (NASDAQ: AACC): AACC is a bad-debt collection firm. It buys written-off obligations from other companies and then attempts to settle with creditors. Results have been hurt over the first six months (-28%) because the price of bad debt went from $0.03 on the dollar to $0.04 on the dollar, crimping AACC's margins. (The company collects $0.09 on the dollar.) The company does not buy any mortgage debt, and the current tight credit conditions make it very likely that the prices paid for bad debt will, once again, decline. That will improve AACC's margins in the second half of this year. Nevertheless, because of fears that AACC had purchased bad mortgages (which the company explicitly denies), the stock fell 40% last month. In 2005, when the price of bad debt was slightly lower, the firm earned $90 million in cash. Its current total market capitalization is only $290 million – or about three times peak cash earnings. At a minimum, we expect the stock to trade for around 10 times current cash earnings, or around $600 million in market cap, which implies the share price should rise by 100%.

If you have other suggestions, please send them to us (feedback@stansberryresearch.com). We'll wade through the ideas and continue to bring you the best we find, on Fridays.

The billionaires are busy. Yesterday, we reported on Buffett's buying spree, and today we learned Carl Icahn boosted his stake in Extreme Value pick Motorola (MOT) to 55.3 million shares from 9.4 million. Also, Eddie Lampert boosted his holdings of 12% Letter pick Citigroup (C) to 24.8 million shares from 15.2 million.

A slew of our holdings were recently upgraded: Bear Stearns upgraded PSIA pick Career Education (CECO) and True Wealth pick PetroChina (PTR) to "outperform." Also, Credit Suisse upgraded PSIA pick Intel (INTC) to "outperform."

Confidence among homebuilders is at the lowest point since 1991. The National Association of Home Builders confidence index is currently at 22 – a rating below 50 means most respondents see poor conditions. The gauge has decreased for six consecutive months.

According to figures published on Wednesday, corporate earnings are growing at the slowest pace since 2001. Earnings, excluding bonuses, rose at 3.4% in the three months ending in June. This equaled the record low reached four years ago.

In the mailbag… because so many of the letters we receive are from new subscribers and novice investors, it's easy for us to forget that many of our readers are older, more experienced… and probably richer… than we are. We've gotten a few good notes recently from real investing gurus. How are you handling the correction in stock prices? Let us know: feedback@stansberryresearch.com.

"I am a 30-year veteran (survivor) of the commodity futures market. I decided to try to diversify some of my funds into the equity markets, so to help me learn I subscribed to your Alliance service. After several years, I have been very satisfied with the research of your editors… I have been around long enough to have seen a number of market crashes and recessions, and I have found the research of your editors to be sound. I believe that their efforts are directed towards helping myself and others to be successful in these difficult markets. Keep up the good work!" – Paid-up subscriber Karl Parker

"Speaking from experience, since I was burned so bad in dot com, I didn't bother to check stock market for 7 years till this March. I listened to yon on the following things:

"Two weeks after this latest round of tumor, I am sitting on a small loss say one week of average earning. I am holding on the stocks I feel confident and able to sleep very well every night. My partners said why am I bothering doing this, seemed fruitless after 5 months but I know I learned heaps and on the way to become a more knowledgable investor, mainly in terms of managing risk. I greatly appreciate the education I received from you guys and I think I could be a lot worse if I haven't listened to you." – Paid-up subscriber Rachael

"Thank you for a lucid explanation in plain English of just why this mortgage market is in such trouble. I am very worried looking forward, which for all you other investors out there, would be an excellent sign of a bottom approaching, given my past experiences." – Paid-up subscriber Scott Beall

"If dividends bring down the price of a stock, what impact should dividends have on a 25% stop-loss strategy. Right now, I use this strategy without factoring dividends. It seems I should be accounting for dividends - though that would be a pain for me to figure out. However, I have never heard it mentioned that when using this strategy you should adjust the price depending on the dividends that have been received. Is this a factor and would this be applicable in this strategy?" – Paid-up subscriber Peter

Porter comment: In high-paying dividend stocks, we've applied the dividend paid toward the stock price, which widens the stop.

"I am curious. How do you envision making a living (assuming you have to) if, indeed, government institutions were dismantled? The current situation (and the Great Depression of the 1930s) clearly shows that banks and other financial institutions can't function without heavy injections of funds from the Fed. Without these financial institutions, the markets as we know them will disappear. And with their disappearance, there will be no need for financial investment newsletters. So, there you are, wondering what to do. Actually, all of us should be wondering what the ramifications would be if such transformational restructuring in our government and financial institutions were to pass. I don't know why, but my gut tells me the process is already under way." – Paid-up subscriber Maria Weaver

Porter comment: Ha, ha, ha... Without the government, I'm sure we'd all starve… No, of course not. Especially in finance, things would be much more efficient. Without the government, institutions would have to operate on a sound basis – like many currently do. Do you think Warren Buffett's Berkshire Hathaway would ever ask for or require a bailout? Imagine how much more efficient our markets would be if there weren't both the tax of maintaining the government and the tax of lecherous institutions supported by it.

"I'm concerned that Dan Ferris is resting on his laurels, from his outstanding record with Extreme Value. I assumed his Penny Letter picks would be nearly as good. The picks, which I bought everyone, were barely hanging on before this market turned everything upside down. I had no idea I could lose thousands of dollars following his due diligence with his stock picks. However, when he says the same fundamentals are in place as when he made the pick, I've just hung on and watch my money go down the drain. In particular: ICO, HDL, ABY, SIX, XJT, WON, FUR. I rest my case." – Paid-up subscriber Norman

Porter comment: This market has been particularly hard on Dan's Penny Letter picks. But we can't pass judgment on what the ultimate outcome will be in the middle of a correction. We'll have to wait and see what happens.

Regards,

Porter Stansberry

Baltimore, Maryland

August 17, 2007

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