Get to Know a Guru

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." In our recurring column "This Just In," we cover the most headline-worthy upgrades and downgrades, testing the analysts' logic and examining their records to help you decide whether they're worth listening to.

In "Get to Know a Guru," we go another route. Here, we use upgrade and downgrade news as a springboard to introduce you to some of the lesser-known names in analyst-land. Up this week: B. Riley.

Profiles in punditry
An unfamiliar name (to me, at least) popped up on MSN Money's tally of analyst upgrades yesterday, when "B. Riley" initiated coverage on Motley Fool Hidden Gems recommendation Volcom (NASDAQ:VLCM) with a "buy" rating. If you're wondering just who the heck B. Riley is, and how clued-in it is to the surfing, snowboarding, and skateboarding subcultures, you're not alone. Fortunately, these are the kinds of questions I aim to address in this column. So without further ado, let's ...

Get to know this guru
Here's what Motley Fool CAPS has to say about the firm:  

Headquartered in Los Angeles, B. Riley provides research and trading ideas as well as investment banking services to middle-market private and public companies. B. Riley centers its research on undervalued small and mid-cap companies located on the West Coast. The company has earned a reputation for providing unbiased and often contrarian research of companies with minimal coverage by Wall Street. Their overall investment philosophy is informed by the notion that superior long-term returns are achievable in areas where no one else is looking.

A bit more trivia about the firm: Riley has been in this business for 10 years, has a staff of eight analysts, and covers a total of 180 small and mid-cap companies -- about half actively, half passively.

Are these guys any good?
According to its website, Riley is "singularly focused on undervalued small to mid-cap companies on the West Coast -- by identifying possibilities where no one else is looking, we achieve superior long-term returns for our clients." Problem is, Riley's CAPS record doesn't quite back up that assertion. On the contrary, this investment banker boasts:

• A negative CAPS score.
• An "Under 20" CAPS rating.
• And a 39% record for accuracy (meaning you're statistically better off flipping a coin than following this firm's advice).

Among its picks that have failed to pan out, we find:

Strangely for a firm "singularly focused" on "West Coast" companies, Riley seems to do a better job of picking winners the farther from home it strays. Witness the following three firms from the U.K., Puerto Rico, and Connecticut, respectively:

Separating the analyst from the analyzed
So yesterday, B. Riley endorsed Volcom. Brings to mind the old chestnut: "Do me a favor; don't do me any favors." For one thing, Volcom operates in the retail clothing industry, which includes two of the three losers listed above. For another, Costa Mesa, Calif.-based Volcom is one of those West Coast franchises on which Riley focuses so singularly -- and so poorly.

That's two strikes against Volcom from the get-go. But I do see why Riley might be willing to push its luck on this one. Volcom put in a strong performance last quarter, with sales growing 49%, net income up 42%, and inventories up only 31% year over year. The valuation looks propitious, too -- at least on the surface. Volcom shares sell for just 15 times forward earnings, while analysts predict the firm could grow those earnings 24% per year over the next five years.

Foolish takeaway
And yet, investors got burned badly for trusting those estimates back in October. Moreover, Volcom hasn't generated positive cash from operations for two quarters running, mostly because of a growing accounts receivable balance -- it's doubled over the past two quarters. Put it all together -- the analyst's lackluster record, the firm's lackluster earnings guidance, ballooning accounts receivable, and the just plain lack of free cash flow -- and I have to disagree that Volcom is, in fact, the buy that Riley tags it.

Disagree? Feel free. Come on over to CAPS and tell me why.

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