This Just In: Upgrades and Downgrades

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." So you might think we'd be the last people to give virtual ink to such "news." And we would be -- if that were all we were doing.

But in "This Just In," we don't simply tell you what the analysts said. We'll also show you whether they know what they're talking about. To help, we've enlisted Motley Fool CAPS, our tool for rating stocks and analysts alike. With CAPS, we'll be tracking the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

And speaking of the best…
The brink of a recession may not be the best place to start investing in retailers, but according to analyst Jefferies & Co., it's not a half-bad vantage point to begin scanning the field for bargains.

Pulling out its binoculars and taking a good hard look at American Eagle (NYSE: AEO), Aeropostale, and Abercrombie & Fitch  (NYSE: ANF) this morning, Jefferies rendered its verdict: AE won the coveted "buy" rating. Aeropostale took the "hold." And A&F got sent home with the booby prize -- an "underperform."

Why?
According to Jefferies, separating the winners from the losers in teen clothing retail basically comes down to two things: Comps and margins. From that perspective, Jefferies thinks AE is winning this race. "Sales trends [are] becoming less negative." Meanwhile, strict control over inventory growth has "margin contraction moderating."

Jefferies sees Aeropostale doing similarly well, stealing market share and "navigating well in a difficult retail environment by offering a compelling assortment at value price points." Unfortunately, Aeropostale shares aren't particularly cheap -- at least, not cheap enough to win the value award.

Lastly and least, there's A&F. Jefferies argues that by refusing to cut prices, A&F is hurting its sales numbers. Worse, holding the line on pricing is supposed to keep a company's margins intact. Instead, Jefferies says Abercrombie's are "starting to crack." (As a consolation prize, A&F does get to keep its reputation as a higher-end retailer.)

But how likely is it that Jefferies is seeing things clearly here? After all, it's only "initiating" coverage on these three firms -- it's not like it's got a track record to prove its skill regarding any of them. Is this analyst any good at picking retailers in general?

Let's go to the tape
As a matter of fact, it is. Jefferies scores high on its picks of Wal-Mart (NYSE: WMT) and Staples (Nasdaq: SPLS). And while it's got a few retail nags in its stable, too (Home Depot (NYSE: HD) and CVS Caremark spring to mind), its biggest mistakes generally tend to crop up more in tech than in trousers:

To sum up, we have a star analyst ranking in the top 10% of investors overall. It's not perfect, of course (Jefferies only gets about 51% of its picks right), but it does seem to have a good feel for retail.

And at first glance, Jefferies' retail ratings today make a lot of sense. With its 10.5 P/E and 12.8% projected long-term growth, AE looks mighty tasty. Aeropostale, sporting a 17 P/E and 16% growth, appears fairly priced, but basically a hold.

Second glance
However, the sell rating on A&F tipped me off to one possible "issue" with Jefferies' ratings. With its 8.6 P/E and growth projections of 13.7%, Abercrombie actually seems to offer the widest margin of safety of the bunch. Looking more closely, though, I noticed that the company doesn't generate as much free cash flow as it reports as net income under GAAP.

Then, looking even more closely, I discovered that this is true for all three retailers. That fact turned all off Jefferies' ratings on their heads for me.

Foolish takeaway
When you compare free cash flow to market cap, A&F is the only one of these retailers that appeals to me. Its 11.8 multiple looks plenty cheap in light of the strong growth projections. In contrast, the growth projections for Aeropostale and AE both look pretty weak -- and insufficient to support either stock's market cap.

Now, I could be wrong about this. If you think so, feel free to click on over to Motley Fool CAPS, post your thoughts on any of these three companies, and set me straight on why Jefferies is right and I'm wrong. In the meantime, my opinion stands: A&F is the best of this bunch. AE and Aeropostale are second-stringers at best.