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 track the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

I take it back. I take it all back ...
For years I've used this column to decry Wall Street analysts as a herd of lemmings, easily distracted by shiny objects and constantly latching onto whatever trend was currently grabbing the headlines. But it seems I've been unfair -- the opposite is true. According to research reports just out from Goldman Sachs and Longbow Research, far from performing research that goes no farther than stating the obvious, it now appears these analysts are occasionally obvious to the obvious as well, even when it's waved under their noses.

Yesterday morning, the Wall Street Journal declared the news in big, bold, 2000-point font: "Steel-Price Rise Defies Forecasts... Despite predictions that worldwide steel prices would remain weak for the rest of 2010, they have started to climb..." Scrap steel -- up 4%. Cold-rolled steel -- up 9%. Steel plate ... up a whopping 12% in price-per-ton.

Yet in the face of this data, what is Wall Street doing? It's issuing downgrades. Goldman dropped each of U.S. Steel (NYSE: X) and Nucor (NYSE: NUE) to "neutral" on Monday, urging investors to roll their cash over into copper and Freeport McMoRan (NYSE: FCX) shares instead.

Longbow went even farther, mimicking Goldman in downgrading USX to neutral, but dropping Nucor all the way to sell, and tossing in a third downgrade to neutral for Steel Dynamics (Nasdaq: STLD) for good measure. Investors are reacting as you'd expect, selling off all three of the steel stalwarts (and curiously, dumping Freeport alongside 'em) yesterday. But is that really the right call? Is now the time to panic?

Let's go to the tape
After all, it's not like these two analysts have proven themselves foolproof when it comes to picking metals stocks. Goldman Sachs -- one of the consistently worst stockpickers we track -- has a record of getting fewer than 40% of its picks right in the Metals and Mining industry. Among its picks still active, the company can only boast of having been right ... about as often as it's been wrong:

Don't laugh, Longbow
Nor is Longbow much better. While in most things a superior analyst to Goldman, Longbow misses the target almost as often when shooting for wins in the metals space. Barely 46% of the analyst's recommendations in this industry "work out," and across the two-dozen odd stocks it's picked over the past four years, Longbow is actually trailing the market's returns by a combined 52 percentage point deficit to-date. Notable losers include each of:

• Nucor (a four-time pick, lagging the market by a combined nine points)
• Steel Dynamics (picked twice for a total of a 43-point loss), and
• USX -- on which Longbow is 0-and-3, losing to the market by a combined 70 percentage points.

Ugh
Ugh indeed. And yet -- at the risk of giving my long-suffering readers whiplash at the speed of this head-fake -- I actually agree with Goldman and Longbow today. The steelmaker stocks are overpriced, and whatever the Wall Street Journal might believe about China's production cutbacks salvaging the industry, these stocks are unlikely to outperform the market going forward. Here's why:

At P/E ratios of 15, 80, and infinity (for Steel Dynamics, Nucor, and U.S. Steel, respectively), not one of these stocks is currently priced to outperform the market. Growth rates that range from 10% (Steel Dynamics) to 15% (Nucor) to even the 30% rate posited for unprofitable USX don't come close to justifying their prices. Moreover, the failure of any one of them to maintain positive free cash flow leaves me decidedly unoptimistic about their chances of rewarding their shareholders from this price-point.

Foolish takeaway
The real wonder here isn't that Wall Street has broken from its habit of investing "in the obvious." To the contrary, the overvaluation of these three steel stocks should have been obvious to even the most casual observer. Not only are Steel Dynamics, Nucor, and U.S. Steel unworthy of investment today...

They probably never should have been rated "buy" in the first place.