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.

Goldman's golden
Happy days are here again for Goldman Sachs. One year after we began our project to determine whether Wall Street's most famous (infamous?) banker’s recommendations beat the market, Goldman has finally emerged into the "green," demonstrating that on average, its recommendations really do beat the market. For investors in Foster Wheeler (Nasdaq: FWLT) and KBR (NYSE: KBR), the news couldn't have come at a better time.

Yesterday, you see, Goldman decided to upgrade the stocks of both these construction companies. Calling Foster Wheeler a "laggard" in the construction industry (over the past year, its shares have underperformed not just the S&P 500 overall, but construction peers Jacobs Engineering (NYSE: JEC), Fluor (NYSE: FLR), and even KBR), Goldman argues that the stock's continued cheapness gives investors a good chance to buy the stock at a bargain price: "Investor expectations [for Foster] are low, prospects are improving and the buyback provides downside protection." Conversely, Goldman sees a growth story at KBR. Once again, we have the potential for a buyback announcement. But Goldman also likes KBR's "improving margin profile" and calls the company "catalyst rich," with multiple pathways to profit.

OK. Good to know why Goldman thinks these stocks are both "buys." But now for the really important question: Should you even care what Goldman thinks about 'em?

Let's go to the tape
I mean, let's face it, folks: Goldman may be "in the green" overall on its stock picks (finally!), but the analyst is still scoring sub-50% accuracy, and blowing the majority of its calls. Goldman's only outperforming the market these days because its winners are slightly outperforming its losers.

But here's the thing: Out of the whole, wide universe of industries Goldman covers, there's nothing this analyst does better than Construction & Engineering. With its record of 80% accuracy, this is the single industry in which Goldman shines brightest. A few examples:

How firm a foundation?
Will Goldman's latest picks fare as well? Well, maybe. When I look at Goldman's latest picks, I have to wonder whether Goldman's gotten a little overimpressed with its own record of success; whether it's stretching to recommend merely fairly priced stocks, when what it really needs to be doing is looking for bargains.

Consider: Selling for 16.6 times earnings, Foster Wheeler looks only slightly overpriced in relation to its projected 13.7% long-term growth rate. The stock doesn't exactly scream "bargain!" and the fact that Foster's free cash flow lags its reported GAAP earnings slightly doesn't really thrill me either. But with an enterprise value-to-free cash flow ratio of 13.2, I can see Foster holding its own against the S&P 500's performance going forward.

Similar story for KBR. Here, the P/E overvaluation is even more readily apparent. Simply put, 14.7 times earnings is usually going to be a bad purchase price for a stock only expected to grow at 10% per year over the next five years. That said, KBR generates a whole lot more free cash than its GAAP earnings let on -- so much more that the resulting price-to-free cash flow ratio sits below 10, and the EV/FCF drops to a tempting 7.2.

Foolish takeaway
In either case, I believe Goldman is right to be choosing large, stable, moderately overpriced construction businesses over smaller shops that trade at much higher multiples to reported income. Shaw Group (NYSE: SHAW) and Granite Construction (NYSE: GVA), with their P/Es of 32 and 159 (!) respectively, spring to mind.

If risk minimization is your goal -- and Goldman's write-ups make it clear that it's keeping "downside risk" front and center in these recommendations -- then I agree KBR and Foster are probably the way to go. Then again, if it's risky valuations you fear, mightn't the best idea be to avoid this overvalued industry entirely, and seek your value elsewhere? (For example, here.)