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." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

Wall Street's new favorite metal
In troubled economic times, investors traditionally turn to gold to safeguard their fortunes. Lately, however, the bankers up on Wall Street have taken a fancy to a different sort of metal: steel. As far back as June, we described how Deutsche Bank was beginning to dip its toe in the water, suggesting that steel prices were nearing a floor and urging investors to buy shares of AK Steel (NYSE: AKS  ) and U.S. Steel (NYSE: X  ) "in anticipation of steel price and demand inflection."

It turned out to be a popular idea. Within just a few weeks, AK and USX received a second vote of approval from the friendly analysts at Susquehanna Securities. Praising AK for its improved "cost structure," and USX for its little-noticed iron-ore assets, Susquehanna agreed that both companies were worth buying. So I guess we shouldn't have been surprised when yesterday, yet a third analyst clambered aboard the steel-industry express and recommended buying -- you guessed it -- AK Steel and U.S. Steel.

All aboard!
This latest recruit to the steel industry's cheerleading team: UBS. Echoing Susquehanna's logic, the Swiss megabanker praises USX's iron-ore and coking coal assets as "a strategic advantage and … a significant portion of total enterprise value." Moving to the income statement, UBS projects "significantly improved EBITDA" at USX and "a return to historical operating margins" in due time. As for what will bring about that improvement, the banker argues that as "the largest North American tubular producer … X stands to benefit from the continued shale drilling in the U.S."

Meanwhile, UBS offers completely different reasons for liking AK Steel. First and foremost, the analyst sees a disconnect between perception and reality at AK: "Front-end loaded pension and capex seem to have spooked the market on an FCF run-rate." However, UBS sees no "liquidity concerns" at AK at this time and argues that the company is "structurally stronger than the market gives it credit for." Best of all, UBS argues that after experiencing a "sharp sell-off … AKS is best positioned within the group to lead the 'bounce' when demand improves in 2012."

Throw mama from the train
But here's the really strange thing about UBS's arguments. At the same time as it praises AK and USX, the analyst relegates steel mini-mill specialists Nucor (NYSE: NUE  ) and Steel Dynamics (Nasdaq: STLD  ) to also-ran status, rating both stocks only "neutral."

Now, I admit I have reservations about Steel-D myself. But at least the company has a history of generating free cash flow from its business -- unlike AK and USX. UBS may pooh-pooh investors' concerns over lack of free cash, but I like companies that can generate cash from their business, and I hesitate to invest in a company that can't. (This, by the way, is a big reason I endorsed Susquehanna fave and steel raw-materials supplier Cliffs Natural Resources (NYSE: CLF  ) last month, and ArcelorMittal (NYSE: MT  ) and Nucor the month before that. Over its history, Arcelor has shown that it can generate strong free cash flow in most years -- Nucor already is.)

Foolish takeaway
Folks, I have nothing against UBS. Fact is, according to its record on CAPS, this is a fine investment bank in many respects, and one that consistently outperforms its peers. My worry here is simply that UBS and a lot of its peers are placing too much faith in cash-burning businesses like AK Steel and U.S. Steel -- when they should be guiding investors toward stronger companies like Nucor and Cliffs. If I were looking for a way to invest in a steel industry rebound, those would be the first two places I'd look.

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Fool contributor Rich Smith owns shares of Veeco Instruments. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 465 out of more than 170,000 members.

The Motley Fool owns shares of Nucor and Motley Fool newsletter services have recommended buying shares of Nucor. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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