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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." While the pinstripe-and-wingtip crowd is entitled to its opinions, we've got some pretty sharp stock pickers down here on Main Street, too. (And we're not always impressed with how Wall Street does its job.)
Given that, perhaps we shouldn't be giving virtual ink to "news" of analyst upgrades and downgrades. And we wouldn't -- if that were all we were doing. Fortunately, in "This Just In," we don't simply tell you what the analysts said. We 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.
And speaking of the best…
Yesterday, in the course of discussing a recent downgrade for Microsoft (Nasdaq: MSFT ) , I showered praise upon the ace software stockpickers at Richmond, Va.-based stockbroker Davenport. Today, I'm taking it all back. Well ... maybe not all of it. I still think highly of the firm's software analysts. But I do want to take issue with a new rating that just issued from the company's metals & mining department -- an upgrade of Alcoa (NYSE: AA ) that, to my Foolish eye, looks likely to tarnish.
Here's the news in a nutshell: Pointing to recent weakness in the price of aluminum, Davenport makes the perverse argument that because Al-prices are below the company's forecast for 2012, it's not Davenport that has made a bad call -- it's the people who buy and sell aluminum for a living who are totally off base. Says Davenport, the fact that aluminum now costs less than forecast is actually good news for Alcoa investors, because it gives "significant upside" to an investment today: "A turnaround in aluminum prices would serve as a tailwind for AA, given the company’s EPS sensitivity is 3-4 cent/share for a 1 cent/lb. change in aluminum prices."
Davenport explains that in recent years, Alcoa will enjoy better profit margins "due to many reasons: strong growth in the aerospace market, a long-awaited turnaround of the company's Russian mills acquired in 2004, divesting underperforming assets such as soft-alloy extrusions, [canceling an unprofitable] contract with a major customer, ongoing cost cutting, and a cyclical improvement in the economy."
Let's go to the tape
Sound good so far? Great. Now let me tell you why Davenport's got it all wrong. Let's begin with the analyst's record. Over the several years we've been tracking its performance here at CAPS, Davenport has racked up a strong record on recommendations such as Monday's recent Microsoft pick. On metals ... not so much.
In fact, according to our supercomputer, most of the time Davenport predicts a metals company will go up more than the market, it instead does the opposite, underperforming the S&P 500 a disheartening 59% of the time. Century Aluminum (Nasdaq: CENX ) , Steel Dynamics (Nasdaq: STLD ) , Reliance Steel & Aluminum (NYSE: RS ) -- you name it, Davenport has called it wrong:
Davenport's Picks Lagging S&P by
|Century Aluminum||Outperform||***||68 points (picked twice)|
|Steel Dynamics||Outperform||***||21 points|
Source: Motley Fool CAPS.
Now, there's certainly a chance that Alcoa will be the exception that proves the rule. In fact, I admit that when I look at the stock today, the numbers all seem to argue strongly in favor of the stock. Alcoa costs only 13 times earnings, after all. For comparison, that's barely a tenth the P/E at China's Chinalco (NYSE: ACH ) . It's also a mere fraction of the 36% annual earnings growth rate than analysts expect to see out of Alcoa over the next five years...
Alcoa: Buy these numbers?
And yet, I cannot shake the feeling that there's something wrong here. I mean, 13 times earnings for a 36% grower should be a no-brainer for a value investor like me. What's more, based on its most recent data, Alcoa could be even cheaper than that; its trailing free cash flow of $1.3 billion is considerably more than reported net income, and gives the stock a price-to-free-cash-flow ratio of less than 10!
Why then can I not bring myself to follow Davenport's advice? I've got three reasons, actually. The first has to do with cash production. While currently looking good, Alcoa has a bad record of generating cash from its business historically. In fact, from 2006 through 2010, the company burned $2.3 billion worth of cash. Suffice it to say that, given a history like this, I'm reluctant to accept analysts' predictions that Alcoa will turn on a dime and begin producing strong double-digit growth in the future.
The second reason is the analyst itself. In addition to the stock-miscues cited above, Davenport was also wrong on the one Alcoa rec it has on record -- recommending the stock in March 2008, then riding Alcoa to a 48-point loss to the market. (Once burned, twice shy, you know?)
My third and final reason has to do with Davenport's arguments in favor of Alcoa. I mean, the analyst is telling us to expect "strong growth in the aerospace market," right? And yet, over at Boeing (NYSE: BA ) , they're just starting to churn out 787 Dreamliners. Dreamliners whose whole reason for existing is to prove that airplanes fly more efficiently with carbon composite wings than with aluminum. Seems to me this is a strange time to be predicting beaucoup growth in aerospace aluminum consumption. Meanwhile, Davenport also tells us that "a cyclical improvement in the economy" is underway, and that this will help lift Alcoa's profits.
Um ... maybe I'm alone in this, but ... does it feel like the economy's improving to you? Cyclically or otherwise?
Maybe I'm crazy here, but I for one am not seeing the improvement. Nor am I seeing the prospects for aerospace reverting to previous levels of aluminum use. Nor do I see the record of successful stockpicking in metals that would lead me to trust Davenport's judgment on this one. So even if Alcoa looks dirt cheap today, taken as a whole, I think I'll take a pass on Alcoa today.