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This Just In: More Upgrades and Downgrades

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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 Rating

CAPS Rating
(out of 5)

Davenport's Picks Lagging S&P by

Century Aluminum Outperform *** 68 points (picked twice)
Steel Dynamics Outperform *** 21 points
Reliance Outperform **** 15 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?

Foolish takeaway
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.

Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 402 out of more than 180,000 members. The Motley Fool has a disclosure policy.

The Motley Fool owns shares of Microsoft. Motley Fool newsletter services have recommended buying shares of Microsoft and creating a bull call spread position in Microsoft. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Read/Post Comments (4) | Recommend This Article (1)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 24, 2011, at 12:43 PM, HankWrightwood wrote:

    When compared to its current market capitalization Alcoa's unfunded pension liability is enormous. I don't get why this is completely ignored by every single analyst of the stock. This is where any extra "cash flow" will go over the coming years and this is the single reason I won't buy the stock.

  • Report this Comment On August 25, 2011, at 2:14 PM, Brettze wrote:

    Why nobody is calling for higher aluminim prices, I dont understand!!

  • Report this Comment On August 27, 2011, at 4:30 PM, Brettze wrote:

    Hank, stubborn repressed aluminium prices make ALCOA's unfunded pension liability loom larger . All is needed is higher aluminium prices. China holds the key to higher aluminium by shutting vast capabilities that were built during the days of the Long March! China is waiting for the new smelting expansions all over the world to be completed before China can feel comfortable with shutdowns of its aging smelters without spooking the aluminium traders in the pits. Overall, aluminium prices should rise but probably not as fast as the other metals like copper, gold, silver , nickel, moly, etc. Aluminium is the biggest metal commodity so industrial users are not anxious to see aluminium prices shoot up too fast if China go ahead and shut down its aging smelters too prematurelly. The only questoin left about ALCOA is whether it is already a prepackaged bankrupted company or not much similar to General Motors. If the economy worsens again and has an major impact on aluminium consumption that sends prices back south to 65 cents a pound again, then ALCOA is in a real fix !

  • Report this Comment On August 27, 2011, at 4:35 PM, Brettze wrote:

    I feel that China will accelerate its shut down of its aging smelters to prevent aluminium prices from heading too far south. Despite glowing stories about ALCOA, prices of aluminium is the key to ALCOA'S survival. Most people would not noitce ALCOA bankruptcy if at all which is the real vexing problem for ALCOA shareholders as well as bondholders.

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