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.

And speaking of the best ...
Four years after America's housing industry got struck by a serious case of dry rot, is it finally time to buy some homebuilders? Ace analyst UBS thinks so -- and considering its skill in this industry, you might want to consider the idea as well.

Yesterday, the Swiss megabanker issued a trio of upgrades on three of America's biggest homebuilders. Motley Fool Stock Advisor favorite Meritage Homes (NYSE: MTH) only received a bump up to neutral, but according to UBS, both Lennar (NYSE: LEN) and D.R. Horton (NYSE: DHI) are out-and-out buys at today's prices.

So what?
Why should you care what some banker over in Switzerland thinks of American homebuilding stocks? Quite simply, because when it comes to this industry, UBS is one of the very best analysts out there. At CAPS, we've been tracking this analyst's performance since way back in 2006, well before the mortgage crisis hit, and well before the housing industry self-destructed. What we've found over these five years may surprise you.

Not only is UBS one of the best analysts out there, period (it ranks in the top 10% of investors we track) -- it's also an absolute wizard when it comes to picking winners in the housing industry in particular:

Source: Motley Fool CAPS.

Somehow, in an industry that nobody has been able to get right these past few years, UBS has managed to call the trajectory of homebuilding stocks right two times out of three. And you know what? They just might have gotten it right again this week.

UBS and the location vocation
Realtors tell us that in real estate, "location" is everything. So how does UBS manage to be in the right place at the right time with its homebuilder recommendations so often? I honestly don't know. And in fact, even I have some concerns that this week's picks may be jumping the gun. Key to UBS's buy theses, you see, are the valuation of the stocks -- and in particular, their price as compared to their tangible book value, or TBV. Each of the three stocks UBS picked yesterday sells for either 1.0 or 1.1 times TBV. By way of comparison, two stocks UBS did not endorse yesterday, PulteGroup (NYSE: PHM) and KB Home (NYSE: KBH) sell for the higher multiple of 1.2 times TBV.

As I say, this argument worries me a bit because ... well, let's take D.R. Horton as an example. The stock may sell for 1.1 times TBV today. But way back in 2007, it was even cheaper, averaging a P/TBV ratio of 1.0. Four years into the Great Recession, I suspect you'll agree with me that the housing market did not in fact "bottom" in 2007 ... yet for much of that year, Horton shares carried a share price more than twice what they fetch today. If the P/TBV on Horton was lower then, though, than it is today, then the only way for that to happen is if the value of the company's supposedly "tangible" assets has been dropping even faster than the stock price. And if that is true, a company's tangible book value isn't quite the floor on its stock price that we might imagine (and hope) it to be.

Foolish final thought
That said, the very fact that so much "tangible" book value has been wrung out of these stocks over the past four years suggests to me that much of the risk of further drops has already been realized. Four years into the downturn, a Fool can hope that TBV finally does equate to real value.

Now, I realize hope isn't the best foundation upon which to build a buy thesis. So let me make one final point in favor of UBS's buy ratings today. Up above, I mentioned that Pulte and KB both sell for higher P/TBV ratios than do UBS's new favorite homebuilder stocks. But here's another thing: Pulte and KB are also currently showing net losses for the past 12 months, while both Lennar and D.R. Horton are firmly profitable (and neutral-rated Meritage is on the cusp of profitability). UBS believes that the new home market is now "at -- or near -- a trough." If these companies are able to make (or get near to making) a profit here at the bottom when everyone else is losing money, they're likely to do even better than their peers as the market revives.

Which is precisely why UBS thinks they're worth buying -- and why I'm inclined to agree.