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 ...
The economy's lousy. The Dow's (INDEX: ^DJI) in the dumps. Half the country (it sometimes seems) is out of work, and the other half is awash in (bad) debt. Clearly, now is the time to be investing in steel stocks -- or so say the analysts at Longbow Research.

On Friday, just before investors left to lick their wounds over the weekend, Longbow initiated coverage on a series of steel stocks. And while only "neutral" on shares of AK Steel (NYSE: AKS  ) and Commercial Metals (NYSE: CMC  ) , Longbow's downright bullish on three of the biggest names in the industry: Steel Dynamics (Nasdaq: STLD  ) , Nucor (NYSE: NUE  ) , and U.S. Steel (NYSE: X  ) itself -- each of which the analyst rates a "buy."

The timing, I must say, seems strange. On one hand, Longbow is clearly trying to get ahead of the curve on these stocks, to provide some "value-added" for its clients. With the notable exception of Arcelor Mittal (NYSE: MT  ) , which we probably won't hear from before November, each of the major steel producers is expected to report earnings over the next few weeks. So kudos to Longbow for trying to provide some pertinent advice ahead of time. The problem is that its advice to start loading up on steel stocks may be too early.

I mean, it was only two weeks ago that Nucor issued guidance for Q3 results that suggest a 40% to 50% fall-off in profits from Q2. Giving color to the pre-announcement, Nucor lamented "the recent deterioration [in] lower steel prices and metal margins ... new domestic supply, increased imports and continued high raw material costs." While Nucor says it's been able to raise prices "recently" to account for some of the higher input costs, management warns that "the fundamentals here are still difficult at best."

Let's go to the tape
And speaking of difficult, have you taken a look at Longbow's record in the steel industry lately? It's not pretty. Out of the 27 recommendations this analyst has made over the past five years, only 38.5% managed to outperform the market. A .385 batting average -- that's pretty good for baseball, but not so hot for a stockpicker. Longbow's recommended buying (or selling) Nucor four times in the past five years -- and gone 1-for-4 on its picks. It's thrice placed ratings on U.S. Steel ... and been wrong each and every time -- hardly a record to inspire confidence. But could this time be different?

After all, if you're bullish on global growth, it must be hard to resist some of the prices being offered in this industry today. Looking at the analyst's "buy" recommendations alone, we find both USX and Steel Dynamics selling for roughly 5.5 times next year's estimated profits, while Nucor costs only a bit more at 8.8. With earnings-growth rates on the stocks ranging from a low of 8% (USX) to as high as 21% annualized (Steel-D), I can see how these valuations might tempt investors.

But in most cases, I still think you should resist the temptation. Steel Dynamics, for example, might have high earnings growth rates to recommend it, but the company's free cash flow still looks anemic at less than 60% of reported net income. USX is actually free cash flow negative for the past 12 months. And both companies continue to carry pretty hefty debt loads.

To me, Nucor looks like the safest bet of the bunch at a price-to-free cash flow ratio of less than 10, with growth projected to average 12%. And with just $2.1 billion net debt against a market cap of $10.2 billion, it's arguably the least-leveraged of the group as well.

Foolish takeaway
Between the economic headwinds facing the industry, and Nucor's clear warning that things will get worse before they get better, I admit I'm not a huge fan of steel stocks today. If you, however, like Longbow and you're looking a bit farther down the road and searching for stocks that will look like bargains once business begins to pick up again, then Nucor's probably your best bet.

Looking for ways to diversify and hedge your bets beyond a single-industry steel focus? Read our free report on 3 ETFs Set to Soar During the Recovery.