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 ...
A few weeks ago, I looked at Longbow Research's controversial decision to recommend buying Steel Dynamics (Nasdaq: STLD), U.S. Steel (NYSE: X), and Nucor (NYSE: NUE) ahead of this month's earnings. While so far the picks seem to be working out (USX is up 6%, Steel-D and Nucor, 10%), the advice got called into question late Tuesday, when another metals maker -- Alcoa (NYSE: AA) -- missed revenue targets badly.

According to Alcoa, aluminum demand around the globe grew at "a slower rate than in the first half, as confidence in the global recovery faded." The sole exception to this trend was Europe, and it was a bad exception. In Europe, aluminum demand actually declined. Worse, Alcoa is now forecasting similar declines in "other regions" as well.

And yes, you could probably argue that "Alcoa's business is aluminum, but steel is different." Or rather, you could have argued this ... up until one month ago, when Nucor warned of a 40% to 50% decline in sequential profits in Q3, said steel prices and profit margins were deteriorating, and "the fundamentals here are still difficult at best." That kind of suggests that the story here is bigger than just aluminum.

This time it's different
Yet in spite of all this evidence, the share prices of steel stocks are rising, and just yesterday, another analyst went on record saying they're headed even higher. Backing Longbow's position, Dahlman Rose argued Tuesday that it's time to "re-evaluate" steel stocks "in light of recent steel price movement and global market and macroeconomic volatility." That suggests a downgrade -- but in fact, Dahlman chose yesterday to upgrade shares of Nucor and ArcelorMittal (NYSE: MT).

Good news? Unfortunately, no.

Let's go to the tape
Last time we looked at steel stocks, I told you that the main reason I don't like them was because the prices weren't right -- but that I was also concerned over Longbow's record of 38% accuracy in the steel industry. Now here's the bad news: As bad a steel-stock-picker as Longbow was, Dahlman Rose is worse:

This is Dahlman's record in the metals and mining industry over the past three years -- 24 picks made, 63% of which underperformed the market. (Although in fairness to Dahlman, it has a couple of market-perform picks that can swing that underperformance by about 10 percentage points).

Foolish final thought
As I mentioned last month, I certainly understand why so many analysts feel so bullish about steel stocks today. I mean, U.S. Steel costs just 6 times forward earnings, for heaven's sake! Dahlman pick ArcelorMittal also sells for 6 times forward estimates, while Nucor costs about 10. Regardless, many of these stocks are still reporting negative free cash flow -- USX and Arcelor included. Others, such as Steel Dynamics, are reporting free cash flow levels far below what's claimed as "net earnings" on the income statement.

My advice: If you feel you absolutely, positively must invest in a steel stock, at least limit your risk. Invest in the best. Right now, Nucor is the only steel company of any real size reporting both respectable profits and strong free cash flow. At 10 times trailing FCF, and long-term growth estimated at 12%, it's the only steel stock I'd even consider owning at today's prices.

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.