This Just In: More 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." 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 this, 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.

A "December to remember" for auto investors
This morning is starting to look like a good one for everyone who's anyone in the auto industry. So far, we've seen Chrysler report a 45% surge in November car sales. Nissan is up 19%. Ford (NYSE: F  ) , 13%. Even General Motors (NYSE: GM  ) says it enjoyed a tidy 7% bump in sales, with sales of the uberprofitable Silverado pickup leaping 34%, and the Cruze econobox morphing into a real pocket rocket -- 54% sales gains over last year. Even Toyota (NYSE: TM  ) picked up nearly a 7% sales gain.

Granted, results were weaker at Japanese auto titan Honda (NYSE: HMC  ) , whose November sales were off 6.4%. Still, across the industry, Americans are buying new cars at a rate faster than we've seen at any time in the past two years -- accelerating to an annual pace near 14 million units.

According to one analyst, this makes now an excellent time to begin buying some car parts stocks. Namely: Tenneco (NYSE: TEN  ) , Johnson Controls (NYSE: JCI  ) , and BorgWarner (NYSE: BWA  ) . Investment banker RBC Capital Markets just named these three its favorite picks in the auto parts industry. Investors immediately swarmed the stocks, sending shares of BorgWarner up 6% yesterday. Johnson gained 9%, and Tenneco rose nearly 13%. But just because RBC loves these stocks, does it mean investors should buy 'em?

One word: "No."
I admit, at first glance, RBC's record of success as a stock picker might incline you to follow its advice. This banker ranks in the top 10% of investors we track on CAPS, and gets the majority of its stock picks right. There is, however, one area of the market in which RBC's record is somewhat spotty: automobiles.

According to our stats, RBC guesses right only about 33% of the time when recommending stocks in the automotive industry, and if you ask me, it's got even worse chances of making a profit off of its three top picks this week. Let's take a look at the numbers:

Company

P/E

Growth Rate

Free Cash Flow as a % of Net Income

Johnson 13 16% NM
BorgWarner 16 23% 62%
Tenneco 16 30% 30%

Sources: Yahoo! Finance, S&P Capital IQ. NM = not meaningful because of negative free cash flow.

Sure, at first glance the numbers look attractive. With each of these stocks selling for P/E ratios far below their predicted long-term growth rates, I can certainly see what might have inspired RBC to recommend them. But dig a little deeper, and you'll notice that none of these firms is generating real "cash profits" at anywhere near the rate they claim to be earning "net income" on their income statements. Best-of-breed winner BorgWarner gets only $2 cash for every $3 in profit it claims to have earned. Tenneco -- less than half that. And Johnson is burning cash.

As a result, when you run the numbers, none of these stocks looks like a particularly good buy when valued on its free cash flow. Now factor in the effects of their hefty debt loads (about $1 billion net debt at Borg, more than $1.1 billion at Tenneco, and a whopping $4.9 billion at Johnson Controls), and I'd argue the stocks are even worse bets than they appear at second glance.

Foolish final thought
What's bad for the goose is just as bad for the gander. If you're inspired by the strong sales numbers coming out of Detroit this week, I'd urge you to take a good, hard look at the companies making the claims of sales success.

General Motors, for example, looks enticingly cheap at a P/E ratio of just 4.6. But much like the suppliers named up above, its value isn't all it's cracked up to be. It may show an accounting profit, but General Motors' cash flow statement shows this company is burning cash. Ford, on the other hand, looks much healthier to me. At 6.4 times earnings, it's not as "obviously" cheap as GM (although obvious enough). But Ford backs up its reported $6.8 billion in trailing net income with a free cash flow haul of $7 billion. It's actually better than it looks.

If you're looking for a real bargain in Detroit, I'd suggest you pass on taking RBC's advice, ignore the parts makers, and focus your research on Ford instead.

Or if you're in the hunt for a real undiscovered bargain, take a gander at the Fool's latest research report -- The Motley Fool's Top Stock for 2012. It's free for the taking. Just click right here.

Fool contributor Rich Smith does not own shares of (or short) any stock named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 319 out of more than 180,000 members. The Motley Fool has a disclosure policy.

The Motley Fool owns shares of Ford. Motley Fool newsletter services have recommended buying shares of Ford, BorgWarner, and General Motors.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.


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