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.

All aboard! (Or if not "all," then at least "most")
In 2009, "Oracle of Omaha" Warren Buffett peered into his crystal ball, saw that high oil prices would make railroads more and more competitive as time went on, and bought Burlington Northern to help build the Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) empire. Three years later, analysts at FBR Capital have decided that Buffett just might have known what he was doing.

So last week, FBR rolled on into railways, too, assigning an "overweight" ranking to the industry. Within it, the analysts see winners and losers, of course. For example, FBR rates Union Pacific (NYSE: UNP  ) , Kansas City Southern (NYSE: KSU  ) , and Canadian National (NYSE: CNI  ) as buys, while sidelining CSX and Norfolk Southern at hold. It even slapped an "underperform" rating on Canadian Pacific. But, overall, the analyst sounds bullish about the whole darn shooting match, Berkshire and Burlington included, arguing that railroads will steal market share from the trucking industry in years to come, and have embarked upon a multi-year "cyclical growth period."

Is FBR right about this? Let's crunch some numbers and find out:

  P/E Growth Rate Dividend Yield
Canadian Pacific 21.8 10.5% 1.6%
Norfolk Southern 12.3 13.7% 2.8%
CSX 12.5 9.0% 2.5%
Canadian National 15.2 12.8% 1.6%
Kansas City 22.5 17.8% 1.0%
Union Pacific 15.8 13.9% 2.0%

All financial data courtesy of finviz.com.

Considering Wall Street's generally lackluster record of picking winners and losers in the market, and FBR's sub-50% record of accuracy in particular, I'm surprised to find myself generally in agreement with FBR on its relative rankings.

For example, bottom-ranked Canadian Pacific sports the second-highest P/E ratio in the industry, but the second slowest growth rate (and it's tied for second-worst divvy). That's three strikes in my book, and plenty of justification for FBR rating the stock a sell.

I also agree with the analyst's picking Union Pacific to outperform. Its strong growth rate (13.9), and modest dividend (2.0), combine to give the stock a total value (15.9) in excess of its P/E ratio. Meanwhile, Canadian National and Kansas City, while not obvious bargains, are close to the mark, and on the surface, at least, look like viable value candidates. It's curious, however, that FBR appears to have overlooked Norfolk Southern, whose lowest-in-class P/E ratio does not appear justified relative to its strong growth rate and best-in-class dividend yield. To the extent that investors want to "judge a stock by its PEG," Norfolk Southern is actually the best bargain of the bunch, and probably deserves a better rating from FBR.

Appearances deceive
But, I say "probably" not without reason. Because while Norfolk looks to me like the cheapest railroad stock on offer today, there is a big problem lurking in the woods here: cash.

You see, building a railroad isn't a cheap enterprise, and keeping one functioning seems to cost quite a chunk of change as well. So the big problem with investing in railroads is that these companies are heavily capital-intensive enterprises -- much more so than you might think, based on the "net profit" they all claim to be earning.

Dig into the firms' cashflow statements, and you soon see that each generates vastly less free cash flow than it reports at net profit under GAAP. Indeed, Canadian Pacific -- there's that name again -- is actually burning cash -- yet another reason to avoid it.

Foolish takeaway
Granted, the other firms on the list carry less risk than Canadian Pacific does. But, even the cash-profitable ones generate so much less real free cash flow than their income statements suggest, that they're not the bargains they appear to be.

My advice? Avoid heavy industry, and heavy capex spending. Instead, invest in the stocks only the smartest investors are buying. Read our free report, and find out who they are.

Fool contributor Rich Smith does not own (or short) shares of any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 262 out of more than 180,000 members. The Motley Fool has a disclosure policy.

The Motley Fool owns shares of Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway and Canadian National Railway.

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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