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.

ISI says: "Buy, buy, buy!" (and that's just the beginning)
Analysts at ISI Group announced a series of seven new upgrades in the machinery sector yesterday -- and they didn't exactly hedge their bets. All seven of the firm's new ratings urge investors to buy the stocks in question: Oshkosh (OSK -0.89%), Illinois Tool Works (ITW 0.31%), Deere (DE -0.65%), CNH Global (NYSE: CNH), Cummins (CMI -0.20%), Eaton (ETN 1.68%), Ingersoll-Rand (TT 1.15%), and Caterpillar (CAT 1.16%).

Come one, come all, we'll say this at least: ISI doesn't bet small. But what is it, exactly, that has ISI so optimistic about this sector of the economy?

In a word, it's "inventories." Or rather, the lack of them. Explaining its upgrades yesterday, ISI noted that its "channel checks" show that makers of heavy machinery are starting to see their inventories decline, as more and more equipment moves out the door to buyers. The analyst is now projecting an earnings "bottom" for these firms somewhere in H1 2013, to be followed by stronger earnings as the year progresses. But is ISI right?

2013: year of the turning point?
There's a lot of optimism out there about the economy, no doubt, in the wake of Congress passing a law to avert (or at least postpone) the fiscal cliff. Pegging a date certain on the economy's recovery, however, is a tricky business. Rather than assume ISI has called the bottom correctly, therefore, investors are probably better off looking at each of these companies from a longer-term perspective.

Basically, what you want to ask is: If a recovery happens this year, or next year, or any time in the next five years, are the stocks priced to outperform based on today's prices? Well, let's find out:

*All financial data courtesy of finviz.com.

ISI's opinions notwithstanding, I have to say that, as I survey this chart, I see very little to get optimistic about. Sure, several of these stocks -- notably, Caterpillar, ISI's avowed favorite of the group -- bear seemingly attractive PEG ratios. Oshkosh, CNH, Cummins, and Caterpillar all sport low valuations relative to reported earnings, and Wall Street's projected growth rates for each of them are higher than their P/E ratios.

Where the bull thesis breaks down for most of them, though, is on the cash flow statement -- where only a bare majority of these firms are generating any real cash profits at all, and where literally not a one of them generates as much cash as it claims to be "earning" on its income statement.

At the risk of stating the obvious, this doesn't give me a whole lot of confidence in the quality of the earnings that these companies are reporting. What's more, when I see that most of these companies are carrying around significant debt loads (indeed, only Cummins has more cash than debt on its balance sheet), I wonder how well any of them will fare in the event an economic recovery doesn't materialize as fast as ISI says it will.

The fact that ISI itself sports a pretty miserable record of picking winners -- on CAPS, we have this analyst pegged for a record of just 28% accuracy on its picks over the past two years -- doesn't exactly increase my confidence in its forecasting acumen.

Foolish takeaway
Granted, even the proverbial stopped clock is correct twice a day. It's at least conceivable, therefore, that this could be ISI's lucky day (or lucky minute) -- but I wouldn't bet on it. Fact is, out of all the stocks named up above, only one looks to have a big enough margin of safety to be worth a gamble.

Priced at 12.6 times earnings, and 13.9 times free cash, Oshkosh appears fairly valued relative to its long-term projected growth rate. The company's debt load, while not ideal, is manageable at about $415 million. And now that famed activist investor Carl Icahn has abandoned the stock, and lowered its profile a bit, it's possible that Oshkosh shares can be acquired at more reasonable prices... so that when the recovery does happen, we'll earn even bigger profits upon it.

All things considered, if you're inclined to gamble on ISI being right at all, I think Oshkosh is the best place to lay your bets.