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." So you might think we'd be the last people to give virtual ink to such "news." And we would be -- if that were all we were doing.

But in "This Just In," we don't simply tell you what the analysts said. We'll also show you whether they know what they're talking about. To help, we've enlisted Motley Fool CAPS, our tool for rating stocks and analysts alike. With CAPS, we track the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

And speaking of the best ...
A little more than three months after I warned investors to stay away from Intuitive Surgical (Nasdaq: ISRG) stock, it seems Wall Street's starting to come around to my way of thinking -- because just this morning, All-Star analyst Brean Murray came out with a downgrade of its own on Intuitive.

Warning of severe budget cuts in Europe, where government famously pays the bulk of health-care costs, Brean suggests efforts to cut spending in Euro-land will, unfortunately, slice deeply into Intuitive's sales this year: "Germany and the U.K. are cutting back on the growth of their health care budgets as part of a broader attempt to rein in sovereign debt. ... We would not be surprised to hear of similar efforts in the other major European markets like France and Italy."

Brean reminds us that 18% of Intuitive's daVinci robots currently practice medicine on the Continent, putting a large chunk of the company's recurring revenues at risk. Worst, the biggest-ticket "razor" section of Intuitive's razor-and-blade business model could suffer disproportionately. Brean suggests that only 53 systems will be sold in Europe this year, down from a previous prediction of 67.

And you know what? Brean's probably right.

Let's go to the tape
Not on the specific numbers, necessarily. While Brean could be right about the precise number of system sales Intuitive will make, I humbly suggest that it's got about as good a chance of hitting them on the nose as does a kid trying to count jellybeans in a carnival jar. Picking stocks that won't just go up, or down, but actually go up or down more than the rest of the market, is a notoriously tricky exercise, as Brean's record demonstrates:

Across the industry and across time, Brean has proved itself something short of a jellybean-guessing genius (scoring less than 50% accuracy on its picks.) But while Brean may be off on the precise numbers Intuitive will produce, I suspect that the analyst has tipped the odds in its favor for getting the big-picture prognosis right by targeting its downgrade on a vastly overvalued stock.

Selling for 46 times trailing earnings -- and 39 times what analysts were expecting it to earn this year and 33 times next year, before these Euro-budget-crunch worries began to surface -- Intuitive was already priced for the perfection of projected 25% annual long-term growth. By way of comparison, less ambitious growth targets for sturdier medical-equipment suppliers such as Baxter (NYSE: BAX), Johnson & Johnson (NYSE: JNJ), and Medtronic (NYSE: MDT) have these companies' growth multiples priced in the mid-to-low teens. (Granted, these guys will be hurt, too, by any pullback in European health-care spending, as they all bring in at least 20% of their revenue from the Continent.)

It stands to reason, therefore, that the more Intuitive's growth rate begins to resemble those of its peers, the more its multiple to earnings will contract -- collapsing the stock price at an accelerating rate.

Foolish final thought
How far might this reversion to the peer valuation proceed? Well, it's not a direct analogy, but at rival med-equipment provider and fellow Motley Fool Rule Breakers recommendation Mindray Medical, we find similar expectations of 25% growth supporting a multiple to earnings of only 23. Not coincidentally, this corresponds pretty neatly to the value investor's "PEG" rule of thumb -- that a stock is appropriately priced when its P/E ratio matches its growth rate. (So is Hologic, with that ratio sitting at 1.1 at the moment.)

Granted, it's a rule that's rarely been applied to hyper-grower Intuitive Surgical in the past. But as that growth slows, it's worth at least considering whether Intuitive's stock might have to play by the rules in the future.