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 ...
Shareholders of laser-equipment maker II-VI (Nasdaq: IIVI) are jumping for joy this week -- and the shares jumped by 2% yesterday -- over an analyst initiation at "buy." Yesterday, the smart lads at Needham & Co. began coverage of this one-time Motley Fool Hidden Gems recommendation, encouraging investors to buy the shares on the strength of its "solid track record of growth and ... remarkable run of profitability every year going back over 35 years."

Needham predicts we'll see "improving demand across [II-VI's] diverse end markets" next year, which combined with "the recent acquisition of Photop Technologies, a Chinese manufacturer of optical components and photonics products" will "set the stage for sharply higher earnings" in 2011. Needless to say, Needham thinks you'll get a better price on the shares by buying before the improved earnings appear, rather than after.

I agree -- but only in part.

Let's go to the tape
Why the hedging call? Why don't I jump on the II-VI bandwagon alongside Needham this week? Well, because of the analyst's record, for one thing. While overall a fine analyst, and ranking among the top 20% of investors we track, Needham has long struggled in calling the ups and downs of the high-tech electronic equipment industry to which II-VI belongs -- scoring around 35% for accuracy in the sector, and underperforming the S&P 500 by more than 250 percentage points across all its picks.

Even more worrisome, Needham's done particularly poorly in that segment of the industry that focuses on laser technology:

So suffice it to say: When Needham turns bullish on a stock, this can be cause for concern.

Lessons from history
In this case, it may be instructive to examine why the "one-time Motley Fool Hidden Gems recommendation" that is II-VI is no longer an active recommendation of our service. Pulling out a copy of our October 2008 sell recommendation to refresh my memory, here's what I found our analysts saying at the time:

II-VI has been an absolute smasher for us, rising 158% against some minor decline for the S&P 500. ... However, when I ... consider the current price ... I see only moderate market outperformance for the next few years. Toss in the fact that this is a stock that's more than half again as volatile as the wider market (the beta is 1.6), and I believe the most prudent course is to sell and watch.

To my Foolish eye, that analysis remains right on the mark today. You see, I happen to agree with Needham's enthusiasm for growth in the laser industry going forward. News that General Dynamics (NYSE: GD) has recently taken on a contract manufacturing role in the industry, combined with the steady drumbeat of laser-related developments from bigger players such as Boeing (NYSE: BA) and Northrop Grumman (NYSE: NOC), has me convinced that lasers are becoming more and more a part of America's military arsenal -- which will only add to underlying industrial demand.

The song remains the same
That said, II-VI's price still seems a bit rich. The stock sells for 32 times earnings -- which in and of itself doesn't worry me, because the company generates a whole lot more free cash flow than it gets to report as net income under GAAP accounting standards. Yet even if you give the stock the benefit of the doubt, as I do, and value it on free cash flow, II-VI commands about a multiple of about 18, which appears ambitious in light of the company's projected 13% five-year average earnings growth.

In short, the reasons we bought II-VI several years back remain in force today -- but so, too, do the reasons we sold the stock all those months ago. This is a superb little company, and one that will do wonders for your portfolio -- but only at the right price.

Needham's bullish prognosis notwithstanding, the price isn't there yet.