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'll be tracking the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

And speaking of the worst ...
Investment banker Friedman, Billings, Ramsey upgraded investment broker (and Stock Advisor recommendation) Charles Schwab (NASDAQ:SCHW) this morning. FBR removed its "underperform" rating and declared Schwab a potential "market performer." For the record, I agree with FBR on the upgrade -- but I don't like its reasons one bit.

Let's go to the tape
We'll get to that in a moment. First, let's go to CAPS, where FBR ranks as one of Wall Street's worst, and take a quick look at FBR's record in the financial-services sector, to see whether we can get a handle on this banker's skill set:

So FBR looks pretty savvy on the sell side. But how does it do when it recommends buying financials?

Oh. Not so well.

Fortunately, though, FBR isn't making one of its ill-fated buy recommendations here. All it's saying today is that Schwab is worth holding. And as I mentioned, I agree. Right now, the stock is trading for a very reasonable price-to-earnings ratio of 14. In fact, you might even call it a bargain, considering that analysts expect Schwab to grow at nearly 17% per year over the next half-decade. So why is it that, with a price this nice, FBR's upgrade still gives me the willies?

Dewey, Cheatham, & Howe
It seems appropriate to hang the apocryphal (I hope) law-firm shingle above the following analysis -- not verbatim as FBR phrases it, but preserving the essence:

According to FBR, Schwab is in the enviable position of being able to improve its profit margin -- and hence its profits -- at the expense of its customers. Focusing on the difference in profit margins between two "cash-like" products in which Schwab keeps its clients' liquid funds, FBR points out that Schwab has better margins on money held in "bank retail accounts" than it pays on funds kept in money market accounts, which to me means lower interest rates paid. If Schwab should elect to tweak the criteria by which it decides where to keep customers' funds, while still paying customers "adequate returns," it could instantly raise its profit margin on more than half of the $202 million of assets under management (AUM) in money funds. Working its abacus, FBR concluded that every $10 billion in AUM thus shuffled could add $0.13 per share to Schwab's annual profits.

Robbing Peter to pay Chuck
But here's the thing -- the perhaps fatal flaw in FBR's grand plan for improving Schwab's profits: Every extra penny that Schwab thus takes for itself is a penny swiped from its customers. Can Schwab swing that? Sure. But probably at the cost of lost customers and a sullied reputation, once those customers figure out what happened.

Now, maybe FBR believes this is good business -- that all's fair in love and banking -- but to this Fool, it doesn't seem worth the risk.