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 best ...
Highly ranked Pali Research used the short interval before the new year to issue a quick rating this morning, upgrading shares of American Eagle Outfitters (NYSE:AEO) to buy.

Positing weaker operating margins of about 9.3%, Pali predicts American Eagle (AE) will earn $0.90 in fiscal 2009, or about "10% below the $0.98 Consensus" -- and advises investors to buy now, just before AE hits bottom. Why buy just before AE reports an earnings disappointment? Reasons Pali: "We think the stock is discounting a weak 2009 and EPS [earnings per share] are close to bottoming. History shows retail stocks bottom 3-6 months before fundamentals and EPS declines another 20% once stocks trough."

So basically, Pali is trying to "time the market" here -- calling the bottom, and swooping in to snatch up cheap shares well ahead of AE's rebound.

Let's go to the tape
I can't really fault Pali's plan to buy low preparatory to selling high, but it seems to me that the strategy does have a risk: Basically, if Pali is buying too early -- if 2009 proves weaker than even Pali expects -- then investors who heed Pali's advice to buy now may not be buying low enough.

Indeed, if you take a look at Pali's record, it has done much better when taking a pessimistic view of retail stocks ...

... than when it waxes optimistic about a rebound:

And yet ...
Has Pali gone bottom-fishing too early yet again with its AE pick? Maybe yes. Maybe no. One thing's for certain, though: If Pali is pulling the trigger too early, it's not missing the bottom by much. Already, AE stock sells for less than seven times its trailing earnings. And if Pali is right in its estimates, the stock is selling for only 10 times next year's numbers.

Either way you look at it, these are good prices for a company that Pali says has "solid" prospects for long-term growth in its aerie, Martin+Osa, and 77kids lines. Consensus estimates call for 13% annual profits growth throughout the company, and even Pali's more pessimistic numbers would seem to build in a sizable margin of safety here.

Foolish takeaway
Granted, there's still the little matter of AE's free cash flow, which continues to lag the "profits" numbers it's reporting under GAAP. Between my own private reservations about retailers with weak free cash flow, and Pali's less than stellar record picking stocks in the retail sector, I don't think I'll be taking the analyst's advice just yet.

But am I getting interested? At these prices, you bet I am. 

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