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 ...
If you know someone who owns stock in L-3 Communications (NYSE:LLL), and they're feeling a little surly today, cut 'em some slack. JPMorgan Chase just downgraded their stock, and as a result, they got hurt worse than most investors when the market took its nosedive yesterday. And that's not even the worst part.

The worst part is that this L-3 downgrade is likely to be only Square One for a slew of defense sector downgrades we'll probably be seeing in future weeks.

The skinny on the downgrade
Now, it's worth pointing out right up front that JPMorgan doesn't hate L-3. To the contrary, as recently as July, JPMorgan had decided investors should be buying the stock. But on closer examination of trends in Pentagon spending, JPMorgan has come to the realization that: "slow contract execution due to the change of administration ... is the beginning of the broader slowdown, hastened in part by program cancellations."

It makes sense that a federal government drowning in red ink would reduce spending on defense through the recession, and a U.S. pullout from Iraq could give Congress just the excuse it needs to begin "rolling back" spending on Pentagon programs. Result: JPMorgan's going neutral on L-3 -- and could become even more pessimistic on its peers in future weeks.

But is that the right call?

Let's go to the tape
Ranked in the top 20% of investors tracked by CAPS, JPMorgan is perhaps best known for its high-profile picks in the tech sector -- Priceline.com (NASDAQ:PCLN) for example, which beat the market by better than 65 percentage points after JPMorgan recommended it last year. Or Shanda Interactive, which has nearly tripled since JPMorgan picked it back in 2006.

But here's something you may not know: JPMorgan is also one of the best aerospace and defense analysts on the planet. Well, maybe not, but they are good. According to our records, this banker has placed buy or sell bets on 16 stocks in the sector over the past three years, and has proven itself right nearly twice as often as wrong. A few examples:

N/A: Axsys was bought by General Dynamics (NYSE:GD) earlier this month.

And while it's true that JPMorgan has made the occasional bad call in this sector ...

... and even took a small loss relative to the market on its L-3 endorsement in July, the fact remains: This bank knows its tanks (and rockets, warships, and fighter jets). And I think it's right about L-3.

Valuation matters
Listen, folks. There's nothing wrong with L-3's business. In recent weeks we've seen this contractor book a contract to teach the Army's infantrymen to shoot lasers. It has landed part of a half-billion-dollar Army logistics deal, been hired to design a high-power electrical generator for the Bradley Fighting Vehicle, and won another multimillion-dollar contract for remanufactured parts for Bradleys -- on the very day of JPMorgan's downgrade, no less.

But while the business is going great guns, JPMorgan's got a point about L-3: Its stock costs too much, at least for value investors. Oh, I know that the company's 10.4 P/E ratio doesn't look expensive. The consensus of analysts on Wall Street is that L-3 can post close to 11.6% five-year growth, the Pentagon's slimmed-down wallet notwithstanding. But there's a reason L-3's P/E looks so cheap, and the reason is debt.

Carrying a $9.2 billion market cap, L-3 is also burdened by a $4.5 billion debt load (offset somewhat by $900 million in cash). What this works out to is an enterprise valued at about 12.3 times its own free cash flow. Not expensive by any means, but probably not priced at a discount relative to its expected growth prospects.

Foolish takeaway
To me, L-3 embodies the notion of a "fairly priced stock." And yes, some may consider that a plus in today's overheated market. Problem is, value investors don't want to pay full price. We know there are better deals out there, and we demand a discount.

L-3 isn't offering you that discount today. Until it does, I'm going to be following JPMorgan's advice, and seeking better bargains elsewhere.