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.

Smoke 'em if you got 'em?
"No good deed goes unpunished" seems to be the theme of the out-of-the-blue twin downgrades Stifel Nicolaus issued yesterday. Closing out the week on a down note, the ace stock picker announced that Altria (NYSE: MO) and Lorillard (NYSE: LO) have outperformed the S&P 500 by such large margins since it recommended buying them, that the "relative valuation gap" on the stocks has burned down to a nub. With Altria now commanding a respectable 14.4 price-to-earnings ratio, and Lorillard lagging only slightly at 13.2, Stifel suggests now's a good time to count your winnings and adopt a "hold" position on both stocks.

Sure, both companies have outperformed expectations as they "continued to price up significantly, creating a strong profit algorithm." True, too, they own premium brands that "continue to gain market share." But investing is a numbers game, and with the S&P 500 selling for just 13 times next year's earnings, there's simply not enough gain remaining in the stocks to risk the potential pain of an adverse litigation result, punitive tax rates, or other unpleasant news going forward.

Time to quit?
Since recommending the stocks, Stifel has booked sizable gains. Altria in particular has outperformed the S&P 500 by nearly 28 percentage points over the past year -- not even counting dividends. Is now really the time for Stifel to be abandoning its star performers, just as they attain superstar status? Actually, it is.

I say this for a couple of reasons, first and foremost: growth. You'll probably not be surprised to learn that tobacco is not exactly a "growth" industry. Analysts who track the stocks don't expect Lorillard to achieve much more than 6% annual earnings growth over the next five years, while even Altria is going to struggle to break 7%.

Neither of these numbers, by the way, looks terribly attractive in light of the double-digit valuations the stocks have now achieved. Fact is, when Stifel surveys the field (and I agree), about the only cigarette maker that does look attractively priced these days is Altria's prodigal son, Philip Morris International (NYSE: PM). Unlike its domestic brethren, PMI boasts:

• A double-digit growth rate (11%).
• Superior free cash flow (15% ahead of reported "net profit" at $8 billion per year).
• A price-to-earnings ratio that's almost as low as Altria's and Lorillard's, and quite low enough to justify the price once you factor in the company's generous 4.6% dividend yield.

Altria and Lorillard may pay more as an absolute number -- 6.4% and 5.5%, respectively -- but to my Foolish eye, neither one pays quite enough to bridge the valuation gap and make their stock a "buy" at today's levels. (By the way -- for any Benson & Hedges aficionados out there, British American Tobacco (NYSE: BTI) offers an even worse value proposition. Its 2.8% divvy is one of the lowest in the industry, while its 17.5 P/E is the highest you'll find anywhere. Too high for even a 9% projected growth rate to salvage.)

Foolish surgeon general says ... Stifel's chart is clean
To my Foolish way of thinking, the valuations on these stocks make it plain as day that Stifel's right about Lorillard and Altria. But for any investors needing further convincing, a quick look at Stifel's record on other consumer goods stocks may be in order:

While I readily admit that Mickey D's, Coke, and Pepsi aren't quite in the same category of "sin stocks" as tobacco, they are akin inasmuch as they cater to consumer vices on an international scale. More importantly, if memory serves, each has had its run-ins with the trial lawyer's bar, and been accused of contributing to increased mortality rates. So the similarities are more than cursory.

Importantly, Stifel has done a superb job of navigating the ins and outs of this industry -- gauging the risks and weighing them against the opportunities afforded by attractive prices, minimizing its losses (Pepsi) and maximizing its gains. Over the years that we've been watching it, Stifel has racked up a record of 79% accuracy in the bubbly-beverages industry, and even come out ahead in the tricky world of fast-food restaurants.

When you combine this with the company's record of literal 100% accuracy on its tobacco picks, and the evident overvaluation of Lorillard and Altria, I think the odds heavily favor Stifel being right this week. If you've got a position in either stock today, it's time to kick that habit.