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.

"A date that will live in infamy?"
Will future generations of investors look back on December 16, 2010, with the same pangs of remembrance that strike them each year that December 7 rolls around? Actually, I doubt it. To the contrary, I rather suspect that yesterday's sneak attack on the defense sector, launched by the analysts at FBR Capital, will be quickly forgotten. Here's why:

Yesterday, FBR launched a series of downgrades, lashing out at a series of defense stocks far and wide. AeroVironment and Alliant TechSystems, L-3 Communications (NYSE: LLL) and Raytheon (NYSE: RTN), and Comtech and Applied Signal to boot -- each and every one of these stocks, formerly blessed with the FBR-equivalent of a "buy" rating, got knocked down to "market perform" -- advice interpretable as a "hold" by some (and a covert "sell" suggestion by many.)

Just one thing
What sparked the downgrades? Details are sparse, with no major media outlets offering details on the downgrades -- only reporting that they happened, full stop. We do know one thing, though: How good of a defense industry analyst FBR has shown itself to be in the past.

According to our records on CAPS, which stretch all the way back through four years of ratings published by FBR, this analyst is actually only of middling quality when it comes to picking winners and losers in the defense space. On average, 54% of FBR's defense picks actually underperform the market. A few examples:

So right off the bat, we know to be skeptical of FBR's skepticism (even -- or perhaps especially -- when it agrees with what we've been thinking ourselves.) Far from infallible, FBR has proven itself Fool-y capable of making mistakes in the defense industry (indeed, out of the six stocks downgraded yesterday, FBR was already underwater on three of its positions.)

And one more thing
As I said, FBR's record on Big Defense is one thing we know for certain, but here's another: While FBR is keeping mum on the reasons for its downgrades, last week, Reuters gave us a clue as to where FBR might be coming from with its skepticism.

You see, it seems there's a competition brewing among many of the companies named above, to acquire one of their number -- Applied Signal. Says Reuters: "Strong interest in an auction of electronic surveillance and intelligence company Applied Signal Technology Inc has sparked a rally in tech firms likely to be targeted by defense contractors facing cutbacks." Supposedly, both Raytheon and L-3 are bidding for Applied Signal right now, alongside other firms such as SAIC (NYSE: SAI) and Britain's Cobham.

Depending on who else gets caught up in the M&A frenzy, this creates two risks for investors: First, if you own the company that does the acquiring, you could get burnt if Mr. Market decides your company overpaid for its new prize. This risk seems especially actual given that we've recently seen Dell (Nasdaq: DELL), Cisco (Nasdaq: CSCO) and other large government tech contractors report reduced spending by Uncle Sam. Anyone who buys Applied Signal, or one of the doppelganger tech firms that are also attracting M&A speculation (Mercury Computer (Nasdaq: MRCY) is said to be another target for potential consolidation in the sector), could get burnt if government tech spending continues to dry up.

But owners of the potential targets aren't exactly safe, either. Try to ride a run-up, and you risk getting stuck, having overpaid for a company that acquirers might lose interest in if the price goes too high, or the prospects for higher government tech spending drop too low.

What's a Fool to do?
When you get right down to it, therefore, what we're looking at here is a real risk, being pointed out by a really poor analyst. So what are you, the individual investor, supposed to do with this information? Do you ignore the analyst and plunge headfirst into risky waters anyway? Or do you trust that this time, for once, FBR is "getting it right?"

My advice: Do neither. Instead, do what we've always advised you to do: Focus on the valuations. Try to guess where things are going, sure, but be even more sure you've got a margin of safety sufficient to protect you if you guess wrong. In this regard, I have to say that the stocks of L-3 and Raytheon, for example -- both of which sell for about 9x earnings, pay respectable dividends, and are pegged for decent upper-teens growth -- look a whole lot safer than that of AeroVironment for example -- which sells for three times the P/E, pays no dividend at all, and whose valuation seems to depend entirely on its achieving growth rates that seem to me rather iffy.

My advice: Even when your only guide is an unreliable analyst, there's still safety in numbers. With defense stocks as with all stocks -- Buy cheap. Limit your risk.