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 worst ...
Shareholders of contract driller and Motley Fool Stock Advisor recommendation Unit Corp. (NYSE: UNT) are cheering this morning -- and cheered. Cheering over the 4% increase in the value of their shares, and cheered by the analyst upgrade that sparked the spike. The question, though, is whether there's any real basis for the optimism.

Just this morning, you see, Capital One Southcoast upgraded Unit shares to "add" -- that's the good news. The bad news is that so far, not a single major media outlet has been able to determine the basis for the upgrade. Oh, we can surmise, of course. Last month, Cap One played host to Unit at its 2010 Energy Conference in New Orleans. Presumably, Unit management painted a pretty picture of its prospects, and it's possible that they swayed the skeptics at Southcoast. On the other hand, if that is in fact what happened, then why has it taken a full month for Cap One to endorse the stock? And why did Cap One give Unit only the tepid, kiss-your-sister endorsement of an add rating, rather than the full-fledged buss-on-the-mouth of a buy rating?

Good questions. Where are the answers?
There are few situations more frustrating to the individual investor than the one Capital One presents us with today. We know the analyst likes Unit ... somewhat. What we don't know is why (and why so apparently little). But here's the good news: Even if you don't always know why an analyst picks a stock, you can at least know how well it does at making such picks -- thanks to Motley Fool CAPS.

But sadly, that's the other bad news of today's story. While Cap One spends a lot of time covering the energy equipment and services industry, it doesn't really do a good job of it. To the contrary -- four years of assiduous study of Cap One's performance in this industry shows us that fewer than 43% of the analyst's recommendations in this sector actually "work out" for its clients. Oh, every dog has his day, of course, and Cap One is no exception.

But when you pick more losers than winners, the law of big numbers tends to catch up to you and overshadows your successes. Overall, Cap One's picks tend to underperform the market by about 4 full percentage points apiece, and sometimes worse than that:

Mistakes were made
So why is it that Capital One seems to go astray so often with its oil services picks? Call me a stock fundamentalist, call me a Fool, but I suspect it's a failure to focus on the prices of the stocks it's recommending.

Consider: At more than 17 times earnings, Unit Corp. looks woefully overpriced relative to consensus estimates of 10% growth (and Unit doesn't even pay you a dividend while you wait for the growth to materialize). That 10% growth rate, by the way, is far slower than what Wall Street expects to see at any of Cap One's three winners named above. National Oilwell, for example, is predicted to hit nearly 15% growth over the next five years, Weatherford 16%, and Schlumberger -- 17%!

Foolish final thought
Now even these three Unit rivals fail to interest me. With the exception of National Oilwell, the P/E ratios seem a bit pricey, and none of these companies generates sufficient free cash flow for my taste. But I'm especially uninterested in Unit Corp., which in addition to carrying a too-high PEG ratio, is in fact burning cash (and has generated only a bare $3 million in free cash flow over the past five years combined).

Long story short, between a discredited analyst recommending it, and no valuation argument to recommend it, Unit Corp. doesn't look to me like the kind of stock that deserves a place in your portfolio.