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 ...
What do you do when one of the smartest minds of Wall Street makes what appears to be a knee-jerk call on a clearly undervalued stock -- and it's exactly the wrong call to make? Do you trust the analyst's judgment, or tempt fate by challenging the advice of a proven performer?

That's the question investors face this week, as we ponder the implications of the downgrade Standpoint Research published on Microsoft (Nasdaq: MSFT) Friday. In the waning hours of the trading week, as investors were looking forward to a carefree weekend -- perhaps one spent spending the profits they've made over Mr. Softie's remarkable bounceback from its July 2010 lows -- Standpoint went and upset the apple cart.

Patting itself on the back for all but "picking the bottom" on Microsoft when it recommended buying shares back in September, Standpoint noted that the stock has already "bounced 19% in the (less than) four months since our recommendation ... not bad for a low-beta name in a rising market." But rather than leave its chips on the table, Standpoint decided discretion was the better part of valor last week, and advised investors to take their winnings, knock the stock back to "hold," and wait for a pullback before hitting the buy button anymore.

I think that's bad advice, and the reason is ...

Let's go to the tape
... not because Standpoint is a bad analyst -- actually, far from it. Ranked in the top 5% of investors we track on CAPS, Standpoint is literally one of the best analysts Wall Street has to offer today. Better than 63% of this analyst's recommendations beat the market. Crush the market, rather, with an average win-rate of 10 percentage points over the S&P, per pick Standpoint makes.

Standpoint's particularly good in the software arena, too, boasting accuracy in this particular industry subset fully 20 points better than its overall accuracy record. Fact is, over the time we've been tracking its performance, Standpoint has only goofed once on a software pick (namely, Amdocs (NYSE: DOX)):

Where's (your) beef?
With a record like the one you see above, you might wonder why I would dare to question Standpoint's judgment on Microsoft today (and did I mention that Standpoint was also right about Microsoft the last time it picked the stock?) And truth be told, I'm a bit hesitant to question it myself, but the numbers compel me to.

Just because Standpoint made a quick 19% gain on its September recommendation doesn't mean there's no more profits in store for you. And honestly, when I look at this stock, selling for barely 12 times earnings, generating in excess of $24 billion (that's billion with a capital 'B') in annual free cash flow, and selling for a price-to-free cash flow ratio barely 10x that number -- I simply cannot help but love the valuation on this stock.

I mean, is Microsoft going to outgrow archrivals Apple (Nasdaq: AAPL), Google, and Oracle (Nasdaq: ORCL)? Of course not. No one's saying it will. But by the same token, neither does Microsoft cost as much as these sexier tech-ternatives. Fact is, at 12 times earnings, Microsoft boasts a P/E only about half as big as these other tech names. Yet most folks on Wall Street still think Microsoft can grow its earnings in excess of 11% per year over the next five years -- which to my mind, makes the stock a bargain. What's more, in case you haven't noticed Microsoft actually outgrew analyst projections in each of the past four quarters -- so it's entirely possible that "11% growth" projection is selling Mr. Softie short.

Foolish final thought
In light of the rather obvious undervaluation of the shares, I almost hesitate to mention that Microsoft pays its shareholders a tidy 2.3% dividend -- four times the payout at Oracle, and infinity-times the dividend yields at Apple and Google, which both pay precisely zilch. Or the fact that the company boasts $32.5 billion in net cash on its balance sheet, a number that when factored into the valuation, pushed Microsoft down to an enterprise value of just 8.6 times its annual free cash flow.

Long story short: Even after a 19% run-up, Microsoft shares are screamingly cheap.