This series , brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, Wall Street gives the thumbs up to UPS (NYSE:UPS), but then turns pessimistic and downgrades two popular mortgage REIT stocks -- ARMOUR Residential REIT (NYSE:ARR) and American Capital Agency Corp (NASDAQ:AGNC). Let's tackle those in reverse order.
ARMOUR and American Capital
Analysts at investment banker Sandler O'Neil cut their ratings on two of the nation's big mREIT shops this morning, advising investors to sell both ARMOUR Residential and American Capital. Details on the precise reasons for Sandler's downgrades are hard to come by ... but it's not too hard to guess.
Over the past year, shares of ARMOUR are down 45%; American Capital has lost 35% of its value. And while it's true that both stocks pay extremely high dividend payouts -- 20.8% at ARMOUR, according to S&P Capital IQ, and 17.7% at American Capital -- that's small comfort to investors. The declines in values of the underlying shares have been so massive as to wipe out any profits from the dividends, entirely.
Meanwhile, concerns continue to grow that the Fed is looking for an exit from its $85 billion monthly bond-buying binge. Interest rates on 10-year U.S. Government Treasury Bonds hit 2.9% not long ago, and according to some pundits, the Fed could decide as early as this week to begin "tapering."
This could all be very bad news for mREITs like ARMOUR and American Capital, as fellow Fool Boniface Mirigu explained in a column just last week. Because mREITs obtain their financing from short-term borrowings, any increase in short-term interest rates takes a bite right out of their profits, by increasing their costs. So what Sandler is suggesting is that if you think the news has been bad for ARMOUR and American Capital so far, just wait and see what happens when interest rates really start spiking ...
Or rather, don't wait. Get out now, before it's too late.
That actually sounds like good advice to me. And yet, investing based largely on what everybody expects the Fed to do, which is what Sandler seems to be counseling, has its own risks. For example, just over the weekend, we learned that Larry Summers -- who had been expected to favor an early tapering of Fed bond-buys -- has withdrawn his name from the contest to replace Ben Bernanke as head of the Fed. Now the odds seem to favor Janet Yellen, whom the Potomac Research Group now calls "the clear favorite" to replace Bernanke, and who is believed to be "significantly [less] aggressive" about tapering than Summers would have been.
Long story short -- no one really knows who will end up running the Fed, or what they'll do when they get there, or what all of this portends for ARMOUR Residential or American Capital. Then again ... that uncertainty alone might be good reason to shy away from the stocks.
Up on UPS
I have to admit -- after witnessing all the navel-gazing going on over Fed policy and what it implies for mREITs, it's a relief to finally move on to a business whose future doesn't depend entirely on the course of politics in Washington, D.C. And with UPS -- just upgraded by Barclays Capital -- we can finally get back to business.
Barclays this morning upped UPS to an "overweight" rating, and increased its price target by a whopping 20% -- to $106 per share. Granted, UPS was already selling for more than Barclays' old price target ($88) when the upgrade came out. But still, from today's price, Barclays' new price target implies about a 17% gain. So add in a 2.8% dividend yield, and you're still talking a near-20% potential profit.
Will we get that?
It's hard to say. On the one hand, the stock's trailing P/E ratio of 105 certainly doesn't seem to leave much room for further appreciation. On the other hand, that P/E ratio is based only on the earnings UPS is allowed to report under GAAP accounting standards. In actual fact, UPS generated $4.6 billion in real free cash flow over the past year -- more than 5.5 times its reported GAAP profit.
That puts the stock at roughly an 18.4-times-free cash flow ratio valuation today. With the dividend yield of 2.8%, I'd say therefore that we would want to see the stock growing its profits at about 15% annually to justify today's price, let alone justify a higher price, such as Barclays is calling for.
Analysts right now project only 11% earnings growth for UPS over the next five years. While certainly respectable, I think UPS will have to do better than 11% growth to justify today's prices -- and accordingly, I think Barclays' projection of a 17% gain in the stock is overoptimistic.
Long story short, while UPS seems less risky than the mREITs, and its business is certainly easier to value -- I'd hold off on going long this stock as well.
Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends United Parcel Service.