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This Just In: Upgrades and Downgrades

By Rich Smith – Mar 17, 2014 at 2:36PM

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Despite the military crisis in Europe and Ukraine, Barclays downgrades the defense contractors.

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 supercomputer 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...
In case you haven't heard, there's a crisis in Crimea. Over the past few weeks, Russian troops first occupied, then supervised a referendum in, the breakaway Ukrainian region, sparking calls for military rearmament in Lithuania, Estonia, Poland -- and Ukraine of course -- and now in Sweden as well.

None of this is "good news" from an objective standpoint. But it does appear to be good news for defense contractors, whose shares are surging on news that Crimea over the weekend ratified a decision to secede from Ukraine and (attempt to) join Russia. And yet, against all odds, one analyst is flying in the face of popular opinion about these stocks and downgrading three of them this morning.

On Monday, investment banker Barclays Capital announced that it's downgrading three of the big defense stocks that have enjoyed strong share price gains over the past year:

  • Huntington Ingalls (HII 0.02%) -- up 91% over the past 52 weeks
  • Harris Corp (LHX 0.78%) -- up 64%
  • General Dynamics (GD 0.76%) -- up a more modest 54%

Barclays now advises investors to underweight (read "sell") both Huntington and Harris. Meanwhile, the analyst has removed its endorsement from General Dynamics, downgrading this stock to equalweight (or "hold"). But is Barclays right to be so pessimistic, in light of current events?

Let's go to the tape
For the most part, yes, I think Barclays is right. And I make this call based both on the valuations of the stocks and on the analyst's reputation for making smart stock picks in the defense and aerospace sectors.

Let's start with the analyst. Here at Motley Fool CAPS, we've been tracking Barclays' stock picks for more than five straight years. What we've discovered over the course of monitoring more than 1,100 buy and sell calls is that Barclays has an outstanding record of performance relative to its peers, outperforming nearly 95% of the investors on the planet. The analyst has been particularly successful in aerospace and defense:


Barclays Said:

CAPS says (out of 5 stars possible):

Barclays Picks Beating (Lagging) S&P By:

AerCap Holdings



833 points

TransDigm Group



474 points




Twice recommended -- for a total of 47 points

Ten of Barclays' 14 recommendations in this sector have outperformed the S&P 500 -- and as you can see above, some have outperformed quite handily indeed. It's of particular note that one of Barclays' past positive picks was General Dynamics -- now downgraded to neutral. Barclays racked up 22 points worth of stock market outperformance the last time it recommended GD to its clients.

Valuations getting steep
But that recommendation is no more. Today, General Dynamics stock costs more than 16 times earnings and Harris nearly 20 times. These may not seem egregious valuations, relative to earnings. But personally, as a longtime investor in the defense sphere, I've learned to get nervous whenever defense stocks start selling for much more than one-times their annual sales, and that may be a better metric to examine today.

Right now, General Dynamics shares cost 1.2 times sales, while Harris shares fetch a pricey 1.6 times ratio. (As a group, the defense sector as a whole costs about 1.2 times sales.) These valuations therefore look vulnerable. The one stock where I see some value still remaining is one of the two that Barclays now rates an effective sell: Huntington Ingalls.

Best of a bad bunch
While selling for a P/E ratio similar to Harris Corp's, Huntington Ingalls stock costs only about 0.7 times sales, which suggests to me -- even after nearly doubling in value over the past year -- the stock may still be underpriced. Huntington boasts hands down the best growth rate in the industry, with most analysts predicting earnings growth in excess of 18% annually over the next five years. And Huntington has been a major beneficiary of Pentagon defense spending on new warships for the Navy, which should help to sustain that growth rate.

Long story short, while on balance I agree with Barclays' decision to begin ratcheting back optimism in the defense sector, I still see one stock here worth investing in: Huntington Ingalls.

Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 394 out of more than 140,000 members. 

The Motley Fool owns shares of General Dynamics. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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