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 ...
Ask an investor who's "the best" banker on Wall Street, and chances are good they'll answer: "Goldman Sachs." But is it, really? For months, I've lamented this banker's refusal to publish its ratings on Briefing.com (as most other investment bankers do) so that we can easily see how its predictions work out.

I then decided to do something about it -- setting up a proxy "avatar" for the analyst on CAPS a few weeks ago. One month later, and now that we've gathered some data on Goldman, it's finally time to put this analyst through its paces -- starting with its latest comments on Home Depot (NYSE:HD) and Lowe's (NYSE:LOW).

One Monday, Goldman reiterated "buy" ratings on both stocks (and I promptly added them to its CAPS scorecard), simultaneously increasing target prices by roughly 10% on each equity. Why? According to Goldman, three factors make Home Depot and Lowe's more attractive today than they have been previously:

• "Stronger housing turnover,"
• "Stronger Q4 sell-through on appliance sales surrounding Black Friday," and last but not least,
• "Winter goods sales due to recent snow storms."

And interestingly, MasterCard's (NYSE:MA) SpendingPulse unit just put out a report bolstering Goldman's claims, arguing that holiday spending this year was up 3.6% over 2008 levels. Weighing the effects of these short-term trends, Goldman upped its fourth-quarter earnings estimates on both stocks, and furthermore raised 2010 projections to $1.73 per share for Home Depot, $1.38 for Lowe's (about a nickel bump for each). As I said, Goldman believes both stocks are "buys" at today's prices. But is Goldman right?

Let's go to the tape
One month into our experiment, here's what we know about Goldman Sachs: First, it seems a bit better than the average analyst, scoring 59% for accuracy across the 39 picks we've collected so far. Goldman's doing particularly well in the Software and Internet Software and Services sectors, across which Goldman's picks are currently achieving closer to 80% accuracy:

Perhaps most importantly, the two Goldman picks we've detected that seem most relevant to household goods retailers like Home Depot and Lowe's are both beating the market:

Yet despite Goldman's reputation for astute stock picking, and the beginnings of a track record to support this belief, investors are selling off both Lowe's and Home Depot (albeit modestly) on a flat day for the markets at large. What gives? Doesn't anybody trust Goldman anymore?

Not at these prices!
Don't take it personally, Goldman. The way I look at it, Mr. Market isn't so much disagreeing with your buy recommendations as it is noticing that the stocks have already been bought -- and bid up to prices where further profits are unlikely.

Home Depot is selling for 21 times earnings; Lowe's multiple is 20. Yet both are expected by most analysts to grow their profits at roughly 10% per year over the next half-decade. Given that, you could argue there's already an awful lot of optimism "priced in" to both of these stocks. It may take more than Goldman's promises of a mediocre housing market, a new dishwasher under the Christmas tree, and an extra snow shovel sale or two to convince investors that these valuations are justified.

Foolish takeaway
Now I'm not saying Goldman is wrong about Home Depot and Lowe's being "buys" -- just that there's a pretty clear explanation for why investors seem to be disagreeing with the banker today. From my perspective, though, Goldman is quite likely right about Home Depot, at least. While the company's P/E ratio suggests it's no bargain, what investors may be missing is the fact that Home Depot today generates free cash flow at nearly twice the level of its reported "net profit."

Generating $4.4 billion worth of such free cash annually, valued at $50 billion (an 11.4 multiple), and paying out a tidy 3.1% dividend yield, Home Depot actually does look attractive. Give it a look, see if you see what Goldman sees in the stock, and click over to Motley Fool CAPS now to tell us what you think.