This Just In: More Upgrades and Downgrades

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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." The pinstripe-and-wingtip crowd is entitled to its opinions, but we have some pretty sharp stock pickers down here on Main Street, too. And we're not always impressed with how Wall Street does its job.

So perhaps we shouldn't be giving virtual ink to "news" of analyst upgrades and downgrades. And we wouldn't -- if that were all we were doing. Fortunately, in "This Just In," we don't simply tell you what the analysts said. We also show you whether they know what they're talking about.

And speaking of the best ...
In a miserable stock market, two stocks at least have done investors proud: oil majors Exxon Mobil (NYS: XOM) and Chevron (NYS: CVX) . Outperforming peers ConocoPhillips (NYS: COP) and Royal Dutch Shell (NYS: RDS.A) handily, and leaving laggard BP (NYS: BP) in the dust, both Exxon and Chevron have returned double-digit gains to their owners over the past year -- even as the Dow Jones Industrial Index (INDEX: ^DJI) and S&P averages have basically flatlined. But I hope shareholders enjoyed the profits while they lasted -- because their run is done.

Or at least that's what JPMorgan says.

In a pair of headline-making downgrades, JP blasted both Exxon and Chevron this morning for having outperformed "the price of oil, the broad equities market, and their peers." Sure,  that sounds like good thing, but in JP's estimation, what it really means is that the stocks are overpriced today and due for a selloff. Consequently, that's just what JP suggested investors do: sell the stocks. Arguing that at 9.6 and 8.2 times earnings, respectively, Exxon and Chevron are overpriced relative to their peers, the banker predicts that both stocks are now priced to "underperform" the market for the next 12 months.

I disagree.

Let's go to the tape
Do I say this because I know for fact that JPMorgan is a dumb analyst? Not necessarily. In fact, JP might be quite bright -- but the banker has in recent months "gone dark" and stopped providing its ratings to Briefing.com for independent review. Consequently, we can't really point to any consistent track record for this analyst anymore, and we're forced to evaluate its recommendations solely on the strength of the arguments it makes.

And Fools, those arguments just don't hold water. To illustrate, let me show you how Exxon and Chevron stack up against two oil stocks that JP says it actually likes, Occidental Petroleum (NYS: OXY) and Hess:

Company

P/E Ratio

Dividend Yield

Growth Rate

Free Cash Flow (As a % of Net Income)

Exxon9.62.6%6.5%67%
Chevron8.23.4%4.5%57%
Oxy10.82.5%12%Negative
Hess6.50.8%10.6%Negative

If JPMorgan believes that Occidental Petroleum and Hess are better bets than Exxon and Chevron, well ... I guess there's some merit in that argument. Oxy boasts the strongest projected growth rate in this group, and Hess isn't far behind. Plus, Hess boasts one of the lowest price-to-earnings ratios in the oil patch.

That said, I still don't think the buy theses here are as strong as JP makes out.

Why not? Quite simply, because I don't believe the P/E ratios at Oxy or Hess are all they're cracked up to be. Unlike higher-quality peers Exxon and Chevron, which both churn out massive, multibillion-dollar streams of free cash, Oxy and Hess are cash-burners. Neither one currently generates any real cash profits whatsoever from its business. Consequently, if their reported GAAP "earnings" are growing faster than at Exxon and Chevron -- so what? The profits were never real in the first place.

Foolish takeaway
Now, mind you -- I'm not saying you should rush right out and buy Exxon and Chevron today. I believe that when free cash flow is barely half to two-thirds of reported net income, that's still too low. I won't get really interested in owning either company until they resume producing cash that more fully reflects the accounting profits they're claiming on their income statements.

That said, with their P/E ratios comparable to those of JP's recommendations, but with superior dividend yields and superior earnings quality, I believe Exxon and Chevron are still better investments than the stocks JP recommends. I believe investors who hold onto these stocks -- rather than sell them as JP is advising -- will be rewarded for their patience.

At the time this article was published Fool contributorRich Smithowns no shares of any company named above, butMotley Fool newsletter serviceshave recommended buying shares of Chevron.You can find Rich on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 276 out of more than 180,000 members.We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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