This Just In: 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." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

UBS, the uberbull
Last week, Nucor (NYS: NUE) announced it would earn less than Wall Street had expected in the current quarter. Steel Dynamics (NAS: STLD) , too, issued a below-market forecast for the quarter, and AK Steel (NYS: AKS) warned that it will actually lose money.  So you might think now is a funny time to go and upgrade steel company shares -- but that's just what UBS did Monday morning.

Citing "improving steel pricing and demand," and stock valuations that look "reasonable given the expectation for growth," the Swiss megabanker observed that "U.S. Steel (NYS: X) remains our most- preferred [stock] on exposure to attractive end markets (auto, manufacturing, tubular), strong earnings tailwinds, and significant operating leverage." But UBS likes Steel Dynamics and Nucor as well, and now recommends that investors buy 'em both.

Why? In unusually colorful language (for an analyst, anyway), UBS argues that "buyers are playing a game of chicken with [steel] mills." They're holding off on buying the steel they need, in hopes that already low steel prices will fall even further. But as a result, steel users' inventories have fallen to bare-bones levels, even as "demand continues to improve." Pretty soon, says UBS, "we see buyers blinking and prices moving up from here." But does UBS know what it's talking about?

Let's go to the tape
It should. After all, UBS has been talking up steel shares for more than half a year now. Way back in August 2011, UBS recommended buying shares of U.S. Steel, predicting "significantly improved EBITDA" and "a return to historical operating margins." It also urged investors to pile into AK, calling the company stronger than the market gives it credit for." How did these bets work out? See for yourself:

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Source: YCharts.

Meanwhile the S&P 500 -- basically every stock other than the ones UBS was telling you to buy back then -- has been going up like this:

anImage

Source: YCharts.

And despite this record of underperformance, here comes UBS and tells us that the stocks it stuck on a shelf back in August, Nucor and Steel Dynamics, are the ones to buy today. Should you believe them?

As it turns out, UBS may have more success with these latest steel picks than it's had with its past recommendations. In recommending the shares, UBS points out that the price of imported steel, such as from China or from the globe's largest steelmaker, Arcelor Mittal (NYS: MT) , is rising in price. In the absence of cheap foreign steel "buyers may be forced to restock [from domestic sources] into rising prices."

Indeed, examining the various options on the table, Nucor and Steel Dynamics do look like the best options available today. Both companies generate positive free cash flow from their businesses (U.S. Steel, AK, and Arcelor do not). But of the two, I now believe that Steel Dynamics is the single stock in the steel industry that offers the most potential for investors.

Valuation matters
Selling for less than 13 times earnings -- despite boasting a 15% long-term growth rate and a 2.7% dividend -- Steel Dynamics offers a prima facie bargain. It's much cheaper than the 18 P/E ratio on offer at Nucor, and growing faster to boot. Even better, unlike rival Nucor, Steel Dynamics is finally generating free cash flow in excess of reported earnings. When valued on cash profits, Steel-D sells for just 10.5 times FCF.

At today's price, I think Steel-D the best bargain in the steel industry -- and I want you to hold me accountable for saying this. Right now, I'm going to go on record and Steel Dynamics it to my "outperformers" list on CAPS. If you think I'm wrong -- follow along and find out.

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At the time this article was published Fool contributorRich Smithdoes not own shares of any company named above. You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 399 out of more than 180,000 members. The Motley Fool has adisclosure policy.The Motley Fool owns shares of Arcelor Mittal.Motley Fool newsletter serviceshave recommended buying shares of Nucor. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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