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.

KeyBanc declares ban on buying gun stocks
The year 2012 has been a banner one for gun violence -- and headline risk. On July 20, a costumed, armored gunman burst into a movie theater in Aurora, Colo., and shot 70 people, killing 12. Less than a month later, a gunman killed a police officer and two civilians near Texas A&M University. Just yesterday, a gunman entered the offices of the Family Research Council in Washington, D.C., and opened fire, wounding a security guard. And on, and on, and on.

Meanwhile, the stocks of gun manufacturers are on full automatic. Shares of Smith & Wesson (NYS: SWHC) , maker of the M&P 15 semiautomatic rifle used in the Aurora attack, have more than tripled in value over the past year. Shares of Sturm, Ruger (NYS: RGR) -- which manufacturers "pocket pistols," such as the LCP and LC9, popular among the "concealed carry" crowd -- aren't doing half bad either -- up a very respectable 65%. But, perhaps, not for long.


Holster your weapon makers
Responding to the spate of gun violence and, by implication, the threat of government gun control legislation, analysts at KeyBanc advised investors yesterday to pocket their profits, and leave the range immediately. Calling S&W's outperformance "significant," KeyBanc downgraded it to "hold," warning that the stock is approaching "peak Near-Term demand trends," limiting further upside. The analyst warned investors away from Ruger in even stronger terms, downgrading the stock to "underweight."

Is KeyBanc right? Is the risk to these stocks' valuations so great that now's the time to walk away? Let's find out.

Ruger
At 16 times earnings, and with weak free cash flow relative to reported income, Ruger looks a bit pricey. Adding to the risk, Ruger shares had gained 14% in value since the Aurora shootings -- and are still up 6% post-downgrade -- probably due to investors betting on an increase in personal defense pocket-pistol sales post-Aurora.

Smith & Wesson
At first glance, the case against S&W looks ever stronger than with Ruger. With superior growth expectations (22% per annum over the next five years), the stock still costs a nosebleed 36 times earnings. On the other hand, S&W boasts superior free cash flow, which brings its P/FCF ratio down to just 24. It's also down 10% since Aurora - here, presumably, due to fears that the use of its rifle in the shootings raises the regulatory risk on this stock.

I think that's a mistake. As Businessweek writer Paul Barrett explained in his recent work Glock: The Rise of America's Gun, the result of gun regulation-talk in Washington has historically been to increase sales of a gun deemed "at-risk," rather than to decrease them. For example, the 1994 passage of the Brady Bill by Congress led to so much Glock-buying in America that, in short order, the company found itself "tens of thousands of orders behind."

In short, Smith & Wesson may have tripled in value over the past year but, in my opinion, it's still not overpriced today, and its run may not yet be done.

A few other ideas
In a similar vein, much of the regulatory talk in Washington today concerns not just guns themselves, but the ammunition in their magazines. Tellingly, the Aurora shooter is said to have purchased thousands of rounds of ammunition "over the Internet." Even as Congress moves towards gun restrictions, therefore, it's almost certain to also target the "Wild West" arms market of ammo sales over the Internet -- and this may lead to gun owners moving to stock up on ammunition ahead of any new legislation.

Investors looking to get ahead of the curve, therefore, should take a close look at ammo manufacturers such as Olin Corp (NYS: OLN) -- 11.5 P/E, 8.5% projected growth rate, and paying a 4.2% dividend -- and also Alliant TechSystems (NYS: ATK) , which at six times earnings, is arguably the cheapest play on gun regulation around today.

Foolish final thought
Personally, I have my doubts that even the recent spate of gun violence will result in any significant legislation -- not in an election year, and not with the NRA funding many of these electoral campaigns. If it turns out I'm wrong, though, and, in particular, if laws are passed to limit ammunition sales over the Internet, investors should take a good hard look at Wal-Mart, which, among bricks and mortar retailers, has historically been considered the cheapest source for ammo available.

At 16 times earnings, and 8% growth today, Walmart's no great bargain -- in fact, in a recent report, our Fool analysts explain why they think Walmart is marked for "death," and urge investors to check out The Real Cash Kings Changing the Face of Retail . Even so, a significant shift in gun and ammunition regulation could work to Walmart's benefit, and it can't hurt to keep your eyes open to that possibility.

The article This Just In: Upgrades and Downgrades originally appeared on Fool.com.

Fool contributorRich Smithholds no position in any company mentioned. You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 286 out of more than 180,000 members. The Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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