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." 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.

Goldman's hardly golden
Responding to my column on Goldman Sachs' A123 downgrade Wednesday, one reader questioned whether Goldman Sachs (NYS: GS) was even "qualified" to be recommending stocks anymore. After all, this banker just finished reporting a sizeable quarterly loss, and miserable performance at Goldman's investing division was the primary reason for this loss. What business does Goldman have telling other people how to invest their money if the Wall Street giant can't rub two nickels together and make a penny itself?

It's a fair question ... but I should point out there's at least one stock that Goldman has made a pretty penny on: Baidu (NAS: BIDU) .

Goldman calls it a day
Anyone who followed Goldman's advice back in December 2008 and bought Baidu stock is today sitting atop a 1,021% profit on the investment. (That's right. A ten-bagger.) Yesterday, however, the banker-whom-everyone-loves-to-hate decided to cash in its chips on Baidu. After praising China's biggest search engine's "quality of growth and immense revenue opportunity," Goldman warned that "channel checks suggest that smaller e-commerce companies are moderating their advertising spend into 4Q11 and likely into 2012 in order to conserve cash."

If Goldman's right, this would be bad news for any number of ad-dependent Chinese firms, from (NAS: NTES) to (NAS: SOHU) to Focus Media (NAS: FMCN) . Unlike these three firms, however, Baidu doesn't have a lot of margin of safety built into its stock price to protect against a decline in spending. To the contrary, if Goldman's right, and Baidu falls short of the 47% annual growth rate that everyone expects it to hit, then Baidu's sky-high 55 P/E ratio would appear particularly vulnerable to a sell-off.

I made much the same point last week, when I argued that Baidu was both the highest-quality name -- but also a pretty pricey stock -- on Barclays Capital's China shopping list. So far be it from me to disagree with Goldman on its decision to take its tenfold Baidu profits and walk away from the table grinning.

What concerns me more about Goldman's advice this week, though, is that this is not what Goldman is doing at all. Instead, it's cashing its chips on Baidu ... and then turning around and making an even bigger bet on (NAS: YOKU) and (NAS: CYOU) .

One Fool's opinion
A risky bet, if you ask me. I mean, yes, according to Goldman, Youku's likely to post a profit at some point in the next 12 months, while Changyou has a strong pipeline of new games coming to market. And yes, as reports, Goldman thinks "concerns over competition and a low-risk appetite for unprofitable companies" have scared too many investors away from these stocks.

But I'm not convinced this makes the stocks "buys." Take Youku, for example. If Goldman has high hopes it will turn a profit next year, this just highlights the fact that for the past 12 months, this company has failed to turn a profit. And even the analysts who agree with Goldman about this one only expect Youku to earn a penny (that's right -- one penny) per share profit in 2012. Meanwhile, the company's still burning cash like it's going out of style. It's quite literally never had a free cash flow-positive quarter.

As for Changyou ... the situation's a little better there. Free cash flow was positive $139 million for fiscal 2010, the most recent period for which the company has provided full financial data. Operating cash flow, at least, looks to be positive so far this year as well. But neither of these numbers yet rises to the level Changyou claims for its "net earnings" under GAAP.

Foolish takeaway
Goldman Sachs made a great call on Baidu three years ago. Were I inclined to follow its advice on Chinese stocks again, though, my hunch is that the Changyou recommendation is the safer bet. I'm still not thrilled with the subpar free cash flow numbers, however. Perhaps the smartest thing to do, if you're interested in the stock at all, is to take the roundabout route of investing not in Changyou per se, but in its parent company: That way, you can capitalize on two-thirds of the potential Goldman sees in the stock -- and, at Sohu's FCF valuation of 10, do so at a bargain price.

Want to learn more about Goldman Sachs' two new most favorite Chinese investments?Add and to your Fool Watchlist.

At the time thisarticle was published Fool contributorRich Smithowns no shares of any company named above. You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 295 out of more than 180,000 members. Motley Fool newsletter serviceshave recommended buying shares of, Baidu, and 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.

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