Friday's Top Upgrades (and Downgrades)

This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, we find out why analysts have reserved an upgrade for Starwood Hotels (NYS: HOT) , and are shooting for the moon at Smith & Wesson (NAS: SWHC) ... but think Williams-Sonoma (NYS: WSM) costs too much.

New high? Sell!
Shares of Williams-Sonoma crested a new 52-week high yesterday, trying and almost succeeding in hitting $43 a share. Analysts at BB&T Capital, however, aren't sweating the last few pennies. With the shares now selling for 18.5 times trailing profits, BB&T thinks it's time to take some profits.

The analyst downgraded the shares this morning to "hold," which isn't as bad as a "sell" rating... which is what the rating probably should have been. While Williams-Sonoma is undoubtedly a fine business, with strong quality of earnings and plenty of cash in the bank, 18.5 times earnings is simply too much to pay for a 12% grower. Free cash flow at the firm is strong, but not good enough to support an argument that the stock is cheaper than it looks. In short, what we've got here is a great business selling for a lousy price. Best advice here is to put Williams-Sonoma on a shelf, and wait for a pullback before buying again.

Bang! Smith & Wesson surprises
In contrast, one stock that's shocked a lot of naysayers and gained 12% in response to a blockbuster earnings report -- but is still cheap -- is Smith & Wesson. (Don't say you weren't warned. I laid out the buy thesis for this one in plain black-and-white just last month.)

Yesterday evening, S&W reported a "record" Q2 profit of $0.28 per share on sales growth of 48%, then proceeded to promise it will earn at least $0.85 per share by the time the year is out. This morning, those results earned the stock higher price targets from analysts at Benchmark ($13 targeted) and Wedbush ($11). Wedbush says it likes how S&W is growing its margins, grabbing market share, and showing "operating leverage." Benchmark takes a bigger-picture view, arguing that "commercial firearms are seeing long-term, secular growth from an increasing social acceptance of firearms for both personal defense and recreation/leisure."

That could be good news not just for Smith & Wesson, but for rival Sturm, Ruger (NYS: RGR) as well. Valuation-wise, though, S&W still has the edge. If you like Ruger at 16 times earnings today, you're going to positively love S&W when those $0.85 in earnings roll in a few months from now, and show the stock selling for a P/E ratio of less than 12.

HOT or not?
And finally, the big upgrade of the day comes courtesy of the analysts at Argus, who are urging investors to buy shares of Starwood Hotels. That might seem like strange advice -- recommending a vacation stock in the middle of a recession and 8.1% unemployment. But the numbers suggest Argus is right about this one.

At 20 times earnings, Starwood looks expensive. But analysts think the company can grow its profits at close to 19% per year over the next five years. Add in a modest 0.9% dividend yield, and it's hard to argue the stock is overpriced. Plus, if you take a look at Starwood's cash flow statement, the thing that jumps out at you right away is how very much cash this business generates -- $681 million over the past 12 months, which is close to 16% more than the amount of "net income" it reports under GAAP.

It all adds up to a strong suspicion that the stock is undervalued... and a strong argument in favor of buying Starwood today.

Fool contributorRich Smithholds no position in any company mentioned.Motley Fool newsletter serviceshave recommended buying shares of Williams-Sonoma.

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