Wall Street Is Killing Your Stocks!

I know I've written this article at least three times before.

Every few months or so, I try to encourage Fools to shun the advice of Wall Street investment houses. I do this because I hate to see the theft of our money -- money that makes a beeline toward the coffers of already very well-endowed investment houses.

So please allow me to repeat the message, particularly because there's new, interesting information to share.

The broken record game
The most recent piece of data to add to this larger discussion comes from a McKinsey & Co. study which reveals that Wall Street analysts tend to be off the mark on their quarterly earnings estimates by a margin of about 100%. For the past 25 years, stock analysts have doled out average earnings growth estimates of 10%-12% for S&P 500 stocks. Meanwhile, real growth has averaged just 6%.

This may sound like benign optimism at work, but it actually is a well-documented phenomenon that constitutes a massive threat to investors. Bad earnings expectations create bad models. These models help determine which stocks are rated as buys, which are added to mutual funds, and which stocks your financial advisor decides to purchase on your behalf. Ultimately, they also help determine the market price for the stock itself.

What happens when these numbers are discovered to be excessively optimistic? Share prices fall, sometimes quite dramatically, and you lose money.

Nothing has changed
This is a big theoretical issue, but rather than deal in the abstract, let's take a look at our present situation and focus on one real-world manifestation of this problem.

Take the earnings expectations of just a few large companies out there:

 

Present Market Cap (billions)

5-Year Analyst Expected Growth Rate

Implied Market Cap in 2015*

Google (Nasdaq: GOOG  )

$162

16.2%

$343

Baidu.com (Nasdaq: BIDU  )

$30

57.7%

$292

ExxonMobil (NYSE: XOM  )

$319

15.3%

$650

Apple (Nasdaq: AAPL  )

$240

18.1%

$551

First Solar (Nasdaq: FSLR  )

$11

25.4%

$34

Celgene (Nasdaq: CELG  )

$26

23%

$73

*Assuming existing multiple premiums.

Considering the state of the world, analysts are not only optimistic about the chances of these companies, they're downright in love.

Now, I have no idea what the future holds. But, what I do know is that earnings estimates tend to be really bad. I wouldn't be surprised if analysts were wrong significantly more than 100% on their guesses with these particular stocks. Why?

Possible? Yes. Probable?
At some point in the future, Apple could turn into a $550 billion company just like Exxon could turn into a $650 billion one (anything is possible). But, given the larger economic outlook for the next few years and given the fact that Apple is already one of the largest companies in the world thanks to a tremendous wave of success, do I think it's probable? Not really.

It's not that I don't like Apple's products; it's just that the numbers don't make a whole lot of sense.

In the past five years, only 56 companies larger than $10 billion have been able to grow their earnings per share at an average of more than 15% per year -- out of 376 possible stocks. Sustained 15% annual earnings growth is very unusual, even for smaller companies. And, Exxon and Apple are already 24 and 32 times larger, respectively, than the floor of this primitive study, which means growth will be that much more difficult.

Chinese search giant Baidu is also fascinating to look at. Though relatively small compared to its peers above, analysts are expecting it to grow earnings at a blistering compounded growth rate of 58% over the next five years. My feeble mind has serious difficultly grasping this number. Do you know how aggressive of a growth assumption that is? Do you know how many $1 billion-plus companies have achieved a 50% annual earnings growth rate in the past five years? Exactly 25 out of a possible 1550, or 1.6%. Do you know how many of the 136 $30 billion companies in 2005 did it? One, and ironically, it was Apple.

These growth expectations all seem way, way too optimistic to me, which only confirms the McKinsey study cited above. And yet, these expectations are already baked into the prices you are paying for these stocks today. If and when these growth estimates are revealed to be too optimistic, there goes your share price.

The Foolish conclusion
I'm not sure analysts on Wall Street realize just how ridiculous their own models appear, especially in light of this growing academic research. But, they should.

By the way, I'm also not attempting to predict the future of these individual companies (any of these companies might prove me wrong). I'm merely attempting to illustrate a much larger problem: You've got to be extremely careful when it comes to analyst predictions.

Investing is all about evaluating the dynamic between expectations and reality. Perhaps it's worth taking a look at some of the expectations that analysts have baked into the stocks that you own. You might be surprised at what you find. These folks tend to be 100% wrong.

Fool Nick Kapur read Great Expectations twice and enjoyed most of it. Baidu, First Solar, and Google are Motley Fool Rule Breakers picks. Apple is a Motley Fool Stock Advisor recommendation. The Fool owns shares of Google. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (17)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 06, 2010, at 1:46 PM, jrmart wrote:

    I think the analysts are wrong about the future of First Solar. As the price of silicon comes down, First Solar, the thin film solar panel leader will continue to lose market share. Suntech confirms that thesis by just announcing a loss of $147 to $179 million due to charges paid to wind down 2 side experiments in thin solar panels. Why make less efficient thin film solar panels when crystalline panels sell for $1.85 a watt? There are really several important issues to consider when you install a solar system. Space requirements, installation requirements, cabling requirements and future maintenance requirements. SunPower is the leader in all of those areas and delivers the most efficient and powerful solar products on the planet, maximizing energy output and delivering more power than competitors in the same amount of space, whether on roof or land. SunPower also installs the most efficient and flexible roof products available. No other available solution performs better on space or weight constrained rooftops. Rooftop installations are non-penetrating, maintaining your roof’s integrity and ensuring that your roof warranty stays intact. Installation is fast and modular, allowing easy future movement for maintenance or site relocation without business interruption. These roof tiles are secure and wind-resistant up to 140 mph. Also in the Utility power plant area, SunPower® Trackers are the planet’s most powerful, offering the greatest power density per tracker or acre of land. They are modular, which means less wiring, provide quick installations and they also lower future maintenance costs. They occupy a much smaller footprint than conventional or thin-film solar energy systems while producing 30% more power. They also have a patented single-axis design, enabling a unique combination of high performance, scalability and simplicity. They require less land, concrete, steel and cabling per megawatt than competing ground systems. These are the reasons why SunPower has completely sold out all of their solar panels for 2010. Additionally, when you see a top level executive from SunPower buying thousands of SunPower B shares in the open market over the last several months, that's a good sign that the future of SunPower B shares will also shine bright.

  • Report this Comment On August 06, 2010, at 2:24 PM, gambatteimasu wrote:

    Nick,

    Nice article but it seems you're glossing over an important point with respect to Apple.

    Apple might be one of this generation's most extreme outliers -- a Black Swan on the upside. The simple argument that "its market cap is too big to have a high probability of strong growth" seems to ignore what might be the bigger picture with this special company.

    I'm not saying this as a diehard Apple fan. Consider this: just to become the largest market cap company right now (over Exxon) would imply 30% upside in Apple shares from here. Nothing to sneeze at. And that's *after* Exxon's share price (and by extension, market cap) has had an extreme downward correction -- from a high of around $95 in December of '07 to its current price of around $61 today.

    GLTA,

    gambatte imasu

    long AAPL

  • Report this Comment On August 08, 2010, at 3:02 PM, ChrisFs wrote:

    But the nature of Black Swans is that they are outliers. You can't predict a Black Swan outlier kind of performance for every company, and you should be wary of predicting it for any company.

    If you flip a coin 5 times, it will come up heads 5 times at one point, but beware anyone that says they can predict when .

  • Report this Comment On August 09, 2010, at 11:03 AM, MegaEurope wrote:

    "Do you know how many of the 136 $30 billion companies in 2005 did it? One, and ironically, it was Apple."

    That's not ironic (or coincidental).

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