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:

*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.