Please ensure Javascript is enabled for purposes of website accessibility

The Wall Street Myth That Could Destroy Your Portfolio

By Joe Magyer - Updated Nov 11, 2016 at 4:45PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Don't let Wall Street analysts wreck your returns.

There's a quietly persistent Wall Street myth that has left the savings of countless small investors in ruins. More likely than not, you've relied on this piece of information while making your own investment decisions. Maybe you told yourself it was too good to be true, but deep down, you wanted it to be true. So you believed it.

A myth debunked
A fellow Fool, dividend jockey James Early, tipped me off to a recent eye-opening study by Patrick Cusatis and J. Randall Woolridge of Pennsylvania State University. Cusatis and Woolridge studied 20 years' worth of published earnings estimates from Wall Street industry analysts ... and reached a startling conclusion.

Cusatis and Woolridge found that Wall Street analysts -- supposedly among the smartest, most well-informed prognosticators -- consistently overestimated the future earnings growth rates of the companies they covered. By a lot. I mean, by a whole lot.

The researchers compared average forecasted annual EPS growth against the actual results over the time horizon of the forecast. Here's what they found:

Time Frame
of Estimate

Estimated Growth

Actual Growth

Overestimated By

1 Year

13.8%

9.8%

4.0%

5 Years

14.9%

9.1%

5.8%

Source: "The Accuracy of Analysts' Long-Term Earnings-Per-Share Growth Rate Forecasts," Cusatis and Woolridge.

That's a tiny table with huge implications.

Why you should be concerned
What you thought you knew about analyst estimates, short or long term, is bunk. Over both short runs and long runs, these highly paid analysts are overestimating the earnings growth of the companies they so closely track by a mind-blowing margin.

On the five-year horizon, actual EPS growth clocked in almost 40% below analysts' estimates. Perhaps just as disconcerting, Cusatis and Woolridge point out that the average five-year estimates were roughly double the rate of GDP growth over the same time period.

So much for efficient markets.

Now, while the cause of this mind-boggling inaccuracy is debatable, the consequence of it for individual investors is straightforward. Namely, you can only take analysts' forecasts with a grain of salt at best. Practically speaking, you should ratchet them down to the tune of around 40%.

Ouch!
For perspective, here is a list of stocks that analysts expect to grow at a rapid rate over the next five years, versus what might be a more realistic growth rate based on Cusatis and Woolridge's analysis:

Company

Analysts' 5-Year
EPS Growth Estimates

Adjusted 5-Year
EPS Growth Estimates

Qualcomm (NASDAQ:QCOM)

14.0%

8.5%

Apple (NASDAQ:AAPL)

20.1%

12.3%

Amazon.com (NASDAQ:AMZN)

23.7%

14.5%

Baidu (NASDAQ:BIDU)

44.7%

27.3%

SunPower (NASDAQ:SPWRA)

38.7%

23.6%

Activision Blizzard (NASDAQ:ATVI)

17.0%

10.4%

Hansen Natural (NASDAQ:HANS)

16.6%

10.1%

Data from Yahoo! Finance.

Bit of an eye-opener, right? Those are some serious haircuts. Perhaps you're thinking, "So what if Baidu doesn't deliver near 50% annual growth over the next five years? I'd be plenty happy with the 27% 'adjusted' scenario." That line of thinking, friends, is how you get burned.

See, the value of most stocks is simply a reflection of current expectations of future growth and profits. If a company misses earnings estimates or (worse) lowers its outlook, its shares usually fall. Hard. If you need any convincing, just ask a Crocs investor what happens when a stock with huge growth expectations fails to live up to the hype.

Your next steps
These new findings demonstrate clearly that you must change the way you look at investing, particularly in growth stocks.

For starters, stop lusting after the next rocket stock. Growth isn't inherently a bad thing, of course. But if this study has shown us anything, it's that the ability to forecast growth accurately over the short run or long run, even when attempted by savvy experts, is akin to long-distance dart throwing. Are you an investor, or a dart-thrower?

Don't overcomplicate things
Robust empirical research by Wharton professor Jeremy Siegel has shown that market-beating performance is as easy as investing in steady-growth, dividend-paying stocks, with the added benefit of lower volatility. Personally, I'll take low-volatility, market-beating returns over the stress of finding the next home run stock any day.

In fact, James Early and I execute just such a strategy with our market-beating Income Investor newsletter service. Try the service free for 30 days to see whether our cash-focused approach is right for you.

This article was originally published May 1, 2008. It has been updated.

Joe Magyer does not own shares of any companies mentioned in this article. Apple, Activision Blizzard, and Amazon.com are
Stock Advisor recommendations, while Baidu is a Rule Breakers pick. The Motley Fool has a disclosure policy.

None

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Apple Inc. Stock Quote
Apple Inc.
AAPL
$165.35 (-0.14%) $0.23
Amazon.com, Inc. Stock Quote
Amazon.com, Inc.
AMZN
$140.80 (-1.24%) $-1.77
QUALCOMM Incorporated Stock Quote
QUALCOMM Incorporated
QCOM
$150.21 (-0.53%) $0.80
Monster Beverage Corporation Stock Quote
Monster Beverage Corporation
MNST
$91.38 (-5.17%) $-4.98
Baidu, Inc. Stock Quote
Baidu, Inc.
BIDU
$137.82 (-1.61%) $-2.25
Activision Blizzard, Inc. Stock Quote
Activision Blizzard, Inc.
ATVI
$80.49 (-0.21%) $0.17

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
377%
 
S&P 500 Returns
123%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 08/07/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.