Avoid This Losing Strategy

Let me ask you something. Do you follow analyst upgrades and downgrades, buying when they say, selling when they tell you?

To judge by the price movements when those calls come out, a lot of people do. But if you're one of them, know this: It's not going to help you succeed at building a winning portfolio.

I don't know ...
The problem is, we aren't the rational investors we thought we were. Buy low and sell high, right? But the flow of money in February and March 2009 was out of equities and into bonds.

Why were people selling so much a year ago and refusing to buy at the bottom? Too much uncertainty? Too much fear? As Warren Buffett says, we pay a lot for a cheery consensus.

And the analysts were right there. In the last two weeks of February 2009, just before the bottom, they issued 207 downgrades and only 184 upgrades, compounding that by lowering 12-month price targets 500 times versus raising those targets just 150 times, all according to Briefing.com.

Buy low would have served us all well -- equities have outperformed bonds 29% to 8% over the past year.

I do know!
No matter how much we like to think otherwise, we're incredibly bad at predicting the future, whether it's price targets or what we'll want to eat. Why? Overconfidence. And experts tend to do even worse.

One study revealed that a group of psychology undergrads were better than a group of stock analysts at picking the outperforming stock of a pair. The students weren't very good, getting only about 50% of their calls right. But the analysts, who were much more confident in their answers, got only 40% of their calls right.

Getting earnings right is so important
Despite the problems of overconfidence and lack of rationality, analysts continue to predict earnings down to the nearest penny. Here's a table showing the latest quarter's consensus estimate for a handful of companies, each heavily followed, along with what was actually reported.

Source: Capital IQ (a division of Standard & Poor's) and earnings.com.

Not too good, huh?

Instead of focusing on what are almost certainly going to be erroneous predictions, it's better by far to focus on what's actually happening.

For instance, Apple grew sales and earnings throughout the recession, and the iPad launch blew past announced expectations. In that context, increased earnings isn't surprising. Not only had Apple grown computer shipments -- on top of iPhone shipments -- so had Dell.

And with that background, you could have predicted that there was more demand for SanDisk's flash memory products, used in both cell phones and notebooks. The same trend would likely boost Intel as chip demand grew.

Ford refused bail-out money from the government while Toyota was facing a PR disaster. Any surprise that Ford did better than expected? Airlines put off fleet replacement during the recession and had to begin ordering new planes sooner rather than later, which helped Boeing. And Goldman Sachs was under extreme pressure -- from itself if nobody else -- to pay back TARP funds and get out from under the restrictions put on the company.

And Home Depot? Well, home sales had been trending up for several months according to the National Association of Realtors, which likely meant good things for this retailer. And the home buyer tax credit certainly didn't hurt.

Lesson learned
As you see, thinking past the surface stat would, at the very least, have given you the opportunity to understand what was happening and thus how you expected the company to perform, without getting into the false precision of overconfident price targets and calls made as much out of fear or optimism as clear-eyed analysis.

After all, it's less important that a company hit earnings expectations on the nose in one particular quarter than that it continues to grow and perform well over the long haul.

At Motley Fool Stock Advisor, Tom and David Gardner and their teams focus on companies, their growth prospects, and what else is going on that affects them -- not on analyst upgrades, downgrades, and earnings targets. That kind of company-centric focus has helped us beat the market by nearly 55 percentage points per pick on average. To find out what we like today, click here to take a free 30-day trial. Your portfolio will thank you.

Jim Mueller owns none of the companies mentioned in this article. Home Depot and Intel are Motley Fool Inside Value selections. Apple and Ford are Stock Advisor recommendations. The Fool has created a covered strangle position on Intel. The Fool's disclosure policy has gone its own way for so long that some say it's lost.