Why Are Analysts Almost Always Wrong About Apple?

“No matter how much evidence exists that seers do not exist, suckers will pay for the existence of seers.”

- J. Scott Armstrong, "The Seer-Sucker Theory"

Wall Street analysts, the well-paid prognosticators that frequently appear on CNBC and generate headlines with their reports, hold enormous sway over the fortunes of a company (and its shareholders). Why should we, as individual investors, place so much emphasis on what they have to say?

Look at Apple : analysts like Toni Sacconaghi at Bernstein and Katy Huberty at Morgan Stanley have outsized influence when it comes to driving its stock price with their reports. Before releasing its earnings report on May 1, Apple stock went down more than 3.5% on April 20 after Huberty predicted that iPhone sales would be more sluggish than expected and the stock would fall post-earnings.

As reported in Barron's, Huberty's note "offers more troubling fodder to an increasingly negative news cycle: The iPhone X isn't the top-seller Apple anticipated, the company is struggling to expand its supply of OLED screens, and demand for its products is weaker in China."

Sacconaghi had lowered his iPhone shipments estimate from 52 million to 51 million.  Bank of America Merrill Lynch analyst Wamsi Mohan wrote in a note to clients, "In our opinion, investors are already expecting a weaker CQ2, but the magnitude could be surprising to some."

So what happened when Apple reported earnings on May 1?

Missing The Mark

iPhone shipments were 52.2 million (led by the top-selling iPhone X), revenue in China increased by 21% and Apple announced a 16% dividend increase and a $100 billion share repurchase program. The stock went from $166.90 on the date of Huberty's report to an all-time high of $190.37 last week.

Analysts are paid millions of dollars a year, their firms have the most expensive algorithms and predictive models and yet, they consistently miss the mark with their predictions. The market, however, responds to these reports as if they were gospel.

Analysts are prone to groupthink — once one analyst changes their rating or price target, others quickly follow suit. Oftentimes, this happens after a company surprises with an earnings beat or news about the company is released. At this point, the market has already priced the news into the stock.

Spencer Jakab, a former analyst for Credit Suisse and currently a writer for the Wall Street Journal, wrote about his former profession, “Analysts are, as a group at least, like the farmer who bolts the barn door after the horse has run into the meadow.”

When the stock drops based on an analyst's report, the markets may be overreacting to misleading or false data. As long-term investors, these drops may be hard to swallow, and we're subjected to them on a quarterly basis. Analysts publish their earnings expectations and a company's stock is affected by whether or not they meet those expectations. There is limited focus on the long-term outlook, and the analysts typically have no accountability for frequently missing their estimates.

Perhaps betting against analyst reports might be a good contrarian play. One prominent investor who clearly doesn't agree with analysts: Warren Buffett, who increased Berkshire Hathaway's stake in Apple by 75 million shares last quarter.

"The idea that you're going to spend loads of time trying to guess how many iPhone X ... are going to be sold in a three-month period totally misses the point," Buffett told CNBC. "Nobody buys a farm based on whether they think it's going to rain next year," he added. "They buy it because they think it's a good investment over 10 or 20 years."

Channel Checks

Analysts frequently use what are known as "channel checks" to gauge supply and demand. They visit Apple Stores and interview employees and survey customers. They interview Apple suppliers such as Taiwan Semiconductors and, based on computer chip orders, extrapolate those numbers to the entire supply chain.

This approach is myopic and consistently fails to be a proper barometer for Apple. CEO Tim Cook complained about this in a January 2013 earnings call, stating that Apple has a vast and complex logistics chain with many moving parts and manufacturers.

"I'd also stress that even if a particular data point were factual, it would be impossible to accurately interpret the data point as to what it meant for our overall business, because the supply chain is very complex, and we obviously have multiple sources for things. Yields might vary, supplier performance can vary, the beginning inventory positions can vary, I mean there's just an inordinately long list of things that would make any single data point not a great proxy for what's going on."

The Hand That Feeds

So who really benefits from analyst reports (hint: it's not individual investors!) and why do they make so much money?

A few years ago a study called "Inside the 'Black Box' of Sell-Side Financial Analysts" was published by Lawrence Brown (Temple University), Andrew Call (Arizona State University), Michael Clement (University of Texas), and Nathan Sharp (Texas A&M) which surveyed 365 analysts. According to the study:

"One important finding is that private communication with management is a more useful input to analysts’ earnings forecasts and stock recommendations than their own primary research, recent earnings performance, and recent 10-K and 10-Q reports. Another notable finding is that issuing earnings forecasts and stock recommendations that are well below the consensus often leads to an increase in analysts’ credibility with their investing clients."

Those investing clients aren't ordinary retail investors, but rather institutional investors like hedge funds, pension funds and mutual funds. One analyst told the researchers that "one of the biggest things the buy-side compensates sell-side research firms for is corporate access: road shows, meetings, access to management teams."

Analysts have a chance to talk privately with management, but do they get the whole story? If they're talking to management for only 20-30 minutes, how much information can they possibly gleam from that?

What about an analyst's bias? As U.S. News & World Report contributor Wayne Duggan wrote, "It doesn't take a genius to see that the fastest way for an analyst to sour a relationship with company management is to slap a "sell" rating on the company's stock."

One analyst told them:

"When a company cuts you off, not only do you lose the information value of that, but you actually lose revenue. The company won't come to your conference; therefore, your conference is going to be less important. Clients pay a boat load for that access."

Clients also sometimes pay for privileged information that's not shared with retail investors. In 2013, Citigroup was fined $30 million after one of its analysts forwarded confidential information about Apple supply checks to institutional clients like SAC Capital Advisors (a hedge fund run by Steve Cohen) and T. Rowe Price.

If you're an individual investor, it still may be beneficial to pay attention to what analysts are saying in order to understand the sentiment surrounding a stock. However, it is crucial to take this with a grain of salt as you do your own research and come to your own conclusion.

Despite the attention heaped on them, analyst's predictions are no guarantee of anything. Analysts may be paid to be seers, but that doesn't mean you should end up as the sucker.

Disclosure: The author and American Dream Investing own shares in Apple.