In my career as a speculator a career that is now well past forty years I have always been a contrarian. I have always bet against the Wall Street consensus because that’s where the money is. I can safely say it has never been more profitable to bet against the Wall Street consensus than it is today. Wall Street today as never before in its history is dominated by “herd behavior.” Day after day, the Wall Street herd stampedes in and out of stocks based on nothing more substantial than today’s headlines. Headlines that are so unsubstantial and of such transitory importance that 60 days from now no one will even remember them. Wall Street’s stupidity has become one of my favorite article topics.
My topic today is one of Wall Street’s greatest stupidities, “missed earnings estimates.”
To explain this stupidity more fully let me fabricate a tall tale. Let us imagine that five skid-row bums decide to become stock analysts and issue estimated future earnings reports.
For their first venture, they pick a stock that is currently being followed by only two analysts. Their stock pick XYZ is earning a profit is well thought of and is rising in value.
They are too bullish on the stock. Their new higher consensus estimate swamps the more realistic estimate of the two old pros who have been following the stock. XYZ does well but not well enough. Its earnings are up a respectable 18 cents a share for the quarter but the new consensus estimate was not 18 cents a share but 20 cents a share.
XYZ has committed one of Wall Street’s greatest crimes. It has missed an earnings estimate. The stock is brutally mauled. Therefore, the next consensus estimate is reduced say 1 cent a share to 19 cents. Once again, XYZ misses its earnings estimate. It reports an earnings increase of only 15 cents a share and once again, the stock is hammered. The stock analysts having now been burned twice reduce their consensus earnings estimate increase for the next quarter to only 15 a share. Once again, XYZ misses the consensus earnings it reports an earnings increase of only 12 cents a share.
In the eyes of Wall Street, this is the kiss of death. What is even worse is that the reported earnings increase has been falling for three straight quarters from 18 cents a share to 12 cents a share The stock is crushed. It is easily possible for a stock that has missed three straight earnings estimates to fall 35% or more in value.
For a contrarian speculator like me this stock is now a raging buy. The overwhelming probability is that XYZ will annihilate the next quarter’s earnings estimate. How do I know this? Let’s take an honest look at XYZ’s real performance. By any rational measure, it has performed very well indeed. In the last three quarters, it has increased its earnings by an impressive 45 cents a share and its reward for this stellar performance is that the stock has fallen 35%. Why has the stock been crushed? It has been crushed because five skid row bums who have nothing whatsoever to do with the company they are covering fabricated over optimistic numbers.
At this point, you might inform me that stock analysts are not skid row bums but respected Wall Street professionals. My response to that is that when you follow these alleged pros for as long as I have it is not hard to conclude that they might as well be skid row bums. These guys will put you into the poor house.
Welcome to the wonderful world of Wall Street where stupidity reins supreme.
There are two additional reasons to love this stock. The first reason is that there are multitudes of stocks on Wall Street whose earnings are strongly seasonally influenced. XYZ has reported three weakening quarters. Thus there is an excellent chance that the next quarter will be it strongest quarter of the year.
The most powerful reason however is the fact that the consensus estimate has been too bullish three times in a row. There is nothing more disastrous for stock analysts than to overestimate earnings for three quarters in a row. The investors who follow their reports are getting killed and they are not going to be happy about it. The consensus earnings estimate will now be ruthlessly cut perhaps to only 8 cents a share. The overwhelming probability is that XYZ will now report a strong quarter and will easily blow away this fear induced low-ball estimate. A return to the 18 cents to 20 cents a share range would not be out of line.
In Wall Street lingo, this is referred to as a “positive earnings surprise.” XYZ has beaten the consensus earnings estimate. There is nothing that Wall Street adores more than a positive earnings surprise and this one is big.
In such a scenario, the stock could be expected to explode in value. Welcome to my world, the world of the contrarian investor.
Forty Years a Speculator
Fred Carach
Oakland Park, FL 33309
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