Apple Makes a Mockery of the System...Again

The Pragmatic Capitalist January 19, 2011

It’s really not shocking that small investors believe Wall Street is a rigged game. There is, perhaps, no better example of this than Apple’s quarterly report. For anyone who isn’t familiar with how the game works I’ll break it down for you. Apple provides an outlook for the upcoming quarter. They set these figures WELL below expectations with the knowledge that they will soundly crush those figures. The analysts, all of whom rely on being able to “sell” Apple want to stay in management’s good graces. This is important because Apple is widely held by most of their clients. For instance, there isn’t a huge hedge fund on Wall Street that doesn’t own Apple. So, the research firms (which are supposedly independent of their sales and trading arms) are incentivized to ensure that Apple stock continues to rise and perform “better than expected”. The pay-off of course, comes in the form of millions in commission dollars.

This quarter was another sign of the ridiculous lack of value that Wall Street’s “best minds” add. Apple smashed their absurd estimates. Sadly, bloggers provide a better analysis of Apple’s quarterly data than the Wall Street analysts do. It’s not surprising that the investment blogosphere is quickly turning into the preferred place for honest and reliable research.

Over the last few quarters I’ve run an analysis in the last 15 minutes of trading that broke down Apple’s earnings (I didn’t do it this quarter because it’s become a waste of time). I literally do it in less than 15 minutes. There is no fancy analysis involved, calls to management or anything of the sort. I don’t cover Apple in my research and I don’t own the stock. My work is just good old fashioned common sense combined with a graduate degree level understanding of an income statement. Last quarter Apple missed my EPS estimate by 2.5%. They beat my revenue estimate by 5%. They beat the average Wall Street EPS estimate by 14% and the revenue estimate by 7.5%. I don’t know about you, but if I hired an independent consultant to provide me with a reliable estimate, paid them several thousand dollars and they came back with a product that missed by 14% I would fire them in a heartbeat.

The most absurd portion of the Apple report is that everyone on Wall Street knows that they sandbag their guidance. last quarter I said the following:

Let me translate that $4.80 guidance:

"We know you will all set your estimates in the $5-$5.50 range and we will soundly crush that. Thanks for playing Wall Street!

Love,

Apple Management"

And of course, Wall Street set its estimate at exactly $5.38 and Apple comes in at $6.43 (an embarrassingly absurd miss of 18%). I know this is how the game works, but where is the value added? Millions of small investors pay millions of dollars a year for access to the big wire houses and their research analysts. Millions more are reading reports or listening to talking heads describe how Apple and corporate America in general is performing “better than expected”. While this might be true so some extent you have to question the analysis when it’s so blatantly clear that the research is not honest. If they can’t provide honest and realistic research then why does anyone trust them and why should anyone ever pay for their services? It makes a mockery of the system and only further erodes the level of trust between Wall Street and Main Street. ——————————————————————————————————————————————————

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More on this topic (What's this?) Apple (NASDAQ: AAPL): Q1 Earnings Preview 2011 (Stock Wizard, 1/17/11) The Next 5 Apple Gadgets To Waste Time Obsessing About (Wall St. Cheat Sheet, 12/30/10) Can Apple Inc. (Nasdaq: AAPL) Thrive Without CEO Steve Jobs? (Money Morning, 1/18/11) 6 Catalysts That Could Send Apple's Shares Soaring "” or Plummeting "” Very Soon (Jutia Group, 12/8/10) Read more on Apple at Wikinvest icBrokerWidget('pragcap', 600, 55); Comments SS

It’s a big joke. The goal is create attention and they succeed.

Reply 01/18/2011 at 6:01 PM FXBot

so we can exploit it. If we know the estimates are too low it means the Wall Street machine will keep buying.

Reply 01/18/2011 at 6:02 PM Joe

Your article is a classic example of hindsight analysis – Wall st analysts base their estimates off of management guidance. it is easy to come in and say, on average AAPL has beat its mid-point of guidance by 35% and therefore next qtr they are going to report (mid-point EPS x 1.35) – guess what…. if a wall street analyst uses this rationale and god forbid if AAPL comes in at (mid-point EPS)x 1.1, the analyst’s career is DONE (not to mention all those lawsuits and retail cry-babies saying this is how wall street pumps and dumps…..

This is why the concept of whisper-numbers come up as investor expectations differ frrom wall st. Can you rationally explain why AAPL is just up 1% on what you call as ‘smashing expectations’.

Reply 01/18/2011 at 6:08 PM Kid Dynamite

exactly – I’m not about to defend Sell Side research, but Cullen, like you said – everyone knows the game, thus the analyst estimates are not what’s priced in! The simple fact that “whisper numbers” exist is enough to slaughter the value of Street Equity Research…

Reply 01/18/2011 at 6:20 PM Cullen Roche

If it were all “priced in” my expectation ratio would be useless. The fact is, earnings are never properly priced in and these reports move the stocks big time. To claim otherwise is absurd.

Reply 01/18/2011 at 6:28 PM Cullen Roche

Plus, defending the game, just because we all know it’s a crock of shit, is ridiculous. That’s like saying that it’s okay to beat the hell out of a freshman in college because that’s just part of the hazing ritual. It’s “how the system works”. That doesn’t mean the system is good, fair or right.

Reply 01/18/2011 at 6:32 PM Kid Dynamite

I was trying to be clear that I was not defending the game.

AAPL is up 1 1/4 percent after hours… so yes – most of it positively was priced in. to claim otherwise would be absurd. evidence: AAPL’s stock price after hours.

On this topic, Cullen, I’m interested in how you feel about sell side research compared to the ratings agencies. In other words, I’m FURIOUS at the ratings agencies’ gross negligence during the credit crisis. i mean GROSS incompetence – but what I can’t quite reconcile in my head is how it’s different from GS putting a “Strong buy” on a stock that goes down…

I think that we think that investors have the ability to do due diligence on equities but not bonds – so we rely on the ratings agencies more there? who knows…

Reply 01/18/2011 at 11:39 PM Cullen Roche

CREE fell 20% after hours. You won’t even come close to convincing me that earnings are always priced into stocks. Just look around yourself for the next 6 weeks and watch how much power these people have over the street.

The ratings agencies are a joke. Beyond a joke.

My point about the banks is that they work for the same institution that is in the business of selling the stock. The conflict of interest was supposed to be eliminated, but it’s 100% clear that it never really was.

Reply 01/19/2011 at 1:04 AM Cullen Roche

It’s not rear view at all. If you look at their Q1 10 data you’ll notice that ipad estimates alone would have put them in the $20B+ revenue range. Add in the fact that iphone sales almost double YoY and there isn’t an analyst on Wall St who shouldn’t have had a revenue estimate of AT LEAST 25B. There’s nothing fancy involved in that. That’s just common sense and using recent data to confirm where the numbers will come in.

A simple income statement breakdown from that point is easy and brings you to $6+. I ran a private analysis that called for $6.19 on 26.55B. It was no-brainer work. The baseline estimate for all analysts should have been at least $5.75 on 25B. That would have been my absolute lowest starting point based on unit sales. And we all know ipad sales have been through the roof.

Your point about analysts getting fired for being overly optimistic is ridiculous. Why should an analyst be ridiculed for being right? You should be overly optimistic about AAPL. It’s the best damn company in America right now…

Reply 01/18/2011 at 6:26 PM Brandon Ferro

To give another example of how messed up the system is here is another personal example I experienced…

Was hold rated on a retail stock but believed a near term short setup was available. Attended a retail conference the company’s CFO spoke at and arranged a 1 on 1 with him and IR after. Got data points that confirmed my short thesis. Immediately wrote up a quick blurb that was sent out to all our clients. Blurb wasn’t even in official “note” form but was sent out as “bullets” as this would circumvent company and IR reading note in public view. Blurb found its way into the inbox of a big long-term owner (thank you salesforce). Owner forwards short call to company. Guess which sell side analyst was permanently put in the penalty box with company as far as management access goes? More than anything management access gets you PAID on the sell side; buy siders give 2 $hits about estimates, as long as they know they’re low balled that is.

Just saying, as my example goes, it is structurally impossible for these guys to do the job they are supposed to given the buy side pays only for the thing that precludes objectivity – management access….

Reply 01/18/2011 at 6:46 PM Cullen Roche

Sounds about right….

Reply 01/18/2011 at 6:59 PM Joe

Brandon nails it. What did retail pay to Goldie to expect them to tell what the real expectations are to the 3rd decimal place? ZERO. IF you talk to the analyst he/she can breakdown line-by-line upside to his numbers and thats how ‘whisper numbers’ comes up. But what is the incentive for goldman sachs to publish their research to retail who pay jack$hit? all they end up doing is their clients who pay millions for research lose edge…. stock investing is information game. If someone (like the retail bloggers you point out) with 25 shares in e-trade account and access to excel sheet can pull up such a model with accuracy, dont you think the guys managing billions will not be able to do it? I hate sell side as well – but dont think sell side is at fault here…. there is NO NECCESITY for them publish all information they have found out and distribute to everyone on the internet for free. Sell siders are paid to bring an edge to the CLIENT, not to someone who pays them NOTHING.

Reply 01/18/2011 at 7:27 PM Cullen Roche

You talk as if these firms are all institutional and nothing else. Sure, I know they cater to their institutional clients, but let’s not forget that these firms also service a huge number of medium sized and small sized investors. And yes, those people are PAYING for the research. I have several accounts at large brokerage firms. I use their research quite a bit – mostly for contrarian purposes. I PAY for it. I’m not a huge fish, but I’m not a small fish either. What good is their research to someone like me when it’s this far off base?

The more important point is that these people are moving the needle. They move markets. They cause stocks to rise and fall by billions of dollars in any given day and their research is a joke. It’s used to generate commission for a sales purpose rather than provide value added research.

If you can’t see the problem there then you’re asleep. Or you’re just an apologist for Wall Street.

Reply 01/18/2011 at 7:45 PM Brandon Ferro

And I will add that a big portion of the time analysts will have their juniors do all the earnings modeling. Often times the senior will tell the junior after a quarter to keep the numbers the same if the stock isn’t important to the franchise and so they don’t have more work to do – even if incremental data changes the outlook. Changing estimates means the analyst has to explain something to the sales force that might not look favorably in the context of their rating. The last thing an AAPL analyst wants to do is come out after a quarter of telling his clients and sales force it is his favorite idea, that he’s lowering his earnings estimates after the conference call. To avoid threading this needle, you just always low ball..

The least amount of work is done for companies that issue guidance – all you do is take guidance and back into it. Many analysts don’t even have functional models – everything is hard coded. The only value add is the management marketing trips. All the research, especially the estimates, is a commodity that is not a revenue generator and thus, warrants the least amount of the analyst’s time.

Reply 01/18/2011 at 7:47 PM Nils

It’s more a general promotion of stock trading, the banks have an interest in a lot of trading taking place (added liquidity and commissions) and the financial media needs to sell copies. An investment bank also earns on stock offerings etc. It’s more general marketing than a direct strategy, trying to create the impression in the general public that the stock market is more predictable and reliable than it really is. That’s also why the financial media uses correlation disguised as causation in reporting stock movements (headlines like “stock/index X moving on stronger than expected earnings”, notice the word “because” being avoided) when the only credible explanation is selling or buying.

Reply 01/18/2011 at 7:56 PM