KARL KAUFMAN | From American Dream Investing

· Podcast Episodes
Wall Street Analysts getting it wrong, are they worth the big bucks?

"No matter how much evidence exists that seers do not exist, suckers will pay for the existence of seers." - J. Scott Armstrong

Karl Kaufman is the resident expert at American Dream Investing helping ordinary investors who are ignored by Wall Street. Despite the fancy MBAs, predictive models, fancy suits and the big salaries, Wall Street analysts are woefully poor predictors of future events. I based this interview on the following blog post written by Karl. I hope you enjoy both.

Why Are Analysts Almost Always Wrong?

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

Look at Apple today: it's down over 3% after a Morgan Stanley analyst wrote that slowing App Store growth could cause weaker Services revenue.

Analysts are paid millions of dollars a year. Their firms have the most expensive algorithms and predictive models, 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. This often 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.

These drops may be hard to swallow as long-term investors, and we're subjected to them every quarter. 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 analysts typically have no accountability for frequently missing their estimates.

“It's just human nature. Unless you're really looking to make a name for yourself or a big impression, you're going to fall in line with everyone else. So, it's the same thing with the stock market. And it's not just analysts, it's economist as well. You see this with the jobs reports predictions, you see this with even what the federal reserve is saying about their inflation data. All of the fed governors and officials are kind of all falling into line with one another. So, group think is a human condition that it's very dangerous when it comes to the stock market. That's another benefit you have as an individual investor is that you can think for yourself: you don't have to answer to anybody, except maybe a spouse, but you don't have to answer to anybody about what you are doing and why.”

One prominent investor who disagrees with analysts is Warren Buffett, who said, "The idea that you're going to spend loads of time trying to guess how many iPhones will be sold in a three-month period totally misses the point.

"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."

Analysts frequently use what is 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 an accurate 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.

"The lion's share of analysts are doing good, honest work and are doing the best they can. Predictive models are only as good as the people who created those models. You can't predict for a great financial crisis, you can't predict for coronavirus, you can't predict for September 11th, any of these things. That's what makes the stock market so unpredictable and so much fun."

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

According to an academic study called "Inside the 'Black Box' of Sell-Side Financial Analysts, "private communication with management is a more useful input to analysts' earnings forecasts and stock recommendations than their own primary research."

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 glean from that?

And 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."

According to an anonymous analyst: "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 not shared with retail investors. In 2013, Citigroup was fined $30 million after an analyst forwarded confidential information about Apple supply checks to institutional clients like SAC Capital Advisors (a hedge fund formerly run by New York Mets owner 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 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, analysts' 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.

Karl Kaufman helps investors think differently about finance & the stock market.

He's the founder & CEO of American Dream Investing, a financial membership service sharing independent and unconventional thoughts on building wealth through the stock market. He aims to educate the public as to why they need to manage their own investments, either by themselves or with the help of a trusted advisor.

Karl has been a contestant on “Who Wants to Be a Millionaire,” and was featured in the Miami Herald after Bruce Springsteen helped me propose to my girlfriend at one of his concerts. He likes bourbon, playing tennis with his wife, and playing guitar while she sings.



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Phil (30s):
Hi and welcome back to Stocks for Beginners. I'm Phil Muscatello. Wall Street analysts are paid millions of dollars a year. Their firms have the most expensive algorithms and predictive models. Yet they consistently miss the mark with their predictions. What's going on, Karl?

Karl (47s):
Hey Phil, how are you? Thanks for having me back on the show.

Phil (50s):
No, thank you very much for coming back on. Now Karl Kaufman is a Forbes contributor and American Dream Investing co-founder and CEO. And if you're not following him on Twitter and LinkedIn, you're missing out on a great newsletter every day, where he's putting his thoughts together for us in terms of what he's feeling is going on in investing. So Karl, tell us about these analysts, where do they come from? I'm assuming they come from the best business schools in the country.

Karl (1m 15s):
Yeah. A lot of them have six figure MBAs and they go to the best business schools in the world and they go to the best banks and they have the best predictive models that cost millions of dollars. And despite all that, they still miss the mark completely.

Phil (1m 34s):
Can you give us any examples of some recent failures?

Karl (1m 39s):
Yeah. One in particular is the Apple iPhone. And back when Apple used to break out how many iPhones they would sell each quarter, I remember analysts from Bank of America and Morgan Stanley and Bernstein all would weigh in and say, "Well, we're cutting our estimates on how many iPhone 10s they're going to sell this quarter because we see that the Chinese demand is not going to be the same. The Chinese don't like the big phones and they have the Huawei and they go through all these different reasons for why they're cutting targets or raising targets.

Karl (2m 19s):
And of course, Apple came out that quarter and blew away estimates. I think that in this particular case, the analysts were expecting maybe 50 million iPhone sold that quarter and Apple wound up selling 90 million. It wasn't even close.

Phil (2m 35s):
So despite being wrong so many times, they still try and make predictions. I suppose they have to do it, don't they?

Karl (2m 42s):
Yeah. That's part of their job. And that's what their clients on the buy side rely on. They will buy and sell based on an analyst recommendation. And you know, these buy-side clients are not individual investors like you or I, they're big pensions and hedge funds and institutions that are going based on these analysts recommendations.

Phil (3m 5s):
Large institutional investors and pension funds, they kind of require this, but even though they've most really seen how many times this analysis has been wrong, is that the way it works? They just need something even though it might not be the perfect way of predicting the future.

Karl (3m 20s):
Yeah. They pay good money for these reports. And I'm sure it's not the only criteria they use to invest in a company. But you know, when you're paying good money for something you want to think or tell yourself that there's some credence to what the analysts are saying. So thankfully as an individual investor, we can use this as one of our data points when we're making an informed decision on whether to buy or sell the institutional investors, who knows what goes on behind the scenes. But I do know that they rely on analysts and there buy and sell ratings on stocks and their price targets.

Phil (3m 59s):
And there's a kind of a group think involved in it as well, because no one wants to be the outlier. They all want to be using the same tools to come up with very much the same conclusions. Don't they?

Karl (4m 11s):
Yeah. Do you have the game show "The Price is Right" in Australia?

Phil (4m 14s):
Yep. We sure do.

Karl (4m 15s):
So you know that nobody wants to be the crazy contestant who goes there and yells out a price that's way off what everyone else is saying. Right? It's always like a dollar more, $2 more just so that they kind of fall into line. It's just human nature. Unless you're really looking to make a name for yourself or a big impression, you're kind of going to fall in line with everyone else. So it's the same thing with the stock market. And it's not just analysts, it's economist as well. You see this with the jobs reports predictions, you see this with even what the federal reserve is saying about their inflation data.

Karl (4m 56s):
All of the fed governors and officials are kind of all falling into line with one another. So group think is a human condition that it's very dangerous when it comes to the stock market. Again, that's another benefit you have as an individual investor is that you can think for yourself, you don't have to answer to anybody except maybe a spouse, but you don't have to answer to anybody about what you are doing and why, unless you're public about it like I am.

Phil (5m 26s):
And I know that a lot of brokerages will publish consensus analysis, won't they? And so you basically think, well, if all of these experts have this view on a particular company, they might be right. And I should possibly be informing my own investing decisions based on these things. But how much of a grain of salt should be added to those reports?

Karl (5m 48s):
They're helpful just to see what other people are thinking and you know, not to denigrate analysts completely. I mean, they do a lot of good research. They have great people on their team and they spend a lot of time and effort really digging into the numbers and the stories behind the stock. They talk to management and they try and get a good picture. So they're doing the best based on the models that they have.

Phil (6m 16s):
They're trying their best.

Karl (6m 17s):
No, I mean, look, you have some shady characters as with anything. I mean, I think there was a case where Citi Group was fined a certain amount, $30 million or so almost 10 years ago for kind of giving some of their clients advanced notice and some of this information. So look, I mean, it happens in any business, especially happens on Wall Street where you have some shady characters that are not operating with integrity, but the lion's share of analysts are doing good, honest work and are doing the best they can. Predictive models are only as good as the people who created those models.

Karl (6m 60s):
You can't predict for a great financial crisis. You can't predict for a Coronavirus. You can't predict for September 11th, any of these things, that's what makes the stock market so unpredictable and so much fun

Phil (7m 13s):
When you're researching, when an individual retail investor is researching a particular company, they should take in some of the, the analysis that they're seeing from this sector, but do your own research. Is that the kind of thing that you're seeing?

Karl (7m 26s):
Always, I think that comes with the territory. I love to read analysts reports and try and poke holes in them and see what's the other side of the coin here? What are they missing or what are they not taking into effect? And this goes to the point of channel checks, which are a major thing that analysts use, especially with a company like Apple, where they'll go to an Apple supplier, like say Taiwan Semi-conductors, they'll go. And they'll interview management. There they'll find anonymous sources within the company and try and get some insight information on what's the production like of these, these parts, even if it's like the screen or a chip or a glass case around it.

Karl (8m 14s):
And they'll take this one data point and try to extrapolate it to the entire supply chain. And you know, Apple's CEO, Tim Cook has complained about this in the past, and he's a supply chain guy. He said our supply chain is so vast and intricate that just looking at one particular thing is myopic. And you really need to kind of look at the whole picture. Just one particular data point is not going to tell you that, Hey, we're not going to sell as many iPhones as we anticipated.

Phil (8m 46s):
That's an interesting observation about Tim Cook these a supply chain kind of guy. What does that mean? He's an expert in supply chains, is he?

Karl (8m 54s):
Yeah. He came up within company as a supply chain expert, a logistics expert, a lot of the negative talk about him and the media over the last decade. Plus that he's been at the helm has been that he's not an innovation guy, that he is a supply chain guy. I don't agree with that argument at all. I think Apple has innovated their products year over year, and they haven't come out with something as astronomically innovative as the iPhone. But you look at an Apple Watch and the way that it's innovating healthcare, I think they're really continuing to be a, an insanely innovative company.

Phil (9m 32s):
That's incredible. Let's just take a bit of a side path here about the health care side of things with Apple. I have spoken to another guest about this, and it's pretty incredible what they're doing, not so much that they're doing any research into actual healthcare products, but they providing the infrastructure for healthcare experts to come up with ideas and innovations. Tell us a bit about that.

Karl (9m 55s):
Well, you think of how many data points they have access to from millions of Apple watches that are connected billions of iPhones that are connected. And I know they've partnered with, I think it's the American Heart Association and sleep researchers and they've anonymized this data. They send it to these studies. There are all kinds of stories that they put in their marketing about how many lives they've saved because someone fell and the Apple watch detected that they were falling. So I called 911. It's amazing. When my wife gave birth to my children, I noticed that every nurse and doctor in the hospital had an Apple Watch and I always ask them how many steps they took.

Karl (10m 40s):
It was always, you know, twenty-five more than I would take in a normal day and they all had their Apple Watches on. So it's incredible what they have with this network of data that they can then use to hopefully make all of our lives better.

Phil (10m 55s):
Outsourcing the innovation. Presumably

Karl (10m 57s):
Yeah, outsourcing the innovation to innovate is not just to create something new, but it's to take something and make it better. Right? And one thing with Apple is that they didn't create the MP3 player, the portable MP3 player, they made the iPod, which was the best MP3 player. They didn't create the tablet, they made the best tablet and they kept making it better year over year. The software is better at year over year. If you look at, you know, the first iOS from the first iPhone and you compare it to now, you're going to tell me that they haven't innovated the software between now and 15 years ago.

Karl (11m 37s):
So they do a great job of that and making these small acquisitions of these small companies, dark sky, being one in particular, which was a weather forecast or an app. And if you look at your Apple weather app, now it's this beautiful app that just has every little attention to detail. And these little things just constantly improve upon what they've done in the past. And some of it's noticeable, some of it's behind the scenes, but I really admire them as a company. And Tim Cook as an executive.

Phil (12m 14s):
I'm just going to read a quote to you from the article that we've based this interview from. And it's from Warren Buffet. We hear a lot from Warren. Nobody buys a farm based on whether they think it's going to rain next year. They buy it because they think it's a good investment over 10 or 20 years. How does this inform your investing style?

Karl (12m 32s):
Yeah, well, to place it in the context of the article, I think Warren himself was complaining about the focus on the quarterly number of iPhone shipments. There were. And he's basically saying you're buying this stock because you don't care. What's going to happen with it between now and the next three months, the next year. Even if you're a long-term investor, as opposed to say a speculator or trader someone who's just doing options or anything of the sort you're in it for the long-term, he can spin a phrase better than anyone in history. Almost, maybe Mark Twain does it better. But when I look at an investment, for instance, I've been buying a lot of Meta Platforms over the last several months as it continues to go down.

Karl (13m 20s):
And my thinking behind that is the company has been so well run for so long that I just have confidence in the management that they're going to figure out whatever short-term problems they have. And I know that I'm buying the stock for a lot cheaper than I did a year ago. And if my thesis proves true five years from now, even I'm going to be very happy with how my stock has done between. Now, when it's trading in the one sixties and five years from now, I think 10 or 20 years from now, Facebook will still be around in a different capacity than what it is.

Karl (14m 3s):
They've been able to innovate their platform insanely well. And that's my focus as a long-term investor. That's straight from the Warren Buffett's school, straight from the Benjamin Graham school, where you buy and hold something. And Warren also said, you want to buy something that you would want to own in the absence of any market. So the stock market could be closed for between now and five years from now. And you'll be perfectly happy owning that stock

Phil (14m 31s):
Because it's a business and it's good. It'll gonna be generating that income.

Karl (14m 35s):

Phil (14m 36s):
So this is completely different emphasis to what analysts are required to do, because like you said before, they've got to go through every quarter and look through all the numbers every quarter. How does that affect the way that they would be looking at companies?

Karl (14m 50s):
Well, analysts will have a short-term focus. They have to provide these reports and they have to get on the conference calls and talk to management and discuss their earnings. Every quarter. They have a short-term focus of what's going to happen between now and three months from now. And then they, they try and guesstimate what's going to happen for next year's earnings and the year after. So, you know, they're taking what's happened in the past and they're trying to put it off into the present and see how exactly their earnings are going to improve or decrease.

Karl (15m 31s):
And they write their reports based on that. You know, I mean, as an individual investor, you're kind of doing the same thing as well. Some go into discounted cashflow models and other kind of value investing formulas and so on and so forth. But you are making an estimate here and nobody knows what the future will hold. If they did, they'd be, you know, wealthier than Elon Musk, but they're taking their best stab at things based on what's happened in the past. But there's a reason that they say past performance is no guarantee of future returns.

Phil (16m 4s):
That's looking backwards in the rear view mirror, isn't it?

Karl (16m 6s):

Phil (16m 7s):
So what do they get paid so much?

Karl (16m 9s):
Well, they got paid because they supposedly do well for their clients. I mean, something must work within this system. Otherwise it wouldn't continue, right? I mean, there's gotta be some sort of efficiency here in order for this to work. So they have their estimates, they have their reports. They tell their clients, you know, on the buy side to buy or sell and their clients usually do well because of this. So I think they probably put their earnings estimates on the low side, on the conservative side so that companies can beat it every quarter and this way, the stock rallies.

Karl (16m 54s):
And they can tell our clients, look, I told you to buy it. It's even better than we anticipated.

Phil (16m 59s):
And it actually works that way. It's almost a manipulation. I don't want to use the word manipulation, but

Karl (17m 4s):
Yeah, look, there are plenty of conspiracies out there. If you read enough message boards, if you're trolling on Reddit or the Yahoo Finance message boards or any of those, there's certainly a lot of thought that there is manipulation involved. I wouldn't go that far. Although sometimes it seems like, you know, it could be a little suspect, but it goes back to the group. Think everybody wants to fall in line management gives a certain guidance. Most companies management gives a certain guidance. The analysts want to make sure it's a little bit below so that management can look good. They can get invited to speak with them.

Karl (17m 45s):
The companies then get invited to conferences and it's one hand washes the other.

Phil (17m 51s):
So there's a bit of a benefit on both sides of the, of the ledger then.

Karl (17m 56s):
Yeah, exactly. I mean, no one wants to be the analyst that slaps a sell rating on a big company, because then you kind of lose your favor with management. They don't want to talk to you. You don't get them to come to your conferences. You're going to lose a lot of money in that respect. So I think what a lot of the clients are paying for also is access and it's access to management and what they think is an inside scoop. But look, you know, if you're spending 20 or 30 minutes with a CEO or CFO, how much are you really going to glean from that? You're not getting the whole story

Phil (18m 33s):
And you don't have the freedom to slap a sell on them. Anyway, presumably

Karl (18m 39s):
Yeah. I mean, no one wants to be the rogue jet pilot. That's that's going off against the captain's orders. So whether or not they have the freedom to do it, or whether or not they just don't want to do it for political reasons. It's a strange world out there that we as individual investors are not privy to.

Phil (19m 0s):
So Hey, you're saying markets at the moment. How are you navigating them?

Karl (19m 4s):
Well, going back to the whole concept of group think it seems like everybody is pessimistic about the market these days, which it's a bear market. No, one's supposed to feel good about it unless you're an expert at shorting the market. I consider myself to be a permit bowl where I always find some reason for optimism. And the good news about a longterm focus is that you look at periods like this as opportunities, wonderful opportunities, because everything is on sale. There's a great quote from an old timer. I forget exactly who, but it's like, you know, the stock market is the only business where the customers don't buy when the merchandise is on sale.

Karl (19m 46s):
So, I mean, we seeing great companies at 50% off. I mean, Target is 25% off in one day. We're close to the point where it seems like maximum pessimism is in the markets. The fed has a very, very tricky road ahead of itself. I think that there's going to be some more pain to come, but if you position yourself defensively enough, and I'm always positioned defensively with companies that pay out dividends so that I'm generating cash in the portfolio, collecting income, that I can then use as expenses or to buy stuff in periods like now, now is a good time I think, to nibble.

Karl (20m 28s):
And that's what I've been doing. I've just been buying a little bit at a time, not going all in on anything because the market could very well go down another 10, 15, 20% who knows there is a lot of negative sentiment out there. There are a lot of very challenging factors at play, whether it's Ukraine, inflation COVID anything. You know, one of these things by itself is a fairly significant challenge. All three of them at once. It's tough to be very positive about the next week, three months, so on and so forth. But a year from now five years from now, 10 years from now, I always quote Peter Maloof.

Karl (21m 12s):
Who's the CEO of creative planning. History has shown that a bull market has followed every bear market. So never bet against the stock market in the longterm is basically what I'm saying.

Phil (21m 25s):
Okay. Karl. So tell us more about American Dream Investing, your podcasts and your newsletters.

Karl (21m 30s):
Sure. American Dream Investing is something I founded with my late father and it was based on the trades that he was making within his own portfolio. So since he's passed, I've taken over the reins of the portfolio and we send out text message and email alerts. Whenever I make a trade within my own portfolio, I have skin in the game. I'm kind of revealing what's inside the portfolio to members and how I'm trading and why I'm trading the exact stocks, how much I'm buying of each one. And members can then use that to make their own decisions about the market, whether they want to buy the same stocks or use that to find a new idea.

Karl (22m 10s):
So that's one aspect. I wrote a book last year called "The Ultimate Profit Playbook", which is kind of like a step-by-step workbook that investors can use to analyze a stock using fundamental analysis. A lot of my dad's strategies, a lot of my strategies, some of Peter Lynch and Warren Buffet and a lot of the great investors of the time. It's basically what the process I take to find a good investment. And to, what I would research if I wanted to add it to my portfolio. And I wrote that last year, that's ultimate profit playbook. It's available on Amazon or ultimateprofitplaybook.com.

Karl (22m 52s):
And I'm approaching episode number 50 of my morning market minute podcast, where I talk about the market each day, what I think is happening and why some strategies, some great quotes, some humor I try and make things informative and entertaining for investors. And I'm writing on Twitter and LinkedIn every day.

Phil (23m 18s):
I know the content is great. I'm really enjoying reading your writings every day.

Karl (23m 22s):
Yeah, thanks. I'm just trying to enlighten as many people as possible with a unique spin on the markets.

Phil (23m 29s):
So how do people find you on Twitter? What's your handle?

Karl (23m 32s):
My handle is KarlKaufmanADI American Dream Investing, or you can just search for me on LinkedIn or look for Karl Kaufman Forbes. That should find the also

Phil (23m 43s):
Karl Kaufman. Thank you very much for joining me today.

Karl (23m 46s):
Thank you. Phil has been a pleasure.

Stocks for Beginners is for information and educational purposes only. It isn’t financial advice, and you shouldn’t buy or sell any investments based on what you’ve heard here. Any opinion or commentary is the view of the speaker only not Stocks for Beginners. This podcast doesn’t replace professional advice regarding your personal financial needs, circumstances or current situation.