Apple, Analysts and the Perils of Prediction
Apple's first-quarter earnings were blow-out numbers. Far beyond what anyone forecast, the figures show Apple arguably had the single-greatest quarterly performance in U.S. corporate history.
A quick overview: Apple’s net profit of $18 billion is an astonishing gain of 38 percent over the already-huge $13.1 billion in the same quarter last year. (So much for the law of large numbers.) Earnings per share rose 48 percent on revenue of $74.6 billion, up a staggering 30 percent.
How did Apple rack up such gigantic sales numbers? It begins with the company’s flagship product, the iPhone. It sold an astonishing 74.5 million of them in the quarter, a gain of 46 percent from the same quarter a year earlier. What's more, the phones sold for an average of $687. (The Wall Street Journal calculated that Apple sold 34,000 phones an hour, 24/7.)
Revenue in China rose 70 percent to $16.1 billion, making it Apple’s third-largest market by sales, after the U.S. and Europe. In the near future, China will probably overtake Europe as Apple’s second-biggest market. At the risk of extrapolating to infinity, it isn't hard to imagine the day when China also surpasses the U.S. as Apple’s biggest market.
The rest of the numbers were, by all accounts, stupendous, enormous, mind-blowing, record-breaking. Yet it seems analysts were, once again, blindsided by the data.
How is it even remotely possible that Wall Street analysts have no idea what the biggest company in the world is doing?
The answer is complex, involving many elements in the quarterly earnings dance. Management, for example, has gotten adept at tamping down expectations. The desire to feather their own nests by helping colleagues -- bank underwriters and loan syndicators -- win business also leads analysts to be overly optimistic about the companies they cover. We know this because, in surveys, analysts say their compensation should be based more on their ability to generate business than on the accuracy or timeliness of their earnings forecasts. They've got their priorities mixed up.
Why so? Many factors lead to the (pardon the pun) standard deviation: First, let’s recall the bullish bias inherent in all analyst coverage. A 2010 study by McKinsey showed that “Analysts have been persistently over-optimistic for the past 25 years, with [earnings] estimates ranging from 10 to 12 percent a year, compared with actual earnings growth of 6 percent. ... On average, analysts’ forecasts have been almost 100 percent too high.”
Worse, the only time analysts aren't too bullish is during recessions, and typically right before a major market reversal. That means they are bearish precisely (and exclusively) when you want them to be bullish.
Despite the bullish bias and misplaced priorities, how did they miss Apple’s success this quarter? The news media reported long lines at Apple's U.S. stores, with people camping out for days to get the new iPhone 6 and 6 Plus. The China story was also well known, with Apple a few quarters ago cutting deals with the biggest Chinese telecom providers.
There are many reasons. I have been saying for a decade that most of Wall Street never really “got” Apple (that’s my pre-existing narrative). Perhaps that plays a role here. Call it the power of story. Once an analyst -- or reporter or media pundit -- locks in a narrative, it's hard to break. That confirmation bias may prevent analysts from looking objectively at a company. Instead of observing changing facts, people selectively ignore them to maintain the integrity of their now-disproven thesis.
In 1957, social psychologist Leon Festinger described what happens when people are confronted by new information that conflicts with their existing beliefs, and called it “cognitive dissonance.” Traders and investors might prefer the way technical analyst Ned Davis reduced it to its most important element: “Would you rather be right or make money?”
Have a look at some of these recent claims, from analysts and pundits alike, that seem to be wholly unconcerned with making money:
• iPhone 6 shunned by fanbois in Apple's GREAT FAIL of CHINA (Oct. 17, 2014)
• Is the iPhone 6 a Flop? (Sept. 29, 2014)
• "Bendgate", iOS 8.0.1 Flop Mask More Critical iPhone 6 Shortcomings (Oct. 2, 2014)
Perhaps this claim from John C. Dvorak deserves special mention as the wrongest of all time:
• Apple Should Pull the Plug on the iPhone (March 2007)
If you enjoy this sort of schadenfreude, then head over to this longer list of awful iPhone predictions at Mac Daily News.
My friend, Leigh Drogan, is the founder of Estimize, which crowd sources earnings estimates. It reflects a wider spectrum of information by relying on observations beyond Wall Street analysts'. Perhaps that’s why it is more accurate than the Wall Street consensus most of the time.
While the analyst scandal in the early 2000s revealed that analysts were subject to inherent conflicts of interest, it was almost beside the point. More important, analysts simply aren't that good at predicting the future of corporate earnings.
This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.
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