Action in Palm Stock Highlights Why Analyst Recommendations Continually Fail Investors

In recent months it would have been difficult to find a stock that Wall Street analysts were more pessimistic about than struggling smart-phone maker Palm (PALM). According to Thomson/First Call, 23 analysts follow the stock, 10 have sell ratings, and only 2 have buy ratings (the rest were neutral). In a world where brokerage firms make money by getting people to buy stocks, such negative sentiment is rare.

As a contrarian, I had actually been accumulating shares of Palm throughout 2008 in some client accounts, as hints of a possible recovery in the company’s business began to appear. Most notably, the combination of a sizable equity investment from private equity firm Elevation Partners (run by Roger McNamee, a man I have great respect for) and the hiring a former research and development star from Apple (Jon Rubenstein).

In recent months Palm had explained to investors that they were revamping their software platform and with the help of Rubenstein and McNamee were set to launch a new set of innovative products in 2009. Given how short-sighted Wall Street is, Palm shares struggled as the iPhone and new Blackberry products came to market. Wall Street analysts were negative on Palm because they claimed Apple and Research in Motion were way ahead of them in terms of products and market share. The stock actually reached a low of $1.14 per share in December, down from $4.00 just a month earlier.

The reason I was interested in the stock was not because I disagreed with the analysts’ assumptions (I too expect Apple and RIM to have higher market share than Palm), but rather because they were ignoring the fact that the global cell phone market is over 1.2 billion units. Palm could lag Apple and RIM and still collect 5% or 10% of the worldwide market, which would translate into tens of millions of units and perhaps several billion dollars of revenue. The idea that Palm had to beat out Apple and RIM to stay in business (some analysts are projecting Palm will file bankruptcy) seemed off the mark to me.

Sell side analysts generally recommend stocks based on what is known, not what could happen in the future. Even though the public knew a successful R&D guy from Apple was now heading up Palm and was slated to introduce a brand new operating system and product lineup in 2009, since the facts at the time were that Apple and RIM were crushing Palm, practically nobody on the Street liked the stock. At a buck or two though, Wall Street was pricing Palm shares based on the worst case scenario, so the risk-reward trade-off highly favored going long the stock, not betting against it.

Last month Elevation Partners increased their equity investment in Palm from $325 million to $425 million, obviously approving of the company’s plan. Yesterday at the Consumer Electronics Show (CES) in Las Vegas Palm unveiled its new operating system and a model of the Palm Pre, the first of its next generation smart-phone products schedule to be released by Sprint in the U.S. sometime during the first half of this year. Palm stock soared 35% on Thursday and is up another 30% today to about $6, bringing its total gain since the December low of $1.14 to more than 400%.

Today analysts are more optimistic (I even saw at least one upgrade) based on the promise of the new operating system and Palm Pre product. Once again, the sell side has waited until the news is out and already priced into the stock (it’s already gone from $1 to $6 in the last month) to become more optimistic on Palm’s prospects. Therein lies the inherent flaw in most brokerage firm research; they base their recommendations on announcements that the market adjusts for immediately, thereby ensuring what they have to say has little or no added value by the time clients read it.

Now, you may insist that an analyst should not blindly assume that a new product being worked on will turn out to be good, so recommending Palm before knowing what the Pre phone looks like would not have been wise. I cannot argue with that, so maintaining a hold rating until seeing the new products is completely understandable if you did not want to put your neck out.

What I cannot understand is a sell rating on a company whose stock price is implying bankruptcy even though the company is getting private equity investments and you know that a highly respected former Apple exec has been leading a new R&D team for over a year. Are we supposed to act surprised that the Palm Pre looks promising? You may not have wanted to bet on it sight unseen, which is fine, but you can’t say that what Palm introduced yesterday was surprising given what we already knew was happening over there.

As usual, Wall Street hated the stock at $1, $2, or $3 but likes it a lot more at $6. Now you know why I like to be a contrarian.

Full Disclosure: Peridot was long Palm shares at the time of writing but positions may change at any time

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3 Thoughts on “Action in Palm Stock Highlights Why Analyst Recommendations Continually Fail Investors

  1. hey chad, great blog re-design, looks sharp.

    congrats on the palm play, definitely a contrarian payoff there. curious as to your thoughts going forward. sprint isn’t exactly in the best shape and they’ve tied their horse to that barn for the first 6 months or so until they can release a version that works with at&t and t-mobile.

    i’ll wait to see the first set of sales #s, but i guess i’d be worried that they are a “1 trick pony” now and have it all riding on this after burning through cash over the past year prepping for this release. i’ll have to go back and read any of your past posts on palm.

  2. Chad Brand on January 12, 2009 at 8:29 AM said:

    I am not as disappointed with the Sprint choice as many in the financial/tech media are. With AT&T having iPhone and Verizon working closely with RIMM, I don’t think either one of those two companies would have a strong incentive to really push the Palm Pre at retail.

    Sprint, on the other hand, is struggling so they could really benefit from a Palm revival. And although Sprint is #3 in subscribers behind T and RIMM, it is not like they are small by any means (they still have 50 million subs) so getting 5 or 10 percent of Sprint subs using Palm products would have a big impact on Palm’s future results.

    Gauging the stock is a tougher call given that margins are hard to predict. At this point, I don’t see why Palm couldn’t get to the low double digits, but I am not expecting anything like an AAPL or RIMM ascent in stock price.

  3. I wouldn’t rush counting on Palm just as I don’t rush congratulating Chad (sorry, Chad :-))

    The verdict is still out on how the Pre and WebOS are going to work out for PALM…and the last few days of excitement could turn out to be as emotional and baseless as the sell recommendation during former Apple CEO commandership and private investment going on at the company.

    I wish them luck, but after all the failures they’ve had lately *and* the changed market landscape, I’d say with PALM you better be safe than sorry.

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