In a move that shocked millions of investors, Morgan Stanley (NYSE: MS) told clients on the morning of July 7 that media darling Shake Shack Inc. (NYSE: SHAK) was too expensive and offered "brand related optimism that is not supported by fundamentals."
The firm then went on to point out that the company's fundamentals did not merit such an expensive valuation, that it was illiquid, and that investors had become "over-exuberant."
I couldn't agree more.
In fact, I told you as much on May 29 - a full five weeks earlier than Morgan Stanley's "Johnny come lately" report.
How did I know?
It certainly wasn't because of the headlines. Here's just a few that were making the rounds at the time:
... Three Reasons the Shorts on Shake Shack Are Wrong - The Street
... Is Shake Shack the New Chipotle? - Yahoo! Finance
... Why Shake Shack Needs Chicken to Justify the $3 Billion Value - The Wall Street Journal
It's no wonder millions of investors fell for the pie-in-the-sky thinking. Moreover, the willful ignorance among analysts and seasoned observers who should have known better was astonishing.
For me, the need for a Shake Shack shakeout all came down to one number.
Shake Shack's Collapse Was Foretold by One Number
A glance at the company's page on Yahoo! Finance would have told even the most casual observer that the company was dangerously overvalued, with a P/E ratio well above 1,200. To put that in perspective, that means the stock was priced at a level that would have required investors to wait 1,200 years to make money back on Shake Shack at the company's earnings rate.
By contrast, the S&P 500 carried a P/E ratio of barely 15, meaning that not only were there far better deals for investors out there, but also that the stock was an insane outlier when it came to its valuation.
Of course, at some level the stock's trajectory tells us far less about Shake Shack than it does about the actors who fueled the artificial bull market. Before May 22, Shake Shack could do no wrong in the eyes of most analysts and financial publications.
The illusion was shattered shortly thereafter.
Source: Yahoo! Finance
There are two key lessons here...
Shakeout Moral No. 1: Wall Street Is Never First in the Water
Millions of investors look to Wall Street analysis with the implicit understanding that it's forward-looking. In reality, they're almost never first to the party.
Ten out of 15 analysts following Enron still rated the company a "Buy" or a "Strong Buy" as late as Nov. 8, 2001, three weeks after The Wall Street Journal reported thecompany's hidden losses, two weeks after the U.S. Securities and Exchange Commission announced its investigation into the company's financials, and months after a single independent analyst working for Off Wall Street Consulting Group first rang the alarm bell on May 6, 2001.
In that sense, Morgan Stanley's comically late acknowledgment of reality is emblematic of a perpetuation of delusion by Wall Street that's very deliberate. There's a definitive bias towards "Buy" ratings.
That's because much of Wall Street has already made its money when a stock goes public by taking advantage of the insider dynamics driving modern IPOs. Morgan Stanley should know... it was one of the firms that helped bring Shake Shack stock to the public in the first place.
Further, it's not uncommon for Wall Street firms to talk their own book - meaning that they are seeking to sway public opinion in such a way that their own predictions become self-fulling prophecies, and profitable ones at that.
More egregiously, they'll also talk against their own book, seeking to take advantage of blindsided investors by shorting whatever stock they're buying, or vice versa, as was the case with Goldman Sachs, which has been identified more than once as trading against clients or counter to their stated public positions.
H.J. Heinz Co. (NYSE: HNZ) stands out as a prime example of what I am talking about.
The firm advised clients to sell Heinz based on risks of top-line disappointment in a Feb. 10, 2013, research note...
...yet decided to invest heavily ahead of a rumored investment by none other than Warren Buffett, reportedly booking at least 20% profits on the proprietary trading desk, according to Business Insider.
Shakeout Moral No. 2: Analysts Are Great at Stating the Obvious, but Not Much More
I don't want to come across as being too hard on analysts, dozens of whom I've come to know and respect during the course of my career. Most are extremely intelligent and very likable people.
It's the way Wall Street forces them to practice their craft that I have a problem with.
By definition, Wall Street analysts are reactionary. They're always looking in the rearview mirror at numbers that are little more than signposts as to where a company has been rather than where it's going.
That's the single biggest reason why analysts make terrible stock pickers.
In the summer of 2011, for example, analysts correctly pointed out that the $600 billion in defense cuts Washington was imposing on America's economy would create severe headwinds for defense contractors. But they failed to identify the immense opportunity that the slump would create for defense contractors like Raytheon Co. (NYSE: RTN), which provides the alternative weapons systems that would prove very profitable as the nature of warfare changed.
Then, in the spring of 2012, analysts were largely silent on the profit potential presented by the demographics revolution that was unfolding as the world's population passed a critical aging milestone, so they certainly weren't going to be the ones to guide readers to 99% profits from Becton, Dickinson & Co. (NYSE: BDX) like we did in the Money Map Report.
More recently, it's taken analysts months longer to catch onto Ekso Bionics Holding's (OTCBB: EKSO) growth potential. Anybody who waited for Wall Street missed out on the opportunity to capture 100% returns within six weeks of my initial recommendation or double-digit profits today.
Speaking of which, let's talk about what's next for shares of Shake Shack before we wind up our time together today.
I think the company is worth $20 a share... at best.
That means the stock could fall another 60% from where it's trading today on top of the 43% it's already shed since I initially brought it to your attention.
Am I right?
That's always hard to say, but I think it's very telling that Goldman Sachs, Morgan Stanley, and Stifel now publicly agree with me that it's a "Sell."
Want fries with that?
Editor's Note: SHAK suffered a decline of more than 40% in the six weeks after Keith explained why it was a bad investment... but there's too much at stake to gloat. Investors get burned by bad IPO deals and Wall Street hype all the time, which is a major reason Keith started his Total Wealth newsletter to help level the investing playing field for you. In addition to his insights against Wall Street's machinations, he'll also lay out his system relying on six Unstoppable Trends to outperform the markets - which already powered one little robot company to 100% gains within weeks of his recommending it. For a full and free report, including ticker symbol, sign up for Total Wealth here - free of charge!