OBSERVATIONS – (IN)EFFICIENT (IN)EFFICIENCY

Monday, October 23, 2006

Investor thinking in equity markets never ceases to amaze me. Believers in Efficient Market Theory - which says that the price of the stock at any time ‘reflects’ all the information pertaining to the stock - wax eloquent that the markets are efficient &, in the long run, it is next to impossible for a money manager to keep beating the general market. However, my observations of the markets for the short period that I have been observing them, makes me question the validity of that belief. (Reading Aid: In the title, you can have the ‘IN’ in parenthesis in only one of the words at a time.)

Prices fluctuate. That is a truism in the market. One of the reasons readily given for fluctuating prices is that opinions about a company’s future tend to keep varying & the price, at any time, supposedly reflects the collective opinions & expectations that the market has out of the company. I agree. However, I have not able to fathom as to why a company’s market value - as reflected by the stock price - has to vary wildly, sometimes in a very short period of time. Do expectations out of the company change so drastically that the markets vacillate between extreme optimism to extreme pessimism & to extreme optimism again within a short length of time? An example will aid this discussion. Given below is the price movement of a company, Amara Raja Batteries over the past 4 years. The company follows an April-March financial year. For further perspective, I have also included the yearend EPS (Earned Per Share) for each of the past 4 years. Comments follow the table.
TABLE 1
Year Ended Mar-06 (D) Mar-05 (C) Mar-04 (B) Mar-03 (A)

EPS (Rs)

21 Feb-06

8 Nov-04 124 46 May-04 142 52 169

1 Dec-03 105 48 Apr-03 120 55 119

7 Jun-02 102 47 Mar-03 116 54 (54)

Price (Rs) – High Price (Rs) – Low

278 92 Apr-05

Market Value (Rs Cr) – High Market Value (Rs Cr) – Low High/Low Difference %

317 105 202

Note: () in Column A signifies a drop. Reading Aid: The Price Low of Rs.47 was hit in Mar-03. Same holds for the other prices as well.

The above table is a good example of how Prices follow Earnings over the long run. However, it also illuminates the extremes of investor thinking in shorter time frames. Remember, stock prices reflect future expectations out of a company.
Comments on Column A (2002-2003)

At the end of financial year March 2003, Amara Raja Batteries did an EPS of Rs.7. The company was expected to experience a bad year in 2004 & promptly the price, which hit a high of Rs.102 in June 2002, dropped by more than 50% to hit a low of Rs.47 in Mar 03. This seems within the realm of rationality. What happened after this in 2004 is the first instruction.

Hemant Sreeraman

-1–

Hope…can’t substitute Reason

OBSERVATIONS – (IN)EFFICIENT (IN)EFFICIENCY
Comments on Column B (2003-2004)

Monday, October 23, 2006

The company, which was widely expected to do badly, vindicated the doom sayers & turned in an EPS of Rs.1, a drop of nearly 86%. However, the 2004 price low of Rs.48 was higher than the previous year low of Rs.47! When the EPS dropped 86% year-on-year, one would have expected the low to be lower than the previous years low. One could safely say that Amara Raja's stock in April 2003 at Rs.48 was overpriced in relation to the Earnings that were expected out of the company. What is even more startling is the fact that the stock quickly turned around to hit a yearly high of Rs.105 in Dec 03. At this price, it was valued at a cool 105 times the Earnings that it would post for year ended Mar 04! If Rs.47 was overpriced then what was Rs.105? Had expectations changed so drastically within 6 months that warranted a price change of 119%?
Comments on Column C (2004-2005)

The markets seem to adhere to Newton's 1st Law of Motion- Inertia. When the results were expected to be bad, the price moved up 119% & when the results were expected to be far better the next year, price dropped about 56%. This also illustrates the Rear-view mirror thinking that permeates the markets. A succession of good or bad results coerces investors to form over optimistic or over pessimistic expectations out of a company. It's the latter that provides the most wonderful opportunities for the long-term investor. However, after hitting the high of Rs.105 the markets realizing its stupidity promptly pummeled the stock to its 2004-2005 low of Rs.46. It’s worth observing that this low (year end EPS: Rs.8) was lower than the previous year low of Rs.48 (year end EPS: Rs.1). With the expectation of better numbers, one would have expected this year’s low to be higher than previous year’s low but…This is where a longterm investor, who could form an objective & realistic opinion about Amara Raja's long-term prospects could have made a killing. This is definitely easier said than done, however, forming an opinion about a company's long-term prospects is like having a bird's eye view of a target. The target is forever moving but a shooter knows exactly in which direction to fire. Admitted, he will not be able to hit bulls-eye with every hit, but he only needs a couple of perfect hits to get his prey. Investing works similarly. The low of Rs.46 in May 04 coincided with temporary stupidity that gripped the overall market. The market conked & so did the stock of Amara Raja Batteries. At Rs.46, given its favorable long-term prospects, the stock was underpriced. Eventually the company did an EPS of Rs.8 in 2004-2005. For a moment lets assume that an investor was able to 'see', say an EPS of only Rs.4 for 2004-2005 . When the company hit a high of Rs.102 in 2002-2003 its EPS was Rs.7 for that year, giving it a P/E multiple of around 15 (102/7). If the investor had assigned the same multiple to his EPS estimate of Rs.4, he was staring at a price of Rs.60 (15 x 4) for the stock. From the low of Rs.46, this was a potential gain of 30%. Not a bad return, is it? The markets had gone from extreme optimism (Rs.105) to extreme pessimism (Rs.46) in 5 months, taking the stock from overpriced to underpriced territory respectively. At the end of 2004-2005, the company did an EPS of Rs.8 & the price promptly followed to hit a high of Rs.124. This was a fat gain of 169%. At this price the stock was priced at a P/E multiple of about 15, which could be considered reasonable, given its good prospects. (Sanity does prevail! & an observant investor had made good money.)

Hemant Sreeraman

-2–

Hope…can’t substitute Reason

OBSERVATIONS – (IN)EFFICIENT (IN)EFFICIENCY
Comments on Column D (2005-2006)

Monday, October 23, 2006

By this time, the company was in for exciting times ahead. It was chosen as the exclusive supplier to Maruti's new offering, the Swift & also to Hyundai Motors. Car sales were growing at a healthy pace & one could see Maruti Swift's everywhere. Why then should the price drop by 26% from the high of Rs.124 to the yearly low of Rs.92? The company had managed to grow its Trailing Twelve Months (TTM) EPS in every quarter over the past 4 quarters. This represented another fantastic opportunity for an investor. At Rs.92, it was valued at a little less than 12 times its 2004-2005 EPS of Rs.8. The prospects were far better than what the company had seen in the past 4 years & inexplicably the markets were gifting the stock away at a throw away price. At this price the stock was underpriced & presented itself as an attractive investment opportunity. The company ended the year 2005-2006 with an EPS of Rs.21, which was a 163% jump over the last year’s EPS figure. I'm tempted to end this section with the last sentence but… Assume, once again, that an investor could 'see' an EPS of only Rs.10 for the full year (This was a good 50% less than the actual figure). This translates to a price of Rs.150 at a P/E multiple of 15. From Rs.92 there was a potential upside of 63%. Following the improved performance, the price promptly followed to hit a high of Rs.278, a gain of 202% from the yearly low! At this price, the stock was once again reasonably priced in relation to its Earnings.
Some final comments (on post-March 2006 performance)

The company continued to do well & increased its TTM EPS for another quarter running. June saw another bout of temporary stupidity gripping the market & this pummeled the stock to a low of Rs.148. This was a ridiculously low price given its vastly improved financial health & prospects. The extreme fear presented a fantastic opportunity to again buy the company’s stock. Lets play out the scenario one last time. Assume, conservatively, that the company would be able to increase its EPS by 20% in 2006-2007. This would result in an EPS of about Rs.25. Assigning, very conservatively again, a P/E multiple of only 10, gives a price for the stock of Rs.250. From the low of Rs.148, this represented a potential gain of 69%. An optimistic scenario (P/E multiple of 15 on the same EPS estimate of Rs.25) gives a price of Rs.375, a gain of 153%! As of this writing, the price is Rs.420. I leave you to calculate the gain... The above discussion presents some key aspects of market behavior. In the long run, a company’s stock price is a slave of the Earnings. If the Earnings trend is up, that is the direction the stock price will head. The mostly inexplicable short-term extremes highlight irrational human thinking. What defines a ‘high’ & a ‘low’ price is an abstract question, the answer to which lies hidden within a load of information. However, even during these moments there are some rational guys who make a fortune by relying on their conviction & observation. As we saw, the shorter the time frame, the more volatile is human thinking. This makes me also posit the validity of a belief of Quantum Mechanics - that says that the more restricted you make a set of electrons, the wilder they get in their vibration - in the stock markets. The violent price movements in shorter time frames, also brings to the fore the myopic nature of the markets. It’s akin to a biker driving with his sights fixed on the ground just 3 meters from the front wheel. At times he lauds
Hemant Sreeraman -3– Hope…can’t substitute Reason

OBSERVATIONS – (IN)EFFICIENT (IN)EFFICIENCY

Monday, October 23, 2006

himself for having deftly handled a bump on the road but after encountering 20 more bumps he changes roads, concluding that the road is bad. However, by his action, he forgoes the comfortable drive that would have awaited him just a kilometer away, if only he had been patient! Conversely, he blissfully continues driving on when there are no bumps on the road. The more he drives without encountering a bump, the more he thinks that the road ahead would be a smooth one. However, at times, the unfortunate end to his drive is a cliff that is a kilometer away! I can’t bring myself to accept the infallible belief of markets being efficient all the time, in the face of evidence such as that presented above. The markets seem to be only partially efficient (else nobody could make money!). Unswervingly, prices gyrate between crests & troughs of madness & anxiety. The latter provides some of the best opportunities for investment, while the former serves as a good checkpoint to review the expectations that the markets seem to have built up from the company. If prevailing prices show that the expectations seem to be hinged on the near impossible, one should at least think about exiting at the stratospheric levels. Although one should abhor unreasonable levels when contemplating investment, one should welcome the same levels when contemplating selling! The questions, “Does the current price reflect, reasonably, the current financial status of a company?” &, “Given the prospects, does the current price offer scope for a reasonable return over a period?” will forever enthrall me. The answers to these very simple questions are often very elusive & difficult to answer, but that should not act as an obstacle to attempt finding an answer. Also, a few perfect hits are all that is needed to make a good investment. Patience is a huge positive in this game, both when buying & selling. The markets may give you a chance to make your investment at your levels but at times there is a risk of one perennially waiting for ‘that’ level. I leave you with a paraphrase of the above essay…
The markets are efficiently inefficient enough to allow one to buy small parts of fine businesses; & also inefficiently efficient enough to ensure that such an investment made generates a reasonable return for the patient & observant investor!

I wish you all a very happy & prosperous (in more ways than one!) Diwali & New Year!

Hemant Sreeraman

-4–

Hope…can’t substitute Reason