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 year-
end 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 8 1 7

Feb-06 Nov-04 Dec-03 Jun-02

Price (Rs) – High 278 124 105 102
Price (Rs) – Low 92 46 48 47
Apr-05 May-04 Apr-03 Mar-03

Market Value (Rs Cr) – High 317 142 120 116

Market Value (Rs Cr) – Low 105 52 55 54

High/Low Difference % 202 169 119 (54)

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 Monday, October 23, 2006

Comments on Column B (2003-2004)

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 long-
term 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 Monday, October 23, 2006

Comments on Column D (2005-2006)

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