Insights into Market Efficiency

Author : Harish Srigiriraju, MBA Capital Markets

 "I'd be a bum on the street with a tin cup if the markets were always efficient." – Warren Buffet

Efficient market hypothesis (EMH) formulated by Eugene Fama in 1970, suggests that at any given time, prices fully reflect all available information on a particular stock and/or market. This implies that the stocks always trade at their fair price or its intrinsic value. Now if this were true then does it make sense in investing in stocks?

If this hypothesis is true then generating excess returns would not be possible. All investors will perceive a stock in the same fashion as it is assumed that all investors are fully aware of all the information on that stock. There would be no need of performing valuation of companies or identifying undervalued stocks. It would not be possible for Warren Buffett to beat the market over several years.

Now it is clear that the markets are not always efficient but in few instances they are. It is generally accepted by value investors that markets are efficient in the long run. So the next question to ask is how long is long? Value Investors look for undervalued stocks in view that they will reach their true value at some point in time. This may vary from stock to stock. A particular stock may reach its value within one year while the other may take ten years. Now the time frame is important as our return depends on this ultimately. So how to identify stocks which will reach its potential quickly? A stock whose information is available to greater set of people will have quicker chances of reaching its fair value. Consider two stocks RIL and KCP(Assumption here is that they are undervalued) . RIL is a stock which will be followed by a large number when compared to KCP. Now if RIL is undervalued there will be many who will invest in this which will lead to price appreciation. For KCP there will be few who track this and hence may take more amount of time to reach the fair value. There definitely will be exceptions to this. So for the value investors out there it should be a learning that just investing in undervalued stocks will not suffice.  

It can be conveniently assumed that Large Cap stocks are more followed than Small Cap. If a stock makes its way in the Sensex 30 or Nifty 50 then all the more attention will be given due to the index funds coming into picture. So if an investor is able to identify stocks in them then it can be called a safe bet. Probably this is one of the reasons why Warren Buffet prefers to invest in bigger companies.

So how can we measure market efficiency for a market say in India. Is it possible to quantify it? One way to do it would be calculate the fair value of each and every stock in the Indian market. Then measure the standard deviation with respect to the CMP. Also as mentioned earlier the stocks would then need to be classified on basis of flow of Information and then efficiency for each category would have to be calculated separately. Even if we were to achieve this the biggest critique would be how will you arrive at a fair value of a company? Is it not a perception and hence will vary? There is no standard method to calculate the fair value of a stock. In most of the research shortcuts are used to avoid hard work. So I can do something similar here. What can be done is ,take the 30 stocks in Sensex. Calculate their fair value in 2000 based on the cash flows from 2000-2005. Here we use 2 stage DCF model as it is the best available tool for valuation. An alternative can be Market multiples but it wouldn’t make sense as the whole idea is to measure inefficiency and in Market Multiples you assume markets to be efficient.

Based on the fair values obtained, the standard deviation can be calculated with respect to the prices in 2000. Similar methodology can be done in 2006. The resultant standard deviation now can be used as a measure to compare efficiency in 2000 and 2006. This can be used in the current scenario also, however the fair value would need to be calculated on the growth estimates from 2011 and this may not be accurate. The values and the results will be presented to you in our next quarterly edition.

This study will be based on the inference that the CMP are the fair values of stocks. However the EMH was mainly focused on the flow of information and not on valuations. To study this, the market needs to be observed for flow of information in various instances like,

1)      Stock Splits

2)      Mergers and Acquisition

3)      Yearly or Quarterly results

4)      Scams

5)      Macro Economic changes

6)      Changes in capital structures

7)      Buyback

8)      Dividend Announcements

Unit root test, Co-integration Test, variance ratio tests, autocorrelation test and few other tests are generally used to test the EMH. For a week form, a study is carried out whether the CMP are a reflection of the previous prices. For a semi strong, a study is done to measure the speed at which a particular piece of information affects the stock price. For a strong form, a study can be done to check if any mutual funds, investment funds or individual investors have generated above average returns over the years. So is a study required for a strong form? Can we straight away say that the markets do not have a strong form of efficiency because there are people like Warren Buffet and Rakesh Jhunjunwala? Can we say that there is no strong form as there are scams like in case of Satyam where investors did not have the accurate information? The answer to these is “yes”. There is only weak and semi strong form. This will again depend on the information flow, media, investors and ultimately the rationality of investors.

So why is it taught in many places that the markets are efficient? It should be taught no doubt but it should be also taught why this theory fails many a times but no doubt holds true in the long term. Flow of information is something which each one should learn as there will be opportunities to make money. In the previous edition of Investocraft, if you have read the article Takeover Arbitrage, we have seen how there is an arbitrage opportunity due to lack of information equally among all investors. "Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn't do any good to look at the cards. It has been helpful to me to have tens of thousands (of students) turned out of business schools taught that it didn't do any good to think."-Warren Buffet. The point Warren Buffett is making is true. Phew! At least the competition is reduced if you know what Buffett and I mean.