A round of applause for style drift

Let's say you paid $7 each back in early 2003 for 1,000 shares of a struggling Cupertino, Calif.-based personal-computer and consumer electronics company that was trading at a fire sale price based on a classic fundamental- valuation metric. Meanwhile, it was sporting a pristine balance sheet loaded with more than $6 a share in cash and boasting a product line that included the soon-to-be wildly popular iPod portable music player. Obviously, given that Apple Inc. trades for more than $165 as of this writing, you would likely be pretty happy that your value-priced initial investment had grown more than fifteenfold in just four years. But what if you were a typical mutual fund manager — one forced to adhere to either value or growth, or small-, mid- or large-cap, investment parameters, lest you be accused of style drift or category creep. Since Apple was a decidedly mid-cap stock four years ago, a small- or a large-cap manager might not even have been able to consider its purchase. Assuming they actually were able to pull the trigger on a buy, a mid-cap manager might have had to let go of the shares on the way up, because at $15 a share, the market capitalization was then more than $10 billion; similarly, a value manager might have had to sell the stock at $30 because the price-to-sales ratio was too high. Never mind that Apple still offered excellent appreciation potential. Wouldn't it be nice to have the freedom to base investment decisions on the merits of the individual stock? Yes, the investment industry fears that style drift can foul up a retirement plan's asset allocation choices and thereby violate rules of the Employee Retirement Income Security Act, creating potential liability for plan fiduciaries. But the problem is manageable. In fact, some of us have never understood the industry's willingness to be boxed in. It is our contention that limiting our investment possibilities by market cap or traditional value versus growth distinctions serves only to limit our returns. And the importance of being flexible is magnified by our long-term approach. After all, the more time that goes by, the more likely it is that opportunity is going to pull up stakes and head for new territory. So if we cut ourselves off from part of the investing universe, sooner or later, we will cut ourselves off from wherever value is residing. Certainly, those of our ilk have always had a strong bias toward classical value investing, as the overwhelming weight of the historical evidence strongly favors stocks that trade at lower price-earnings, price-to-sales and price-to-book-value ratios. Consider that back in 2005, Morningstar Inc. of Chicago calculated that value stocks returned 12.5% a year, compared with 9% for growth stocks, over the period 1927 to 2004, based on price to book value, with value stocks having lower ratios and growth stocks higher ones. More recently, Morningstar de-termined that large-cap-value stocks returned 12.0% a year, compared with 9.1% for large-cap growth, from 1927 to 2006. The same story held for small-cap value, returning 14.8% a year, versus 9.6% for small-cap growth. Likewise, author James O'Shaugh- --n--essy performed an extensive comparison of stocks with the highest and lowest p/e and price-to-sales ratios in his book, "What Works on Wall Street" (McGraw-Hill, 1998). In an updated edition, he found that from 1963 to 2005, high-p/e stocks re-turned just 6.9% a year, compared with 15% for a low-p/e grouping. The differences were even more striking when taking into account price-to-sales ratios. According to his analysis, low-p/s stocks returned an annualized 15.6%, versus 2.6% for the high-p/s cohort. Not surprisingly, more than half of the stocks we currently like fall into the value category, according to calculations made by Morningstar. We also aren't shy about recommending growth stocks, as long as we think that they are undervalued, according to our analyses. And many stocks we find to be inexpensive have both value and growth characteristics. Looking at market cap, Morningstar calculates that the lion's share of our recommended stocks are small-cap, even as we have 30 undervalued names in the mid-cap arena, and 31 large-caps. Liberating oneself with a style-agnostic mind-set enables one to go forth and seek bargains wherever they may hide. If small-cap stocks have had a great run, it is time to start looking at mid- and large-cap companies. If a $900 million Internet stock with a cash-rich balance sheet is inexpensive, one should have no anti-tech bias that is going to preclude one from buying it. If a $225 billion financial behemoth with a single-digit p/e is on sale, we say buy it. Wouldn't you? John Buckingham is chief executive and chief investment officer of Al Frank Asset Management Inc. in Laguna Beach, Calif.