The Buckingham Report

Please note that a version of this article first appeared in Financial Week, October 8, 2007.

Let's say that you paid $7 back in early 2003 for each of a thousand shares of a struggling Cupertino-based personal computer and consumer electronics company that was trading at a fire-sale price based on classic financial fundamental valuation metrics, while also sporting a pristine balance sheet loaded with more than $6 per share in cash and boasting a product line that included the soon-to-be-wildly-popular iPod portable music player. Obviously, given that Apple Computer trades for more than $175 as of this writing, you would likely be pretty happy that your value-priced initial investment had grown more than twenty-fold in less than five years!

Of course, imagine if you were a typical mutual fund manager who is usually forced to adhere to value/growth or small-/mid-/large-capitalization investment parameters, lest he or she be accused of being undisciplined and guilty of 'style drift' or 'category creep'. Because Apple was decidedly in the mid-cap camp four years ago, a small- or a large-cap manager might not have been able even to consider its purchase.

Assuming he or she actually was 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 at $15 because 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, rather than on arbitrary constraints?

We've never understood the investment industry’s willingness to be boxed in, though we recognize that in the minds of pension fund consultants and their clients, as well as many academic types, style boxes facilitate asset allocation and, in theory, provide a sense of security that risk is being controlled. Of course, we would assert that style boxes are more likely to eliminate alpha (the excess return of a fund relative to the return of the benchmark index) as we believe that limiting investment possibilities by market-capitalization or traditional value-versus-growth distinctions has a better chance of limiting upside than boosting return.

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. It doesn’t stay in one place forever. So if we cut ourselves off from part of the investing universe, sooner or later we’ll be cutting ourselves off from wherever value is currently residing.

Interestingly, on October 16, 2007, AdvisorPerspectives.com conducted an interview with William F. Sharpe whom they describe as "a Professor of Finance, Emeritus at Stanford University’s Graduate School of Business. He was one of the originators of the Capital Asset Pricing Model, developed the Sharpe Ratio for investment performance analysis, the binomial method for the valuation of options, the gradient method for asset allocation optimization, and returns-based style analysis for evaluating the style and performance of investment funds. In 1990 he received the Nobel Prize in Economic Sciences."

One of the questions asked by AdvisorPerspectives.com dealt with the subject of free-range investing:

Q: A number of studies have asserted that index-hugging active fund managers deliver inferior returns, and that superior managers can be identified – in part – by looking for those that have the flexibility to select investments from the broadest possible universe. Do you agree with this proposition? If so, what implications does this have for the mutual fund industry, with its almost universal adherence to style box categorization?

A: I agree with the proposition. To find superior managers, you must look for those with some degree of flexibility. But, in doing so, you will undoubtedly find some managers that are inferior. To beat an index you can’t be too close to it, but that is not a guarantee that you will succeed. Whether managers should get a broader mandate depends on their knowledge of the markets. If a manager is hired, for example, to manage large cap growth stocks, and that is the manager’s realm of expertise, you don’t want that manager deviating from this charter. There is a limit to the amount of information a manager can gather and process. Technology helps in this respect, as does ‘feet on the ground’ (e.g., visiting companies and speaking with management). The implications for the mutual fund industry are straightforward. If you believe that you are superior in evaluating companies with certain characteristics you should concentrate on such companies. If your superiority is great enough to overcome the added costs, investors should consider putting at least some – but by no means all -- of their money in your fund.

And speaking of evaluating companies with certain characteristics, we do think investors should have a strong bias toward classical value investing as the overwhelming weight of the historical evidence strongly favors stocks that are trading for lower price-to-earnings (P/E), price-to-sales (P/S) and price-to-book value (P/BV) ratios. Consider that Morningstar is showing that the professional finance duo Eugene Fama and Kenneth French have calculated a return of 12.9% per annum for Value stocks versus 9.3% per annum for Growth stocks over the period 1927 – 2006 with P/BV (lower = Value; higher = Growth) the distinguishing factor. More recently, Morningstar shows the team determined that Large-Cap Value (12.0% per annum) beat Large-Cap Growth (9.1% per annum) over the eight decades spanning 1927-2006. The same story held for Small-Cap Value (14.8% per annum) versus Small-Cap Growth (9.6% per annum).

Likewise, James O’Shaughnessy performed an extensive analysis comparing stocks with the highest and lowest P/E and P/S ratios. In an updated edition of his investment tome, What Works on Wall Street, O’Shaughnessy found that over the period spanning 1963-2005, high P/E stocks returned only 6.9% per annum, compared to 15.0% per annum for a low P/E grouping. The differences were even more striking when looking at the price-to-sales metric, as his analyses of stocks with low-P/S ratios saw an annualized rate of return of 15.6% versus an annualized loss of 2.6% for stocks with high ratios.

For those willing to give free-range investing a try, consider that recently (as of October 19, 2007) more than half (88) of the stocks on the recommended list of our investment newsletter, The Prudent Speculator, fell into the Value category according to calculations made by Morningstar. Of course, that doesn’t mean that one shouldn’t also consider stocks that fall into the Growth category as long as they are attractively priced. And many undervalued stocks actually have both Value and Growth characteristics. Looking at market capitalization, Morningstar calculates that the lion’s share of The Prudent Speculator’s recommended stocks are small cap, even as 27 undervalued names fall into the mid-cap arena and 35 land in the large-cap space.

 
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Liberating one’s investment strategy with a style-agnostic mindset allows a manager to go forth and seek bargains wherever they may hide. If small-cap stocks have had a great run, it’s time to start looking at mid- and large-cap companies. If a $1 billion Internet stock with a cash-rich balance sheet is inexpensive, there should be no anti-tech bias that’s going to preclude buying it. If a $160 billion pharmaceutical behemoth with a single-digit P/E is on sale, that’s OK to buy as well. Bargains are bargains (ticker symbols for 18 of our current favorites are detailed below), and a fund manager should be able to freely take advantage of them!

 
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