The fund world's comeback kids

Dozens of US stock funds, some run by well-known managers, are back on top after ending 2008 in the cellar. Here's how some of the best recovered.

As comebacks go, it may not be as dramatic as the Boston Red Sox in the 2004 playoffs or Harry Truman in the 1948 presidential campaign. But many mutual fund managers who ended last year in the dumps now find themselves leading the pack.

Ninety-four diversified U.S.-stock funds that finished 2008 in the bottom 10% of their peers ended the first half of 2009 in the upper 25% of their categories, according to researcher Morningstar.

Some highly respected managers belong to this group, including Harry Lange of Fidelity Magellan Fund (FMAGX), Bill Miller of Legg Mason Value Trust (LGVAX), David Decker of Janus Contrarian Fund (JSVAX) and the teams at Dodge & Cox Stock Fund (DODGX) and Longleaf Partners Fund (LLPFX) .

These portfolios and others like them lost 40% or more in last year's market meltdown. But some badly beaten stocks have been on the mend since mid-March, enabling the funds that own them to outpace the benchmark Standard & Poor's 500 Index ($INX) this year.

The funds' spectacular wreck and road to recovery mirror investors' panic and relief. Moreover, they underscore the challenges of siding with managers who stick to their guns -- or simply stumble -- in tough times.

"The best managers are unemotional, logical thinkers who invest with conviction," says Russel Kinnel, Morningstar's director of mutual fund research. They may have stock and sector weightings that are very different from those of market benchmarks like the S&P 500. "When things are going well, that conviction and ability to think beyond the current market looks brilliant. But even the best investors make significant mistakes," Kinnel says.

Misjudging the crisis

Some of those mistakes can be costly, as was the case last year with some "value" buyers, who favor bargains and dividends. As stocks fell heading into 2008, many of these managers saw shares of companies they perceived as strong and stable trading at what appeared to be fire-sale prices. They bought into banks and brokerage firms, technology companies and energy producers, betting the economy wouldn't scar brand-name leaders.

"They misjudged the depth of the financial crisis and the recession," says Mark Salzinger, editor of The No-Load Fund Investor newsletter. "Stocks with a lot of leverage were hurt very badly (as) credit markets seized up."

As prices fell, many managers stayed the course -- and bought more shares. The results were devastating.

"They're not thinking, 'How can I produce performance for the next three months?'" says Morningstar's Kinnel. "They're thinking, 'How can I grow this portfolio over 10 years?'"

Many shareholders didn't wait to find out. They rushed the exits when stocks went over the cliff, taking funds with them.

Road to recovery

Not everyone has the patience and long-term focus to stick with an independent-minded fund manager. But sometimes the point at which investors are ready to throw in the towel is just the time they should hang on. The challenge, of course, is figuring out if a fund's slump -- or rebound -- is temporary or likely to last.

For many of the fund managers on the comeback trail, the same discipline that landed them in hot water last year is aiding their revival this year, as investors have become more comfortable with riskier, economically sensitive plays.

"It's partly a cyclical and leveraged rebound," says Kinnel. "People decided the economy is in bad shape, but it's not going to keep getting worse forever. Maybe a lot of these businesses will do OK."

Exposure to non-U.S. companies has also helped performance because international stocks, particularly those in Asia, Latin America and other emerging markets, have come back stronger than their U.S. counterparts.

"They're getting a bump," says Tom Roseen, senior research analyst at fund tracker Lipper. "What drove them up? A big jump in oil prices, stronger gold prices and a general resurgence in commodities."

That has been a big help for Janus Contrarian, for example, which at the end of May had about one-third of its assets invested outside of the U.S., notably in India, and for Fidelity Magellan, which as of the same period had 21% of its portfolio invested abroad.

Funds that held fast to U.S.-based firms with a broad global footprint also benefited from a weaker U.S. dollar, because revenues earned overseas are worth more when translated back to dollars. Many U.S. tech companies, for instance, earn half or more of their revenues overseas. The weaker dollar helped funds that own international assets for a similar reason -- gains earned on local exchanges are worth more in dollars.

A poster boy for the recovery is Tom Soviero, the veteran manager of Fidelity Leveraged Company Stock Fund (FLVCX), which lost 55% in 2008 but gained 21.4% in the first half of this year, bouncing from the bottom 10% to the top 10% of Morningstar's midcap blend category.

Soviero has held on to positions that were decimated in 2008 but whose long-term prospects he believed in, such as global mining giant Freeport-McMoRan Copper & Gold (FCX, news, msgs), which has soared 88% this year after tumbling 74% last year.

"It's funny how quickly things can change," Soviero says, "but I'm glad I had the level of conviction and stuck with a concentrated strategy."

Soviero also has made a major push into financial stocks, a sector he had shunned since before the credit collapse, and a major contributor to performance this year. One such holding is Bank of America (BAC, news, msgs), which the fund manager says is a proxy for a stabilizing economy and easier access to lending. The bank's shares are up fourfold since early March.

Meanwhile, with few stocks unscathed by the bear market, some managers have taken the opportunity to dump lagging and lower-quality shares that add risk to their portfolios and buy stocks they believe in more strongly.

Ajay Krishnan, manager of Wasatch Ultra Growth (WAMCX), a small-cap fund that returned 26% in the first half after falling 55% in 2008, is one of them. He has weeded out companies with large debt loads, in the belief that a solid balance sheet will give a business a faster ticket out of the recession.

"We've been looking for companies that have a sustainable competitive advantage and are well-managed with insider ownership," he says. "We're also trying to identify themes that would have legs in the downturn."

That list includes a newer holding, MYR Group (MYRG, news, msgs), which is involved with building and upgrading electrical power lines and facilities, and MSCI (MXB, news, msgs), a leading developer of global market indexes that are licensed to exchange-traded funds.

Bloodied but unbowed

Alex Motola, manager of Thornburg Core Growth (THIGX), says his team has tried to adjust to the market changes, too, while keeping its discipline.

"There are pockets of strength with relatively sustainable levels of growth," says Motola, whose fund was up 22.3% in the first half after losing 51% in 2008. He singled out a newer purchase, Britain's Telecity Group (TLCTF, news, msgs), which provides data centers in Europe and complements a core portfolio position in Equinix (EQIX, news, msgs), a leader in data warehousing.

Fund shoppers might take a page from these comeback kids and look for seasoned managers who, like the stocks they own, are bloodied but unbowed. Morningstar's favorite laggard-to-leader picks include Longleaf Partners, run by Mason Hawkins and Staley Cates, and Clipper Fund (CFIMX), run by Christopher Davis and Ken Feinberg.

Salzinger likes Fidelity Magellan, run by Lange, and Fidelity Leveraged Company Stock, run by Soviero.

"They're well-positioned now if the credit markets continue to thaw," he says.