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Five of Our Favorite Comeback Candidates

Can these funds go from the outhouse to the penthouse?

Greg Carlson, 09/23/2008

Morningstar's fund analysts cover 2,000 mutual funds. Their full analyst reports, including Stewardship Grades, are available in Morningstar Principia Mutual Funds Advanced and Morningstar Advisor Workstation Office Edition.

Unless you've been hiding under a rock, you're all too aware that it's been a lousy 12 months for stocks. The credit and liquidity crunches kicked off by the implosion of lower-quality mortgages and a slowing economy have caused a lot of pain for investors: For the year ended Sept. 9, 2008, the MSCI U.S. Broad Market Index declined 13%, and some of our favorite funds have done substantially worse.

Those are the kinds of results that make investors want to toss out their statements unopened and avoid looking at funds at all. But just as some of the savviest value managers we've talked to say they benefit greatly from the buying opportunities presented by a bear market, fund investors can do the same by scooping up some real gems when they're down and out.

True, the situations aren't completely analogous with stocks and funds that are down. Funds that have seen big losses sometimes ditch stocks that haven't worked out, only to see them rebound sharply as fundholders miss out on those gains. But big rebounds do happen in the fund world, particularly when the managers and approaches haven't changed. Managers' strategies and favorite sectors go in and out of favor; the best time to buy is when they've hit bottom. Certainly, it's been a winning formula in the past--just look at all the value funds that were left for dead in the late 1990s, only to rise with a vengeance once valuations started to matter again. They included such long-term standouts as American Funds Washington Mutual AWSHX, Clipper Fund CFIMX, and Longleaf Partners LLPFX. (The latter two funds show up on the list below, although one has a different set of managers now.)

We've come up with a list of five funds that have posted very poor relative performance, yet still have bright futures ahead. We sorted through all of our Fund Analyst Picks and singled out open, diversified funds with the worst relative performance over the past 12 months. We vet our picks regularly to make sure we include only those funds in which we have a great deal of confidence going forward--those with sensible strategies, proven management teams, moderate costs, and a history of treating shareholders well.

Clipper Fund CFIMX
This fund's shareholders have had a rough go of it in recent years. The fund's veteran management team left at the end of 2005 after a stretch of poor performance (though its long-term record was superb). True, the team was replaced by the accomplished duo of Chris Davis and Ken Feinberg (who manage large-blend Picks Davis NY Venture NYVTX and Selected American Shares SLADX), but they have since struggled mightily as their favorite sector, financial services, has been hit hard by the credit crisis. As a result, this fund has declined 24% over one year, lagging 97% of its peers. Nevertheless, we think Davis, Feinberg, and team are among the best around when it comes to assessing the long-term risk/reward prospects for complicated beasts like big banks and insurers. And although their other funds aren't nearly as concentrated as this one, the pair has run a very compact portfolio in their sleeve of Masters' Select Equity MSEFX for a decade. Finally, this fund is cheap at 0.69% and its managers have millions stashed in it. PAGEBREAK

Longleaf Partners LLPFX
This large-blend fund has lagged 95% of its category rivals over the 12 months ended Sept. 9, 2008, losing 21% over that span. Blame can generally be pinned on the fund's exposure to companies reliant upon consumer spending, such as media firms and retailers, as well as General Motors GM. (Consumers have tightened their belts as the economy has slowed.) Managers Mason Hawkins and Staley Cates are hardcore contrarian investors who insist on buying companies that are dirt-cheap relative to their estimates of intrinsic value. They invest with conviction (the fund recently held just 23 stocks) and hang on for the long haul. So a few bumps in the road for their picks don't mean a lot to them. We have a lot of faith in their abilities--Hawkins and Cates were Morningstar's Domestic-Stock Fund Managers of the Year in 2006, and with good reason. They've posted superb long-term returns here since the fund's 1988 inception (as well as at the firm's small-value and foreign large-value funds), invest heavily in their charges, and close their funds when opportunities are scarce or the funds threaten to get too big for their liking. This offering reopened in January 2008. While we don't know when it will bounce back, we think it represents a fine buying opportunity for patient investors.

Oakmark Select OAKLX
Lead manager Bill Nygren's struggles have been well-documented, particularly his most glaring misstep--betting big (to the tune of 15% of assets at times) on mortgage lender Washington Mutual WM, which has nosedived in recent years as issues with its subprime mortgages have come to light. Thus, the fund has lost 20% of its value over the past year, lagging 94% of its large-blend rivals (and trails roughly as many over five years). But we see plenty of reason to own this fund, despite the mistakes. Nygren and comanager Henry Berghoef are still on board employing a fundamentally sound strategy--they act as business owners, attempting to buy at a hefty discount to their estimate of a company's future worth. Like most of the other funds on this list, this one has a concentrated portfolio, so individual stock risk is high (as Washington Mutual has painfully demonstrated). But we have confidence in the managers (who own a fine long-term record here) and the crack team of analysts that supports them, and we're encouraged that they're acknowledging and trying to learn from their mistakes. They plan to shy away from huge stakes in companies with leveraged balance sheets in the future--thus, Washington Mutual is now down to a 5% position, while financially stronger picks like Yum Brands YUM have moved up the list of holdings. PAGEBREAK

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