Contrarian Investment Ideas for 2010

Talk about drawing the short straw: Generating a list of contrarian ideas for 2010 is no easy task with nearly every domestic- and foreign-stock category gaining more than 20% in 2009 and their fixed-income brethren not far behind.

And the few categories that have posted losses this year, like long-government and bear-market funds, don't appear obvious candidates for a rebound. But with some digging, I came up with a few ways to successfully counter prevailing wisdom.

Two Strikes�
A handful of funds that had a putrid 2008 and have also lagged badly in this year's rally still have something to offer.

 CGM Focus 
A poster child for this group, Ken Heebner's fund lost 48.2% last year and is up just 9.8% in 2009, trailing 99% of its large-growth rivals. Ouch. Heebner is a rapid trader who makes big, bold bets. He's gone off the rails lately, but this fund has always had a feast or famine risk/reward profile, and Heebner has delivered in spades over time: The fund still tops nearly all its peers over the past decade. This one isn't for the faint of heart, but Heebner's past history says he's down but far from out.

 Brandywine (BRWIX) and  Brandywine Blue (BLUEX)
These two haven't fared as badly as CGM Focus, but they've been plenty stinky. Veteran manager Bill D'Alonzo and his team run both funds with a focus on firms that have rapidly accelerating earnings. They do their homework, spending loads of time interviewing not only firms, but their suppliers and vendors. Still, they've been badly off the mark lately. But this team has had big dry spells before and has always proven resilient. Expect the same.

 Bridgeway Aggressive Investors 2 ,  Small Cap Value (BRSVX),  Small Cap Growth , and  Ultra Small-Company Market (BRSIX)
Bridgeway's funds prove that quant-heavy strategies can have trouble in extreme, momentum-driven markets. These funds have all been hit hard, losing more than most in 2008 and not keeping pace in 2009. But John Montgomery and his team have proven themselves over the past decade, and they should get back on track. The funds are reasonably priced and provide great small- and micro-cap exposure.

Quality Counts
Equity funds with high-quality portfolios lost much less than most in 2008's meltdown and looked poised to rake in assets as investors who were spanked by big losses in funds holding dodgy fare sought safe harbor. It didn't happen. Some investors abandoned stocks altogether. And the rally that started in March 2009 has brought risky funds back from the dead, erasing investors' collective memory about the importance of downside protection. How quickly we forget.

The rally in speculative fare has also left many funds that shun junk trailing the pack this year, and investors have stayed away. That's too bad. Though they may lag racier peers, funds that can acheive solid gains in buoyant markets while losing less in downdrafts have a recipe for long-term success. And owning cautious funds after big rallies is a good way to avoid getting whipsawed in a shaky recovery.

 Sequoia (SEQUX),  Jensen (JENSX),  Tweedy, Browne Value (TWEBX),  Meridian Growth (MERDX),  LKCM Equity (LKEQX),  Vanguard Dividend Growth (VDIGX),  Chase Growth (CHASX),  Westport Select Cap , and  FAM Value (FAMVX) are among the funds you can expect to continue delivering over time while letting you sleep at night.

One way to identify mutual funds with high-quality portfolios is through the economic moat ratings that Morningstar's equity analysts assign to each stock they cover. The ratings measure the strength of a company's competitive advantage, if any, and Morningstar has calculated the weighted-average moat rating for funds based on their underlying holdings. For more, see "Five Great Funds That Own Wide-Moat Stocks" by Morningstar fund analyst David Kathman.

The Taxman Cometh
Muni bonds have rallied hard in 2009, and fundamentals are deteriorating in many municipalities, but muni-bond funds still have one redeeming feature other funds don't: their tax-exempt status. With tax rates more likely to rise than not, shielding a portion of your income from Uncle Sam makes more sense than ever. No need to get fancy. Stick with a cheap, proven fund that doesn't make big interest-rate bets or court a ton of credit risk, such as  Fidelity Intermediate Municipal Income (FLTMX) or  Vanguard Intermediate-Term Tax-Exempt (VWITX).

Praise for the Money Fund--Sort of
As my colleague Russ Kinnel recently pointed out, the humble money market fund still has a place. The bond rally of 2009 appears to be slowing, and the macroeconomic gurus are predicting that the Fed may start hiking interest rates in 2010's second half. If that happens, the short-term bond funds many now use instead of money markets may lose out as the issuance of higher-yielding bonds causes their holdings to be discounted. Money markets certainly won't skyrocket, but their yields will plump up as rates rise.

Morningstar.com Ideas Week
Gear up for the new year with Morningstar analyst insights on the economy and state of the recovery; our top equity, fund, and ETF picks; critical portfolio-planning opportunities; how Washington reforms may shake out for your investments; our Ultimate Contrarian Moves for 2010; and much more. Click here to learn more.