Down but Not Out

Actually, "dreadful" was the term Bill Nygren used in his August letter to shareholders of his Oakmark Select fund, referring to his 2007 performance. The concentrated fund's top holding, Washington Mutual, had fallen 28% and proceeded to slide even further, thanks to the subprime fiasco and the housing slowdown. Nygren, who's hanging on to the WaMu position, spent the year trying to soothe the concerns of wary investors. "They need to ask themselves if the past quarter is a predictor of future performance or if the past decade is," says Nygren.

He's not the only manager making such a pitch. Many of the funds bringing up the rear in the past year or so happen to be run by managers with some of the best long-term track records. Indeed, 63 funds in the bottom quintile of their peer groups during the past 36 months are in the top 20% over the past decade. They include funds from Ariel, Calamos, Legg Mason, Mairs & Power, Oakmark and Pimco. But given these funds' stellar long-term performance, investors should think twice before doing any portfolio cleansing. A fund can lag because its style is out of favor or a few bad picks go south, and investors who don't understand that can make the wrong decision. "If you invested in growth stocks the past few years, you had a crappy fund," says J.J. Burns, a wealth manager in Melville, N.Y., who notes that many of those stocks are now turning around. "Ultimately, you want a guy who will stick to his guns."

Three funds in particular have strong portfolios and even stronger managers — making them smart buys despite recent poor performance. Current investors should sit tight: "I wouldn't sell any of them," says Christine Benz, head of mutual fund analysis at Morningstar.

Nygren has been making big bets on the American consumer in two funds, Oakmark Select and the firm's flagship, Oakmark. Both did well in 2007 with McDonald's, which benefited from a revamped breakfast menu. But Pulte Homes shares lost 66% in the housing slowdown, hurting Select. Slower domestic sales at Harley-Davidson, another Oakmark holding, caused shares to slide 38%. WaMu dinged both funds. Nygren is sticking by his picks and anticipating a rebound in housing and the cooling off of some sectors that juiced the returns of his competitors — such as energy, which he's avoided recently. And Nygren admits he owned a lot of consumer stocks that lagged this year but says he's "comfortable having a different conclusion than the consensus."

Bill Miller is known as the manager who beat the returns of the S&P 500 for 15 straight calendar years. But recently, he's been stumbling: In 2006 his Legg Mason Value Trust trailed the broad market by almost 10 percentage points. He also lagged in 2007, thanks to Pulte and mortgage lender Countrywide Financial. In his latest shareholder letter, Miller defended his Countrywide position, saying it's worth $40 a share, almost triple its current price. Contrarian? Sure. But Miller points out that the last time his fund trailed the S&P 500 for two years straight was 1990 — the next year his famous streak began.

Almost $1 billion has vanished from the Muhlenkamp Fund in less than two years, as it trailed the broad market by an astounding 14 percentage points. But we aren't ready to bail yet. Manager Ron Muhlenkamp was heavily invested in the housing sector for several years, and although it did well for a time, he admits he sat on it too long. Now he's buying Cisco Systems, electronic-component maker Wesco and mining firm NovaGold. Muhlenkamp doesn't usually mind being mentioned in the same breath as Miller and Nygren. But in this case he wishes he weren't one of the gang. "I like the company I'm with," he says. "I just don't want to be at the same party."

This story originally ran in the January 2008 issue of SmartMoney magazine. The numbers have been updated as of Dec. 13, 2007.