Independence Day

Partly it's because Fidelity Small Cap Independence (FDSCX) has delivered an absolute return of 24% in 2003. That's not too shabby compared with the 21% gain by the S&P 500, though not as nice as the 39% year-to-date spurt by the average small-cap growth fund.

But Small Cap Independence isn't your typical growth fund. For one thing, it shuns expensive techs. Manager Jamie Harmon prefers obscure service niches where he can buy growth at a reasonable price. And he's happy to load up on overlooked and poorly understood companies that ring no bells for the layman. "To me, that sounds like an opportunity," he says.

I'll second that, because I think this value-minded fund has an excellent opportunity to outperform its friskier rivals over the next 12 months. Its holdings aren't popular enough to lead the latter stages of the current rally, but they'll still benefit, and should hold up better than most in the ensuing correction. Harmon knows how to play defense, having racked up average annual returns of more than 10% over the last five years. And his 1.4% annual return over the last three years beats 85% of small-growth funds — sad but true.

Still, if the point of this exercise was merely to prepare for the worst, I'd be writing about bear funds expressly designed to rise as stocks fall. Small Cap Independence is a bet that stocks will rise in the medium term even if the economy disappoints in the long run.

But the main reason it accounts for nearly half of my 401(k) assets is simply that I love its portfolio, with its apparent emphasis on services and pricing power. Among Harmon's top holdings is a big munitions supplier, as well as a specialist in forensic accounting and corporate investigations. Health care is by far the heaviest sector bet, encompassing investments in a major hospital chain, a dialysis treatment provider and a fast-growing surgery network, among others.

That leaves Independence well positioned to profit whether the future plays out like "John Q" or comes to resemble "Blade Runner."

And Harmon's top pick is Corrections Corp. of America (CXW), which should thrive whether or not the overloaded criminal justice system degenerates into an over-the-top Kurt Russell movie.

The leading operator of private prisons has gone through a boom and bust to rival the Nasdaq's as a result of bad gambles made by previous management. One unexpected benefit of the speculative building boom that nearly fried the company is that the 60 detention centers in its prison archipelago now have some 7,000 spare cots to absorb growing demand from the penny-pinching states and security-obsessed feds. The former Immigration and Naturalization Service has dropped Naturalization from its name and is also shipping more detainees to Corrections Corp. these days. Harmon notes that the company is the only industry player with spare capacity, and that the additional prisoners it stands to gain should boost its margins.

Coincidentally, Corrections Corp's price/sales ratio of 0.9 landed it a starring role in yesterday's Stock Screen. And while that's a lot cheaper than the S&P 500 average of 1.5 or the Russell 2000 mark of 1.9, Corrections Corp. is no cheaper than the rest of the Independence portfolio.

Not that Harmon feels bound by a rigid formula. While the top holdings haven't changed much in recent years, he trades smaller stakes opportunistically (annual turnover of 290%). And despite the small-cap focus, Harmon holds a stake in Berkshire Hathaway (BRK.A) in "a tip of the hat" to personal hero Warren Buffet.

Like the Oracle of Omaha, the 1994 Harvard grad doesn't want to follow the herd. Yes, his performance relative to other small-cap funds has been "pretty dismal" this year, he concedes, and yes, it will cut into his year-end bonus, though three-year and five-year records count for even more when Fidelity divvies up its spoils. But Harmon isn't rushing to catch up to his benchmark via industrial laggards and speculative high-beta stocks.

"Everyone is real excited about GDP growth this quarter, and that's terrific," he says. "And the economy really is recovering. But the economy also was recovering when it grew 5% last March." Periods of rising optimism, Harmon adds, are less than ideal for buying expensive stocks.

Whereas almost any time over the last four years has generally been a good time to buy small caps, whose main indexes are closing in on last year's all-time highs. "Small caps have seven-year cycles of outperformance, so that probably means we have three good years left, and that's an eternity in this business," says Harmon. The more so since, in periods when small caps outperform the market, they do so by an average of 13 percentage points a year, according to the fund manager. That implies that this year's wide performance gap is no fluke.

But just in case, I've hedged my small-cap plunge with sizeable bets on the Fidelity Equity Income fund (FEQIX), which concentrates on the relatively inexpensive large caps among financials and energy suppliers, as well as the Fidelity Overseas fund (FOSFX), which is heavily exposed to the bull market currently raging in Japan.

And Fidelity is getting all my money only by default, as the manager of my 401(k). Equally prudent sector bets are available from other top fund families like Vanguard, American Funds, Putnam Investments and T. Rowe Price.

But whichever fund family you like, try to buy its next standout, not its last one. Listen to Putnam's strategists, for example: "Within stocks, we anticipate a rotation in market leadership from higher-volatility issues geared to continued economic vigor toward those with more consistent operating performance. If investors' faith in a prolonged rebound is shaken or destroyed, there will likely arrive an inflection point — though its timing is unclear — when investors will shun the economically sensitive stocks and sectors they now favor and turn to those with steadily positive cash flows not as dependent on the ebbs and flows of the business cycle."

In other words, Independence's day is coming.