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Last month I wrote about a method for outperforming the market using a contrarian strategy of investing in actively managed mutual funds.

In a nutshell, the strategy calls for finding a few great managers, putting some money with them, and then adding more whenever one of them has a bad quarter or year. Over time, this strategy forces you to “dollar cost average” into great mutual funds, which allows you to do better than you would if you simply invested a set dollar amount in an index fund every year.

I received a lot of reader feedback, mostly positive. The most common question was: How do I find these great managers you talk about?

Unfortunately, in last month’s column I didn’t have space to highlight any managers (except Bill Miller from Legg Mason), so a follow-up is necessary.

As an equity hedge fund manager, my job is to find stocks that present a skewed risk/reward trade-off. I’ll invest in a stock only when the potential upside (the “reward”) is at least three times larger than the potential downside (the “risk”). If I can’t find such a situation, I do nothing; I hold cash. I feel that if I take care of the downside, the upside will take care of itself. And when I find a situation that meets this risk/reward criterion, I take a large position and wait for my investment thesis to play out.

Given this investment philosophy, it shouldn’t surprise you that I favour managers who focus on the downside risk of investing at least as much as the upside potential. I also favour managers I have met in person and talked to directly about their strategy.

With this in mind, here are three of my favourite mutual fund managers, with an overview of the funds they manage. In my opinion, each of these three would be a good fit for the investment strategy I recently outlined.

The first is Charles de Vaulx of First Eagle Global. I sat next to de Vaulx at a dinner in New York a couple of years ago and used the opportunity to fire a round of questions at him. He impressed me with his candour and humility.

Plus the performance of the funds he manages has been outstanding. For example, the $20bn First Eagle Global Fund has outperformed its benchmark, the MSCI World Index, by a wide margin over every time period longer than one year. De Vaulx has worked on this fund for two decades and, since he took over as sole manager in 1999, the fund has not lost money in a calendar year, even during the bear market of 2000-02. The fund invests in both US and non-US stocks.

Then there’s Bruce Berkowitz of the Fairholme Fund. I had lunch with Berkowitz a few years ago near his office in Short Hills, New Jersey. Nothing he said caused me to suspect that his incredible record was luck. This guy is the real deal.

Since its inception in 1999, the Fairholme Fund has dramatically outperformed the broader market and has only had one down year. It lost a paltry 1.6 per cent in 2002, a year when the S&P 500 index lost 23 per cent.

Berkowitz takes large, concentrated positions in a handful of stocks and typically holds a lot of cash. In my opinion, he’s the closest thing to
Warren Buffett that exists in the mutual fund world.

Next come Whitney Tilson and Glenn Tongue of the Tilson Focus Fund. This is a relatively young fund with only $16m in assets and is way under the radar of most investors and financial advisers. I know the managers well and am comfortable giving a positive review of the fund so early in its life because I agree with the fundamental, bottom-up investment strategy practised by Tilson and Tongue.

(In the interests of full disclosure: Tilson writes a monthly Financial Times column and also owns a small piece of my money management business, Sellers Capital. He is also a friend of mine so I may be biased. That said, I would never recommend a fund and put my reputation on the line if I didn’t believe in it.)

Tilson has managed a successful hedge fund, T2 Partners, since 1999. The T2 Accredited Fund has outperformed the S&P 500 index by more than 10 percentage points a year since inception. He and investment partner Tongue rolled out a mutual fund for smaller investors at the beginning of 2005, and the fund was the top performing large-cap blend fund in the US in 2006, gaining 25.7 per cent. The fund is concentrated, with 67 per cent of its assets in the top 10 stocks.

Tilson and Tongue follow the Buffett approach, looking for companies with economic moats selling at a significant discount to intrinsic value. Over the long term, I expect the fund to do quite well as long as the managers adhere closely to this strategy. The one negative is that the expense ratio is higher than most mutual funds, but the performance has been more than sufficient to make up for this.

For more information on these and other great mutual funds, I suggest going to Morningstar.com and looking at the “fund analyst picks” section of the website.

Mark Sellers is a former equities strategist at Morningstar who manages a hedge fund, Sellers Capital, in Chicago. msellers@sellerscapital.com

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