A fund battles back: up 45% this year

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NEW YORK (Fortune) -- Longleaf Partners Fund: (LLPFX)
Managers: Mason Hawkins and Staley Cates
Return since 12/01: 70%

None of our fund picks for 2009 delivered a stronger performance this year than Longleaf Partners, which is up a dazzling 45% since January, 26.5 points better than the S&P 500.

Of course, that's after a 51% free fall in 2008.

"We've had a great run so far this year," says Lee Harper, a portfolio manager at Southeastern Asset Management, Longleaf's advisory firm. "But that's also indicative of how low the price to value ratios were."

Longleaf's veteran manager, Mason Hawkins, has helmed the fund since 1987 (co-manager Staley Cates came onboard in 1994). Their short-term record is negative, due largely to lackluster performance in 2007 and 2008, but the fund, which has $7.5 billion in assets, has beaten the S&P 500 (SPX) by 3.5% annually over the last ten years.

Last year, Longleaf took a nosedive because of its concentrated portfolio: They invest in about 20 stocks, with a focus on technology, energy, and media. As of June 2008, the fund's top holdings were Dell (DELL, Fortune 500), Chesapeake Energy (CHK, Fortune 500), and Liberty Media (LINTA), all of which tanked during the financial crisis.

Managers Hawkins and Cates not only held on to those companies, but also added to their stakes. Longleaf nearly doubled its shares of Chesapeake between June and December last year. So far this year, the stock is up 62%.

Harper says Longleaf's managers held on to its top stocks -- and continue to like them -- because they are industry leaders. "Chesapeake has the largest natural gas reserves in the U.S.," she says. "Liberty/Direct TV is the dominant satellite TV provider."

Dell is still a top pick, she adds, because of its ability to cut costs during the recession. "Nobody believed that Dell could cut so much," she says. "When we get a recovery, their value ought to explode because the incremental profits on revenue will be huge."

Harper points out that many of Longleaf's stocks are still trading below their appraised valuations. The average stock in the portfolio has a price to value ratio of about 60%, she says. Longleaf's managers typically buy their stocks at that discounted level. "They're still cheap historically," she says. "We have a lot of room to go."

Hawkins and Cates wrote in their last letter to shareholders: "If prices simply rose to our appraisals of intrinsic value, we would double our money."

That doesn't mean the managers are sitting still; they've sold some of their stocks, including their massive investment in Sun Microsystems (JAVA, Fortune 500), which appreciated 130% while the hardware maker debated whether or not to sell itself (Longleaf exited the stock when rival Oracle (ORCL, Fortune 500) announced its bid). The managers also sold shares of eBay (EBAY, Fortune 500), which they felt had rallied to their fair value, and Walgreens (WAG, Fortune 500).

"Our appraisal [for Walgreens] changed, as did the competitive outlook for the business," says Harper, who cites new management and increased competition from grocery stores as the reasons why Longleaf unloaded the shares.

Going forward, says Harper, Longleaf's managers see fewer opportunities, though they do like some segments of the market. One of those is insurance, which is why they picked up shares of Aon (AOC, Fortune 500) and Berkshire Hathaway (BRKA, Fortune 500) this year. "As other insurers have been compromised, the ones that remain have a huge competitive advantage," she says.

Another potential target for Longleaf is health care. While Longleaf hasn't disclosed ownership of any stocks in the sector, Harper says they're looking at it carefully. "At the surface, some [health care stocks] could arguably be trading at 60% (price to value)," she says.

--Over the course of this week, we're checking in on five funds we recommended last December: Osterweis, Fairholme, Vanguard Primecap Core, Longleaf Partners and Third Avenue Value. All five are beating the market by big margins.