(FORTUNE Magazine) – Robert Martorelli, 31, dreamed of playing center field for the Yankees. Instead, the onetime Little Leaguer from New York City's Staten Island got an MBA at Fordham University. Today, when he's not cheering on the Yankees, he roots for down-and-out companies as manager of the $106 million Merrill Lynch Phoenix Fund. In the past three and five years, the fund has beaten Standard & Poor's 500-stock index, according to CDA Technologies of Silver Spring, Maryland. Through the end of June it is up 28.4% this year, more than double the market's 12.7% return. In a recent interview with FORTUNE's Joshua Mendes, Martorelli described his favorite losers.

Isn't investing in losers dangerous? When something bad happens to a company, investors tend to act emotionally and sell. So we can get in at a low price. Many people view these stocks as highly risky, but I prefer them any day to, say, a growth stock selling at a huge price/earnings multiple. If the growth company has a down quarter, the stock tumbles. When we buy a stock, most of the bad news is out.

What makes for a tarnished treasure that can shine again? First, we look for a company that has a product or service people want. That sounds simple, but an awful lot of companies hit hard times because their product was faddish or just didn't work. Second, we look for new management, because they didn't create the problems and are usually eager to solve them. Third, we look at the assets. We want a company that can sell off some divisions, pay down the debt, and concentrate on a core area where it can generate a decent return. Last, we look at how much the company can earn ultimately and how soon. We multiply that figure by ten and discount the result back to the present at a 20% interest rate. That's the maximum price we will pay for the stock.

How patient are you? Our normal holding period is two to three years. I don't care about next quarter's or even next year's earnings. We're concerned with the long term. The road to recovery is often bumpy.

What companies are on the road now? I see several in retailing. Investors have ignored these stocks since October because they expected consumers to spend less. But retailing stocks tend to have fairly consistent cash flows throughout all phases of the business cycle. Among our favorites is Ames Department Stores, which follows the Wal-Mart concept of setting up stores in small to medium-size towns. The company was once a darling of Wall Street but ran into problems with employee and customer theft. It has now totally revamped its inventory control system, bringing theft below industry norms. The stock trades at $15, and we think it can earn $2.25 a share in two years. We also like Ross Stores, an off-price clothing chain that lost money when it expanded into economically depressed Texas. The solution was simple: Ross closed its Texas stores. Now it makes its bread and butter on the West Coast, and growth has resumed. The company trades at $7 and should earn about 80 cents a share this year, building to $1.30 in a few years.

Do you look at other out-of-favor industries? We're optimistic about oil for the long term, but we don't want just another rig operator. The company has to have a special niche. A prime example is Offshore Logistics, one of the three largest helicopter operators in the Gulf of Mexico. At $2.50 per share, or seven times expected 1988 earnings, it is one of the cheapest oil service companies around. It is also one of the few that will make money this year. I don't know when helicopter usage will increase, but it's going to happen sometime. We also own GEO International, which used to be just an oil service company. When that business turned down, management sold off most of it and moved into making silk-screening equipment used to print labels on plastic bottles. Through growth and acquisition it has become one of the world's largest suppliers. But most Wall Streeters still think GEO is an oil service company.

You're bullish on the silk-screening business? It's not sexy, but it's very steady throughout all economic cycles. The stock sells for $5, and the company should be able to earn $1 a share in two years.

Any others? We like OMI Corp., an oil tanker operator. It is no secret that the U.S. is ) not producing enough oil at home. Some has to come from overseas, and the only way is by tanker. Since there is a big chance of a shortage of them in the future, the upside is tremendous.

Your portfolio is 15% in bonds. We like to buy securities of bankrupt or near-bankrupt companies that are selling at deep discounts to their par value. We own Public Service of New Hampshire 17 1/2s of 10-15-04. The fate of the utility's nuclear plant is still up in the air, but we are encouraged by Long Island Lighting's settlement. The bonds are selling at 50 cents on the dollar, and we think they could rise to at least 70 cents. We also like Midway Airlines 8 1/2% convertibles of 12-15-02. Here's an airline that was near bankruptcy in the early 1980s when its attempt to capture the high-priced business traveler flopped. New management came in, cut costs, and consolidated the airline's dominant position at Chicago's Midway Airport, which is the alternative to congested O'Hare. The stock is trading at $12 and the bonds are convertible at $17. We think they're a great buy.