(MONEY Magazine) – Last May on a sweltering 100[degrees]F evening, I joined more than 400 people in the reception center of the Memphis Botanic Garden to attend the annual meeting of a mutual fund company. The company is Longleaf Partners, which is run by Southeastern Asset Management of Memphis. Its chairman is O. Mason Hawkins, whom I've come to regard as the Warren Buffett of mutual fund investing.

Clad in a plain dark suit, Hawkins stands only five feet, six inches tall and doesn't wear a name tag. But one after another, shareholders manage to find him in the crowd. Tim McCarthy, a retired seafood executive, has traveled from San Diego to ask about Longleaf's growing investment in Japan. J. Floyd Kyser, a retired surgeon from Little Rock, has come to look Longleaf's managers in the eye and see if they are as sincere in person as they appear to be in their quarterly letters to shareholders.

Of the more than 700 firms that run mutual funds, only a handful--Acorn, Aquila, Baron, Benham, FAM and Longleaf among them--bother giving their shareholders the opportunity to attend regular meetings and get their questions answered. That's one reason it's tempting to call Mason Hawkins the Warren Buffett of the mutual fund business. He makes competing portfolio managers look like monkeys and, like Buffett, he devotes enormous effort to treating his shareholders fairly. And that's why, even though two of Longleaf's three funds are closed, I think smart investors (and other mutual fund companies) can learn a lot from the way this firm does business.

THE US VS. THEM MENTALITY

The folks at Longleaf share a bedrock belief: Fund investing should be a partnership between the portfolio managers and the investing public. The first page of Longleaf's prospectus is devoid of the usual boilerplate; instead, it features the firm's statement of principles. The first: "We will treat your investment in Longleaf as if it were our own." The second: "We will remain significant investors with you in Longleaf."

To understand that that's not just talk, it helps to know how Longleaf got started. Southeastern Asset Management had been in business for a dozen years, building a track record as one of the best value investors around, before Hawkins introduced the Longleaf Partners Fund in April 1987. The firm did no advertising or direct mail to whip up interest in its new fund. For three months, it wasn't even listed in the newspaper tables.

That's because Hawkins started the fund primarily so he and his colleagues could pool their money with that of their clients without creating the conflicts of interest that tend to arise when money managers buy and sell stocks for their own accounts. As Hawkins says, "How can you in good conscience allocate a good investment to yourself at the expense of your customer?" So the fund bought the same stocks Southeastern had already selected for its private clients, and Hawkins and his colleagues put all their money in it. The same kind of thinking went into the subsequent start-ups of Longleaf Small-Cap, which Hawkins co-manages with G. Staley Cates, and Longleaf Realty, whose lead manager is C.T. Fitzpatrick and which is the one Longleaf fund that remains open to new investors (with a $10,000 minimum).

That's a far cry from the way the typical fund gets started, explains Don Phillips, president of Morningstar, the fund research firm: "Most fund companies see themselves as product developers, manufacturing whatever will sell well at the time. It's an 'us vs. them' mentality: 'Let's sell this fund to them.' Instead, Longleaf has a 'we' mentality: 'Let's invest in this fund of ours.'"

Hawkins went even further: He prohibited Southeastern's employees (as well as their families) from buying any stocks or funds outside of Longleaf. Those employees are even required to invest 100% of their bonuses and profit-sharing payments in the firm's funds.

So far as I know, no other fund company puts such a hammerlock on its employees' investments. In fact, in the past few years, managers at Invesco, Janus, Montgomery and Oppenheimer have been fined by the Securities and Exchange Commission for making personal trades that allegedly raised conflicts of interest. Most fund executives say they can't ban personal trading, lest they harm their ability to recruit talented managers. But when I asked Hawkins if his ban on trading has scared off potential employees, he just laughed. Longleaf gets more than 400 unsolicited resumes a year and has just hired Andrew McDermott, an investment banker at J.P. Morgan, as a foreign-stock analyst. (McDermott will also help launch, possibly later this year, Longleaf's first international fund.)

Instead of trading stocks for their own account, Longleaf's employees and directors, along with their families, have more than $175 million invested in the firm's three funds, which together have total assets of $5.8 billion. "Our substantial stake in these funds," executive vice president Lee Harper tells the audience at the shareholders' meeting, "ensures that we will always seek to lower their expenses. We're interested in making money with you as partners rather than from you through fees."

THE INTELLIGENT INVESTOR

Mason Hawkins, 50, grew up in the small town of Thomasville, Ga. His parents grew timber, specializing in lumber cut from longleaf pine, a local species that lives for centuries and produces remarkably durable, weather-resistant planks that have long been favored for use in seagoing ships.

For a value investor like Hawkins, longleaf pine is rich in symbolism: When its seedlings first sprout, they hunker down in the grass for several years, building a deep network of roots and waiting for brush fires to roar harmlessly overhead. Then, in a sudden rush, the longleaf grows as much as five feet in a year and takes off from there--much the way undervalued stocks often lie dormant for years and then shoot up suddenly when the market recognizes their worth. Today, Southeastern Asset Management's offices are paneled in longleaf planks that were recovered from river bottoms in Alabama, Florida and Georgia, where they had lain submerged for as long as 200 years.

In a place of honor on a sideboard in the lobby of Southeastern's offices, under a painting of a stand of longleaf pines, is a well-thumbed copy of Benjamin Graham's The Intelligent Investor. When Hawkins was a senior in high school, his father gave him this copy of the classic stock guide, written by the father of value investing. "It made an indelible impression on me," recalls Hawkins. "The single thing that Graham talks about that allows for success is establishing firmly what a company is worth." Adds Hawkins: "Only if you've done rigorous analytical work that has a high probability of being right can you control your emotions and act against the collective mind-set of the moment."

Hawkins has built his career on investing against the grain. In 1974, he became director of stock research at First Tennessee Bank in Memphis--just as the stock market was suffering its worst crash since the Great Depression. Around the country, hundreds of money managers were quitting the business in despair. Undaunted, Hawkins joined with four partners, each ponying up $5,000, and set up Southeastern Asset Management as an independent firm in September 1975. The timing was equally inauspicious when Hawkins opened Longleaf Partners in April 1987, right before the October crash. But instead of selling, Hawkins bought, reducing his fund's cash level from 40% in July 1987 to just 13% a year later, much the way he's buying in Japan today.

In a nutshell, Hawkins and his team look for stocks selling at 60% of their appraisal of intrinsic value, creating the price cushion that Graham called the margin of safety. But Hawkins and his team of seven analysts and managers are extremely choosy. In 1996, they researched approximately 180 large stocks and bought three (Philips, Nabisco and United HealthCare); last year, they studied some 200 and bought three (MediaOne, News Corp. and Host Marriott). Unlike most fund managers, who reduce the risk of underperforming the market by amassing more than 100 stocks, Longleaf rarely owns more than two dozen per fund. Explains Staley Cates: "We believe risk goes down if you put your money only in the investments you understand very well." Longleaf holds its typical stock for five years; of the 24 holdings in the flagship Partners fund, four date back to 1988 (Knight Ridder, Alleghany Corp., 360[degree] Communications and Federal Express).

The result: one of the best track records around. Over the past decade, Longleaf Partners has outperformed 96% of all other funds with an average annual return of 19.8%. Over the past five years, Longleaf Small-Cap has beaten 91% of all other funds, compounding at 20.6% annually. And over the past year, Longleaf Realty has beaten 60% of all funds and 81% of all real estate funds.

But it's not only this superb performance that sets the Longleaf funds apart. More so than any other firm I know, Longleaf takes the term "fund family" literally, treating its shareholders as true partners. Over the past decade, a cascade of research has proved that the past performance of mutual funds is a poor guide to future returns. Investors do better when they focus on a fund's more durable qualities: Does it charge fair fees? Does it keep out short-term speculators? Does it seek to keep taxes low? Do its managers have incentives to stay? Do they believe in what they're doing enough to invest alongside their shareholders? Do they have the integrity to stop taking new money, or will they imperil the fund's performance for the sake of higher fees?

DOING THE RIGHT THING

Longleaf's Partners and Small-Cap funds stopped taking new investors when they hit, respectively, $1.8 billion and $760 million in assets. "We could have $20 billion to $30 billion in fund assets today [instead of $5.8 billion] if we had run this firm to maximize the amount of money we manage," says Hawkins. "And if you're a shareholder in the management company instead of an investor in the funds, that would make sense. But our mission is to compound our invested capital, not to generate higher fees."

Fund managers have long known that it becomes harder and harder to get good investment returns as funds grow in size. That's especially true for small-stock funds, which start to become unwieldy as they pass $1 billion in assets.

Of course, it's also true that the bigger a fund becomes, the more fees it generates. So instead of doing the right thing and turning down new money, most fund companies gleefully keep waving investors in, treating them like teenagers in a Volkswagen-stuffing contest. If Longleaf had assets of $20 billion, its annual fee income would be $160 million--instead of just $47 million.

The Partners fund closed to new investors in 1995, and Small-Cap shut in 1997. "If we'd kept the funds open," explains Hawkins, "we could have maximized our fee income, but we would have damaged our record and impaired our ability to compound our own capital as well as our customers'. So we closed them." Hawkins says the Partners fund will reopen if stocks get so cheap that his team could put more cash to work. But, he tells me, Small-Cap may never reopen its doors: At $1.2 billion in assets, the fund has reached the point at which "the economics aren't right" for more asset growth.

Each Longleaf fund began life with annual expenses of 1.5%; they've been falling ever since. Since 1987 Longleaf Partners' fees have dropped to 0.93%, which is 28% cheaper than those of its average peer. Since 1989, Longleaf Small-Cap's fees have shrunk to 1%, or 34% below the going rate for similar funds. And since 1996, Longleaf Realty has dropped its fees to 1.16%, or 26% below average. Those lower management fees mean higher net returns for Longleaf's investors.

Similarly, Longleaf treats taxes as though they were a disease. Since Longleaf does not churn stocks, Longleaf Partners' shareholders have kept 88% of their gains after tax, Small-Cap's 92% and Realty's 91%.

Longleaf also keeps taxes low by banning short-term speculators. When a shareholder sells out, a fund must send the proceeds in cash. Normally that's no big deal, but if a large investor dumps a fund in a hurry, the manager may have to sell stock to raise enough cash to meet the redemption. That's why Longleaf closely polices its customers. "Unexpected large redemptions can drain assets that we'd rather be able to use to buy stocks for the fund," says marketing director Mary Williamson. So Longleaf tracks all purchases of more than $1 million--and if an investor (typically a financial planning outfit) sells within three months of buying, then "that firm is not permitted to buy our funds anymore," says Williamson. That was Longleaf's policy even when all three funds were open.

GETTING RICH SLOWLY

In short, Hawkins and his colleagues have systematically aligned their own interests with those of their outside shareholders. A few small fund companies--Ariel, CGM, Clipper, FPA, Nicholas, Numeric Investors, Oakmark and Torray among them--have shown they care deeply about their investors. But, in my opinion, no other fund outfit has so clearly put its investors first.

Many fund companies are like giant revolving doors. Since 1991, for instance, Berger 100 has had four different portfolio managers; since 1990, Fidelity Value has had five. I asked Longleaf Realty manager C.T. Fitzpatrick and senior analyst John Buford what it would take for another fund company to hire them away. They looked at me as if I were a dog who had made a mess on the carpet. "What more could I ask for?" sputtered Fitzpatrick. "I'm doing exactly what I want to do, exactly where I want to do it." Buford added flatly: "We practice money management the way I think it should be practiced, and I don't know of other firms that do."

What's more, Hawkins has shared his ownership of Southeastern; while he holds more than 50% of the equity in the firm, Cates has more than 10%, Buford owns more than 5% and a half-dozen others have sizable pieces. With a big stake in both the funds and the company that runs them, each senior employee has twin incentives to stay put.

"The people at Longleaf," Don Phillips says, "could have gotten rich a lot faster by running their funds the way most other companies do--by maximizing their own short-term profits. Instead, they have gotten rich slowly by making their investors rich. And that's exactly how it should be."