(FORTUNE Magazine) – FANS OF THE FIGHT GAME OFTEN HEAR the cliché that a good big man will beat a good little man every time. Not so in investing. The top-performing diversified stock fund over the past five years? It's not an offering from one of the industry heavyweights. It's the pint-sized CGM Focus fund run by Ken Heebner.

In fact, small firms can have several advantages. Managers at boutique firms talk about their nimbleness when compared with the lumbering giants of the business. "It's the difference between steering a lithe speedboat and steering a battleship," says Morningstar's senior fund analyst Christopher Traulsen. Boutique managers also note that without the corporate pressures that weigh on their counterparts at large firms, they can better focus on their portfolios--and their shareholders. "We're in the investment management business, not the fund marketing business," says Ron Muhlenkamp of the Muhlenkamp fund.

To pick the best bantamweights, we started with data provided by Lipper on more than 18,000 mutual funds. We excluded funds from the 25 largest families, and identified top performers over three, five, and ten years. Then we narrowed down our list by looking at such factors as expenses and whether managers showed a real commitment to shareholders by investing their own money alongside them. Turn the page to find seven that are in your corner.

SELECTED AMERICAN SHARES (SLASX) • LARGE-CAP CORE

Lead Manager

Christopher C. Davis

RETURNS (annualized)

Three-year 7.6%

Five-year 4.2%

Ten-year 14.2%

Expense ratio

0.93%

Minimum investment

$1,000

Assets

$6.6 billion

Company

Davis Advisors

New York

Number of funds: 11

Total assets

$33.3 billion

800-243-1575

selectedfunds.com

SMART INVESTORS KNOW THAT ALL EARNINGS are not alike. That's why Chris Davis, CEO of Davis Advisors and portfolio manager of the Selected American Shares fund, doesn't focus on a company's reported earnings. Instead he adjusts that figure, subtracting nonrecurring items, options expenses, and the like to arrive at a number that better reflects the state of the business. Davis then uses those "owner earnings" to search for undervalued gems--companies with solid managers who know how to reinvest in their business wisely. The recipe works: Davis and co-manager Ken Feinberg have delivered a 14% return over the past year.

Davis's emphasis on well-run but modestly valued companies has led him to place more than half of the fund's assets in financial stocks, broadly defined, with large stakes in American Express, AIG, Berkshire Hathaway, and Golden West Financial (GDW, $113). The California savings and loan run by Herbert and Marion Sandler accounts for nearly 3% of the portfolio. "Nobody knows who they are, but they are just first class in every way," he says.

Davis Advisors, with $33 billion under management, is by far the largest firm on this list. And Selected American has ballooned to $6.6 billion in assets. But that heft hasn't changed the firm's shareholder-friendly ways. The Davis family, along with employees and directors, are the largest investors in the funds they run, with more than $2 billion invested. In May, Davis introduced a cheaper "D" class of Selected American Shares for investors who don't buy through fund supermarkets. That's the kind of stewardship shareholders deserve.

ARIEL APPRECIATION (CAAPX) • MULTICAP CORE

Manager

John C. Rogers Jr.

RETURNS (annualized)

Three-year 12.2%

Five-year 11.1%

Ten-year 14.6%

Expense ratio

1.20%

Minimum investment

$1,000

Assets

$2.8 billion

Company

Ariel Capital Management

Chicago

Number of funds: 4

Total assets

$6.2 billion

800-292-7435

arielmutualfunds.com

JOHN ROGERS'S JOB HAS GOTTEN TOUGHER. The recent strength in small-cap stocks, including last year's powerful rally, has made it more difficult to turn up the kind of values Rogers, who specializes in up-and-comers, looks for. Not that he's complaining. His funds have been prime beneficiaries of the surge, as the flagship Ariel fund jumped 28% last year and is up more than 12% so far this year. The multicap Ariel Appreciation fund has also benefited, gaining 31% last year and climbing 3% in 2004.

But if small-cap bargains are harder to come by these days, Rogers says he's having an easier time finding value among mid-caps. The $2.8 billion Ariel Appreciation fund is a mix of those midsized stocks and large-cap companies. The fund typically owns 40 or fewer stocks, and its holdings have an average market cap of $8.6 billion. Rogers looks for companies with low P/E ratios trading at a 40% discount to his estimate of private market value, or what a private buyer would pay for the business.

In recent months Rogers has been building a position in Aramark (RMK, $23), the Philadelphia-based food service and uniform rental business. After a stretch of poor performance that dropped the stock price below the $23 level at which it went public in late 2001, the company recently brought back Joseph Neubauer as chairman and CEO. Rogers believes that at its current market cap of $4.3 billion, Aramark sells at a significant discount to its private market value. And with a P/E below 15 based on the company's estimated 2005 earnings, Rogers says, "It's one of our cheapest stocks."

PERRITT MICRO CAP OPPORTUNITIES (PRCGX) • SMALL-CAP CORE

Manager

Michael Corbett

RETURNS (annualized)

Three-year 27.3%

Five-year 22.5%

Ten-year 14.7%

Expense ratio

1.44%

Minimum investment

$1,000

Assets

$174 million

Company

Perritt Capital Management

Chicago

Number of funds: 1

Total assets

$174 million

800-332-3133

perrittcap.com

SMALL STOCKS PROVIDE THE BEST PATH TO BIG profits. That's the thesis on which Dr. Gerald Perritt, a former DePaul University finance professor and investing-newsletter publisher, launched the Perritt Micro Cap Opportunities fund in 1988. The idea is that small- and micro-cap companies may be riskier than large caps, but over the long term their faster growth makes them worth betting on.

That thesis has seemed right on target of late. The average small-cap fund gained nearly 44% last year, and many small funds are so flush with cash that they've closed their doors to new investors. Perritt's portfolio has benefited as well. Under lead manager Michael Corbett, who took over day-to-day oversight of the portfolio in 1999, the fund shot up more than 63% last year. Over the past five years the fund has been 22 percentage points better than the S&P 500 on average and 13.5 percentage points ahead of the small-cap Russell 2000 index.

That kind of performance gets investors' attention, and the fund's assets have swelled from $20 million in 2000 to a still-manageable $174 million. The fund holds 143 stocks with an average market capitalization of $160 million. To find the right ones, Corbett examines scores of financial statements for nine indicators of financial well-being such as expanding profit margins and decreasing debt levels. Companies with six out of nine points are considered for the portfolio.

Corbett remains bullish on the fund's top holding, Flanders (FLDR, $8), a maker of air filters that has been in the portfolio for close to three years. The company has seen its shares rocket more than 60% over the past 12 months, but Corbett expects them to continue climbing. Flanders, with a market cap of $222 million, trades at a 2004 P/E of 23 and analysts expect it to grow earnings by 27% next year.

CGM FOCUS (CGMFX) • MID-CAP CORE

Manager

G. Kenneth Heebner

RETURNS (annualized)

Three-year 26.8%

Five-year 32.7%

Since inception* 19.5%

Expense ratio

1.18%

Minimum investment

$2,500

Assets

$766 million

Company

Capital Growth Management

Boston

Number of funds: 4

Total assets

$2.2 billion

800-345-4048

cgmfunds.com

* Sept. 3, 1997

IN A WORLD WHERE MOST MUTUAL FUNDS AIM for consistency, both in returns and investment style, Ken Heebner's CGM Focus fund roams freely. "I am a style drifter," he says, "and proud of it." Heebner's priority is making money, and he aggressively maneuvers his fund to capitalize on opportunities wherever he sees them, loading up on companies of just about any size--or even selling stocks short.

From his Boston office, the 61-year-old Heebner uses a combination of big-picture analysis and fundamental research to pick a concentrated portfolio, which as of Sept. 30 held just 26 stocks. Heebner trades frequently--turnover in the Focus fund runs at more than 200% a year--making the fund inefficient for taxable accounts. He's also perfectly willing to make big bets on individual stocks or sectors, placing more than 50% of the fund's assets in its top ten holdings.

Those aggressive moves haven't always paid off--in 2002, for instance, CGM Focus was down 17.8% and trailed the average fund in its category by more than two percentage points--but they have helped the Focus fund climb an average of more than 31% a year over the past five years. That's an astounding 34 percentage points better than the S&P 500. Only two mutual funds have done better in that time (both are specialized funds investing in Russia). And Heebner's success has continued this year. The CGM Capital Development fund, which is closed to new investors, was the top-performing stock fund in the third quarter, with a 7.3% gain. The Focus fund was a close second, with a 7.1% rise.

Nowadays Heebner is pumping money into the energy sector. He believes oil prices will stay higher than Wall Street expects, so he's guided a quarter of the Focus fund into oil and gas stocks, and another 20% into oil service companies. One that Heebner really likes is Murphy Oil (MUR, $81), an explorer and refiner based in Arkansas (no, it doesn't make the wood-cleaning product). The stock has already risen 30% this year, but Heebner sees added upside as the price of oil stays high and Murphy increases its output. "Based on the discoveries they've already made and the development plans they've already announced, this company will double its production in four years," Heebner says.

THOMPSON PLUMB GROWTH (THPGX) • MULTICAP CORE

Lead Manager

John C. Thompson

RETURNS (annualized)

Three-year 6.2%

Five-year 11.1%

Ten-year 16.2%

Expense ratio

1.07%

Minimum investment

$2,500

Assets

$1.4 billion

Company

Thompson Investment Management

Madison

Number of funds: 4

Total assets

$1.5 billion

800-999-0887

thompsonplumb.com

JOHN C. THOMPSON KNOWS THAT BAD HEADLINES can make for good opportunities. The 36-year-old manager of the $1.4 billion Thompson Plumb Growth fund often jumps on the chance to snap up shares in fundamentally sound companies that have been battered by bad news. "The key to beating the market, in our opinion," he says, "is to buy when there's controversy and to sell when everything's going well."

Thompson holds out for businesses that have clean balance sheets and generate strong free cash flow, but he isn't afraid to make large wagers on individual holdings--even those scandal-plagued, beaten-down ones. That appetite for unpopular names runs in the family. Thompson's father, John W., now 61, co-founded Thompson Plumb & Associates and was the Growth fund's first manager. John C. joined his father in 1993 and gradually took over as the lead portfolio manager. The two have all of their liquid assets, more than $4 million, invested in the fund. (The father-son duo created Thompson Investment Management in Madison, Wis., at the beginning of 2004, after splitting with former partner Thomas G. Plumb.) And their bold strategy has helped the Thompson Plumb Growth fund post annualized gains of more than 11% over the past five years, better than nearly all of its peers and ahead of the S&P 500 by more than 12 percentage points.

One controversial name that Thompson remains bullish on is Fannie Mae (FNM, $69), the top holding in the fund. He doesn't believe its accounting problems are serious, and cites research calculating that Fannie is worth $60 a share based on its current mortgage holdings alone. The stock is trading at just over eight times estimated 2005 earnings, compared with its average historical trailing P/E of 14. "We have a tremendous amount of confidence in it," says Thompson.

POLARIS GLOBAL VALUE FUND (PGVFX) • GLOBAL VALUE

Manager

Bernard R. Horn Jr.

RETURNS (annualized)

Three-year 25.0%

Five-year 11.5%

Since inception* 7.7%

Expense ratio

1.75%

Minimum investment

$2,500

Assets

$84 million

Company

Polaris Capital Management

Boston

Number of funds: 1

Total assets

$84 million

888-263-5594

polariscapital.com

* June 1, 1998

BERNIE HORN'S POLARIS GLOBAL VALUE FUND is proof that even a company with limited resources can venture to the far ends of the earth--and produce world-beating returns. Lacking the deep research staff or budget of his larger competitors, Horn racked up a 47% gain last year. In fact, he's guided the fund to an average return of 25% over the past three years. That far outpaces the MSCI World Index and puts Polaris in the second percentile among international funds.

Horn posts those impressive numbers by screening 24,000 companies in some 40 countries, including the U.S. He looks for companies with strong and sustainable free cash flow that are trading at discount prices. The result is a watch list of about 250 names and a portfolio that currently holds nearly 75 stocks, most of which are not actively traded on U.S. exchanges. Once he buys, he holds on until the market recognizes the value he perceives: Stocks stay in the portfolio for an average of more than three years.

Lately Horn, based in Boston, has been finding more opportunities overseas than at home. He notes that the price-to-cash-flow ratio for the U.S. market was 12.1 at the end of September, while for the rest of the world it stood at 8.5. Those valuations have led Horn to keep less than 37% of his fund's $84 million in assets in U.S. stocks, down from a more typical 50% allocation. And while he's still underweight Japan, he's been increasing holdings there and says he's likely to continue doing so through the end of the year. "We're finding enough really good values outside the U.S. that we're thinking about even adding a few extra names to the portfolio," he says.

One recent addition to the portfolio is Portugal Telecom (PT, $11). Horn likes the company's dominant position in Portugal's mobile-phone business and its growing broadband operations. And at a 2004 P/E below 16 and a price-to-cash-flow ratio of 8.7, Horn says the price is right.

MUHLENKAMP (MUHLX) • MULTICAP VALUE

Manager

Ronald H. Muhlenkamp

RETURNS (annualized)

Three-year 16.6%

Five-year 13.6%

Ten-year 16.2%

Expense ratio

1.18%

Minimum investment

$1,500

Assets

$1.2 billion

Company

Muhlenkamp & Co.

Wexford, Pa.

Number of funds: 1

Total assets

$1.2 billion

800-860-3863

muhlenkamp.com

PICKING STOCKS IS LIKE SHOPPING FOR USED cars, Ron Muhlenkamp likes to say. First, you must exhaustively research the potential purchase. Ideally you should then talk to the owners or managers. Occasionally, though, no matter how thoroughly you investigate your choice, you'll still end up with a lemon.

Muhlenkamp, 60, shuns the stock market equivalents of flashy hot rods and gas-guzzling clunkers. Instead he essentially looks for fuel-efficient vehicles--the ones that deliver the most for the money. In investing terms, that means companies with an above-average return on equity. But Muhlenkamp keeps a close eye on value, too, so he holds out for companies whose price/earnings ratio is below their ROE. As Muhlenkamp puts it, "We're buying Buicks but at Chevy prices."

The resulting portfolio is a mix of nearly 80 stocks of all sizes, including a smattering of foreign names, selected with the broader economic climate in mind. Muhlenkamp then minimizes churn among his holdings, keeping turnover around 10% for the past few years. That buy-and-hold approach has paid off handsomely for shareholders. (Muhlenkamp, the fund's largest individual owner, invests all his own money in the fund. "I own a farm, a couple of tractors, a motorcycle, and a mutual fund," he says.) The fund has returned an annualized 16% over ten years, five percentage points better than the S&P 500.

Muhlenkamp still sees opportunities in the current market. One group he likes is homebuilders, and his portfolio includes names such as Centex, NVR, and Meritage Homes (MTH, $74). While some money managers have turned tepid on the sector because of rising interest rates, Muhlenkamp says demographic trends and industry consolidation will continue to drive growth in the business. "If you brought me fresh money today, one of the first things I'd buy you would be housing stocks," he says. He owns nearly 4% of the outstanding shares in Meritage, which builds single- family residences in the Western U.S. With a projected 2004 return on equity of 26% and a P/E of 8.6, Meritage, he believes, has plenty of mileage left.