Surviving the bad times in the fund industry.

And the meek equity fund shall inherit the mutual fund industry.

A few years ago managers of a group of small stock funds-usually part of smaller shops with rather modest asset bases-didn't go along with the New Age nonsense that proclaimed the business cycle was dead, earnings meant nothing, and stock P/E ratios didn't matter. These staid funds, which were unpopular in the last go-go decade, now are the top performers of a humbled industry.

"The theme of these funds tends to be small-cap and value, but there have been a few large-cap growth funds that have also done well," says Russ Kinnel, Morningstar's director of fund analysis.

The "meek" funds have made money even in bad times. Some examples cited by Kinnel include Liberty Acorn-up 3.38% annualized for three years through the end of April-a fund that is buying low-priced financial concerns, such as Americredit, and service companies, such as ITT Educational Services and Global Payments.

Another meek group is Franklin Templeton's Mutual Series, which includes its Beacon Fund. The latter (which recently included lead positions such as Berkshire Hathaway, Kroger, Liberty Media and British American Tobacco) is plus 2.29% in the same period. The S&P 500, in the same three years, is down an average 12.96% a year.

"Most of all, the few equity funds that made money were run by people who didn't get carried away and overpay for stocks in the 1990s," Kinnel adds. What other characteristics do these funds share?

They are not overconcentrated in a few stocks or a sector, Kinnel notes. They aren't betting on a few companies. They didn't make wild promises about the supposed end of the business cycle and the market never going though bearish times. They didn't go gaga over techs or dotcoms that had yet to show any earnings or potential earnings. They ignored the advice of a famous fund manager, James Craig, who justified a 44 p/e portfolio ratio in 2000 by saying: "We're now heavily weighted in the new media and technology area, but that's where the big changes in the economy are. I don't see that there are going to be any major changes in that thesis."

Traditional managers disagreed with that thesis. But they also had investors who were angry with them in the late 1990s, when they were lagging the market and their peers.

And sometimes, to the consternation of shareholders, they have had considerable cash holdings. "We got a lot of grief from many of our clients, who took their money and went out the door," says Gerald Perritt, manager of the Perritt Micro Cap Opportunities Fund (up 12.5% a year for a three-year period through the end of April. He typically buys low-price stocks such as Matrix Services). Perritt runs a one-fund shop based in Chicago, and is part of a small group of funds that are muddling through the bear market very well. Some even have had a fat year or two during this gruesome period.

We're speaking of a select class of equity funds that have made it through this rough three-year period in which most equity funds were bloodied. These funds were making money or just about breaking even in the last three years-a period that came right after the "New Economy" promised an end to bear markets and which saw trillions of dollars in equity get vaporized.

But some contrarian managers didn't lose any of their clients' money at a time when a typical popular fund of the late 1990s, the Janus Fund, lost some 22% annualized over the three-year period ending April 30. In the wake of those losses, Janus has reorganized its management. "We've had some disappointing three-year numbers," says James Gott, director of research for Janus, vowing that the numbers are now going to improve.

But what about those who are succeeding in this difficult period? How are they doing it?

"It has everything to do with a disciplined strategy. Many of our competitors lost it. We didn't," says Eric Schoenstein, director of business analysis for Jensen Investment Management, a one-fund shop in Portland, Ore.

"There's no shame in holding cash sometimes. And that is what we've done at times," says David Winters, manager of the Mutual Beacon Fund. "We just wouldn't buy at the top of the bubble. We wouldn't buy overpriced securities with P/Es of over 100-and that got us in trouble with some shareholders. But that's fine, because basically we want shareholders who are ready to stay with us for the long haul."

Mutual Series' six funds all had positive three-year numbers except the Mutual European Fund, and that is down only slightly (negative 1.85% annualized). Winters says that his funds buy distressed securities or good companies that are suddenly available at a big discount.

For instance, Mutual Beacon's portfolio recently had an average P/E of 14 and a beta of 0.57. All these managers, now in favor because they were not taken in by the silliness of the 1990s and the overweighting of techs, emphasize that they merely followed commonsense rules of investing.

"I'd love to say that we did something brilliant, but we didn't. We just had a low-risk approach to small-cap investing, an approach that we know will work over the long term," says Chuck Royce, founder of the Royce Funds. He says that his funds were shedding assets in the late 1990s. That's when clients were losing patience with their returns.

"Some people didn't think they were getting a good deal then, but we believe that value wins over the long term, even though it often doesn't look so good in the short term," Royce says.

Royce's six funds have all been in the black during the three-year period in which most equity funds have been black and blue. The top performer is Royce Special Equity, which is plus 18.2% a year. The "laggard" is Royce Opportunity, which was ahead only 1.3%, a number that would be called outstanding by most shellshocked fund investors these days. Royce Opportunity plays low-priced industrial and retail stocks such as Hughes Supply, Spiegel and Esterline Tech.

Royce has, as do many of the other managers interviewed, one distinct advantage over his younger peers. "I remember the 1973-74 disaster. And I remember the Nifty 50 mess," Royce says. Perritt, a friend of Royce for many years, says that he didn't predict the exact time of this recent bear market, but he knew in the 1990s that it was going to happen sometime.

"The fund industry has made this mistake before. I was sure it would happen again. And, even after all this, I say this will happen again sometime. The fund industry hasn't learned anything," Perritt warns.

Many managers believe the basic problem of the industry-regardless of whether a manager is growth oriented or value oriented-is not sticking to promises of a fund charter, of becoming carried away by the need to bring in large new assets. That, they say, distorts investment fundamentals.

Sticking to its principles explains much of why Jensen was lagging its growth peers late in the last century. But over the past three years, it virtually broke even (-0.17% annualized through April 30), which meant it beat its peers by about 2000 basis points. (Large growth funds in this period averaged an annual return of -20.5%, according to Morningstar). The fund, which was very small until two years ago, has a conventional philosophy. Its p/e ratios are low compared to its peers, averaging about 20, and its beta is about two-thirds of the S&P 500.

"The most important component of our strategy is ensuring that the business and pricing risks are held to a minimum," says Bob Mullen, a principal of Jensen Investment Management. "We want to buy great companies with a margin of safety."

Typical lead holdings are Jones Apparel Group, Stryker, State Street Advisors and MBNA. Most of the portfolio has companies with P/Es in the high teens or low 20s. Mullen says most managers wouldn't take this tack in the late 1990s.

"That's when we were lagging most growth funds," Mullen adds. But then things changed quickly. Consequently, when the market blew up, they found that "they had lost their way," he says. Jensen's asset base, by the way, has exploded. It has gone from some $18 million three years ago to more than $1 billion today.

Perritt also will not buy pricey entries for his portfolio, which has grown but is still a rather modest $45 million. Perritt, who actually had a 35% gain one recent year, blames the big fund families for the industry's woes. "They just hate me at Fidelity, Janus and Vanguard, but they were coming up with the flavor of the month funds just to get in the bucks. They were coming up with sector funds that were inherently dangerous, and I said so," says Perritt. "They didn't like me at the big shops for saying nasty things like that in public, but so be it."

History can be nasty. But Perritt's friend, Chuck Royce, says that it is essential for successful portfolio managers to study it. "So many managers had never lived through this kind of thing before, and that's one reason why they made so many of the same mistakes that managers made back in the early 1970s," says Royce. "And that's a reason why another generation of managers will make these mistakes again."

And then, once again, the meek will inherit a shattered fund industry.