The perfect portfolio for 2007

By Tim Middleton

This is the time of year to take a hard look at your portfolio. Even long-term investors need to weed out funds that aren't performing up to expectations and rebalance as circumstances -- like getting a year older -- change.

I've gone through this process with my own holdings and made some course corrections. My guiding vision is this calculation: The stock market rally we've enjoyed for three years now seems likely not only to continue, but possibly to accelerate.

I hate to talk about new paradigms, but we're blazing a trail through a period in economic history unlike anything since at least the late 19^th century, when the United States was the foremost emerging market. Whole continents are prospering as they never have, creating an unprecedented volume of capital eagerly searching for a home.

I want to own the kind of securities these global capitalists are shopping for.

Here are seven best-of-breed mutual funds I think will succeed in the new year. I'm not wagering that they'll be the best-performing funds; almost certainly, they will not. Together they are broadly diversified, and any year's top performers are inevitably highly focused on whatever sector or country happens to be hottest at the moment.

These are all equity funds. I think 2007 will be good for fixed-income investors as well, but that's a story for another day. Equity investors have more choices to make and need to put a little more effort into their portfolios than income investors do.

Fidelity Capital Appreciation

In a letter to clients last month, Morgan Stanley made this remarkable observation: "The average bull market return has been 70% attributable to multiple expansion. In the bull market that started in 2003, there has been none."

Let me translate. Price-earnings ratios for stocks today are almost exactly where they were three years ago, because although stock prices have risen, earnings have risen just as much. But price-earnings ratios are almost always driven up in bull markets because the supply of great companies can't keep up with investor demand.

Fidelity Capital Appreciation (FDCAX) is likely to be a beneficiary of this trend. Manager Fergis Shiel is the kind of seat-of-the-pants investor that made Fidelity famous. He's been with this fund only one year, but before that he ran Fidelity Independence (FDFFX), and, as Morningstar analyst Dan Lefkovitz wrote: "At one point, he had 30% of that fund's assets invested in two tobacco stocks, in which he made a killing. In his one year on the job here, he has beaten 92% of his large-growth peers."

Big-capitalization growth stocks have been lagging since 2000, but they have begun to catch up. This fund is ahead 13.5% this year, as of Dec. 8.

Fairholme Fund

Fairholme (FAIRX) is up 17.2% this year behind an equally brilliant and eclectic manager, Bruce Berkowitz. I've written about this outstanding fund several times, most recently last May, in a piece about midcap funds.

Fairholme is a mid-cap fund by accident: It invests in companies of all sizes, so the average is in the middle. The fund's largest holding, with nearly 15% of assets, is megacap Berkshire Hathaway (BRK.A, news, msgs), but another Top 5 position is Mohawk Industries (MHK, news, msgs), a mid-cap producer of floor coverings.

Berkowitz is an advocate of deep, patient value investing, just like Berkshire's Warren Buffett. Whereas Shiel is a heavy trader, Berkowitz has an average holding period of three years. This fund, therefore, is likely to be less volatile than some of my other recommendations, and every portfolio needs more-stable funds to moderate the price swings of the more aggressive ones.

Bridgeway Small Company Value

Bridgeway Small Company Value (BRSVX) is, as Morningstar notes, "one of the few good small-value options still open to new investors." Manager John Montgomery, one of the best investment managers in the socially responsible camp, uses computers to pick stocks, which holds down expenses. The fund's expense ratio of 0.77% is about half the group's average.

Bridgeway is the opposite of Fairholme in one respect: It is extremely volatile. That's because Montgomery stresses the very smallest stocks, which are prone to enduring the most crushing defeats as well as the most spectacular successes.

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