For months now, the economy has been in dire straits. As it begins to resettle, both businesses and consumers are getting serious about their efforts to deleverage. They will undoubtedly borrow and spend less in the years ahead, leaving the outlook for corporate earnings and stock returns muted. But despite this dismal forecast, many fund managers are finding outstanding opportunities at the individual stock level, even after factoring in the negative corporate environment.

These two views aren't necessarily at odds. Occasionally, periods are driven by economic extremes (such as the financial meltdown last year or the bursting of the tech bubble in 2000). During these times, stock prices become disconnected from fundamentals (even admittedly, bad fundamentals). And as we've seen in the current meltdown, this results in the underpricing of some stocks and the overpricing of others. Ultimately, these mispricings must be corrected, which can create a great opportunity for skilled active managers.

One reason for this disconnect is that as highly stressed financial institutions (including hedge funds) were forced to reduce their leverage, they sold any liquid assets they could to raise capital, dumping some stocks at any price. Supply and demand imbalances can create pricing anomalies in the short term. And with a temporary glut of supply as hedge funds and other investors dumped stocks, as well as a lack of demand as investors hunkered down to weather the storm, our managers saw some stocks trading at what they considered to be irrational levels. And they continue to see what they believe are some of the most compelling individual stock opportunities of their investment lifetimes.

BACKING IT UP

A number of data points suggest that the current picture is encouraging for stock pickers. First, let's look at data from Empirical Research on the spread between individual stock valuations (see "Open Wide," on page 76). It goes back to the early 1950s and, based on a composite of four traditional measures of valuation, compares the magnitude of the variation between the cheapest group of stocks relative to the overall market.

The spread in valuation reliably increases at times of major distress. And as the most recent economic crisis unfolded last fall, this measure revealed extremely wide stock valuations, about as wide as they have ever been during the 50-plus years Empirical has collected data. This suggests that distressed environments do, in fact, favor active management.

We pursued this idea further by looking at our own equity model performance in years when valuation spreads were very wide. In multiyear periods beginning in early 1991 and 2001, our model outperformed by material amounts in each of the three years following the points at which stocks reached historically wide valuation spreads.

We then looked at data on a range of large-cap U.S. equity funds with histories dating back to 1991. We divided the funds into growth, blend and value groups, and then selected the top half (based on performance over the full 18-year period, through the end of 2008) to create subsets of outperforming funds.

We were curious about whether these better-performing funds earned more of their outperformance during periods beginning when valuation spreads were widest (see "Waiting for Opportunity," right). We looked at the median annualized margin of outperformance over the full period, as well as for each of the three-year periods that began at times of historically wide valuation spreads. Since the majority of managers outperformed by wider margins during the periods that began with wide valuation spreads, the results for this broader group of equity managers suggest that these types of environments can favor active managers.

If we are in a period in which some stocks may do very well even as the overall market does not, we'd expect to see some performance evidence. Our data shows just that. A review of the nine domestic large-cap equity managers we use widely in our model portfolios reveals that their average margin of outperformance was 829 basis points over the period from January 2009 through May 2009. The largest margins were posted by Longleaf Partners (24.5 percentage points ahead of its benchmark), Touchstone Sands Capital Growth (20.1 points), Oakmark Select (17.6 points) and Fairholme (9.1 points).

Of course, there is no guarantee that the active managers we use will continue to outperform. But the recent data is consistent with what we'd expect in a highly dislocated environment. Hopefully time will show that we are, in fact, at the early stages of a great opportunity for truly skilled active managers.

Steve Savage is managing director of AdvisorIntelligence, Litman/Gregory's web-based research and practice management service.