Motto: Invest 'em if you got 'em

Franklin Mutual Discovery Fund's Anne Gudefin doesn't smoke, but her fund ranks among the best performers because Russian, Korean and Chinese smokers light up more than one billion cigarettes a day.

The $12.3 billion Franklin fund has about 10 percent of its assets in tobacco stocks, six times the amount in the Morgan Stanley Capital International World Index. Its biggest holdings are British American Tobacco P.L.C. and South Korean cigarette-maker KT&G Corp.

"Tobacco stocks are undervalued," said Gudefin, comanager of the fund, in an interview from the Short Hills, N.J., office of Franklin Resources Inc.'s Mutual Advisors L.L.C. unit. The number of nicotine addicts is growing, so "if you're hooked up," she said, "you're hooked up, and that's it."

The Mutual Discovery Fund returned 24 percent in the last 12 months, placing third of 174 funds whose managers buy companies they view as inexpensive, according to data compiled by Bloomberg.

It rose at an average annual rate of 15 percent since 2002, compared with the Standard & Poor's 500 index's 6 percent gain. While the number of smokers is declining in America, it is rising in emerging nations, said Gudefin, who comanages the fund with Charles Lahr. The companies also have increased cigarette prices in developed countries in recent years.

As many as 100,000 children start smoking every day around the world, and about a third of the male adult population have picked up the habit, according to data compiled by the World Health Organization. Tobacco companies sell 15 billion cigarettes every day.

About two-thirds of Chinese and Korean men smoke, compared with 24 percent in the United States, according to statistics from the WHO and the American Heart Association.

Tobacco companies, including Philip Morris USA Inc., now Altria Group Inc., agreed in 1998 to settle with 46 U.S. states and Washington by paying about $210 billion over 25 years and limiting advertising.

"Litigation risk is nonexistent outside the U.S.," Gudefin said. The Franklin fund owns shares of Altria, which trade at about 16 times earnings compared with 18 for the average stock on the Standard & Poor's 500 index, Bloomberg data show. British American is priced at about 17 times earnings, and KT&G is at 16.

The fund's managers "aren't afraid to have a portfolio that doesn't look like anyone else's," said John Coumarianos, an analyst at Morningstar Inc., of Chicago. "They are looking for things that have some negative sentiment."

The top-performing "value" fund of the last year was T2 Partners L.L.C.'s $12.8 million Tilson Focus Fund, up 27 percent. Its three largest holdings are Warren Buffett's Berkshire Hathaway Inc., fast-food chain McDonald's Corp., and software-maker Microsoft Corp. The Kinetics Paradigm Fund ranked second, gaining 26 percent as shares of NYSE Group Inc. and Chicago Mercantile Exchange Holdings Inc. climbed.

The Franklin fund has a three-year Sharpe ratio of 2.01, higher than similar funds' 1.23. The greater a fund's Sharpe ratio, the better its risk-adjusted performance.

Morningstar gives the fund four stars, its second-highest ranking. The Franklin fund's tobacco investments have paid off as cigarette prices increased. The cost for a carton, or 10 packs, rose 12 percent in the United States since 2001 to $32.83, according to Information Resources Inc., a Chicago-based market-research company.

The Franklin fund began building its tobacco stake 10 years ago as governments in Europe sold state-owned cigarette-makers to companies including London-based British American and Britain's Imperial Tobacco Group P.L.C. British American bought Italy's Ente Tabacchi Italiani S.p.A. in 2003. Italy has ranked as Europe's second-largest cigarette market by volume after Germany.

Shares of British American, the fund's largest position at 2.2 percent of assets, climbed every year since 2000 and returned 23 percent in the last year. The maker of Lucky Strike cigarettes has lured investors with a dividend yield of 3.3 percent and annual stock buybacks of about $990 million. The S&P 500's dividend yield is 1.78 percent.

Takeover speculation has boosted the stocks. Mergers and acquisitions in the industry totaled $24.6 billion last year, up from $8.4 billion in 2005, Bloomberg data show.

The Morgan Stanley Capital International World Tobacco Index gained at an average annual rate of 20 percent since the end of 1999, beating the broader MSCI EAFE Index's 2.4 percent advance.

Shares of Madrid, Spain-based Altadis S.A. rose to a record earlier this month on media reports that Imperial Tobacco may offer to buy the company for $12.9 billion. Officials at both companies have declined to comment. The Franklin fund holds shares of both.

Shares of Tokyo-based Japan Tobacco Inc., another holding, jumped 63 percent in the last year. The world's third-largest publicly traded tobacco company agreed to buy Gallaher Group P.L.C. of Britain for $14.8 billion in December. The takeover makes Japan Tobacco the leading distributor of cigarettes in Russia.

KT&G's stock rose 23 percent in the period.

Fund managers: Anne Gudefin, Charles Lahr.

Assets under management: $12.3 billion.

Performance:

Up 24 percent in

the last 12 months.

Significant holdings: KT&G Corp., British American Tobacco P.L.C., Imperial Tobacco Group P.L.C.

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