I recently chatted with Mark Sellers, founder of Sellers Capital. The hedge fund boasts roughly $115 million in assets and annualized returns of 35% (before fees) since inception, including a 45% year-to-date return.
In the hour or so I spent on the phone, I learned a great deal about topics like measuring downside risk, evaluating management, and dealing with volatility:
Emil Lee: How does your firm go about researching an investment idea?
Mark Sellers: The first thing we do is figure out what the problem is. Ninety percent of making money in stocks is not losing money, which has to do with knowing what the problem is and how it can be solved. Every company we buy has a problem with it, otherwise it wouldn't be cheap.
We read sell-side reports, SEC filings, and talk to management. Within one or two days, we decide if we're comfortable that the company can solve the problem. Then we do another week or so of further research.
Lee: How important is management to your theses?
Sellers: Judging management is one of the most important things. Everyone says "We look at management," but only a few really spend a lot of time like: Ruane, Cunnif, Bruce Berkowitz [of Fairholme Capital], Sellers Capital, and [chairman of Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) ] Warren Buffett.
Lee: Are there any examples of times when you visited a management team and were able to make a decision based on subtle cues?
Sellers: We went and visited a company and were completely turned off by the CFO. We thought he wasn't forthcoming, he didn't give us good answers, and he didn't seem to understand the concept of capital allocation or share repurchases. We sold the stock the next Monday at a small loss. Since then, the stock's down 50%. Good management teams can't always make a stock go up, but bad management teams will always make a stock go down. When we find out a management team isn't who we thought, we're outta there.
Lee: Do you have any other advice on how to judge a management team?
Sellers: If a company puts out a press release saying "Company XYZ Beats Guidance," then that company may be too promotional and too focused on "beating" earnings estimates. If another company puts out a press release saying, "XYZ Reports Third-Quarter Earnings," they're not being too promotional. You can tell a lot from just observing and reading.
Lee: Can you tell us about your experience with Contango? (Contango Oil & Gas (AMEX: MCF ) is one of Sellers Capital's big winners, and is up 120% since the fund put 50% of its holdings in it).
Sellers: We had it at about 8% of our fund. We bought it originally because we had visited the company and really liked the management team. That was enough for us to make it an 8% position. They hit a huge well in the Gulf of Mexico, and that's when we bought it big, and made it about a 50% position. No one was giving them credit for [the well].
Lee: I feel like that happens a lot, where news events aren't reflected in the stock price even after the fact.
Sellers: Yeah. In a binary event, such as drilling a well, you can probability-weight [the outcomes] and buy [the stock] before the event. Or you can buy it after the event; there's no black-and-white line. We sometimes buy before or after [an important event]. If a company is already priced as if it'll drill a dry hole, then just buy it before -- what've you got to lose? It's the same thing with a non-binary event. It all depends on how much you can lose if you're wrong.
The other thing that's unique about our strategy is our selling process. We sell a lot. We sell when a stock hits our fair value and we think we'll only get a market return. Our hurdle rate is 20%. Another thing we think is unique is that if we realize we're wrong, or if we develop a distrust and no longer respect a management team, we'll sell the stock immediately.
Lee: You're fund is extremely concentrated. How do you deal with volatility and downside risk?
Sellers: It (downside risk) makes me wake up in the middle of the night and make sure I'm not missing any risks. I'm always worrying about it. When the fund is down, I think I'd be lying if I said it wasn't bothering me. But I've learned how to deal with it. We reanalyze, and make sure our theses are the same. When we're down, all our research turns inward and we focus on the existing portfolio.
We don't take any bankruptcy risk. It's easier to sleep at night when you have a company where there's no way in hell they can go bankrupt, like Contango or Lowe's (NYSE: LOW ) .
For example, for MBIA (NYSE: MBI ) , if you go long on them, you better be willing to lose 100% to make 100%. Generally, with a levered company, it's a coin flip. But for a company like Wells Fargo (NYSE: WFC ) , with a very conservative balance sheet, or a community bank with very high reserves, I'd potentially look at those. But right now I don't see them as being cheap enough.
When you get into a company where the cash flows are uncertain, like a consumer finance company, that's where you have to be careful. When cash flows are uncertain, you tend to panic at the worst times.
Berkshire vice chairman Charlie Munger once said, "One of the advantages of a fellow like Buffett is that he automatically thinks in terms of decision trees." During my conversation with Mark, he seemed to have an innate ability to really identify the key probabilities and risks involved with his positions and funnel capital toward the most favorable propositions. Best wishes to all of the members of Sellers Capital!