Tom Brown is the founder of the $550 million hedge fund Second Curve Capital, which specializes in financial-services companies. I once worked at one of America's largest funds, and ever since, I've been obsessed with all things alternative. From my experience, Tom Brown may be the best financial services analyst on the planet, and I doubt I'm alone in that opinion.

About six months ago, I decided to read every article in the archive of the Second Curve-run website bankstocks.com. It was almost like getting an MBA in finance. I wanted the Fool's readers to learn about Second Curve's methodologies and some of the companies in which the fund is interested. I called Tom Brown up for a phone interview; the notes in italics are my own commentary.

Question: I read some statistics on how you turned some initial capital from your father into a large sum. Can you provide me with details?

Tom Brown: My father got a lump sum contribution in 1984 of $130,000, which subsequently became $18 million by the early 2000s by investing only in financial stocks.

Brown calculated the annual average rate of return at roughly 40%.

Question: Why do you stick solely to financial-services companies?

Tom Brown: Well, financial-services businesses are in my circle of competence. I can try to grow that circle, but I just don't know other industries as well.

Question: Can you describe your due diligence process?

Tom Brown: We look at 350 companies in our "universe." Then we use valuation tools to identify where there's an attractive opportunity with our team of five analysts. Then we take a position and build upon our knowledge. We only own 15-20 stocks in our portfolio, so we're focused in our investment activity.

Question: How detailed do your valuation models get? Do you get into specific unit costs?

Tom Brown: For the model, it really depends on the company. Sometimes they don't matter, sometimes they're critical. It could be a cash flow model, and sometimes it's an earnings model. We do 360-degree research; we go visit the company and talk to senior level management, but we also talk to mid-level management. That's one of the benefits of bankstocks.com. We also talk to frontline employees and customers.

Question: How do you calculate free cash flow for financial services companies?

Tom Brown: You can't. For our cash flow model, a company might securitize assets, which is accounted for with a gain on sale [taking the net present value of the profit]. We're looking for the cash flow value of residuals.

When a financial-services company securitizes assets, it usually sells a portfolio of loans to other investors. The investors are entitled to an annual interest rate payment, and the seller often retains the right to excess cash flow (the residual interest). Valuing this residual interest can be tricky, because it's based on management estimates and can be used for accounting trickery. Second Curve's intimate knowledge of management gives it a competitive advantage in estimating whether residual values are real or not.

Question: So in general, you use an earnings-power model?

Tom Brown: In most investments, that'd be the case.

Question: What do you look for in insurers, banks, and other spread lenders?

Tom Brown: Well, there's a list of what we like to see, and a list of what we usually have to deal with. ... A big part of our job is our evaluation of the management and constantly searching for new information that will lead you to support or lead you to change that [view of management]. Management is critical. We try to find companies with a competitive advantage. Take a company like First Marblehead (NYSE:FMD); their advantage is in private student loans.

First Marblehead provides outsourced underwriting services for private student loans. Its stock took a dive when the market got scared that Marblehead's business model and cash flows were unsustainable, but Second Curve believed otherwise. Since bankstocks.com posted a bullish article on First Marblehead in 2005, the stock is up 80%.

Question: So how did you go about finding this investment idea? Did you already know about the company before the stock dropped?

Tom Brown: At beginning of 2005, I knew nothing about First Marblehead. We hired an individual who knew a lot about the company. The stock started to weaken in 2005, and the analyst who used to work here recommended it and we took a small position. We grew the position as the stock declined, and as we learned more about the story.

At which point I thought to myself: Nice!

In conclusion...
I had heard the story before, but didn't realize how high the 40% rate of return that Tom earned for his father was. I was also surprised that Second Curve sticks to a relatively small universe of 350 companies; that's truly a defined circle of competence, and it explains why Second Curve was able to make the contrarian bet on First Marblehead. After reading the analysis on bankstocks.com it seemed like Second Curve knew the company like the back of its hand.

It's also noteworthy that Second Curve, because of its intimate knowledge and hard work in doing due diligence, had the conviction not only to stick with its First Marblehead position as the stock kept going down -- at the time, it seemed as if everyone and their mother thought Marblehead was going to hell in a hand basket -- but also to buy more stock, a move which has since paid off in spades.

I also noted that in doing due diligence, its important to get a holistic view by talking to midlevel and frontline employees and customers. I think readers should note that most due diligence methods are available to anyone who's willing to pick up the phone and call a copy, or drive to its nearest location -- not just to employees of multimillion- dollar hedge funds. Second Curve employees often visit a bank's branch to get a firsthand sense from the customer's perspective, a trip that anyone can make. In fact, visiting stores in person helped keep me out of Cost PlusWorld Market (NASDAQ:CPWM) and Pier 1 (NYSE:PIR), both of which are down 40% in the past year.

Check back tomorrow for the second part of this interview, in which Tom Brown talks about some of his portfolio holdings, including RenaissanceRe (NYSE:RNR), Montpelier Re (NYSE:MRH), and a pick he describes in bankstocks.com as the single most attractive opportunity in the financial services sector.

Learn more about financial services:

First Marblehead and Montpelier Re are Motley Fool Hidden Gems recommendations, while Montpelier Re also made the list at Motley Fool Stock Advisor . Follow the preceding links to try either newsletter free for 30 days.

Fool contributor Emil Lee is an analyst and a disciple of value investing. He owns shares in Montpelier Re. Emil appreciates comments, concerns, and complaints. The Motley Fool has a disclosure policy.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.