Mark Sellers, Intelligent Investor

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.

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Joe Feshbach: How Feshbach Nailed a 3-Bagger

Emil Lee: Can you describe your thought process leading up to your purchase of Tempur-Pedic?

Joe Feshbach: I got involved in September 2005, after Tempur issued a disappointing forecast for the third quarter of that year. The bears were convinced that Tempur had a business with low barriers to entry that [competitors] Sealy (NYSE: ZZ) and Simmons would be able to threaten.

My thesis, in contrast to the bear case, was that Tempur was the leader in specialty bedding, that it was already a leading global brand, and that displacing it would be a lot harder than conventional wisdom [believed at the time].

Our lowest cost basis on the stock was $9.70. Our core position was built around an average of $11.

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Breaking Down Berkshire's Equitas Deal

Emil Lee: Can you walk us through the economics of the Equitas deal?

Marc Mayerson: Under the deal, [Berkshire subsidiary] National Indemnity will reinsure all of Equitas' liabilities and provide a further $7 billion of reinsurance coverage for Equitas. Equitas has [loss] reserves presently of $8.7 billion (as of March 31, 2006), and National Indemnity will commit an additional $5.7 billion of reinsurance capacity.

Once Equitas pays out $8.7 billion in future losses -- which will probably take a couple of decades -- Berkshire is on the hook for an additional $7 billion of coverage.

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Emil Lee: Buffett's Capital Riddle

Here's a riddle for you. Say you could own one of two companies:

• Company A, which earns $2 million with $8 million in net tangible assets, and costs $25 million to purchase.
• Company B, which earns $2 million with $18 million in net tangible assets, and costs $18 million to purchase.

Furthermore, let's assume both companies will have flat unit volume for the foreseeable future. Which one would you pick?

A value investor's dream
Hmm ... let's think about this. If you pick Company B, you get more tangible assets, the same amount of earnings, and you're buying at a multiple of earnings of 9, versus 12.5 for Company A. Not only that, but wasn't Ben Graham, the godfather of value investing, a proponent of buying stocks at a discount to asset values?

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Don't Lose Money Even When You're Wrong

Charlie Munger, vice chairman of Berkshire Hathaway believes that investors equipped with the right mental models can achieve long-term returns superior to their less-informed peers. One of the best mental models Fools should stick in their arsenal is the concept of backup systems.....

Final thoughts

Do your own research. Osmium Partners, a hedge fund whose flagship fund boasts 23% annual net returns since inception, requires that its investments pass a rigorous gauntlet in order to be considered a candidate. You should have your own process as well. Put together an investment thesis for yourself.

Need some ideas? Osmium's criteria include substantial net cash on the balance sheet, owner-oriented management, a dominant market share in a niche industry, and extremely low multiples of cash flow. Each additional criterion puts in place another backup system to ensure positive returns, helping to explain Osmium's ability to find multibagger opportunities in small-cap stocks. Put together an investment thesis of your own, and you'll be a better investor in the long run.

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How Berkshire Built a Super-Cat Powerhouse

As of 2006, Berkshire Hathaway wrote the third-largest amount of net premiums in the reinsurance industry -- an amazing feat for a firm that started out making textiles. One of the key foundations of Berkshire's reinsurance business is its super-catastrophe line, and the company's annual shareholder letters offer an incredibly valuable case study of that segment's success. Let's take a closer look at the integral components of Berkshire's reinsurance division.

Against all odds

Berkshire's success in super-cat reinsurance, which insures very large catastrophic loss events, becomes more impressive in light of the challenges it faced. Capable reinsurers such a RenaissanceRe , XL Capital, and Montpelier Re compete fiercely for market share. In addition, barriers to entry are minimal, with recently formed reinsurers such as Flagstone Re and Greenlight Re almost constantly emerging. Lastly, reinsurance is a commodity to some extent.

Thus, Berkshire boss Warren Buffett had to overcome considerable obstacles to build his reinsurance operations into the juggernaut they are today. Since day one, Buffett based his strategy on three simple strengths: speed, size, and security.

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Tom Brown: An Interview with Tom Brown

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.

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Sardar Biglari: Sizzlin' With Sardar Biglari

Emil Lee: Please tell me about your hedge fund.

Sardar Biglari: I started Biglari Capital right after I graduated from Trinity University. Biglari Capital is the general partner to The Lion Fund, L.P., a private investment partnership. I am a value investor, and I apply the same principles in running Western Sizzlin as I do in operating The Lion Fund. I focus intensely on evaluating an array of situations, searching for pockets of opportunity that are within my sphere of competence.

This maneuver leads me to be risk-averse, concentrated, and conservative with our capital. The right occasions for investment arise when there is general misunderstanding -- and therefore mispricing -- of the worth of an asset. In other words, our plan does not revolve around using common sense -- the logic of the lemmings can be flawed -- but, rather, around good sense, which can be uncommon.

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