Mark Sellers Interview

Thanks for surfing over from the Sellers Capital web site. Here is the interview that Joe Bradley, founder of Investor’s HOTLINE, conducted with Mark Sellers, managing member of Sellers Capital, LLC, and portfolio manager for the Sellers Capital Fund.

You can listen to Mark’s explanation of what traits make a great investor, how conviction and other emotions impact the investment process, and which strategies average investors should consider utilizing. He also discusses his own investment approach, names some of his favorite picks and issues cautions on some past favorites. Mark tells what he is not buying and why, and he warns listeners about a common pitfall for value investors that he must watch himself.

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Mark Sellers: Rational investors should rejoice

Two months ago in my Financial Times column, I listed some of the things I have learnt about the stock market over the years. I likened the market to a game of online poker, with anonymous opponents and continuously evolving probabilities. I received some good reader feedback, so this month I’ve decided to revisit the topic. Here are a few more things I’ve learnt about the stock market.

1. People can’t handle high returns.

People say they want to make a lot of money in the stock market but, because of human psychology, very few can handle the volatility that comes with this pursuit. The pain of losing $1, even temporarily, is much greater than the pleasure of making $1.

The book Fortunes Formula details the origins of a formula developed by Bell Labs mathematician John Kelly. His formula allows a gambler to determine the optimal bet size if the gambler can estimate the odds of winning the bet and the pay-off for winning compared with the penalty for losing. The formula can also be modified so that it applies to multiple simultaneous bets – in other words, a stock portfolio.

By studying the Kelly formula, as I have, it becomes apparent that in order to get optimal portfolio returns, an investor has to be willing to endure a lot of volatility. That is because the Kelly formula will have you making large, concentrated bets when you find favourable risk/reward opportunities. And concentration brings volatility.

This is unacceptable to most people because they irrationally equate short-term volatility with risk. So rather than achieving optimal portfolio returns coupled with high volatility, people would rather achieve sub-optimal portfolio returns coupled with low volatility. And that’s why few funds stand out from the crowd; they’re giving their customers what they want.

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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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Mark Sellers: Irrational world of institutionalised money managers

One of my favourite films is The Shawshank Redemption, based on a short story by Stephen King. It stars Tim Robbins and Morgan Freeman, and the whole thing takes place inside a prison. There is a scene where Freeman’s inmate character is talking to another inmate about a guy named Brooks who has been locked up for 40 or 50 years and has basically lived his whole life in prison. Brooks is now an old man and up for parole, and he is terrified of getting out because he does not remember how to live in the real world. My favourite line is in this scene, when Freeman says: “These prison walls are funny. First you hate ’em, then you get used to ’em. Enough time passes, you get so you depend on ‘em. That’s institutionalised.”

This notion applies to many areas of life. It is easy to resign yourself to a bad situation and accept your lot in life. After a while you do not know how to live any other way. You make up all sorts of reasons to justify why it is alright to remain in a bad situation. This can be true of jobs and relationships and other things. Like the money management business.

I think a lot of money managers are like Brooks. They have become institutionalised.

The average actively managed mutual fund in the US holds about 100 stocks. This means the managers can’t possibly be doing in-depth research on each company they hold. So how is the average fund managed, if not by researching each stock in the portfolio?

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Mark Sellers: Tend to overanalyse stocks? Bring out the dart-wielding monkey

Should you spend countless hours researching a stock before buying it, or just a few hours? The common wisdom is that the more time you spend on research, the better your investment results will be. But is this correct?

Not according to studies on the subject. At least two I have seen came to the conclusion that anything more than a cursory review of a company’s prospects is a waste of time. One study looked at whether more information was useful to experienced horse racing gamblers. The researchers first gave the gamblers a few items of relevant information (age of horse, pedigree, jockey, etc) and asked them to predict which horse would win the race.

They then gave out dozens more items of information about the race and asked the experts to predict again, based on the additional information they had received. The conclusion was that the first few items of information given to them were useful but further information had no effect on the accuracy of their predictions. The gamblers were far more confident about their predictions after receiving more information, but this didn’t translate into accuracy.

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Mark Sellers: Optionalities add up to buying opportunity

When I use the term “optionality”, I’m referring to a situation where binary outcomes are possible and it’s difficult to determine the likelihood of either scenario occurring. When it’s difficult to determine something, the market will sometimes take the lazy route and just ignore it. That’s where the inefficiency comes in. Bill Miller has said the market won’t pay for optionality. In my experience, this is often true.

One such situation is occurring now with Carrizo Oil & Gas, in which my fund invests. Based in Houston, Carrizo is an exploration and production (E&P) company with natural gas reserves in the Barnett shale in Texas and onshore Gulf of Mexico coastline, coal bed methane deposits in the western US and a recent oil discovery in the North Sea.

The company’s current enterprise value is approximately $1.4bn. To get a fair value for Carrizo’s shares at, or below, the market price of $43 a share, you have to ignore a lot of optionality. I come to this opinion based on the following sum-of-the-parts valuation.

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Mark Sellers: Wide-moat companies with hidden assets

My investment firm focuses its research on two types of companies: those with wide economic moats, and those with hidden assets that are worth nearly as much as the value of the entire company.

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Source: Lincoln Minor

Mark Sellers: Value proposition

Sellers likes big companies with few competitors -- "wide-moat" businesses -- buying when they're out of favor and shares are trading at levels he considers a bargain. He also invests in small companies with hidden assets that other investors haven't factored into the price -- stakes he calls "small-cap asset plays."

The hedge fund is extremely concentrated, holding between five and 15 positions, and typically closer to five. Nowadays, just six stocks make up 90% of the portfolio, he says, with one position accounting for half of the fund's assets.

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Source: Lincoln Minor