Lessons From the Man Who Sells to Buffett

What's his style and what's his secret? That's part of his thing. He really has no style.

He tries to buy dollar bills for 50 cents, which makes him a value guy. But a lot of his big positions don't look like traditional value plays anymore. Companies such as casino supplier International Game Technology(IGT Quote), where he's the largest shareholder. Or software maker Computer Associates(CA Quote), where he's the largest shareholder. Or Ryan's Family Steak Houses(RYAN Quote), where he's the largest shareholder. Or trading-card and candy maker Topps Co.(TOPP Quote), where he's the largest shareholder. Or Raymond James Financial(RJF Quote), where he's the largest shareholder. Or Callaway Golf(ELY Quote), where he's the second-largest shareholder. Or Bear Stearns(BSC Quote), where he's the largest shareholder. Or Interstate Bakeries(IBC Quote), where he's the largest shareholder. Or Apple Computer(AAPL Quote), where he's the third-largest shareholder.

Sherman calls himself an all-cap manager with an emphasis on small-caps and mid-caps, but he considers companies with market caps of $1 billion to $5 billion to be the sweet spot of his style. "When we reverse engineer the numbers and see where we've made the most money over the years, we can see this is the right place to be," he said in an interview last week from his office.

And that's lesson No. 1 for Sherman wannabes: Don't lock yourself in a box. Follow the value wherever it may lead, to any industry, any size, anywhere.

Sherman's Definition of Value

Private Capital Management has no mutual fund, and just a small hedge fund. Most of its money is in individually managed accounts for high-net-worth individuals with $2.5 million or more to put in its care. The firm was purchased by Maryland-based financial services company Legg Mason(LM Quote) last year, but it is run as an independent operation far from the nation's financial hubs.

How to determine the value? That's the hard part, of course. And the part that takes most of Sherman's attention. His model for owning significant stakes in hundreds of companies over the years has been to find companies with clean corporate governance and high levels of discretionary cash flow. The formula: Try to buy big stakes in decent businesses at a big discount, so long as they're not run by some third-generation member of the founding family who's loaded up the board of directors with golfing buddies, his insurance agent and his own kid.

He never takes a board position himself, despite his high level of ownership, preferring to find managers with whom he shares a "high level of goal congruency," which is a cute way of saying ones that are incented to earn their money through equity appreciation rather than through W-2 income. He also prefers companies that disclose a lot about themselves in the exhibits to their 10-Qs and 10-Ks, such as detailed lease agreements and executive employment contracts, so he can do the most complete analysis of enterprise value possible.