Lessons From the Man Who Sells to Buffett

The spiels about cash flow and corporate governance sound very voguish today, but Sherman's been a hawk on both for a long time. His preferred definition of free cash flow removes capital expenditure for equipment maintenance and adjusts for balance-sheet growth and for required working capital changes. In other words, it's a pretty hard number to figure out unless you've got his spreadsheet on your computer -- and he's not handing it over. "You can't find that number anywhere, but you'll find it is substantially less than earnings at most companies," he says.

Sherman hunts for high levels of discretionary cash flow because he wants substantial amounts of money left over after all the bills are paid each quarter to buy back shares -- lifting earnings per share -- or to call in debt. He won't buy companies that grow primarily through acquisition, and he won't pay up to chase a good idea that's rising ahead of him. The point, in a nutshell, is to get lots of underutilized assets and cash flow for the price paid, not to get stuck as a minority shareholder fighting with family members who would object to a takeover or restructuring -- and to be patient. "If you buy 50-cent dollars, over time, the good news should take care of itself," he said.

He learned all of this on his own, gathering street smarts on the fly, either when rising to be the youngest audit principal at Arthur Young in the mid-1970s, or when helping the Colliers manage their disparate banking, real-estate and media interests in the early 1980s, or when running and selling his own bank before starting Private Capital in 1986.

Here's what Sherman saw in companies he later sold to Buffett:

In Dairy Queen, he saw a niche-dominating franchiser with tremendous cash flow that was grease-cheap and shrinking its outstanding shares through buybacks.