Lessons From the Man Who Sells to Buffett

There's dumb money, and there's smart money. And then there's Sherman money.

You know all about dumb money, and a little bit about smart money. But, chances are, you have never heard of Sherman money. That's the kind of well-informed money that buys the most-hated stocks at very low prices ahead of the smart money, holds a long time and stealthily feeds them out, usually amid a love fest, at high prices to the dumb money.

Bruce Sherman is that kind of money, that kind of investor. The kind that even Warren Buffett comes to see when he's in a buying mood. The kind that we can be thankful to learn from in this week of gratefulness.

Chief executive of secretive Private Capital Management of Naples, Fla., Sherman specializes in taking large to very large stakes in up to 75 companies at a time, and holding for as long as it takes to make a bloody fortune. In the past four years alone, he has sold four companies to the Buffett investment vehicle Berkshire Hathaway ( BRK.A), including the ice-cream joint International Dairy Queen, carpet maker Shaw Industries and children's clothing maker Garan. Gross returns for his account are 18% annualized over the past three years through Sept. 30, while the market was down 13%; 19% annualized over five years, while the market was down 2%; and 24% annualized over the past 10 years, while the market was up 9%.

Not bad for a public-school kid from Queens who spent his first decade in business as a Big Eight accountant fancying up financial statements for public companies -- and learning where the bodies could be buried. Not bad for a shy number-cruncher whose first big job outside New York was as financial consigliere for the fabled Collier family of Florida. Not bad for a University of Rhode Island grad who started with a stake of just a couple million dollars and has parlayed it into the least-celebrated, $11 billion investment company in the nation.

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), where he's the largest shareholder. Or software maker Computer Associates ( CA), where he's the largest shareholder. Or Ryan's Family Steak Houses ( RYAN), where he's the largest shareholder. Or trading-card and candy maker Topps Co. ( TOPP), where he's the largest shareholder. Or Raymond James Financial ( RJF), where he's the largest shareholder. Or Callaway Golf ( ELY), where he's the second-largest shareholder. Or Bear Stearns ( BSC), where he's the largest shareholder. Or Interstate Bakeries ( IBC), where he's the largest shareholder. Or Apple Computer ( AAPL), 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) 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.

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.

  • In Shaw Industries, he saw a "colored concrete" maker whose shares were out of step with the technology-focused 1990s, despite the fact that it dominated its market and had great cash flow. "Price paid, value received," he says.

  • In Garan, he saw a toy maker that sold 80% of its merchandise to Wal-Mart Stores ( WMT), yet managed to maintain decent margins.

    Recent Buys

    So what's he buying now? He's tight-lipped, declining to name names except to say he's paid a buck or two above the current price, on average, for his 7.4% stake in Computer Associates -- the much-reviled software giant that has been the subject of two corporate board fights and a series of Securities and Exchange Commission investigations. After all the company has gone through, he believes it has a model board of directors; it has done a lot to make its once-opaque financial statements more transparent; and he considers new Chief Executive Sanjay Kumar an excellent manager, who has a large equity stake in the company's success.

    Meanwhile, Sherman's partner, Gregg Powers, a former engineer, believes the company's products will have adequate longevity. "We have been through all the issues and we are comfortable that it is well-managed and inexpensive," he said before echoing a familiar refrain: "Price paid, quality received."

    Before you dismiss this attitude as the conflicted comments of a big shareholder, consider that he compares this situation with the biggest coup of his, or just about any other value investor's, career: He was a longtime supporter of Qualcomm ( QCOM) in the mid-1990s, when any number of experts in the media called Chief Executive Irwin Jacobs a snake-oil salesman and forecast that its CDMA wireless technology was going nowhere. Sherman named a large boat parked off Naples "SeaDMA" to prove the skeptics wrong. He kept holding the stock through most of its 2,000% rise in 1999. Though he sold most of his stake by mid-2000, he still owns 1%, or about 7.7 million shares, of the company.

    To learn which stocks Sherman has been buying recently, I visited my favorite site for SEC filings, 10KWizard.com, and looked for his firm's last two Form 13F filings. These are reports that managers of more than $100 million must file quarterly that list all holdings in dollars and shares.

    If you put the two quarters' lists on the same spreadsheet, and line up the stocks alphabetically on the same row, you can calculate which ones he has been adding to and withdrawing from, and which ones have been added as new. I pay particular attention to ones where he's bought more shares, but the value has dropped -- indicating you can possibly pay less than he did.

    And here's something to look forward to after the holidays: Sherman slyly says there will be "a surprise" in his Feb. 15 report.

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