From 1991 – 1995, Bruce Sherman achieved what some consider the holy grail of investing. Sherman beat the S&P 500 without taking on more volatility with the portfolio for Private Capital Management.
Private Capital Management was ranked by Money Manager Review as the #1 value manager on a risk-adjusted basis over this 5-year period. The returns for the 5 years ending 1995 were 25% annually, compared to 17% for the S&P 500.
How did Bruce Sherman find success?
In this article, we will examine his investment strategy, as shared in a great interview by Peter Tanous in the 1997 edition of his book Investment Gurus.
- How Bruce Sherman Looked for Great Stocks
- What Kind of Stocks Did Bruce Sherman Like?
- What was Bruce Sherman’s Sell Strategy?
- Which Stocks Did Bruce Sherman Avoid?
Let’s start with the basics.
How Bruce Sherman Looked for Great Stocks
Said simply, Sherman wanted to know what the value of a stock was. He looked for stocks trading at a good price compared to its intrinsic value.
It was not enough to know the company, as some investors might operate. Bruce Sherman would rather think about “price paid, quality received.” Like he said, seeing your kids spending all of their money at the Gap is not a reason to own the stock.
During his great run ending 1995, Sherman found many great investments with the following general process:
- Run a screen to identify stocks trading at a good price
- Read lots of company reports, especially 10-K’s and proxy statements, even during his free time in the jacuzzi
- Visit a company’s management
- Estimate the free cash flow and valuation of a stock
Let’s look at each of these. Most of these activities can be emulated by average investors looking to work at beating the market themselves.
What’s a stock screen?
A stock screen can help an investor filter out thousands of stocks in a few seconds. By setting some parameters, an investor can instantly exclude stocks which don’t meet their criteria.
Say you don’t want to buy stocks that are trading at a high P/E ratio or low revenue growth. You can simply use Finviz’s dropdown to set a parameter for the maximum P/E or minimum revenue growth a stock must have to pass the screen.
In Bruce Sherman’s case, he did not want to see a company at a 40-45x multiple to free cash flow, like Coca Cola’s stock was trading at during the interview.
Sherman also generally liked to see stocks that were buying back stock. He also liked insider buying—when management was buying the stock personally as well.
What are proxy statements and 10-K’s?
Bruce Sherman really wanted to know the ins and outs of a business and its accounting. There is no better way to accomplish those two things than to read a company’s financial statements and reports.
The first place to start, in Sherman’s opinion, is a company’s proxy statement.
A proxy statement, or DEF14A, contains important details about the leadership of a business. In there, investors can see who the board of directors is and how the board is constructed. They can see how management is compensated and how financial incentives are set up.
Then you have a company’s annual report and the 10-K.
The 10-K has the most critical financial reporting that all publicly traded companies in the U.S. must file (those that are regulated by the SEC).
An annual report, which is sometimes just the 10-K, has things like the description of a business, a company’s 3 main financial statements, and the risk factors for investing in this business. It can be a lot to process for beginners; our good friend Dave Ahern wrote a wonderful post on how to read a 10-K which can make it much simpler for you.
You can tell from the interview in the book that Bruce Sherman really examined these documents closely for the stocks he bought (and didn’t buy).
Sherman drew from his background at the accounting firm Arthur Young to comb financial statements and pick up details that most of Wall Street missed. While much of Wall Street likes to focus on the Income Statement, Sherman would look at things like deferred tax liabilities and Days Sales Outstanding to make better intrinsic value estimates of a business.
Visiting Company Management
As a money manager with a significant number of Assets Under Management, Bruce Sherman had access to many of the small-to-mid cap value stocks which he focused on. Over a 10-year period, Sherman talked about having visited over 250 companies.
Sherman used these visits to pick up insights about the business and its management.
For example, during a drive with someone from investor relations, Sherman was able to pick up that the chairman of a company was likely to continue buying stock even as Wall Street was selling it.
On the other side, Sherman saw the CFO for a company with a Bloomberg Terminal on his desk. This small detail could be a sign of a management with incentives that were not aligned with shareholders. Investors should look for management that cares more about the performance of their businesses than its day-to-day stock price.
What Kind of Stocks Did Bruce Sherman Like?
Sherman tended to buy stocks that were trading at a low multiple to their Free Cash Flow per share.
In his words, Sherman would analyze the “discretionary free cash flow” of a business and compare this to its stock price. In other words, it was not about just the company’s reported free cash flow, but also expenses or capex the company might have in the future.
Investors can have better insight into the intrinsic value of a business by using accounting.
By looking at a company’s free cash flow, investors can forecast how much cash can be returned to shareholders, or be reinvested for future growth. It is a great way to find wonderful long term investments, because it starts at the source of future earnings or Total Return.
It can all be understood through accounting.
Why Does Accounting Matter?
At its core, accounting is the language of business.
More in-depth accounting helps paint the picture of the realities of a business. Every business is different, but they share certain characteristics, like revenue, cash, and assets.
Some companies, like retailers and distributors, are inventory heavy.
To grow, many of them must invest in lots of inventory, and manage this inventory well. Poor inventory management, such as buying too much compared to future demand, can lead to future losses. That affects the long term value of a business and its future stock price.
Other businesses, however, are not inventory heavy at all.
A technology company like Microsoft does not have much inventory at all, but must invest in other assets. For example, their cloud business Azure is Property, Plant, and Equipment heavy. That business invests heavily in data centers, and then charges other businesses to use these servers as a service. Investments of cash still must be made, but to different types of assets.
Looking at a company’s accounting and financial statements helps you understand the drivers of a business, and how the company is performing with these drivers over its history.
That can be key in helping you evaluate a company’s competitive advantage, and the compounding potential of a stock over the long term.
What’s Free Cash Flow?
As Bruce Sherman explained,
“Free cash flow allows a company to buy back its own stock, pay down debt, or buy incremental new businesses.”
It is a better metric than earnings because it takes into consideration the investments a business must make to operate.
Thinking back to the examples above, a retailer that also spends a lot to constantly refurbish its stores might not generate as much cash flow as a distributor with no store front. Both might post high earnings growth now, but the retailer that must constantly refurbish won’t have much cash left to give back to shareholders in a dividend or share buybacks.
Free Cash Flow (FCF) is easy to calculate from a company’s financial statements.
By looking at the cash flow statement, we can find the two line items needed to calculate the definition of FCF:
FCF = Cash from operations – capital expenditures
Cash from operations includes changes in working capital, which accounts for investments in inventory and other factors affecting the balance sheet. Capital expenditures accounts for those investments in long-term physical assets.
You can see how the two different types of investments needed to run a business are covered by free cash flow.
That’s why it’s a great metric for understanding what makes a business tick.
A company that generates more free cash on its assets, such as Microsoft, can be identified by looking at FCF. It’s a great way to identify wonderful businesses.
What was Bruce Sherman’s Sell Strategy?
There’s no easy answer to the question of when to sell a stock. For Bruce Sherman, this decision was admittedly just as difficult.
While Sherman didn’t lay down any hard-and-fast sell rules, he did offer a framework. For him, the strategy is to sell when a stock is approaching full value, not when it is already trading at intrinsic value.
That can be hard to do because it’s easy to fall in love with a stock, especially when it does well.
It all depends on an investor’s personal strategy.
For an investor looking to participate in the long term compounding of a business, holding a stock rather than selling it would be a better sell strategy for them. This is because over the long term, most stocks seem to trade at-or-above intrinsic value, making holding for the long term next to impossible in great compounding businesses.
In contrast to that, an investor looking to compound their portfolio as a result of constantly taking advantage of market inefficiencies, should probably sell when a stock is close to intrinsic value, as Bruce Sherman did.
One example of a red flag for Sherman was when a stock was trading at a higher FCF multiple, and then management announces a secondary stock offering. In other words, the company dilutes (sells) shares in order to raise cash.
Many investors might interpret that action as a signal that management thinks their stock is too expensive. And it makes a lot of sense for most stocks intellectually.
Which Stocks Did Bruce Sherman Avoid?
As already mentioned, Sherman looked for value stocks in the small cap and mid cap range. The result of this was a lot of “lousy companies,” especially selling below book value.
Buying stocks that are trading below book value is a common strategy among many value investors.
Benjamin Graham, the “father of value investing” proposed the idea in his investment classic The Intelligent Investor. The appeal of this sort of a strategy is that, in theory, a company could liquidate its assets, with the resulting cash being its book value. If an investor were to buy a stock trading below the reported book value, and the company were to liquidate, the investor would profit.
In reality, however, this can lead to buying value traps. A value trap is a stock that looks like a good deal but actually becomes a bad investment, because the underlying business continues to struggle.
A good example of this is businesses which are losing money. When a business loses money instead of making a profit, their book value will likely decrease over time.
Even a discount paid to book value would not save an investor from a business hemorrhaging cash.
Bruce Sherman looked to avoid lousy businesses such as these, as part of his screening process. He also avoided expensive stocks on a Price to FCF basis, such as Coca Cola in 1997.
We can learn many great things from Bruce Sherman and his impressive 5 year track record running Private Capital Management, especially the basics of free cash flow and accounting.
My favorite takeaway was that Sherman was clearly passionate about the stock market.
There’s just no better way to describe that than a guy in his free time, reading 10-K’s in his jacuzzi (which is what he did).