if you’re traveling with an associate,all you’re thinking and talking about is that company. No phones,no Bloomberg screens, no trading calls, nothing.
Tanous:There’s always HBO.
Sherman: I'd rather read my stuff. When you spend a few hoursat the company the next morning, you are totally immersed. You arenot seeing the people on a road show, not seeing them with chartsin front of a hundred analysts. You’re seeing the CEO in his office.
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You ask to spend a half-hour with the CFO. You're seeing the cars inthe parking lot. You’re asking the in-your-face questions that hedoesn’t want to answer.
I just took a big position in International Game Technology. Iwanted to own that stock five or six years ago. It’s always been tooexpensive. It was never close to being a value stock. They dominatetheir industry; they’re a casino without walls, because they have theselink progressive machines. But the stock disappointed. They had flatearnings instead of up 25%. They promptly lost half of their marketcapitalization. The company was buying back their stock. The stockhad gone from 25 to 12, and I established about a two million shareposition between 12 and 12 1/2. But before I did that, | had to findout what I didn’t know; I had to go visit the company. Here they arein the casino business, the world’s largest slot machine manufacturer,and I want to know what these people are like. | was supposed tomeet the CEO, but the chairman terminated him about a week beforeI got there. But, in speaking to all the other people up and down theorganization, I was able to come away with things I never would havededuced without a company visit.
Tanous:How about an example?
Sherman: I asked: Tell me about the people who are talking negat-ively about your company. Tell me about the new technology thatyour competitors have. I don’t want to read it in Bear Stearns research.I want to see it myself.
Now here we are in Reno, Nevada in winter, and I get a call thatmy daughter at Northwestern is sick, so I had to fly to Chicago, butI didn’t have a coat. So I asked this fellow, the investor relations guywho was schlepping me around, to drive me to a store to buy a coat.We get there. He tries to take me to the fancy coat section, and I goto the cheap coat section. But I found more out in the 45-minute driveto the clothing store where I bought an overcoat than I did anywhereelse.
Most important, on the way to the airport, I ask him, what doesthe chairman do? And he says all he does is keep busy managing thebuyback of the stock. Now I really wanted to hear that they were stillbuying the stock back before I bought it. My original premise forpossibly buying it was: You’re getting the manufacturing of the slotmachines for free if you pay $12 for the stock. That gives you thevalue of the cash flow generation from their megabucks, their link
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progressive machines. They link up machines around the country [andcreate giant jackpots]. So I was glad to hear that the chairman appar-ently agreed, and was still buying the stock.
Tanous:Is the point of this that you learned about the buyback asa result of the detour to buy the coat?
Sherman: The point is, that when you take somebody out of theirelement and you’re not sitting in their office in a formal structure,you can relax. I was on the fence about the stock situation. That detourhelped me learn things I would not have learned in my office analyz-ing numbers.
Tanous:How’s your daughter?
Sherman: Oh, she’s fine now.
Tanous:Any other examples?
Sherman: | also went to Brinkers International, a stock | didn’tbuy.
Tanous: Those are the Chili’s people?
Sherman: Yes, the Chili’s restaurant chain. I was sitting in theiroffices, actually on the same trip, and the CFO has a Bloomberg [afinancial newswire and data terminal]. Why does a CFO need aBloomberg in his office? Is he worried about stock quotes for therestaurants’ accounts? Not with my money!
Tanous:Let’s get a little deeper into your style. I want to quotesomething from your brochure. In bold letters, which jump out at you,it says: “One inviolable standard is DON’T LOSE MONEY.” That’s atough thing to do with your record. Your five year returns average25% on your composite portfolio, and your risk, measured by standarddeviation, is the same, or less, than the market as a whole. That’spretty amazing.
Sherman:Money Manager Review came out with us in it. SEI falarge investment management and financial consulting firm] just camein and looked at us sixteen-ways-to-Sunday. And I get really boredbecause I don’t know how they do what they do. I really don’t carebecause, to me, all this is about absolute dollars. What counts to meis comparing net worth in period A to net worth in period B. I alsowant to adjust for taxes in taxable accounts. Money Manager Reviewsaid we were in the top 7% of value managers for the five years endedDecember 1995, and number one out of 641 on a risk-adjusted basis.If you ask me how they got to that, I don’t know. It probably has todo with portfolio volatility against the mean, by quarter.
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Tanous:But Bruce, you can’t ignore that! Surely you appreciate thevalue of a risk-adjusted performance. Your performance, as great asit is, is enhanced by the fact that your investors, for some reasonwhich you may or may not be conscious of, are not taking the samekinds of risk to get these returns as they might have to with anothermanager. I think that’s an important point.
Sherman: I'll bet that 90% of today’s investment managers havenever experienced a bear market. There really hasn’t been much of abear market since 1985. The year of the crash [1987] we were up18% and the overall market was up slightly. In the last four or fivedays, we’ve been pretty heavy sellers of some of our positions. Why?Because a lot of the stocks we bought at 50 cents on the intrinsicdollar, are now trading at 80 or 90 cents on the dollar. It’s hard tokiss them good-bye, but you have to.
But the answer to your question about our emphasis on never losingmoney, is that the bulk of our money is private capital. Private moneyis a precious, irreplaceable commodity. With confiscatory taxation,it’s very hard to earn it.
Remember the old line, what’s the definition of a good investmentfor a doctor? Answer: He gets his money back. It’s the same for myown account. It’s the only thing we know how to do. For example,Coca-Cola is a great company. The market capitalization, as I sit herelooking at a Coke can, is greater than the capitalization of the bottom100 companies in the Standard & Poor’s 500 combined. Coke probablysells at 40 x to 45 x free cash flow, and it’s a great product. But tome, that’s an inversion of a 2% yield. And I don’t know why peoplewould pay that.
Tanous:Please explain that.
Sherman: Well, it’s probably selling at 30 x to 35 x earnings, andCoke does have capital expenditures. If you adjust the numbers, youwould see that it is probably selling at 40 x free cash flow, by ourdefinition. If something is 40 x free cash flow, inverting that is a 2.5%yield on that cash. [In other words, for every $100 spent to purchasestock, the company generates $2.50 of free cash.] And why do I needto hold something at 2.5%? Having said that, it’s been a wonderfulholding for some people. But no bell is going to go off when it’s over.Let me get back to your question. Your question was about our intenseantagonism to losing money.
Tanous:Also, the one you haven’t answered yet about volatility.
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Maybe there is no answer. Are you saying that you don’t manage withvolatility in mind? Does it just happen?
Sherman: We do not manage with volatility in mind. We are thefirst, second, or third largest shareholder in about 50% of the namesin our portfolio. I want to know more about the companies thananybody. I want to be thinking like an owner. I want to be thinkinglike a CEO. And our names are companies that are traditionally sleepy.No one on the Street follows them. They’re not out selling stock. Theywant to be off the radar screens. They may be public for some of thestrangest reasons. Maybe they were public for 25 years and they havesince disappointed investors, but they have inherently good, strongcash flow characteristics.
Nirvana, to me, is a stock like BHC Communications, which is aGabelli [page 77] stock. The company is Herb Siegel's company. I'moversimplifying, but it’s the company that was created when he be-came the white knight for Time Warner. It owns the third or fourthlargest group of independent TV stations in the country, including aTV station in New York and a TV station in L.A. It pukes out cashflow. It has about $65 to $70 a share in cash. No debt. It sells at about93, and it’s run by smart people. It started the UPN network which,is trying to become the fifth network. Of the 12 million shares thatwere publicly floated four years ago, there are now only 6 millionshares of public float. Siegel is a patient man. He bought 6 millionshares back in the open market.
Tanous:How much of that do you own?
Sherman: We own about 12% of the 6 million share float. [Thefloat is that portion of the stock that can trade in the open market.]It’s a big position. Remember, there were 30 million shares outstand-ing. Chris Craft Industries owns 18 million shares [not part of thefloat]. That left 12 million shares outstanding. The company retired6 million shares of the stock and now that’s down to only 6 millionoutstanding. Theoretically, I want to own the last share. I want to seemanagement face-to-face. If I think it’s worth 50 cents on the dollar,and they don’t think it’s worth 50 cents on the dollar and they’re notbuying the stock back, then I’m making a mistake. So I want to bein-their-face and ask them, why?
Software Spectrum is a classic example. The stock has done wellin the past two or three years. It started showing up on our radarscreen at 9 or 10 and the stock recently got over 20. We’re the biggest
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shareholder of the company. They’re the world’s largest corporatereseller of software products. They’ve gone to electronic distribution,as opposed to hard, shrink-wrapped software distribution. Most oftheir employees around the world work out of their homes. Theyprovide service to people. So when this stock got down to 10, myassociate kept asking, why aren’t they buying the stock back? It’sselling below book value; it’s got $3.00 a share in cash; it’s tradingat 7 x cash flow; so why aren’t they buying back the stock? We wroteletters to the board. In the end, we find out that they’ve been workingon a strategic acquisition for two years which consumes all the cash.That’s a good answer. I don’t want to invest in cash for cash’s sake,because I can do that myself. Our clients can hold cash. I want to seestock buybacks or I want to see that cash utilized. [A secretary comesin with an important phone message and shows it to Bruce Sherman.He replies that he’ll have to return the call.]
Sherman: That guy who just called is the CFO of Albank FinancialCorp. It’s a $3 billion bank. I’m the largest shareholder. When thestock was about $18, I wrote a check for 600,000 shares. The stockis now 28. They just turned down an offer of $35 a share for thecompany. I am leaping out of my chair! Not only did I write themanagement a letter, I sent a copy to all the directors. I got the direct-ors’ addresses by having somebody look them up. I wanted them toget the letters at their home addresses. They have a fiduciary obliga-tion! If they turned down the offer, | want to ask them: Why did youturn it down? What other alternatives do you have? They said, “If wesell, now is not the right time and we’re not sure they’re the rightpurchaser.” My question is, who is the right purchaser, and when isthe right time? They have an obligation. At least the company justannounced a buyback of stock.
Money managers don’t like to get in there and mix it up. It’s myobligation, if somebody pays me compensation, to get in there andprotect their interests. Shareholders have rights and they need to beprotected. Michael Price [page 33] did it with Chase. We can do it ona smaller scale.
Tanous:Let’s talk about your sell discipline.
Sherman: It’s much harder to sell than to buy because, before youbuy you can crunch numbers, visit management, understand the dy-namics, and you don’t have to think about what the economy is doing.
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Of course, you ought to know what’s going on in the industry,whether it’s media, health care, or software.
The sell side is difficult. You have to sell not when they’re fullyvalued, but when they’re close to fully valued. To be candid, mostsales in a bull market have been good intellectual sales, but the stocksreally haven’t gone down. So I’m really converting a piece of paperto cash.
The discipline is, if I buy and I think it’s trading at 50 to 60 centson the dollar, or 8 x to 10 x free cash flow [which is a good multipleof free cash flow], and then it goes up to 15 x or 16 x free cash flow,and I think management is about to announce a secondary stock of-fering, I run for the hills. If you think management’s going to builda new corporate headquarters, you'd better run for the hills. (I'moversimplifying.) And you need to read those proxies, read thosefootnotes. Where is the value accruing to? Is it accruing to manage-ment as compensation? Is it accruing to the shareholders? So it be-comes intuitive, but it all goes into the mix. It’s hard to be a seller,other than a disciplined seller. We sell on a graduated basis.
Rio Hotel. We went out and visited them. RHC is the symbol. It’sa Las Vegas stock. Rio Hotel & Casino is extremely well run. It alwayswins the Best of Vegas awards. It’s an all-suite hotel, great property.All of sudden, they had a flat quarter. Stock was hit down to about$11 or $12 a share. What an opportunity. Now it’s only 5 x or 6 xEBITDA [Earnings before Interest, Taxes, Depreciation, and Amortiz-ation], 8 x or 9 x cash flow. I’m looking for a reason to buy, butmanagement hasn’t bought a share. All of a sudden Marnell, thechairman, buys 150,000 shares in the open market. He’s already arich guy. He thinks the same way I do. That’s unusual. This is 3 monthsago. Stock went right up to 18. You want to be lucky rather thansmart sometime? I can’t tell you why it happened, other than BearStearns picked up coverage and started writing about the stock. It’sgone from 12 to 18.
Tanous:How did you find it originally?
Sherman: It showed up on the computer screens. The company’sEBITDA and multiples against residual market value got our attention.We have formulas to calculate this. Gregg Powers, a valued associate,does a tremendous job. I say, give me a listing of all companies inthis order: percentage of outstanding stock they bought back, ratedby EBITDA multiple, compared to residual market value. Then take
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free cash flow, by lumping all capital expenditures against the number,without analyzing it. Then run the computer screens. Sometimes youget garbage. Half of it is junk, but you’ll find some oddball companieswhich were once followed by the Street but are no longer followed.Those might become great ideas.
That’s the starting point. You read the material; make a lot of phonecalls. You talk to the company’s customers; get the investor relationspeople; get the management on the phone, see how they respond.Now you don’t go into a meeting and ask: What’s your next quartergoing to look like? That’s what Wall Street does. Understand whatyour two-to-five year time horizon is, and then go visit the company.The company visit is half of it.
Tanous:It’s interesting when you talk about doing this work. Asyou know, some of the people I’m interviewing are efficient markettheorists. Their view is that everything about a company is reflectedin the price of the stock at all times. So they think the idea of runningthese screens and finding stuff is a waste of time because, as thetheory goes, anything you might be able to figure out is already in theprice of the stock.
Sherman: I had a client call up who gave us about $3 million andnow it’s worth $11 or $12 million. I don’t remember the timeframe,but it’s been about 7 or 8 years. He wants to put some money in large-cap stocks. This happened last Friday. He thinks that we’ve been great.At the time we represented about 50% of his net worth; now it’s about80% of his net worth. And he thinks it’s reasonable for him to wantto go large-cap. So he asks if we can recommend a large-cap manager.I said, I’m going to save you some money. Don’t buy a manager, buythe index. You can own the index by buying “spiders” [so-called be-cause the abbreviation is “SPDR,” which stands for Standard & Poor’sDepository Receipts] on the American Stock Exchange. Symbol SPY.You'll own the index; you won’t pay taxes; and you can own itforever, if that’s what you want. And, if I don’t outperform that indexfrom here forward, fire me, and maybe Ill put my money with you.
Tanous:In essence, you are challenging the efficient market crowdby putting your money where your mouth is. Your message is, if Ican’t beat the market, don’t pay me; in fact, fire me. That certainlyseems fair. But in your case, Bruce, you go beyond what most man-agers do in their investment strategy. Of all the managers I’m inter-viewing for this book, you are the only one who uses short sales, albeit
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to a limited extent. I deliberately avoided interviewing hedge fundmanagers because I want the readers of this book to be able toidentify with managers who invest the way they do. You don’t callyourself a hedge fund manager, and I don’t think you identify withthem. So please explain. Give us examples of stocks you've shortedand how those shorts fit in with your philosophy.
Sherman: I think the best way to describe shorting is, if you believein value, by definition you believe in anti-value. If you’re looking forcompanies that have certain characteristics, you can make money onthe long side. The same is true on the short side for companies thathave the following characteristics: no free cash flow, heavy insiderselling, no franchise value, poor to average management, and fungibleaccounting. Remember, | spent ten years of my early professional lifemaking earnings per share. | know you can be pretty creative inmaking earnings. If you had those characteristics, at least up untilthis crazy momentum market of 1996, it was a great vehicle for us.We identified four or five accounting shenanigans, where we wereamong the first to identify them. I think of Delmed and Media Vision,for example. We made a lot of money for our clients that way.
But, so far in 1996, that’s not possible. Every Monday morning,mutual fund companies are pouring money into names like Iomega.The stock has quadrupled. I wouldn’t be in business if we had shorteda lot of that. I can tell you that, in the first quarter of 1996, anythingthat had sex-appeal and a story behind it, even if it met my shortcriteria, was going up in your face. So first, we want to be right, likein 1994 when the market was flat and we had an overall return of14%. The shorts paid off handsomely. I think it’s going to happenagain in 1996.
Tanous:What are you shorting now, with all these stocks goingcrazy?
Sherman: You want names?
Tanous: Sure.
Sherman: Okay. We have a company called Just for Feet whichhas 22 (going to 30) sneaker super stores. It has a market capitalizationof about $850 million, or about $30 million per store. You can putone of these stores up for about $1.5 million. In the proxy statement,not the annual report - always read the proxy first - the presidenthas personally guaranteed $17 million worth of vendor payables.That’s for a company with a market capitalization of $850 million.
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Why did he have to guarantee those payables? Their format is a su-perstore selling sneakers. Now, at last count, there are about 25,000mall units around the country selling sneakers. According to the proxystatement, the company borrowed $50 million on January 28th, andpaid it back on February 2nd, so they could show good cash per sharein their annual report (their fiscal year-end is January 31st). Theyhave ten months of inventory, but they don’t take markdowns fontheir balance sheet]. They got through their audit this year; we don’tthink they'll get through their audit next year.
Tanous:Where’s the stock now?
Sherman: The stock is around 50. Management has cashed outabout $200 million worth of stock. We've visited seven or eight stores.They’re good merchants. The guy had one shoe store for about fifteenyears. He probably took home half a million dollars a year. Now, onlyin America, in two short years he’s probably worth about $300 million.
Tanous:Short sales are risky, of course, because if the stock keepsgoing up, there’s no theoretical limit to your losses. How do you assessthe risk in this situation?
Sherman: The risk is if you believe there will be, maybe, 3,000super sneaker stores around the country. Or, if you believe what theytold us, and I quote, “We’ve invented entertainment retailing.” Theyhave a popcorn stand and a hot dog stand and, they say, “We taughtBarnes and Noble how to do it.” I think it’s a phenomenal short idea.I should point out that it’s gone up since we shorted it.
Tanous:That does sound like a great idea. But I presume theseshorts are a small percentage of your portfolio.
Sherman: Typically, we have two types of accounts. We have long-only accounts, and we have long-and-short accounts. We let the clientmake that decision. In the long/short account, the shorts will be asmall portion of the total account.
Tanous: What are your minimums?
Sherman: Minimums are $1.0 million. Fees start at 1.5%.
Tanous:What advice would you have for investors who might notbe able to put money with you?
Sherman: The stock market has offered higher returns than almostany other vehicle since early in the century. It is an efficient mechan-ism over time. But a lot of people don’t have the patience and don’tlook at it over a five year horizon. I think people who get into themarket should stay in the market and understand what they own.
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Peter Lynch [page1 19] puts it pretty simplistically, “Know what youown.” I would buy a mutual fund and find out who is really runningit. | would also open a discount brokerage account somewhere andbuy one or two stocks. Figure out a reason you want to own them,and don’t just say, I’ve been to the Gap and my kids spend all theirmoney there. It’s not that simple. Understand how much you're payingfor it, because in our business: price paid, quality received. Mercedesat a Cadillac price, or a Cadillac at a Chevy price. That allows roomfor error. If you can’t find that, there’s nothing wrong with cash.
The bottom line of the whole process is doing work. One magazinereporter asked me once, what do you do in your spare time? I said, Iread 10Ks in the Jacuzzi. So he asked, could we take a picture of youdoing that? I said my body doesn’t warrant taking a picture in theJacuzzi. But you've got to have a passion. The thing that differentiatesgood managers from mediocre managers is, you’ve got to have apassion.
You can take the man out of New York, but you can’t take NewYork out of the man. Welcome to in-your-face investing! But person-ality aside, it’s interesting how your individual background and in-terests will find their way into whatever it is you decide to do. If Ihadn't told you that Bruce Sherman was a professional accountant,could you have guessed? Of course you could, because his investmentphilosophy is rooted in value and, boy, does he know how to readthose financial statements! His success in investing proves that hisapproach really makes sense, too.
Let’s review some of the Bruce Sherman basics. You want to owna company that has a lot of free cash flow - that’s cash flow after allthe company’s expenses, but also allowing for any necessary capitalexpenditures the company might have, or is planning to have, whichwill also use that cash flow. The search for the free cash flow isvaluable because companies that have extra cash can do interestingthings, like buy back their own stock (something else that Bruce likesto see), or retire debt. Then there’s the management. Bruce Shermanwants to make sure that the management is up to the task, so hevisits them and sees them in their own environment. This, of course,is something that’s a lot harder for the rest of us to do, since whenBruce calls up, they know he might be prepared to invest $50 millionor so in their company.
If any of this has a familiar ring, let me help you out. The common
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element is what the lawyers call “due diligence” and you and I call“hard work.” Fortunately, Bruce Sherman actually enjoys what hedoes. Poring over financial statements is major recreation to him. Butas we consider how he invests, we begin to see the elements of hissuccess. Research is the key to finding value, particularly undiscoveredvalue. You may not be able to do everything that Bruce Sherman does,either because you may not be a professional accountant or have in-stant access to corporate managements, but there are a number ofclues in this investing approach that each of us can learn from. Justremember to take those 10Ks into the Jacuzzi with you.
176ERIC RYBACK
The Lindner Funds - named after legendary investment managerKurt Lindner, who died in 1995 - are managed by Lindner’s protégé,Eric Ryback. Based in St. Louis, Missouri, the fund group todaycomprises six mutual funds: the Lindner Growth, Lindner Dividend,Lindner Utility, Lindner/Ryback Small-Cap, Lindner Bulwark, andLindner International. A nice collection, but we’re here because ofjust one of them: the legendary Lindner Dividend Fund, which has,arguably, the best risk-adjusted performance of any fund in America.This fund was started in 1976. Since then, it has compiled a recordof 17% annual growth (through the end of 1995). Yes, you can finda few others that have done that well, but you won’t find anotherfund, or I daresay another manager, with that kind of return in a verylow-risk investment style. In fact, the Lindner Dividend Fund statesthat “capital appreciation is a secondary goal.” The fund, long a fa-vorite of very conservative investors, continues to compile an enviablerecord year after year.
Eric Ryback has been managing the Lindner Dividend Fund since1982. If we were looking for clues and common background traitswhich lead to successful investment management, here’s another oneto add to our list: backpacking. Eric Ryback’s claim to fame, prior tojoining the money management community, was that while still incollege, he became the first person to complete backpacking’s “triplecrown” by hiking 8,000 miles, over three summer vacations, therebycompleting all three cross country routes: the Appalachian Trail, thePacific Crest Trail, and the Continental Divide Trail. Imagine the kindof discipline, perseverance, and character that exploit takes! We wereeager to speak with Eric Ryback about how he does it.
Tanous:How did you first get interested in stocks?
Ryback: I think it goes back to high school. My mother was tryingto get me interested in reading, so she bought me this book on J. PaulGetty. It was a paperback. I remember reading about this man whomade millions in the oil industry. I was very impressed with that. Ithen gravitated away from the investment side of things and moretoward the outdoor life. I had an outfitting and guide business.
Tanous:So I heard! Your hiking record is quite impressive.PETER J. TANOUS
Ryback: That’s what Kurt [Lindner] was impressed with, believe itor not! He had done a lot of hiking, and I think he related to the factthat it took a lot of planning, perseverance, and foresight to accom-plish one of these major hiking events. I’ve applied that to the invest-ing I do.
Tanous:Indeed you have. In fact, Eric, you’re the only manager I’minterviewing who focuses on yield [dividend per share as a percent ofstock price and interest as a percent of bond price]. Would it be correctto say that a manager who is very interested in yield uses selectioncriteria similar to that of most value managers?
Ryback: I would think so, particularly if, like us, you’re going afterhigher yield. Higher yield traditionally equates to higher risk. Sincewe are seeking high yield, we have to overcome that risk factor. Ifwe apply a value approach to it, or a fundamental approach, we hopewe can define what we call “the intrinsic value” of an entity or acompany. If we can define value correctly, we know what the companyis worth, and then we attempt to buy that security at a discount. Ifwe can apply that same kind of analysis when we’re going after yield,we can overcome the risk factor - that is, the higher the yield, thehigher the risk. I think we’ve proven that with our long-term trackrecord.
Tanous: Yes. I’ll get to your performance record later - I certainlywant to talk about it - doesn’t the process we’re discussing involvefinding overlooked securities?
Ryback: Definitely.