DSCP's- biggest shareholder
Guest Interview:
Private Capital
Management, Inc.
Bruce Sherman
Chairman, President, &
Chief Portfolio Manager
* Bruce, I understand your firm had an atypical beginning. Tell me how and why Private Capital Management, L.P. (PCM) was formed.
Mr. Sherman: I formed PCM in 1986 with a "Forbes 400" family. Over the years, the family had their financial assets managed through many of the different "traditional" venues (bank trust department, independent money management firms, venture capital partnerships, etc.). At the end of the day, the family was dissatisfied with both the investment results and the process with which their assets were being managed. The family concluded that their best interests would be served by forming an internal money management operation where they could exercise control over the investment management style, the personnel, and the analytic process. In forming the firm, my mandate was to build an optimal structure for managing the family's capital with an emphasis on capital preservation and absolute return.
* What do you mean when you say absolute return?
Mr. Sherman: It was the family's experience that the investment management industry quite often focused on relative returns and relative valuations. For example, if the S&P 500 is down 25% and a manager is down 15%, he has had relatively good performance. However, his clients have lost 15% of their capital. Our clients believe that any successful management strategy needs to be centered first around capital preservation. They have worked long and hard to build wealth and truly view their capital as an "irreplaceable commodity." Further, relative return to us implies almost an acceptance or tolerance of mediocrity. If your goal is merely to meet or exceed average returns, then it is clearly an extraneous exercise to spend the time and energy required to build an internal capability. There are no shortages of average or above average shops out there. Rather, the founding family and I believed it possible to set an absolute return standard that would both be a superior long-term objective for growth of their capital as well as one that made the formation of PCM a worthwhile undertaking.
* What was the return/objective that they set for you?
Mr. Sherman: Our goal at PCM is to research and invest in a portfolio of businesses that will position our clients to double their assets every five years. Obviously, this implies compounding money at approximately 15% per year. Thus, we attempt not only to preserve but also prudently expand our clients' wealth.
* Given that mandate, what were your considerations in building Private Capital Management L.P.?
Mr. Sherman: First of all, my background as a CPA and my working experience in mergers and acquisitions, business valuations and restructuring gives me a rather different perspective on investment management. In my view, Wall Street spends too much time on short-term financial prognostication relating to quarterly earnings per share and not enough time trying to determine the long-term fundamental value of the underlying business enterprise. Thus, I decided that the strength of our firm was going to be the ability to independently research and determine the intrinsic value of a business.
* Are you saying, then, that you don't have much use for Wall Street research?
Mr. Sherman: That's correct. We find most Wall Street research to be short-term oriented and superficial. In addition, I will not put my clients' capital at risk unless I have absolute confidence that we accurately understand the investment situation. The only way that I can achieve that comfort level is to be directly involved in the analytic process.
* If you don't rely on Wall Street, how do you develop and implement investment ideas that meet your value criteria?
Mr. Sherman: Our investment team has a great deal of experience analyzing and investing in undervalued situations. Yet, they also bring different industry expertise and analytic skills that supplement my background. If we perform our research work properly, we capture and create an information advantage.
* Give us some additional insight into your research process.
Mr. Sherman: Our approach is equivalent to acquisition due diligence. We view a stock investment the same way an entrepreneur views a business acquisition. The essence of this approach is discretionary cash flow analysis. Simply put, a business enterprise's value is directly related to its ability to produce cash for its owners.
* Why discretionary cash flow?
Mr. Sherman: The cash flow cut, while somewhat arbitrary, is designed to differentiate between reported book income and true cash earnings. We understand the subjective nature of some of the situations that go into making reported earnings. Cash can be used to buy back stock, retire debt, buy new businesses - we really want to determine the cash flow generation ability of a business.
* How do you determine discretionary cash flow?
Mr. Sherman: To be perfectly honest, this is as much an art as it is a science. Obviously some industries, typified by the manufacturing sector, require substantial and sustained capital reinvestment. Others, including computer software, media, publishing, and financial services for example, require far less investment in physical plant and equipment. Consequently, as a starting point, we are strongly partial to businesses that have structurally superior free cash flow characteristics. After winnowing the investment universe in this fashion, it is necessary to intimately examine a business's economic opportunities in conjunction with its capital requirements, and to differentiate between mandatory and discretionary investment. For example, a rapidly growing computer software company will typically require cash to fund receivable growth. As long as such working capital requirements grow in proportion to the business, we would view this an appropriate discretionary investment. Conversely, if a textile company continuously replaces its capital equipment every five years in order to remain competitive, this capital reinvestment is not discretionary and has direct implications for the business' underlying value.
Simply put, we recognize that some businesses have superior economic characteristics, and that these companies can generate substantial free cash flow and are capable of internally financing growth. Coincidentally, we often find that as a byproduct, such companies are generally superior from a financial structure standpoint. However, it is important to underline the significance of qualitative factors beyond financial statistics.
* Can you elaborate?
Mr. Sherman: Yes, the most important qualitative factor is management. Great management creates opportunities and knows how to win, while bad management is particularly adept at finding new ways to lose. Consequently, an evaluation of management's competence, integrity, and concern for the creation and enhancement of shareholder value, is integral to the analytic process. We will not invest in situations where we feel that we don't have goal congruency with management. Additionally, we will not invest in a company that has what we perceive to be inadequate management, regardless of how statistically attractive the investment may be.
* How do you make an assessment of management?
Mr. Sherman: Before we make a substantive commitment of our clients' capital, we will generally meet the management personally at the company's premises. Our objective in meeting with senior management is not to be educated about the business per se. Before the meeting we will have already invested substantial time and effort learning about the most important opportunities and challenges. Therefore, if we have done our job, we will not be asking questions which we do not already know the answers to. As a consequence, we can critically evaluate the candor and honesty of senior management. This insight is particularly important when something does not go according to plan, and the business produces disappointing results. We like to know that management will candidly assess the issues, and answer our questions to the best of their ability, as opposed to giving us public relations fluff. Style is important. For example, I have a visceral dislike for gratuitously expensive corporate headquarters. Why should the shareholders' money be invested in such a non-earning asset? Said another way, I do not want to invest with a management team that does not spend shareholder capital in the same fashion that they would spend their own money.
* Does your analysis conclude with the management visit?
Mr. Sherman: No, that's just the starting point. An entrepreneur would never buy a company solely as a result of a satisfactory meeting with management. It's necessary to assess management's depth, to spend some time with middle managers and when possible, visit the competitors, suppliers and customers.
* That sounds like a lot of work. Realistically how many companies can you follow in this detail?
Mr. Sherman: We repeatedly screen thousands of companies, do preliminary work and review the financial statements on several hundred and visit as many as possible. As we continue to cull, we will generally end up doing a full-blown due diligence on roughly one-third of the companies we visit.
* Do you concentrate on specific industries or a certain size company?
Mr. Sherman: Remember, my background and mind-set is that of a businessperson rather than one of a traditional money manager. Likewise, my research associates also have certain specific industry and operating experience. We believe this business experience makes us better investors and that it would be foolish for us not to use this experience to our clients' advantage. We believe that we do some of our best work in the industries with which we are most familiar. These would include financial services, media, software, real estate, health care, gaming and retail. These industries give us a large universe of companies to choose from and to perform our initial screening on.
We are in the business of identifying intrinsically undervalued companies with favorable cash flow characteristics, in industries that we understand. We don't have a size or capitalization restriction, mandate or predisposition. What's important to note is that the valuations and opportunities are what attract us, not specifically the size of the company.
* This sounds like a very bottom-up approach. Is that a fair description?
Mr. Sherman: Yes it is. We do not have a pre-determined asset allocation model to which we manage. Further, we don't spend a lot of our time or energy trying to predict the unpredictable. When we can find ideas that meet our value criteria, selling at prices where we would like to own the whole company, we will buy those stocks. When we have difficulty finding ideas, we sit on our hands and don't buy stocks. So as it relates to a market allocation, we're really idea-driven rather than top-down macroeconomic analytically driven. While we consider the economic backdrop, we don't disdain what is going on in the marketplace.
* How large is the staff of Private Capital Management, L.P.?
Mr. Sherman: My efforts, along with those of President and fellow Co-Portfolio Manager Gregg Powers, who has been working with me at PCM since 1988, are supported by an eight member investment staff. The firm has three dedicated traders that solely concentrate on obtaining the best prices for our clients as well as an experienced account management team headed by Gary Queen and Michael Feldman. Each member of the firm treats our clients' money as if it was our own and endeavors to provide a high level of performance to our clients in all aspects.
* Do you have a dollar minimum for a new client relationship?
Mr. Sherman: Yes. We offer individual account management beginning at $2.5 Million. We also offer a couple of commingled fund products with lower minimums.
* Where can people go to learn more about the firm?
Mr. Sherman: PCM maintains a website at www.private-cap.com.
* Do you have any closing comments?
Mr. Sherman: The detailed and tireless execution of our bottom-up value investment philosophy has consistently earned our clients substantial returns at minimal risk levels. As I mentioned before, our goal since inception has been first to preserve capital and second to double capital every five years, which is equivalent to a 15% annualized return. Though we have no way of predicting future returns, we are proud to say that each and every rolling five-year period since the inception of the firm in 1986, PCM has achieved an annualized rate of return equal to or exceeding 15%. All the while, PCM's returns have maintained a very similar standard deviation to both the S&P 500 and the Russell 2000.
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