Bear Trap

On a balmy February day in 2007, Bruce Sherman drove to the Ritz-Carlton Golf Resort in Naples to attend the Credit Suisse Financial Services Forum.

The annual high-level confab brought together the chiefs of most major U.S. financial institutions for presentations with analysts and investors like Sherman, who at the time was chief executive officer of Naples-based money management firm Private Capital Management.

Sherman went to the Ritz to confront Warren Spector, then co-president and co-chief operating officer of Bear Stearns, the seventh-largest Wall Street investment-banking firm. At the time, Sherman controlled the largest, longest-held block of Bear stock totaling 5.9%. It was a stake valued at just over $1.1 billion.

With so much money on the line, Sherman had become increasingly concerned about the effects of the falling housing market and rising defaults of subprime mortgages on the price of Bear Stearns stock. After all, Bear Stearns was the largest U.S. underwriter of mortgage-backed securities in 2006 and the second largest in 2007, when it underwrote $83 billion in such toxic loans.

It wasn't just Sherman's clients' money at risk, though PCM clients owned most of the Bear stock controlled by Sherman. (Bear stock made up 4.8% of PCM's portfolio in December 2006.)
“We've publicly disclosed that [Sherman's] own holdings were in the tens of millions of dollars,” says Philip Korologos, a partner with the New York City firm Boies, Schiller & Flexner, who represents Sherman.

On the day Sherman met with Spector in February 2007, Bear's stock closed at $159.73. One year later, on March 19, 2008, a few days after JPMorgan “rescued” Bear Stearns from certain failure, Sherman sold all his shares of Bear for less than $6 each.

In a lawsuit filed recently against Bear chiefs Spector and James Cayne, Sherman describes in agonizing detail how he was allegedly misled into holding onto his Bear stock until the bitter end. Even more painful, Sherman acquired 70,000 more shares of Bear Stearns stock while it was falling in 2007 and sold all his shares for $6 each before JPMorgan finally acquired the firm for $10 a share. Earlier this year, Sherman retired from PCM after his flagship equity fund suffered a nearly 49% drop in 2008.

Korologos says Sherman would not be available for an interview, citing the pending litigation. What's more, Korologos says Sherman is busy with other endeavors since he retired from the money management business, including indulging in his passion for baseball.

Sherman has season tickets to the New York Yankees and recently became an owner of the Charlotte Stone Crabs, a minor-league team affiliate of the Tampa Bay Rays in Charlotte County. He is an owner of the Stone Crabs with Baltimore Orioles baseball legend Cal Ripken Jr.

Attorneys for Bear Stearns, Cayne and Spector couldn't be reached. Bear's accounting firm, Deloitte & Touche, also named in Sherman's suit, says through a spokesman: “Deloitte believes the complaint to be totally without merit and will defend against it vigorously.”

Big returns
Why did Bruce Sherman wager so much of his clients' money as well as his own on Bear Stearns?

After all, Sherman built Private Capital Management by presciently spotting undervalued small- and medium-sized companies long before others. As a “value” investor, Sherman would be considered a more conservative investor than a speculative “growth” investor.

Indeed, his portfolio consisted of stodgy newspaper companies, hospitals and small regional banks. “Since our inception 19 years ago, PCM's research process has relied upon one inalienable principle: the worth of any business is determinable via a net present value analysis of the free cash flow available to its owners,” Sherman wrote to his investors in December 2005.

That's one of the reasons he largely avoided speculative bets on cyclical sectors such as energy and technology, whose long-term value was uncertain. PCM's mandate was capital preservation, Sherman told clients.

In fact, that kind of conservative stock-picking prowess helped PCM avoid the technology bust. Sherman was proud of that fact, telling investors in a letter during the summer of 2006: “By staying true to our discipline we avoided the debacle, while substantially exceeding our absolute-return objective.”

Sherman built PCM's large positions in smaller local and regional banks by picking through the wreckage of the savings-and-loan crisis of the late 1980s. “During the late 1980s, we believed that the market was overreacting to the S&L crisis, discarding good institutions along with the bad. To fully capitalize on the opportunity, at one point we committed almost a third of our assets to the sector,” he wrote investors.

At the time, some questioned Sherman's investments in flagging newspapers and criticized him for missing the big rally in oil. But it was hard to argue with Sherman's success because that value-oriented strategy had worked superbly over long periods. For the 10-year period ending Dec. 31, 2005, for example, PCM's annualized returns net of expenses were 20.2%, more than double the returns of the Standard & Poor's 500-stock index.

As a result, investors poured money into the firm and assets under management swelled to $30 billion. As any money manager will acknowledge, huge inflows of investor money makes it very difficult to invest in the kinds of small- or medium-sized companies Sherman typically sought. In fact, many managers will close a fund to new investors if assets grow too fast.

In a recent interview with Citywire, a European business publication, Sherman's partner at PCM, Gregg Powers, explained it this way: “Anyone who tells you size doesn't matter is lying. It constipated our process.”

Powers, now chairman and chief executive officer, couldn't be reached and Korologos, Sherman's attorney, declined to answer questions relating to Sherman's investment strategy because of the litigation. Through a combination of investment losses and client redemptions, PCM today manages $1.4 billion. While PCM isn't a part of the lawsuit, individual investors with PCM may join Sherman in his action, Korologos says.

Subprime slime
In the interview published in October with Citywire, Powers says he foresaw the mortgage crisis and its potential to be a global threat.

“A particular frustration was that I understood and wrote about the subprime crisis in great detail in 2006 and 2007,” says Powers. “What exasperates me is that we understood and predicted it, but didn't adapt our portfolio to reflect that world view because we were so focused on stock picking.”

Sherman saw it coming, too.

In his lawsuit, he says he grew increasingly worried when two Bear Stearns hedge funds that invested in risky mortgages collapsed in the summer of 2007. He quizzed Cayne and Spector about the way Bear was accounting for its own mortgage securities and other complex financial instruments. Cayne and Spector allegedly told Sherman that the funds failed precisely because they hadn't used Bear's superior valuation methods.

Despite his status as a major shareholder, Sherman was never permitted to review Bear's asset-valuation models. All he had to judge the company by were publicly available financial statements, Sherman says in his lawsuit. As it turned out, the Securities and Exchange Commission in 2005 reported “risk management of mortgages at Bear Stearns had numerous shortcomings.” The suit quotes SEC findings that weren't made public until much later.

Still, Sherman had more private access to Cayne and Spector than ordinary investors due to the size of his holdings. At the Ritz Carlton meeting in February 2007, for example, Sherman says in his lawsuit that he and Spector spoke privately for nearly an hour about Bear's subprime-mortgage exposure.

Whatever assurances Sherman received in this and subsequent private conversations with Bear's top executives, he ultimately bought 70,000 more shares of Bear for his own account on two occasions in 2007 even as the price of the investment-banking firm continued to fall.

Had he known the true financial straits that Bear was facing, Sherman says in his lawsuit that he would have sold all or a “substantial number” of shares of Bear stock.

Sherman accuses Cayne and Spector of deliberately misleading him and other investors about the value of the firm's assets, liquidity and capital reserves, among other issues. Cayne and Spector “knew that the market and the financial press would view Sherman's sale of his Bear stock as a loss of confidence in Bear by a well-known and long-standing investor,” Sherman claims in the lawsuit.

Still, it's hard to imagine that someone as shrewd an investor as Sherman would allow a $1.1 billion investment to shrink to almost zero. In mid-March, JPMorgan offered to rescue Bear for $2 a share. That offer was later amended to $10 a share, but not before Sherman finally sold his and PCM's stake for $6 a share.

Although Korologos declined to discuss Sherman's investment strategy because of the litigation, Powers offers some other possible reasons why Sherman didn't sell his Bear stake. While not mentioning Bear specifically, Powers says PCM was focused more on evaluating companies in the portfolio than on what was happening in the broader economy. “This led to a far greater exposure in 2007 and 2008 to financials and consumer discretionary than I am proud of. It was a mistake,” he told Citywire.

While Sherman and PCM were superior stock pickers, it's not evident that they had a clear strategy of when to sell stocks. For example, some money managers sell when a stock falls below a certain price or constitutes too large a percentage in the portfolio. Others subscribe to the “cockroach theory,” which calls for selling a stock the minute you see bad news because there's more hiding.

Because it was focused on undervalued companies, PCM appeared willing to hold stocks longer than growth-oriented managers who might sell at the first sign of slowing earnings. In his correspondence, Sherman often preached patience and urged clients to look beyond the volatility of quarterly earnings.

Powers says the financial crisis has forced him to revisit PCM's past investment strategy of investing in companies without giving proper weight to broader economic trends, according to the interview with Citywire. “That was the largest mistake we made and it's never going to happen again,” he told the publication.

To fix that, for example, PCM has hired a former petroleum engineer to help the fund identify good investments in the energy sector. He also plans to spread out investments more broadly, avoiding big concentrations in certain industries.

Powers tells Citywire: “Make a mistake, sure, but never make the same mistake twice. If you're not a learning animal then get the hell out of this business.”

REVIEW SUMMARY
Who. Bruce Sherman
Industry. Money management
Key. Even some of the shrewdest money managers didn't foresee the impending financial crisis of recent years.

Top holdings
As of June 30, Naples-based money management firm Private Capital Management oversaw $1.4 billion. Here are its top 10 stock holdings:
CA, Inc.
Hewlett Packard Co.
Symantec Corp.
International Game Technology
Motorola
Sprint Nextel
John Wiley & Sons
Novellus Systems
Northern Trust
Raymond James Financial

Source: Securities & Exchange Commission