By Shawn Tully

(FORTUNE Magazine) – ON NOV. 1, MONEY MANAGER BRUCE Sherman wrote a scathing letter to the directors of newspaper publisher Knight Ridder, demanding that the board "aggressively pursue the competitive sale of the company" and "install new management." It was an extraordinary move, particularly for the secretive Sherman, a patient long-term investor who normally shuns public brawls. It also raises a fascinating question: How did a crack manager boasting 19.8% annual returns over 20 years, who rode a wireless upstart named Qualcomm to the heights and has repeatedly put money into companies later purchased by Warren Buffett, get mired in newspapers, a business that seems destined for dreary decline?

Knight Ridder is only one part of Sherman's massive bet on the stricken industry. His Private Capital Management (a Florida-based fund he founded and sold four years ago to Legg Mason for $682 million) has parked 15% of its assets, $4.5 billion, in newspapers. PCM has outsize stakes in eight of America's biggest publishers, including 6% of Gannett, 14% of New York Times Co., and 19% of Knight Ridder. Most of them are struggling. Between early 2004 and October, for instance, Knight Ridder shares dropped from $80 to $52, rebounding to $63 when Sherman called for a sale.

Sherman isn't talking, but he's also not the only shrewd investor caught in the newspaper muck. Bill Nygren and Henry Berghoef of Harris Associates and Mason Hawkins of Southeastern Asset Management, which together hold another 17% of Knight Ridder, are also old-media believers. "Newspapers even now have good margins and generate significant amounts of free cash," says Berghoef, explaining the allure of the sector to value investors. He insists the talk about newspapers' demise is greatly exaggerated.

The wider market doesn't seem to agree. The attention instead is on falling circulation figures--the latest industry report earlier this month showed a 2.6% nationwide decline--and the continuing shift of ad dollars to Internet providers like Yahoo. The rising cost of everything from newsprint to pensions is draining profitability. With Knight Ridder, it's hard to imagine who would fork over a premium price. Rivals like Tribune Co. and Gannett have their own issues (Tribune is struggling to integrate its purchase of Times Mirror Co.; Gannett is restrained by its own languishing share price). Private-equity buyers like Blackstone or KKR seem even more unlikely. If an acquirer turned around and sold off the newspapers one by one, it would be liable for a huge capital-gains bill on the profits because of the low tax base on individual newspapers. One seasoned investor estimates that a buyer would need to reap the equivalent of $80 a share just to recoup Knight Ridder's current price of $63.

Merrill Lynch projects that Knight Ridder will earn $234 million next year. With the company carrying a $4.3 billion market cap, that represents only a 5.4% return for someone buying in at that price. And Knight Ridder's earnings are shrinking. Even Berghoef admits that the industry's fundamentals are deteriorating: "Growth rates are down, and there's a question if publishers can maintain their margins," he says. "My crystal ball is cloudy right now." So is the exit strategy.