His purchases of shares in Pier 1 Imports and US Airways were poor investments, and he compounded his ill-fated acquisition of Dexter Shoes by using Berkshire shares instead of cash as currency. In fact, Berkshire itself was a poor investment -- Buffett greatly underestimated the capital requirements and competitive pressures endemic to the textile industry.
The only time a “value investment” turns out to be a “value trap” is when you made a mistake in your initial assessment of the company’s value, that is, it was not a “value investment” to begin with. One mistake we made was investing in Pier One Imports, a home furnishing retailer. We misjudged the competitive economics of the business, and incorrectly assumed shoppers would be willing to pay a premium for the shopping experience at Pier 1. Well, it turned out shoppers care about the lowest price, not shopping experience, owing to the commodity nature of the retail business. And in a commodity business, it is the low-cost producer who wins, and a low-cost producer Pier 1 was not. However, since we paid a cheap price for Pier 1, we managed to get out of our position with a minimal loss, despite misjudging the fundamentals of the business.
The only time a “value investment” turns out to be a “value trap” is when you made a mistake in your initial assessment of the company’s value, that is, it was not a “value investment” to begin with. One mistake we made was investing in Pier One Imports, a home furnishing retailer. We misjudged the competitive economics of the business, and incorrectly assumed shoppers would be willing to pay a premium for the shopping experience at Pier 1. Well, it turned out shoppers care about the lowest price, not shopping experience, owing to the commodity nature of the retail business. And in a commodity business, it is the low-cost producer who wins, and a low-cost producer Pier 1 was not. However, since we paid a cheap price for Pier 1, we managed to get out of our position with a minimal loss, despite misjudging the fundamentals of the business.
You follow a metric of buying businesses for “8 to 11 times normalised cash flow”. What is so sacrosanct about 8 to 11 times?
PB: We tried to reverse-engineer most of Buffett’s purchases to find out the multiple of cash flow that he typically pays, and it appears that generally he would pay about 10X. And so we ended up adopting that valuation level as our baseline, and we are willing to adjust it slightly based on the quality and growth profile of the specific business in question.
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