In the unpredictable world of stock trading, numerous strategies aim to maximize profits and minimize risks. One of the most popular is short-selling stocks. Warren Buffett and Charlie Munger are two well-known figures known for their sage advice and successful investment careers. This article delves into their insightful perspectives on one such tactic—betting against the market or profiting from a stock’s decline through selling it short, a practice often as fascinating as contentious. Drawing from their experience and unique wisdom, they provide enlightening views on the practice’s complexities, potential perils, and misconceptions surrounding it. Their lessons offer invaluable guidance for both novice traders and seasoned investors. Discover how these investment titans navigate the challenging and volatile stock market arena.
Warren Buffett and Charlie Munger on Short Selling
In the below transcript from the 2001 Berkshire Hathaway annual shareholder meeting. Warren Buffett and Charlie Munger explain why they dislike shorting stocks.[1]
The question asked, “Hi, I’m Dave Staples from Hanover, New Hampshire, and I’ve got two questions for you. First, I’d like to hear your thoughts on selling security short and what your experience has been recently and over the course of your career. The second question I’d like to ask is how you go about building a position in a security you’ve identified. Using USG as a recent example, I believe you bought most of your short shares at between 14 and 15 a share, but certainly, you must have thought it was a reasonable investment at 18 or 19. Why was 14 and 15 the magic number? And now that it’s dropped to around 12, do you continue to build your position? How do you decide what your ultimate position is going to be?”
Warren Buffett replied, “Well, we can’t talk about any specific security, so our buying techniques depend very much on the kind of security we’re dealing in. Sometimes, a security might take many, many months to acquire and other times you can do it very quickly. And sometimes, it may pay to pay up, and other times it doesn’t. And it’s true that you never know exactly what the right technique is to use as you’re doing it, but you just use your best judgment based on past purchases. But we can’t discuss any specific one.”
“Short selling is an interesting item to study because it’s ruined a lot of people. It is the sort of thing that you can go broke doing. Bob Wilson, there are famous stories about him and Resorts International. He didn’t go broke doing it, in fact, he’s done very well subsequently, but being short, something where your loss is unlimited, is quite different than being long, something that you’ve already paid for.”
“It’s tempting. You see way more stocks that are dramatically overvalued in your career than you will see stocks that are dramatically undervalued. It’s the nature of securities markets to occasionally promote various things to the sky. So, securities will frequently sell for five or ten times what they’re worth, and they will very seldom sell for 20 or 10 percent of what they’re worth. So therefore, you see these much greater discrepancies between price and value on the overvaluation side.”
“So you might think it’s easier to make money on short selling. And all I can say is it hasn’t been for me. I don’t think it’s been for Charlie. It is a very, very tough business because of the fact that you face unlimited losses and because of the fact that people that have overvalued stocks, very overvalued stocks, are frequently on some scale between promoter and crook. And that’s why they get there.”
“And once they’re there, they also know how to use that very valuation to bootstrap value into the business. Because if you have a stock that’s selling at 100, that’s worth 10, obviously it’s to your interest to go out and issue a whole lot of shares. And if you do that when you get all through, the value can be 50.”
“In fact, there’s a lot of chain-letter type stock promotions that are sort of based on the implicit assumption that the management will keep doing that. And if they do it once and build up to 50 by issuing a lot of shares at 100 when it’s worth 10, now the value is 50. And people say, ‘Well, these guys are so good at that, let’s pay 200, 400, or 300, and then they can do it again and so on.”
“It’s not usually that quite clear in their minds, but that’s the basic principle underlying a lot of stock promotions. And if you get caught up in one of those that is successful, you can run out of money before the promoter runs out of ideas. In the end, they almost always work. I mean, I would say that of the things that we have felt like shorting over the years, the batting average is very high in terms of eventual outcomes. They would work out very well eventually if you held them through.”
“But it is very painful, and it’s been my experience that it was a whole lot easier to make money on the long side. I had one situation, actually, an arbitrage situation, when I moved to New York in 1954. There was a surefire type transaction and arbitrage transaction that had to work, but there was a technical wrinkle in it, and I was short something, and I felt like, for a short period of time, I was failing. It was very unpleasant.”
“You can’t make, in my view, really big money doing it because you can’t expose yourself to the loss that would be there if you did do it on a big scale. And Charlie, how about you?”
Charlie Munger adds, “Well, Ben Franklin said, ‘If you want to be miserable, borrow a lot of money to be repaid at Lent,’ or something to that effect. And similarly, being short something which keeps going up because somebody is promoting it in a half-crooked way, and you keep losing, and they call on you for more margin; it just isn’t worth it to have that much irritation in your life. It isn’t that hard to make money somewhere else with less irritation.”
Buffett adds, “It would never work on a Berkshire scale anyway. You could never do it for the kind of money that would be necessary to do it with in order to have a real effect on Berkshire’s overall value. So, it’s not something we think about. It’s interesting, though; I mean, I’ve got a copy of the New York Times from the day of the Northern Pacific corner, and that was a case where two opposing entities each owned over 50 percent of the Northern Pacific Railroad. And when two people each own over 50 of something, you know it’s going to be interesting.”
“Northern Pacific on that day went from 170 to a thousand, and it was selling for cash because you had to actually have the certificates that day rather than the normal settlement date. And on the front page of the New York Times, which incidentally sold for a penny in those days, right next to the story about it, it told about a brewer in Newark, New Jersey, who had gotten a margin call that day because of this and he jumped into a vat of hot beer and died. That’s really never appealed to me as the ending of a financial career.”
“And who knows, when they had a corner in Piggly Wiggly, there was a corner in Auburn Motors in the 1920s. There were corners that was part of the game back when it was played in a kind of a footloose manner. And it did not pay to be short actually during that period you might find it interesting, in the current issue of the New Yorker, maybe one issue ago, the one that has an interesting story about Ted Turner, there’s also a story about Hedy Green. Hedy Green was one of the original incorporators of Hathaway Manufacturing, half of our Berkshire Hathaway operation, back in the 1880s. And Hedy Green, she was just piling up money; she was the richest woman in the United States, maybe in the world. Maybe some queen was richer abroad. Hedy made it by the slow, old-fashioned way; I doubt if Hedy was ever short on anything. So, as a spiritual descendant of Hedy Green, we’re going to stay away from shorts at Berkshire.”
Key Takeaways
- Short selling is a complex and high-risk strategy involving the potential for unlimited losses.
- Market anomalies often lead to more overvalued stocks than undervalued ones, making it tempting for traders to engage in short selling.
- However, successful short selling is challenging due to the unpredictability of market forces and the manipulative tactics of promoters and fraudsters.
- While short selling can result in substantial profits in the short term, it’s often more rewarding and less stressful to invest in undervalued stocks over the long haul.
- Making money through short selling is not conducive to significant financial growth due to the associated risks and the inability to do it on a large scale.
- Short selling often brings more frustration and irritation than it’s worth, especially when dealing with deceptively promoted stocks.
- Despite its enticing nature, short selling is not a viable strategy for large-scale investment entities like Berkshire Hathaway.
Conclusion
In their detailed analysis of short selling, Warren Buffett and Charlie Munger emphasize the perils and complexities that overshadow its potential profits. They argue that the sheer unpredictability of the stock market, coupled with the potential for dishonest stock promotions, can cause catastrophic losses. While substantial short-term gains may be tempting, their experiences suggest a long-term, value-driven approach is the more lucrative, sustainable, and less stressful investing strategy. It becomes clear that the rigors and risks of short selling, especially on a large scale, outweigh the potential rewards. Therefore, aspiring and experienced investors alike would do well to heed this advice from two of the most successful investors of our time.