I recently discussed Warren Buffett (Trades, Portfolio)'s short selling activity when he was operating his partnerships in the first few decades of his career.
In his early years, Buffett made use of short selling to hedge his long portfolio. He used to go around trying to borrow share certificates from institutions such as college endowments, pay them a small fee and use these holdings as a way of shorting the market.
He didn't bother to pick individual shares; he just wanted to short as much stock as possible to provide downside protection. By his own admission, these positions didn't really generate too much profit.
Despite this activity early on in his career, the Oracle of Omaha has tended to stay away from short selling because, as he explained at the 2001 Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) annual shareholder meeting, "It is very painful."
Buffett on shorting stocks
The guru was responding to a question from an audience member, who asked him to share his thoughts on shorting securities -- presumably because the attendee was interested in betting against some of the overhyped, overvalued dotcom stocks dominating the market at the time.
Buffett opened his response by saying that "being short something where your loss is unlimited is quite different than being long something you've already paid for." He goes on to say that while being short is tempting, as most investors will see "way more stocks that are dramatically overvalued" than stocks that are "dramatically undervalued," during their careers, it is a "very tough business because of the fact that you face unlimited losses."
The Berkshire Hathaway CEO went on to say shorting overvalued stocks is also tricky because "people that have overvalued stocks... Are frequently on some scale between promoter and crook. And that's why they get there." He went on to add:
"And 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 it 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 for it or 300,” and then they could do it again and so on"
According to Buffett, if you get caught up in one of these stock promotion schemes,"you can run out of money before the promoter runs out of ideas."Â
Buffett's right-hand man, Charlie Munger (Trades, Portfolio), added that "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." He summarized that it is not that "hard" to make money somewhere else with less irritation.
After Munger's comments, Buffett opined that shorting stocks would "never work on a Berkshire scale anyway" because it would be difficult to find an opportunity that would generate so much profit to have a substantial impact on the conglomerate's overall value.
That's why Buffett and Munger do not short securities today, even though they have done so in the past.
Disclosure:Â The author owns shares of Berkshire Hathaway.
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