I have recently been going through some old issues of the Graham and Doddsville newsletter, where I found some gems of advice from some of the best investors of all time.
One such nugget is from value investor Li Lu. One of the world’s best investors, and a close friend of Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio), Lu’s interviews are always full of worthwhile information.
In the Spring 2013 issue, Lu covers several topics, including why he does not run short positions at his fund, Himalaya Capital. His response to this question is not long, but it sets out the risks of shorting and why most investors should stay away:
G&D: You don’t short stocks at Himalaya, correct?
LL: That’s right; not anymore. That change occurred nine years ago. Shorting was one of the worst mistakes I’ve made.
G&D: Is your lack of a short book due to your desire to be a constructive third-party for companies and their management teams?
LL: Yes. But also, you can be 100% right, and you could still bankrupt yourself. That aspect of shorting just frustrated me too much! [laughs]
Three things about shorting make it a miserable business. On the long side, you have 100% downside but unlimited upside. On the short side, you have 100% upside and unlimited downside. I do not like that math. Second, the best short has some element of fraud. However, a fraud can be perpetrated for a long time. Of course you borrow to short, so they could really just wear you down. That’s why I could be 100% right and bankrupt at the same time. But, you know what, you go bankrupt first! Lastly, it screws up your mind. Shorts just grab your mind and take away from the concentrated effort that is required to do proper long investing. So, those are the three reasons why I just stay away from shorting.
It was a mistake on my part. I shorted for a couple of years. I don’t discard people who are really doing well at shorting – it’s just not me. If I want to add a fourth reason, it is that the economy overall has been really growing at a compounding rate for 200-300 years, ever since the modern science technology era. So, naturally, the economic trend favors long positions rather than short.
But you cannot live life without making a mistake. Every time I make a mistake I learn something.
Put simply, the odds are stacked against shorters and, after realizing this, Lu has avoided the practice ever since.
After discussing shorting, the interview moves on to the process of finding long positions. Here, Lu goes on to describe how the experience has, once again, shaped his investment process to avoiding things he does not understand, something he learned, in part, from Munger.
G&D: Are there industries that you completely stay away from?
LL: I’m not ideologically opposed to anything. I am against any ideology. [laughs]
There are lots of things I don’t know. I’ll be the first one to admit. But it doesn’t mean that I’m not curious from time to time. Maybe I know some aspect of the story. That little aspect might even constitute the investment. I don’t know. I don’t want to rule it out, but I can say that when you present me an idea, I can quickly tell you whether it’s a “no” within a few minutes.
There are basically three buckets that Charlie has. “Yes”, “no”, or “too hard”. Most of the things fall in "too hard." Some get a quick “yes” or “no”, but if it’s too hard, it’s too hard. So you end up not doing a lot. You end up really concentrating on the ideas where you truly have the time and energy to fully understand the situation better than anybody.
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