Warren Buffett is the preeminent conservative value investor. He’s certainly not known as for his shortselling. But at Berkshire Hathaway’s 2001 shareholder meeting, he said something surprising:
“You’ll see way more stocks that are dramatically overvalued than dramatically undervalued. It’s common for promoters to cause a stock to become valued at 5-10 times its true value, but rare to find a stock trading at 10-20% of its true value.”
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Did the Oracle of Omaha, the Greatest Investor In History, actually state that it's easier to make money shortselling stocks than long investing? Well not exactly. The fact is that Buffett has never practiced shortselling -- but not for the reason you might believe.
Buffett went on to say: “So you might think shortselling is easy, but it's not. Often stocks are overvalued because there is a promoter or a crook behind it. They can often bootstrap into value by using the shares of their overvalued stock. For example, it it's worth $10 and is trading at $100, they might be able to build value to $50. Then, Wall Street says, ‘Hey! Look at all that value creation!’ and the game goes on. [As a short seller,] you could run out of money before the promoter runs out of ideas."
Buffett is of course a disciple of Benjamin Graham, often called the Father of Value Investing. And like all followers of Graham, Buffett’s lifeblood is finding companies that trade at discounts to the real world -- or intrinsic value -- of the companies’ assets and cash flows.
In his book The Intelligent Investor, Graham famously created the metaphor of “Mr. Market” to dramatize how the greed and fear of market participants drives stock prices on bipolar swings of depression to exuberance and back:
"...Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
...if you are a “sensible businessman...you may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low.”
So in his 2001 speech to Berkshire Hathaway shareholders, Warren Buffett was in effect saying that Mr. Market tends to get much more euphoric that he does depressed -- there are more wildly overpriced stocks than cheap ones. However, while ‘buying good companies when they’re on sale’ is a solid way to build wealth, Buffett is saying the opposite isn’t true -- shortselling bad companies when they’re ridiculously priced, doesn’t work.
There’s an assumption that’s been internalized by the great majority of investors -- including most financial professionals -- that shortselling is inherently riskier than going long.
As Buffett sees it, one risks “running out of money” shorting an extremely overvalued stock, because it could shoot much higher -- subjecting the short seller to big losses -- before falling back to intrinsic value. According to the Oracle, because an overpriced stock can get even more overvalued, shortselling is much, much riskier than buying undervalued stocks.
But is this really true? Is timing a short sale and managing short position risk really vastly different than timing the sale of a long position and long risk management?
In her classic 1996 classic, The Art of Short Selling, Kathryn Staley acknowledges that “short-selling is not for the faint-of-heart, or the inexperienced investor....Simple selling, however is a discipline for even the faint of heart, and the skills are the same. How to make money by shorting and how not to lose money by selling [a long position] are different sides of the same coin.”
Financial experts commonly warn of this key difference between buying long and shorting:
When you’re long a stock, your risk is limited to 100% -- the amount you invested; but when you’re short your risk is unlimited. Because theoretically a stock can rise to infinity. So when a short position goes against you there’s no limit to how much money you can lose. Scary stuff.
I don’t know about you, but to me it’s a poor argument that one investment is better than another because it can only lose you 100%. That’s a bit like saying that climbing mountain A is less risky because you can only fall 200 feet compared to Mountain B where you could fall 500 or more. Either way, you fall and you’re dead. One would prefer not to fall at all -- or at least not very far. In rock climbing, as in investing, managing risk is vital.
Also, in rock climbing beginners are well advised to stick with simple ascents until their skills improve. Likewise, when it comes to investing, novices should avoid advanced strategies -- short or long -- until more experience and skill is acquired.
Is shortselling Icky, Shady, Unethical?
In addition to the widespread fear that shorting carries excessive risk, it seems there is an inherent suspicion that short selling is, if not illegal, somehow dishonorable. Shorting is the Dark Side of investing, where one profits from the misfortune of fellow citizens. Just recently, NYSE Group President Tom Farley told lawmakers in Washington that “it feels kind of icky and un-American, betting against a company.”
According to Bloomberg, Farley said that because short-selling can actually improve markets, public companies don’t necessarily want to ban it outright – instead they want to see more stringent disclosure. “They say, ‘Let’s have a little more transparency.”’
But the head of the NYSE is biased -- he wants to attract firms to his exchange and keep existing listed companies happy. And public companies typically despise short sellers. Mr. Farley wants NYSE stock prices to go up -- just like shareholders, employees and the great majority of investment managers. And you can include stock analysts in the “conspiracy” of higher stock prices -- there are probably 100 buy reports for every sell report published by sell side analysts.
The truth is that almost all interested parties -- with the exception of short sellers -- want share prices to go up. That includes employees, stock analysts, and the great majority of investment managers.
“How to make money by shorting and how not to lose money by selling are different sides of the same coin.”
Kathryn Staley in The Art of Short Selling
While Mr. Buffett said that “promoters” often push prices up to valuations 5x to