Wednesday, January 27, 2021

Warren Buffett and Charlie Munger on Short Selling

In order to become a successful investor, you need to survive first.

You need to put yourself into a position, where your investments cannot be taken away from you due to temporary fluctuations in stock markets, driven by short-term events. Sometimes, you can see that a company is worth zero, but that does not mean that it is easy to profit from this.

The past week has shown us why it is so difficult to make money even if you know that a certain company may go to zero at some point.  I am referring to the epic short squeeze of companies like Gamestop (GME). The stock, which sold as low as $4/share last summer is currently selling above $347/share. Check this article describing the situation in more detail: "The GameStop Saga"

If you look at the business, it does not seem inspiring. It is very likely that this business may not survive in the future, as more folks buy their games online, and not need a store for it. It has suspended its dividend, amidst the fact that business conditions have been slowly deteriorating.

This business is not worth $347/share.

This is a perfect example of what Ben Graham was referring to, when he stated that in the short-term, the market is a voting machine. Short-term events can temporarily distort prices above and below intrinsic value.

As an investor, the goal is to survive long droughts, before prospering. In my case, this means diversifying heavily into a broad number of companies with established track records. Some of them will do very well, while others would not do that well. However, the worst that I can get is a loss of 100%. This is mitigated by any dividends I receive of course, and offset by any tax benefits on capital losses.

This means that I can theoretically hold on to my investments for as long as possible. No one can really shake me out of a position, unless my conviction changes based on new information I uncover.

This is not the case when you invest on margin however, because a temporary but severe enough decline may force you to sell, in order to cover your margin loan. Using margin turns your long-term advantage of a patient long-term investor into a disadvantage. You could theoretically lose more than your original capital as well, if a stock declines faster that anticipated. However, the downside is still clear, because a stock cannot go below zero. 

Selling a stock short is a whole different ballgame however. When you sell a stock short, you borrow the security at a given price from someone that owns it. You hope that the price goes down, so that you can purchase the shares back  at a lower price, and return them back to their owner.

In other words, if you think that a stock like Johnson & Johnson (JNJ) is overvalued at $165/share, you can find someone that owns it to borrow their shares. You will pay them a small fee in the process. If you are correct and the share price declines to say $150/share, you can buy the stock and return the shares to the original owner. However, if Johnson & Johnson stock rose to $180/share and you cover your short, you would have to buy it back at a higher price in order to return the shares to the owner.

The reason why I do not sell short is because the upside is limited. If you sold 1 share of Johnson & Johnson (JNJ) short at $165/share, and the business goes bankrupt in one year, the most you will gain is $165, minus any fees you paid to the original holder of the stock. As a short seller you also need to reimburse the original holder for the dividend they missed out a payment on. 

However, your downside is virtually unlimited. If Johnson & Johnson tripled overnight to $495/share, you would have lost 200% on your original trade. In other words, you started with a net worth of $165 to short 1 share, but since that share is now $495/share, you have a negative net worth of $330. That’s because you need to buy 1 share to return to the original owner, but it costs $495 now and you only have $165. This is how you can easily bankrupt yourself with short selling stock.

Of course, shares of Johnson & Johnson do not fluctuate so widely. That’s because they are stable and predictable and boring. 

As an investor in a stable, boring and predictable business, I can afford to hold on through the bad times. The scandals in 2010 were one such time. Even then, my downside was protected by the amount I put up to invest. Any dividends I have received since have acted as an instant rebate on my purchase price. Dividend income has increased since, as earnings have increased, and the stock price has risen too. My downside is limited with an investment in a company like Johnson & Johnson. But my upside is unlimited. 

(click chart to expand)

This is the type of intelligent investment to make. It is no wonder I do not do short selling.

But shares in companies that face trouble are often easier to move by a large percentage gain or loss. They value is more difficult to determine, and they are more speculative in nature. 

This is what happened with Gamestop in a nutshell. Hedge funds believed that the business can go to zero, which means they borrowed shares to short it. They were right for a while, until they weren’t. When share prices start moving up, these Hedge Funds need to cover their short positions at higher prices, because they are probably facing margin calls. If you have a portfolio worth $100, and you sold one share of Gamestop short at $5/share, you can easily withstand the stock doubling to $10/share.

However, when the stock goes to $20 and then $50/share, your losses are growing exponentially. If you do not sell by the time the stock exceeds $100/share, you are going to be wiped out.

With speculative companies, there may be some manipulation of the stock prices. If your competitors see you short a stock that is growing in price, they may start buying it, in order to drive the price up, and drive you out of business as you need to cover at a higher price. You cannot simply sit tight and wait for it to be over – you will be out of money if you are short a stock and the price rises above a certain point. You can easily get in trouble where you owe more than what you are worth.

Hedge funds usually try to manipulate short-term stock prices to their own advantage. For example, a short-seller would go out and sell short a company, and then issue a press release stating why the company is a bad one. They may do interviews on TV, and even attend conferences, trying to present their case for a short sale. Even if they are wrong, they can still shake out investors who lack conviction into selling, which pushes the price down. 

Jim Cramer actually received some criticism a few years ago for discussing some techniques used by Hedge Funds to drive prices up or down. It is pretty interesting to see what happens on a day to day. You can read this article here at Reuters. I have highlighted the most interesting parts below:

The interview described methods including tactical buying, shorting or using options to create an impression in the market that could prompt other traders and investors to buy or sell a stock.

“A lot of times when I was short at my hedge fund ... meaning I needed (a stock) down, I would create a level of activity beforehand that could drive the futures,” said Cramer. “It’s a fun game and it’s a lucrative game.”

Cramer, host of the popular CNBC television show Mad Money, described tactics that could be used to drive down technology stocks such as Research in Motion RIM.TO or Apple Computer AAPL.O to make them cheaper to purchase later. CNBC is owned by General Electric Co. GE.N

In the interview, Cramer said a hedge fund manager’s favorite tactic is to get a rumor about a stock to an unwitting reporter -- at the Wall Street Journal or at his current employer, CNBC -- and hope that it moves the stock in the direction the manager wants.

Cramer said some tactics are “blatantly illegal,” but sometimes essential for poorly performing hedge funds. He did not say he ever used such tactics himself.

Cramer said if a market participant wanted to get shares of a company like RIM lower then he should first get investors “talking about it as if there is something wrong with RIM”.

"Then you call the (Wall Street) Journal and get the bozo reporter in Research in Motion and you would feed that (rival) Palm's PALM.O got a killer it's going to give away," he said. "These are all the things that you must do on a day like today and if you're not doing it, maybe you shouldn't be in the game."

“It might cost me $15 million or $20 million to knock RIM down but it would be fabulous because it would beleaguer all the moron longs who are also keying on Research in Motion,” said Cramer.

He also said the SEC does not understand some illegal activity.

I have personally witnessed this with a short attack on Realty Income in 2009, as well as a short attack on Digital Realty Trust in 2013. Both times were actually good times to acquire decent businesses at good prices. If you took those bears seriously however, you missed out on gains. 

Not all short sellers are bad of course. They are needed in an effort to contain enthusiasm for equities, so the net effect is that they keep share prices more affordable in the short-run due to an increase in supply of shares to sell. Some notable short-sellers like Jim Chanos has uncovered major corporate fraud at Enron for example.

There was a famous short corner in 1901, which caused shares of Northern Pacific to increase from $165/share to $1000/share, wiping out short-sellers. 

There was another famous short squeeze in 2008, which caused shares of Volkswagen to increase dramatically.

Warren Buffett has also discussed why he does not like short selling. Basically your upside is limited, but your downside is wide open. This does not strike as intelligent behavior. 

You can also see the video by clicking on this link below.

You can read his thoughts on short-selling from this 2001 Berkshire Hathaway Meeting Transcript:

"Warren Buffett: Short selling, it’s an interesting item to study because it’s, I mean, it’s ruined a lot of people. It is the sort of thing that you can go broke doing.

Bob Wilson, there’re 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.

And it’s tempting. You see way more stocks that are dramatically overvalued in your career than you will see stocks that are dramatically undervalued.

I mean there — it’s the nature of securities markets to occasionally promote various things to the sky, so that securities will frequently sell for five or 10 times what they’re worth, and they will very, very seldom sell for 20 percent 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 there —

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.

It’s not usually that — quite that 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 know, 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 — that they would work out very well eventually if you held them through.

But it is very painful and it’s — in my experience, it was a whole lot easier to make money on the long side.

I had one situation, actually, an arbitrage situation when I was in — well, it was when I moved to New York in 1954, so it would’ve been about June or July of 1954 — that involved a surefire-type transaction, an arbitrage transaction that had to work.

But there was a technical wrinkle in it and I was short something. And I felt like a — for a short period of time — I felt like Finova was feeling last fall. I mean, it was very unpleasant.

It — you can’t make — in my view, you can’t make 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: Well, Ben Franklin said, “If you want to be miserable, you know, during Easter or something like that,” he says, “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.

WARREN BUFFETT: It would never work on a Berkshire scale anyway. I mean, 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 business titans each owned over 50 percent of the Northern Pacific Company —the Northern Pacific Railroad.

And when two people each own over 50 percent of something, you know, it’s going to be interesting. And — (laughter) — 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. It’s had a little more inflation than Coca-Cola — front page of The New York Times, 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. And that’s really never appealed to me as, you know, the ending — (laughter) — of a financial career.

And who knows? You know, when they had a corner in Piggly Wiggly, they had a corner in Auburn Motors in the 1920s. I mean, there were corners. That was part of the game back when it was played in 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 the interesting story about Ted Turner, there’s also a story about Hetty Green.

And Hetty Green was one of the original incorporators of Hathaway Manufacturing, half of our Berkshire Hathaway operation, back in the 1880s. And Hetty Green was just piling up money. She was the richest woman in the — maybe in the world. Certainly in the United States. Maybe some queen was richer abroad.

But Hetty Green just made it by the slow, old-fashioned way. I doubt if Hetty was ever short anything.

So as a spiritual descendent of Hetty Green, we’re going to stay away from shorts at Berkshire."

For reference, here is the cover of New York Times from the day of the Northern Pacific Corner. Check this article from Global Financial Data for more details too:

Warren Buffett discussed why he does not like short selling. That's because your upside is limited, but your downside is wide open. This does not strike as intelligent behavior. It has ruined a lot of people and it is the sort of thing that you can go broke doing.

He has previously discussed Long Term Capital Management, the famous hedge fund that went bust in 1998, after its trades almost took down with it the US Financial System. It was a heavily leveraged hedge fund, which essentially wiped out its founders, who were Nobel Prize Laureates. 

But to make money they didn’t have and didn’t need, they risked what they did have and did need. That is foolish.

You can read more from his 1998 speech from this transcript compiled by Novel Investor.

The other thing to consider is that even if a company is worth zero, its stock may not go to zero for a long period of time. If you are a short seller and the price rises above a certain threshold, you may be ultimately right about the demise of the company, but you will be wiped out anyways because your received a margin call. 

In addition, some companies may issue shares to the public when a short-squeeze increases the price of those shares. As a result, the value of that business may actually increase due to the cash infusion from selling stock through the capital markets.

This is why I do not play short-term games. As an investor, my edge is in buying companies, and holding them for the long-term. In order to avoid being shaken out of my position, I avoid leverage, and I avoid the noise. To succeed, think years and decades, not days or weeks.

Relevant Articles:

Realty Income (O) Dividend Stock Analysis 2010

- The Case for owning Digital Realty Trust (DLR): When Hedge Funds Don’t Know What they are talking about

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