(GuruFocus) Short-selling is a specialist skill. While it is possible to make money from selling stocks short, it is also tough. Most people who try end up losing a lot of money. Others, who do all the legwork required to establish whether or not a company is a fraud, can make a lot of money. These traders are few and far between, however.
By "short selling," I mean shorting a stock based on fundamental analysis, not going short based on technical analysis and looking for a quick profit.
There are some short-sellers who have made a fantastic fortune for themselves and built a good reputation in the industry by spending much time and effort on identifying targets -- people like Marc Cohodes, Jim Chanos and Carson Block.
These traders approach short-selling in the same way that a journalist approaches writing a good story. Once they find the initial target, they then spend hundreds of hours researching the business, its management, market and financial situation, and contacting sources and competitors to try to figure out what it is that the business is doing, where the money is going and why they should be short.
Investors on the long side should use the same approach, but so many don't.
The reason short-sellers have to be so thorough is that it is so easy to lose money selling stocks short.
Unlike on the long side, where can make many times your initial investment, when you short stocks, you can only make 100%, but you can lose an infinite amount.
Unattractive risk-reward
This unattractive risk-reward profile is the reason Warren Buffett avoids shorting stock altogether.
When asked for his views on naked short-selling at the 2006 Berkshire Hathaway annual shareholder meeting, Buffett answered:
"I have no objection philosophically to shorting stocks. We're not allowed to lend our shares out to short-sellers, but I'd love to be able to, because it's a very profitable activity. There's nothing evil about short-selling. But it's a tough way to make a living. It's tough emotionally. If you short a stock at $20, the most you can make is $20, but there's no limit to how much you can lose. People on the short side will do and say things to try to get their positions to fall; people on the long side do, too. Some of the things they do may be inappropriate."
The problem is, while it is easy to identify stocks that might be frauds, the people running these businesses are generally good at deceiving the market, which makes these stocks difficult to short profitably:
"Historically, a lot of stocks that have high short interest are later shown to be frauds or semi-frauds. I've had 100 ideas to be short, and have often been right -- eventually, but long after I've covered, and the stocks have risen a lot. The people who run those companies tend to be good at keeping their stock prices up."
These comments seem to suggest that the Oracle of Omaha has tried to short stocks before, but he has had relatively little success.
It makes sense that Buffett would try to short some stocks. After all, there are only a handful of other investors in the world who know businesses and the stock market as well as he does. If anyone is going to know when a business is a failing fraud, it is Buffett.
Still, that he doesn't enjoy the process is revealing (of course we don't really know what Buffett has done privately, as he does not publish his personal investment returns).
He went on to say in 2006 that being short stocks is a "tough psychological game," and he didn't recommend it. That's all investors need to know about the subject.
