Berkshire Hathaway 2002 Annual Meeting Audience Question # 27

Warren shares his thoughts about the long/short equity model of Alfred Winslow Jones

Warren Buffett:

Six?

Audience Member:

Hi, I’m Steve Rosenberg. I’m 22, from Ann Arbor, Michigan. It’s a privilege to be here.

First, I’d just like to thank you both for serving as a hero and positive role model for me and many others. Much more than your success, itself, I respect your unparalleled integrity.

I have three quick questions for you. The first is how a youngster like myself would develop and define their circle of competence.

The second involves the role of creative accounting in the stories of tremendous growth and success over many years. GE, Tyco, and IBM immediately come to mind for me, but I was hoping you could also discuss that issue in relation to Coke.

Some people have said that their decision to lay off much of the capital in the system onto the bottlers, who earn low returns on capital, is a form of creative accounting.

On the flip side, others counter that Coke’s valuation, at first glance on, say, a price-to-book metric, is actually less richly valued than it seems because they earn basically all the economic rents in the entire system.

My final question is, if you could comment on the A.W. Jones model, the long/short equity model. I understand that it doesn’t make sense for capital the size of Berkshire’s to take that type of a strategy.

But it just seems to me that playing the short side in combination also seems incredibly compelling, even giving the inherent structural and mathematical disadvantages of shorting. And I was wondering if you could talk a little bit more about why you would have lost money on your basket of a hundred frauds.

Warren Buffett:

Yeah, it’s an interesting question. And we’ll start… we’ll go in reverse order.

Many people think of A.W. Jones, who was a Fortune writer at one time, and who developed the best-known hedge fund, whenever it was, in the early ’60s or thereabouts, maybe the late ’50s even.

And for some of the audience, the idea originally with A.W. Jones is that they would go long and short more or less equal amounts and have a market-neutral fund so that it didn’t make any difference which way the market went.

They didn’t really stick with that over time. And I’m not even sure whether A.W. Jones said that they would. But they, you know, sometimes they’d be 140 percent long and 80 percent short, so they’d have a 60 percent net long, or whatever it might be.

They were not market-neutral throughout the period, but they did operate on the theory of being long stocks that seemed underpriced and short stocks that were overpriced.

Even the Federal Reserve, in a report they made on the Long-Term Capital Management situation a few years ago, credited A.W. Jones with being sort of the father of this theory of hedge funds.

As Mickey Newman, if he’s still here, knows, I think it was in 1924 that Ben Graham set up the Benjamin Graham Fund, which was designed exactly along those lines, and which even used paired securities.

In other words, he would look at General Motors and Chrysler and decide which he thought was undervalued relative to the other, and go long one and short the other.

So, the idea… and he was paid a percentage of the profits. And it had all of the attributes of today’s hedge funds, except it was started in 1924.

And I don’t know that Ben was the first on that, but I know that he was 30 years ahead of the one that the Federal Reserve credited with being the first, and that many people still talk about as being the first, A.W. Jones.

Ben did not find that particularly successful. And he even wrote about it some in his… in terms of the problems he encountered with that approach.

And my memory is that a quite high percentage of the paired investments worked out well. He was right. The undervalued one went up and the overvalued… or the spread between the two narrowed.

But the one time out of four, or whatever it was, that he was wrong lost a lot more money than the average of the three that he was right on.

And you know, all I can say is that I’ve shorted stocks in my life, and had one particularly harrowing experience in 1954. And I have… I can’t… I can hardly think of a situation where I was wrong, if viewed from 10 years later.

But I can think of some ones where I was certainly wrong from the view of 10 weeks later, which happened to be the relevant period, and during which my net worth was evaporating and my liquid assets were getting less liquid, and so on. So, it’s… all I can tell you is it’s very difficult.

And the interesting thing about it, of course, is A.W. Jones was a darling of the late 1960’s. And Carol Loomis is here, and she wrote an article called “The Jones Nobody Keeps Up With.” And it’s a very interesting article, but nobody’s writing articles… nobody was writing articles about A.W. Jones in 1979.

I mean, something went wrong, and there were spin-offs from his operation. Carl Jones spun off from his operation, Dick Radcliffe spun off from his operation. There were… you can go down the list.

And out of many, many, many that left, they… a very high percentage of them bit the dust, including suicides, cab drivers, subsequent employment… the whole thing. And these people were…

There was a book written in the late ’60s, it had a lot of pictures in it. I don’t remember the name of it, but it showed all these portraits of all these people that were highly successful in the hedge fund business, but they didn’t bring out a second edition. So, it’s just tough.

Logically, it should work well, but the math of only… you can’t short a lot of something. You can buy till the cows come home if you’ve got the money. You can buy the whole company if need be, but you can’t short the whole company.

A fellow named Robert Wilson, there’s some interesting stories about him. He’s a very, very smart guy, and he took a trip to Asia one time, being short, I think it was Resorts International or maybe it’s Mary Carter Paint, it was still called in those days.

And he lost a lot of money before he got back to this country. He’s a very smart guy, and he made a lot of money shorting stocks, but it just takes one to kill you.

And you need more and more money as the stock goes up. You don’t need more and more money when a stock goes down, if you paid for it originally and didn’t buy it on margin. You just sit and find out whether you were right or not.

But you can’t necessarily sit and find out whether you’re right on being short a stock.

I think I’ll let Charlie comment on that before I go to your other two questions.

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