- Ackman's claims will no longer be taken seriously, which removes downward trading pressure on HLF.
- The primary downward trading catalyst has neutralized himself.
- Traders now have a short-to-medium-term window with little interference.
- Short-selling claims may or may not have merit, but only the FTC/DOJ/FBI matter now.
- Path of least trading resistance is up, but fundamentals may be a different story.
I have no idea whether or not Herbalife (NYSE:HLF) is a legitimate multi-level marketer or a pyramid scheme. I have not analyzed the facts, and cannot speak to their merit or lack thereof.
This is merely a commentary on trading opportunities resulting from recent events.
Bill Ackman's attempt to nuke Herbalife has backfired, so much so that his dirty bomb blew up in his face, and his trade is now radioactive. This was a critical, probably fatal, tactical error in Pershing Square's short-selling campaign. Ackman will no longer be taken seriously, and that removes a lot of uncertainty as far as trading Herbalife stock.
The Ackman Error
Ackman's error is intriguing. He has made mistakes before, of which J.C. Penney (NYSE:JCP) is the most famous. The J.C. Penney debacle, however, resulted from a fundamental misunderstanding of that company's consumer.
In the Herbalife situation, Ackman mistakenly believed his own passion would be infectious, and that others would see the magnitude of Herbalife's alleged deficiencies as he does. That may be partially due to arrogance. It may be partially due to being too emotionally involved in the trade.
Regardless, the presentation of his life appears to have underwhelmed the market, to the point where Herbalife soared 25% during and after Tuesday's presentation. Perhaps it is the result of Herbalife repurchasing stock at the same time. Perhaps it truly was an unimpressed market, expecting "Enron-like fraud" and instead getting…well…it really isn't clear what they got.
The presentation focused on alleged improprieties in Herbalife's nutrition clubs, primarily in developing countries. The problem for the media, investors, and Herbalife skeptics is - to be perfectly blunt - they don't care about third-world folks being allegedly led to believe in the rags-to-riches campaign.
Whether the clubs are just schemes to boost revenues or not, at this point, it's irrelevant. It's an outlier in the story that Ackman was trying to sell. It's all about the story, and for this investor, the story has never been terribly clear.
Because he touted this presentation as the be-all-end-all, and it didn't support the storyline in a clear and direct manner, Ackman is now irrelevant to the Herbalife story. Even Whitney Tilson, another short-seller, agrees that the narrative was jumbled.
In addition, I think Ackman made two tactical errors. The first was that he apparently converted his short position to derivatives, probably put options. The result of the transition was to reduce his risk exposure. If the stock kept rising, he would continue to lose money. Buying a derivative short position, however, limited his total risk. However, it also created a ticking clock by which those derivatives had to get into the money.
Like a movie studio that rushes a script into production without a real clue as to what the story is, Ackman rushed this presentation out without tightly tying its narrative to the overall story of Herbalife - itself a story that has never been crystal clear to this investor.
Path of Least Resistance is….
At this point, any subsequent move by Ackman will be considered, "the boy crying wolf." If he didn't deliver with the nuclear strike, nothing is going to deliver.
The only thing that moves the stock lower in any substantial way is if another high-profile short-seller enters the game with a specific story of alleged malfeasance, or if one of the federal agencies uncovers something criminal.
However, investigations by the FTC, DOJ, and FBI take forever - as in, years. Between now and then, the path of least resistance for Herbalife trades is UP, i.e. long. That is not to say that company fundamentals will or will not support the long trade. All I'm saying is that the primary downward catalyst has been rendered inert in the short-to-medium term.
Ackman's allegations may turn out to be completely true. Facts, however, do not always matter in the stock market. He may even turn out to be 100% correct, but if the government agencies don't act, none of it may matter.
How might I play Herbalife, strictly from a trading perspective?
· Go long with tight stops.
Volatility will still exist as institutions and retail investors grapple over the stock. That may push the stock lower. Poor earnings quality may result in the same.
· Sell covered calls
Go long, but hedge your position by selling calls. Volatility will result in substantial premiums. You may even want to sell the calls out a few months, and pick up a substantial premium. If the stock gets called away, you made money while hedging your downside risk.
· Sell naked puts
This is similar to the call strategy. In this case, you are selling puts for the big premium, and the stock will get put to you if it falls below your strike price.
In all cases, however, use caution. This story still has legs, even if one of the major ones is now broken. Avoid situations in which you have substantive loss potential, and don't be afraid to close out an option position if it moves against you.