Well, Bill Ackman likes a challenge, and he found himself one in Herbalife (NYSE:HLF), but it would be a mistake to focus on the epic battles of Bill Ackman. We certainly should not even dwell on the duel with Icahn, nor even their subsequent reconciliation. It all has nothing to do with the price of beans. These are the distractions along the way. Entertainment, really, that risks clouding the analysis of the situation. To the extent that Tuesday's meeting was over-hyped, nevertheless the pre-publicity ensured a good turnout.
Herbalife is in an industry that has been plagued with problems since the outset because its legal foundations are shaky, and regulation has been haphazard, as a recent SA article by Bruce Craig reminded us again, in the form of his letter to the Chairwoman of the FTC. We should not forget that Amway entered into a $150 million settlement in 2010, which included the allegation that they were a pyramid scheme. They could not have been too confident of their chances...
Cognitive Dissonance and IMH puts Bill Ackman in business
IMH, the Inefficient Market Hypothesis, might explain the inconsistencies of our "real life" experiences which disturb the ever so attractive mathematical elegance of EMH. EMH is a rationalization which very much belongs in an ideal mathematical world, and does not deal with the messy realities. If all the information were in the stock price, Bill Ackman's MBIA research would have had no value, for all he did was to read publicly available information, and question some of the assumptions. What was different was he dared go beyond the surface and really analyze the data, and come to the conclusion that things were not what they seemed, and that in fact the emperor had no clothes on.
For those who want the full story, the book Confidence Game is very valuable, because again the case is similar in some ways. Trading opportunities exist in many cases by taking a different view of the same data, and if you've done the research firsthand, in your own mind you are dealing with facts that have not yet been digested by the market. In the case of Herbalife the consensus view is that the company has passed FTC challenges in the past, and it has shrugged off a consent decree in California, and besides, MLM must clearly be legal given the growing number of MLM companies that are exchange traded...
Cognitive dissonance is when new information is ignored or misinterpreted, because it flies in the face of what's generally known and accepted. People tend to preserve a belief system, an existing paradigm. The classic on that is Thomas Kuhn's The structure of scientific revolutions. As Bill Ackman reported, NONE of the "analysts" who cover Herbalife have ever even spoken with them. Pershing Square did the actual research, and based on the FACTS and their own analysis, and became convinced that Herbalife is a pyramid scheme. The back story is forty years of near inaction and/or haphazard enforcement by the FTC, but since Pershing Square initially unveiled its position, that back story includes the recent BurnLounge decision, which strengthens the hand of the FTC, prosecutors, and other regulators (SEC).
Belief systems of this sort are unstable, it can turn on a dime. Ackman has been through that with MBIA, and, for now, Herbalife offers the same scenario, it seems to resist all information that conflicts with the premise that it is a legal business that will easily survive a few scrapes with the law. But rationally, with six investigations pending, any of which could trip up the company completely, already the only rational valuation methodology is a 50/50 chance of either $90 or zero, which puts the stock at $45.
What happened on Tuesday?
More information arrived. Certainly it seems it was too much information for many, while it would seem that the market wanted to see at least the public lynching of the CEO of Herbalife, which they did not get. Bloomberg TV's Julie Hyman was emblematic for the cognitive dissonance that is going on, for after listening to a detailed presentation of relevant evidence as to why the Nutrition Clubs are a pyramid within a pyramid, evidence which Pershing Square will turn over to the government, she still asked Bill Ackman: when he was going to get around to proving that Herbalife was a pyramid scheme? She called the case "circumstantial." It was reminiscent of Harry Markopolos' experience with the SEC (see his 60 minutes interview here), who experienced firsthand how he thought he handed them a case on a silver platter, but clearly they might have recognized it if he had presented the detailed legal case, when all he did was hand them the proof, and they would actually have to build the case themselves. Bill Ackman delivered the proof (subject to verification, etc.), but not the full-fledged legal case. Evidently markets read that as a shortfall, and the stock came roaring back. I would argue that this has everything to do with the market defaulting back to shielding itself from the information because of cognitive dissonance - protection of the prevailing belief system.
Meanwhile, the information that was presented is damning when properly understood, but again, it was in the nature of evidence that remains subject to verification and an actual case will need to be built, much like in the Madoff case, where an investigation was never even started until it was already too late. But this time investigations are ongoing. The new picture, on top of what we already knew about the doubtful legality of the Herbalife business model, is that of another pyramid scheme nested within Herbalife, in the form of the nutrition clubs, and it accounts for an estimated 50% of revenue (company documents seem to put the number at 40%). The resultant liabilities include the following (not an exhaustive listing):
- Possible misinformation to shareholders about the retail aspect of the business volume conducted through the clubs, because it is not free traffic, but overwhelmingly induced by misleading expectations. As a result a large part or maybe all of that volume would have to be reclassified as "recruiting sales," not free and unencumbered retail sales to clients outside the network.
- The presentation at the nutrition club level is indeed a mini pyramid within the bigger pyramid, because it rests on the same fraud, namely offering the lure of unlimited income potential to an unlimited number of hopefuls, and statistically that is a lie, somewhere between 99.0 and 99.9% of the time. That kind of misrepresentation is what regulators typically focus on.
- Potential violations of labor laws, which include Herbalife paperwork on how club operators should skirt the labor laws.
- An even stronger case for the FTC based on the evidence produced, which Pershing Square is turning over.
- Likewise more ammo for an eventual SEC action.
- Significant detail on the low-income and ethnic targeting by Herbalife, with their program that turns 99% of people into losers who will never see returns on any money they put in.
In short, we in fact witnessed a review of evidence that is now being turned over to the agencies that are already conducting an investigation.
Reinforcements in the back story
The recent letters to the FTC (by Bruce Craig here), to the SEC (by Prof. William Keep) here, and the explanation of the "cognitive dissonance" that pervades Wall Street, and why they are constitutionally incapable of understanding multi-level marketing by Robert Fitzpatrick, here, taken together make a compelling case why there is reason for action this time. Alongside all of that there is the whistleblower novel Downline... intolerable potential to deceive, by E. Robert Smith, that provides an insider's view that was not available when Pershing Square first publicized its position.
In short, there is growing pressure for seriously dealing with the problem, including concerns from some other countries even if they have not so far been specific to Herbalife by name. It all indicates the need to sanitize the industry in a categorical fashion.
We don't know either the buyers or the sellers in Tuesday's 27.5 million shares traded, about 20 times the trailing 3-month average at that time. When the veil is lifted on that, there may be more light being shed on the situation.
Unrealistic expectations is the only rational explanation of the market's reaction to Tuesday's presentation, but this is not the French Revolution, and heads were not going to roll on stage. Anything short of that was apparently not enough for Mr. Market. Further, there is the effect "cognitive dissonance," where "too much information," gets no immediate results, and lastly the imminent earnings release exercising upward pressure.
The presentation was incredibly detailed and thorough, and interesting particularly because Pershing Square clearly found more than they were looking for. This was sooner a case of information overload than of failure to produce. The Nutrition Club is embedded in Herbalife's operations Russian Doll-style, as a low-income version of its program, accounting for 50% of sales. It will take time for prosecutors and regulators to digest and validate the huge amount of information they are being offered, and likewise, it will take time for the market to digest and interpret the information. Bill Ackman already knows that the information being available and being widely appreciated and understood are two different things. Time will tell.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.