One of my favorite writers on the financial markets is Dr. John Hussman. He publishes a weekly commentary at hussmanfunds.com. I consider this gentleman's thinking brilliant. He is also decidedly charitable. I have learned a tremendous amount reading his insights over the years.
This week, Dr. Hussman wrote the following:
Through the recurrent bubbles and collapses of recent decades, I've often discussed what I call the Iron Law of Finance: Every long-term security is nothing more than a claim on some expected future stream of cash that will be delivered into the hands of investors over time. For a given stream of expected future cash payments, the higher the price investors pay today for that stream of cash, the lower the long-term return they will achieve on their investment over time.
Great investors understand this financial truth. Warren Buffett, perhaps the greatest investor of the past 100 years, looks for businesses with barriers to entry and steady and stable cashflows.
If you can't readily forecast what future cashflows are going to look like then valuing a business with accuracy becomes very difficult.
The efficient market hypothesis basically argues that all known information is "priced in" to asset values. Therefore, it is supposed to be impossible for an investor to gain an advantage over the market over time. In my own view, this argument is nonsense. Market prices reflect the aggregate of varying views, opinions, etc. The supply and demand curves for any given security find a market clearing price. Price and value may often not be the same thing at all.
Great investors tend to see things that others do not see. That is to say that they often have a "unique insight" or contrarian view of any given situation or asset price. In much the same way as baseball statisticians can measure Ted Williams batting average we can also measure the results of great capital allocators. The longer the track record the more likely the hitter or investor is the real deal.
Wednesday, Pershing Square released its Q2 Letter to Investors. In the opening section of the letter Mr. Ackman revealed his and his firm's track record over time since inception. This letter can be found here. If Mr. Ackman were a baseball hitter he would have "Hall of Fame" statistics. The numbers are irrefutable. Here they are.
Returns Since Inception
Over the last ten and one-half years, we have generated net returns to our investors of 626.7% or 7.3 times day-one investor capital. Over the same period, the S&P 500, our principal benchmark, as it has historically comprised most of our holdings, has returned 118.8% or about 2.2 times. Expressed as a compounded annual return, the funds have returned 21% net per annum versus 8% for the S&P 500
In a world in which investors are pleased to earn returns that are one or two percentage points per annum above the S&P over 10-year periods, our approximate 13 percentage point annual net margin over the index is notable.
My own view is great investors are constantly on the lookout for mispricing of securities. Put another way, when is Mr. Market's assessment of the Present Value of the cashflows that will be delivered over time at odds with what is likely to happen? Put another way, when are market participants just plain wrong.
To invest this way one has to be courageous, one has to be willing to look dead wrong. One has to be willing to play the fool. Only when everyone else is loaded on one side of the boat is it possible for outsized returns to be earned. If you are on the side of concensus then there is no real mispricing perhaps or at the very least no way to take advantage of it.
Today, Mr. Market tells us that the present value of all future cashflows that will be delivered to stock and bondholders of Herbalife is roughly $6 billion. This is what longs are banking on as a result assuming no margin of safety at all. Mr. Ackman thinks this is wrong. My guess is that after paying restitution to victims he values this identity at a negative NPV. In his mind as a great investor this disparity equals opportunity. We're going to find out soon enough what actually happens.
Herbalife (NYSE:HLF) is a decidedly curious company. It competes in the Meal Replacement space. This space is extremely competitive and ruthless. Hundreds of skus of Protein Powder are on the market. Brand names like GNC and Slim Fast and Ensure are marketed by talented people with well-capitalized support. Heck, even POST Holdings is in on the act as it markets its own family of protein based products and meal replacement bars.
If you imagine yourself in a Satellite looking down at Planet Earth's market for these kinds of products, certain things immediately stick out. For me what sticks out is the following:
- Even though competition is fierce
- Even though competitors are talented and innovative
- One firm's financial metrics seem to stand alone
Herbalife prints stunning financial results.
- 80% Gross Margins
- 15% Operating Margins
- 12% Net Margins
- 99% Return on Equity
- $600 million in free cashflow
- Hundreds of Millions of $ in Executive Compensation
- Hundreds of Millions of $ in Mark Hughes bonuses over time
The question Mr. Ackman asked is "How on earth do they do it?"
When something seems to good to be true it usually is. Or as Shakespeare wrote in Hamlet "Something is rotten in the state of Denmark."
You see capitalist economies function very efficiently and effectively. If competitors discover that a given firm in a given industry is earning outsized returns then the forces of competition seem to set-in to grab a slice of the pie.
Curiously, however, that doesn't seem to be the case with Herbalife. Not only do we not see efforts by Unilever or Kainos Capital or Abbott Labs or Post Holdings to knock-off Herbalife's distribution model, "in practice" we actually see the Chairman and CEO of Post investing in one of his own competitors.
Think about that. Instead of suing Herbalife for operating a prohibited marketing scheme that competes against POST shareholders for profits in the macro-economy, POST's CEO is actually investing in one of his competitors and giving them free advice as an Activist to boot. Am I the only one who thinks this behavior is a complete conflict of interest?
Clearly, the allure of this cash generating machine called Herbalife is just too much to ignore. Here's the thing to consider though. There's a stunningly obvious reason to ignore Herbalife's free cashflow. The reason is because it is generated by defrauding low-income business opportunity seekers the world over.
You see, Herbalife's operating metrics function like the tip of an Iceberg. In Money transer schemes, of course we should expect those "upline" to be above water. After all, that is how these schemes work "in practice".
Below water level, of course, the business model is on spin-cycle. This year alone 1.5 to 2.0 million failures will be churned out of the salesforce.
Mr. Ackman has figured out that without the failure of these victims Herbalife's outsized returns would be impossible. That is to say that Herbalife' economic results are proceeds of crime.
Mr. Ackman's "unique insight" is that Herbalife is a fraud.
Today many market participants seem ambivalent. Some like Bob Chapman from Los Angeles or John Hempton from Australia seem thoroughly unconvinced. On the contrary they say, Herbalife has cracked the code and is a true and honest differentiator in the weight loss arena. This idea, of course, explains why its products sell almost ubiquitously to poor people at a price premium in many Latino markets around the world. This also explains why we see skinny young Latinos attending graduation ceremonies with friends and family. Doesn't GNC do the same thing?
Whether or not you are long or short Herbalife, one thing remains true. The media targets investors of all stripes who dare to look "wrong" in the short run. Stock price movements are often used to gauge whether or not an investor is successful or not in the short run. Great investors, however, know that the stock price moves and often in a manic fashion. Stock price movements can also be used to average into positions, restructure positions, etc. When prices move against you this may, in fact, be a friendly dynamic if one is confident in one's thesis.
One week an investor can look dead wrong. 24 hours later a cogent investment thesis can indeed crystallize into a successful result.
Herbalife is a fascinating investment for one simple reason. Two extremely successful activist investors are on opposite sides of the trade. One thing is for certain, one of them will be proven wrong. I happen to believe that Mr. Ackman's investment thesis makes the most sense. I consider Mr. Icahn's and Mr. Stiritz's positions more supportive of financially engineering the company in the short run. I fail to see how this company's future cashflows are either:
a) predictable or
Mr. Market now seems to be telling us too that the recapitalization might not have been the best idea - at least for now.
"In practice" the company actually tells us that most of its "Members" fail in less than 12 months. To me, this makes most future cashflows decidedly invisible v. not.
Wednesday's letter from Pershing Square reveals one significant truth. Mr. Ackman has gravitas. His track record speaks for itself. Though it may be de rigueur to attack him ad hominem on his ideas on Herbalife it may not be all that wise in the end.
Recall, investors thought Mr. Ackman was loony when he questioned MBIA's AAA rating. MBIA management also attacked him directly much in the same way Herbalife's executive suite and PR firm have attacked him on HLF.
To me, this reaction tells me that he is on to something. The simple way to refute Pershing Square's thesis is with evidence. Herbalife seems to struggle in this area. (Retail Sales data anyone?)
To be clear, Mr. Ackman's track record at Pershing Square does not mean his thesis on Herbalife is necessarily correct. That would be a fallacy. What it does reveal, however, is his batting average. Whether or not he hits a home run on HLF remains to be seen. Still, investors who have bet against him do so at their own peril.
As you contemplate your own thesis think about what Dr. Hussman has to say above.
Is HLF good for $6 billion in cash down the road or not?
What are the odds?
Still Short. Look Out Below
Disclosure: The author is short HLF. 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.