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How To Profit From My Early Call To Short This Overvalued Stock

Thursday, March 27, 2014 - 8:30am

It's difficult to admit that I was too early with a market call. It's even harder to accept when I realize I was riding the coattails of a billion-dollar bet made by a renowned activist investor.

While I can take comfort in the fact that I judiciously used a stop-loss order and stuck to my investing rules despite being very confident, it's still not a good feeling. On a positive note, things are finally happening that may vindicate the investor's billion-dollar bet and my own bias.

Here's the story. Multi-level marketing (or MLM, as it's commonly called) has long fascinated me from a distance. Hearing rags-to-riches stories and attending presentations is a sure way to get excited about the wealth-building power of the MLM concept -- until you look past the hype and realize that many MLM firms are thinly disguised pyramid schemes.

With that said, the MLM health products company Herbalife (NYSE: HLF) has been under fire since December 2012, when activist investor Bill Ackman announced a $1 billion short position in HLF. Ackman asserts that Herbalife is an illegal pyramid scheme that sells dubious products to naive buyers/distributors. To support his argument, Ackman launched a full-scale informational war that included a several-hundred-slide presentation by his hedge fund, Pershing Square Capital.

Herbalife has denied Ackman's allegations and has garnered support from such investing luminaries as Carl Icahn, George Soros, and others. Based on my own research and experiences with the MLM industry, I agreed with Ackman in a March 2013 article.

Despite Ackman's huge short position, Herbalife surged higher in 2013.

HLF climbed more than 300%, crushing shorts along the way. Ackman's cumulative losses on the position totaled 49%, making it his worst investment of all time -- that is, until January of this year, when share prices started dropping.

Despite HLF's rise, Ackman has maintained his intense bias against the company along with a non-stop campaign to have it investigated and even shut down. This month, the Federal Trade Commission said it has launched an investigation into Herbalife, resulting in analyst downgrades. HLF is down 37% this year.

In the meantime, another MLM company, Nu Skin (NYSE: NUS), was investigated and fined $540,000 this month by Chinese authorities, who accused the firm of violating direct selling rules. The share price drop stabilized on word of the fine, which should be manageable for the company.

So what exactly is a pyramid scheme? According to the FTC, a pyramid scheme is any organization in which the participants obtain their monetary benefits primarily from recruitment rather than the sale of goods and services to consumers. Two additional signs of an illegal pyramid scheme: Distributors sell more products to other distributors than to the public, and they make more money from recruiting than they do from outside sales.

Every presentation by an MLM firm I've ever attended -- and I've been to several, including Herbalife's -- emphasized the recruitment of a sales team. Very little was said about actually selling the products to consumers outside the company. This is why I suspect many businesses fit the description of an illegal pyramid scheme, regardless of their rhetoric.

Risks to Consider: While I think there is little question that Herbalife is a pyramid scheme, it's important to note that the company is waging a vigorous defense. There is no telling what the FTC investigation could lead to. Maybe the company will be let go with a slap on its wrist... maybe it will be fined and forced to change its business model... or perhaps it will be shut down. Be sure to use stop-loss orders when shorting.

Action to Take --> I think there is much more downside to come in Herbalife. My strategy is to wait for $50 to be broken on the downside. I recommend stops at $61 and a 12-month price target of $10.

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David Goodboy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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