1 Company to Avoid Completely

Kyle is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It’s not every day that a highly regarded investor makes a $1 billion bet on the demise of a company, but that is exactly what Bill Ackman of Pershing Square Capital Management is doing. In mid-December 2012, Mr. Ackman announced a $1 billion bet against Herbalife (NYSE: HLF). The company uses multi-level marketing to sell its weight loss and nutritional supplements to its large network of distributors. Mr. Ackman argues that rather than being a multi-level marketing company, Herbalife is a pyramid scheme, claiming that its distributors make more money by signing on new distributors than they do selling the company's products. Mr. Ackman and his army of analysts at Pershing Square make a convincing argument, but I believe investors should avoid this company completely. Let’s look at the situation a bit further.

In order to place his bet, Mr. Ackman sold millions of borrowed shares from current Herbalife owners, hoping that he would be able to buy them back for a much lower price down the road. After disclosing his position, shares of Herbalife dropped nearly 15%, giving Mr. Ackman large gains on paper. As the drama unfolded, some unexpected players entered the field. Daniel Loeb of Third Point LLC announced an 8.2% position in the company. This caused the stock price of Herbalife to drift back up into the low $40s, hovering around the price where Mr. Ackman initiated his position. Third Point is only one of a number of things that Mr. Ackman should be worried about.

The problem with shorting a stock is that you have to be right on the price and the time frame. If the share price stays flat for 5-10 years before a decline, you may be forced to sell your position due to borrowing costs associated with a short. A second problem occurs when you short the stock of a company that not only is making money, but also has a large amount of cash on the balance sheet. As you can see in the chart below, the company’s net income and cash have been rising over the past few years. Herbalife can put a lot of pressure on Pershing Square by initiating a large dividend, announcing a large stock buyback, or doing both simultaneously. By doing this, the company forces Mr. Ackman to cover his short position, or be forced to pay the dividend amount to the original owners of the shares. Also, a large share repurchase might make it significantly harder for Mr. Ackman to find enough shares to buy in order to return his borrowed shares to their rightful owners.

<img src="http://media.ycharts.com/charts/b011eace9b5179455703029d96d0a915.png" />

data by YCharts

It will be some time before we see the story above play out, but I wanted to point out another short thesis that was made by Whitney Tilson of T2 Partners in late 2010. The company in question, Netflix (NASDAQ: NFLX), was racing to all-time highs as its subscriber numbers skyrocketed. Mr. Tilson went short, expressing concerns over valuation and predicted that the business would slow in the coming year. Instead of fall, Netflix shares continued to race higher, forcing T2 Partners to close its position near $200. The stock continued its climb to $300 per share, and then proceeded to fall to as low as $53 last year. I think it is important to remember that no matter how confident you are in your thesis, it is important to remember that the market can remain irrational for longer than you can remain solvent.

A second case I want to mention involves J.P. Morgan Chase (NYSE: JPM) and its now well-known London Whale calamity. In this case, a group of traders built up a large position that began to move against them. With losses mounting, the traders were forced to sell off some of its positions. Unfortunately for them, other market participants caught wind of what they were doing, and forced their positions even lower. In the end, losses mounted up to more than $6 billion. I think Mr. Ackman may want to take this incident into consideration when regarding his Herbalife short. Market participants stand to make significant gains if they can force a short-squeeze on Mr. Ackman’s position.

As was the case with Whitney Tilson and Netflix, shorting on valuation alone can be quite dangerous. I have heard a number of investors claim that Amazon.com (NASDAQ: AMZN) is extremely overvalued, pointing to its price-to-earnings ratio of 3,637. That’s right; its PE ratio is in the thousands. That being said, I would still not short Amazon. The company continues to invest heavily in its business which has prevented earnings from showing up in the bottom line. Also, as you can see in the chart below, the company has a large cash horde and steady free cash-flow. I would stay away from shorting this company.

<img src="http://media.ycharts.com/charts/e0b051a4735d0b00fb385978cba2e38f.png" />

data by YCharts

If I utilized short selling in my portfolio, one candidate that I would be looking at is Southwest Airlines (NYSE: LUV). Sitting at the bar last night, I met a group of Southwest employees who were expressing their extreme dislike of the company and the way it treats its workers. That, combined with airlines being historically terrible investments, would put Southwest on my list of short candidates. Looking at the chart below, you can see just how bad the economics of the business are. Increasing long-term debt and declining net income are great qualities of a terrible business.

<img src="http://media.ycharts.com/charts/b35934fb8d17ab1a90588cf9775ae245.png" />

data by YCharts

To wrap this up, I think there is something to learn from the stories of Bill Ackman, Whitney Tilson, and J.P. Morgan Chase. Markets move in unpredictable ways and market participants will act in a way which brings them the most profit. You can be spot-on in your analysis of a short candidate, but if enough big players catch wind of what you are doing and take the other side of the trade, look out! It is for that reason that I am staying as far away from Herbalife as possible.

RoyalScribe owns shares of Netflix. The Motley Fool recommends Amazon.com, Netflix, and Southwest Airlines. The Motley Fool owns shares of Amazon.com, JPMorgan Chase & Co., and Netflix and has the following options: Long Jan 2014 $50 Calls on Herbalife Ltd.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus