A great example of how investors’ beliefs, about other investors’ future behaviour, drive stock valuations.

I was born in 1956, the same year as Mark Hughes, the founder of Herbalife, a nutritional supplement direct seller headquartered in the United States. Sadly, Mark died in 2000, but Herbalife is till going; I was going to say it was “going strong”, but it is currently at the centre of a battle between competing hedge fund managers, trying to either, talk it up, or down, in order to maximise the contrasting financial positions they have taken with the stock.

Herbalife’s share price crashed by a third to $46 last May after this all started. Now Pershing Square’s Bill Ackman is betting that the stock will crash further; meanwhile, Third Point’s Daniel Loeb, and possibly even Carl Icahn, are buying. The stock price has now gone down to under $40, valuing the business at about half what it was worth last May.

This level of uncertainty about the business comes about because of a degree of ambiguity with its trading model. The central accusation made against the company is that is operating an illegal pyramid scheme. Although I have heard this term bandied about many times I turned to Wikipedia for a definition, which goes something like this…” A pyramid scheme is a non-sustainable business model that involves promising participants’ payment or services, primarily for enrolling other people into the scheme, rather than supplying any real investment or sale of products or services to the public.”

I really have no idea just how close Herbalife comes to being a pyramid scheme, but the FT’s LEX column says the “case isn’t proven” and Herbalife can at least find one business school professor prepared to stand up and defend it, saying that all it is doing is multi-level marketing and that there is nothing wrong with that. However, there are clearly enough similarities to raise doubts in peoples’ minds and those doubts have been exploited here by the speculating classes.

Surely though the value of a security is based on some hard-nosed financial considerations, like discounted cash-flows and all that? Perhaps, if sentiment is with it, but exactly what is sentiment when it’s at home anyway? Well, I like the idea that successful short term investors (or are they speculators?) both long and short ones, are far less concerned with financial mechanics and far more concerned with perceptions; they act based on what investors think and how they believe that will influence others’ future investing behaviour. It matters little just how subjective, or unproven, that thought might be; fundamentally, they make their investment decisions based on a hunch about how people are going to behave, irrespective of the facts of the matter.

At this stage of the Herbalife game, the early shorts are probably in the money and clearly some now see it as a recovery stock after all the pummelling it has been through. Trading ambiguity is the cause of all this uncertainty and ambiguity is always a hotbed of competing beliefs. Interestingly, the top Herbalife options position will only make money if the stock drops below $22 by May, a year after all this began. That’s not very reassuring if you have been holding Herbalife, as a long term investment, before all this started.


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