Who says that finance is boring? This Herbalife (NYSE: HLF) controversy is extremely entertaining! In fact, an Australian hedge fund manager named John Hempton of Bronte Capital has called it “hedge-fund porn.” Now, there is a hedge fund that allegedly invests in porn websites, but that is not the type of hedge-fund porn Hempton is talking about it. Rather, he is enjoying the war of words between hedge fund managers who are shorting Herbalife stock and hedge fund managers who are buying Herbalife stock. 

Herbalife vs. Ackman

As a recap, the stock of Herbalife – a direct marketer of diet shakes and energy bars – has experienced a bungee jump. This past December, the stock plunged 49% on news that Pershing Square hedge fund manager Bill Ackman had shorted 20 million shares of the company and accused it of being an illegal pyramid scheme that would go out of business (i.e., his target price is zero). The stock bottomed at $24.24 on December 24^th within a couple days of Ackman’s December 20^th bearish presentation. Tim Ramey, an analyst at Oregon-based brokerage firm D.A. Davidson, called Ackman’s attack “almost unprecedented in the history of investing.”

Between December 24^th and January 10^th, however, Herbalife’s stock skyrocketed as much as 77 percent, culminating with Herbalife’s bullish presentation refuting Ackman’s accusations about the company. News that the Securities & Exchange Commission (SEC) had initiated an inquiry into Herbalife temporarily halted the stock’s rebound, but it quickly rebounded when investors realized that the inquiry may focus more on the purchase of put options prior to Ackman’s December presentation than on pyramid-scheme allegations.  

The give-and-take between Ackman and Herbalife CEO Michael Johnson has been entertaining enough – Johnson said that “the United States will be better off when Bill Ackman is gone” and Ackman dramatically claimed that Johnson’s statement constituted a physical threat. After Ackman’s presentation, Herbalife said it was a “malicious attack” based “on outdated, distorted, and inaccurate information.” After Herbalife’s presentation, Pershing Square replied with similar blustery verbiage, saying that Herbalife had “distorted, mischaracterized, and outright ignored large portions of our presentation.”

Spirited disagreements between short sellers and company management is relatively commonplace – who can forget Overstock.com (NasdaqGM: OSTK) CEO Patrick Byrne accusing a mysterious and evil hedge-fund “Sith Lord” of trying to take the company down? But what makes the Herbalife situation so, uh, pornographic is the battle shaping up between Ackman and some very smart hedge-fund managers who have lined up on the other side of the bet.

Is Whitney Tilson Supporting Ackman the Kiss of Death?

To be fair, Ackman isn’t totally alone on the short side, although his 20-million-share short position comprises the vast majority of the 25 million total Herbalife shares sold short. Joining Ackman is hedge-fund manager Whitney Tilson of T2 Partners, who announced that he was short a “minuscule amount” of Herbalife because he thought Ackman’s presentation was “the most remarkable piece of investment analysis I have ever seen.”

But Tilson is considered a lightweight in the hedge-fund world and, as I wrote in My Evening with Options Trader and Entrepreneur Tom Sosnoff, doesn’t know anything about options either. The investment website Zero Hedge recently said of Tilson: “As far as we are concerned, the second Tilson goes long, we dump everything.”

The mutual fund Tilson manages – Tilson Focus (TILFX) – has a one-star rating from Morningstar (worst possible) and its performance has been in the 100^th percentile (worst possible) over the last one and three-year periods. Five-year performance is slightly better at the 98^th percentile.

Ackman vs. Loeb, Chapman, and Icahn

If I were Ackman, seeing Tilson jump on the short side wouldn’t give me any confirmatory comfort. In contrast, the hedge fundies on the long side are very smart and very successful and would scare the crap out of me:

• Daniel Loeb of Third Point Capital
• Robert Chapman of Chapman Capital
• Carl Icahn of Icahn Enterprises

One hedge fund manager said “it was going to be an Ackman sandwich” (i.e., a short squeeze). Loeb has taken an 8.2% stake in Herbalife, which constitutes 3% of his hedge fund assets, and he claims that the stock is worth $55-68 per share and “could even trade well above our current price target.” He goes on to say:

The pyramid scheme is a serious accusation that we have studied closely with our advisors. We do not believe it has merit. The short thesis rests on the notion that the FTC has been asleep at the switch, missed a massive fraud for over three decades, and will shortly awaken (at the behest of hedge fund short seller) to shut down the Company. We find this thesis to be preposterous, particularly since the FTC has been sensitive to frauds of this kind. 

Loeb doesn’t like Ackman, having lost money investing in Ackman’s Target Fund back in 2008. He also reportedly was short JC Penney (NYSE: JCP) at the same time that Ackman was long.

Chapman has taken an even-larger position relative to his assets under management – an almost obscene 35%. You don’t want to mess with Chapman, who is one tough hombre. Legend has it than when he was 20 years old and was riding his dirt bike to a job interview with Salomon Brothers in San Francisco, he got hit by a car. Rather than go to the hospital, he insisted on going forward with the interview in his bloody clothes. He got the job.  Chapman doesn’t have very flattering things to say about Ackman, calling him the “P.T. Barnum of hedge funds” and relishing the prospects of watching him suffer a short squeeze:

Ackman makes mistakes just like the rest of us, even catastrophic financial ones (e.g., call options on Target). Indeed, Ackman closed down a previous hedge fund advisory entity called Gotham Partners after he reportedly marooned his investment funds in an illiquid and devastating combination of a closely held REIT (First Union Real Estate) and a portfolio of golf courses (Gotham Golf) for which no exit was possible. So while Ackman is quite good at what he does for a living, his hubris makes him vulnerable to spectacular failure. He has a high financial IQ, but it may be the delusional and narcissistically 15 surplus IQ points he awards himself that have been, and may again be, his undoing. 

Like Loeb, Chapman sees no chance that the FTC will shut down Herbalife:

During my due diligence, I spoke with the country’s top lawyer specializing in MLM/regulatory dynamics. During our conversation, he offered his legal opinion, pointedly stating that there won’t be any FTC injunction, much less any regulatory action to put HLF out of business (“hell freezes over before this happens”).

Chapman values Herbalife’s intrinsic value at $47 per share, with the chance of much higher prices of $70 or even $100 possible because of a short squeeze of Volkswagen-like proportions.

Lastly, although specifics of Carl Icahn’s alleged long position in Herbalife has not been disclosed yet, it is well known that Icahn despises Ackman because of a seven-year court battle over a real-estate deal that Ackman finally won in 2011. During the litigation, Ackman called Icahn a “shakedown artist” whose word is “worthless.”

Publicizing Your Short Sales Invites a Short Squeeze

Given all these enemies foaming at the mouth for a chance to destroy Ackman through a short squeeze, I’m surprised that Ackman was so public in disclosing his massive 20-million-share position in Herbalife. Usually, short sellers keep their positions secret to avoid the prospect of other investors ganging up on them on the long side. For example, Dan Loeb’s hedge fund has flatly stated that it never discusses its short positions – Ever.

Hedge fund manager Gregg Hymowitz of EnTrust Capital is an investor in both Loeb and Ackman’s funds and never spoke truer words when he said: “One of them is going to be very wrong,”

I’m betting on Ackman (being wrong).