Herbalife Ltd. (HLF), Chipotle Mexican Grill, Inc. (CMG): The Folly of Hubris

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If you haven’t been watching closely over the last few months, it’d be easy to miss: A battle of titans is being waged between some of the richest and most prominent investors on Wall Street.

Herbalife Ltd. (NYSE:HLF)

It all began last December, when hedge fund manager Bill Ackman announced he was shorting shares of Herbalife Ltd. (NYSE:HLF). Characterizing the company as a pyramid scheme, he said that his fund’s “target price is zero, because we think the business will fail.”

The move seemed prescient. Over the course of the next week, shares in the company tanked, losing nearly 40% of their value.

But then something happened. Ackman’s equally well-heeled enemies, including none other than George Soros according to accounts this week, started lining up on the other side of the trade. Their intent was, and continues to be, to both get rich and, as a consolation prize, to bring Ackman’s fund to its knees via a coordinated short squeeze.

The first rule of short selling
It’s axiomatic in the hedge fund industry, and particularly among short sellers, that you never make a move without first identifying a near-term catalyst that will make the stock go in the desired direction.

Earnings announcements are a prime example of these. As are, in the pharmaceutical sphere, the results of FDA-mandated drug trials.

But the problem with these is that, in the absence of insider information or some other type of edge, it’s hard to accurately and consistently predict the outcome. And, suffice it so say, being wrong is anathema to a hedge fund’s performance.

The result is that many hedge fund managers and other types of activist investors are sufficiently noteworthy that they’re able to create their own catalysts. How many times have you read about this prominent investor or that one making a speech at some industry conference about his or her latest short?

The most recent one that comes to mind was Jim Chanos’ revelation at last month’s Ira Sohn Conference that he was shorting Caterpillar Inc. (NYSE:CAT). Shares of the industrial giant promptly fell, closing down by more than 2% despite gains that day in the broader market.

Or, how about Chipotle Mexican Grill, Inc. (NYSE:CMG), which dropped like a “lead burrito” after David Einhorn announced at the Value Investing Congress last October that he was shorting its stock because, among other reasons, “Taco Bell has started to eat Chipotle Mexican Grill, Inc. (NYSE:CMG)’s lunch.”

In short, this has been a tried and true way to make a quick buck on Wall Street since at least the days of Daniel Drew and Cornelius Vanderbilt.

But — and here’s where it gets good — sometimes things don’t go according to plan. “No battle plan survives contact with the enemy,” observed the 19th-century military strategist Helmuth von Moltke. And indeed, this is the lesson Bill Ackman is learning the hard way.

A battle plan gone astray
The problem isn’t with Ackman’s theory on Herbalife Ltd. (NYSE:HLF). In fact, there’s reason to believe it has merit.

At the beginning of last year, for instance, a Belgium court held (link opens PDF) that the company had “established, managed or promoted a pyramid scheme, whereby the consumer or a business stands to make money which is more likely the result of introducing new consumers or businesses into the scheme than from the sale or use of products.”

But what qualifies as a Ponzi scheme here in the United States is a surprisingly ambiguous matter, and Herbalife Ltd. (NYSE:HLF) has successfully defended itself against analogous naysayers for more than three decades now.

The problem instead is Ackman. “He seems to look at other members of society, even legends such as Carl Icahn, as some kind of sub-species,” Chapman Capital’s Robert Chapman told Vanity Fair’s William Cohen.

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