Wouldn’t it be fun to be the kind of guy who could swoop into an earnings call and be all “aren’t you just a giant fraud?” and freak everybody out and cause the stock to plummet? I feel like that would be fun. I am not that kind of guy, which is just as well, because I sort of go around assuming that selling (1) weight loss drugs through (2) network marketing just automatically makes you a giant fraud,* so I would probably use my powers irresponsibly.
Anyway David Einhorn didn’t do that at all! He asked some perfectly reasonable questions of weight-loss network marketer Herbalife. Here is a comically anodyne description:
Herbalife Ltd. (HLF), the maker of nutritional supplements and weight-management products, fell the most in more than three years after hedge-fund manager David Einhorn asked executives why it has stopped providing information tracking certain groups of its distributors in its filings. …
Chief Financial Officer John DeSimone told Einhorn on the call that when he took over as finance chief in January 2010 he decided to stop breaking out information on distributor groups as it isn’t “valuable information to the business or to the investors.” Herbalife “can easily provide the exact same breakout going forward,” DeSimone told Einhorn.
“That sort of follow up” would be “helpful,” Einhorn said on the call.
How cozy. You can read the questions and, crucially, listen to the skepticism in his voice here. You can see the 20% price drop here.
Here you can read a view that David Einhorn has done his research and thinks Herbalife’s business model is flawed and its stock overbought. I take no position on that.** Let us, however, spin a hypothetical.
Let’s say you are a short seller. You find a company that is Bad. You short its stock. So far so good. But markets can remain etc. etc., so you want everyone to know that it’s Bad so the stock goes down and you can make money. This is not necessarily easy. If it’s Bad because it’s mismanaged or doing stupid things, then if you tell everyone that, the company can fix whatever it’s doing wrong, and the stock might go up. (This is not me being silly, or not entirely; it’s also some Wharton and Columbia professors being silly.)
But maybe it’s Bad because it’s a giant fraud, in which case it’s harder to fix. Then all you have to do is tell people about the fraud and the stock should go down. The problem, though, is that people seem to prefer not to learn that their investments are frauds, and the people who run those investments tend to get you prosecuted for calling them frauds. To a first approximation, no non-affiliate investors ever get in trouble for publicly saying nice things about stocks they are long. Short sellers, on the other hand, do. This is a problem even if you’re right, but it’s a big problem if you’re wrong, as sometimes people are. Shorting a company and publicly calling it a fraud, if it turns out not to be a fraud, is the sort of thing that gets you sent to jail for market manipulation.
But what if you just ask innocuous questions on a conference call? No one could possibly read Einhorn’s questions to Herbalife as any sort of factual assertion that Herbalife is in fact Bad. Not even Herbalife:
The fact that recognized short seller David Einhorn asked questions on the call put pressure on Herbalife’s stock price.
To be clear: Mr. Einhorn’s questions raised no new subjects or concerns. They were elementary questions usually asked by investors new to our industry. These are issues that have been thoroughly addressed before. Analysts and investors can review the specific answers to his questions on our website later today at www.herbalife.com.
Here is the silly minimal version of the trade: company announces earnings, stock doesn’t move much. There’s a call at 11am. You short the stock. You get on the call. You ask questions like “why are you no longer disclosing what you used to disclose?” The company answers “because it’s not helpful.” You’re all “thanks.” You hang up. The stock drops 20%. The company announces it’s a buying opportunity and they have a $428mm share repurchase authorization. You … go sell back to them the next morning. 24 hours, 20% profit.
There are obviously some necessary conditions here. The tone of your voice in asking those questions is crucial. It sure helps if the company is … umm … let’s say, a network marketer of weight loss pills. It is critical that you be a famous short seller with a good track record of getting short calls correct.
But once you have obtained that track record, why not monetize it, in the lowest-risk way possible? On the long side, this has been Warren Buffett’s business model for years. It’s nice if you keep being right – certainly it prolongs your ability to monetize the reputation – but it’s not completely necessary. Warren Buffett’s investing in a company is to some extent self-fulfilling; so is David Einhorn’s shorting. If you sold Herbalife as soon as he was announced on the earnings call, you are probably grateful to him.
Anyway, I highly doubt that the silly minimal version is what actually happened here – people always seem to like to, y’know, do research and work hard and get to the right answer and stuff. But at the least, the silly minimal version is a neat use of management’s time for a short seller. Better than doing a one-on-one call, anyway.
Herbalife Falls After Fund Manager Queries Disclosure [Bloomberg]
Herbalife Responds to Stock Drop Today [Herbalife]
AUDIO: David Einhorn Singlehandedly Crushed A Stock Today By Asking These Questions [BI]
* Like, it seems overdetermined, no? How can this be good?:
We are one of the largest network marketing companies in the world with net sales of approximately $3.5 billion for the fiscal year ended December 31, 2011. … We are focused on building and maintaining our distributor network by offering financially rewarding and flexible career opportunities through sales of quality, innovative and efficacious products to health conscious consumers. We believe the income opportunity provided by our network marketing program appeals to a broad cross-section of people throughout the world, particularly those seeking to supplement family income, start a home business or pursue entrepreneurial, full or part-time employment opportunities. Our distributors, who are independent contractors, can profit from selling our products and can also earn royalties and bonuses on sales made by the other distributors whom they recruit to join their sales organizations.
But how can this be good?:
We offer science-based products in four principal categories: weight management, targeted nutrition, energy, sports & fitness and Outer Nutrition. … The weight management product portfolio includes meal replacement shakes, weight-loss enhancers, appetite suppressors and a variety of healthy snacks. Our collection of targeted nutrition products includes dietary supplements which contain vitamins, minerals and natural ingredients that support total well-being and long-term good health.
Science-based! Anyway, how can they be good together? Actually I could quote from the 10-K all day; it’s wonderful:
To become a distributor in most markets, a person must be sponsored by an existing distributor and must purchase an International Business Pack, or IBP. The IBP is a distributor kit available in local languages. The product and literature contents in the kits vary slightly to meet individual market needs. An example is the large size U.S. IBP, which costs $90.95 and includes a canister of Formula 1 shake mix, two bottles of nutritional supplements, Herbal Concentrate (Tea), Liftoff® (an energy drink), and Hand Sanitizer, along with a handy tote, booklets describing us, our compensation plan and rules of conduct, various training and promotional materials, distributor applications and a product catalog. The smaller U.S. version costs $54.95 and includes sample products, a handy tote, and essentially the same print and promotional materials as included in the larger kit version. To become a sales leader, or qualify for a higher level, distributors must achieve specified volumes of product sales or earn certain amounts of royalty overrides during specified time periods and must re-qualify for the levels once each year. To attain sales leader status, a distributor generally must be responsible for sales of products representing at least 4,000 volume points in one month or 2,500 volume points in two consecutive months. An additional optional qualification, introduced globally in October 2009, allows for a distributor to achieve sales leader level by personally placing orders with Herbalife that accumulate to 5,000 volume points within 12 months.
The hand sanitizer! I love it. This is a $7bn company. $8bn yesterday.
** But … I mean … right?