Herbalife (HLF): A Case History in Bad Due Diligence

By Jan 16, 2013, 9:25 AM Author's Blog  

That all of the banter about Herbalife (NYSE:HLF) is of passingly little significance is a foregone conclusion. Whether Mr. Ackman’s short and subsequent publicity campaign to force Herbalife’s stock price adhere to his reality and thus endow him with further billions works out will in due time be decided. As of now it looks as if he made a bad bet and a blogger/short seller gives a good object lesson in what he did wrong and along the way what ails most financial decision making.

First, if you are not familiar with the whole enchilada let me refer you to an article by Matt Yglesias. He does a very good job of explaining  the players and the basic arguments. Mr. Yglesias also sees some positive benefit to the exercise regardless of the outcome.

But for those of us who are just spectators, it’s a case—an all-too-rare case—of the financial system acting in a real way to test and probe the actual economy. Herbalife’s various accounting and business practices are now being but under the microscope in a way that doesn’t happen to most companies. If the company survives, it’ll be by withstanding scrutiny rather than flying under the radar—exactly the way it should be.

Yglessias is right but only partly so. Finance in all its varieties as practiced today involves intense analysis of numbers, securities filings and industry analysis. Fine and good so far as it goes, but Wall Street has an aversion to the really dirty work of due diligence. That involves really dreary work like talking to customers, visiting facilities, tipping back a beer with the workers at the bar next to the factory and counting things like automobiles traveling down a freeway or trucks leaving a plant or even perhaps the number of excess pallets stacked in back. In other words validating the blizzard of numbers which are subject to endless manipulation.

Enter John Hempton, an Australian who runs a short fund. John also blogs regularly often explaining the rationale behind his bets. He has to the best of my knowledge no financial interest in the outcome of the Herbalife battle but has taken an avid interest in it. So, he did what no one else with a modicum of financial savvy has done, he went to a Herbalife meeting in Queens.

What Hempton found is the reality of Herbalife. You have to read the entire post to get a sense of what the company is about or more appropriately why the company’s customers patronize it, but here is a brief excerpt.

It was striking how totally Bill Ackman’s thesis fell apart from observing for just a few hours in a nutrition club.

The best way of analysing Herbalife that I can find is as alcoholics anonymous for fat (and very often Hispanic) people. I joke: “my name is Jose and I am fat”.

Herbalife works in the same way as alcoholics anonymous – by supplying (and in this case selling) a support group to help you kick the “fat addiction”.

Like Alcoholics Anonymous it has millions of members and looks – at least externally – a bit like a cult.

Herbalife like Alcoholics Anonymous has millions of members because it works. It does not work because one nutrition powder is better than another (indeed some nutritionists argue soy based powders are inferior). Herbalife works because of the support group.

AA is probably the single most effective way devised by humanity to cure alcoholics. It is far more effective than any drug developed by pharmaceutical companies and if a drug were devised as effective as and as free of side effects as AA then it would be worth tens of billions of dollars. Even then AA probably fails a majority of times. Herbalife is among the more successful ways of curing morbid obesity (but even then it probably fails a majority of times). [I shudder to think what a weight-loss drug as effective as the Herbalife support system would be worth though - considerably more than Herbalife's market cap.]

Hempton does not put any lipstick on the Herbalife pig. He readily admits that many of the distributors don’t make much money and that, in fact, the rewards are decidedly skewed upwards in the company. His concludes that Herbalife will survive and Bill Ackman was just too lazy to figure out what he was dealing with.

What this story is really about

Herbalife is a company which combines a lot of good (think the life-saved diabetic above) with some pretty ugly features.

But this is not really a story about Herbalife – Herbalife will survive globally. Like all multi-level marketing schemes it will have its ups and downs. There will be all sorts of problems (such as tax compliance throughout the scheme, cash handling, perhaps even using Herbalife accounts to launder money).

What this has (deservedly) become is the story about how Bill Ackman can be so wrong. He spent (by his own admission) a year and a half analysing this company and his thesis can be falsified by visiting a few clubs in his home city. Bill Ackman’s thesis is the most easily falsified bear-thesis I have seen from a major hedge fund ever.

You have to wonder how this happened. So I am going to tell you: 

Bill Ackman a Harvard educated (magna cum laude) billionaire New York hedge fund manager bet over a billion dollars on a short position (imperilling his fund and his reputation) without checking the facts.

And he did not check the facts because he was so rigid with a misplaced silver spoon that he could not stoop to sit on a subway for thirty minutes and talk with poor people for ninety minutes.

Now, the purpose of this post is not to opine one way or the other on Herbalife. As I said in my introduction, I have no real position r Ackman’s success or failure, and just for the record I have no position in the company. No dog in the fight. The purpose is to highlight the benefits that can accrue to real due diligence. Hempton did it, Ackman did not. Arguably had we had banks and mortgage companies stuffed to the gills with John Hempton like skeptics we might well have avoided the mortgage meltdown. Think what a few well placed phone calls to mortgage applicants or a visit to a the new home tracts that popped up everywhere might have revealed. And imagine what might have been discovered had some investment bankers bothered to get some real estate agents or mortgage brokers in their cups. Instead all was presumed well because the models’ numbers said what happened just couldn’t happen. The problem was that the models and those who believed them had no clue that the inputs were all wrong. The tragedy being, of course, that the reality would have been easy to establish.

As you watch CNBC or read financial analyses keep the due diligence factor in mind. Odds are that you’re in an echo chamber in which all the participants are filtering the same numbers in a manner which will prove their point. They have no idea as to the accuracy of the numbers. If this scares you then start looking for the John Hempton’s of the world. It’s not too late to learn that most of what you hear from the experts is based on shoddy work.

Disclaimer: I have no financial interest in John Hempton’s funds, but if I did have investable cash some of it would be with him.

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