For some investors, the hardest thing to do is throw in the towel when a position continues to move against you -- that is, the share price continues to sink, potentially eroding profits and leading to losses. Sometimes steep losses. The prudent move is to check, re-check and even triple check the underlying thesis by collecting and assessing data points to make sure the investment thesis remains intact, strengthened or waned. As much as we would like to think it does remain intact, that is not always the case.
When it goes awry, one of the struggles that investors need to be mindful of is vanity -- the inability to admit that we were wrong, did not see what was really going on or missed something. For some, however, it means abandoning the data and the sound investing process, as emotion -- and perhaps the desire to be right -- take over. When that happens, odds are it's not going to end well.
One of the more high-profile examples in recent history has been hedge fund manager Bill Ackman's short position in Herbalife (HLF) . Ackman has been a vocal enemy of the nutritional shake and supplement company over the last few years as his hedge fund, Pershing Square, held a short position in the stock. After a reported year of investigating the company, the investment narrative for the negative stance was Herbalife was a pyramid scheme and would eventually fall to zero. Backing up that view, Pershing Square placed a $1 billion short bet on the nutritional supplement company in 2012.
That trade served Ackman well in 2012, and his team pressed as they urged the Securities Exchange Commission (SEC) to investigate Herbalife and organized "a series of meetings with lawmakers and their staffs to encourage them to call on federal regulators to investigate Herbalife."
In January 2013, the SEC opened an investigation into Herbalife and focused on examining its sales practices -- and then In March 2014, Herbalife reported the Federal Trade Commission opened a civil investigation into the company. In between those announced investigations, the company responded by defending its business, winning the support of other hedge funds in the process. This led to a now-infamous dust up between Ackman and investor Carl Icahn, and likely contributed to Ackman's resolve.
As the FTC investigation wore on, in March 2015 -- when Herbalife shares were down more than 50% from their just-over-$80 price in January 2014, Ackman shared that, "shutting down the company is 'one of the most important things' he can do." One might suspect this was the start of emotion -- and the need to be right -- taking over vs. being a prudent investor.
In May 2016, Herbalife's stock rose more than 25% when it shared its talks with the FTC were in an advanced stage with a settlement expected to include "injunctive and other relief as well as a monetary payment with our best estimate of a payment being $200 million."
Then in July 2016, Herbalife settled with the FTC, which determined "the nutritional supplement marketer is not a pyramid scheme," but called not only for changes to Herbalife's operations, but also that it would "need to prove that its business model is legitimate going forward." This led HLF shares to rally to a 2016 high near $68, well above the January 2015 trough share price near $31. For a short position, that rise in the share price meant generating losses, which helped contribute to Ackman's Pershing Square dropping roughly 20% in 2016 after falling by a similar amount in 2015.
So far in 2017, even though it is off its October highs, Herbalife shares have climbed more than 40% -- due, in part, to the company completing a share buyback program in October. Another driver for the move occurred in May, when 90% of Herbalife's three million retail transactions in the U.S. were documented as purchases by consumers (as opposed to distributors), which exceeded the 80% threshold called for in the company's agreement with the FTC.
Seeing the writing on the wall after almost five years, Ackman recently covered his short position in Herbalife shares, which even now he apparently sees as too risky to stomach any longer (although Ackman did buy put options on HLF that will rise in value if the stock's price falls). Had he covered his short position in late 2012 or in January 2015, the trade's returns would have been in the range of 50%-60%. This should remind us of the age-old Wall Street saying, "Bulls make money, bears make money, pigs get slaughtered."
The reality is, it is a slippery slope from following the data and thinking your investment thesis is on track to looking for almost any means to support the belief that you are right instead of listening to the data, especially, and noting things have changed. There is nothing wrong with recognizing the changing landscape -- in fact, the real issue is falling prey to the "crockpot investing" think that has an investor "fixing and forgetting" the position. Much like Rip van Winkle, a crockpot investor may wake to find things have changed dramatically.
One central concept to sound investing is to remain as cold blooded as possible and not become emotional or fall in love with your investments. It is a time-tested strategy of prudent investors that helps keep discipline and one's investment process in place. That's not to say people don't wander off the path sometimes -- they do. Ackman isn't the only person this has happened to, but it's an example that bears remembering and learning from.
(Editor's note, this article has been updated to clarify that Ackman did not directly say shorting Herbalife has become "too risky to stomach any longer," and to add the fact that he bought put options on the stock.)
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