The Herbalife Battle Is About to Heat Up

Thursday marks an important day for multilevel marketer under fire Herbalife . Thus far, the alleged pyramid scheme company has weathered the fury of Bill Ackman remarkably well. The stock crashed 38% in the moments following the release of Ackman's website, www.factsaboutherbalife.com, but since then has recovered to a price higher than it was prior to the short announcement. Herbalife's investor day meeting today comes at a fascinating and tumultuous time for the company, with now two battling hedge fund managers and an open inquiry from the SEC. Is Herbalife heading for zero, or is it going above $30?

Battle of the Wunderkinds
Dan Loeb of Third Point and Bill Ackman of Pershing Square are two members in the upper echelon of hedge fund managers in the United States. Both managers, in my opinion, are tremendously talented investors with a rare and valuable ability. Lately, Loeb's fund has been the outperformer -- in 2012 one of his funds returned 35% net of fees. Ackman hasn't had the same successes as of late, mainly due to his giant bet on J.C. Penney. Still, the two are among the best out there. This is what makes the increasingly juicy Herbalife debacle so fascinating.

By now, everyone is aware of Ackman's 20 million share short in Herbalife and his allegation that the company is little more than a pyramid scheme, defrauding the thousands of people at the bottom of the totem pole. At the Sohn Conference in New York last month, Ackman confidently declared that he would hold on to his short position until Herbalife hit zero.

On Wednesday, Dan Loeb's Third Point fund announced a staggering 8.2% position in the $4 billion company. Though the details of Loeb's findings are not yet publicly available, he did say that his firm had closely reviewed Pershing Square's allegations that Herbalife was a pyramid scheme and that his team found this to be inaccurate.

If that wasn't enough to raise the stakes, the SEC also announced it would be opening an official inquiry into Herbalife's business. This follows two previous investigations by various branches of the SEC into Herbalife's business.

In addition to the army of short-sellers who piled onto the trade following Ackman's $1 billion short, we now have an all-star fund manager taking a large long position and the SEC opening an investigation. If you currently hold no position (in either direction) in Herbalife, this is certainly not the time to start.

What does the government think?
The SEC's decision to weigh in on the debacle lends at least some support to Ackman's thesis -- or, at least enough for the underfunded and understaffed government organization to devote time and resources to the subject. The SEC has taken a close look at Herbalife before and both times has recommended no further action.

The Los Angeles branch of the SEC was the first to pry into the mystery behind the company. In 2007, it was disclosed that the LA SEC had looked into distributors' personal use of products (much of the lower rungs of the Herbalife distributor model are basically distributors using the products themselves for a discount), as well as a peculiar insider trade. No formal action was taken beyond this.

Last year, the corporate finance division of the SEC looked into Herbalife's financial reporting. This time around, the regulator inquired as to why the company had stopped reporting certain metrics. (This reminds me of when Green Mountain Coffee stopped including its K-cup consumption per user metric.) Herbalife management stated it believed those metrics were not of value to investors and analysts. Though no further action was taken, I find that to be a red flag.

Since Herbalife has been able to convince the government in multiple prior investigations that there is no wrongdoing, I doubt the SEC will make any major discovery. This is, however, another dose of negative attention for the company and, I believe, will help Ackman's thesis in the long run.

Loeb or Ackman?
Dan Loeb did a great job prodding the Yahoo! board to get their act together and appoint a great leader. As an activist investor, Loeb has been able to really set himself apart as a very influential and beneficial voice in the investment community. Ackman's battles have been a little more uphill, and his latest have yet to prove themselves in the public eye, but I cannot see the typically conservative investor betting $1 billion on anything less than a bulletproof thesis.

For the average retail investor, my best piece of advice is to stay away -- long or short. There is a lot of emotion, rumor, and deception going on here, and it is next to impossible for a far removed party to be at the forefront of the information pipeline. Focus your attention elsewhere and let the big guns battle this one out. If you are already invested in the stock, I feel for you.

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The article The Herbalife Battle Is About to Heat Up originally appeared on Fool.com.

Michael B. Lewis has no position in any stocks mentioned. The Motley Fool has the following options: Long Jan 2014 $50 Calls on Herbalife Ltd.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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