Investment Lessons From Hedge Fund Thunderdome


Hedge fund managers have been making big news lately, and much of it has been dramatically contentious. Investors can learn some lessons from these public squabbles (and maybe even be a little entertained by all the insults and salty language). However, the entertainment value shouldn't be distracting. Investment lessons abound in these matches.

Mano a mano
One of the high-profile skirmishes swirls around Herbalife. Hey, I'm not sure what could possibly go wrong with a nutritional supplement and diet food company based in the Cayman Islands, and hey, it also uses the notorious Ugland House address, used by, no joke, somewhere around 18,000 companies as a tax haven (that's one huge house!). Granted, our own tiny, business-friendly Delaware is big enough to apparently "house" 945,000 companies, but such themes are for a different article on a different day.

Star investor Bill Ackman has publicly called Herbalife's business a pyramid scheme and is short the stock. Among his arguments is the concept that Herbalife makes more money off luring new distributors than it does on its actual products -- distributors don't stick around for long.

Ackman's latest contribution to the Herbalife controversy is pretty scathing, according to The Wall Street Journal: "If the [Federal Trade Commission] misses Herbalife, it's the equivalent of the SEC missing Madoff." He also had a message for the company's auditor, KPMG: "If I were KPMG, I'd take a very, very careful look at that financial statement before I slap my brand on it." Oh, snap.

On the other side of the fence is Carl Icahn, who has vocally supported Herbalife's legitimacy and publicly berated Ackman. Daniel Loeb has also gone long on Herbalife shares. For a while, it was only a matter of conjecture that Icahn is long Herbalife, but he has now disclosed a 13% stake; he's definitely short Ackman.

Ackman doesn't have a perfect track record. He held Borders for years during its demise, and he is long J.C. Penney right now, which has been struggling to compete.

Icahn doesn't have a perfect track record either. While he can clock some activist wins for changes at companies like Chesapeake Energy (embattled CEO Aubrey McClendon recently stepped down, in a partial victory for shareholders), remember other situations. For example, he didn't save Blockbuster.

Investment lessons:

  • The fact that renowned investors could have such wildly different and dramatically passionate opinions on a single investment shows that all investors will be wrong on some calls. While it will be interesting to see who turns out to be on the correct side of this battle, we regular investors should stay on the sidelines.

  • No one has a perfect track record. We investors should remember that in our own portfolios, during good times and bad, and give ourselves a break and take every wrong call as a learning experience.

  • Door-to-door, multi-tier marketing companies, regardless of whether they're indulging in illegal behavior or not, are using a pretty creepy model. In just one interesting factoid in this case, Herbalife's lowest-tier representatives -- 88% of its distributors -- don't make a cent from the company. Ick.

Depressions, bread, and circuses
David Einhorn has taken Apple to task (and filed a lawsuit) related to its renowned and rather epic cash hoard. Many dividend-hungry Apple shareholders may agree. For years, many investors have begged Apple to do something with its money, and big dividends are usually high on the list.

Einhorn called Apple's attitude "Depression-era." Apple's Tim Cook shot back, dubbing Einhorn's move a "sideshow."

Shareholders should be aware of another element of this situation. Einhorn is recommending that shareholders vote against a proposal that would give its shareholders an important corporate governance change that's been needed for a long time: the ability to vote for directors on an annual basis. Shareholder advisory firms Glass Lewis and Institutional Shareholder Services and pension fund CalPERS have all publicly advocated voting for the proposal.

Hedge fund manager Einhorn is obviously a smart guy who has made good calls like his Green Mountain Coffee Roasters short, but again, that doesn't mean he's right all the time. (Some might say Green Mountain's recent share price recovery proves this.) In this case, I'd say he's very, very wrong. Apple's cash stash makes it a conservative investment in troubled times, and if naysayers are correct that it's losing some momentum, then a cash cushion is even more important.

Investment lessons:

  • Many of the smartest guys in the room love financial engineering. Long-term investors don't have to, and really, they shouldn't. Distributing cash and levering up is often problematic for the real long term, and some activists push for this kind of behavior on a regular basis. (Granted, Einhorn is focusing on a new kind of preferred stock, not leverage, as he explained to Business Insider's Henry Blodget in great detail.) Still, investor, beware. There's something to be said for keeping it simple.

  • The economy remains uncertain. Cash on the balance sheet helps companies ride out difficulties. Shareholders should want their companies to have resources for R&D and smart acquisitions if times get tough. (Note that I said smart acquisitions. Many are stupid.)

  • Activism is important but needs to be thought through. Corporate governance is an important element of shareholder rights, and is far more important to long-term investing than immediate cash in hand detached from long-term thinking.

Mind the distractions
Obviously there are plenty of lessons in both of these controversial hedge fund smackdowns, but I've got a general one, too. Shareholders are gaining power and voice (as they should), but that's why it's important that we all pay attention and vote for the real long-term best interest at the companies we own.

Let's not let the opponents of shareholder rights be proven correct: that shareholders only care about short-term profits, and that activists could skew companies toward negative results. All shareholders are responsible for weighing these situations to prevent value-destroying outcomes.

Last but not least, some shareholder activists may not be acting in our true best long-term interest. During fighty moments like these, let's not get distracted by "sideshows" and Thunderdomes. Let's pay attention to activism and exercise critical thinking. That's what true shareowners do.

There's always more to learn
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Check back atFool.comfor more of Alyce Lomax's columns on environmental, social, and governance issues.

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Alyce Lomax has no position in any stocks mentioned. The Motley Fool recommends Apple and Green Mountain Coffee Roasters. The Motley Fool owns shares of Apple and has the following options: Long Jan 2014 $20 Calls on Chesapeake Energy, Long Jan 2014 $30 Calls on Chesapeake Energy, Short Jan 2014 $15 Puts on Chesapeake Energy, and 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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