Why It's Dangerous to Short a Bubble

Before you go, we thought you'd like these...
Before you go close icon

The Carl Icahn vs. Bill Ackman spat over Herbalife was probably the most entertaining public feud in 2013. It's very rare that two high profile investors go head-to-head in this manner. Moreover, in doing so, they put their reputations at risk in a very public manner. It's difficult not to conclude that Icahn has come out the winner in 2013. Herbalife's stock is up over 130% this year, and Ackman's short position has hurt his fund. However, is it possible that both investors are right?

What matters to direct-sales companies
Herbalife belongs within a class of companies that use a direct-sales model. In other words, they rely on local representatives to generate their sales revenue. There is nothing new about this model. In fact, Tupperware Brands parties and rictus-grinned Avon Products ladies knocking on the door have become part of most Americans' vocabulary. In addition, Nu Skin Enterprises (a stock up more than 250% this year) and Herbalife are rapidly acquiring household awareness.

All these companies critically rely on their representatives to generate sales. Nu Skin can talk all it likes about the science behind its skin-care products and Herbalife can wax lyrical about the benefits of its nutritional products, but if their sales distributors aren't motivated then their businesses will fail. Keeping representatives happy isn't easy. For example, Avon has been forced to fundamentally restructure its sales organization after some disappointing performance.


The bottom line is that these businesses don't solely rely on the intrinsic value of their products. The good news is that having products targeted at growth industries such as skin care (Nu Skin) and nutrition (Herbalife) is obviously going to inspire distributors and their customers. In addition, Tupperware has gone to great lengths to expand into emerging markets, therefore tapping into a new distributor base to offset its slow growth in North America.

Enter George Soros
Ackman's short arguments on Herbalife center around the lack of intrinsic value of its products (he cited poor price comparisons for Herbalife products on eBay),  and his belief that the company is structured to sell products to its distributors. He may well turn out to be right!

However, the entry of George Soros as an investor in Herbalife goes a long way to help explain why -- even if you are sympathetic to Ackman -- it's dangerous to short in this sort of situation.

Soros is best known for his theory of reflexivity, and how it causes investment bubbles. The basic idea is that pricing movements generate feedback loops into earnings, which then encourage higher pricing. A bubble is formed, which then collapses when a tipping point is reached.

The key point to understand here is that the positive effect on earnings from the feedback loop makes the stock look fundamentally cheap. In other words, this isn't about a stock reaching a sky high valuation! In fact, the stock will look a great value. Confused? I will try and explain what could happen with these direct sales companies and their distributors.

How the bubble might burst, but not when you are short
Say, for example, a listed direct sales company launches a new product that captures distributors imagination. It could be anything. Perfume, laundry powder, skin cream, nutritional tablets or whatever.

Sales start slowly and hit a $1 million a year, the company trades on ten times earnings or $10 million, and has had steady 5% growth for a while. So its P/E ratio is 10, and its PEG (PE divided by growth rate) ratio is 2.

Suddenly, the product starts to accelerate sales, a buzz forms around the product and more distributors are recruited. Sales go up 20% for the company, as does its earnings. A sober and conservative analyst produces a report stating that its growth rate is now 20%, with projected earnings of $1.2 million.

He goes on to argue that if it trades on its previous PEG ratio of 2, and its growth is 20%, then the 'correct' P/E valuation should now be 40 times earnings. So, now its valuation should be $48 million instead of $10 million. Remember what I said above about the fundamentals looking cheap?

After a while, the product's popularity starts to peter out. New distributors find it tough to become profitable. Sales start to slow again, then suddenly everyone is looking at their stock holding in a company on a valuation of current 48 times earnings with a 5% growth rate again. The stock crashes. It could even be on 20 times earnings and still be very expensive at this point.

Again, the key point is that Herbalife, Nu Skin and the others all have a critical reliance on their ability to recruit and maintain distributors. The problem is that no one rings a bell when the crash is about to come, and you could find yourself shorting a stock that just moved from a valuation of 10 times earnings to 48 times.

Why Ackman and Icahn may both be right
If this is the sort of scenario (and I stress "if") that awaits Nu Skin and Herbalife, then investors need to consider what stage these companies are at in this process. Are you buying/selling it in the middle of the bubble-like euphoria? Do you really want to short a stock during this strong momentum phase?

Ackman and Icahn may both turn out to be right. Icahn may end up being lauded for riding the stock higher and getting out early. Ackman could be feted for sticking to his guns while he waits for the inevitable collapse. If this scenario is correct, then the only ones not winning any prizes will be the long-term investors who are stuck in their positions after the possible collapse.

The article Why It's Dangerous to Short a Bubble originally appeared on Fool.com.

Lee Samaha has no position in any stocks mentioned. The Motley Fool has the following options: long January 2015 $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.

Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

Read Full Story

Want more news like this?

Sign up for Finance Report by AOL and get everything from business news to personal finance tips delivered directly to your inbox daily!

Subscribe to our other newsletters

Emails may offer personalized content or ads. Learn more. You may unsubscribe any time.

From Our Partners

Man Suspects His Wife Is Cheating On Him - Then His Daughter Reveals What's Really Going Man Suspects His Wife Is Cheating On Him - Then His Daughter Reveals What's Really Going
Large Numbers Of Horses Are Being Stuffed Into These Crates For A Despicable Reason Large Numbers Of Horses Are Being Stuffed Into These Crates For A Despicable Reason
13 People Recount Their First Kiss Horror Stories 13 People Recount Their First Kiss Horror Stories