Hedge fund titan Bill Ackman had an easy time vanquishing the sclerotic board of Canadian Pacific Railway last year.
He's now in an even more fascinating bare-knuckles fight, this time with Herbalife Ltd., the big U.S. direct marketer of weight loss products. Mr. Ackman claims the company is a pyramid scheme, and is shorting $1-billion (U.S.) worth of its stock.
We're used to seeing larger-than-life market players like Mr. Ackman win against adversaries. It isn't often that one of them steps on a banana peel, but at Herbalife, we might see a case of a famed hedge fund manager in a rare slip.
At this point, a profit on his massive Herbalife position is far from certain. The big risk: A dreaded and rare event on the stock market known as a short squeeze. For all of us in the cheap seats, the outcome will be fun to watch. The situation is already drawing in other well known hedge fund managers, such as Carl Icahn and Daniel Loeb, who would be delighted to burnish their own reputations at Mr. Ackman's expense.
As the name suggests, a squeeze isn't a pleasant experience for those selling stock short, and leaves them exposed to huge losses if a company's share price begins to move up.
In a short sale an investor borrows stock from a broker and sells it, hoping to buy it back later at a lower price to produce a profit. It sounds complicated, but it's really just the opposite of buying stock. The way the math works, short sellers can make a maximum return of up to 100 per cent if their target stock falls to zero. Losses, on the other hand, are unlimited because a stock can just keep on rising if players who are long the stock flood the market with buy orders.
Mr. Ackman is at risk of a squeeze because other hedge funds could flood the market with buy orders, driving Herbalife shares higher and putting him under pressure to cover his position. Mr. Ackman's buy orders would then likely drive the market even higher, causing his losses to snowball.
Given the threat of unquantifiable losses, short selling is a dangerous game, and not to be conducted by amateurs. It's the preserve of the pros, and to get a reality check on the Herbalife situation, we checked in with John Del Vecchio, a Wall Street player who has written the book – quite literally – on short selling.
His professional opinion on the run against Herbalife? "This is probably the worst short of 2013. We don't want to be anywhere near it."
Mr. Del Vecchio is a portfolio manager at Ranger Equity Bear, a New York-listed ETF that only sells stocks short, and is co-author of What's Behind the Numbers, a book on how to spot stocks to sell.
If other players gang up on Mr. Ackman to squeeze him, he could be facing big losses. "That stock could go to $70 or $80," Mr. Del Vecchio says. It's currently around $43.
Interestingly enough, Mr. Del Vecchio was short Herbalife when Mr. Ackman announced his position last month. Herbalife had come up poorly on a model he uses for analyzing earnings quality. But when the stock was slammed to as little as $24 following Mr. Ackman's announcement, he closed out his position at a profit. It was easy to bail because he had only around $5-million exposure.
Mr. Ackman is in a much more vulnerable position, due to the $1-billion size of his short. There are about 37 million Herbalife shares sold short, or about 35 per cent of the float, with Mr. Ackman accounting for more than half. That means he's highly exposed if the stock begins to rise and other hedge funds try to inflict maximum pain on him. Mr. Loeb's hedge fund has picked up about $350-million in stock for an 8.2-per-cent stake. Mr. Ichan has bought stock too.
"The problem is if you are the trade, then you better be right, otherwise there is really no way to kind of unwind that in any reasonable fashion," Mr. Del Vecchio observes.
Part of Mr. Ackman's thesis is that Herbalife is a pyramid scheme and should be shuttered. But the allegations have dogged Herbalife before, and regulators haven't moved against the company.
Mr. Del Vecchio estimates the probability that regulators would shut Herbalife "is like zero" and "we would never short a company" based on what regulators may or may not do.
"So if you've taken a massive position in something that has a very low chance of happening, that's a pretty dicey situation to be in. I wouldn't want to be in that situation," he says.