This is an excellent little piece of investigation by John Hempton at Bronte Capital. As you will know Bill Ackman has a massive short position on against Herbalife. His basic contention is that the company is similar to a Ponzi scheme and therefore cannot continue indefinitely. As such it will inevitably collapse and thus the massive short on it doing so. All of which seems fair enough as an expression of a view. But the interesting part of the discussion then becomes whether it is indeed a Ponzi and is thus inevitably going to collapse. And a part of that story is that if it is indeed a Ponzi then it should be forcibly closed down, thus making Ackman’s short almost self-proving.
But is it? No one doubts at all that Herbalife is a multi-level marketing scheme (MLM). But there’s nothing illegal about that: the potential illegality is if it crosses the line into a Ponzi. As Hempton points out, this is reasonably well defined in law as well:
This legal definition is the core to the whole Herbalife story – so I will write it out:
If an organization sells goods or services to the public and the participants in the organization obtain monetary benefits from (1) recruiting new members and (2) selling the organization’s goods and services to consumers, the organization is deemed a pyramid scheme if the participants obtain their monetary benefits primarily from recruitment rather than the sale of goods and services to consumers. [Emphasis as per Bill Ackman…]
In summary: real sales to consumers is kosher. Sales to distributors (and not to end consumers) are not kosher. A little of the latter is OK (the distributors do need to have some stock). A lot of the latter is not.
The critical question is how much are sales to consumers.
The beauty of what Hempton does next is that he uses the scientific method to try and work out which of those two descriptions is true. That scientific method being that you use your thesis to make predictions. You then try to show that those predictions are wrong: meaning that your thesis must be wrong as well. It simply doesn’t accord with that real world out there. In this case Hempton’s assumed working thesis is that Herbalife is indeed a Ponzi scheme. Which means that most (or perhaps “too much of”) the revenue comes from selling stock to distributors who have just been recruited. Distributors who don’t then manage to sell the stuff on.
Well, what would be the effect of this? Clearly, it would be that there’s therefore some large number of failed Herbalife distributors with large amounts of paid for stock on their hands. And if that were true then we would see people trying to sell the stuff for whatever they could get. Hey, it didn’t work out so let’s get at least some pennies on our dollars back. We also know where such sales are likely to happen: on e-Bay of course. So, let’s go look at e-Bay and see if there’s lots of dead Herbalife materials being offered for cheap. As Hempton reports:
I looked and looked. Honestly I did. And I could find no evidence of large sales at distress – the sort of sales that would happen if there were 50 thousand tonnes per year build up of unsold inventory in the hands of “failed distributors”.
And so we have it. Bill Ackman had a thesis. I calculated the implications of that thesis (distress selling on Ebay and Craigs List). This observation did not accord with reality.
Therefore Bill Ackman is wrong. And it does not matter how beautiful Bill Ackman is, how smart he is, how rich he is, or whatever. He is still wrong. And there isn’t any room for argument about it.