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 (NYSE: HLF  ) . 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 (NYSE: CHK  ) (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 (NASDAQ: AAPL  ) 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
There's no doubt that Apple is at the center of technology's largest revolution ever, and that longtime shareholders have been handsomely rewarded with over 1,000% gains. However, there is a debate raging as to whether Apple remains a buy. The Motley Fool's senior technology analyst and managing bureau chief, Eric Bleeker, is prepared to fill you in on both reasons to buy and reasons to sell Apple, and what opportunities are left for the company (and more important, your portfolio) going forward. To get instant access to his latest thinking on Apple, simply click here now.

Check back at Fool.com for more of Alyce Lomax's columns on environmental, social, and governance issues.


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  • Report this Comment On February 15, 2013, at 4:22 PM, catoismymotor wrote:

    I agree about Einhorn. I like it when bigwigs don't let their hubris run amok. Flinging mud at other companies is far from classy. Einhorn's ego seems to be fighing his intellect for the reigns and that causes me great concern. I own a ton (for me) of GLRE and have contemplated selling it because of his actions.

  • Report this Comment On February 15, 2013, at 5:48 PM, TMFLomax wrote:

    Hey Cato,

    Yeah the ego/hubris thing is important in investing -- red flag risk IMHO. Like that old saying "check yourself before you wreck yourself." And definitely if the ego is fighting with the intellect to get control it's scary!

    Thanks for the thoughts, good luck with the GLRE decision, and as always great to "see" you. :) Have a great weekend!

    Alyce

  • Report this Comment On March 22, 2013, at 4:36 AM, thidmark wrote:

    There is no justification for a $100 billion cash cushion. None.

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