Herbalife: Dog, or Just an Underdog?

Short-sellers and hedge funds may be shadowy, but sometimes they're the smartest guys in the room. They've done their homework, and they're willing to bet their capital against the crowd -- an investing strategy that can be as lucrative as it is contrarian.

On Motley Fool CAPS, the 180,000-member-driven investor community where informed opinion is translated into stock ratings of one to five stars, we also have investors who find the chinks in a company's armor and correctly call its fall. We call them "Underdogs" if they've earned 100 or more CAPS points by correctly predicting that one or more stocks would underperform the market.

Today I'm looking at nutritional supplements maker Herbalife (HLF 2.91%), which lost more than a third of its value after becoming the centerpiece of an argument between dueling hedge fund operators. Investors remain wary of its multi-level marketing structure, so there's little doubt why the nutritionals seller carries the lowest one-star CAPS rating.

It's been a bit of a wild ride, so if there are any who've scored big by correctly predicting which stocks will fail, it may be worth our while to check out those they think will ultimately succeed. And CAPS All-Star Valyooo is one who's earned the underdog moniker and recently predicted that Herbalife would rout the shorts.

Herbalife snapshot

Source: FinViz.com.

Of course, not every short sale goes as planned, which makes shorting a risky proposition. Stock prices can be irrational longer than you have money to stay in the game. And you don't want to end up with fleas by lying down with the dogs, so make sure you do your homework.

A scary opportunity
Not that there haven't been doubts before about Herbalife and its MLM business model, but when David Einhorn of Greenlight Capital appeared on the supplement maker's conference call early last year asking some tough questions about its operations, investors immediately suspected the worst and bolted for the exits. Einhorn never did take a position in Herbalife -- short or long -- and it seemed to be on its way to a comeback when Pershing Capital's Bill Ackman made a very public splash of his very large short position, raising all the same fears and once again plunging the stock into chaos.

That itself turned into a bit of a melodrama when Daniel Loeb and Third Point Capital went very long on Herbalife, saying it was ludicrous to think the FTC would shut down the company. Then Ackman's longtime arch-nemesis, Carl Icahn, came out and disparaged his rival's position, with the two getting into a verbal sparring match on CNBC.

The MLM business model has always had its detractors simply because the math usually doesn't hold up under scrutiny. Having to constantly recruit new salespeople below you in the food chain creates a situation where you run out of people in the global population who can sell your products. It's a fine line between a pyramid scheme and a self-sustaining operation.

Yet there are MLM businesses that have successfully grown for decades, with Tupperware (TUP -6.88%), Avon Products (AVP), and Amway being among the best-known examples. As I've noted in the past, however, Tupperware at least distinguishes itself from other MLMs in that its end users are generally not also recruited to sell its plastic bins. It says 90% of the people who buy Tupperware products don't sell them, compared with only 10% of its users who are distributors, too. In comparison, some 30% of Herbalife distributors are self-consumers. Tupperware has 2.8 million direct sales reps, while Avon has more than twice as many at 6 million. Herbalife has 3.2 million.

Herbalife views its reps who also consume its products as end users, too. It says it's the consumption of the product that is key rather than who is consuming it. Sold product is sold product regardless of who is buying it, and you'd be hard put to argue that Herbalife products don't have diehard adherents who believe in the supplements' efficacy.

A smaller piece of the pie
The investment thesis then comes down to whether you believe an MLM business model is essentially a pyramid scheme or not. The FTC has guidelines for determining when an MLM business crosses the line, and while Herbalife is being investigated for a variety of reasons, most would probably agree it hasn't gone over that threshold.

I tend to side with those who view the MLM marketer as just that and not a criminal enterprise, so I'd say it does fall into the "underdog" camp as opposed to just being a dog, but that doesn't mean I think it would be a good investment, too. The continuous questions that swirl about it, the investigations that sap its capital, and even the occasional losses -- a Belgian court last year declared Herbalife to be a pyramid scheme -- means that the stock will continue to fare badly.

Each time a hedge fund weighs in on the company the stock gyrates wildly, a situation better suited for day traders. I'd wait till the dust settles before wading in, even if it means not catching the stock at its absolute lows.