If you haven't been watching closely over the last few months, it'd be easy to miss: A battle of titans is being waged between some of the richest and most prominent investors on Wall Street.
It all began last December, when hedge fund manager Bill Ackman announced he was shorting shares of Herbalife (NYSE:HLF). Characterizing the company as a pyramid scheme, he said that his fund's "target price is zero, because we think the business will fail."
The move seemed prescient. Over the course of the next week, shares in the company tanked, losing nearly 40% of their value.
But then something happened. Ackman's equally well-heeled enemies, including none other than George Soros according to accounts this week, started lining up on the other side of the trade. Their intent was, and continues to be, to both get rich and, as a consolation prize, to bring Ackman's fund to its knees via a coordinated short squeeze.
The first rule of short selling
It's axiomatic in the hedge fund industry, and particularly among short sellers, that you never make a move without first identifying a near-term catalyst that will make the stock go in the desired direction.
Earnings announcements are a prime example of these. As are, in the pharmaceutical sphere, the results of FDA-mandated drug trials.
But the problem with these is that, in the absence of insider information or some other type of edge, it's hard to accurately and consistently predict the outcome. And, suffice it so say, being wrong is anathema to a hedge fund's performance.
The result is that many hedge fund managers and other types of activist investors are sufficiently noteworthy that they're able to create their own catalysts. How many times have you read about this prominent investor or that one making a speech at some industry conference about his or her latest short?
The most recent one that comes to mind was Jim Chanos' revelation at last month's Ira Sohn Conference that he was shorting Caterpillar (NYSE:CAT). Shares of the industrial giant promptly fell, closing down by more than 2% despite gains that day in the broader market.
Or, how about Chipotle (NYSE:CMG), which dropped like a "lead burrito" after David Einhorn announced at the Value Investing Congress last October that he was shorting its stock because, among other reasons, "Taco Bell has started to eat Chipotle's lunch."
In short, this has been a tried and true way to make a quick buck on Wall Street since at least the days of Daniel Drew and Cornelius Vanderbilt.
But -- and here's where it gets good -- sometimes things don't go according to plan. "No battle plan survives contact with the enemy," observed the 19th-century military strategist Helmuth von Moltke. And indeed, this is the lesson Bill Ackman is learning the hard way.
A battle plan gone astray
The problem isn't with Ackman's theory on Herbalife. In fact, there's reason to believe it has merit.
At the beginning of last year, for instance, a Belgium court held (link opens PDF) that the company had "established, managed or promoted a pyramid scheme, whereby the consumer or a business stands to make money which is more likely the result of introducing new consumers or businesses into the scheme than from the sale or use of products."
But what qualifies as a Ponzi scheme here in the United States is a surprisingly ambiguous matter, and Herbalife has successfully defended itself against analogous naysayers for more than three decades now.
The problem instead is Ackman.
"He seems to look at other members of society, even legends such as Carl Icahn, as some kind of sub-species," Chapman Capital's Robert Chapman told Vanity Fair's William Cohen. "The disgusted, annoyed look on his face when confronted by the masses beneath him is like one you'd expect to see [from someone] confronted by a homeless person who hadn't showered in weeks. You can almost see him puckering his nostrils so he doesn't have to smell these inferior creatures."
Stories of Ackman's hubris are legion. He went toe to toe, and ultimately prevailed, against MBIA (NYSE:MBI), the municipal bond insurer, and at the time, one of the largest players on Wall Street, that nearly collapsed after it began insuring mortgage-backed securities. He successfully sued Carl Icahn after a verbal agreement between the two soured. And he made a fool of himself on an infamous bike ride with Third Point Capital's Dan Loeb.
These are the reasons Ackman has now found himself in a most unenviable position. Shortly after announcing his bearish stake in Herbalife, the list of people who began lining up against him soon read like a who's who list of Wall Street scions.
This could be the "mother of all short squeezes," Carl Icahn said on CNBC.
"This is like Wall Street's version of the movie Kill Bill," Chapman said in the same Vanity Fair interview. "Bill Ackman has been so arrogant and disrespectful to so many people, presumably on the theory that he would never be in a position where these subjects of his disrespect could actually act on their deserved hatred for him. But now, with J. C. Penney and Herbalife going against Ackman, his 'stock' has moved down, allowing once again, a decade later, for those holding their Kill Bill puts [i.e., options they have been waiting to cash in] to exercise them against him."
And now comes news that yet another "master of the universe" has joined in the anti-Ackman crusade: "Billionaire investor George Soros has taken a large long position in [Herbalife]" The Wall Street Journal reported yesterday. "His stake ... is said to be among his top three positions."
The law of unintended consequences
While it's hard to say exactly how much damage has been inflicted on Ackman, there's no question it's significant -- the most recent estimate I've read places the loss at $300 million. Over the past week alone, thanks to Soros' rumored stake, shares of Herbalife are up nearly 16%. For the year, they've gained more than 100%.
For the average investor, beyond the undeniable entertainment value of watching this play out in real time, the point here is that things don't always work out as planned -- not even if you're a billionaire hedge fund manager.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill and has the following options: long January 2014 $50 calls on Herbalife. 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.