The last Friday Digest of the year...
Who actually buys Herbalife's products?…
In today's Digest Premium, we dig deeper into billionaire hedge-fund manager Bill Ackman's charges against nutritional supplement maker Herbalife… a company he claims makes all its money off its own distributors.
To continue reading, scroll down or click here.
Yesterday, billionaire hedge-fund manager Bill Ackman took a roundhouse swing at nutraceutical company Herbalife… accusing it of running a vast pyramid scheme.
Company officials decried the claim… countering that Ackman was merely trying to drive down shares for his own gain.
As we said yesterday… both sides will have plenty of time to state their cases. We've done no research into the firm ourselves. We're only laying out Ackman's work (and Herbalife's counter statements) because it's become a major story…
The Federal Trade Commission gives the following description of a pyramid scheme…
|
Pyramid schemes now come in so many forms that they may be difficult to recognize immediately. However, they all share one overriding characteristic. They promise consumers or investors large profits based primarily on recruiting others to join their program, not based on profits from any real investment or real sale of goods to the public. Some schemes may purport to sell a product, but they often simply use the product to hide their pyramid structure. |
|
There are two tell-tale signs that a product is simply being used to disguise a pyramid scheme: inventory loading and a lack of retail sales. Inventory loading occurs when a company's incentive program forces recruits to buy more products than they could ever sell, often at inflated prices. If this occurs throughout the company's distribution system, the people at the top of the pyramid reap substantial profits, even though little or no product moves to market. |
|
The people at the bottom make excessive payments for inventory that simply accumulates in their basements. A lack of retail sales is also a red flag that a pyramid exists. Many pyramid schemes will claim that their product is selling like hot cakes. However, on closer examination, the sales occur only between people inside the pyramid structure or to new recruits joining the structure, not to consumers out in the general public. |
Pyramid schemes are illegal because the folks at the bottom of the pyramid eventually run out of new recruits. Meanwhile, the folks at the top reap huge benefits from the failures of those at the bottom.
Herbalife has been around about 30 years. And if Ackman's allegations are right… there aren't many suckers left to sign up.
Herbalife measures itself against the Federal Trade Commission (FTC) rules that prohibit pyramid schemes. In order to be safe, Herbalife needs to earn less than 50% of its revenue from recruiting. On paper, Herbalife meets this criterion. But Ackman disputes those numbers.
To become an Herbalife distributor, you buy a "starter package" of Herbalife products that costs between $55 and $91. The distributor buys the product at a 25% discount. Let's say the distributor buys $75 in product and sells it at the suggested retail price (SRP) of $100. The distributor makes the spread between SRP and his discount.
But Ackman says that's not what happens... The retail sales figures on Herbalife's annual filing (10-K) assume 100% of its products are sold at full SRP, and there is zero consumption among distributors.
And Herbalife charges its distributors at minimum a 7% surcharge on the full retail price, Ackman reported. (In some countries, the fees are more than 30%, so distributors are actually paying a premium to SRP.)
During his 15 months of research, Ackman and his team bought Herbalife products... And they were able to do so at a 40% discount to SRP from online distributors. They also studied tens of thousands of eBay transactions, which showed the product sells for a 25%-50% discount on eBay.
Hedge-fund manager David Einhorn asked Herbalife on a conference call in May if the management knew how much of its product was actually resold to retail customers. (Remember, it assumes, 100% is sold at SRP.) The company responded with "we don't track this number and do not believe it is relevant to the business or investors."
The stock fell 20% after that call...
So where does the product go? Ackman believes the bottom-tier distributors are stuck with it (or forced to sell it at a huge discount).
Distributors don't make any money selling the product, Ackman says. They make money recruiting other distributors. (They're paid commission for the money new recruits spend on product.)
And to be a "sales leader," someone who can earn commissions from new recruits, you have to pay Herbalife $2,600 (a huge sum for the typical Herbalife distributor). You also get a 50% discount on products you buy.
Once you reach the sales leader position, statistics show you still probably won't make any money.
The top 1% of Herbalife distributors (27,000 people) makes $6,000 a year and up. The top 0.04% (1,080 people) earns $336,902 a year.
Plus, these figures are gross figures. They don't include any costs associated with running the business.
And to earn the right to collect higher and new commissions, you have to pay Herbalife more money.
Herbalife reports the average retail profit for its distributors is $87 a month. Ackman estimates 93% of its distributors earn nothing.
Herbalife's churn rate (the number of distributors dropping off) is 90%. Part of that could be because if distributors want to return a product they purchased, they have to resign.
Ackman said he's taking his presentation to the FTC. And he'll donate any money he makes on his short position to charity. He says he doesn't want the "blood money" from a company he alleges has conned millions of low-income people hoping for a better life.
Who actually buys Herbalife's products?…
You can breathe a big sigh of relief. This is the last Friday Digest of 2012…
I'm taking next week off to celebrate the holidays with my family at our home in Miami Beach. Everyone from my side of the family will be there – my parents, my brother and his family, and my sister and her family. That's seven kids under the age of 12. I'll have my hands full with things that are far more important than money. I hope you will have the same kind of experiences over the next few days.
But before I sign off for the year... I want to reflect on some things I wrote this year. As you must know by now, I write these weekly letters personally because I want you to know the things I've learned about finance that can give you a genuine edge in the markets. I want you to learn how to invest safely and profitably.
I believe anyone of average intelligence can become a great investor. All it takes is a modicum of effort, a great deal of emotional discipline, and a few simple strategies. You can do it. You really can.
If you haven't read our stuff about capital efficiency and the role long-term compound returns should play in your investing... please... don't let this year end without taking the time to really understand what we're saying.
Go back and read the December 2007 issue of my Investment Advisory... Read the January 2007 issue of my newsletter… Read the October 7, 2011 issue of the Digest. Read the October 2011 issue of my newsletter.
|
And read the latest (December) issue of my Investment Advisory. In it, I share the most valuable and most important ideas I have ever learned in finance. They are simple, intuitive rules. Use these strategies to invest in extremely low-risk businesses... and earn around 15% a year. It's very, very hard to beat this strategy over time. And it's the very lowest-risk way to invest.
The next step in your evolution to becoming a great investor is to understand... to really, truly understand... valuation. Most of the folks reading this letter don't have even the most basic grasp of how to value a stock or a bond. Here's a warning and a bit of tough love: If you can't value a stock better than your broker can, you will die poor.
Learning how to value equities is easy. With operating companies (firms that sell a simple product or a service), you base your value on free cash flow. For a firm like Apple, that's growing very fast, has great margins, and produces a lot of free cash flow, you might pay 10-15 times free cash flow. Legendary investor Warren Buffett has been known to pay more than 20 times free cash flow for extremely high-quality businesses, like Wrigley's for example. We prefer to pay 10 times free cash flow, or less. We are willing to pay a bit more to invest in companies that are still relatively small (less than $10 billion in market cap) that we believe will grow for a long time.
How do you figure out how much free cash flow a company earns? It's easy. You pull up its cash flow statement and look up how much cash it made. In 2012, Apple made $50 billion in cash. It spent $9 billion (roughly) on capital investments. That leaves $40 billion in "free cash flow." In theory then, we'd be willing to pay up to $400 billion to invest in Apple. The market cap today is $486 billion... so it's still just a bit outside our "no-brainer" buy price.
Now... I'm not saying Apple isn't a buy right now. It's certainly reasonable to pay more than 10 times free cash flow for a great business with the kind of brand following that Apple has. My point, however, is important: Never buy any stock unless you thoroughly understand the best way to value it.
Resource companies and asset-holding companies, for example, are valued differently. I wrote a special report for Investment Advisory subscribers on "Trophy Asset" investing. Don't invest a penny unless you completely understand the risk you're taking in terms of valuation.
Richard Russell, the dean of the newsletter industry, wrote the best advice on this topic. [We ran his classic "Rich Man, Poor Man" essay in our Weekend Masters Series. It's a must-read.] I've quoted him several times over the years. And I'll do so again, now.
Print this out. Tape it to your computer or to your desk. Read it frequently. Think about it every time you're about to do something in the markets…
|
But what about the little guy? This fellow always feels pressured to "make money." And in return he's always pressuring the market to "do something" for him. But sadly, the market isn't interested... And because the little guy is trying to force the market to do something for him, he's a guaranteed loser. |
|
The little guy doesn't understand values so he constantly overpays. He doesn't comprehend the power of compounding, and he doesn't understand money. He's never heard the adage, "He who understands interest – earns it. He who doesn't understand interest – pays it." |
|
The little guy is the typical American, and he's deeply in debt. The little guy is in hock up to his ears. As a result, he's always sweating – sweating to make payments on his house, his refrigerator, his car or his lawnmower. He's impatient, and he feels perpetually put upon. He tells himself that he has to make money – fast. And he dreams of those "big, juicy mega-bucks." |
|
In the end, the little guy wastes his money in the market, or he loses his money gambling, or he dribbles it away on senseless schemes. In short, this "money-nerd" spends his life dashing up the financial down-escalator. But here's the ironic part of it. If, from the beginning, the little guy had adopted a strict policy of never spending more than he made, if he had taken his extra savings and compounded it in intelligent, income-producing securities, then in due time he'd have money coming in daily, weekly, monthly, just like the rich man. The little guy would have become a financial winner, instead of a pathetic loser. |
And that brings me to my last idea... something that every investor had better understand immediately, deeply, and intuitively. If you want to become wealthy, you have to be a disciplined saver. You have to learn how to consume far less than you earn. You have to learn to be patient with your capital. You have to learn to wait to make your investments when there's a genuine opportunity. You have to learn to evaluate opportunity on the basis of valuation... not your emotional or financial needs.
You can do it. If you'll keep humoring me each week by reading these missives, I'm 100% certain you'll continue to improve. As your knowledge grows, so will your discipline. And as your discipline grows, so will your brokerage account.
I wish you all the best in 2013. And I thank you most sincerely for the support you've given to my business and my family this year. Happy holidays!
Finally, I highly encourage you to try my new favorite way to profit from my highest-conviction ideas. It's called Stansberry Alpha. In this strategy, we only buy the highest-quality companies at good prices… And using our proprietary methods, we have potential triple-digit upside, while taking on less risk than if we simply bought the stock outright.
Along with the lessons above, if you learn and understand our Alpha strategy, we believe you will become a vastly better and more successful trader. Many of our subscribers have already tried this new service. And as you can see in the mailbag below, the feedback has been overwhelmingly positive. We've recently opened Alpha and are offering subscriptions at a special "charter member" discount… To learn how to become a charter member, click here.
New 52-week highs (as of 12/20/2012): Berkshire Hathaway (BRK), Guggenheim BulletShares 2015 High Yield Corporate Bond Fund (BSJF), iShares Germany Fund (EWG), iShares High Yield Corporate Bond Fund (HYG), SPDR Barclays High Yield Bond Fund (JNK), Sequoia Fund (SEQUX), Brookfield Asset Management (BAM), Sysco (SYY), Monsanto (MON), and Home Federal Bancorp (HOME).
With the holidays coming up… we know the eggnog and mulled wine will be flowing… Always a great time to fire off a screed to us… Send your diatribes (drunken or otherwise) to feedback@stansberryresearch.com.
"Porter & Brett: Thanks for the [Alpha] update. I am loving the product. I did get in on the CBI trade; MGM ran away before I could get in but I'm keeping an eye on it. Keep up the great work." – Paid-up subscriber Mark J.
"I'm a quite satisfied subscriber to a set of five newsletters, but after about two years, I've decided I'm going to spend less time reading each monthly issue. At this point, I'm 'fully allocated' and other than have a few puts and calls to watch, I feel like I am wasting my time tracking my portfolio. I'm also wasting time looking at each month's new recommendations an agonizing over whether a new pick might be better than one of my existing positions. So here are my resolutions:
"1. Set up and follow the trailing stops on all current positions.
"2. Continue with covered calls, but shift to longer timeframes (three months) to avoid creating churn in my portfolio (and extra brokerage fees).
"3. Read Stansberry Digest but start ignoring monthly newsletters unless I stop out and have new funds to invest.
"4. Delete the portfolio on My Yahoo page, my cell phone, and my Windows Surface tablet. Also, don't login to my brokerage account every day.
"5. Find a new hobby, or walk my dogs more often.
"Cheers!" – Paid-up subscriber Kevin
Regards,
Porter Stansberry
December 21, 2012
Howard, Pennsylvania
Who actually buys Herbalife's products?…
In today's Digest Premium, we dig deeper into billionaire hedge-fund manager Bill Ackman's charges against nutritional supplement maker Herbalife… a company he claims makes all its money off its own distributors.
To subscribe to Digest Premium and access this today's analysis, click here.
The last Friday Digest of the year... Why you ought to know more about valuation than your broker... A classic line from Richard Russell... The link between knowledge and discipline...