Oct. 3 (Bloomberg) -- Herbalife Ltd. tumbled the most in four months after Bill Ackman cut his equity short stake, replacing the bearish wager with put options in a move that deterred traders from betting against the hedge-fund manager.
Herbalife fell 6.6 percent to $68.25 today, the biggest retreat since May 22. The Cayman Islands-based company’s share price has more than doubled this year as about 18 percent of Herbalife’s shares outstanding were sold short as of Oct. 1, according to Markit, a London-based data provider. Ackman alleges that Herbalife is an illegal pyramid scheme, which the company has repeatedly denied.
Ackman’s decision to replace his short position with put contracts that give the right to sell the stock limits his risk against a short squeeze, while still allowing him to profit if he is right about Herbalife’s business model, according to Alec Levine at Newedge Group SA in New York. That removes an upward pressure on the stock as buyers are no longer able to bet that Ackman will buy back Herbalife shares to cover his shorts.
“Short positions are often the fuel for why stocks go higher -- the guys who are short cover because they can’t take the pain and you have other guys buying the stock just to bust the short,” Levine, an equity-derivatives strategist at Newedge, said in a phone interview today. “Now that there’s no longer this enormous pressure on Ackman to cover his short, the buyers who think they can squeeze him are not there any more.”
In a letter to Pershing Square Capital Management LP’s investors, Ackman, who is taking a loss on his short sales, said he replaced a portion of his original bearish position, that was valued at about $1.5 billion, with long-term put options. The move lets Pershing still make money if the company fails “within a reasonable time frame” even as it reached an all-time high last month.
Barb Henderson, a company spokeswoman, declined to comment on the short seller’s letter or the trading in the stock.
Pershing Square was looking to protect itself against a short squeeze, Ackman wrote. In a short sale, an investor borrows stock and then sells the shares in anticipation of returning them at a lower price in the future. A short squeeze occurs when other investors begin buying the same stock, pushing its price up and forcing the short seller to buy back the shares, possibly at a loss.
Ackman declined to comment beyond the letter or elaborate on the move, which reduces the equity short position held by Pershing Square to 12 percent from 16 percent of the firm’s $10.8 billion portfolio, he told investors. Pershing funds declined by more than 5 percent in the third quarter and were little changed, net of all fees, for the first nine months of the year, according to the letter.
Ackman has accused Herbalife of swindling unsophisticated consumers with false get-rich promises using overpriced products that hide a pyramid scheme. He has urged U.S. regulators, elected officials and community activists to help shut it down.
“We have not learned any facts that are inconsistent with our belief that the Company is a pyramid scheme that engages in unlawful and deceptive marketing practices,” Ackman wrote in his letter. “In fact, there have been a number of materially positive developments that increase the likelihood of regulatory intervention and the Company’s closure.”
Operators of pyramid schemes typically seek to make money by recruiting new members who pay fees to existing members rather than relying on just the sale of goods and services. The Federal Trade Commission has said modern pyramid schemes can use products to hide their true intent.
While short selling in Herbalife has retreated from a record 27 percent at the end of 2012, it is still more than six times the average of bearish bets in the Russell 1000 Index, Markit data show. Herbalife is the 14th most-shorted stock in the equity index.
“From this point forward Herbalife will trade more on its own merits and be less of a billionaire battlefield,” Levine said.
To contact the editor responsible for this story: Lynn Thomasson at email@example.com