Icahn Vs. Ackman: Highlights Danger of Short-Squeezes

In one of the all-time great moments in financial television, Carl Icahn and Bill Ackman engaged in an epic verbal throw-down live on CNBC last month. The two legendary investors have a contentious history with one another and recent developments suggest that their previous battIcahn Vs. Ackman Highlights Danger of Short-Squeezesles may have just been a warm up. The two men have lined up on opposite sides in shares of multilevel marketer Herbalife HLF and one of them is likely to lose hundreds of millions of dollars and possibly their reputation in the process.

Ackman, the founder of Pershing Square Capital Management and a hedge fund manager with a top-flight track record as an activist investor, launched a bear raid on Herbalife in December. Never one to take half measures, Ackman went about taking down the stock in rare fashion. First, Pershing Square sold short around $1 billion, or 20 percent, of Herbalife's float -- a massive position which accounts for roughly 10 percent of the fund's equity.

Not satisfied with just making his bet and keeping quiet, Ackman found it necessary to give a three-hour presentation at the Ira Sohn Investment conference which was accompanied by 342 PowerPoint slides. In his brutal take-down of Herbalife, he called the company a "pyramid scheme" and said that the stock was going to go to $0. For his efforts, Ackman got exactly what he wanted -- at first. Herbalife shares plunged in the ensuing days as investors panicked out of their positions. Between December 18 and December 24, the stock fell from around $42.50 to a low of $26.

On paper, Pershing Square made a hundreds of millions. Unfortunately, the fund manager may have bit off more than he could chew in publicly attacking the company and recklessly betting 10 percent of his firm's capital on a single short position. He also provided other investors with a good example of the risks inherent in short-selling and how small traders can capitalize on the moves made by Wall Street whales.

After Ackman went public with his crusade against the multilevel marketer, which sells weight-loss and nutritional products through a network of third-party distributors, a couple of very high-profile names lined up on the other side of his trade. Specifically, hedge fund Third Point LLC's Dan Loeb and legendary activist investor Carl Icahn purchased large stakes in Herbalife, setting the table for a potential epic short squeeze in the stock.

First, Third Point revealed that it had acquired an 8.2 percent position in the company. In his fourth-quarter investment letter to Third Point's limited partners, Loeb called Ackman's short thesis "preposterous" and noted that Herbalife is a well-managed, "classic compounder" which has demonstrated shareholder friendly behavior.

Soon rumors emerged that Carl Icahn was also buying the stock. His verbal lashing of Ackman on CNBC, along with his contention that Herbalife could become a massive short-squeeze, seemed to suggest that there was merit to the rumors. On Thursday, February 14, the whispers were validated as a filing with the SEC revealed to the market that Icahn had bought a nearly 13 percent stake in Herbalife. The stock jumped 20 percent in after-hours trading but fell throughout much of Friday's session, only closing up only around 1 percent.

Nevertheless, the news had to make Ackman sweat. Even worse for Pershing Square, the filing suggested that Icahn may potentially push for a sale of the company or even participate in a go-private transaction.

The filing stated that "The Reporting Persons have concluded that the Company has a legitimate business model, with favorable long-term opportunities for growth. The Reporting Persons intend to have discussions with management of the Issuer regarding the business and strategic alternatives to enhance shareholder value, such as a recapitalization or a going-private transaction."

In light of this latest development, Pershing Square finds itself in a very dangerous situation. If the stock, which is up roughly 49 percent from its lows in the days after Ackman's presentation, continues to rise or there is a buyout, Pershing Square could lose a fortune. It is conceivable that the hedge fund could lose even more than the $1 billion it bet against Herbalife.

This situation is a perfect example of the risks involved in short-selling -- namely short-squeezes and buyouts. The billionaire battle between Ackman, Loeb, and Icahn also highlights how the moves made by big investors can lead to substantial opportunities for small traders. Specifically, HLF has been an awesome trading stock since Ackman went public against the company.

In the subsequent days after the presentation, the stock dropped like a stone on an intra-day basis. The one way action in the name was extreme enough to make a small fortune. The ensuing rally after HLF bottomed out on Christmas Eve Day was equally powerful and lucrative. Thankfully, there will likely be similar periods of volatility in Herbalife going forward in 2013.

This battle is just starting to heat up, and with Ackman short around 20 percent of the float and Icahn and Loeb long around 20 percent of the float, Herbalife is looking like it will be one of the top trading stocks in the market for the foreseeable future. The uncertain outlook for the company from an operational and regulatory standpoint along with the massive amount of money at stake on both sides almost guarantees that Herbalife will continue to experience intermittent flurries of volatility, which should yield some excellent trading opportunities.