Investment and Finance

Scams: Multi-Level Marketing, Herbalife

Carl Icahn and Bill Ackman – WSJ

Not to seem unduly negative, but sometimes they are out to get you.

Abuse of social ties to rope people into schemes to enrich a few is still common, and now we have the extended social networks of the Internet to entice us into trusting people we shouldn’t. One example: the Kickstarter boys who took $40K to develop a game and then squatted in an AirBnB apartment in Palm Springs.

But much financial fleecing still happens because we trust someone in our community or network of friends. Very commonly financial fraud artists will prey on a religious community, where being “one of us” seems to lead to blind trust; biggest example, Bernard Madoff’s pyramid scheme which took mostly Jewish investors for billions of dollars.

We’ve all experienced the “friend” who starts pressuring us to buy products from the multilevel marketing scheme they’ve signed on for; in the 70s, it was Amway distributors you avoided at parties. Some of these schemes burn out and collapse, but others go on to become more honest businesses. But most start out dishonest and stay dishonest, pushing products that are inferior or fraudulent like the “ion water” (water with a trace of salt) a friend of mine swore by. These companies mine the enthusiasm and greed of the unwary and get them to fleece their friends as well, destroying social ties and trust. One thing you know about anyone who tries to use friendship to sell products: they’re not very bright and they don’t understand friendship.

The Washington Post has a good story about the consequences for those who go all-in to do multilevel marketing:

Enrique Martinez didn’t like chocolate, but he was eating as many as 10 pieces a day, drinking chocolate protein shakes and rubbing a chocolate-based skin cream on his face. It was expensive chocolate, too. Martinez and his wife, Michelle, were going through $2,000 in chocolate a month.

The debt they accumulated this way — more than $100,000 over five years — is now with a consolidation company. Their credit is ruined. There is a crack in the driveway at their home in Albuquerque from a 14-wheeler that once delivered 12,000 cans of chocolate energy drinks to their garage.

The chocolate came from MXI Corp., which uses a controversial business model called multilevel marketing. MXI has more in common with Avon Products, Herbalife and Amway than with a conventional candymaker such as Hershey. These are companies without a sales force that recruit their customers to sell products, often in bulk to other customers, who might in turn sell to other customers, and so on.

Critics accuse multilevel marketers of using slick pitches to persuade the unwary to buy goods in bulk, promising them that they’ll make money by selling those products to others. In this way, the companies are paid upfront, and the rank and file bear a good deal of the financial risk.

Defenders of multilevel marketing say the business model makes sense. They say the customers are largely enthusiasts who initially join to buy their favorite products at wholesale prices, not to make money. They add that, in any industry, satisfied customers often make the best salespeople.

The FTC has tried for years to make multilevel marketers be honest about costs and probabilities of success for people who join them. It turns out that companies can be scrupulous about disclosing the costs and low probabilities of profit, and still find willing victims. So the best recourse is educating everyone; only losers join multilevel marketing schemes.

Meanwhile, the large and successful multilevel marketer Herbalife is under attack from short sellers. In short selling, an investor borrows the stock of a company, sells it to pocket the cash, then hopes that the price of the stock drops so it can be repurchased with only a fraction of the cash received from selling it. Ideally the company collapses completely and the shares never have to be returned. So short sellers look for companies which are scams or fraudulently misleading investors with fudged financial numbers, sell the stock short, then publicize the ugly data they have found. This is healthy for the system, since there are already buy-side investors eager to promote glowing news about companies, and the short-sellers bring balance.

The Economist has a detailed writeup on the story to date:

The “death blow” that Bill Ackman promised to land on Herbalife this week raised expectations of a dramatic ending to one of the most remarkable battles in the history of Wall Street. On July 22nd the billionaire boss of Pershing Square, a hedge fund, delivered a three-hour presentation that he said would kill off the seller of nutritional shakes and foods by showing it to be a criminal enterprise that preys on the poor. But as he spoke, Herbalife shares ticked steadily higher. The low-point for Mr Ackman—whose fund has reportedly made a $1 billion “short” bet on the company’s share price falling, was when his father asked how close he was to proving that Herbalife is a pyramid scheme. He replied, wearily, “Dad, if you don’t know it by now…”

Appearing before an audience of nearly 500, plus 10,000 or so viewers online, Mr Ackman, at times tearful, attacked targets ranging from Carl Icahn, a rival billionaire so bullish on Herbalife he has put five directors on its board, to David Beckham and Lionel Messi, two footballers whose shirts have borne the firm’s name, Madeleine Albright, a former secretary of state who also champions it, and PwC, its auditor.

It remains a possibility that Mr Ackman, who first went public with his attack on Herbalife in December 2012, has delivered a mortal blow of the Shakespearean kind, deadly in the end but only after much fighting talk and rolling around. He has spent $50m on an army of investigators to look into the firm’s activities around the world, in particular its “nutrition clubs” that focus on poorer people. Mr Ackman says that most of those attending these clubs are “fictitious customers”.

Who they are goes to the heart of the matter. If they are genuine retail customers, buying nutritional shakes and other products because they want to consume them, that supports Herbalife’s claims to be a legitimate multi-level marketing company. Neither side disputes that Herbalife’s main retail channel has a structure in which participants share in revenues generated by the salespeople they recruit, as well as revenues generated by the recruits of those recruits. But Mr. Ackman says his investigations show that the vast majority of nutrition-club “customers” are people paying through their consumption of Herbalife products for training they need to qualify to open a nutrition club of their own, in the hope (for most, false hope, he says) that this will provide a decent living and perhaps one day make them rich.

Having studied a sample of clubs in New York, Mr Ackman claims that they lose $12,000 a year on average, even before taking into account all their running costs, and that the accounting system used for the clubs greatly overstates any income earned by the self-employed people running them. Herbalife’s own figures show that barely 7,300 of the almost 409,000 people in its sales channel earned more than $5,000 in 2013. The company says that is because the great majority join up to get a discount on its products rather than to make money selling them.

Mr Ackman points out that in recent months, while Herbalife has been carrying out a share-repurchase programme, some of its executives have been selling their shares. In May its boss, Michael Johnson, sold shares worth $15m. Mr Ackman says Herbalife bought its own stock during his presentation to make its price rise.

Herbalife says all of Mr Ackman’s allegations are baseless and that it complies with all laws. On July 22nd it called his claim about the nutrition clubs’ earnings “completely false and fabricated”. It pointed to a study by an economist it hired, which concluded that 39% of Herbalife’s sales were to people outside its network and a further 41% to people who had joined it mainly so they or their families could buy the products cheaply, and that therefore the products “have significant intrinsic value and market demand.”

Mr Ackman called on Herbalife staff to blow the whistle on any illegal practices they know of, and reminded its directors and advisers of the legal risk they would run were the firm found to be fraudulent. That is now a question before the Federal Trade Commission, the Department of Justice, the FBI and at least two state attorneys general: all of them are reportedly conducting investigations into the firm.

Also of interest: Wonkblog’s take.

Mate-Seeking: The Science of Finding Your Best Partner

Brad Pitt in “Moneyball”

One of my many hats is investor/economist, so this story from NPR by Sean Braswell about applying economic thinking to mate-seeking got my attention:

… [T]here’s another type of virtual eyewear that many of us spend even more time donning — one that has the opposite effect of beer goggles. Call them “expectancy spectacles” if you’d like, because wearing them causes us to raise our standards and expectations, often unrealistically, of everything from potential mates to job prospects.

The primary culprit behind this altered vision is not booze, but a potent concoction of Hollywood movies, social conditioning and wishful thinking. And fortunately, there are a few scientists on the case.

One is Ty Tashiro, a psychologist specializing in romantic relationships who writes for Discovery Fit and Health. His recent book, The Science of Happily Ever After, explores what “advances in relationship science” can teach us about the partners we choose. Almost 9 in 10 Americans believe they have a soul mate, says Tashiro, but only 3 in 10 find enduring partnerships that do not end in divorce, separation or chronic unhappiness. Clearly something is going wrong — and it starts with our expectations.

That’s because in real life the pool of potential partners looks rather different from the cast of The Bachelorette — something Tashiro hopes to address by putting some cold figures to the mating game, employing an approach similar to the one used by scientists who calculate the chances of life on other planets.

For example, say a bachelorette enters a room of 100 male bachelors who represent the broader U.S population. If she prefers a partner who’s tall (at least 6 feet), then her pool of possible prospects immediately shrinks to 20. If she would like him to be fairly attractive and earn a comfortable income (over $87,000 annually), then she’s down to a single prospect out of 100.

If you choose to specify further traits, such as kindness, intelligence or a particular religious or political affiliation, well, let’s just say we’re going to need a much bigger room. And then, of course, there’s the small matter of whether he actually likes you back.

Such long odds are the product of misplaced priorities, says Tashiro, but it’s not strictly our fault. Our mate preferences have been shaped by natural selection’s obsession with physical attractiveness and resources as well as the messages our friends, families and favorite shows transmit about sweethearts and soul mates. And it is at the start of relationships, when we need to make smart, long-term decisions, that we are least likely to do so because we’re in the throes of lust, passion and romance.

Or, as Tashiro puts it, returning to our alcohol analogy: “It would seem wise to hand off the keys to someone with more lucidity until your better sensibilities return.”

Which is why Tashiro advocates a new approach to dating, one that is not so much about lowering standards as giving yourself better ones. Call it “Moneyballing” relationships (Tashiro does); it’s all about finding undervalued traits and assets in the dating market. And, just like with baseball, it starts with trying to ignore the superficial indices of value — attractiveness, wealth — in favor of hidden attributes with a stronger correlation to long-term relationship success.

Citing research that finds no reliable link between income level or physical attractiveness and relationship satisfaction, Tashiro steers his readers toward traits such as agreeableness. With married couples, he points out, “liking declines at a rate of 3 percent a year, whereas lust declines at a rate of 8 percent per year,” so the smarter, long-term investment is finding someone you genuinely like. Plus, he adds, studies also suggest that agreeable partners are in fact “better in bed” and less likely to cheat over the long haul.

Being confused about what you are looking for in a mate is epidemic — part of the cost of freedom to choose yourself (instead of having parents arranging your marriage for you) is valuing the wrong things and being unrealistic about what your partner should be like. Programmed by the Fairy Tale model (“(s)he should be just perfect and make me happy!”) most young people don’t have the sense to look beyond the superficial unless they are lucky enough to accidentally come into close contact with a person who they can love unconditionally. Much more likely is to dismiss many good long-term partner candidates for failing to be exactly as expected — not tall enough, not rich enough, not goodlooking enough… “I deserve better!”

The “Moneyball” reference is to the problem of assembling the best baseball team for the least money. The obvious stars are pursued by many teams and their salaries bid up; because of the overvaluation of the very best players, one manager discovered he could assemble a great team at a lower cost by focusing on the less obvious players, who might be very good at one or two things which went unrecognized.

In the mate-seeking problem, the analogous strategy is to not be distracted by good looks or superficial factors like current wealth, height, or sexiness. The people who have all those things are in great demand, know it, and are less likely to pick you for partnership. Meanwhile, the shy, short guy with the entrepreneurial spirit and drive will someday be wealthy, the plain and unfashionably dressed girl with smarts may blossom into a glamourous woman as she makes it out in the world and has the time and money to work on appearance.

When you are thinking long-term, think like an investor — go after the future great partner, not the ones who satisfy all your shallow “must haves.” Love and commitment make high achievers out of good partners, and young people who are loyal and reliable can build each other up and create that successful life the Fairy Tale talks about; but it doesn’t just happen, you have to work for it and believe in your partner. Look for someone you can trust and believe in.

Tuitions Inflated, Product Degraded, Student Debts Unsustainable

Bloated Administration, Starved Teachers

Explained well by analogy in this post by Omid Malekan (via ZeroHedge):

Imagine for a moment that you are the owner of a popular restaurant located on a street with many restaurants. You do your best to provide the best experience to your customers while staying ahead of the competition by keeping your prices down. You try to avoid spending too much on labor, and do as much of the work yourself as you can, often putting in long hours. Although there is a good wholesale market nearby, you drive an extra hour to another market just to get your ingredients a little cheaper.

One day a wealthy patron who is a big fan of your cooking announces a new idea. Because he wants as many people as possible to enjoy your food, he is going to pick up the tab for most of your customers. You can just go on doing what you always do, but when the check arrives for many tables, this wealthy patron will pay the tab. The next day, your waitress complains that there are too many tables and you should hire more help. What would you do?

Normally, you would try to find a way to avoid hiring another person as it would eat into what little profits you make. But now you realize there is another solution. You can just raise prices. Since most of your patrons are not paying for their meals, your place will still stay popular and you won’t have to worry about losing business to your competition. So why not hire another waitress? While you are at it, why not hire a manger so you don’t have to be there all time, and stop driving to the further market?. Whatever increase in costs you suffer you can make up for by raising prices more and more.

Now imagine all your competitors also have wealthy benefactors picking up the check for many of their customers. You can all raise prices constantly without losing any sleep – or business.

This scenario is effectively what America’s higher education financing system has turned into. There are many reasons why college tuition is rising faster than virtually anything else, from more applicants than ever to state budget cuts for public universities, but all of those factors are allowed to persist because often times the person getting the degree is not the person paying the tab – not for today anyway.

Presently over 60% of all undergraduate students receive some sort of Federal aid for their education, and the amount of money the government has shelled out for student loans is now over a trillion dollars, double what it was just 7 years ago. Like the hypothetical wealthy patron in the example above, the government doesn’t ask for much when it gives out the money – neither from the student nor the University. If our wealthy patron had said “I will pick up the tab so long as you keep your low prices” then we would have a reason to keep prices down. But by fully removing the value of what customers get from the equation, all incentives point towards inflation.

…

This is exactly what’s happening at America’s major colleges and universities. As shown by the chart below, which was put together by the American Association of University Professors, since the 1970s positions for non-faculty professionals have seen the highest growth for jobs at American Universities.

Number College Employees

Meanwhile, University Presidents and other executives have been giving themselves big raises while leaving the professors and their assistants in the dust.

College Salaries

The peculiar places tuition money has been flowing to is further discussed in this fascinating paper by the Delta Cost Project.

We could debate all we want about how much a University should spend on professors, secretaries, sports facilities or free unlimited Nutella, but that would be a waste of our time, just as it would be for the patrons of a restaurant to debate how many waitresses there should be.

Imagine if suddenly our wealthy restaurant benefactor declares he’s going to stop paying for peoples meals. Given our now sky-high prices, our tables would be empty and given all these new expenses, like more waitresses and shopping at the closer market, we’d go out of business. To survive, we’d have no choice but to get leaner and enter the murky waters of business uncertainty, where every decision is complicated and viewed through the lens of “what can I get away with?”

As long as the majority of the cost of college education is not born directly by students but rather by Government loans and grants, our institutions of higher learning will not be forced to adapt and find innovative ways of delivering quality education to more students at a decent price. They will go on keeping supply low, tuition higher and expenses growing. If we care about our children and want them to stop taking on more and more debt to get a degree for a tougher and tougher job market we need to break the current cycle.

The kindest thing our government might do for our kids is to stop throwing money at inefficient Universities in their name, or at least demanding more from those institution in return for that money. Imagine for a second if college loans were given to the school and not the student, and tied to metrics of success, like whether the student graduates and how good a job they land afterwords. Much like our restaurant, in such a world the school’s focus would then shift to keeping prices down while offering good value.

Students in recent years have been shafted by this easy-financing debt scheme, and student loan debt is now a staggering $1 Trillion in the US, mostly held by Uncle Sam, and the debt per student debtor has risen to $27,000 on average. Students who have graduated into careers in high-paid fields like medicine and business have manageable if burdensome debt, but millions of people were induced by financing to start college and fail, or to get degrees in fields with low salaries and minimal demand. College administrators have expanded their empires and salaries while the student debt burden prevents many former students from buying homes and starting families. Currently about half of Federal student loans are 90+ days delinquent or in deferment or grace periods. Some politicians promise to make the problem worse by increasing student loans and lowering rates, meaning even more Federal subsidies will flow to bloated college budgets. None of these schemes get at the underlying problem: only stopping the subsidies will open up space for innovation to bring quality higher education to more people at lower cost.

Addendum: Reason discusses the harm easy access to loans without evaluating credit risk of the proposed program does to poor or easily-misled students, as well as the colleges that have marketed to them.

Also, read this Atlantic article on why less privileged students take so long to graduate, if they graduate at all, and how this fact makes their spending on even community colleges almost as high as a 4-year degree in the Ivy League.

Death by HR: How Affirmative Action Cripples Organizations

[From Death by HR: How Affirmative Action Cripples Organizations, available now in Kindle and trade paperback.]

The first review is in: by Elmer T. Jones, author of The Employment Game. Here’s the condensed version; view the entire review here.

Corporate HR Scrambles to Halt Publication of “Death by HR”

Nobody gets a job through HR. The purpose of HR is to protect their parent organization against lawsuits for running afoul of the government’s diversity extortion bureaus. HR kills companies by blanketing industry with onerous gender and race labor compliance rules and forcing companies to hire useless HR staff to process the associated paperwork… a tour de force… carefully explains to CEOs how HR poisons their companies and what steps they may take to marginalize this threat… It is time to turn the tide against this madness, and Death by HR is an important research tool… All CEOs should read this book. If you are a mere worker drone but care about your company, you should forward an anonymous copy to him.

More on education and child development :

Student Loan Debt: Problems in Divorce
Early Child Development: The High Cost of Abuse and Neglect
Child Welfare Ideas: Every Child Gets a Government Guardian!
Free Range Kids vs Paranoid Child Welfare Authorities
“Crying It Out” – Parental Malpractice!
Brazilian For-Profit Universities Bring Quality With Quantity
The Affordable, Effective University: Indiana and Mitch Daniels
Real-Life “Hunger Games”: Soft Oppression Destroys the Poor
“Attachment Parenting” – Good Idea Taken Too Far?
Real Self-Esteem: Trophies for Everyone?
Public Schools in Poor Districts: For Control Not Education
YA Dystopias vs Heinlein et al: Social Justice Warriors Strike Again
Steven Pinker on Harvard and Meritocracy
Social Justice Warriors, Jihadists, and Neo-Nazis: Constructed Identities

Zero-return Investing: NYTimes Weighs In

Employment Graph

The market is down today, probably because investors have had a chance to look at the supposedly good employment report released Friday and discovered some shocking bad news: “full-time jobs declined by 523,000 and part-time jobs surged 840,000.” It’s widely believed employers continue to replace full-time workers with part-time workers to avoid increased benefits expenses, notably the Obamacare mandates-to-come on over-30-hours-a-week employees. The widely-cited unemployment rate is declining because discouraged workers have simply dropped out of the labor force or work off the books in the growing underground economy. A move toward European-style micromanagement of employment means a move toward European-style underemployment and corruption….

For those of you who don’t accept ZeroHedge (with its tendency to sensationalize) as a source of investment thinking, we have this recommended New York Times piece saying the same thing: probabilities favor very low or no returns on almost all categories of investment for the near and medium term. This situation has been engineered by the world’s central banks, who decided to suppress interest rates and savers’ incomes to lower long-term rates on riskier investments, which supposedly would bring back the growth economy and full employment. It hasn’t worked, and the recovery from this recession has been slower and weaker than the historical norm, but it did boost bank profits and bail them out at taxpayers’ and savers’ expense. Diversion of investment funds to politically-connected firms and interests has led to massive losses (Solyndra et al) and misinvestment: what capital is being invested is misallocated because the central banks have put a thumb on the risk scale, so risky projects that would not make sense at free market interest rates are getting funds while more valuable projects without political sponsorship go unfunded.

In Spain, where there was a debt crisis just two years ago, investors are so eager to buy the government’s bonds that they recently accepted the lowest interest rates since 1789.

In New York, the Art Deco office tower at One Wall Street sold in May for $585 million, only three months after the going wisdom in the real estate industry was that it would sell for more like $466 million, the estimate in one industry tip sheet.

In France, a cable-television company called Numericable was recently able to borrow $11 billion, the largest junk bond deal on record — and despite the risk usually associated with junk bonds, the interest rate was a low 4.875 percent.

Welcome to the Everything Boom — and, quite possibly, the Everything Bubble. Around the world, nearly every asset class is expensive by historical standards. Stocks and bonds; emerging markets and advanced economies; urban office towers and Iowa farmland; you name it, and it is trading at prices that are high by historical standards relative to fundamentals. The inverse of that is relatively low returns for investors.

The phenomenon is rooted in two interrelated forces. Worldwide, more money is piling into savings than businesses believe they can use to make productive investments. At the same time, the world’s major central banks have been on a six-year campaign of holding down interest rates and creating more money from thin air to try to stimulate stronger growth in the wake of the financial crisis.

“We’re in a world where there are very few unambiguously cheap assets,” said Russ Koesterich, chief investment strategist at BlackRock, one of the world’s biggest asset managers, who spends his days scouring the earth for potential opportunities for investors to get a better return relative to the risks they are taking on. “If you ask me to give you the one big bargain out there, I’m not sure there is one.”

But frustrating as the situation can be for investors hoping for better returns, the bigger question for the global economy is what happens next. How long will this low-return environment last? And what risks are being created that might be realized only if and when the Everything Boom ends?

In my personal investments, I’ve reduced exposure to stocks and bonds, raised cash, taken a small position (15%) in precious metal miners, and done what I could to reduce risk since this environment will probably either result in another decade of stagnation a la Japan, or crash in some unforeseeable way when the imbalances prevent any central bank response. As I said a few years ago, the Fed has bailed out all the banks, but who bails out the Fed if their newly risky balance sheet assets go south? The Paul Krugman answer (print money as needed!) will not stop the collapse. If things muddle along and resolve without a crisis, my investments will return a bit less, and I will be happy if that happens!

Wall Street versus Main Street

In the normal operation of a capitalist economy, high profit margins in some products would make it very profitable to invest capital in increasing supply of those products, reducing their price, the margins of production, and eventually the returns on investment in that product; this increases everyone’s standard of living as capital is allocated to the projects that best serve consumers.

But if you look at the products that have gone up most in price without any improvement in quality, you find sectors that are heavily regulated and bureaucratized, where barriers to entry from political management are so high it is not worth investing until profits are enormous and some can be kicked back to the politicians. Health care: supply constrained by government regulation of supplies of doctors, nurses, and treatments. Education: K-12 innovation squelched by union contracts, local monopoly, and federal oversight; post-secondary, half government run and 100% regulated, with increasing salaries to ballooning numbers of administrators, subsidized student loans, and dumbed-down programs suited for the dumbed-down graduates of modern public high schools. Rents: in highly-regulated coastal cities like San Francisco and New York, where local governments already have rent-controlled or mismanaged their way into housing shortages, even stratospheric rents call forth little new supply because the process for obtaining permission to build new housing is so slow and politicized. It takes a huge premium to induce builders to even try where their projects can be made worthless by lawsuits and local vetoes. Newcomers seeking an apartment to rent find themselves in a scrum of 20 or more people at open houses and are sometimes asked to offer more than the asking price along with their life history, credit report, and occasionally bribes. $5,000-a-month one bedrooms are starting to appear in good locations. Meanwhile, transit service is poor and subject to whimsical strikes and slowdowns by the overpaid union workers who might as well own the systems, so transit to lower-cost areas is slow and inconvenient. This is not normal!

Cable TV: has increased in price much faster than inflation as Congress encouraged local monopolies and local governments resist new services (unless bribed.) People are voting with their feet: they already left their landlines, and soon the cable companies will only be rescued by their monopolies on broadband access.

All of these regulations and restrictions on new entrants keep profits high for incumbents and are supported by their political donations, but at some point the losses to consumers add up and they revolt — by not buying, or working off book, or not getting married, or not buying a house. The younger generation is slowly realizing that they’re being bled dry by old people and politicians who lie to them without consequence and promise free or low-cost routes to a better life that turn out to be crap, while the politicians enjoy golf, jet about at public expense for their party fundraisers, and pile up magically-increasing net worth. The economy is stagnant and rigged in favor of the donors to the political parties, and the future has already been mortgaged and sold.

Jeb Kinnison

Writing About Life and Love

Investment and Finance

Mate-Seeking: The Science of Finding Your Best Partner

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Tuitions Inflated, Product Degraded, Student Debts Unsustainable

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Zero-return Investing: NYTimes Weighs In

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