As of Friday, January 29th, GameStop Corp. (NYSE: GME) shares closed at US$325.00, up US$131.40 or nearly 68% for the day. For additional context, the shares ended 2020 at US$18.84 and skyrocketed to a high of US$483.00 just last week, good for a stratospheric return of over 2,400%. As a result, the “value” of the company has grown from US$1.31 billion to US$22.67 billion.
Despite videogames being more popular than ever (benefiting from pandemic-related lockdowns, global sales tallied nearly US$180 billion in 20201), GameStop is struggling. With the recent jump in stock price, you would think the outlook for GameStop’s business took a dramatic turn for the better.
However, GameStop’s business isn’t doing better. They didn’t find an advantage in their sales battle with online retailers, big-box stores and digital copy sales. They didn’t develop an exciting new game streaming service. GameStop is just a brick-and-mortar videogame store (parent company to Canada’s EB Games) that can’t open due to the pandemic.
So, what’s going on?
Hedge funds, Reddit and the short squeeze
In a nutshell, a large group of individual investors are inflating the share price (by buying and holding the shares) of companies (GameStop being the highest profile of these “meme stocks”) that are well-known targets of hedge fund short selling.
- What is a hedge fund?
A hedge fund is an investment partnership (typically between the fund manager and the investors) that may use non-traditional, more complex investment strategies (like short selling, leverage and derivatives) more extensively in efforts to generate greater returns. They are generally only available to investors that meet minimum income and net worth requirements and are regulated less than mutual funds.
- What is short selling?
Short selling is an investment strategy designed to create positive returns when a stock price goes down. If an investor believes the stock price will fall, she can borrow the stock and sell it. She then buys the stock back later (when the price has fallen) to return to the lender, earning the spread. If the stock price goes up, the investor would lose money, having to buy shares at a higher price than what she sold at.
- Why are individual investors buying the shares en masse?
After their analysis of GameStop’s prospects, hedge funds like Melvin Capital Management decided to short sell the stock. As this was a widespread position among hedge funds, a flash mob of individual investors (synchronized via social media platform Reddit) took the opposite position, piling into the stock.
Rationale to buy the stock spans from “sticking it to the man,” to ignorance, to get rich quick, to pure entertainment. Unfortunately, the economic fundamentals and business merits of GameStop are likely not being considered at all. As popularity of the Reddit thread r/wallstreetbets continues to grow, so too does the number of people buying and holding the stock, driving up its price further.
- Why is this a big deal?
U.S. Senator Elizabeth Warren’ s letter to the U.S. Securities and Exchange Commission (SEC) perhaps best outlines the issues. Firstly, this type of activity prevents the proper functioning of markets, in this case, the assimilation of available information about GameStop’s business to determine the appropriate price for GameStop shares. Due to the wild change in price, some have made a lot of money, while others have lost a lot.
Secondly, as we described earlier, as the price goes higher, investors engaged in short selling come under pressure – this is known as the short squeeze. This could challenge the solvency of the hedge funds (Melvin Capital lost 53%, over US$5 billion2) and may trigger a broader sell-off of other stocks to raise cash as additional capital will be required to keep the short sell position open or to settle their losses if they choose to close the position.
Lastly, market manipulation is illegal. Securities law prohibits market participants from misrepresenting a company and/or coordinating actions to artificially change its share price to profit off the movement. In this case, it’s not entirely clear who all the investors are, what all their intentions were and if Reddit served as a medium for collusion.
Taking candy from a stranger
To put it bluntly, buying GameStop shares at these elevated levels is irrational. To blindly bet that the stock price will appreciate based on Reddit discourse without the objective consideration of economic and business rationale (like earnings expectations and free cash flow) in search of short-term benefit is comparable to gambling. As such, gamble responsibly (financial hardship should not be linked with this bet if lost).
In other words, this play has no place in a prudent investment strategy.
GameStop shares will eventually come back down to a level that is reflective of reality but it’s unclear when that will happen as it depends on the temperament of r/wallstreetbets or potentially regulator intervention. I’ve seen this movie before. In reality, the blind buying behavior is reminiscent of the tech bubble in the 1990’s, the current valuations for some stocks like Tesla (which is trading at over 1600 times its earnings) and quite literally in the film Boiler Room.
Quick synopsis: The movie follows the happenings of a company that uses telemarketing (the movie is set in 1999) to create fake demand for speculative investments. After the investment value has been pumped up, the company dumps the investment for outsized profits. As the investment plummets, it’s the misled investors that are left holding the bag.
It really is hard to argue that this isn’t a bubble: r/wallstreetbets has gone viral and people are rooting for them, Google searches for most shorted stocks has seen a dramatic increase in 20213 and according to Goldman Sachs, investments into profitless companies is up nearly 400% since 2019.
Pressing pause: How this all plays out
We’ve already seen the squeeze on the hedge funds. Most have closed their positions in GameStop and are licking their wounds. We’ve seen a similar situation play out with other popular short sell targets like AMC, BlackBerry and Nokia. What is left is the eventual sell off as the individual investors start to take profits. While this will benefit the early adopters of the r/wallstreetbets “strategy,” many who blindly jumped in (for reasons of FOMO, greed, entertainment or actual altruism) afterwards may get burned as the share price normalizes.
At MD Financial Management, we are about developing an investment plan that minimizes risks while being able to achieve your financial goals. Rather than focus on the headlines and the unpredictable price fluctuations of any given stock at any given time, we rely on the time-tested strategies of goals-based financial planning, informed investment selection and diversification. More often than not, fear and greed, not missing the latest hot stock, are the greatest risks to not achieving your long-term financial objectives.
The complete picture that is our investment strategy is much larger and goes beyond a few stocks and current events. Our strategy takes into consideration a much longer time frame and many other variables – geopolitics, economics and prudent individual investment analysis just to name a few. Our portfolios will also never concentrate risk into a single investment decision as to potentially lose comparable value on a single incorrect call.
It is worth noting that the MD Strategic Opportunities Fund and the MDPIC Strategic Opportunities Pool have marginal exposures to GME, which have benefitted from the recent share price appreciation. We don’t expect this position to materially impact the performance of MD portfolios regardless of how this plays out. While we are not overly concerned, we will continue to assess the situation.
It’s also interesting to see the impact of social media. While it can create narratives that can impact the company’s share price and potentially the broader market, in this case, it did not change the actual economic fundamentals of GameStop. However, it’s not hard to imagine that social media could encourage people to actively buy videogames and related products from them, potentially improving their outlook.
Similarly, it will be intriguing to see how regulators respond to uphold the confidence in markets to do their job properly. Ironically named trading platform Robinhood (and other discount brokers) decided to restrict the purchase of GME based on mandated requirements from the SEC. As of writing, these brokers have resumed limited trading.
3 State Street Global Markets, Bubble goes viral, January 26, 2021
The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.