GameStop: Making Sense of it All
The spectacular rise in GameStop (GME) this past week has been nothing short of eye-popping. As with most things in life, the truth is a bit more nuanced and complicated than the soundbites and media headlines would have us believe. In the end, fundamentals (profits) still ultimately determine the long-term viability of any business.
Here’s the short-short story as I described it last week to the press and our advisors:
- Hedge funds short GameStop’s stock, GME (among other thinly traded microcaps).
- Individual investors organize on Reddit and in other corners of the web to go long GME, pushing up the stock price and subsequently forcing a major “short squeeze” on hedge funds.
- Hedge funds lose $20 billion.
- Hege funds cry foul and lobby regulators to intervene to stop individual investors from targeting specific hedge funds and organizing on social media to go long specific stocks.
Now for a little more narrative. The spectacular rise in GameStop (GME) this past week has been nothing short of eye-popping. The stock began the month at around $17 per share. Last week, the stock hit an intraday high of $508 before closing out the week at $325. On Thursday of last week, GME’s trading volume eclipsed that of Apple or Tesla.
Media commentators have framed what’s happening in GME stock as a sort of David versus Goliath narrative with innocent, humble “Redditors” (day traders who congregate and communicate through Reddit, an online social media platform) seeking to level the financial playing field against the rich and powerful represented by evil, mighty hedge funds. As with most things in life, the truth is a bit more nuanced and complicated than the soundbites and headlines would have us believe.
GameStop is anything but special. The rise of GameStop’s stock is completely divorced from the company’s underlying fundamentals. It’s a brick and mortar retailer of video games. The company has fallen on hard times as video game purchases have moved online. It’s a narrative not dissimilar from that of Sears, Barnes and Noble, Bed Bath & Beyond, and many others. And the ongoing pandemic certainly hasn’t helped either. Today, GameStop is a company in dire straits. Sales are down nearly 50% since 2018 and the company hasn’t turned a profit in over two years. Earnings per share (EPS) is currently -$4.21 (that’s a negative sign in front of the dollar sign). Finally, despite what some may think, GameStop the company hasn’t benefited from the stratospheric rise in their stock in the secondary market; the company has raised no cash and continues to lose money with the passage of time.
What does it mean to “short” a stock?
Shorting is the practice of borrowing stock and selling it. It’s a means by which investors can profit from an expected decline in a company’s stock by selling it now and buying it back at a (hoped for) lower price in the future. There of course has to be someone to take the other side of the trade who presumably sees more value in buying rather than selling it. Shorting is a legitimate investment strategy employed by institutional investors that helps keep market valuations in check. In the case of GameStop, a number of hedge funds had entered into short positions against GME (the “shorts”), so much so that the total amount of shorted (borrowed) stock outstanding was greater than the total amount of shares outstanding.
Shorting and securities lending: Two sides of the same coin
Why would anyone in their right mind lend their stock to someone to sell? For a fee, of course. It’s called securities lending and it’s quite lucrative. And just because a hedge fund believes a particular stock is about to decline in price doesn’t mean they’re right or that we agree (GME is a classic example). For long-term investors, what matters is that hedge funds are willing to pay a lucrative fee for the privilege of borrowing our securities. In lending out our securities, we don’t sacrifice upside; the borrower is always on the hook for any gains in the stock plus the daily interest they pay on borrowed positions.
What are “hedge funds”?
Hedge funds are nothing more than private partnerships that pool investor capital—typically contributed by high net worth individuals and institutions—to make concentrated investments in specific strategy. Rather than Reddit, hedge funds typically solicit, organize, and pool capital from wealthy investors at investment banks, brokerages, and country clubs. While they’ve unfortunately become synonymous with all that is evil and broken on Wall Street (they’re not), there is nothing illegal or unethical about hedge funds; they’re simply private investment partnerships not all that different from mutual funds, ETFs, or even a partnership one might enter into with some friends to purchase real estate or start a business.
The strategy of shorting GME’s stock would’ve worked beautifully had the stock continued to decline. The stock fell 51% from the beginning of January 2018 until August 20201. But by late August things were looking up for the company as the economy began to rebound from COVID and new investors began pushing management to make some changes. At the same time, apparently, a number of astute investors congregating on Reddit’s Wallstreetbets chat room had noticed the sizeable amount of shorted stock outstanding (known as “short interest”) and saw an opportunity to create a “short squeeze” by going long the stock (the “longs”). A “short squeeze” is when a sharp rise in the stock forces those who bet against it to buy the stock to avoid further losses. Given GME was previously a very thinly traded stock—average daily volume prior to last week was about one-twentieth of what is today—it didn’t take much to begin moving the stock price north. Still, to meaningfully move the stock, the longs would need to corral support, and they do so in the far corners of the internet in places like Reddit’s Wallstreetbets chat room, a fact that’s leading some hedge funds to accuse the longs of market manipulation and prompting interest from regulators.
Why is this happening now?
There are a number of reasons we’re seeing this drama playout now. Low interest rates, high market valuations, the popularity of social media, and the rise of “free” online trading have all created an ecosystem where individual investors can easily congregate, communicate, and pool their resources to invest around a common theme. COVID has also contributed in its own way with large numbers of investors stuck at home. Unable or unwilling to travel to their favorite casinos, online trading has for some become an entertaining proxy.
For the moment—and only for the moment—the Redditors’ plan seems to have worked. To date, hedge funds have lost over $20 billion covering their shorts. At the moment, GME continues to hover around $300 per share. Melvin Capital, one of the largest hedge funds burned by the short squeeze in GME, lost 50% in January and had to raise additional capital; it quickly raised $2 billion from outside investors last week to shore up the fund’s losses.
But this saga ultimately won’t end well for the Redditors. While GME rocketed north on a wave of rage-fueled momentum, gravity—specifically the company’s poor fundamentals—will eventually pull it back to Earth, perhaps violently. Momentum is, after all, ephemeral. For now, it appears most hedge funds have covered their short positions in GME, which mean GME’s current momentum is likely fueled mostly by individual investors at the moment. Attempts to keep GME trading in the stratosphere will require a never-ending cadre of new, enthusiastic, and patient investors with deep pockets (the fools in the greater fool theory) to keep it there. This seems unlikely. It’s a classic game of musical chairs. Eventually, the music will stop. And when that happens, the losses will most likely be deep and painful.
Three key takeaways
What are the key takeaways for long-term investors?
- Technology continues to change how we invest (e.g., online trading, social media) and will certainly continue to do so. That’s nothing new. Reddit, “free trading”, and other developments make trading easier than ever. But regardless of new technology or the passions fueling short-term GME’s short-term momentum, we should remember that fundamentals (profits) still ultimately determine the long-term viability of any business. Despite the 2,000% rise in GME, GameStop the company continues to lose money each quarter.
- Shorting is a common activity that adds value for long only, long-term investors. We should resist populist narratives that seek to denigrate shorting as an evil, unethical activity reserved for the wealthy. This isn’t the case and, indeed, shorting is critical to ensuring liquid, healthy markets. Finally, securities lending generates additional revenues for long-term investors, adding an additional source of return to your portfolio.
- Taking highly concentrated bets (long or short) or relying on the greater fool theory to drive returns is not a prudent approach to managing long-term wealth. Investors would be wise to stick to a globally diversified, long-term portfolio grounded in fundamentals and avoid the temptation to invest in high-risk investment strategies or vehicles.
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