Beyond The Headlines
Can we learn anything from GameStop?
In the last few weeks, everyone’s attention has been captured by unusual price action in a particular stock – GameStop. It rose many times over, and a few more times on top of it. It’s gone up about 20x in a matter of weeks, and most of it in days. The media gave small retail investors credit for this eye-popping price move, and it came at the expense of a small group of prominent hedge fund investors who were on the other side of that trade. At first, it may seem that we are looking at a biblical moment of David’s victory over Goliath – but is it really so?
What happened with GameStop? We don’t usually comment on individual investments unless they are curious case studies that we feel compelled to share, and we think we can all learn from them. Let me try to cut through all the noise and fuss, and explain GameStop’s debacle.
GameStop is a video game retailer that was flirting with bankruptcy. They sell games through over 5,000 store locations. With consumers shifting away from physical towards downloaded video games, GameStop sales have been declining for years now. Bankruptcy is a legal process through which a company seeks relief of some or all of its debt to the creditors at a time when it can’t repay it. GameStop has struggled for a while, not being able to earn a profit, while the debt burden left them with few options. It wasn’t the first, and it won’t be the last company to find itself in this predicament. Usually, it’s a combination of a shrinking business with fixed costs, which leads to falling profits that turn into growing losses. The cash gets depleted, and often enough, a company on this path has substantial debt accumulated earlier, which eventually leads them into bankruptcy. In the last few years, and especially in 2020, we have seen many retailers go bankrupt, and GameStop was on a similar trajectory. In a bankruptcy, the shareholders, the equity investors lose it all and get completely wiped out in the process.
This creates a peculiar opportunity, though. As a shareholder, you own a small piece of business, and you potentially participate in its success. As a short-seller, you can benefit from the stock’s demise. Any investor aims to buy low and sell high. The shareholder does it in this particular order. The short-seller does the latter — first, and the former — second – he or she sells high and buys back low. A short-seller borrows shares, sells them with the hope of buying them at a much lower price later, and returning them to the lender.
I personally, and we as a firm have never done short-selling. We don’t like the risk/reward offered by this kind of trade. In simple terms, when you sell a stock short, your hypothetical upside maxes out at 100%, while your potential loss is unlimited. Imagine anyone shorting GameStop at $20 and covering his or her short position at $400; that’s a loss that amounts to 20x the initial invested capital. If it was a coin toss with a $1 bet that pays you a double or you lose $20, would you play? Usually, short-sellers do their work and research a company inside out, finding out every detail that could lower the odds of a 20x loss.
If the risk/reward wasn’t enough, from experience, we know that it’s intellectually and emotionally difficult to argue that there will be absolutely no good news ahead that could turn the fate around for an almost bankrupt company. We enjoy owning companies because they continue to surprise on the upside with new products, new markets, new ways of growing the business or doing business. The repertoire of good things that can happen is usually broader than a list of bad things that can truly tank the stock and bring it down to zero. We try to be rational optimists. There is no one size fit all, but for our clients and us, we don’t like the odds of short-selling; it’s one of many things we choose not to do.
What happened to GameStop is not unprecedented. It was a heavily shorted stock, which means many shares were borrowed and sold in anticipation of a price drop. Short-sellers don’t make a company go bankrupt; it’s lack of customers, the lack of demand for its products or service, or in other words — the shrinking, failing business that makes companies go bankrupt.
What followed wasn’t that unusual either. It’s referred to as short-squeeze. When something suddenly moves the stock up, the short-sellers quickly face an ever-growing loss. They sold the stock at $20, but now they have to buy it back at $40, $100, $200, $400, etc. To cut their losses, they tend to buy back the stock and return it to the lender. They close out the position. What happens, though, is that they create additional demand for the stock. The more shares were sold short earlier; the more has to be bought back to limit the losses. This will make the price go higher and move faster. It doesn’t mean it will stay high forever or even for long. It is no reflection on the failing business either. If the business was bad before, it remains bad no matter what happened to the price.
GameStop was doubling in price every few days recently, forcing short-sellers to act quickly. Who was on the two opposite sides of this intriguing price action? We had the buyers and the short-sellers. The buyers were apparently small retail investors who decided to jump in. The short-sellers were big hedge funds with billions on the line. There was probably more than one reason why buyers chased shares of an almost bankrupt company. Maybe some of them even genuinely hoped for a miraculous turnaround. Part of it was attributed to a coordinated effort from Reddit forum users. This was followed by Elon Musk’s tweet, and the stock was soon on fire. The more it rose, the more demand there was for the shares. Speculators were no longer interested in just the stock. They also bought derivatives, call options, which can potentially offer an even bigger upside if the stock price continues to go up.
Eventually, the trading in the stock was briefly halted on the stock exchange, and some retail brokers restricted trading in it. The whole debacle invited a big reaction from all directions, including the world of politics, with some congress members chiming in.
All noise and fuss aside — I still believe in the distinction between price and value. Without it the stock market becomes just a casino where pieces of paper trade with no regard for the businesses behind them. The value is what you get, and the price is what you pay. If a business is failing and short of a miracle it’s worth zero, the price will eventually be also zero. It doesn’t really matter if the price runs up 2x or 20x in between, and it doesn’t matter if it happens due to a sudden and potentially short-lived optimism around the businesses or frenzied share buying. It also doesn’t matter if the buyer is a handful of multi-billion dollar funds or tens of thousands or even millions of small investors. Again, short of a miracle, they are defying gravity here and making the price rise, while the value is what it was — likely still not far from zero.
Whether it’s a handful of big investors or millions of small ones, a coordinated effort to move a stock price (if that’s what indeed happened here) has a name, a reputation, and a long history. It’s commonly known as stock market manipulation, defined as a deliberate interference in the operation of the market. The way it happens has evolved. Participants don’t do it in person with paper receipts screaming on a floor of a stock exchange anymore; they do it with their smartphones from their couches. They don’t meet behind closed doors; they communicate in online forums. This doesn’t make it any easier to prove. WSJ recently wrote how the GameStop stock surges test the scope of the SEC’s (U.S. Securities and Exchange Commission) manipulation rules. WSJ further added that what happened resembles an all-too-familiar pump-and-dump scheme, when the stock is bought up at first to inflate the price and sold soon after to book a gain before it drops.
GameStop’s price rally suddenly became everyone’s business. The media painted a picture of David and Goliath, a small retail investor with hundreds of dollars, took on a big hedge fund honcho with deep pockets, and billions on the line. We weren’t there when David struck Goliath, but we were all here to watch this show live. I got messages and calls, and I have to confess that I almost missed the first leg of this performance until someone asked me what’s going on with GameStop? It’s not the first or the last market’s unusual behavior that might escape my attention.
With stocks, you can make money, and you can lose it. As long as you can afford what you are losing, I’d count it as tuition, the cost of an investor’s education (it’s cheaper to learn from other people’s mistakes, though). It’s a chance to learn from it and never do it again. If you are losing what you can’t afford or, worse, what you borrowed, and don’t even have, I think it’s a risk not worth taking. When the dust settles, GameStop will still be what it was earlier, an almost bankrupt company with failing fundamentals, too much debt, and growing losses. I know that miracles happen in life and business, and the management might have just earned a second chance to save the business. If some recent stock buyers truly wanted to save GameStop, their money would have been better spent actually shopping at GameStop, not bidding up its stock.
Will the stock hold the $200, $300, $400 price? We are yet to see – but there is the price, and there is the value, and the two don’t stay far apart for too long. Small investors might have taught the big hedge funds a lesson in the process, but I worry that the last bill is still due, and unfortunately, too many might be left with losses they can’t stomach.
I never owned it, I never shorted it, and I never will. I have no bone in the fight. I’m just a curious observer. It’s another case study for the books. The stock market can be a casino or a wealth-building machine. You can be a day trader or a lifelong investor. I don’t know of any lifelong day traders. They all eventually run out of money to lose. The beauty of investing is that you can have a lifetime of successful investing without ever participating in the noise of the day, and that’s what I’d recommend — if you asked.
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