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The recent fireworks in GameStop have dominated headlines the past couple of weeks. Folks are naturally curious about what happened and are asking how it will end. So, I thought you might find it interesting for me to unpack the GameStop situation, without getting too far into the weeds.
Briefly, some multibillion-dollar hedge funds (lightly regulated investment pools) built massive short positions in GameStop, betting the stock price would fall. Their fundamental belief was that GameStop is a struggling brick-and-mortar retailer of video games (it closed 1,500 stores, or 20% of its locations, over the past five years) at a time retailers are abandoning physical stores, and game consoles are migrating to “disc-less” formats.
In other words, GameStop would eventually be the next Blockbuster Video.
A virtual army of individual investors formed on Reddit’s WallStreetBets online forum and seized upon a couple of positives for GameStop. First, Michael Burry of The Big Short fame (he correctly bet on the bursting of the housing bubble that led to the global financial crisis in 2007-2008), announced he had accumulated a large long position, based on the fact that more than 100% of GameStop’s tradeable stock had been sold short (a massive sum that would eventually have to be repurchased). Second, Ryan Cohen, co-founder of pet e-commerce company Chewy, also disclosed a large long position and the company added him to its board.
This populist army of individual investors coalesced around the idea that coordinated buying of GameStop would cause the stock price to leap, a “short squeeze” would ensue, and major pain would be inflicted on the hedge funds. The group declared war on the easy-to-despise billionaire “Masters of the Universe” (picture Gordon “Greed is good” Gekko, portrayed by Michael Douglas in the 1987 movie “Wall Street”), with individuals placing tens of thousands of zero-commission buy orders on platforms like Robinhood, TD Ameritrade and E*Trade. Importantly, there were also instructions posted to WallStreetBets on how to prohibit your broker from lending your GameStop shares, further squeezing the shorts.
Mission accomplished! GameStop closed at $18.84 at year-end 2020 and traded as high as $483 on Jan. 28, giving it a market value of $33.7 billion (slightly less than Cummins Inc.). The hedge funds were forced to cover their short positions by repurchasing shares, losing tens of billions of dollars.
When you buy 1,000 shares of XYZ at $10/share, you have a “long” position. You profit if the stock price increases, and your upside is theoretically unlimited. The worst you can do is lose 100% of your investment ($10,000 if the stock goes to $0).
Conversely, you can “short sell” 1,000 shares of XYZ at $10/share. You arrange with a broker to borrow 1,000 shares, sell the shares, pay “rent” on the borrowed shares and agree to cover the short (repurchase the shares) by a future date. You also deposit 150% of the proceeds with the broker as collateral.
You profit if you can repurchase the shares at a lower price. Your upside is limited to $10K (if the stock goes to $0), but your downside is theoretically unlimited.
A “short squeeze” occurs when the stock price rises rapidly. The broker that loaned the stock will demand more collateral as the stock price rises (the dreaded “margin call”). You can either deliver the additional collateral or cover your short. Buying to cover short positions adds even more upward pressure on the stock price, leading to a melt-up in price and even more pain.
Buying stock is purchasing a piece of a business, not a ticker symbol. While stock prices can fluctuate wildly, the value of the underlying business does not. As Ben Graham (Warren Buffett’s professor) famously said, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” This means stock prices can be affected by the madness of crowds, short-squeezes and a thousand other factors. However, in the harsh light of day, stock prices reflect the cash-flow generation prospects of the underlying business (its “intrinsic value”).
Baseball philosopher Yogi Berra once said, “It’s tough to make predictions, especially about the future.” Rampant fee-less online day trading conducted by individual investors who, thanks to the pandemic, have more time than ever at home to trade with the ease of a thumb swipe might make this time feel different, but bubbles and manias have been around as long as financial markets have.
When the memes stop, the excitement fades and the GameStop mania has run its course, what will be left is the underlying business. The “flash mob” successfully drove GME to $483, but it cannot make GameStop’s business worth $33.7 billion. Once all of the shorts have been covered, whom will they sell to?
As J.P. Morgan said, “Nothing so undermines your financial judgment as the sight of your neighbor getting rich.”•
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Kim is Kirr Marbach & Co.’s chief operating officer and chief compliance officer. He can be reached at 812-376-9444 or mickey@kirrmar.com.
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