The recent move in GameStop’s (NYSE: GME) stock has been dizzying. The situation has dominated financial headlines and social media. Here, we will try to put it all into perspective. This is not the full story as it is still playing out, but is our assessment based on our observations and several information sources. Some of the links to other articles may be inaccessible without a subscription. *
First of all, what does GameStop do?
GameStop is a retail company that owns thousands of stores which sell new and used video games and related accessories.
Isn’t that a good thing? Don’t people spend a lot of time playing video games?
Yes, video games are very popular. But GameStop’s business model is geared towards customers buying physical discs for game consoles. Additionally, a significant portion of their business is second-hand games, where customers buy, then trade-in for another one. Those with a negative outlook on the business believe downloading games will take market share away from buying discs in stores. Thus, GameStop will suffer from both the loss of the new game sale, plus from the trade-up. Competition from other retailers (online and in-store) also pose a risk.
Wall Street analysts that cover the company have an average price target of $13.44. The high is $33.00. According to S&P Global Capital IQ, of the nine analysts with a stock recommendation, four rate the company a ‘Hold’, three rate it ‘Underperform’, and two rate it ‘Sell’. Basically, sentiment from the “pros” is poor.
So, what exactly happened to the stock?
As of the close on January 29th, the stock had a one-year return of 6,436% (S&P 500 Index +16%; Russell 2000 Index +20%). The stock began 2020 around $6.00 a share, dropped to a low of $2.80, but then finished the year at $18.84. That in itself was an impressive 210% price gain. In January, the stock grew 1,625%. This all happened with very little (if any) fundamental change in the business.
Why did the price rise so much, and so fast, if nobody likes the business?
This is where the story gets interesting. Many large institutional investors (hedge funds)[i] expected the business to deteriorate and the current stock price (at whatever level it was at the time) was too high. To financially benefit from this belief, investors sold the stock short. Basically, they sold shares of GameStop, which they did not own, in anticipation of the price declining. Selling short is betting the stock price will decline, not go up. They expect to then buy the shares back at a lower price (see Appendix for more detailed explanation on stock shorting). Instead of “buying low and selling high”, they expected to “sell high, then buy low”.
The negative sentiment on GME stock became so widespread that the “short interest” (again, see Appendix) actually exceeded 100%. Essentially, more shares were sold short than there available for public trading. Shorting stocks is perfectly normal and has led some astute investors to uncover fraud and accounting irregularities at other companies. It also acts as a balance in a market that has a positive upward bias.
How does the stock go up if everyone is betting against it?
To continue, the very high short interest is the setup. A mix of several trends converged to create what is called a “short squeeze”. A short squeeze occurs when investors that have shorted the stock have to quickly buy the shares at increasing prices to avoid losses. This causes the stock to rise even more causing other short sellers to cover their positions.
According to the architect of the Reddit/GameStop trade, sticking it to hedge funds was not the original motive. He held the belief the share price was too depressed and not reflective of a potential turnaround in the business. His Redditt username DeepF-ingValue is an indication of finding value where others believe there is none. There was a belief that a short squeeze could ensue, but he did not envision the dynamic currently unfolding. After building his position and posting screen shots of large gains and losses, and through his YouTube channel, his online following grew. Eventually though, the foxes took over the henhouse as users became intensely focused on creating enough demand to send the share price “to the moon”. They rallied behind him with the not-so-secret additional motive to inflict financial damage on “evil” short-sellers. They used their own lingo to describe how dedicated they were to this trade. Users described themselves as having “diamond hands” (holding the stock despite all risks and volatility) in search of their “tendies” (slang for chicken fingers, the term has evolved into describing large financial gains). Several other trends converged to help create this dynamic:
Zero/low-commission trades, pioneered by Robinhood, a popular online/mobile investing tool whose retail customer base is often characterized as having minimal investing experience.
Social media. The plan was promulgated through an online forum on the website Reddit.
A general dislike (to put it mildly) and moral opposition to large Wall Street banks stemming from the financial crisis, due-in-part to the belief they were responsible for it. Many 20-to-30 somethings were coming of age and into the workforce during the 2008-2009 recession.
Cheap, real-time, availability of information to the masses.
COVID-19: a) Kids home from school all day; b. No sports (i.e., no gambling)
6. Options-buying and leverage
7. Human behavior, including other influential social media/business leaders cheering on the retail investors.
In short (pun intended), a group of retail investors identified GME has an opportunity to make money by creating a short squeeze whereby they create demand through buying shares and/or call options. With some or all the factors above in play, they were able to pull off a short squeeze.
So, you are saying a group of “unsophisticated” retail investors hanging out at home, posting crude comments online, presumably with little financial capital, were able to cause pain for large hedge funds?
Well, yes and no. Yes, the stock rose to meteoric levels, hurting those who were short. Painful as it was, they have either received fresh capital and/or exited their positions and moved on. Furthermore, it is not a systemic risk to financial markets and there are large institutional investors and hedge funds who have gained by owning the stock.
Characterizing the entire group as unsophisticated is inaccurate. Some that have been profiled are college educated and have financial industry experience. They are not dart-throwing monkeys. That said, they have been emboldened by the notion that Wall Street “elites” look down on them. Like an underdog, they have coalesced around the outsider mentality to use it against those not giving them enough credit.
Judging by the increase in volume (number of shares traded) It is also likely that many other investors – including large ones – participated, in addition to the Reddit users.
Is this legal?
On the surface it sounds shady, especially considering some of the commentary on WallStreetBets viciously attacking certain investors. However, there also does not seem to be any outright illegal activity. Emotional behavior and malicious motives aside, there has not been any obvious fraud or misstatements. Ultimately though, it is up to market regulators. The Securities and Exchange Commission issued this statement.
How does this impact me/my portfolio?
We currently do not own GameStop in any client portfolios. Our models are influenced by sell-side analysts’ financial estimates and as mentioned above, they have a very negative outlook. If their expectations improve, our models may ascribe a ranking that could warrant us to purchase it.
GameStop is a member of the small company Russell 2000 Index. At the beginning of this year, GME had a 0.0435% weight in the index based on a $1.3 billion market cap. At the end of January, it is market cap was over $22.0 billion and had a 0.716% weight in the index (2nd largest in the index). This means GME stock moves have a larger influence on the overall index than it previously did. Extreme moves can have a noticeable impact. For our small cap strategy, on days the stock experienced very large gains, it detracted from our performance since we did not own it. Conversely, on days it dropped significantly, it contributed positively to our performance.
Hopefully, this simple narrative will help answer some questions regarding this situation. Please fee free to contact us if you have any additional questions about GameStop or any aspects of your portfolio.
Jackson Creek Investment Advisors
* Disclaimer: We do not have an opinion on GameStop’s business, nor what the stock’s value should be. The stock is a constituent in the Russell 2000 small company index. We do not currently own shares, options, or have any economic interest in the security. Our investment process is quantitatively driven, and we may own the stock in the future if it becomes highly ranked in our models. Nothing in this post should be construed as investment advice.
[i] Not all institutional investment firms are hedge funds. Hedge funds come in various shapes and sizes themselves and are generally defined by having a limited number of clients with a minimum threshold of investable wealth. Institutional investment companies are difficult to define broadly, but often do ultimately include the interests of smaller investors – think 401(k) sponsors, mutual funds that individuals own, pensions, etc.…
“Short sale”, “Shorting a stock” – this is a trading strategy that seeks to profit from the expectation that a stock you do not own will decline in the future. It takes the traditional mantra of “buy low and sell high” and reverses the order of the transactions.
For example, ZZZ stock is trading for $100 and you think it is going to decline. You can sell it short at $100 (this creates a short position). If you are correct and stock falls to $50, you would then buy it at $50 to close the position. You profit from the difference. In this instance, the cash was received up front (sell for $100) and the net profit was realized when the stock was purchased (bought for $50). Receive $100 from short sale minus $50 purchase = $50 gain per share.
To “sell short”, the trader must borrow the shares from another investor. In practice, this is handled by a broker. The short seller will pay a fee to the owner that lent the shares. When the short seller buys back the shares, they are then “given back” to the original owner.
Short selling is not inherently bad nor evil and is part of an efficient market. Short selling does have excessive risk, compared to traditional buy-and-hold investing. When a stock is bought, the maximum loss is capped at the price paid (if the stock went to $0). For a short seller, losses are theoretically unlimited. Continuing the example, if the investor above shorted ZZZ at $100, but the stock subsequently rose to $500, they would have a $400 loss on the gross proceeds of the $100 short sale. At this point, the broker would demand the investor post margin (cash to cover the loss), liquidate other positions, or buy the stock to close the trade at a loss.
This last one is how a short squeeze occurs. As investors “cover their shorts” by buying the stock, it increases demand, thus drives the price up. This creates pressure on other investors that are short who then are forced to cover, and so on.
“Short interest” is the percentage of the available shares that have been sold short. If there are 1,000,000 shares outstanding for ZZZ and 500,000 were sold short, the short interest is 50%.
How can the short interest exceed the total number of available shares?
I own 10 shares of ZZZ and lend them to ShortSeller A. ShortSeller A sells them to Buyer1. Buyer1 can then lend the same 10 shares to ShortSeller B. ShortSeller B sells them to Buyer2. Starting with my original 10 shares, there are now 20 shares sold short, plus the 10 Buyer2 “owns”. There are also instances where brokers can allow a customer to sell short without obtaining any borrowed shares. This is known as a “naked” short.