Posted on 3/2/2021
If you’ve picked up a paper, tuned into the news or browsed social media over the past couple weeks, chances are you’ve heard at least something about the astronomical rise in the share price of American video game retailer GameStop.
The recent short squeeze on GameStop, led by popular online forum Reddit, has brought the concept of short selling to global attention, and sent shockwaves across Wall Street that have even been felt here in Australia. While this story has raised important questions about market manipulation, it once again highlights the importance of adequately insulating your portfolio against volatility.
With more than 5,500 retail outlets, including owning EB Games here in Australia and its own magazine, GameInformer, GameStop is the largest company of its kind in the world. Despite this, changing market conditions, led by an increase in online video game retailing and digital downloads, have heavily impacted its bottom line.
Over the past five years, the company has closed hundreds of stores and experienced significant financial impacts, culminating in a US$673 million loss in 2019. Until late January of this year, the price of GameStop shares had been declining steadily over the past five years, from around US$30 per share to US$17 per share.
Despite these challenges, there were those out there who still believed GameStop was a fundamentally sound business and an undervalued share.
Reddit is a popular online news and discussion forum. In mid-2019, a user going under the moniker (excuse the language) Deep F*$#ing Value started posting on Reddit’s ‘Wall Street Bets’ forum, sharing his thoughts on GameStop and updating other users each month on his own investment position in the then struggling stock. DFV believed GameStop was under-appreciated and could transform from a battling bricks and mortar video games retailer into an online powerhouse. While he was initially ridiculed for his investment in what many viewed as a dying business, other Reddit readers slowly began to buy into his belief, and things began to change in late 2020.
In September last year, the founder of Chewy.com – a successful online pet supplies retailer – took a nearly 10% stake in GameStop, obtained some board positions and outlined a plan to turn the company into an Amazon rival. So, suddenly it looked like DFV’s theory was coming true.
Another key point DFV made in defense of GameStop was that hedge funds were far too ‘short’ on GameStop – i.e., they bet far too heavily that the company would continue to do poorly. Indeed, GameStop was shorted to about 140% of its market value.
Essentially, an investor borrows a stock, sells the stock, and then buys the stock back to return it to the lender. Short sellers are betting that the stock they sell will drop in price so when they buy it back to return it to the lender they do so at a lower price. However, if they’re wrong, they would need to buy the underlying stock at a higher price than what they sold it for, so it can be returned to the lender. This is called a short squeeze.
It is also important to note that the shorting of a stock can exceed its total market capitalisation, as occurred in the case of GameStop. This occurs because borrowed shares can be lent to other investors, meaning the same shares ending up getting borrowed and sold twice.
This process is exactly what happened with GameStop shares listed on the US stock market. The hedge funds that shorted it had to cover their positions, resulting in significant demand for the stock, forcing buying and driving the share price higher. It worked so effectively that there has been a ripple effect across US markets. Shares in American cinema chain AMC Theaters have also skyrocketed recently, and many other stocks shorted by hedge funds have risen in value this year.
Perhaps of more importance to investors is that, apart from these stock prices being squeezed up, hedge funds were reluctantly forced to sell some of their long positions in order to cover their shorts. For example, a fund holding Apple shares on the rise may be forced to sell some to have enough cash to cover its short positions on GameStop.
This activity caught the attention of markets and the media alike, and not just because of the rapid rise in the stock price of what many had viewed as a dying business but also because of the internet campaign behind it.
It represented perhaps the first instance of a semi organised group of retail investors pooling their resources to ‘take on’ billion-dollar hedge funds.
This experience is likely to be discussed for some time. Is it collusion, market manipulation, or just the new digital world we live in?
Pardon the pun, but the short answer is nothing. However, what this experience does show is how multi-layered, sophisticated instruments of our modern financial world can quickly cause bubbles, market dislocations, and potentially significant damage.
Another relevant example of forced buying is Exchange Traded Index Funds. Funds that track a particular index are forced, by their mandate, to buy more and more shares in companies as they rise within the index. Here in Australia, Afterpay is a good example, as is Tesla in the US. Both made their way into large indices (ASX 200 and S&P 500, respectively), causing Index Funds that track those benchmarks to buy those stocks. As they do, the price of each stock rises in a cycle causing progressively more buying as they become even larger parts of the index. Both are popular companies, but such price rises are not always due to sound fundamental analysis.
As always, diversification is a key protection against such bubbles, just as it is important to focus on underlying value and company fundamentals. Though DFV started this GameStop saga over a year ago on the basis of company value, current euphoria misses that point and valuation no longer seems to matter. Of course, we all know that in the end it will.
Value and fundamentals analysis are a critical part of the Perks investment process. While we may miss some spectacular rises in share prices like that of GameStop, we focus on preserving your capital for enduring portfolio and income aligned to your long-term financial goals.