Is GameStop a Game Changer?

bryan-taylor

The recent move in GameStop has raised eyebrows and set the social media world on fire.  Like most fires, once the wind begins fanning the flames, the fire spreads and others begin to take notice!  In today’s hyperconnected world, those “others” include FINRA, the SEC, stock exchanges, clearinghouses, and custodians.  Of course, we wouldn’t want to forget the media. They are more than happy to have something new to talk about, and the idea of an “old technology” company’s stock price suddenly blasting toward the stratosphere is the kind of thing your everyday journalist dreams about! 

Many wonder what is actually happening behind the scenes as it relates to GameStop, AMC, Naked Brands, and other stocks that have suddenly hit the headlines because of huge upward moves in their stock price. Given the questions we are fielding, many are also concerned about ramifications for the broader markets.  While it is certainly possible that some impact from the GameStop frenzy could bleed over into the market at large, we believe the likelihood is quite low.  Unique aspects of single stock events happen from time to time for different reasons, and they rarely act as a trigger for market disaster…one need look no further than Tesla to see this.

However, there are some unique elements to the GameStop story.  Let’s begin by explaining a few terms.  Professional stock/equity managers sometimes structure their investment vehicles in a very flexible format, allowing them to invest in many different assets through various means.  These vehicles are often referred to as “hedge funds” because the manager can “hedge” his or her risk by holding an asset “long,” anticipating that it will go up or selling an asset “short,” anticipating its decline.  For various regulatory reasons, most traditional mutual funds are prohibited from participating in some of these transactions, and consequently they are often referred to as “long only” funds.  While there are a few exceptions, for the most part “long only” mutual funds purchase stocks with the idea that they will sell them at a higher price at some point in the future.

Most of us would recognize this as capitalism at work.  We own shares in a corporation so that we benefit from the earnings that company makes as it sells its product, grows, acquires other companies, distributes dividends, etc.  However, even the best companies sometimes drop in price.  Professional money managers try to pick companies that will appreciate, but while doing the necessary research to identify winners, they may also find companies they believe will decline.  Perhaps the company is poorly managed, their products are dated, or their business model is flawed.  By obtaining this knowledge, the manager has something of value, but to profit he or she needs to have a way to profit from the stock declining. 

There are a few ways to accomplish this objective.  One of those is “selling short,” a practice in which the manager borrows the stock from various owners (e.g., custodians who are holding the stock on behalf of other investors) and then sells the stock immediately. The plan is to buy the stock back later at a lower valuation, utilizing this lower valued stock to pay off the loan.  This is a very common practice, and “short interest” across the market is widely available.  The newspaper Barron’s and other media outlets regularly report “short interest” across the market as well as the current short interest in various stocks.  For many years Tesla has been one of the most well-known shorts in the world.

Managers shorting a stock seek to profit from the failure of the business model, and are often maligned in the public press.  It seems un-American to profit from someone else’s failure!  Of course, in most cases there are investors on the other side who believe the stock will go up, and the equilibrium passes back and forth over time.  Sometimes, however, that balance gets distorted.

To understand this situation, you must understand that there are, at any given time, a limited number of shares outstanding (tradeable in the market) for a given stock.  If a large number of those shares has been borrowed and sold short and depresses the stock price, when enough buyers enter the market, the stock price will begin to rise steeply, and those who have borrowed shares will begin to feel the pressure of the stock price going against them.  Remember they borrowed the shares they sold short in a form of levered bet.  They must repurchase the shares to pay off the bet…it’s like a squeeze play in baseball or a game of chicken.  At some point either the buyers give up and the stock price falls back down and the short sellers win, or the price gets so high that the short sellers are forced to “re-purchase” the stock and cover their bet at a huge cost.

The challenge is that a stock can rise a theoretically infinite amount if there are enough dollars chasing it…while on the flip side it can only drop to zero.  So, while the buyer can only lose the money they have put in, the short seller can lose a theoretically infinite amount!  Usually, the short sellers are “informed,” and they are competing against both informed and uninformed purchasers.  However, what makes the GameStop story unique is the buyers are a bunch of retail investors who harnessed the power of social media forums to band together to force the stock price up and try to panic the shorts.  Utilizing a relatively new trading platform for small retail investors called Robinhood, they have banded together to force the price of GameStop to completely unrealistic levels, cause many shorts to cover, putting additional upward pressure on the stock’s price.  Over the last two weeks GameStop rose from $15 to $350 before falling.  Along the way Robinhood limited trading in various securities and had to raise additional capital to support the trades its army of small investors are placing.  Ultimately this story will most likely end, like other unsustainable bets on Wall Street, in tears! 

In our view there are a few key insights that may be gleaned from the drama.  First, if you don’t understand derivative securities, short selling, and leverage, you should be careful getting involved in these investment vehicles which utilize such strategies or even utilizing these strategies yourself.  Second, while individual “markets” for a single security can be distorted, regulators do have mechanisms in place (e.g. margin requirements, trading collateral, circuit breakers, etc.) to protect the entire system and the corresponding infrastructure. These systems have been helpful during the recent market events and have helped insulate the broader markets from the GameStop volatility.  Third, and perhaps most troubling, the GameStop situation highlights the power of social media.  Of course, it also highlights the power of a relatively uninformed “group” taking collective action and forcing an outcome which may or may not be desirable.  There are many psychological implications of this “social media” effect which are beyond the scope of our short summary, but we should be aware that the power to unite the “herd” can be both beneficial and dangerous.  It doesn’t take much to turn a well-ordered herd into a massive stampede, and we all know what can happen to those who are caught in the way!