With apologies to Mel Brooks, I wanted to talk a bit about the big news of the week as regards the Reddit group WallStreetBets. As an aside – isn’t it nice that the big news isn’t what the president tweeted about now? At any rate, for those that have not heard or are reading this sometime in the future and need a refresher, the stock for the company GameStop went from $97 at the start of the week to a whopping $328 by the end of the week (at one point getting as high as $497). Since Jan 1st of 2021, the stock is up 1,784.06%! To put that in perspective, if you had invested roughly $10,000 in $GME at the start of 2021 and sold it this past Friday, you would have roughly $192,000 now.
So – what amazing thing did GameStop do to drive the stock up faster than Tesla, Apple, or any other of the big tech stocks? Did they magically find a way to get a PlayStation 5 to everyone that wants one (and if so, can we tackle them with the Covid-19 vaccine distribution next, a slightly more realistic goal)? Well, no – nothing of the sort. Their stock did surge late in 2020 based on some investment goals, which I’ll talk about shortly, but it remains dubious if they can pull them off. Instead, it was driven up primarily by a group on Reddit called WallStreetBets, a group dedicated to making some profit for themselves while they also “sticking it” to hedge funds. In this case, they were encouraging people to buy heavily into stocks that were being “shorted” by hedge firms, stocks like GameStop, AMC, etc.
How does a short exactly work in the stock market? Well, other than the idea that you are betting against a stock gaining in value, I’ve always been a bit fuzzy on the mechanics of short selling, so I did a bit of research (maybe you are more savvy than I am on these things). Basically it goes something like this – a brokerage firm can decide to “lend” out some number of stocks (either from its own margin accounts or another brokerage firm) to an investor (who becomes the borrower) for a specified amount of time. The stock is then sold, and the money deposited into the short seller’s brokerage account. During the time the stock is “on loan”, the borrower agrees to pay some amount of interest on the stock.
As the short seller, the goal is to find the opportune time to “rebuy” the stock during the time period allotted, preferably at a much lower price. The potential upswing in profits, then, is the difference between the price you borrowed it at vs. the price you repurchased the stock at, minus any commissions and interest. So, say for example, you borrow 100 shares of Tesla at $600 each, for a total price of $60,000 for a period of six months. If, during the time, the stock price then dips to $500, you can close out the position. By buying 100 shares at $100 less than you borrowed it at, you have made $10,000 in profit minus interest and commissions paid to the brokerage.
But what happens if the stock price moves up quickly instead of down? This can create substantial risks for the short position (in theory, the risk is infinite, though in practice there are mechanisms to control this). To protect the position of the initial borrow, a short seller is required to keep a balance of 150% of the value of the original stock price at the initial time of the short. So, in the example above, in order for an investor to short Tesla for a total of $60,000, they would have already needed to put up $30,000 to cover the margin requirements.
There is a also a maintenance margin requirement to cover if the stock price continues to rise – this is typically lower than the 150% initial value, but will be at least 100% the price of the stock plus another 25% of the value of securities. If the stock price goes down, this works in the borrower’s favor, and the margin requirements decrease. If they go up, then the borrower is forced to place more money into the account to cover the margin.
The lender can also decide to close our a short position at any time with very little notice before the agreed upon time. In practice, they rarely do this since they are making some amount of money on interest and the initial principal is protected due to the margin account (and the brokerage firms are performing a service to investors, so they do not want to turn investors off from making this type of investment in the future). However, when a stock starts moving up very quickly, the brokerage firm may decide to close out the short in the fear that the resulting price hike may cause the investor to not be able to pay the amount and become insolvent.
This begs the question, is shorting a stock bad? Not always, per se. In some cases, an investor may just be taking advantage of cyclical flows in the market (for example, maybe a particular retailer has it stocks decline in the summer when sales are slow, but rises again after holiday sales). However, the investor is betting against the success of a company and/or its stock, so it is often perceived as a cynical move.
And, remember, when you borrow a stock it is immediately sold – so, if a stock is very heavily shorted, this can cause a high sell off of the stock, which has the effect of driving the price of the stock downwards since more people are selling the stock than buying. A quick decline in a stock can also cause other investors in that stock to get spooked and sell their shares as well, causing a rapid decline in the stock price. On one level, this doesn’t directly affect a company since the performance of its stock is not tied to its day to day financials operations – this is only helping/hurting the individual stock holders that owns shares in the company.
But, in the long term, this can have negative affects on the company overall. A weak stock position can make it difficult for a company to raise more capital, which often companies need to make investments in new lines of business or transforming their business with the times. It is also not uncommon for employees to own stock in a company they work for, sometimes through an employee stock purchase plan. It can be demoralizing for employees of a company, then, to see the stock for the company they work for become quickly devalued. In the worst cases, a short seller may pay “stock bashers” to publicize negative articles about a company in an attempt to further drive down the price of the company.
By the way, if you think short selling is a newer thing, remember this – short sellers were blamed for the stock market crash of 1929. In fact, the concept of short selling may go all the way back to the 1600’s Denmark. What may be different today is the accumulation of wealth to an increasing smaller group of people, and the rise of very sophisticated algorithms meant to analyze and manipulate the markets in favorable ways to those with the financial power to do so. And keep in mind that, if multiple different investors/hedge firms are shorting a stock, they are all competing against one another for the ideal time to repurchase. In the same way a rapid sell off drives the stock downwards, a rapid rebuy will drive the price of the stock upwards. You are often seeing an arms race of different firms for when to rebuy, and chances are if you don’t have a lot of computational power in your court, you are going to be late to the game in buying back.
So, what it the deal with Gamestop and why did this suddenly cause a fuss? Previously known as Babbages and founded in Dallas, Texas in the mid-eighties, it was purchased by Barnes & Noble Booksellers in 1999, who eventually took the company public in 2002. A couple years later, they acquired Electronics Boutique (EB), further consolidating them as the go-to store for video game consoles, peripherals, and games. However, as malls have slowly started to disappear, and the sales of games has increasingly gone digital, sales have started to decline since 2016, and in the past two years the company posted a net loss.
With Covid-19, however, there has been a surge in demand for home electronics, and this has in part helped Gamestop to recoup some of its losses (though, you may remember that they received some amount of controversy at the start of the pandemic for placing profits over the safety of its employees by trying to classify themselves as an essential business). Overall, however, the future prospects for Gamestop are not great, which in some ways led to the short selling in the first place.
But, unlike a lot of retail companies that may be suffering, there is definitely a nostalgia for a store like Gamestop where many a youth may have frequently visited – in a way that a company like J.C. Penny’s would not. The interest, then, for the WallStreetsBet group was already piqued, and this was further driven in August of last year when Ryan Cohen (co-founder of Chewy Inc), took a big stake of shares through his RC Ventures company. This began a rise in the stock price starting from last August. However, with the announcement of three new members on the Gamestop board (including Ryan Cohen) in mid January, this seems to have sparked a powder keg last week.
How did this hurt the hedge funds? Well, remember when the price of the stock goes above the price it was at the time of the short, an investor may be forced to sell it back, or put up additional funds to cover the margin requirements. And, when a large number of stocks get repurchased, this can cause the price of the stock to increase even more (a term called a “short squeeze”). By all accounts, though, it doesn’t seem like the short squeeze was a big factor in this case, so much as it was lots of folks jumping on the bandwagon, and some of them (the early adopters), probably making a very nice profit along the way. This is estimated to have lost hedge funds somewhere around 19 billion in losses (that is billions with a B), in many cases they were forced to close their shorts at a staggering loss.
One of the prominent hedge funds in the news (Melvin Capital), has already received an infusion of 2.75 billion in funds added last week by another firm. This is on top of the 8 billion in funds that Melvin is still operating. So, while this is probably embarrassing for them and will post a loss for this year, in the long run, they will most likely be fine. And while they have stated that they will be more judicious with stocks in the future, that doesn’t mean they will stop.
Does this actually save Gamestop? Well, other than giving them a boost of free publicity, it is doubtful. Yes, their stock is currently better positioned and it gives them a chance to raise more capital in the future, but that is only if the stock remains high – chances are likely that this will come crashing back down in the next few weeks (and when it does, it will most result in some rather large loses for those that bought in at the height of the craze – the type of people with thousands of dollars to loose, not billions).
For his part, Cohen wants to try and transform Gamestop and push ecommerce to greater heights. He has stated that he thinks Gamestop can sell a broader range of products online, and ship them faster – to the point where they could rival Amazon. A lofty goal – and very unlikely.
So, is what played out last week a good thing, bad thing, or merely an amusing thing? The jury is out, though it certainly makes for amusing entertainment at a time when there isn’t a lot of great news to be excited about. For my own part, I think this will play out in many ways like the Occupy Wall Street movement – something that gets people excited for a short period of time, but will not result in any long term changes. If anything, maybe it will help remind people of the inherent danger of companies gambling with billions of dollars at a time, and maybe get people to avoid the types of risks that led to the recession around the home house crash.
For those of you that have gotten in on this or are thinking about it, I’d caution you to think of this like you would a casino – only enter with as much money as you are willing to loose. While it may be fun to make some bets, chances are a lot of people are going wind up on the negative side. If this scratches an itch in a time when many of us are still stuck at home, go for it! Just avoid the shorts (it is much too cold anyways)!
I actually meant for this to be a longer post talking about my own views on what happens to companies when they go public, about the concept of 401ks as a public safety net, and my own journey and learnings with investing, but that will have to wait for another post.