Updated: Mar 3
Okay so this week we are going to talk about perhaps one of the biggest stories in the United States which is about GameStop.
They have been turning the financial world upside down due to its astronomical share gains which is up about 1,134% for the year as of this recording. Some of you out there may need to assess perform the annual financial check up due to some impressive gains in this stock.
Yeah this is crazy. This is another unprecedented occurrence in the market over the last year, which kind of seems par for the course from 2020 with the Coronavirus; however, it's not that it hasn't happened before, as in stock manipulation, it's just in the way that it happened due to technology and social media.
Without a doubt there have been some people who made a lot of money as well as those who've lost a lot of money.
Who is GameStop?
Okay so let’s explain the basis of what the GameStop story is all about.
If you are not aware, GameStop is a retailer that sells video games and game consoles using the brick-and-mortar model by selling in malls and shopping centers. Over the last several months and perhaps years really, is that GameStop doesn't have a business model to support stock growth and they may not be in business down the road.
Due to technology the main culprit of GameStop's demise has to do with being able to play games digitally. According to gamerant.com 83% of games are played digitally.
Therefore, without even getting into other contributors to GameStop's failing business model, that speaks for itself.
In December of 2020 GameStop announced that they will close 1,000 stores by March 20th of 2021 and they've already closed roughly 800 stores in the past year.
So, Tara just pulled up this stat about their last earnings report and in the last quarter they lost .53 cents per share. So they aren't making money and they have a large debt load.
So that was a quick synopsis but in short GameStop's future hasn’t been looking bright and even if they sustain their business model it would not be a company that would be a darling of Wall Street to invest in.
Now that we have laid the tracks let's ask the question . . . what the hell is going on?
The Short Squeeze
To put it simply GameStop's large increase in share price has to do with what's called a short squeeze.
So to be very simple about the concept, traders place bets on the shares and namely in this case stock options.
To put it simply this type of trading in other words is a legalized form a gambing. It's all about betting which way a stock is going to perform.
When people or entities bet against a stock it's called shorting it. Shorting the stock means that shares are borrowed from a broker on margin, and the broker says I'll give you these shares, but you have to return them later, and pay me margin interest in the meantime.
This means when you short the stock or borrow the shares, you want them to go down in price. Why do you want them to go down, you ask? Because, when that happens the investor can buy the same amount of shares at a lower cost if they do; and if that happens, the investor gets to pocket the difference, meaning I sold the borrowed shares at a higher price, betting that the stock is going to go down, because I don't believe in the company’s stability.
Honestly, this is an age old strategy for more sophisticated investors, and really, there’s nothing wrong with this. It’s not illegal, but you do have to be fully prepared to deliver the shares back to the broker, because you borrowed them to sell.
Short Selling Example
The whole point of short selling is betting on, and profiting from, a drop in a security's price. This can be contrasted with long investors who want the price to go up, because they’ve bought them to hold them for growth and potential income.
Here is a loose example for simplicity. Suppose I plan in my budget to borrow 10 iPhones from Cindy that have a value of $100 each. So then that’s $1,000 in my pocket now because when I borrow them, I immediately sell them to buyers willing to pay $100 for each phone.
Now, on my hunch, I am betting that the market value of that iPhone will drop, thinking a better model might come out, and these will inevitably drop in value. So lucky me, they did go down to $80, now I can go back and buy these iPhones back for $800.00.
In this example, I would pocket $200, and I’d then deliver them back to Cindy to repay her for the iPhones I originally borrowed from her to sell at a profit. Now, that worked out great for me, because the phones did what I hoped they would do; which is lose value!
So let's do this with the stock where there is a loss to the investor that borrowed stock to sell. Let’s say Tesla currently trades at $300 a share and David borrows 20 shares from me. So at that point in time that means those shares are worth $6,000.
Knowing that the whole point is that you want the shares to go down in price, let's say that the shares shoot up to $400 in price. The shares would be valued at $8,000. So in performing the calculation, the stock is sold for $6,000 but the stock went up instead of down, and now David has to buy them for $8,000 so he can deliver them back to me, and now David is $2,000 in the hole. He has to come up with extra cash out of his pocket so he could buy the shares to give them back to me, and he has to pay me interest in the meantime.
So the reason that GameStop has had such a run-up in the stock price is that when the short sellers are losing money it is due to the fact the stock is being purchased by investors in the open market. This drives the price up, and now those short sellers need to close their position. This means they need to buy up their shares to pay them back to the lender, and this creates more buying in the open market, which then continues to increase the stock price due to the demand.
So in short, not to use a bad pun, if a short seller investor doesn't act quickly when a stock starts rising in value, their stock position just keeps getting more and more into the negative because they have to come up with big dollars to buy them back.
This is a lot of crazy information we are talking about. Nothing for the faint of heart in the investment world.
The important thing to keep in mind is that short selling is different from owning a stock. If an investor buys 10 shares of Facebook at $100 it's worth $1,000. So hypothetically if Facebook goes bankrupt and the shares are worth $0 the investor is out only $1,000.
However, when someone wants to short sell a stock and it keeps going up in price over your borrowing price, you will continue to owe additional money unless you buy it back quickly to narrow your loss. If it shoots up so quickly, as GameStop did, unless you are on the ball, you may be out a lot of money fast.
As for the trading, with GameStop, it moved at warp speed. Because of the high speed electronic trading platforms, even if you get your bid in to buy, you may be getting a buy price much higher than you anticipated.
Technically it can be a bottomless pit.
So prior to GameStop hitting astronomical prices, the people and the investing firms were just selling short as their normal course of their business and it made sense because GameStop has a dying business model and doesn't have a favorable outlook for the company. Hence, they felt that their risk was moderately low when they short sold them, meaning they felt that the market was stable.
They had no idea that what occurred on Wall Street over the last week could ever be a reality; we assume that this thought never crossed their mind and how would they?!!
Okay now let's get into the framework that allowed this to happen.
Let’s start with the easiest explanation which is that the amateurs out there drove up the price.
This goes back to what we said earlier where technology allowed for the masses to be an unsuspecting disruptor.
Over the last year the armchair traders or day traders were watching like a pack of wolves during the Coronavirus pandemic to look for an opportunity to make some money.
This certainly makes sense because we are investors and we certainly stuck to our guns investing with our dollar cost averaging and putting money in certain parts of the market and buying into names that we're down; however, we knew that they were solid companies and expected them to recover nicely at some point.
Ultimately, we stick to quality, value, solid fundamentals of the companies and their balance sheets, as we preach often on our podcast. We invest this way for a successful long-term approach which is a more conservative growth formula.
Another opinion out there had to do with the shutdown of sports as many leagues were delayed or canceled for a period of time. Hence, people needed to fulfill their gambling needs and decided to go into stocks. Another consideration is that stimulus checks went out to people which provided a small infusion of cash. Hence, they decided to use it in a way that was opposite than what the government intended to be used for, which was rolling the dice on the stock market.
So a good question is: Why GameStop?
Now this gets back to again what we said with technology more so, with the power of social media. All of this started in Reddit’s Wall Street Bets forum aka, WSB.
The people in that message board provide their analysis on trading and there's no ending to the number of posts. The buzz around GameStop actually started last year when the founder of Chewy bought a stake in the company and took a seat on its board.
Somehow; someway, the company gained the attention of WSB from traders who hang out on another social media service called Discord. The people who use Discord are gamers and the recipe was born as GameStop sells video games and consoles.
The full motivation is not necessarily known; however, one prevailing thought is that the gamers wanted to squeeze Melvin Capital which is a hedge fund that was shorting GameStop, and play wall street at their own game. Taking on Big Wall Street is also a big motivation of why Robinhood was born, which was to give the average person a venue to invest alongside the big wall street wealth.
Another one, is that people were saying that “it's not about the money, it's about sending a message,” which was taken from The Dark Knight movie. So they wanted to stick it to the man!
So the strategy makes sense in that if these investors colluded to push the stock price up, then it can damage the short sellers.
We should point out that this engineering of the system has been going on for many years and it’s not illegal, it's just that the technology and the right environment was rife to make this happen, because there is a venue that people can meet virtually to discuss it, and execute on this type of trading strategy.
In the past it's been the big Wall Street people who know when to jump on an opportunity; however, people may not have known about it in the general public per se.
How Hedge Funds and Brokers Were Affected
So when is this going to end and what is the aftermath?
For starters, Melvin Capital needed $2.75 billion in cash to make up for their losses by short-selling and closing out their short position, meaning they had to buy back the shares. Another firm, Citron Research sold out their short position at a 100% loss.
Based on traditional ways of valuing stocks, eventually GameStop will right size itself and lose much of its stock price as people start to sell off to take their profits; however, it is fair to say that we’re living in different times and the more people that get into the market, the more we may see this type of activity. We’ve been watching a lot of people making incredible amounts of money in just one day and buying those fancy new homes.
Let's Do the Recap
What is short selling? In the simplest explanation: short selling occurs when an investor borrows a security and sells it on the open market, planning to buy it back later for less money.
This type of trading with GameStop and others is not a normal practice. This is something that is not safe meaning, great you made money; now take your money and run!
If you hold on thinking the stock will go higher and stay there, you may be fooling yourself as much as thinking you are on a roll at the craps table. What this is called, is irrational exuberance, coined by our former fed chairman, Alan Greenspan, meaning there is unfounded market optimism that lacks a real foundation of fundamental valuation, but instead rests on psychological factors.
Thus, if your college kid calls to borrow money for this, deny him or her! This means, people are not buying this because it's a solid company, they are buying this because they see others making money, and the stock is irrationally going up.
The bottom line, unless you are playing with money you have to lose, enjoy the ride up, sell, and beware. Just say, it was fun, and I’ve made money to buy things, pay bills, or help people. For the long term, this is not a video game. This is real money, and it can go down as fast as it went up.
So, what do we always say? Stick to the fundamentals with companies: quality, value, healthy balance sheets with cash on hand and dividend strength. This is how you win in the long term. However, for those that made money this week and got out with profits, congrats! Especially for the F.I.R.E investors. Good for you for getting in on the game for a minute anyway!
Lastly, do your own homework, but the priority in life, should be the budget, the emergency fund, rainy day fund, retirement and risk tolerance. If you have all of this in place then great. If you have money to lose, go for it. We recommend that the people who are short selling or playing around with GameStop should be experienced and should only do this with play money providing that the personal finance goals are intact.