February 2021
Reddit users! Short-selling! Robinhood! Meme stocks! Trading halts! Stonks!!! Recent financial headlines have been nonsensical, provocative and seemingly guaranteed to stoke confusion and fear. “This is perhaps the most ludicrous thing I have witnessed in the financial markets,” I said to my friend Pauly. Having spent years on active trading desks, both of us have scores of abnormal market events seared into our memories. Ludicrous indeed, but not the most impactful, we agreed, knowing full well that recent market events pale in comparison to the likes of the 2007-09 Financial Crisis.
A Physics Lesson
Pauly, who was a physics teacher prior to joining the investment industry, went further, “Do you know the difference between temperature and heat? A thimble in your yard could be full of material at 10,000 degrees. It has an extraordinarily high temperature, but the heat it gives off is limited. Stay a few feet away from it and you will be fine. Now imagine a dump truck in your yard full of material heated to 300 degrees. The temperature is much lower, but the heat given off is much higher. Your kids cannot play in the yard and the paint is peeling off your house. The Financial Crisis was a dump truck; the GameStop saga is a thimble.”
For those who missed the GameStop Corp. (GME) drama, a handful of distressed companies experienced exponential moves higher in their stock prices, followed by extreme volatility, beginning in January 2021 – with GME as the posterchild. The company operates ~5,000 electronic game and PC entertainment software stores around the world, mostly in U.S. shopping and strip malls. Those of you with children and grandchildren may note one big weakness with this business model: When was the last time your young gamer asked you to take them to the mall to buy a game?
Back in mid-December, GME traded around $13 per share with a market capitalization of just under $1 billion. That valuation does not seem too outrageous for a company that generated $7.3b in revenue and free cash flow of $150mm in the previous year. The trajectory, though, was suboptimal, to say the least. Five years ago, revenue was 29% higher and free cash flow was 223% higher, while the company had $330mm less debt. Not surprisingly, GME shareholders had lost 41% in the five years ending 12/15/2020.1
Then came January and an exponential rise in GME stock. GME was a highly-shorted stock (meaning many investors were betting on further declines in the stock price), but some investors identified it as a possible turnaround story. There was new management, a highly anticipated release of the latest Xbox and PlayStation gaming systems and hope that the company’s fortunes could improve. Highly shorted stocks can sometimes experience a “short-squeeze,” which occurs when a stock jumps, thereby forcing those who are short to close their position by buying shares, which adds upward pressure on the stock. That is exactly what happened in the case of GME.
I will pause at this point of the story and say that nothing novel has yet occurred. Turnaround stories and short-squeezes happen all the time; however, this is where the GME saga takes an interesting turn.
Betting Against the Establishment
Many of those who were buying the stock were individual investors, some of whom spent time in various online chats on websites like Reddit and decided collectively to make the stock a weapon against the “establishment.” After learning that many of those who were short the stock were hedge funds and big institutions, many GME proponents cheered online and touted two major benefits of buying the stock: 1) you can make money, because it is going higher (of course, right?); and 2) you can cause those who have “rigged” the market against you for years to lose lots of money. Thousands of individual investors bought stock (or options to do so) in a frenzy to support the cause. A few famous billionaires even got involved and tweeted their support (Elon Musk, Chamath Palihapitiya). My teenagers asked me if Hamilton Point owned GME, resulting in a lengthy dinner conversation. This once inconsequential company, thought to be in a decaying business, dominated financial news for weeks (along with AMC Theatres, Express Inc. and Dillard’s) as the share price ripped from $15 to $500 per share, giving the company a market capitalization of $25 billion (on par with companies such as Clorox and Kroger). GME had morphed from a stock into a social cause.
This brings me back to my original claim about how crazy this all seemed. The internet bubble had countless companies with outrageous valuation metrics but, then again, the internet was new, so perhaps Pets.com, with less than $1mm in revenue, would revolutionize the pet care market. Likewise, the depths of the Financial Crisis saw the opposite when even high quality assets, including some of the safest bonds in the world, were on a clearance sale. Then again, seemingly indestructible investment banks like Lehman Brothers and Bear Sterns had failed, and the collapse of the financial system made anything possible. GameStop lacked the same mystery. We know what the company looked like in a booming economy (it shrank) and we know what it looks like in a pandemic (it shrinks faster). A business reinvention is possible, but it’s far more likely that GME is a melting ice cube, on par with RadioShack or Blockbuster Video, not Kroger.
The Reddit Revolution is Not Upon Us
Nevertheless, we have been asked, “Are our stocks at risk of this extreme volatility?” and “Can these Reddit users sink the markets?” We would answer, “Not likely,” to each of those questions. For Hamilton Point portfolios, our quality-focused criteria generally steer us clear of holding the companies that short-sellers most often target — those with 1) deteriorating businesses, 2) excessive debt and/or 3) obscene valuations. If our forecast is wrong and we do end up owning a stock that begins trading at obscene valuations, we will happily part with our shares and move on to the next one (as we suspect the billionaires in the GME saga did).
Further, we would argue that the frequency of these “culture war” situations is likely to decline over time due to a drop in the number of willing buyers and sellers. On the buy side, much of the Reddit crowd has lost substantial sums on these trades. Will they continue to lose money for their cause (and will brokerage firms continue to extend margin for them to do so)? Hedge funds also haven’t enjoyed getting caught short in these smaller, less liquid companies experiencing irrational stock moves. There are plenty of drawbacks to hedge funds, but being dim-witted and slow-moving are not two of them. They will adjust their models and avoid the majority of Reddit-fueled short squeezes in the future. I would compare the situation to individuals learning to count cards in Vegas. You may have noticed that the casinos survived and are still doing fine.
You may wonder if online chat communities could try to take a share price down, instead of trying to push one up as they did with GME. That is possible, but the dynamics are much different and the result would not be nearly as impactful – which is probably why you have not yet seen shares in a defense contractor, oil producer or some other company perceived as “evil” come under siege by chatroom investors.
While it is good theater with sound and fury aplenty, these events of early 2021 have signified little. If anything, the saga only reinforces our view that spending time on stock research to “follow the cash” is still the way to go. In the meantime, we would argue to avoid any white-hot thimbles that you may come across – even if your neighbor tries to tell you that they will make you rich. We will keep our eyes out for those worrisome dump trucks that tend to come around every once in a while.
1) Source: Bloomberg