Categories
Market Trends

A Dangerous Game(Stop)

As of the time of writing, the current valuation of GameStop stands at 8.94bn USD with a closing price on January 28th of $193.60 per common unit — this is after a one-day drop of 44%. It truly is a sign of the times when in a short few days we see a horde of frenzied retail investors suing online brokers, large financial institutions incurring billions of dollars in losses, and an aging US games firm, with an outdated business model that many considered to be in a death spiral, all somehow entangled together.

Introduction

To call the unfolding drama surrounding GameStop tumultuous and chaotic would be nothing short of a massive understatement. As of the time of writing, almost all major news outlets are covering the slow-motion train wreck happening before our very eyes and sending shockwaves throughout the financial world. GameStop was briefly the biggest stock on the Russell 2000 index this Thursday morning (28/01/2021) as its share price surged, peaking at a price 900% of what it was at the beginning of this year, before crashing and breaking a meteoric six-day rise. Fueled by a volatile mix of retail investing spurred on by an online investing community on popular social media site Reddit and outsized short positions by large institutional investors, GameStop shares saw a volume of up to 55 million by Thursday afternoon. To top it all off, online brokers clamped down on retail activity by placing a ban on the trading of GameStop shares amongst others.

It has been dubbed a financial revolution of our time, a product of the irrational exuberance of inexperienced investors, and even labelled as an uprising against the financial elite — but whatever we may come to call it, there is no doubt that we are witnessing a momentous shifting of the scales.

The long and the short of it

It begs the question, how does an aging brick-and-mortar games retailer whose share price has been on a steady decline the past few years see its stock shoot up from $4 a share a few months ago to a peak of $450? The answer is two-fold; GameStop saw a management overhaul as Ryan Cohen, founder of online pet store Chewy, was appointed as its new head. With a track record of success and no shortage of new ideas, investors reacted positively to this news. While that was happening, some online users on social media site Reddit, particularly the now infamous forum r/WallStreetBets which has gained nearly two million new users since the start of the week, noticed that several hedge funds had large short positions against the stock. On top of that, at one point in time the total volume of shares shorted exceeded 100%, resulting in what is referred to as a “naked short” in financial lingo, and astute observers noted that the stock was primed for a “short squeeze”. Confused? You’re not alone, data from Google trends shows the amount of interest in those terms have gone through the roof since news first broke.

Short-selling is a financial practice in which the short-seller borrows shares of a company off its broker before selling them off, with the aim of turning a profit by purchasing the shares back in the future when the price has fallen. This is often done in the belief that the share price will fall in the future and may sometimes prove to be a self-fulfilling prophecy, which is an ethical dilemma in and of itself. While there is lots to be made, the potential downside to the short-seller is unlimited if the price continues to rise against their predictions.

In the case of large institutional investors, the pattern was clear in the case of GameStop and it was assumed to be a safe bet with its downward trajectory and gloomy future in the post-Covid world. Thus when interest in the stock took hold on Reddit with retail investors piling into it as word spread, the price unexpectedly shot up leading to short sellers having to cover their position at a loss. To explain, short covering is when an investor buys back the borrowed shares or securities to close out an open short position, and can sometimes be forced when sellers are subject to margin calls which is what usually happens in a short squeeze. It acts as a feedback loop, with short-sellers buying back their stock and causing the price to rise even further before triggering even more margin calls which then further tighten the short squeeze. With short interest exceeding the total available float of the share, meaning that short sellers had basically sold GameStop shares without borrowing it in the first place, the situation remains highly volatile as large hedge funds such as Citron Research and Melvin Capital closing their positions at a massive loss.

This short squeeze is one of the leading factors contributing to GameStop’s meteoric rise and what many fresh-faced retail investors are betting on. History has set a precedent for such price movements before, with Volkswagen (OTCPK:VWAGY) briefly becoming the most valuable company in the world back in 2008 after a similar short squeeze. One thing that remains clear is that the share price of GME will remain extremely volatile over the coming days, especially in light of growing interest from online brokers, politicians, and regulators alike.

Coming back down to earth

A common school of thought tells us that all financial assets trade at the present value of its discounted future cash flows with the exception of highly unusual external circumstances similar to the one we find ourselves in. Whilst in today’s stock market, fundamentals seem to be overlooked more often than not, it is worth noting that GameStop is no longer trading on its business model and any expected cash flows in the future. It’s numbers don’t paint a pretty picture. Profits from continuing operations declined steadily from $379.2m in 2015 to -$464.4m in 2019, with operating cash flow dropping from $384.5m in 2018 to $96.3m in 2019. The most optimistic valuation models accounting for a turnaround in its business models, high growth, and a booming video game industry still place the fair value of its share price orders of magnitude below where it currently stands. As certain as the short squeeze will push the price higher, once shorts start to cover, GME prices will come crashing down to earth in an equally spectacular manner leaving many of those retail investors “holding the bag”. 

Yet of all the many pictures painted of the large following GameStop has now accrued on Reddit, from a delirious mob of feverish rookies hoping to make a quick buck to a coordinated group of individuals making a targeted attack on financial institutions, this is a watershed moment for the future of retail investing. Almost anyone can have access to margin nowadays, and individual investors are estimated to own more than a fifth of the US equities market, with the number set to rise with the widespread proliferation of cheap, app-based trading platforms such as Robinhood. Alongside the allure of easy money, there is a strong undertone of resentment and distrust of the established financial system with its opaque inner workings and ruthless quest for profits. Growing inequality and an ever-widening wealth gap have further exacerbated the tensions between a disappearing middle class and the upper echelons of society who have seen their fortunes soar despite the ongoing pandemic. As a result, some have come to view this unique opportunity as a way to get back at the establishment and retaliate against unjust treatment. Such is the sentiment on the NSFW online forums which are playing an increasing role in the minds of investors.

This has already caused some people to take a step back and reevaluate their approach to investing, taking into account a new kind of risk, one driven by the madness, or rather, wisdom of crowds. “This phenomenon of retail investors jumping on a bandwagon to dominate trading activity is a new kind of portfolio risk,” said Jay Raffaldini, global head of sales and distribution at UBS O’Connor. “It’s going to cause a lot of hedge funds to rethink how they approach their long and short investment strategies.”

All eyes will be on GME, and by extension how the financial sector reacts to this. Whether it comes in the form of increased regulatory oversight for short-sellers or a tightening of restrictions on retail trading, what we have seen here only drives home the unpredictable nature of the stock market, the mercurial players behind it, and the formidable force of the average joe when given unfettered access to information and a trading platform.

Sources

https://www.bloomberg.com/news/articles/2021-01-28/gamestop-resumes-rally-after-reddit-forum-s-brief-outage?srnd=premium-europe

https://www.bloomberg.com/news/articles/2021-01-28/robinhood-customers-sue-over-removal-of-gamestop

https://www.ft.com/content/17450cc8-506d-4c3c-928c-628f5f92efa8

https://www.ft.com/content/56658052-76fe-4910-8cb7-810039753f7c

https://www.bloomberg.com/news/articles/2021-01-27/what-s-the-23-billion-gamestop-really-worth-maybe-2-billion#:~:text=With%20GameStop%20Corp.%20soaring%20once,and%20more%20than%20Kellogg%20Co.

https://finviz.com/quote.ashx?t=GME

https://www.forbes.com/sites/joanverdon/2021/01/11/can-ryan-cohen-work-his-chewy-magic-at-gamestop-heres-a-possible-game-plan/

https://www.bbc.co.uk/news/business-55837519

https://www.bloomberg.com/news/articles/2021-01-27/bros-on-reddit-bludgeon-melvin-capital-in-warning-to-wall-street

One reply on “A Dangerous Game(Stop)”

Leave a Reply

Your email address will not be published. Required fields are marked *