The recent move of GameStop’s stock price is not about investing. It is more important than that. Had it been about investing someone would have said “GameStop’s stock price is undervalued and does not accurately reflect the true worth of the business. It should be bought and held for the long term until the price rises to meet its true value.” No one said that. No one should. GameStop as a company is irrelevant. It can and likely will go away.
What made the price jump from $18 at the beginning of the year to $467 at its recent intraday peak? A movement. A social movement. And frankly one more eruption of the underlying race/gender/socioeconomic turmoil that is brewing just under the surface of our nation. Occasionally, the pressure gets too great, and a geyser bursts.
It was the unification of “small” investors trying to band together to fight a large institutional hedge fund. In their pursuit of profit, a social battle emerged. David versus Goliath. The little guy against The Man. The everyday investor versus the Wall Street establishment. In short, a group trying to come together as a collective to battle a bully by using his size against him.
More specifically, here is what happened, why it worked, and what it revealed. It started with a hedge fund called Melvin that managed $12.5 billion using a long-short strategy. That means they can invest in stocks they think will go up. (When you own something, you are said to be “long” that asset.) They could also bet that stocks they didn’t like would go down. One way to do that is too “short” a stock. This is a technique that involves borrowing shares of a stock you don’t own, selling them in the market, and then buying them back later to replace the borrowed shares, hopefully at a lower price.
Let’s say Melvin borrowed 1,000 of GameStop (ticker GME) shares from a brokerage firm when it was trading at $25 per share. They promised the brokerage they would pay those shares back at some point and agreed to pay a small rate of interest along the way. Then they would have sold those shares and pocketed $25,000. In December of last year, they could have bought 1,000 shares in the market at $18 per share, returned them to the brokerage firm, made a profit of $7,000, and been done with the trade. But they didn’t. They and others were so confident that GME would go down further there were more shares short (borrowed) than there were total shares available!
Now, this is where Reddit comes in. If you are not familiar with Reddit, the company defines itself as “a network of communities based on people’s interests. Every day, millions of people around the world post, vote, and comment in communities organized around their interests.” Registered users congregate in interest-based chat rooms called subreddits to post comments, links, and other content related to their common interests. It’s kind of like the old AOL chatrooms on steroids.
In the fall of last year, a group of Redditers in a chat room called WallStreetBets (WSB) noticed the short situation in GameStop and likely devised a plan to make money. If they could get a bunch of people together to start buying the shares of GME, they could push the price of the stock up. If they pushed it up far enough, the short sellers would have to cut their losses and buy back shares to satisfy their borrowings. That would push the share price up even further, causing more short covering and so on. The stock would be on a repeating feedback loop of higher and higher prices. This is what’s known as a “short squeeze” and can result in some dramatic and rapid price appreciation.
Short squeezes are nothing new. In fact, we look at short interest as one of the data points in reviewing stock investments all the time. But several factors converged to push the stock up 2,500% in a matter of days which made this one so dramatic it captured the attention of the world. First, the excessive short position was unusual, meaning that a lot of buying had to take place to cover the borrowed shares. And once there was blood in the water, institutional investors joined the fray, exacerbating the magnitude of the move. In this case, David may have started the fight, but he was joined by other big boys on the playground taking their shots at the wounded Goliath (or Melvin). In fact, we will admit to ducking in and out that day to make a profit for clients at the expense of the wounded shorts.
But more importantly, there had never been so much organization, dedication, and militance of the buyers of the stock. Messages on WSB included “hold the line”, “do not flinch”, and “don’t sell”! These weren’t just investors anymore. They were on a mission with a message about the system. They were a band of brothers alerting the world that the independent investor could stand up to what they believed to be a “rigged” establishment. That is the social message that will echo forth.
Then, an unexpected and jolting truth was revealed. Robinhood’s true allegiance was revealed. The site has become the pioneer and champion for the small investor. Despite some occasional snafus where tools they provided without instructions have blown up, Robinhood polished that “little guy” mantle diligently. Until the Wizard’s curtain was torn open.
On January 28, at the height of the battle, just as the WSB army was trying to hold strong and push upward against the oncoming forces, Robinhood tied their hands. Trading in GME was suspended on their platform. Investors could sell existing shares. But they could not buy more. Just when they needed to buy the most, Robinhood shut them down. And they got run over by the onslaught of sellers. The stock peaked at $467 at 10 am just before Robinhood and interactive Brokers stopped allowing buys. It finished the day at $261. Down 46% in six hours.
But why would those harbingers of the individual investors abandon them? Was it the back-office logistics of settling so many trades? Was it for the protection of small investors as they claimed? Maybe. Or maybe we should follow the money.
As one of the first firms to offer commission-free trading, exactly $0 of Robinhood’s revenue comes from the trading commissions of its customers. (Make no mistake, as active managers of our client’s accounts, we love paying $0 for trades). Yet Robinhood had an estimated $180 million in revenue in Q2 of last year. So where does that exploding revenue come from? Largely from selling their clients’ orders to large sophisticated quantitative-trading firms who shave small fractions off bids and offer prices. These firms make pennies per trade. Multiplied by millions of trades.
According to a June report from the Financial Times, $39 million of Robinhood’s revenues came from Citadel Securities. Citadel is Robinhood’s largest source of revenue. Citadel is also an investor in Melvin. One could speculate that Citadel flexed its muscle and forbade Robinhood from allowing further damage to its fund. Stop the buying. Stop the Melvin bleeding. Citadel is also one of two firms investing a total of $2.75 billion into Melvin this week to bail them out. I’m not accusing. I’m just saying.
So, in the end, who won? As of this writing, it is estimated that short sellers have lost over $5 billion by betting against GME. So WSB and its army inflicted some damage and hopefully made some profits. If the battle is over, the stock will likely drop back to where it started. One can hope that the “little guy” makes his profit and gets out. Unfortunately, there will be some soldiers who will die on that hill by holding on too long. But their message still got out. And a light of truth was shined on Robinhood. And the world has taken notice.
We still like the stock market. It is still investable. It has its chinks, and it always will. But understanding that, it is still a terrific engine for long-term wealth creation. We also welcome the return of the individual investor. We found that one of the keys to successful investing in the current environment was to check our academic snobbery at the door. We professional stock assessors and portfolio constructionists are classically trained in the art of valuation analysis. We diligently apply our formulas and our spreadsheets to a company’s financials to determine what the stock’s fair value should be. Then, if the stock is trading below fair value, we buy it. If it is selling much above fair value, we revel in our cunning and sell it. And if we don’t own it, we wrinkle our credentialed noses and scoff at those foolish enough to buy. And had we followed that ivy-covered mantra in 2020 we would have gotten our big brains beat in by the Robinhood nation. Further evidence that if the market were a math problem, we would all get the same answer. Emotions are part of stock prices with varying degrees of impact. Right now, the math doesn’t matter much. Stock prices go up when there are more buyers than sellers. For whatever reason. And THAT is an unbreakable rule.
There is a lot of momentum behind the current market. And we continue to be fully invested. In the low-interest rate environment that will persist for some time, there are few alternatives. Valuations can stay elevated for a long time in such an environment. We expect the economy to grow throughout the year, based on the pace of vaccinations. Stimulus in the form of direct checks and infrastructure spending will add fuel to the advance.
There are of course things we are watching to tell us when to get more cautious. For those of us in the business long enough, this is starting to feel a bit like the late 1990s. Outsized gains and craziness like we just witnessed get our senses up. Unemployment may prove stickier than expected. So, while we are riding the wave of the market, we are watching for fins in the water to know when to head for the beach.
We at StreamSong feel a kindred spirit with the WSB warriors. We left larger banks to start a firm to offer individual investors more pro-action, customization, independent thought, and objectivity. This purpose was rewarded again in 2020 as we navigated the COVID market with nimbleness and diligence that rewarded clients with great absolute and relative returns.
We are all in when individual investors realize they deserve better than what most large firms and banks offer. We love the democratization of investment expertise and the demystification of Wall Street jargon. We say individual, independent investors of the world unite! And let us help guide the way.