Accretive On: GameStop and "Meme" Stocks

February 10, 2021

Accretive does not have a position in GameStop or any companies discussed in this blog post.  We have no current opinion on GameStop’s business, nor an assessment of its investment merits over the short or long-term.

January was an interesting month.  We had a contested election, an inauguration, and the country seemed as divided as it had been in almost 160 years.  Then, suddenly, people just started buying GameStop.  

If you are reading this, you are probably aware of the unusual trading activity in GameStop and a handful of other “meme” stocks.  What’s occurred has been amazing and we have been fascinated by the way things have unfolded in the market, how the underlying market plumbing has held up, the role played by a young high profile brokerage firm (and their troubles), along with the takes various commentators have had.  

We think what one sees when they look at what is happening with GameStop is kind of a financial markets Rorschach test.  It may tell you more about the person than what has happened with any of the meme stocks.  

What might some people see?  We think it depends on where they are in the market ecosystem.  Some retail investors see it as some kind of modern-day proletariat revolution where “Main street” finally beats “Wall Street” and “the shorts”.  Some investment professionals may see it as a sign of an overheated market, others may lament the gamification of the market.  Sophisticated funds may have seen and participated in an opportunistic trade, others may be facing existential risk from taking the other side of the trade.  Regulators may see it as a market structure issue, they may also see the social media aspect as something that needs to be examined.  Politicians may see it as an opportunity to grandstand and politick.

What Happened

We think the first investors involved in GameStop were probably more traditional value investors, the most notable being Dr. Michael Burry of “The Big Short” fame, and short sellers, investors betting on a decline in the price of GameStop shares. These investors had a fundamental view of the company and its prospects.  The prevailing market view was that GameStop’s business had a lot in common with Blockbuster, which no longer exists.  Short interest, a measure of how many investors are betting against a stock, was over 100% of the shares outstanding.  This short interest, in and of itself, tends to create more volatility in a stock.  

Reddit has a popular thread with millions of subscribers called WallStreetBets (WSB).  WSB is a forum where investors of widely varying experience, expertise, and skill post their ideas and trades. It is largely anonymous which helps feed its own subculture and language (“tendies”, “diamond hands”, etc.).

A popular WSB idea was and is GameStop.  At some point, so the story goes, some posters in this group figured out that they could engineer a short squeeze in smaller, high short interest stocks by coordinating their efforts and magnifying their effect with options.  In the case of GameStop those efforts were successful, and the net result was an initial short squeeze.  A rising stock price created losses for the short sellers, which led to more short covering (buying) and more losses.  In short, the activity created a feedback loop.  

From there, reports began to leak out about the hedge funds that had sold GameStop short taking large losses and the story took on a life of its own.  More investors, presumably both retail and institutional, began to actively participate in the GameStop short squeeze.  Further, they realized that the trade could be replicable and began to seek out other stocks that had a similar profile:  high short interest and a smaller market capitalization that could become a meme stock.  

This activity increased across a handful of smaller companies and risks to brokerage firms from their customer’s behavior increased.  In an effort to reduce risk, firms began to put restrictions on certain kinds of trading activity.  A few brokerages limited activity to closing out positions in the meme stocks.  Conspiracy theories started to circulate, as there was speculation that hedge funds were using their political capital to limit the influence of retail investors.  

We think the reality has far less intrigue.  We believe too much risk was building for certain brokerage firms.  There is a 2-day lag between when a stock trade is placed and when it is completed (or settled).  What happens during that period is a risk to the brokers, particularly when their customers are using borrowed money (margin) and transacting in very volatile securities.  Brokerage firms could be on the hook for their customers’ losses.  Risk managers at the clearinghouses likely recognized this and demanded more cash collateral from the brokers themselves.  As a result, a very popular brokerage firm that purports to democratize investing had to draw on its credit lines and raise a few billion dollars of fresh equity capital over the course of a few short days.

What We Think

While GameStop’s short squeeze has gotten a lot of attention, this kind of action in markets is not new.

- In 2008 Volkswagen became the most valuable company in the world due to a short squeeze.

- In 1980 the Hunt brothers tried to corner the silver market and subsequently went bankrupt.  

- In 1923 the founder of Piggly Wiggly borrowed $10 million on margin to purchase shares in the grocer and punish the short sellers.  This turned out to be a bad idea as he eventually went bankrupt.

It is our view that some early investors spotted and executed a very sophisticated and clever trade.  That said, it has subsequently turned into a speculative frenzy and we think trying to predict the behavior of a frenzied crowd is foolish.  There is a quote attributed to Mark Twain, “There are two times in a man’s life when he should not speculate:  when he can’t afford it, and when he can.”  Put us in the Twain camp.  Early investors may have done well and gotten to dine on some well-earned tendies, but late comers may regret getting swept up in the frenzy.

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