The rise and (likely) fall of GameStop

It all began with a brilliant idea.

GameStop is a US video game retailer that’s been in trouble for years. It sells new and secondhand video games, and struggles to compete with downloadable games and Amazon. Most of its stores were closed for parts of 2020, leading to big losses.

Some hedge funds thought its business was in terminal decline. So they shorted GameStop – by borrowing shares from investors and selling them. Their plan was to make money as the GameStop price fell, then buy the shares back cheap and give them to the original owners.

Short squeezes and their aftermath

It’s fun if you short a stock and its price falls. But what if its price begins to rise? You can take the losses at first, but after a while you begin sweating and buy some stock to cover your losses. You push the price up – increasing the pain on your remaining short position. You buy some more. The price rises some more. You panic and buy more and the price soars. Eventually, you’ll be out of your position, having lost a lot of money along the way.

That’s called a short squeeze – when investors who are short a stock are forced to buy it back and drive the price up.

Last year, somebody noticed that rather a lot of GameStop shares were being shorted by hedge funds. By some estimates more than 100% of the company was being shorted, through ‘clever’ financial engineering.

What if you could put together a team of investors who would act together to buy GameStop shares and not sell? They would push the price up, hedge funds would suffer losses, they would try to buy GameStop shares but few would be available… and the price would shoot up. Hello, short squeeze!

And so it came to pass. A few months ago a bunch of investors from the Reddit group Wall Street Bets began buying GameStop shares for around $4. The price began edging up.

Hedge funds that were short GameStop eventually realised they were in trouble and began buying back shares big time in December. In late January, after the mother of all short squeezes, GameStop reached $468 – up over 100 times in six months.

Poor Melvin

Then in the space of a couple of days, GameStop plunged. At the time of writing it’s around $100. Lots of hedge funds are still short. The Reddit team is trying to maintain solidarity, not sell and buy more shares, to spark another phase of short squeeze. But, while the hardcore members think GameStop could hit $1000, there are plenty of people who made a tidy profit during the rise from $4 to $468. They’ve been choosing their bank accounts, above their online pals.

One of the main hedge funds shorting GameStop, Melvin Capital, lost more than 50% in January. Hedge funds are still shorting GameStop. They must be hoping that the Reddit team cracks and begins offloading their shares.

Short sellers serve an important economic function. If an Enron, say, is fooling the world with the biggest fraud of all time, you need people to be saying so and looking out for such frauds… otherwise the kind of pensioners who invested in Enron will suffer even bigger losses.

But short selling is scary. Short sellers don’t relax on holiday – they’re always watching the markets, just in case one of their shorts blows up.

Let’s look at another example…

Lessons from VW

On Tuesday 28 October 2008, Volkswagen was the biggest company in the world. For a few hours.

A bunch of hedge funds thought they could make money by shorting VW shares through late 2008. By 24 October, 12% of all VW shares were sold short, around $10bn worth.
But there was a problem. Unbeknownst to investors, the Porsche car company had been hoovering up VW shares. On Sunday 26th they announced that they owned 74.1% of VW. Governments held another 20%. So less than 6% of shares were available on the open market; less than half of what hedge funds needed if they were forced to cover their losses.

Which led to the greatest short squeeze of all time, during the middle of the global financial crisis. Hedge funds bought VW furiously, to try and avoid going bust on their short position. Its price more than tripled in two days, before Porsche relented and sold a chunk of shares. Hedge funds lost about $35bn in the episode.

You might have thought the hedge fund industry would have learned from the experience. Don’t over-short a stock. Never over-short a stock! Wrong. Greed is the enemy of common sense.

Does it matter?

There’s been lots of grand talk about investor democracy and the power of the little investor in the last couple of weeks. That’s an exaggeration. A few hedge funds had been careless, and a bunch of investors were able to profit from it.

But the amounts involved are small – far less than the losses from Volkswagen 13 years ago. GameStop is nothing more than a tiny sideshow to the US equity market. And markets are volatile. Whether it’s GameStop or Gridcoin or Tesla or Donald Trump, investors will always find something to get excited about.

And in the long run, there’s no way GameStop is worth $100, let alone $1000. It will revert back towards some low price that’s related to its cashflows and future prospects. It may be doing that already. The Game may already be Stopping.

On paper, the fall from $438 to $100 has caused about $27bn in market value to disappeared, much of it from the accounts of retail investors. Let’s hope the least affluent of them got out in time.

In case you were wondering, 7IM does not make a habit of investing with short sellers. It’s too dangerous and unprofitable. And we had almost zero exposure to GameStop and similar stocks in index-type products coming into 2021, as they’re too small and niche to feature in the large, liquid market indices in which we predominantly operate.

Day trading is not for us. We take little notice of GameStop and other stocks targeted by Wall Street Bets and prefer to focus on the big asset classes and the long-term factors affecting investment returns.