Has GameStop ‘flash mob’ changed rules for successful investing?

Mr. Kim is the Chief Operation Officer and Chief Compliance Officer for Kirr
Marbach & Co. LLC, an investment adviser based in Columbus IN. Please visit
www.kirrmar.com <www.kirrmar.com> .

The recent fireworks in GameStop (GME) have dominated headlines over the
past couple weeks. Folks are naturally curious about what happened and how
does it end. So, I thought you might find it interesting for me to “unpack”
the GameStop situation, without getting too far into the weeds!

Briefly, some multi-billion-dollar hedge funds (lightly-regulated investment
pools) built massive short positions in GameStop (GME), betting the stock
price would fall. Their fundamental belief was GameStop is a struggling
bricks-and-mortar retailer of video games (it closed about 1500 stores or
20% of its locations over the past five years) at a time when retailers are
abandoning physical stores and game consoles are migrating to “disc-less”
formats.

In other words, GameStop would eventually be the next Blockbuster Video.

A virtual army of individual investors formed on Reddit’s WallStreetBets
(WSB) online forum and seized upon a couple positives for GameStop. First,
Michael Burry of The Big Short fame (he correctly bet on the bursting of the
housing bubble that led to the global financial crisis in 2007-2008),
announced he had accumulated a large long position, based on the fact more
than 100% of GameStop’s tradeable stock had been sold short (a massive sum
that would eventually have to be repurchased). Second, Ryan Cohen,
co-founder of pet e-commerce company Chewy, also disclosed a large long
position and the company added him to its board of directors.

This populist army of individual investors coalesced around the idea that
coordinated buying of GameStop would cause the stock price to leap, a “short
squeeze” would ensue and major pain would be inflicted on the hedge funds.
The group declared war on the easy-to-despise billionaire “Masters of the
Universe” (picture Gordon “Greed is Good” Gekko, portrayed by Michael
Douglas in Wall Street-1987), with individuals placing tens of thousands of
zero-commission buy orders on platforms like Robinhood, TD Ameritrade and
E*Trade. Importantly, there were also instructions posted to WSB on how to
prohibit your broker from lending your GameStop shares, further squeezing
the shorts.

Mission accomplished! GameStop closed at $18.84 at year-end 2020 and traded
as high as $483 on January 28, giving it a market capitalization of $33.7
billion (slightly less than Cummins Inc.). The hedge funds were forced to
cover their short positions by repurchasing shares, losing tens of billions
of dollars.

When you buy 1000 shares of XYZ @ $10/share, you have a “long” position.
You profit if the stock price increases and your upside is theoretically
unlimited. The worst you can do is lose 100% of your investment ($10K-if
the stock goes to $0).

Conversely, you can “short sell” 1000 shares of XYZ @ $10/share. You
arrange with a broker to borrow 1000 shares, sell the shares, pay “rent” on
the borrowed shares and lastly return the shares (“cover the short” by
repurchasing the shares) by a future date. You also deposit 150% of the
proceeds with the broker as collateral.

You profit if you can repurchase the shares at a lower price. Your upside
is limited to $10K (if the stock goes to $0), but your downside is
theoretically unlimited.

A “short squeeze” occurs when the stock price rises rapidly. The broker
that loaned the stock will demand more collateral as the stock price rises
(the dreaded “margin call”). You can either deliver the additional
collateral or cover your short. Buying to cover short positions adds even
more upward pressure on the stock price, leading to a melt-UP in price and
even more pain.

On January 28, Robinhood (along with Charles Schwab’s TD Ameritrade, Morgan
Stanley’s E*Trade, Interactive Brokers and Webull) incited investor fury and
invited hearings from Congress (first one scheduled for February 18) and
inquiries from the Securities and Exchange Commission when they restricted
buying in GameStop and a handful of other highly volatile stocks the WSB
army had been buying en masse. The Davids smelled a rat and saw the brokers
colluding with the Goliaths, which were being pummeled.

I suspect the real reason is more mundane and has to do with the market’s
internal “plumbing.” The Depository Trust & Clearing Corporation, or DTCC,
is owned by its member brokers and is responsible for “settling” trades,
guaranteeing the buying broker delivers cash and the selling broker delivers
the stock.

The sell side of the trade is straightforward, but the buy side can be
problematic, since it involves coming up with the cash. Similar to how a
broker limits its exposure to a customer not paying by requiring collateral
or “margin,” DTCC limits its exposure by requiring every member broker to
post collateral.

DTCC operates quietly and in the background 99% of the time, but it became
concerned when GameStop and a handful of other stocks became insanely
volatile (daily moves of 100% or more) at the same time the online brokers’
customers’ trades were essentially 100% on the buy side.

DTCC was worried that if XYZ were to drop 50% in the two days between “trade
date” and “settlement date,” the buyers might balk at paying.

To protect itself, on January 28 DTCC required Robinhood (and the others) to
immediately post additional cash as collateral in order to keep buying these
stocks. Robinhood was unable to meet this margin call (reportedly a
whopping $3 billion), so was forced to cease taking buy orders from its
customers. It was able to partially lift its buy restrictions after drawing
$500 million from its bank credit lines and raising $3.4 billion from its
current owners, but Robinhood’s own liquidity remains uncomfortably tight.

Buying stock is purchasing a piece of a business, not a ticker symbol.
While stock prices can fluctuate wildly, the value of the underlying
business does not. As Ben Graham (Warren Buffett’s professor) famously
said, “In the short run, the market is a voting machine but in the long run,
it is a weighing machine.” This means stock prices can be impacted by the
madness of crowds, short-squeezes and a thousand other things. However, in
the harsh light of day, stock prices reflect the cash flow generation
prospects of the underlying business (its “intrinsic value”).

Baseball philosopher Yogi Berra once said, “It’s tough to make predictions,
especially about the future.” Rampant fee-less online day trading conducted
by individual investors who, thanks to the pandemic, have more time than
ever at home to trade with the ease of a thumb swipe may make this time feel
different, but bubbles and manias have been around for as long as financial
markets have.

When the memes stop, the excitement fades and the GameStop mania has run its
course, what will be left is the underlying business. The “flash mob”
successfully drove GME to $483, but it cannot make GameStop’s business worth
$33.7 billion. Once all of the shorts have been covered, who will they sell
to?

As J.P. Morgan said, “Nothing so undermines your financial judgement as the
sight of your neighbor getting rich.”

The opinions expressed in these articles are those of the author as of the
date the article was published. These opinions have not been updated or
supplemented and may not reflect the author’s views today. The information
provided in these articles does not provide information reasonably
sufficient upon which to base an investment decision and should not be
considered a recommendation to purchase or sell any particular stock or
other investment.