When will the GameStop game stop?

Ok so there has been a lot of crazy things to happen this week. Very little of it has anything to do with what I would call investing. But in the interests of helping people understand this madness, I decided to write a post about it.

First we need to start with the basics, as always. This market craziness has involved a few different companies including Blackberry, AMC, Koss, and American Airlines. But since GameStop has been by far the most talked about and publicized I will stick to talking about that company.

Let's Talk About GameStop

GameStop is in many ways an unremarkable company. It is a retailer of video games and has thousands of stores around the world. There are a number of GameStop stores here in Winnipeg and they are fairly common across Canada and the US. GameStop is in other words, a 'real business', with employees, inventory, sales, and at times, profits (though less profits in the last few years).

GameStop has been struggling like many retailers with the shift in consumer tastes towards e-commerce. For video games it is particularly bad because the games they sell are intangible lines of software code. They can be easily distributed through the internet and it is far more cost effective and convenient to do just that. So GameStop has a real challenge to try and stay relevant. Why should people go into a video game store when all the games can be downloaded from the comfort of your own home? I don't have the answer and I'm not sure GameStop does either, but there is still some chance that GameStop might be able to turn things around.

We actually owned a small amount of GameStop shares in a couple clients' accounts leading up to this and the thesis was that we had bought in so cheaply that there was some value there. We sold when the price hit a level we thought was well beyond our fair value. This is where we leave the confines of reality! GameStop's current share price, and the violent movements in that price this week, have very little to do with the business of GameStop. There are a number of factors at play here, and I am going to go through them one by one so that the picture will become more clear.

Markets Are Not Always Rational

First of all, if you haven't realized this yet, markets are not always rational. 2020 provided lots of examples of this, but this rally in GameStop really takes the cake in terms of an irrational rally. What is clear is that the twin emotions of fear and greed, the emotions talked about by Ben Graham in Chapter 8 of the Intelligent Investor, are on full display. For those of you who are exasperated and say to me, this makes no sense! No it doesn't, and you know what, that's pretty normal for the stock market. Sometimes the market does things which just don't make sense. These are usually opportunities, not problems.

Value of a Stock in a Business Can be Valued in a Variety of Ways

Second of all, the value of a stock in a business can be valued in a variety of different ways. As business owners we like to stick to fundamentals and determine the value of a business based on the cash it can generate for us. This makes the most sense to us. But that's not the only way to value a business. We could value a business based on the sum of its parts, or we could simply value a business based on what the market is willing to pay us for it. My Dad always says, something is only worth what you can get somebody to pay for it. And for a lot of things that can be totally true, even for businesses.

A gold coin is an essentially useless piece of yellow metal, but because we can find other people who will pay us a lot for it, it has value. A Wayne Gretzky rookie card is arguably even more useless. It's just a piece of cardboard with a picture on it. But recently someone was willing to pay over a million dollars for one, so it has value.

It's Not Based on Fundamentals

GameStop right now has value, not based on any fundamentals of the business but because we can find other people who are willing to pay a high price for it. To give you an idea how valuable it is, imagine GameStop is your home. You purchased your home for $500,000 last year. Well now a year later there is a frenzy of buying and you are fielding offers to sell your home. The offer price? Based on the same multiples GameStop is getting your home is now worth $32,500,000. THIRTY TWO MILLION FIVE HUNDRED THOUSAND DOLLARS! Insane you say! Yes it is.

How can this happen? Well that brings me to a third factor, and that is shorts. I've already outlined that GameStop is a company with challenges. Because it has these challenges, many smart and professional investors think GameStop will fail to meet these challenges and their stock will go down. In order to profit from the stock going down, they have sold the stock short.

When You Short an Investment, You Are Betting Against It

As described in one of my favourite movies The Big Short, when you short an investment, you are betting against it. The way you actually do this is you borrow a share of that company and you sell it to a third person. You collect the proceeds of the sale and you still owe a share of the company to the person you borrowed it from. If all goes according to plan, the stock price will go down, and you will be able to purchase another share in the market for a lower price, which you can then give back to the person you borrowed the original share from. That will close out your position, and you will pocket the difference between what you sold the original share for and what you paid to purchase the share later.

Here's an Example

I have an account with Endeavour Wealth. Endeavour Wealth through our dealer iA Private Wealth will lend me a share of GameStop to sell short. I take my share of Game Stop and sell it today for $300. 3 months from now, when this GameStop frenzy has died down and the share price has returned to where it was before, I want to close out my short position. So I buy a share of GameStop in the market for $20. My profit will be $300 - $20 = $280. I will also have to pay interest on the share that I borrowed. That interest will vary but for the sake of easy math we will say it amounted to $5. So my total profit is $300 - $20 - $5 = $275. Pretty good!

This is ideally what short sellers want. The stock went down, and it went down a lot – fast. What happens when the stock doesn't go down? Glad you asked. Shorting can be risky because there is no upper price limit on how high a stock can go. When you are short the stock, you lose money when the price goes up. The higher the price goes up, the more you will lose.

Let's say I shorted $500,000 of GameStop stock last year. From our home example above, we know that I now owe $32,500,000 worth of GameStop stock. This is very bad. Not only do I owe a lot of money in GameStop shares, but I also have to pay interest on the market value of those GameStop shares. This is very very bad. What's even worse, iA Private Wealth, the person who lent me those GameStop shares is not sure I am good for my $32,500,000 worth of GameStop shares, so they will want me to post collateral in my account. That means I have to come up with millions of dollars of cash just to infuse into my account. Otherwise they will liquidate my account and I will be bankrupt. This is very very VERY bad.

A Short Squeeze

This is exactly the scenario many hedge funds shorting GameStop stock have found themselves in over the last two weeks. When their shorts start to spiral because the price is going up, it creates a situation called a 'short squeeze'. We know from above that in order to close out a short position, we need to buy back the stock. When shares are in high demand however this can create a real tricky situation.

By buying back the stock we are increasing demand, which pushes the price of the stock up. If the stock price is rising rapidly, a lot of shorts will be getting squeezed. They will either have to post more collateral to maintain their short, or they will have to buy back the stock to get out of their short position. But their buying pushes up the price even more, leading to even more shorts trying to cover their positions, which pushes the price up more, and so on it goes.

Financial Engineering

In GameStop's case, the stock was over 140% shorted, meaning that for every share of GameStop there was 1.4 shares of GameStop sold short. It's a bit of financial engineering that even allows this to happen but needless to say, there are a lot of people who need to cover their shorts. Another factor at play here is that many of the people who are buying GameStop, aren't actually buying the stock. They are instead buying call options.

Call Options

Call options are something we've talked about in the past, but the basics are that a call option gives me the right to purchase the stock in the future at a set price. When I buy a call option, another person has sold the option to me. They are said to have written the option. If I have the right to buy at a set price, they have the obligation to sell me that share at that price.

Many times when someone writes an option, they will buy the stock to make sure that they have it when they need to sell it to me. It's a way of hedging their risk. When an army of Reddit traders are buying call options, this means that the dealers they are buying those options from are also buying stock of GameStop in order to hedge the call options they wrote. So Reddit traders buy calls, which causes their dealer to buy stock, which causes more Reddit people to buy calls, which leads their dealer to buy more stock, and so on and so on.

Index Funds are Needed to Keep the Appropriate Weight in the Index

If that weren't enough, we live in a world of passive investing. GameStop is a part of the Russell 2000 index. While certainly not as common as the S&P 500, the Russell 2000 index is still a widely used index for small cap stocks and there are a number of passive index ETFs which allow you to invest in the whole index. If the indexes are market weighted, this means that as the price of GameStop goes up, index funds need to buy more of it in order to keep the appropriate weight in the index. This in turn pushes the price up even further.

At today's valuation, GameStop is now larger then about a third of the S&P 500. If GameStop was added to the S&P 500 (I don't think it will be, but if) then that would probably unleash a whole new round of buying from index funds which track the S&P 500.

Here's a Little About Reddit

Lastly but not leastly, we get to Reddit. This story began on Reddit as a number of people posted fundamental value based analyses of GameStop and tried to rally people to buy it. That has turned into a monster where millions of people are buying GameStop to: Have fun and gamble; Try to get rich quick; Try to cause suffering for hedge funds who they perceive have wronged them; and/or Try to strike a blow for social justice against the 1% of wealthy people.

Without weighing too much into politics here, I don't think any of these reasons are valid reasons to buy GameStop stock. Nevertheless, millions of people disagree with me, and they are doing it. While this kind of coordinated short squeeze is not new, it's certainly been enabled by technology to be more effective perhaps. While what the Reddit traders are doing might not be illegal, I do think it is on the line of manipulating the market to point where it could be illegal activity.

Insanity With No Question

In any case, it's not up for me to decide and I'm happy to watch from the sidelines. What are we to do as investors? Absolutely nothing. This is insanity no question. But it is not new, and is not really that unusual actually. Short squeezes do happen, and the market certainly is irrational a good portion of the time. When we invest, we are looking to invest in a business. We are not looking to trade stocks like they were pieces of paper, trying to find the next buyer who will pay more then what we paid.

When will this madness all stop? I have no idea. It really doesn't matter that much to us. It is quite the show, but I'll sleep much more peacefully watching the show from afar.

- Craig White, BA, LL.B., CIM

Craig White is an Investment Advisor at Endeavour Wealth Management with iA Private Wealth, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Craig White an Investment Advisor for iA Private Wealth and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.