A struggling video game reseller became the talk of Wall Street
Overleveraged hedge funds were squeezed by a new breed of online traders
Diversification is paramount when investing in small companies
If you are not a gamer or a parent of one, there is a chance you had never heard of GameStop prior to this year. The retail firm sells all things video games with a niche for buying used games and reselling them at a higher price. The company went public in 2002 and was initially a strong performer. As the popularity of video games grew, so did GameStop’s footprint. By 2017, GameStop had 7,535 stores around the world. (Figure 1)
In recent years, as broadband internet speeds improved, a crack developed in GameStop’s business model. Rather than buy physical video game cartridges, gamers could download their favorite titles directly to their console. This new distribution channel has been a punch in the gut to GameStop. Annual revenues have been nearly cut in half from their 2012 peak of $9.6 billion. (Figure 2)
From November 2013 to the market’s pre-pandemic peak last February, GameStop shares lost 89% of their value compared to the S&P 500 gain of 113%. (Figure 3) Most investors wrote the company off, assuming it was following in the footsteps of Blockbuster Video.
Short selling is a way of benefitting from a stock’s price going down. It is a tactic typically employed by hedge funds. GameStop’s problems were no secret on Wall Street and at the start of 2020 it was the most heavily shorted stock in the U.S. (Figure 4)
By early April, GameStop’s share price had sunk to $3.
Then GameStop's fortunes started to change. As lockdown restrictions eased, investors piled into beaten down brick-and-mortar retail stocks. There were also positive catalysts unique to GameStop. XBOX and PlayStation released new consoles in November. Historically, console upgrade cycles had been a boon for the video game industry. In addition, the co-founder of online pet supply company Chewy disclosed a 10% position in GameStop. Despite this, hedge funds did not lighten up on their short positions.
This is where things get interesting. During the pandemic, a new group of traders emerged. With sports halted, most of the country working from home, and $1,200 stimulus checks burning a hole in their pockets, many millennials turned to the stock market. Apps like Robinhood gamified the trading experience for them.
Many of these new traders swapped ideas on an online message board called /WallStreetBets on Reddit. It was there that a contributor brought the oversized short position in GameStop to the attention of the group. Many of these millennials had shopped at GameStop as kids. The idea that Wall Street was profiting from GameStop’s failure did not sit well.
The group of traders started buying shares of GameStop. Short sellers held onto their bearish bets, despite a doubling of the stock price from $9 to $18 in the fourth quarter. As the new year began and a fresh round of stimulus checks were mailed out, the young group of traders became more aggressive in their tactics. They started buying call options on GameStop, a levered bet on the stock’s advance.
Emboldened as the stock rose to $40 by mid-January, the group started buying even more aggressive call options. Eventually, as the stock continued to rise, the brokers that sold the options were forced to buy GameStop stock to cover their risk. A “short squeeze” ensued sending GameStop shares to an intra-day high of $483 on January 28, 2021.
On the 28th, most brokerages instituted trading restrictions on GameStop and a few other heavily shorted stocks. This sent shares plummeting. On the surface, it looked like these brokerages were bailing out the short sellers, but they were worried about their own survival. Stock trades take two days to settle and brokerages must put up cash on the trade date to ensure settlement. The explosion in trading had left firms like Robinhood short on cash.
In the past few days Robinhood has raised $3.4 billion, which allowed it to loosen trading restrictions. Despite this, GameStop’s shares have continued their slide. GameStop shares went from $55 to $450 and back to $55 in a matter of nine trading days! (Figure 5)
Not surprisingly, several concerned clients have called in asking about GameStop’s potential impact on their portfolio. When investing in the shares of smaller/less liquid companies, Allegiant’s Investment Team insists on diversification. The impact of a GameStop on our clients’ portfolios is minimized by utilizing funds that spread the risk across thousands of small companies.
There are broader concerns about how an episode like this impacts the public’s confidence in the stock market. Expect regulators to take a hard look at Robinhood in the coming weeks. Many of their clients lacked the experience to trade options and are now left holding the bag.
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