• Capital Access

GameStop: Hammer Time!

Gamestop (ticker: GME) was the most heavily traded share on the NYSE on Tuesday [26th January 2021]. It beat Tesla, Apple, Microsoft and Amazon, in that order. Think about that for a minute. Gamestop. A company few outside the US had heard of until this year. A company with a mere $1bn market cap just two weeks ago. A company whose market cap is, “at time of writing” (I have to say this as it will probably be markedly different by the time of publication!), $24bn– easily large enough to be eligible to join the S&P500 index.

And where did this fame and fortune come from? An online user-generated content platform called Reddit. More specifically, a sub-community called Wall Street Bets, which had 300k users 2 years ago, 2.8m yesterday, and 4.5m today. I won’t go into detail on that here; it’s been covered in myriad other publications. Suffice to say, the atmosphere of this community represents a combination of the archetypal enthusiastic amateur (albeit probably more tolerant of risk than average) retail investor and the comradery and idea germination/cultivation of a top end hedge fund dinner – only opened up to thousands of people.

With GME topping $450 yesterday, though closing at $197 and back up around $300 in the aftermarket, and short interest still some 62 million shares, or 122% of free float, this ride doesn’t seem likely to stop now. Indeed the claims from Melville that they’ve closed their short position were met with a mixture of derision and exuberance on Wall Street Bets – “they’re so desperate they’re lying”, “we’ve got them on the ropes” were the prevailing attitudes.

Then of course, some brokers halted retail buying (but not selling) of GME and its associated equities (AMC, BB) yesterday, leading to what might be the fastest-filed class action lawsuit in history? The reasoning behind these measures is still unclear, though capital adequacy and the clearing houses seem to have been the driving forces.

The most important questions here are (i) what might happen next?; (ii) is this likely to be an enduring, or even permanent, change?; and (iii) how can investors benefit from this in the short and medium term?

What might happen next?

Interestingly there’s a chance, albeit one I see as slim, that the explosion of volatility chokes off this trend - options will clearly get more expensive as volatility increases, which makes these trades less obviously attractive to retail investors.

This would have a knock-on effect on institutional investment strategies and hedging strategies that rely on low priced options. This could push up the cost of these materially and make them less attractive.

However, it’s difficult to see localised volatility spreading to wider markets from an event such as this.

This might impact other short positions though: there is a question of whether anything is safe to short at the moment. The Goldman Sachs Most Shorted Index was up +9% yesterday, is up 25% in the past 4 trading sessions, and is up 60% YTD. This is going to hurt quite a few hedge funds.

This behaviour introduces an unpredictable and sometimes apparently vindictive campaign to “squeeze shorts” and means many hedge funds may wish to close positions until they understand the process better. This in turn could result in further short squeezes in illiquid shares with a material short interest outstanding. Funds should be particularly fearful of names that are recognisable or emotive for retail investors.

Where losses made on margin need to be covered with cash, funds may also need to sell their long positions to cover this. I would also suggest there’s an increased risk of redemptions as pension, trust, and charitable fund managers start to weigh the reputational/career risk of being caught up in all this. Imagine the impact selling pressure resulting from a combination of loss covering AND redemptions could have on companies most widely held by hedge funds: TDG, Pelaton, Paypal, Micron, Mercado Libre, IAC, and JD.com top the ‘hedge fun holdings’ list. Ironically the only way for investors to play this angle would be to short those shares!

However, these positions are high conviction favourites and will not likely be reduced until hedge funds are desperate, and it may not come to that. It’s worth monitoring them for heavy selling though, because If it does come to that they could be a useful indicator of the desperation of this class of market participant.

So how else could this spill over into broader markets? It’s hard to tell, but it’s unlikely there are no automated momentum and other purely algorithmic strategies that are poorly programmed or naïve. Any automated screen fund or passive fund will have to buy short squeeze names when they rebalance, and if so are setting themselves up for major losses. They may also have to sell them though, as in the case of the S&P Retailer ETF that’s up 50% YTD (XRT US). This is ostensibly an equal-weighted ETF holding 95 retailers in the US - but as of Tuesday GME represents >10% of its AUM! There will be heavy selling when this next rebalances.

The question this raises for investors is: what potential surprises might you be holding in your passive exposure?

This might also bring about the end of the trend of public short theses, which was popularised by Muddy Waters in 2011 with its paper accusing on Sino-Forest of being a massive Ponzi Scheme. Hedge funds can’t really risk running around shouting “We’re short x million shares in this company” as that’s, for now, potentially going to be perceived as a weakness that can be exploited by causing a squeeze.

Someone, preferably investors in hedge funds, also needs to ask how on earth they got into a position of shorting >100% of the free float? Was this not a basic component in their models and risk management? It points to a degree of complacency; something that markets almost always end up punishing.

However, perspective is key: no matter how much may change, we do need to remember that this movement is unlikely to break markets – there simply isn’t the money behind the active retail market to damage any systemically important equities. Does this add yet another safety premium to large caps?

How sticky is this change?

Will this new action invigorate people? Is it like cryptocurrency, a self-sustaining movement? It has all the hallmarks of something that is here to stay: new retail investors have had a year of sitting at home with spare time and a stimulus cheque, many remaining gainfully employed but with nothing to spend in. This has combined with a slew of easy-to-use apps offering 0 commission trades in the US. These have acted to strip all friction from the commencement of ‘investing’ – there are basically no interface or financial barriers to trading now.

These investors have then spent a year sitting at home, watching their favourite known brand shares (TSLA, AMZN, etc) rise all year against the advice of what they call “The Experts”. So they’ve spent a year learning that stocks go up, investing is simple and easy, and watching the incredible community spirit in Wall Street Bets that makes investing fun to boot. It also gives frustrated American people a purpose, a cause to rally behind, a way to “stick it to the man”: in other words, a perfect storm.

The frenzy has already spread, with BB, AMC, and Tootsie Roll (who knew that was even public?) experiencing breakneck gains on no material news.

This feels like a cat has been let out of the bag, and nothing can be done about it now. This concatenation of events has now been supercharged by the algorithms of attention used by social media. These algorithms are designed perfectly to create a herd that can move rapidly.

Herds can and do splinter though. In fact they normally do – and we’re already seeing a number of other shares being pushed on WSB with minimal follow-up. What will be interesting to see is how the herd reacts to a failure. A move that doesn’t work as planned. Or worse, and possibly inevitably, a move that goes completely against them and loses them significant money. How many participants will then think “that was fun, now I’m bored of it”, will give up when the immediate dopamine hit fades and fails to repeat, and will move on? I’d bet the majority.

Furthermore, how much of the ability to ‘invest’ like this is driven by working remotely? It would be impossible to spend the attention required to trade intra-day with a manager leaning over your desk constantly. If people don’t tire of this, a resumption of anything like a normal working life will probably throttle the Wall Street Bets movement.

How can investors benefit from this trade?

I’ve touched on this in my ramblings above, but to add specifically, this could result in increased retail investing activity (CMC Markets anyone?) and lead people to drink (Naked Wines? Rogue Baron if we need to drink something a bit stronger?).

Being more serious for a minute, investors will have to be extremely careful of which long/short funds and funds of funds they invest in – due diligence may need to be materially extended to cover this new risk. The key points to look for in their portfolios at this specific moment in time are the retail awareness, liquidity, and short interest outstanding.

Clearly an existing but forgotten risk has also been uncovered – grill your L/S manager on how they account for the potential that, in aggregate, more than 100% of free float could be sold short!

Another winner!

As an interesting note on which to close: the CEO, who joined in April 2019 and presided over a further 50% drop in the share price, placed one hell of a trade in April 2020. He bought c.25k shares at around $4! Still, this won’t make too much difference to his life: when he joined he was given 2.3m shares – which are currently rushing towards a $1bn valuation. The CFO also owns 534k shares. If you like insider ownership, this could be the share for you!

The question of whether management here is worth its money will, I believe, be answered soon – in my view they should consider doing something uncomfortable. They could bail out the shorts by issuing them new equity in an ABB. They could raise a monumental amount of new equity from the now-desperate shorts, and save GME in the process: even making it a cash rich business ready to hit the acquisition trail. And given how the market is currently treating SPACs, it wouldn’t even need a business plan to justify a high valuation – just a pot of cash and some loosely-defined vision!

“To the moon” indeed.


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