The email was short and to the point. Titled “Gamestop”, a client asked what we are doing to capitalize on the meteoric rise of the beleaguered video game retailer.
In case you haven’t been following, or are just confused as to what all the fuss is about, Gamestop is a retailer that specializes in video games, new and used. As video game makers have increasingly sold their products through online delivery though, the retailer has struggled to adapt their business model. As a result, many have viewed Gamestop as a relic of a foregone era, much as Blockbuster Video is thought of today.
That thesis led some investors to bet against Gamestop by selling shares borrowed from brokers. This is a strategy known as “short selling” and the idea is that you can sell the stock today and buy it back another day at a lower price, netting the difference as profit. The risk, however, is that the stock can hypothetically go up an unlimited amount. That limited upside for unlimited downside tradeoff has led to regulations that limit this type of investing to well capitalized and experienced traders, such as hedge funds.
There are regulations that limit how many shares can be borrowed by an investor based on how much equity they have in their account. Other regulations require investors and brokers to disclose how many shares have been borrowed or loaned. That information can be used by other investors to buy stocks that have been heavily shorted to try and cause the the price to increase. As the price increases, short sellers are required to maintain minimum amounts of equity in their positions, which forces them to either come up with cash or to buy back their position at a higher price. When this is successful, it is known as a “short squeeze”.
Gamestop (GME) 1 month price chart 2/19/21.
This is what happened to Gamestop. In the course of a month, the stock rose from around $40 per share to a high of $483 and then fell back to around $40. Some think it may be a new era where individual investors can leverage the power of social media to identify these types of opportunities and capitalize upon them. Perhaps there is some truth to that, but by the time the vast majority of the public became aware of what was happening with Gamestop, the top was in. Even as the stock was up 1000% in a couple of weeks, posters on social media sites such as Reddit’s WallStreetBets were encouraging each other to hold on and even buy more of the stock.
Traders that had made quick profits sold to others that wanted in on the action. Quickly the market’s price discovery mechanism brought the price back down to where it was at the beginning of the mania. Some may suggest that this is an example of how markets are inefficient but even the “Father” of the Efficient Market Hypothesis, Eugene Fama, acknowledges, “The point is not that markets are efficient. They’re not. It’s just a model.”
“The point is not that markets are efficient. They’re not. It’s just a model.”
EMH says that prices reflect all available information. The model doesn’t tell investors the “correct” ways to use that information or how prices should be set.
Meme stocks, as Gamestop and others have been labeled, seem fueled by investor demand that is part of a grassroots movement but it is important to remember that there are millions of investors, including individuals, governments, and corporations who invest on behalf of others. Ask two buyers why they invest the way they do, and you’ll likely get different answers.
Ask two sellers, you’ll similarly find different reasons.
The stock market is not always efficient, or rational, but it is always in equilibrium. Every trade has two sides, with a seller for every buyer and a profit for every loss. But is there a way to capitalize from occasional inefficiency and irrational behavior in the markets?
The short answer is yes.
Instead of reckless trading strategies, though, it can be done systematically. Start by owning the market. If you own all of the stocks, you’ll own the winners (and the losers). Over the long haul, stocks (including the losers) have outperformed other assets such as bonds or cash.
Then overweight areas of the stock market with higher expected returns. Small companies, value stocks, and profitable businesses have historically offered higher returns than the stock market overall. Overweighting those companies should lead to higher returns over time.
Gamestop hasn’t been profitable, but may be over weighted in a strategy that employs size and valuation as factors for investment.
Finally, if you own the whole market, you should have shares to lend to short sellers. Like cash, when a stock is loaned, interest is charged. The higher the demand is for the stock, the higher the interest rate that can be charged by the lender.
All of this equates to the answer of how we (or the mutual funds and exchange traded funds we use) capitalized on the Gamestop frenzy. It may not be as exciting as the casino like experience many gamblers had over the past month but for long term investors, it was all part of the plan.
If you need a plan, get a touch.