Next Generation Newsletter | Feburary 2021

By 213 Strategic Partners on February 23, 2021

Game Over for GameStop?

in·​vest |  in-ˈvest (verb)

1: to commit (money) in order to earn a financial return

2: to make use of for future benefits or advantages

gam·​ble |  ˈgam-bəl (verb)

1a: to play a game for money or property

b: to bet on an uncertain outcome

Source: https://www.merriam-webster.com/

To understand the self-proclaimed “meme stock” phenomenon that has transpired over the last few months, it’s prudent to begin the discussion by first spelling out the difference between investing and gambling.  Our team thinks about investing through the lens of a rigorous four-step process, tailored to the needs of each client:

1. Profiling and Risk Assessment
2. Investment Policy Statement
3. Implementation and Portfolio Construction
4. Portfolio Monitoring

The importance of this process cannot be understated.  We’re creating and sustaining wealth to allow our clients to meet their retirement goals, support philanthropic and other meaningful causes, and ultimately leave a legacy for their successors.

As you have probably seen and read about in the news the past few weeks, there was recently a market frenzy related to several “meme stocks” including GameStop (GME), AMC Entertainment (AMC), Nokia (NOK), and others. Below we will clarify a few things to help provide an understanding of what occurred.

GameStop is a video game chain that was negatively affected by the pandemic. Because of this, it was targeted by short-sellers betting that the stock’s price would go down.¹  Short selling is typically thought of as the opposite of what most investors do – they try to make money when a stock’s price falls.  They do this by borrowing shares from their brokerage for a fee, selling them immediately, and then planning to buy them back later at a lower price when the price falls.  This strategy is used by certain types of hedge funds.

Shorting stocks can be risky, as any positive news or interest in a company can drive the stock’s price up. When short sellers bet wrong and a stock’s price rises, they can be forced to buy shares at higher prices to cover their losses.  A squeeze occurs when short-sellers scramble to buy shares to cover their positions when the stock price is rising. The more investors who buy and hold those shares, the harder it is for short-sellers to find shares to buy – potentially exposing them to large losses. Academically, short selling carries an infinite amount of risk.  When investors are long a stock, the maximum loss that can be sustained is the entirety of their investment.  However, with shorting, a stock’s price theoretically has no ceiling to how high its price can rise.

GameStop became the focus of the WallStreetBets (WSB) forum on Reddit, a popular online community of chatrooms and forums. After an analysis of trading data supported the notion that short sellers were over-levered speculating on GME’s decline.  Several traders on Reddit banded together to gobble up GME stock and these small-time traders boosted the stock’s price far above what the company’s financial fundamentals support, putting pressure on the hedge funds that were shorting the stock.²

However, the cautionary tale soon transitioned from investing to gambling.  As the GME stock price soared 8,000% over six months, it garnered mainstream attention in the second half of January, becoming one of the top stories in our country.  Regrettably, several uninformed opportunists were misguided into believing GameStop’s meteoric rise would continue and several late arrivals suffered substantial losses.  At the time of this writing, the GME stock price has declined over 90%, dropping from $483 to $48, in just two weeks.

I firmly believe there are meaningful takeaways to be had from this recent spectacle:

•  As an investor, have a rationale and understanding for the securities you purchase.  Simply put, following strangers on a message board, without performing adequate due diligence or having a basis for an investment, is not a strategy.  “Get-rich” schemes rarely prevail and unfortunately, nest-eggs of savings were destroyed in the last few weeks.  Anyone can post ‘Hold the Line’ (a phrase on WSB encouraging GME shareholders not to sell), when in fact, the poster is doing exactly that.
• Have some familiarity with the investment platform you use to invest.  The popular brokerage site, Robinhood, nearly became insolvent during last month’s frenzy and needed emergency funding to stay afloat.  Even before the fiasco, we have expressed caution with using relatively new platforms such as Robinhood for a multitude of reasons.
• We’re unlikely to see an event like this occur in the same manner.  Investment firms are always performing stress tests, attempting to prepare for worst-case situations by creating dire, theoretical scenarios.  A leading cause for GameStop’s run-up was that retail investors were sitting on extraordinary paper gains and refusing to sell their shares to realize a profit.  It’s unlikely this form of irrationality was adequately stress-tested but that will not be the case moving forward.

Tom Macaluso CFA^®

Financial Advisor & Analyst

¹_{https://www.morningstar.com/articles/1019249/what-the-heck-is-going-on-with-gamestop}

²_{https://www.marketwatch.com/story/gamestop-stock-has-another-volatile-trading-day-with-more-price-spikes-and-trading-halts-11611686411}

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