Last night, a friend texted me wondering what I would write about today. To be sure, there is no shortage of topics to discuss. However, the GameStop imbroglio, which I think is an apt word, is the low-hanging fruit. What in the world, huh?
In case you haven’t been following the news, let me give you some background color. GameStop is a retailer which specializes in selling video games and gaming equipment, both new and used. As of its most recent earnings release, the company had 5,100 physical locations, down from 7,586 at the end of January in 2017. These are often in shopping malls or strip centers near a larger ‘anchor’ store like a Walmart, etc.
If this business model reminds you of Blockbuster Video, you are not alone. I would argue GameStop is to gaming what Blockbuster was to movies. Actually, a lot of people would argue that, a whole lot. So many, in fact, it has led to the situation at hand.
Before I go much further, let me make the following caveats: 1) I do not personally own, either directly or indirectly, any investments in GameStop Corp; 2) Oakworth Capital Bank does not make a market in the company, and; 3) Oakworth Capital Bank does not purchase investments in GameStop Corp in client accounts for which it exercises investment discretion. Essentially, I and we don’t have any skin in GameStop; no dog in the hunt, if you will. I am a complete outsider looking in on the situation.
There, I think that just about covers it.
When the company opened its first location back in 1984, shopping malls were still the rage and at home gaming was still basically in its infancy. Sure, there was Pong in the 1970s, and some lucky kids had an Atari 2600, Intellivision, or even a Coleco handheld device; however, the games were relatively few in number and lacking in quality.
Then, in 1983, companies started coming out with higher resolution 8-units, and 16-bit models weren’t far behind in 1987. It was during this time, the late 1980s and early 1990s, when the video arcade went from the shopping mall to the teenager’s bedroom or family room. The final death knell to the arcade came in 1994, when Sega released the Saturn console, and Sony came out with PlayStation. These were game changers, literally and figuratively.
Of course, the Wii and Xbox weren’t too terribly far behind.
Yes, we really did watch other people play games like that. What a colossal waste of time.
As a result, there were a lot of gaming consoles from which to choose, each with their own games. What’s more, programmers were developing new games faster, making them better as the technology/coding evolved. So, a store where consumers can find any number of different systems and games? Where they can sell their old games and parlay the cash into new ones? GameStop’s business model was a slam dunk, just as Blockbuster’s had been. However, advancements in streaming/download speeds put a wrinkle, or five, in things.
Gamers no longer HAVE to go to GameStop to get the newest games. They can simply download them onto their consoles. Trust me, I know every time my son downloads something onto his Xbox, as it pops up on my phone. Further, why make a special trip to the store when you can do all of your research and purchasing online? That is a great question, one which a lot of people have been wondering
Suffice it to say, the company has been, is, and will continue to face significant ‘headwinds.’ I forgot who said it, but someone told me recently: “GameStop is out of business, they just don’t know it yet.” If you don’t like the Blockbuster comparison, maybe Circuit City is better or JCPenney. After all, companies effectively compete one of two ways: 1) on price, or; 2) on product (service). Those that don’t are ‘stuck in the middle.’ They will eventually vanish, and most people won’t even notice let alone care.
With this little history lesson out of the way, just what the heck happened this week. First things first, investors had been ‘shorting’ the stock like crazy. This is when someone sells shares they don’t own in the hopes the stock price will fall, and they can buy the shares back cheaper. Here is a good explanation of the practice from investopdeia.com:
“There are no standardized regulation relating to just how long a short sale can last before being closed out. A short sale is a transaction in which shares of a company are borrowed by an investor and sold on the market. The investor is required to return these shares to the lender at some point in the future. The lender of the shares has the ability to request that the shares be returned at any time, with minimal notice. In the case of this happening, the short sale investor is required to return the shares to the lender regardless of whether it causes the investor to book a gain or take a loss on his or her trade.
In practice, requests to return shares are rare, as the lender of the shares is a brokerage firm that has a large inventory of stock. The brokerage firm is providing a service to investors; if it were to call shares to be returned often, investors would be less likely to use that firm. Furthermore, brokerage firms benefit greatly from short sales through the interest they earn and commissions on the trades. There is also limited risk for the brokerage firms in a short sale transaction because of the restrictive margin rules on short sales.
In a short sale, brokerage firms lend shares out of their inventory, out of their clients’ margin accounts, or they borrow them from another brokerage firm. If a firm lends out shares from one of its clients’ margin accounts and that client, in turn, decides to sell their position, the brokerage firm will be required to replace the shares lent out from that client’s account with other shares from their inventory, another clients’ margin account, or from another brokerage firm. This situation does not impact the short seller.
However, there are some cases in which the lender will force the position to be closed. This is usually done when the position is moving in the opposite direction of the short and creating heavy losses, threatening the likelihood of the shares being returned in the future. In this situation, either a request will be made to return the shares, or the brokerage firm will complete the closing of the transaction for the investor. The terms of margin account contracts allow brokerage firms the freedom to do this.
Short covering can also occur involuntarily when a stock with very high short interest is subjected to a “buy-in”. This term refers to the closing of a short position by a broker-dealer when the stock is extremely difficult to borrow and lenders are demanding it back. Often times, this occurs in stocks that are less liquid with fewer shareholders.
While the lender of a short sale transaction always has the power to force the return of the shares, this power is usually not exercised. An investor can maintain a short position for as long as they are able to pay the required interest and maintain the margin requirements, and for as long as the broker lending the shares allows for them to be borrowed.
A short squeeze involves a rush of buying activity among short sellers due to an increase in the price of a security. The increase in the security price causes short sellers to buy it back to close out their short positions and book their losses. This market activity causes a further increase in the security’s price, which forces more short sellers to cover their short positions. Generally, securities with a high short interest experience a short squeeze.
For example, suppose the short interest in company XYZ Company is 50%. In this example, many traders are short from $50 due to poor earnings, and the stock is currently trading at $35. However, over the next quarter, the company reports stellar earnings and doubles in value to $70. Since many traders are short, they would need to cover their short positions to limit their losses; this creates buying pressure on the stock and causes the price to increase to $80, exacerbating the problem.
When an investor decides to short sell, it’s because they expect that the market price of a stock will fall, enabling them to replace the shares in the future at a lower cost. If a stock doesn’t drop in price quickly enough, it can cost the investor money. As a result, it is far more likely that the investor will close out the position before the lender will force the position closed.”
But why now and why has the market reaction been so extreme? The why now is pretty simple: some pretty bright people recently noticed something pretty peculiar about GameStop stock. Short interest, or the number of shares investors had shorted (sold without owning) had ballooned to 71.2 million by the end of last year. The float, the number of shares available to the investing public, was only 50.2 million (142%). Somehow, the market had sold more shares than it had. Hmm. That doesn’t have to be a problem, and cab ordinarily self-correct, unless someone exploits the mismatch. As we now know, someone did. Perhaps it is more accurate to say some people and some hedge funds did.
You see, if you buy shares of stock, someone has to give them to you. If they don’t have them, they have to get them from somewhere else. I think you can see what happened next. The so-called smart money starting buying shares of GameStop, knowing full well there weren’t enough shares, in aggregate, to make delivery. Ordinarily, a brokerage firm will simply ‘borrow’ shares from other client accounts which own them OR use any they might have in inventory. If the firm doesn’t have enough, guess what, the folks (clients) who sold the stock without owning it had better figure out a way to get their hands on some, pronto.
So, when the big money started dropping tickets to buy shares on the 13th, it set the wheels in motion for this week. On that day, the volume in GameStop trade activity reached 144.5 million shares. Boom. To put that number into perspective, the 3-year daily average from 12/31/2017 – 12/31/2020 was, get this, 5.4 million. Again, boom.
This started a domino effect, or a death spiral if you had shorted the stock. It is craziness…the buy side wants to buy the stock and the sell side needs to buy the stock in order to sell to the buy side. Again, the market had shorted more shares than are available. So, what happens when demand is greater than supply, for anything? That is right, the price goes up.
And what happens when a brokerage can’t come up with the shares it has promised to deliver since its clients don’t have them? That’s right, it restricts trading on the stock until it can close the mismatch in the orders. Nothing particularly nefarious about that.
However, the headlines on the matter seem to be pitting Goliath against David. The big, bad hedge funds and other greedy Wall Street types are out to squeeze and crush the little guy. Right? Well, there IS a lot of truth to that, a lot. However, who is really to blame? In the current court of public opinion, it seems those exploiting the mismatch, buying shares, are the bad guys, not those betting against the company by selling shares they don’t even own.
Since when, pray tell, are short-sellers the good guys? The hapless innocents the government needs to protect with new rules and regulations? And I thought 2020 was weird.
Let me start closing this up by relaying a conversation I had with my son on the matter this week. He has relatively recently opened his own Robinhood account, and I have told him to be extremely careful. In fact, let me share with you:
- Don’t be blinded by quick bucks…investment is a marathon and not a sprint.
- Also, remember this, people always talk more about their home runs than their strikeouts.
- Find some stocks which interest you and do some homework. However, make sure the company has a comparative advantage and some tangible value.
- If you find some good ones, perhaps I can throw in a little money and we can buy them together. Cool?
Yeah, that about sums it up. However, let me end with this: I don’t care one way or another about GameStop, the company or its stock. I really don’t. However, I have caution anyone who is interested in short-selling: it is highly speculative, even if it appears to be a slam dunk. If you aren’t prepared to take a beating, you aren’t prepared to employ this strategy. Finally, the higher the short-interest the greater the likelihood you could get ‘squeezed’ by folks who have more money and no compunction with taking yours.
Take care, and have a great weekend.
John Norris
Chief Economist
As always, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as those of our investment committee, are subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the reset of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself.