GameStop: How the short hit the fan

Traditional investors make money by buying low and selling high. Short-sellers make money by selling high and buying low – in that order.

A short bet is when you believe that a stock is overpriced and its value should correct (and fall). If you think so, you will borrow it from someone who owns the stock and sell it in the market. When it falls, you can repurchase it and give it back to the lender of the stock.

This phenomenon is bittersweet and can be very risky. The most amount you can make is the value you sold it at (shorted it at). This would happen if the stock price went to zero.

However, if the stock rallies, your losses are uncapped. If you shorted it at Rs. 100 / share, you can only make a maximum of Rs. 100 when it goes to zero. If it rallies and heads to say Rs. 400 / share, you have a loss of Rs. 300.

One mustn’t be faint-hearted in approaching this strategy.

We’ve seen many very public and storied famous shorts in recent years. The movie, The Big Short, was based on betting that the housing market would collapse across 2007-2008, based on the overpricing of housing value during that time. It resulted in exceptional investment gains for a few managers – notably John Paulson, who many believe made the greatest trade ever through the tumultuous times.

In 2013, Bill Ackman of Pershing Square and Carl Icahn of Icahn Enterprises, both revered fund managers and billionaires, had a very public fight on Herbalife. Ackman was very publicly short Herbalife, calling it an illegal pyramid scheme and Icahn buttressed Herbalife by making a sizable investment. Icahn won that battle with over $1bn in profits.

Whenever new PlayStation and Xbox consoles are released, thousands of customers flock to the nearest GameStop store. But as technology advances, store-based purchases are being relegated to the background.

It’s no surprise, therefore, that GameStop’s market-cap had been steadily dropping. Gamestop is a video game, consumer electronics, and gaming merchandise dealer. Even as videogame publishers reported a massive surge in sales as people stayed home, GameStop’s store sales had been dropping. The company has lost nearly 90% of its market value since the launch of the Xbox One and PS4. In 2020, GameStop shut over 462 stores (783 store closures in the last two years).

In August 2020, Chewy’s co-founder Ryan Cohen bought a 9% stake in GameStop and implored its board to undertake a dramatic strategy shift. Last quarter, online channels accounted for about 20% of GameStop’s total revenue. The company inked a deal with Microsoft, which will give it a cut each time a user downloads a digital-only product from store-purchased Xbox.

However, some hedge funds believed that the prospect for GameStop wasn’t bright. They placed shorts on the stock expecting it to fall, given its high retail footprint.

One Reddit user had been religiously following GameStop for over a year and noticed that it had strong financial positions, which seemed unwed from its stock price of USD 2-4. The reason was intense short pressure on the stock. He corralled the Reddit board for investment enthusiasts, WallStreetbets, to join in on his war against the shorts. Michael Burry, of The Big Short fame, also invested after him. The stock slowly began to rise.

However, if the stocks were bought for cash, the rise may not have been as meteoric — many bought options. To hedge options, the market makers need to buy the underlying stock, contributing to the rally. If some were short the stock, they’d need to cover it by buying the stock. This fuelled the rally evermore.

The apathy against hedge fund managers became quite public. Influential names such as Elon Musk and Chamath Palahapitiya joined in on pushing GME up. Tesla had been a short-sellers’ favourite till recently. Elon doesn’t have much love for them.

The short interest was over 100% of the total market cap. The short sellers were expecting the stock to go bankrupt and never having to cover the short.

Melvin was bleeding, but it didn’t budge. On Monday, it took an additional USD 2.75bn. By Wednesday, it closed out its short, adding to the rally.

On Thursday, many brokerage houses in the US stopped the purchase of GameStop shares, resulting in a public outcry against the measure and a natural fall in the stock price. Investors were only allowed to sell their positions.

Beyond GameStop, the cinema chain AMC, Nokia, and Blackberry have also seen a retail mob rallying their prices up.

In India too, we’ve seen a fair interest in GameStop. The drama around the stock and the story received equitable interest. However, it is still early days for a sizable part in the US market’s speculative play. Note that the movements can be very sudden.

At Winvesta, we’ve observed that the first set of investors were dabbled in Gamestop on the 9th of December when we’d carried out the Winvesta Crisps story on the stock’s fundamentals. It was barely the sensation it became over the last two weeks. The stock price was less than USD 17.

In recent days, we’ve seen more investors pile into the stock, a 7x increase compared to the last few weeks. However, we were encouraged to see that these transactions’ size is small – as if to dip their toes.

We visibly avoid very low priced stocks for the excessive speculative nature these may attract. Not all brokerages have fractional shares. This does rally up low priced penny stocks during speculative behaviour.

As India discovers investments in the rest of the world, we can expect our engagement with the world to significantly increase and play a more significant role in the good, the bad, and the ugly.

Originally published as an authored article in Moneycontrol.