Investor insight #1: When will the Game Stop?

Tuesday 02 February 2021

Industry insights

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For those who haven’t heard, a sub-group of Reddit users that operate under the channel r/WallStreetBets (WSB) have been in a David and Goliath battle with US hedge funds on Wall Street. Hedge funds, for many years, have made money from shorting stock of companies they believe will decline in value. If they form a view that the price of a company will decline, they take a ‘short’ position by borrowing shares of the company from another holder and selling them at the current price, with the intention of buying them back later at a lower price and returning them to the original lender.

Keith Gill (AKA Roaring Kitty) one of the instigators of the GameStop trade on Reddit

The act of shorting is very controversial as on the one hand, it is said to keep markets efficient by increasing transparency and awareness of poor performing companies, weeding out the losers and putting management on call for their lackluster stewardship. On the other hand, it can crush the value of these companies and force many to shut down, potentially creating big losses for investors on the other side of the trade and large job losses for employees. No matter the intentions, short positions will experience losses if the price of their companies rise instead of fall (as predicted) because they now have to buy stocks back at an ever-higher price to return to the original lender.

This is basically what the WSB group are trying to achieve by encouraging retail investors en masse to purchase the stock of companies that attract plenty of ‘short interest’, bidding up their prices and creating large losses for the aforementioned hedge funds trying to close out their positions. Their intent is to stop the ‘greedy fat cats’ on Wall Street from stealing from the poor and ripping off retail investors. Said another way, they’re trying to go all Robin Hood on, well, RobinHood.

Regulators are now looking intently on both sides of the transaction. There are undoubtedly many questionable tactics that hedge funds use in pursuit of large investment gains and some of their practices do arguably require more regulatory scrutiny. The fact that they can use 10x leverage and 140% short interest beg two obvious questions; how is this even possible and/or should it be allowed? On the flipside of the argument, the WSB group are certainly executing their own form of market manipulation, though it’s just taking the opposite view. In the process, they are encouraging unsuspecting and unsophisticated investors to buy stocks of a company without considering its fundamentals.

Gamestop % shareprice change since December

For instance, the actions of the group have caused the price of GameStop stock to rise from less than $10 per share in October to more than $347 per share last week. At the time of writing, its current $325 share price implies a market cap of almost $23 billion. A quick glance of its latest balance sheet suggests something far less. If one subtracts all claims against the company (i.e. liabilities owed) from all assets owned, it has a book value of a little over $332 million. It has been experiencing declining revenue, earnings and operating losses for the better part of four years, with the worst of the operating performance suffered last year. GameStop is a traditional brick-and-mortar retailer in structural decline, so a stunning turnaround in fortune seems unlikely in 2021. This suggests that the company’s net debt position of approx. $227 million will likely get bigger before it gets smaller and serviceability of this debt will likely become harder, perhaps one day becoming unsustainable if the business does not execute a strong turnaround in the near future.

Regardless of your views on these events many questions need to be asked by regulators and, correspondingly answered, when this game of cat and mouse stops. Recent volatility in GameStop’s share price over the past few days demonstrates the lack of correlation to the company’s fundamentals. Once the buying stops, the share price drops. Ironically, for all of their well-placed intentions, the WSB group will likely leave many unwitting investors suffering large losses when the music stops. As fundamental value investors, we like to maintain a disciplined approach to investing, buying high quality companies at a discount to their estimated intrinsic value. We’ll continue sticking to our own tune. Block out the noise. Avoid GameStop.