How Main Street Beat Wall Street
With the amount of news coverage GameStop is getting, we felt it was necessary to explain what exactly happened in the GameStop trading battle and how it’s possible that a group of Redditors caused hedge funds to implode.
A Quick Background
First let’s go back to November when Ryan Cohen, who’s best known for founding the online pet product retailer Chewy, wrote a letter to the GME board of directors (see the letter here) saying he had a 10% position in GME stock and that he thinks the company needs to evolve from a primarily brick & mortar retailer with physical stores to a technology focused company. The letter was dated November, 16 2020 and as you can see below GME’s stock started to go up after this news came out.
His letter states “GameStop is also one of the most shorted stocks in the entire market, which speaks volumes about investors’ lack of confidence in the current leadership team’s approach.” He spoke of the company’s need to capitalize on the growth in gaming (which has been helped by everyone stuck at home during covid). I do not want to speculate on the short sellers’ thesis, but the two most obvious knocks on the company are: (1) GME has to pay rent on all these stores, a lot of which are in mall locations seeing less traffic, and (2) gaming platforms can now sell the games directly through the gaming systems, so people no longer need to go to a store to purchase a game.
Writing a letter to the board is a page straight out of the activist investor playbook. Usually you demand some changes, a seat on the board, among other things. Ryan Cohen actually didn’t demand a board seat in his initial letter, but on January 11, 2021 GME announced that he would be added to their board. If we extend the date on our prior GME stock chart to encompass this timeframe, you can see that the stock price on January 12, 2021 went from $20 per share to $40 per share on much higher volume (trading volume is indicated by the bar charts at the bottom of the graph).
This is when you started to hear about hedge funds that were short GME’s stock getting in trouble. The two I’ve seen mentioned most are Melvin Capital and Citron Research (see here). In fact, Melvin got an additional $2.75 billion from Steve Cohen (of Point 72 and formerly SAC Capital) and Ken Griffin (of Citadel).
The stock chart from here gets a little crazy. Extending it through Jan 27, 2021 we get:
To explain this price movement, we have to explain shorting stocks and how options work.
An Overview of Short Selling
Shorting a stock is when you make a bet that the stock price will go down. It is the opposite of going long a stock, which is when you own the stock and think it will go up in value. If I have an account with Fidelity and I call them up and I say “I’d like to short stock XYZ” the process works like this: Fidelity looks around and sees who amongst their millions of users own shares of XYZ. They’ll find someone that’s long and let me, the short seller, borrow that stock. If the stock was trading at $10, I would then sell it and pocket the $10 dollars while making the promise to buy it back and return the stock of XYZ to the person I borrowed it from. If the stock goes down to $6 dollars, then I can buy it back at $6 and “cover” my short. I make $10 — $6 = $4 profit, and the previous owner still has his shares of the stock. Note that Fidelity also charges a fee for arranging this (called “the borrow” which is usually stated as an annual interest rate). The more popular the short is, the harder it is to arrange, and the higher the borrow.
Before you can even short a stock, Fidelity will make you have a special account called a margin account. They do this to make sure you have enough cash/collateral in your account so that if you’re wrong and the stock moves against you (goes up) you can pay for it. Let’s walk through a hypothetical example of a short that does NOT work. Let’s say my margin account has $10 in it, and I short the same stock as before at $10. Now I have $20 in my account ($10 I originally put in + the $10 that I got from selling the stock short). Now, let’s say that the stock goes up to $17. Fidelity only has $3 of cushion now and they’re probably going to call me and say “sir, the stock that you promised to buy back has run up to $17 and you only have $20 in your account — we need more cushion than $3 so please add some money to your account.” This is called a margin call. You either have to put up more cash and hope that you’re right and the stock eventually trades down, or you have to throw in the towel and close out your short, crystallizing the $7 loss (you got $10 up front when you sold it, and now you’re paying $17 dollar to buy it back = $7 loss). If you don’t have extra cash when you get the margin call, Fidelity will close out the short for you, and so you end up in the same place.
One could speculate that margin calls are what caused Melvin to raise additional capital from Point 72 and Citadel the other week. Shorting is a risky game because if you’re long a $10 stock, you can only lose $10 (it goes to $0). If you’re short a stock… well as we saw in GME it can just keep going up…
What does this all mean? If a stock has a lot of people that are shorting it, which GME did, it can cause a short squeeze. This happens when all the people that are short decide they don’t want to be short anymore and throw in the towel, or they don’t have enough cash to keep pressing their shorts and their broker closes out the trade for them. Recall that we short a stock by selling someone else’s shares and promising to buy them back — so to close a short the short sellers (or their brokers who are forcing them to close the position) buy the stock back. People were buying GME on the news that Ryan Cohen joined the board, then more people started buying, then the shorts got squeezed and started buying… and there’s your stock chart.
So… Is Short Selling Bad?
I’ve seen the question posed “short selling sounds bad, why is that legal?” Some regulators have subscribed to this view. In Europe, they have banned short selling at times when stocks were going down with the goal of preventing short sales from causing more downward momentum (see here). I personally don’t subscribe to this view. If a stock goes down so much that you think it’s cheap, then buy it!
There are also times when short selling can be beneficial to society. Let’s take Enron as an example. If you did a lot of work combing through their financial statements and thought the company was a fraud, you could short the shares and make a profit. One could argue that regulators should catch these bad actors and then there would be no need for the short sellers; but for whatever reason these fraudulent companies have occurred frequently enough throughout history that I think it’s safe to say the regulators won’t catch everything (remember Madoff — people told the regulators about him multiple times and they still didn’t catch him). This happened more recently with a company called Wirecard in Germany. Interestingly enough, the company’s lawyers tried to use the regulators against the short sellers by encouraging them to look into the short sellers for market manipulation (see here)! The short sellers were ultimately right. So short selling can provide a service to society by catching corporate bad actors before their lies go too far. And if you think a short seller is wrong, you can keep them in check by buying the stock (as the reddit crowd did with GME!). A recent example is when hedge fund manager Bill Ackman went short Herbalife and was in the press calling for regulators to look into it. Carl Icahn disagreed and bought a lot of the shares and wound up having the more profitable trade. Checks and balances.
An Overview of Options
This part is going to get a little mathematical. If you’re into that, enjoy the rest of this. If you’re not, consider this paragraph a very concise summary and you can skip ahead to the next section. The summary version is that when people buy a call option, the dealers hedge their exposure by buying stock. Dealers don’t like to make directional bets, they prefer to just stay neutral and make a fee on every trade. How does that apply here? Well, in addition to the short squeeze, GME had people buying a lot of options, and so dealers hedged themselves by buying stock. The combo of redditors buying + short squeeze + option dealers hedging their exposures by buying stocks created a one way move up!
For those of you that are curious how that works and willing to dabble in some math, continue on. A call option is the right to buy a stock at a specified price in the future. Options give the buyer a lot of leverage. For example, if you think AAPL is going to go up, you can buy 100 shares of AAPL at today’s closing price of $137. That costs $137 x 100 = $13,700.
Or… you can buy a call option that expires in June with a strike price of $150 for ~$9 (each option is for 100 shares, so the cost is $9 x 100 = $900). What that means is, you have the “option” to buy 100 shares at the strike price of $150 from now until June (you’ll only execute that option if the stock price is above the strike price of $150). If AAPL’s stock goes up ~25% from $137 to $171, you make $171 minus the strike price of $150 = $21 x 100 shares = $2,100 dollars on your $900 investment, for a profit of $1,200. That’s equivalent to a 133% return, when the stock only went up 25%. You can shell out less money and get higher returns, which is why people say that an option gives a buyer more leverage.
However, if APPL’s stock doesn’t move at all, the option buyer loses $900 and the stock owner doesn’t lose any money. In fact, if APPL goes from $137 to $150, you made a 9% return on the stock, but your option is still worthless and you lose $900 dollars. You actually need the stock to go $9 above the strike (since you paid $9 for the option) before the option starts to be profitable. In this case it has to go to $159 for you to breakeven on the option. At $159 you breakeven and the shareholder would be up 16%. It’s always difficult to write sentences about math so I’ve summarized this in a table below as well.
Here is where I’ll give the disclaimer — options are complex instruments and you should probably stay away unless you’re a sophisticated investor.
There are a lot of things that go into the valuation of an option prior to expiration. The longer the time to expiration, the more valuable the option (there’s more time for it to get in the money). The closer the stock is to the strike price, the more valuable the option (it doesn’t need to move as much to get in the money). The more volatile the stock is, the more valuable the option is (if it moves around a lot in big swings, it’s more likely to get in the money).
Now for the fun stuff. An option doesn’t move $1 for $1 with the stock price. In fact, it depends where the stock is relative to the option’s strike price. I drew a hypothetical of this below (it’s drawn in excel so it won’t be perfect, but it will work for our example). Let’s say you have a $100 strike price on an option and the stock is trading at $200. You’re really far in the money. At that point, if the stock goes to $201, your option value is probably going to go up $1 for $1 (that’s “zone b” of the graph). If the stock is trading at $10, even if it goes to $11 you’re so far away from the option’s $100 strike that the value of the option isn’t going to go up much (that’s “zone a” of the graph). This concept is called delta. Delta is how much the option price changes, for a $1 change in the stock price. It’s the first derivative in the chart below (graphically, the first derivative is those tangential lines I tried to draw in green in red).
Dealers try to do something called delta hedging. As mentioned in the introduction of this section, dealers generally don’t want to take directional views on the market. They prefer to help you execute trades and they clip a fee (called the “bid ask”) for doing so. If everyone is buying call options, the dealer could lose a lot of money if the option buyers end up being right and the stock price goes up. So the dealers delta hedge. In “zone a” of our chart, the delta might only be .20 — meaning, if the stock goes up $1, the option value only goes up $0.20. So if the dealer sold a call option for 100 shares, they would buy 20 shares to stay delta hedged. That way, if the 20 shares they own go up $1, it perfectly offsets the $0.20 increase in the option value they sold you (100 shares x $0.20 = $20). However, as the stock approaches the strike price the delta approaches ~0.50. So now the dealer needs to buy 30 more shares to maintain his delta hedge. If the stock keeps going up and is very far in the money, the delta approaches 1 and the dealer needs to buy the full 100 shares to stay hedged. (For those curious, the second derivative of the graph is called “gamma” and gamma is how much delta changes for each $1 move in the stock price). This delta hedging (you’ll also hear things like “gamma squeeze” or “dealers are short gamma”) exacerbates upward momentum in a stock when there is heavy call option buying. It also causes downward momentum when there is heavy put buying, as a put option is the exact opposite of a call option.
So… Did Main Street Beat Wall Street?
Let’s bring back our price chart. This stock was trading 7m shares a day on average in November 2020, with a high of 12m. As you can see below, in recent days the stock was trading between 100m and 200m shares a day.
Every 2 weeks FINRA (Financial Industry Regulatory Authority) gets a report outlining the short interest in stocks. That’s shown on the graph below. At year end 2020, GME’s stock hit a high of 71m shares short. Recall in November, this thing was trading ~7m shares a day (it was similar in December), which means it would take all the shorts ~10 days to cover their short positions based on normal market volumes. Said another way, there’s 70m shares outstanding and 70m shares shorted — this is an incredibly high short interest… If the stock were to move up (we all know what happens), it’s a name that was primed for a short squeeze.
There was also an increase in people buying options, particularly in GME (link) which simultaneously caused that “gamma squeeze” we talked about in the options section. Here is another article (note: it’s behind a paywall), which has a graph of options trading on GME. The most recent date on the graph is January 22, 2021 so it’s not perfectly up to date, but it still works to get the point across. Options trading had gone from under 100k contracts most days to over 2m contracts on January 22, 2021. So the gamma squeeze was undoubtedly a contributing factor.
This impacted more than just Melvin. The Reddit crowd found other popular shorts and started buying them. While the other stock moves were not as dramatic as the price moves in GME, the hedge funds saw what happened there and didn’t want to be part of the sequel.
Hedge Funds usually run a combo of long positions and short positions. If you’re long 100% of your capital and short another 50% (established hedge funds can use borrowed money from a prime broker, similar to the margin account for individual investors), then in industry parlance you’re running a “150 gross” and a “50 net”. Guys will also run longs over 100% by using borrowed money. So you could have a 120% long book, a 50% short book, for a 170 gross and a 70 net. The allocation will vary depending on the strategy. For example, a long-short equity strategy will typically try to keep his/her net closer to 0, so that the longs balance out the shorts.
The price moves in the shorts caused a lot of hedge funds, particularly long-short equity hedge fund strategies, to start losing money (sometimes a lot) on the short leg. The market has mostly been down the last few days (the S&P 500 index is down ~2% in the last 3 days), so they’re losing a little money on the longs and potentially a lot of money on the shorts. Usually, these will balance each other out (and if you’re good at picking stocks your longs should do well and your shorts should do poorly!), but this week it has been a lose-lose. Your brokers are calling and asking for more collateral on the short book, so you have to sell your long positions to raise cash in a soft market, and use the cash to “cover” your shorts that are running up. The end result is that a lot of these funds had to take down their gross exposure (called “de-levering”) and they lost money on both sides.
So… What Happens Next?
Stock movements are a function of market participants buying and selling. If more people want to buy a stock than there are sellers, the stock goes up until supply and demand find an equilibrium. There are technical factors that can cause momentum to get ahead of itself (the short squeeze and gamma squeeze). But if things move too far, they tend to correct themselves over time. At the end of the day a stock is an ownership share in a company. If the company is growing very fast, or the company is being disrupted by technology, it can be harder to value that company — but ultimately the stock price converges with the right valuation, even if it takes years to do so. While people may disagree on what the right value is at a moment in time, people on Wall Street spend a lot of time researching companies, meeting with management, and trying to come up with an opinion on what the right value is. That’s not to say that Wall Street analysts are always right (Elon Musk fans made a lot of money before Wall Street got on the bandwagon and Warren Buffet has made a career out of finding value where others didn’t see it), but at least the Wall Street estimates give us a starting point. So let’s start there. According to CNN Business, the median target price for GME is $12.50 with a high of $33 and a low of $3.50 (here). The current closing price at the time of writing is closer to $200, and it has touched $400 in the last few days.
We can also compare the company’s valuation to other companies that are similar. Let’s take Dick’s for example, another company with a large brick and mortar store base that you may have even seen near some GameStops. In the last twelve months, Dick’s generated ~$845m of EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization). Now let’s look at the Enterprise Value of Dick’s. The Enterprise Value is what you’d have to pay to buy the company (you have to buy all the shares, which is the market value of equity + repay all the debt — the cash on the balance sheet which can go towards paying down the debt). Dick’s has $575m of convertible notes (we’ll treat this as debt), a $6.1 billion market cap, and $1.1bn of cash for an Enterprise Value of ~$5.6bn. That means you can buy the company for ~6.7x earnings ($5.675bn EV / $844m of EBITDA).
One could argue that Dick’s has some advantages that GameStop does not. While both gaming and outdoor activities have seen increased participation during covid, you can buy a video game through your console now without ever stepping into GameStop. That’s much harder to do with a canoe or golf clubs, which are large products that you may want to get fitted for or speak to an expert before buying.
However, if we do the same analysis on GME… Well it’s harder to do that as the company hasn’t actually been profitable this year and only generated a small amount of EBITDA in 2019. That means we can’t use the same earnings multiple, because the denominator (earnings) is negative. In fact, GME has had declining sales for the last 11 quarters. The declines are actually worse now than they’ve ever been. That being said, markets are forwarding looking, and maybe the crowd on Reddit plans to help Ryan Cohen turn the company’s performance around by frequenting GameStop stores. I am no expert on video games, but based on a quick comparison to Dick’s and where the company has traded in the past, you need to believe in a dramatic turnaround at GameStop to justify the current trading prices.
Investing in the markets always has risks, but those risks can be mitigated by having a diversified portfolio and keeping your money invested over a long time horizon. If you save a little money each month or each year, you may end up buying when the market is expensive but you’ll also end up buying when it’s cheap. The more you can remove the emotions from investing and know that over the long term compounding returns will work in your favor, the better. Certain products like call options can have large payouts, but they can also wipe out all of the money you put into them. While it may be enticing to dabble in some of these names, just beware that stocks can move up and down so be prepared to ride the roller coaster both ways.