Framed globally by media outlets as a resounding victory of small-time retail investors over imposing Wall Street institutions, the GameStop short squeeze was a bizarre and fascinating event. Nonetheless, questions remain. Why was GameStop the subject of this madness? What is a short squeeze and how did it actually go down? Is there a takeaway here for those who stayed on the sidelines?
The Perfect Short?
GameStop was and still is the world’s largest brick-and mortar video game retailer. Although initially a thriving business, GameStop ran into problems between 2013-2016. The launch of a new generation of consoles by Microsoft and Sony had introduced two massive digital storefronts for games: Xbox Live and the PlayStation Network. Paired with the rising popularity of PC equivalents such as Steam, these services heralded an evolution in the video game industry. For consumers, digital downloads were practical as gamers didn’t have to travel to stores to obtain physical copies. For sellers, digitalisation produced higher profit margins, partly because they could cut out the middle man – companies such as GameStop.
Although this development was not fatal in itself, management’s inability or unwillingness to adapt was. In an effort to reduce the company’s exposure to what seemed an old-fashioned and shrinking market, executives decided to diversify into other areas. Specifically, the company set its sights on smartphone stores, acquiring Spring Mobile together with hundreds of outlets from AT&T. This spending spree meant that GameStop ran almost 1,500 smartphone stores under the Spring Mobile name by 2016. However, as is often the case, what was framed as prudent diversification turned out to be a case of diworseification. Indeed, according to Wedbush analyst Michael Pachter, GameStop had spent $1.5 billion on a string of acquisitions which failed to meet expectations, forcing the company to sell Spring Mobile to Prime Communications for a humiliating $700 million in 2018. This debacle left the company stranded, with $800 million in debt and nothing to show for it. Faced with a seemingly insurmountable problem, management began to court private equity firms in the hope of a buyout. Although New York based Sycamore Partners expressed interest in June 2018, discussions collapsed, leading management to give up its search for a suitor in January 2019, citing “a lack of available financing on terms that would be commercially acceptable to a prospective acquirer”. At the risk of misinterpretation, this statement could have meant that whilst buyers were available, no creditors were willing to lend money to the company – a prerequisite for rebooting the ailing enterprise.
Already in dire straits, disastrous financial results between 2017-2019 only exacerbated GameStop’s struggle. Revenue (the top line) fell 32.2% during this period, whilst the company’s miniature profit of $35 million in 2017 spiralled into losses (the bottom line) of $673 million in 2018 and $471 million in 2019. Naturally, GameStop’s stock price cratered alongside these deteriorating financials, dropping from $24.5 in January 2017 to $11.34 in January 2019.
GameStop’s rapid decline, which was accompanied by tumultuous management changes, drew the attention of activist investors who perceived the company to be undervalued and ripe for a turnaround. Indeed, Michael Burry – famous for predicting the housing crisis – acquired a 3% stake in the company in August 2019 on behalf of his firm, Scion Asset Management. In a phone interview with the investment magazine Barron’s, the investor argued that the market was undervaluing GameStop, citing the strength of GameStop’s balance sheet (in February 2019, the company held twice as much cash as debt) and the fact that the next generation of consoles would retain disc drives as reasons for establishing his position. Scion Asset Management sent a letter to GameStop’s board, suggesting that a $238 million share buyback was an excellent application of the company’s excess cash.
However, whilst a handful of optimistic investors such as Michael Burry established long positions, thereby betting that GameStop’s market value would recover, many other hedge funds were pessimistic and shorted the company, wagering that it would continue to shed value – a logical course of action considering the company’s seemingly endless problems. The case for shorting GameStop only became stronger with the onset of the COVID-19 pandemic in March of 2020, which forced the company to shutter all of its storefronts to comply with national safety measures and stay-at-home orders. As a consequence, the fiscal year of 2020 (which ended in January 2021) featured a 27% drop in sales and a $215 million net loss.
Shorting a stock is a three-step process. First, the short-seller borrows shares from a broker and instantly sells these at the market price. Next, assuming that the share price has fallen, the short seller repurchases (covers) the shares at a lower price, keeping the difference as profit. The shares are then returned to the broker (the lender) together with interest to close the trade. Importantly, shorting is extremely risky relative to a conventional long position (where you own the shares and hope they appreciate). That’s because share prices can theoretically increase to infinity so your losses as a short-seller, who bets that the price will go down, are equally infinite. In contrast, the maximum you can lose with a traditional long position, is what you put in (your inlay) – the stock price cannot fall past zero. In addition, shorting often involves the use debt (also known as leverage) to supercharge buying power, adding another level of risk/reward because both potential gains and losses are magnified.
According to the data analytics firm S3 Partners, GameStop had a short interest of 142% in the first week of 2021, which means that 141% of shares were actively being shorted at the time. How could this proportion exceed 100%? A number of shares which were already being sold short were being re-lent out to other short-sellers, meaning that they were effectively shorted twice. Let’s use four investors to demonstrate this. Max owns shares of GameStop and has an agreement with his broker to lend these out to short-sellers. Max decides to lend these shares to Anna, a short-seller, who sells them instantly in the market. Another investor, David, buys these shares. If David has the same agreement with his broker as Max does, he can lend these out again to a short-seller such as Emma. None of the characters in this scenario know where the shares came from or whether they were already being shorted. The point here is that GameStop was a crowded short: a large number of extremely bearish (pessimistic) hedge funds had sold short an astronomical proportion of shares, exposing them to a short squeeze.
Short-squeezes, although rare, typically occur when the short interest for a stock is extremely high, the number of buy orders exceeds sell orders, and few shares are changing hands. Remember that short-sellers bet that the share price will decrease. However, if things don’t go to plan and the share price increases due to a positive catalyst (e.g. good news for the company leads to many investors buying the stock), short-sellers rush to cover (close) their positions and buy back the shares at whatever the current price is to limit their losses which, as mentioned, are potentially infinite. Short-sellers do not always do this voluntarily. Indeed, traders who trade on margin (i.e., using money borrowed from their brokers), may be forced to cover their positions by the broker if their paper losses mount (due to a share price increase) in what is known as a margin call. This is a procedure in which the broker demands that either more collateral is put up or that some of the trader’s positions are sold in an attempt to secure the trader’s ability to repay the loan. Here’s the catch. If there are already few sellers available and crowds of buyers, the act of covering actually drives the share price up even further as demand increases whilst the supply remains at the same level. This is why short squeezes can result in dramatic price increases which ‘squeeze out’ short-sellers and produce windfall profits for long-side investors.
Although short-squeezes have happened before, the GameStop squeeze was unique because it was triggered by retail traders of the Reddit forum r/wallstreetbets – who provided the positive catalyst for the price increase – and morphed into a worldwide movement against the financial establishment. Members of the subreddit, which was initially established as a place for users to post absurd gains and losses from speculative all-or-nothing trades, caught on to the GameStop opportunity in January of 2021 and began buying up shares in an attempt to squeeze short-sellers. Admittedly, there was interest in GameStop as a value opportunity (it was cheaper than its prospects would suggest, and therefore a good investment) prior to the squeeze. In what must have perplexed short-sellers, the r/wallstreetbets forum, which had effectively initiated a tremendous squeeze, was actually characterised by memes, vulgar language, and a cult-like mentality (see the below video).
The ‘hold’ strategy referred to in the video refers to the aim of the forum’s members to buy up GameStop shares – often using leverage (debt) and high-calibre derivatives such as options – and not selling them in an attempt to restrict supply as much as possible. This would amplify the price increases brought about by those short-sellers who covered and ‘trap’ other hedge funds whose positions were too large to close, forcing them to sustain massive losses. The selfless mission of the forum’s members, who were willing to bleed as long as hedge funds bled more, attracted the support and involvement of high-profile celebrities such as Elon Musk, Mark Cuban, and Chamith Palahipitiya, whilst creating some of its own.
Needless to say, the squeeze was extremely successful. GameStop’s stock price skyrocketed from approximately $20 at the turn of 2021 to $350 in late January and was the most traded stock by value (quantity of shares traded multiplied by the stock price) in the entire U.S. on January 26th. Interestingly, between now and then, the stock price has continued to show pronounced volatility. See the graph below.
Halting of Trading
The frenzied trading in GameStop didn’t last. In a series of highly controversial moves, popular brokers such as Robinhood (alongside others), which had explicitly marketed itself as a friend of the retail trader, halted new purchases of GameStop shares on and around January 28th and only permitted sales. To justify their actions, brokers claimed that clearing houses (link to an explainer) were requiring them to post extra collateral in order to continue executing buy orders. Naturally, regardless of whether brokers had legitimate reasons to halt trading or not, their actions infuriated Reddit users who expressed their view that this was the exact type of unfairness that had inspired the squeeze. Class-action lawsuits followed and the topic became the focus of political exchanges and side-taking. Brokers gradually unlocked their freeze on GameStop trading throughout the beginning of February, although the damage dealt to their reputation was irreparable: they were widely perceived to be shielding hedge funds from financial losses.
The r/wallstreetbets forum’s short squeeze burned certain hedge funds, notably Melvin Capital and Citron Research. The former was rumoured to have suffered a decline of 53% of the value of its investments in January alone, necessitating an emergency cash infusion of almost $3 billion by Citadel LLC and Point72 Asset Management. The latter firm, led by well-known short-seller Andrew Left, announced that it would cease short-sell analysis after 20 years of providing the service. In total, hedge funds were understood to have lost $6 billion – an incredible victory from the eyes of motivated Redditors. See Andrew Left’s statement below.
What has the GameStop squeeze taught us? To some, the event may signal the growing importance of social media exchanges as an influence in increasingly democratised financial markets, where the playing field is fairer and hedge funds are no longer running things. Retail traders have both faster and greater access to information, suggesting that they are no longer the clueless rabble that they are typically made out to be. Alternatively, the squeeze may simply constitute a freak event symptomatic of a speculative and overvalued market, with record retail participation and ‘dumb money’ inflows, which would also be a perfectly valid interpretation. Certainly, with the catastrophic losses of hedge funds in mind, the squeeze begs the question of whether short-selling is actually a viable strategy anymore – does the potential reward still outweigh the risk? That’s a question which hedge funds may be asking themselves. From the perspective of Reddit investors, the constant media coverage of the entire event, particularly the halting of trading, could have a positive impact in the sense that it has inspired political debate which could lead the current system to be tweaked in retail traders’ favour. This may be unlikely, but it is certainly worth hoping for.
Johan Lunau – 01/06/21
Headline image source: https://www.moysig.de/moysig/projektview/gamestop/