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Is GameStop a Game Changer? By Bryan C. Taylor

Social Media becomes the game changer for GameStop.

The recent move in GameStop has raised eyebrows and set the social media world on fire.  Many wonder what is actually happening behind the scenes. Given the questions we are fielding, many are also concerned about ramifications for the broader markets.  While it is certainly possible that some impact from the GameStop frenzy could bleed over into the market at large, we believe the likelihood is quite low.

Basic Terms

To explain what is happening, let’s begin by defining terms.  Professional stock/equity managers sometimes structure their investment vehicles in a very flexible format.  These vehicles are often referred to as “hedge funds” because the manager can “hedge” his or her risk by holding an asset “long,” anticipating that it will go up or selling an asset “short,” anticipating its decline.  For various regulatory reasons, most traditional mutual funds are prohibited from participating in some of these transactions, and consequently they are often referred to as “long only” funds.  While there are a few exceptions, “long only” mutual funds purchase stocks with the idea that they will sell them at a higher price at some point in the future.

Profit from Decline

Most of us would recognize this as capitalism at work.  We own shares in a corporation so that we benefit from the company’s earnings.  However, even the best companies sometimes drop in price.  Professional money managers try to pick companies that will appreciate, but while doing the necessary research to identify winners, they may also find companies they believe will decline.  Through this knowledge the manager has something of value, but he or she needs to have a way to profit from the stock declining.

Selling Short

One of those ways is “selling short,” a practice in which the manager borrows the stock from an owner and then sells the stock immediately. The plan is to buy the stock back later at a lower valuation, utilizing this lower valued stock to pay off the loan.  This is a very common practice, and “short interest” across the market is widely available. In most cases there are investors on the other side who believe the stock will go up, and the equilibrium passes back and forth over time.  Sometimes, however, that balance gets distorted.

Depressing Stock Price

To understand this situation, you must understand that there are, at any given time, a limited number of shares outstanding for a given stock.  If a large number of those shares has been borrowed and sold short (depressing the stock price), when enough buyers enter the market, the stock price will begin to rise steeply. Those who have borrowed shares will begin to feel the pressure of the stock price going against them.  The short sellers must repurchase the shares to pay off their bet.  At some point either the buyers give up and the stock price falls back down and the short sellers win, or the price gets so high that the short sellers are forced to re-purchase the stock and cover their bet at a huge cost.

Manipulating the Outcomes

The challenge is that while a buyer can only lose the money he or she has put in, the short seller can lose a theoretically infinite amount!  Usually, the short sellers are “informed,” and they are competing against both informed and uninformed purchasers.  However, what makes the GameStop story so unique is the buyers are retail investors who harnessed the power of social media. Utilizing a relatively new trading app called Robinhood, they have banded together to force the price of GameStop to completely unrealistic levels, causing many shorts to cover, and putting additional upward pressure on the stock’s price.

Over the last few weeks Game Stop rose from $15 to $350 per share. Along the way Robinhood limited trading in various securities and had to raise additional capital to support the trades its army of small investors are placing.  Ultimately this story will most likely end, like other unsustainable bets on Wall Street, in tears!

Key Insights

In our view there are a few key insights that may be gleaned from the drama.

  1. If you don’t understand derivative securities, short selling, and leverage, you should be careful getting involved in these investment vehicles.
  2. While individual “markets” for a single security can be distorted, regulators do have mechanisms in place to protect the entire system.
  3. The GameStop story highlights the power of social media.  Of course, it also highlights the power of a relatively uninformed “group” taking collective action and forcing an outcome which may or may not be desirable.  There are many psychological implications of this “social media” effect which are beyond the scope of our short summary, but we should be aware that the power to unite the “herd” can be both beneficial and dangerous.

It doesn’t take much to turn a well-ordered herd into a massive stampede, and we all know what can happen to those who are caught in the way!

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Bryan Taylor has over 20 years of experience in portfolio management and design. He is a Cornerstone Principal and currently serves as Chief Investment Officer and Chief Executive Officer of the firm. Bryan oversees all operations and is Chairman of the Cornerstone Investment Committee.

 

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