Over the last one month we have heard this name quite frequently – GameStop. What is GameStop? Why has it become a famous name?
Let us first understand what GameStop is?
GameStop Corp. is an American video game, consumer electronics, and gaming merchandise retailer. It offers games and entertainment products in over 5,000 stores and e-Commerce platforms.
Since last few years, this company is not performing well. Its revenues have declined from $9.2 billion in financial year ended Jan 2018 to $ 6.5 billion in year ended Jan 2020. Operating profit has turned to operating losses during this period.
The Covid pandemic put further pressure on its business leading to further decline in quarterly revenues and profits in 2020.
Despite this declining operating performance, its share price increased from $3 last year to $18 in December 2020 and then to a high of $ 483 on 28th Jan 2021. Yes, you read it correctly. Within four weeks its stock price jumped by more than 25 times. What was the reason for this stock price increase?
Then, why a fundamentally weak company become stock market favorite this year?
Is there any change in the business model for GameStop which led to the drastic improvement in investor expectations? Is it another turnaround story? If you are thinking along those lines, it is not correct.
GameStop’s share price started increasing in September 2020, when an investor and founder of Chewy.com, Ryan Cohen bought 13% stake in the company. When GameStop’s share price started increasing, hedge funds started shorting its share on the anticipation that prices would fall due to poor operating performance. As prices rose, they kept on shorting it to make profits.
Let us discuss how. When an investor anticipates that price of a share will go down due to poor operating performance or for any other reason, he borrows the shares from his broker and sells (shorts) it.
Later, when the price of the share declines, he buys the shares and gives back to the broker. The difference in the selling price and the buying price is the profit. In case the price of the share increases, then the investor would incur a loss.
Similar was the case for GameStop. Due to the poor operating performance of the Company, may hedge funds in the US had shorted the stock in anticipation that its price would fall.
Quite often we hear stories of retail investors getting trapped in the bull market. The GameStop case is a story of multi-billion hedge funds getting trapped by small retail investors.
The number of GameStop shares shorted (around 72 million) by hedge funds were around 1.4 times of the free float of the Company (50.6 million).
Free Float is the number of shares available for trading.
A group of investors posted about this short selling on a forum (known as wallstreetbets) on reddit which has around 2 million subscribers.
This post caught the attention of many retail investors on the forum. They came together and started buying the shares of GameStop knowing that the prices would increase. As the number of buyers increased, the share price started increasing.
Hedge funds were caught in a “short squeeze” created by the retail investors and were forced to cover their positions forcing the stock prices to newer highs. On 28th January the stock price reached a high of $483. In this process, the hedge funds incurred significant losses. Total loss of the hedge funds was around $24 billion.
A hedge fund known as Melvin Capital lost around $4.5 billion because of this short selling and is likely to file for bankruptcy.
There were many other Companies (Black Berry, Bed Bath & Beyond etc.) which were shorted by the Hedge Funds. Price of these Companies also rose significantly because of buying interest by the retail investors leading to further losses for the hedge funds, while retail investors made significant profits.
After this incident, a few brokers allowed only selling/ limited trading of this stock on their platform. As the number of buyers reduced the stock price for GameStock started falling. It fell by 90% during the course of next one week. Many retail investors may also have been trapped during this fall.
Share prices are driven by operating performance of the business. There may be mispricing for short period of time but ultimately fundamentals will bring it back to the intrinsic value. So, before making any investment understand the business and its operating performance.
Invest if you understand the business. Buying a share because others are buying it is not the right strategy. Warren Buffet has said, "You should be Fearful when others are Greedy and Greedy when others are Fearful." This case clearly shows why he said this.
When you buy a share, you can lose up to 100% of your investment. But when you short sell anything, the loss can be unlimited. So, never short sell anything.