One of the points I like to make when I teach classes on investing is that, in the long-term, a company’s earnings and fundamentals are the key drivers of stock price appreciation. In the short-term, however, any number of factors, both conceivable and inconceivable, can affect a stock’s price both negatively and positively.
This dichotomy of the power of market forces has rarely been more evident than in the kerfuffle regarding GameStop (GME) that was in headlines this last week of January 2021.
If you haven’t heard the tale, a band of individuals, all coming together on an Internet message board, realized from publicly-available information that a hedge fund was selling short GME stock. This hedge fund was betting that the midsized money-losing operator of mall-based retail videogame stores would see its stock continue to decline. After all, who goes to malls anymore? And who buys videogames when you can download them? This strategy of short-selling seemed like an easy way to big profits.
But GameStop’s daily volume and float was typically very small, and it appeared that the short seller were over-extended, shorting more shares than were actually available (120% by one estimate). The Internet marauders realized that it wouldn’t take much buying of GME stock to bump up the price. And as GME’s stock rose, the short sellers would be required to buy more shares to cover their short positions, thus ironically pushing the share price up still further.
This is a classic “short squeeze,” and the hedge fund behind the short selling was quickly feeling quite squeezed indeed
As retail investors bought GME, the price did rise―and rise, and rise, and rise, growing from around $17 at the beginning of 2021 to over $460 at its peak.
By this time, other folks began to notice, including the media, politicians, market regulators, and brokerage firms.
Circuit breakers were tripped, halting transactions in GME stock on the NYSE.
Some internet brokerages restricted buying in GME and other brokerage firms had trouble coping with the massive increase in trading volume across the board.
The hedge funds that were behind the initial short selling of GME were soon not only feeling the squeeze, but at risk of running out of liquidity and closing their doors or seeking additional funding to shore up their balance sheets.
Other heavily-shorted stocks like BlackBerry, AMC, Tootsie Roll, and Koss have since faced their own short squeezes and trading halts as individual investors have seen that it is possible to take on the community of established Wall Street professionals and beat them at their own game.
Of course, without the impetus provided by a company’s sound fundamentals, the gains seen in GameStop can and will only be short-lived. Without a crystal ball or a foolproof black box stock price predictor, these kinds of speculative bets are going to leave a lot of traders with empty pockets while others head to the bank with newfound wealth.
Our style of investing focuses on the only true driver of success in the stock market—the ability of management to generate profits quarter-after-quarter, year-after-year, and cycle-after-cycle. Stick to this path and you can build wealth without playing games.
Reprinted from the February 2021 issue of the SmallCap Informer.
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