Late last month we saw the share prices of a handful of US equities make dramatic moves in unprecedented trading volume that was the first in my career and truly one for the record books: A group of companies with mainly bad fundamentals saw their stock prices skyrocket in price over just a matter of days. These price increases were not simply 10% or even 20% up-moves, but rather jumps of 300% in a single day. What caused these violent price moves?
The two companies we will focus on that experienced these unusual price increases are AMC Movie Theatres and GameStop. Other firms such as Black Berry, Nokia, Bed Bath and Beyond and a few others also got caught up in the action, but we will keep our discussion with the two aforementioned firms. In addition, the topic of discussion is fairly complicated for most investors, so we are going to stay away from such terms as naked short selling, short-interest ratios, days to cover, etc.
For disclosure purposes, I must first state that I was a previous shareholder in AMC Movie Theatres, which I had purchased early in the year as a speculative position. By ‘speculative’ I am referring to a 1 or 2% weighting in the portfolio of an investor who is comfortable with a substantial amount of risk (an investor with a high appetite for risk). AMC was a company that started 2021 with the threat of bankruptcy in the near future, a pile of debt, a business moving towards streaming movies in-home versus in-theater viewing and the overhang of the Covid-19 pandemic still in force. However, there was ‘still’ a possibility for the company to turn things around when Covid-19 restrictions were removed and the theater business got back to normal (not to mention a potential buyout from Amazon or even Netflix).
In short, the reason for the temporary price hikes in AMC and GameStop was a conflict between two groups of investors: A handful of retail investors like you and I attempting to battle it out with Wall Street’s bigger players, a David vs Goliath situation if you will. Many of these retail investors were millennials (aged 20 to 40) upset with the perceived inefficiencies of Wall Street which they believe favor large managed-money institutions (‘hedge funds’). Hedge funds are essentially a mutual fund or exchange traded fund that manage huge sums of money for individuals and institutions, however, with one big caveat: Hedge funds, depending on the strategy they employ, essentially have the ability to invest in practically any product. This includes what is called ‘shorting’ the individual stocks of various companies.
When an investor shorts a stock they see an opportunity to make money if the price of the stock declines. Stocks are shorted when an investor feels that that the common stock of a company is over-valued at its current price and therefore could decrease in the future. When shares are sold short, these shares are actually ‘borrowed’ from a broker. The short-seller then sells them into the market with an agreement that they will purchase the shares back and return them to the lender at an agreed upon time. These shares can come from the brokers’ own inventories, or from customers that have allowed the brokers to lend out their shares. When it’s time to return the shares, if the stock price has fallen, the short seller can buy the shares back at a lower price than they originally paid for them, thus, locking in a profit. On the other hand if the price has risen, the short seller must buy back the shares at the higher price, resulting in a loss. On top of this, the short seller must pay the lender interest on the value of the stock borrowed.
The practice of shorting a company’s stock is perfectly legal, and AMC and GameStop were perfect candidates. Both firms were having a tough go with their respective business operations, even before the onslaught of Covid-19 began. AMC was getting a double punch from less theatre traffic due to Covid-19 along with streaming services from Netflix and Disney where customers could watch movies in the comfort (and safety) of their own homes. On the other hand, GameStop is in the dying business of selling first and second-hand video games for the Sony and Microsoft gaming consoles (with the majority of gaming going online hurting sales). Both company share prices have declined precipitously over the last few years with AMC going from $35 to $2 and GameStop $55 to $4.
Here’s where the smaller retail investor comes into play. Regular investors like you and I are clearly able to see how much of a company’s stock is short and as discussed earlier eventually needs to be repurchased. Bloomberg, YahooFinance and a host of other organizations publish this information on a daily basis. Through online forums such as Reddit’s (commonly referred to as ‘The Front Page of the Internet’) section WallStreetBets, individuals are able to share information about anything, including the stock market. These thousands of individual investors saw the situation where companies such as AMC and GameStop were being heavily shorted by Wall Street’s hedge funds and decided to do something about it. At their heights, AMC stock was in the area of 50% short with GameStop over 140% short. When a stock is in the 10% to 25% range shorted, it’s typically viewed as ‘heavily’ sold short.
So how can an investor profit from companies that are being heavily shorted? The smaller investor had it figured out: The ‘short squeeze’. With the knowledge that short-sellers would eventually have to purchase their borrowed shares back at some point, many of these retail investors began banding together and starting placing what are called ‘limit sell orders’ on the shares they owned personally. Limit orders are when the investor decides what price they will buy or sell at if prices reach a certain level. With AMC and GameStop, these were of course very high sell order prices. Having to paying interest on their short positions, the big hedge funds were in essence forced to purchase their shares back, many from retail investors, at a much higher price than they expected. Many had to be purchased back at big losses.
As a result, several big hedge funds really took it on the chin. Melvin Capital Management, who had been short GameStop stock for six years, declined a whopping 53% in January. Maplelane Capital dropped 45%. All-in-all, short-selling cost hedge funds in the area of $12.5 billion dollars in the month of January.
To complicate matters, at the center of this David-vs-Goliath controversy is a brokerage firm called Robin Hood. Robin Hood, who bills itself as catering to the ‘average’ investor, was established with its gimmicky name to help represent the smaller investor (‘steal from the rich and give to the poor’) by offering zero-commission trades to its clients. Robin Hood was having success in the business until the short-squeeze began to take place. After prices started to skyrocket in stocks like AMC and GameStop, Robin Hood (along with a few other discount brokerages) actually began to limit buying in these stocks and others, to what CEO Vlad Tenev stated was, ‘to help customers stay informed’. This action infuriated many smaller investors.
However, there is more to the story than meets the eye. Was Robin Hood actually working to help bring down prices in for Wall Street’s hedge fund manager’s to buy back their short positions as lower prices? If investors are unable to buy but only sell, an influx of sell orders will drop prices rather quickly, which is exactly what happened. Furthermore, Robinhood routes its trades through a group called Citadel Securities, which in turn operates a handful of hedge funds. Last, Robinhood offers zero-commison trades for its clients but many individuals close to the situation state that the zero-commission trades come with poor execution prices (high-priced buys and low-priced sells). CEO Vlad Tenev has actually moved out of his house and into a hotel in fear of backlash.
Robinhood, along with others, is now in the midst of a serious inquisition as to their practices by the Department of Justice (DOJ), the Commodity Futures Trading Commission (CFTC) and both chambers of Congress. Even Treasury Secretary Janet Yellen and the Securities and Exchange Commission have raised an eyebrow. The parties involved in these unusual actions were required to meet on Capitol Hill last Thursday in front of the Financial Services Committee as to what their role in the market turmoil was. Under the eye of Chairwoman Maxine Waters, the investigation was cutely entitled ‘Game Stopped’.
In conclusion, companies like AMC and GameStop are not healthy companies who have a clear view of their own sales and profits and should be avoided by the majority of investors. The stock market generally speaking is very efficient and with the actions of millions of buyers and sellers around the world, prices eventually move to their true fundamental value. With AMC and GameStop, due to the heavy short-selling, their prices may have been artificially low, but after the huge short-squeeze (which some say is not even fully played-out yet), prices flew way beyond any meaningful value. As such, unless one has a big appetite for risk and return and can afford a very small (1-2%) position in these type of companies for a truly long-term investment, it’s best to steer clear of companies who get caught up in this type of hype.