Oh, how the mighty have lost fortunes.
Several hedge funds like Melvin Capital and Citron Research thought they were onto something when they started to ‘short’ shares in GameStop, a brick and mortar gaming store that supposedly had an obsolete business model.
The thinking was that they could make money from the expected slide.
But they made a big miscalculation. Instead of seeing the value of GameStop shares fall, over the past few months the share price rose and in the past few weeks it skyrocketed.
GameStop, which was trading at $4.21 a year ago, had risen to $18.81 by the end of 2020 and shot up to $472 on Thursday.
So how did the likes of Melvin Capital, which had to be bailed out to the tune of $2.75 billion (R41.5 billion), and Citron Research get it so wrong?
On the surface, they had a solid investment thesis …
A business that sold games through stores (think Musica) would soon be upended by digital distribution rivals.
They reasoned that by ‘borrowing’ shares and then selling them at the current price, they would make money by later buying shares at a cheaper price than they had been priced at when they initially sold them. These shares would then be returned to whoever they borrowed them from.
In effect, the short seller sold something it did not own and planned to make money by buying shares at a lower price than they had sold them for in the future.
But two things happened that they didn’t count on.
The one is that GameStop got a new shareholder in Ryan Cohen, a man who made his money founding and running an online pet food and related products group called Chewy.
Cohen ended up taking a 13% holding in GameStop, and engineered some former Chewy executives onto its board on January 11.
Now things are different at GameStop. Its prospects have changed for the better as it is now effectively being run by people who have the skill set to help it adapt to a digital distribution sales model.
GameStop also got a lift from the launch of the PlayStation 5 and new Xbox gaming consoles, which are expected to boost sales.
The other thing they didn’t expect was a ‘short squeeze’ sparked by the two million members of the Reddit community WallStreetBets.
WallStreetBets members knew the hedge funds had tried to short GameStop, which meant they would at some stage have to return the shares they had ‘borrowed’.
The WallStreetBets members also knew that the funds would pay anything to cover their position when it became clear that GameStop’s prospects had changed for the better.
So they bought up as many shares as possible and waited for the hedge funds to start panic buying.
This resulted in a spike in the share price as the hedge funds would basically pay any price to get hold of shares to ‘return’ to their owners.
The resulting kerfuffle has not only lost and created fortunes, it has also drawn scrutiny from some powerful people.
US senator Elizabeth Warren has called for regulators to take a look at the behaviour of the hedge funds.
Treating the market ‘like their own personal casino’
“For years, the same hedge funds, private equity firms, and wealthy investors dismayed by the GameStop trades have treated the stock market like their own personal casino while everyone else pays the price,” Warren said in a statement.
This is not just sabre-rattling as Warren is a leading member of the Democratic Party, which now has control of both legislative houses and the presidency. The Democrats also tend to take a more jaundiced view of Wall Street than their Republican counterparts.
Some on Wall Street also want the regulators to take a closer look – but for different reasons. They want an investigation into price collusion between the smaller-time investors for pushing up the price.
One way of viewing what has happened at GameStop is that this was a once-off, and that the fancy hedge funds have learned their lesson after being given a walloping by 20- to 30-year olds sharing stock market memes on an internet forum.
Another is that this is just a bit of creative destruction on the part of the market.
Something quick and nimble gobbled up something slow and fat.
I don’t think it is a once-off.
I think there has been a profound shift. The mob strength of retail investors proved they were more than a match for the balance sheets of some of Wall Street’s largest heavy hitters.