Background

A couple of years back, we took a deep dive into the GameStop phenomena. With a new movie hitting theaters – Dumb Money – we thought now would be a good time to revisit this sordid tale.

For background, equity markets were sent into a bit of a tailspin at the end of January of 2021 largely on the back of a surge in interest and share price of a company known as GameStop (GME). For those not familiar with GameStop, it is basically the video game retailer that you see in every mall in North America. As you can imagine, this has not been a booming business for some time as most video games are either sold online (and GameStop does not have much of an online presence) or are downloaded directly from the video game console operator (so if you have a Microsoft XBOX, you go to the XBOX website and pay to download the game onto your console rather than buy a cartridge). And you can also imagine that while GameStop was not a particularly great business before COVID-19, it became an especially bad one after COVID-19 as traffic in malls was way down.

In the fall of 2020, a man named Ryan Cohen, formerly the CEO of a company called Chewy (as in what a dog would chew on and not the Star Wars Wookie), started buying some GameStop stock. He did so because he saw some potential in GameStop shifting from a bricks and mortar video game retailer to an online retailer. Whether or not Cohen was right is irrelevant, what matters to our story is that Reddit, which is an online community of various news and discussion forums, became infatuated with GameStop. One of these forums (actually referred to as a sub-Reddit) is called WallStreetBets (WSB) and they may or may not have caught wind of Cohen’s investment. In addition to this and because GameStop was a troubled business, the shares of GME were a popular short amongst the hedge fund community, which also appeared to entice WSB members.

What’s a short?

If you know what a short is – skip this paragraph. In a nutshell, you can buy a stock and that is called going “long” the stock. Or, if you wanted, you could borrow shares of a stock that you don’t own and sell it to someone else – this is called going “short”. Why would you want to do this? Well, for one, because you think the stock is going to go down in price and shorting it is one way to benefit from this (of course, if it goes up, you lose money). Or you may think that GameStop’s top competitor GameGo (made that one up) is a better bet and you go long GameGo and short GameStop on the idea that GameGo will do better than GameStop in which case your return would be the difference between their two returns. As mentioned, GameStop was a popular short because it was not a very good business in a world that was not very kind to businesses in malls.

So WallStreetBets started to talk about GameStop. And the various members of this forum got together and decided collectively that they wanted to own shares in the company. Since there are not a lot of shares outstanding in GameStop that are not held by guys like Ryan Cohen, these WallStreetBettors all started buying shares at roughly the same time when there was not a lot of supply available. Most if not close to all the WallStreetBettors did so on the Robinhood platform, which is essentially just a trading platform that charges very low commissions on trades. With not a lot of supply out there and suddenly a lot of demand, shares of GME started to rise rapidly.

The shorts get “squeezed”

As shares of GME started to rise, this created a big problem for the shorts because they started losing a lot of money. Unlike when you are long a stock in which case the most you can lose is 100% of what you put in, there is no limit to what you can lose when you short a stock (which is why most people don’t do it). Let’s look at a chart and then continue:

As you can see, the shorts lost some money in the fall with shares of GME more than doubling and by the end of December 2020 they were getting downright slaughtered. And then came January 2021 when it all went to heck (family publication, but you know what we mean) for them. This is known as a “short squeeze” where the rise in the shares of a company forces shorts to cover (buyback the stock they have sold), but because the shares are rising and they usually have a lot of stock to cover, it ends up driving the stock even higher. Now, there are squeezes and there are squeezes on steroids and GME was a short squeeze on Superman steroids.

GME roils the market

As you can see, shares of GME were rising steadily for months, but the broader stock market took little notice. However, in January 2021 and especially the last week of that month, this all changed. Part of this was due to the short cover already discussed. When hedge funds cover shorts, they are also forced to sell some of their long positions. This is because covering shorts (especially when you are losing money on them) costs money, so you need to sell longs to help fund this. And it wasn’t just GME that was rising, but a bunch of other heavily shorted stocks, which had also been mentioned on WallStreetBets (Blackberry was amongst the names that enjoyed a WSB lift). Thus, hedge funds were scrambling to cover shorts and selling longs to help fund this, which started to impact the broader market. Further, many hedge funds that were not short GME or the other stocks mentioned on WallStreetBets started to cover their shorts on fears that they could be next. And then the media got a hold of what was going on, which further spooked investors as good businesses were declining in value and a bunch of Mountain Dew drinking gamers (the perception of what a typical WallStreetBets member might look like) were responsible.

Robinhood cuts off trading

Now, you may have heard that Robinhood, which is just a means in which to trade shares in GME and any other stock you want to trade decided to shut down trading in GME along with 50 other stocks, many of which were favorites of WallStreetBets. Many in the media and many political figures lashed out at this announcement as it looked very much like the little guy, who for the first time appeared to be winning, was being punished so that the evil hedge funds could be saved. Of course, it’s hard to call yourself Robinhood and be perceived to be shafting the little guy, so this was not a great look. So why did Robinhood do it? Was it some nefarious plot to protect the evil Empire (ahem, hedge funds)?

With anything, the answer is nuanced (although we grant that we live in a world in which nuance is often ignored). When an investor buys a stock, there is 2-day settlement for that purchase. What this means is that while you own the stock almost instantaneously, it takes 2-days for the trade to settle and for the money and the shares to officially change hands. At the center of all trades is an exchange and at the center of all exchanges is a clearinghouse.

The clearing house essentially takes both sides of every trade that is made. So, if you buy a stock, you are not actually buying it directly from some other regular person, but rather you are buying it from the clearinghouse, which is matching your buy order with someone who is trying to sell the stock. If the guy selling the stock fails to deliver, this is not your problem because the clearinghouse is guaranteeing your purchase. Of course, this carries risk for the clearinghouse, especially with 2-day settlement. To correct for this, clearinghouses require trading platforms such as Robinhood (or firms such as RBC DS) to post collateral on the off chance that buyers or sellers fail to deliver on settlement day. This does not happen very often because firms such as Robinhood or RBC DS have many safeguards in place, but some collateral is demanded by the clearinghouse at all times.

But when a stock like GME is skyrocketing, the amount of collateral also rises rapidly because the clearinghouse is facing more and more risk. Put another way, 10 million shares of GME trading at $20 is $200 million of exposure. 100 million shares (which is what GME was trading on a daily basis during the last week of January 2021) at $300/share is $30 billion of exposure.

Thus, the clearinghouses were demanding billions in collateral from Robinhood in order to continue to trade GME and Robinhood basically had two choices – raise money to fund this or shut down trading. It chose both and as a result, shares of GME began to fall sharply as the first week of February kicked off because all those WallStreetBettors had no way to buy or sell it. Does this make Robinhood the bad guy (we stand by the Kevin Costner Robinhood)? Maybe, but there is clearly more to the story than the headlines might suggest.

So what now?

Fast forward more than 2-years and GameStop is now getting a movie. Many people thought that the GameStop phenomena would ultimately fade as the company was really not worth a lot (arguably even worthless), so let’s look at a chart and then comment:

We are going to note a few things here: 1) GameStop split 4 for 1 in 2022, so the current share price of ~$17.50 is actually a pre-split equivalent of ~$70; 2) GME is on its fifth CEO in 5-years, which may or may not be a record; 3) it has no earnings; and 4) it still has a market capitalization of close to $6 billion.

If you had asked us back in 2021 what we thought the likely outcome for GME would be, we would have said the following: the stock either continues to go to the moon – in other words – the dumb money wins, or the stock goes to zero or close to it as the Mountain Dew crowd moves onto something else (a bag of Doritos, maybe). We would not have pegged – somewhere in between as the outcome as the current state of the stock would seem to treat GameStop as though it was a real business, which we are not really sure it is or has been for some time.

Either way, we love movies and Dumb Money had us at hello (or what’s up, bro), so we will happily share a popcorn, pass on the Mountain Dew in favor of a bottled water and watch with interest.