An online-driven short squeeze

Several obscure and smaller stocks (GameStop Corp is the poster child) worldwide witnessed extreme price moves over the past few weeks. One common characteristic has been that each of these stocks had been heavily “shorted” before the recent action. A “short” is a position some investors – typically institutional– take when they believe that a stock price will fall.

I want to take a moment to explain some of these dynamics at a high-level. If a hedge fund borrows 2 million shares of GameStop from Morgan Stanley, then sells them in the market for $20/share, it would have a $40 million cash balance in a trading account. The hedge fund would eventually owe Morgan Stanley the 2 million shares back, and it would also pay a hefty interest rate (20%+) to borrow the stock. If the shares were to fall to $5, the hedge fund could buy back the 2 million shares owed at $10 million and pocket a tidy $30 million for their investors. In theory, this is how successful short selling works.

What happened to GameStop?

Over the past week, a large online community of retail investors has been responsible for the surge higher in stocks like GameStop. Acting together, they were able to buy vast amounts of shares and options in these stocks, bidding up the prices and forcing some of the institutions to unwind their “short” positions, which then exacerbated the upside pressure creating a sort of feedback loop.

Continuing with our hedge fund example above, at $300/share (an actual price that GameStop traded at this week), the same hedge fund would now be short $600 million of GameStop stock or a loss of $560 million. It would need to buy back the GameStop stock shares at a higher price of $300 per share to close out the short position. This example illustrates one of the biggest dangers of short selling. Your downside is theoretically unlimited as the price of the stock you are betting against moves higher. As the GameStop shares soared, short-seller losses ballooned to the point that many were forced to buy back shares to close their trade. We call this dynamic a “short squeeze. “

This development caught many by surprise, given the extent of some of the moves. It is also noteworthy that social media coordination among retail investors helped fuel the situation. While it has limited implications for the long-term economic outlook, this recent trading behaviour contributed to the current market volatility. Most institutional trading desks acknowledged that the sell-off we experienced on Wednesday was driven by these same hedge funds that made short bets having to liquidate billions of dollars in investment holdings to cover their losses and pay off their margin loans.

What does the online community see that others are missing?

What we need to emphasize here is that GameStop has ZERO businesses having a $23 billion valuation. GameStop is a company that operates 5,000 brick and mortar stores that sell new and used video games. In the last 12 months, they had $5.2 billion in sales and a net loss of $275 million. These kinds of businesses face long-term disruption as retail shifts further towards online channels.

The rising price of GameStop stock as an investment was fueled by some degree of coordination among retail investors socializing online. This scenario is also noteworthy as it highlights the growing force of a retail investor base that is increasingly willing to collaborate. However, we can’t help but wonder how many of these investors are motivated by the potential for gains they perceive to be quick, extreme, and easy. Some have likely undertaken the proper due diligence, but most pay little attention to the business value underlying some of these equities. Ultimately, we expect fundamentals will return at some point, as they always do, to be the biggest driver of these share prices.

What does any of this mean for our portfolios?

Aside from the odd spike in market volatility, not much. Our portfolios invest in high-quality companies that possess demonstrated long-term track records of earnings and cash flow growth. The dynamics discussed above are taking place in fringe parts of the markets. We see limited implications for the businesses we own, such as Apple, Home Depot, Canadian National Rail, or the Canadian Banks.

Despite the sell-off triggered by short squeezes and hedge funds having to cover, nothing has changed our outlook for the economy from a fundamental perspective.

• We expected monetary and fiscal support to remain firmly in place, driving consumption, global trade and demands for goods.
• We expect the COVID-19 pandemic to subside in the back half of the year as vaccines and population immunity continues.
• We expect cash on the sidelines to make its way back into the stock market over time.

For those that want to learn more

There has been a lot of ink spilled covering the developments discussed in today’s letter. If you want to read another take on the GameStop story, here is a link to Matt Levine of Bloomberg’s his best pieces on the topic.

Always here to help

As always, if you have any questions or concerns, please contact us. Our entire team is available to listen and speak to you. We are also available to talk to family members or friends who might like to be reassured.