Setting The Scene

Citron Research, an activist short-selling firm and renowned for their bearish research reports, announced that they had taken a short position on GameStop, citing that the company was on a terminal decline and had significantly struggled with revenue during the pandemic. When one takes a long position on a stock, they are essentially stating that the company is undervalued by the market and would profit by buying the stock in the hopes that the stock price rises at which point they would sell. When one takes a short position on a stock, however, they are taking a stance that the company is overvalued by the market and is not fundamentally sound. Therefore, a short seller would borrow shares from a broker and sell them to the market with the intention of buying them back at a lower price, at which point they will return the shares to the broker plus some prior agreed-upon fee and profit from the difference.

In simple terms, imagine you borrow a comic book - currently worth R100 - from a friend, as you believe that the value of the comic book will decline. You then sell it to another person for R100. A month later the value of that same comic book is now R10 at which point you buy it back. You then return the comic book to your friend plus a fee of, let’s assume R20, and you make a profit of R70.

A short squeeze, however, is if a short-seller’s belief that the stock price will drop does not play in their favour and the price actually appreciates. The short seller would have to buy it back at a higher price and thus incur a loss.

Figure 2: GameStop Stock Price

The GameStop frenzy spilled over to another heavily shorted stock, AMC Entertainment. With the momentum gained during the successful pump of GameStop’s stock price, the WallStreetBets group – now standing at 8.9 million subscribers – targeted AMC Entertainment, driving the stock price up 900%, from a low of $2 to a high of $20 per share.

Contrarians at The Gate

Fuelling the GameStop rally was the news that Ryan Cohen, founder of the successful ecommerce business, Chewy, and The Big Short investor himself, Michael Burry, had taken a 12% and 2.4% stake in the company, respectively. Cohen and Burry both believe in a potential turnaround strategy that could help GameStop transition its current business model of being a bricks-and-mortar retailer to a competitive e-commerce player in the gaming industry niche market. Ryan Cohen had proven his ability to drive the transition successfully from bricks-and-mortar to e-commerce when he established Chewy.

Furthermore, a survey conducted by Bespoke Intel in February 2020, showed that despite the growing demand for digitalisation, the company still had a 30% market share for new video game purchases.

Figure 4: Loss of Physical Market Share

Although turnaround strategies can be challenging, there is certainly a case for GameStop’s upside potential, perhaps just more conservative than 1800% in one month.

Looking Ahead

It appears as though the Reddit-fuelled frenzy has officially died down and the prices of these volatile stocks have decreased significantly since then, with GameStop currently trading at $48 per share. There were many lessons learned during this saga, no matter which side of the spectrum you sat on. For the retail investors, the importance of diversification and taking undue risk would have come to the fore as investors who got in early and got out at the right moment made a lot of money, while those who entered late or held too long suffered significant losses. For the hedge fund managers, perhaps covering their short positions in future would be more reasonable from a risk management perspective, rather than taking a naked short position on a stock.

There are no heroes or villains in this scenario as both positions could be justified. On the side of Wall Street’s hedge fund managers, taking a short position in GameStop seems fundamentally justifiable as it puts downward pressure on an overvalued stock price to reach its lower intrinsic value. This is a useful economic function to stagger the formation of a growth bubble in the financial industry, which was the catalyst to the Global Financial Crisis in 2008. On the side of Reddit’s WallStreetBets retail investors, taking a long position, because you believe in the upside potential of a turnaround strategy, or as a speculative trade or as a way of “sticking it to the man”, could also be viewed as justified.