The so-called “Nerds versus Wall Street” battle over GameStop is grabbing headlines and attracting speculators hoping to cash in on the dramatic stock price movements. The controversy also has captured the interest of people who had previously expressed little interest in the financial markets. Watching from the sidelines may be entertaining and some people will make money, but speculative activity like this may not be the right strategy for investors.
What’s Going on with GameStop?
Once a leading retailer of video games and consoles, GameStop is fighting the same headwinds that have led to the demise of countless brick-and-mortar retailers in the age of Amazon. Between 2017 and 2019, the company’s net income dropped from a profit of $353 million to a loss of $795 million. Its stock declined from $25 per share to $6 during the same period.* COVID-19 has further accelerated the demise of the company’s traditional retail business model and its stock price dropped to $2.80 per share on April 3, 2020.*
Many professional hedge fund managers saw this as an opportunity to profit using a risky technique known as short selling. This involves selling borrowed GameStop shares in the hopes of reacquiring them at an even lower price. The manager makes (or loses) money on the difference between the short sale price and the cost to buy the shares back.
The key risk for short sellers is that the stock price can go up. Theoretically, the price can go up infinitely, forcing them to reacquire the shares at a much higher price than they sold them.
Why Is GameStop’s Stock Price Going Up?
After struggling for years, GameStop rebounded slightly in 2020 due to an uptick in game sales amid the pandemic, rising to $19 by the end of the year. Since the beginning of this year, however, the stock price surged to $347 on January 27.*
This incredible rise began when a group of investors sought to trigger a “short squeeze” by buying GameStop shares or purchasing options to buy the stock. These purchases caused the stock price to rise and squeezed short sellers because they had to buy quickly at a higher price to reduce losses. The short sellers’ purchases inflated prices further. This, in turn, drew even greater speculative momentum as more investors joined into buying the stock.
Anatomy of a Short Squeeze
Investors’ interest in short-selling goes up as stock price continues to fall. Investors experience a “short squeeze” when they have to buy the stock at a higher price to reduce losses.
Hypothetical results shown for illustrative purposes only and are not a guarantee of future results. Source: American Century.
Surging Stock Prices Do Not Reflect the Company’s True Value
If I offered you a dollar for quarters, would you pay me more than four quarters in exchange for my dollar? The answer is an obvious “no.” In our view, recent trading activity around GameStop and other notable highly shorted stocks, including Bed Bath & Beyond and AMC Theatres, does not reflect their financial strength or competitive position.
Despite its slight business improvement during 2020, GameStop lost $296 million—or $4.56 per share—during the first three quarters of 2020.* We believe the disconnect between its rapidly rising stock price and business reality is partly due to the rising influence of speculative investors. These investors collaborate on trading ideas through chat forums on sites such as Reddit and then implement their ideas through digital apps such as Robinhood.
Invest to Achieve Your Goals
We don’t discourage investors from trading individual securities. In fact, we offer brokerage services to those who wish to do so. However, we believe this should take place in the context of a sensible, repeatable, long-term investment strategy.
An investment strategy focuses on identifying securities whose values are expected to rise through growth and income. Speculation, on the other hand, is a risk-taking endeavor that exclusively pursues price gains without any concerns about the quality or true value of the investment. As stewards of our clients’ investments, we choose to focus on understanding each security’s risk and reward potential. While speculation may yield a lucky short-term windfall, we believe implementing sound investment strategies is a far more reliable approach to helping our clients achieve their financial goals.
Author
Source: MarketWatch. Data as of 1/28/2021.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Glossary:
Short selling
Short selling is a trading strategy intended to capitalize on a falling stock price. In a short sale, a portfolio manager borrows and sells the stock that he anticipates will decline in price. The manager does not own the stock. Instead, he must buy back the shares in the future to return them to the original owner. The profit (or loss) from short selling is the difference between the amount the manager originally sold the stock for and the amount paid to buy it back.
Option
A financial contract between two parties that gives the buyer the right, but not the obligation, to buy or sell an asset or instrument at a specified price on or before a specified date. The seller has the corresponding obligation to fulfill the transaction if the buyer exercises the option.