The Story that has Wall Street Shaking in its Boots

Jan 30, 2021

Editor's note: Dear reader, this is a special edition of the Profit Hunter. We wanted to share with you our view on the big story in the financial world. It has taken Wall Street by storm and threatens to revolutionise the way people trade in the market. Rean on for the amazing story of Wall Street Bets...


Rahul Shah, Editor, Profit Hunter

There's a defining moment in every bull market. A speculative excess that's as clear as daylight in hindsight.

However, for even the most brilliant minds who live through one, it's blurry and hazy at best. It's as if they're totally oblivious to the writing on the wall.

You can blame it on our herd mentality. Our inability to keep our heads when everyone around is losing theirs.

At the peak of the Japanese real estate bubble, Tokyo's Imperial Palace was worth more than the entire State of California.

Crazy, right?

And yet there was no shortage of experts who felt that these valuations were justified at that time.

Crazier still was the idea that you can get a billion dollar valuation by attaching the suffix 'dotcom' to your name and then promising your investors the moon even as you rake in losses year after year.

And yet, this was a perfectly 'normal' phenomenon back in the dot com bubble days.

If you are looking for something closer home, how about Infosys and Wipro together having a market value more than three times the entire market value of steel and cement sector combined back in 1999?

And yet, there were fund managers making a beeline for these two stocks and giving a cold shoulder to the steel and cement!

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A Giant Falls by the Wayside

I think you will agree with me that we are in the middle of another big bull market.

And if you are looking for a defining moment that will help put the current bull market in perspective, I have a strong contender for you - Wall Street Bets.

Here's the story...

Until few days back, GameStop, was just another US company struggling to make ends meet as the pandemic threatened to snatch its lunch and take it online.

In fact, GameStop was struggling even before the pandemic hit. The pandemic only ended up piling more misery.

GameStop is a victim of a world swimming in digitisation. It's the world's largest video game retailer.

But even the largest can be brought to its knees if you strike at its very foundation. GameStop's foundation was video games in physical discs.

But things started changing from 2013. Digital storefronts operated by videogame biggies like Sony and Microsoft started chipping away at Gamestop's core market.

Within a few years, an existential threat came knocking at GameStop's doors in much the same way as digital music sounded the death knell for physical stores.

Then came the big folly. Instead of trying to take the attack to the competition, GameStop decided to double down on its own business model. It kept buying chains, even paying top-dollar if push came to shove.

Did this work?

Absolutely not.

The trend of the video game buyer preferring to buy from a digital storefront continued unabated.

Soon, GameStop was staring at a double whammy. A balance sheet that was now swimming in debt courtesy all the acquisitions and cash flows that were a pale shadow of their former selves.

As per businessinsider, Gamestop went from no debt and generating about US$ 400 m in cash, to US$ 800 m in debt and generating US$ 300 m in cash.

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The U-turn No One Saw Coming

It's not surprising the company's share price was taken to the cleaners.

In early 2019, the bottom fell out of the company's stock price. It collapsed from US$ 16 per share to under US$ 4.

And it stayed there for almost two years.

There's a good reason I presented all this info on the company.

If you've not been able to keep track, let me tell you that the company's share price has taken off like a rocket.

Between 20 and 26 January this year, GameStop's share price has soared from just over US$ 35 per share to north of US$ 140 per share.

By January 27, the stock had hit new highs of over US$ 325 per share!

This is an over 8,000% increase from the lows of US$ 4 per share it had fallen to just a few months back.

Before you even think of the 'f-word' - f in this case being the fundamentals - let me tell you the stock's stratospheric gains has nothing to do with it.

And it has everything to do with wild, rampant speculation. In fact, this is a classic case of what happens when the key tenet of value investing i.e. 'Investing is most successful when it is most business like' is turned on its head.

The new version seems to be more like, 'Investing is most successful when it is most speculation like.'

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You see, you can't sell the houses you don't own.

You can't sell cars you don't own.

But...

You 'can' sell the stocks you don't own.

And this at the heart of GameStop's share price mania.

A few weeks ago, it came to the notice of a group of Reddit group - Wall Street Bets - that a hedge fund, Melvin Capital Management, held short positions in Gamestop.

These are trades where you expect the stock to fall and benefit from it by selling the scrip without owning it at the time of the trade.

The hedge fund went around town tom-tomming the trade and was soon joined by another famed short seller who also had a similar trade on the stock.

Given GameStop's deteriorating fundamentals, it looked like the perfect move to make. The odds certainly seemed to favour them.

However, what transpired next will go down in investing folklore as one of the strongest counter punches ever landed on the big institutional guys.

The guys at Wall Street Bets who first noticed the trade, decided to teach the Wall Streeters a lesson they will never forget.

They banded together and started buying Gamestop shares so as to envelop the hedge funds in a short squeeze the like of which they would have never expected.

And this is precisely what happened.

As the stock price of the company started going up, the hedge funds had no other option but to cover their position by buying the stock and cutting their losses.

And what did this new buying do? Well, it pushed the stock price even higher, squeezing the short sellers further.

David vs Goliath Redux Anyone?

That's the collective power of a 5 m strong chat forum for you.

The buying by Wall Street Bets was enough to turn a beaten down stock into a 10-bagger in a week's time and may be go even higher.

Recently, the head of one of India's largest fund houses had said on a public platform that social media has emerged as the biggest risk for India's mutual fund industry given how it can influence share prices on a scale hitherto unheard of.

The entire GameStop saga has made him look eerily prescient. However, that's big money expressing its view.

What about the other side? The small retail guys who until now were used to being taken for a ride by the latter.

The information explosion over the past few years and the so called 'democratisation' of both the capital markets as well as the social media, seems to have narrowed the gap between the big and the small considerably.

The average retail investor, now has both the information and the collective bargaining power to put it across his big counterpart.

And the whole GameStop story could well be the first in a long list of similar face-offs in the future where the person ending with a bloody nose is not who we are used to seeing.

As our colleague Vijay Bhambwani put it so eloquently to us.

  • 'This is a financial revolution, a class struggle with financial markets being the battleground. It's history in the making. We have ringside seats.'

It does certainly looks like it, isn't it?

Circling Back to the Basics

However, it will be wrong on our part to give this entire piece a David vs Goliath ending.

Of course, this entire story has captured the imagination of investors. It has implications that go well beyond the business of making money and compounding your wealth.

However, we are worried that the wrong lessons will be taken away from this episode.

Lessons like how investing has changed forever and old rules no longer apply.

And that it does not take more than a demat account and the willingness to take risk for anyone to make a killing in the stock market.

Indeed, there are examples galore of retail investors becoming multi-millionaires within weeks and of millennials amassing fortunes that took their parents a lifetime to make.

However, dig a little deeper and you'll realise that these are more the exceptions than the norm.

Wall Street Bets investors who minted millions by buying GameStop may be laughing all the way to the bank right now.

However, at the end of the day, there's nothing in the fundamentals of the company to justify such a high price.

The rise in the company's stock price is entirely speculative in nature. The investors in the company seem to be playing a dangerous game of passing the parcel.

When the music stops, someone would be left holding the stock at a ridiculously high price and staring at a black hole of losses.

I think Michael Lewis was his usual eloquent self when he once opined that the line between gambling and investing is artificial and thin. The soundest investment has the defining trait of a bet, and the wildest speculation has the salient characteristic of an investment. Maybe the best definition of 'investing' is gambling with the odds in your favour.'

Well, he is right except for the last line.

Sound investing doesn't necessarily have to be gambling. Comparing it to gambling makes it sound like investing is more luck and less skill.

Nothing could be further from the truth. You can beat bad luck in investing by employing a sound process that places value above price and margin of safety over upside potential.

Don't get me wrong. I am not asking you to not speculate at all.

However, reserve speculation for only 4%-5% of your total corpus. For the remaining 95%, make 'what to buy' and not 'when to buy and sell', the cornerstone of your long term investing strategy.

Even if you want to participate in a mania like GameStop, you will sleep well knowing you have all your bases covered.

Good Investing,

Rahul Shah
Rahul Shah
Editor, Profit Hunter
Equitymaster Agora Research Private Limited (Research Analyst)

Publisher's note: Richa Agarwal was live at the Smallcap Revival Summit. Thousands of astute readers of the Profit Hunter attended the summit and have begun to profits from Richa's top smallcap recommendations. Join them by watching the video of the summit.

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2 Responses to "The Story that has Wall Street Shaking in its Boots"

RAJEEV GARG

Jan 30, 2021

Very beautiful & well articulated article on Gamestop Story & Investing in general.

Like (1)

Manjunath

Jan 30, 2021

I had heard about this, very well articulated. Excellent!

Like (1)
  
Equitymaster requests your view! Post a comment on "The Story that has Wall Street Shaking in its Boots". Click here!