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Uncommon Stocks: The GameStop Story

Gunnar Jaerv
Gunnar Jaerv 16 February 2021

GameStop is a computer games retail store, facing an uphill struggle in the days of lockdowns and downloadable games.

If you’ve ever heard of Steam, you’ll see why GameStop could face difficulties that aren’t pandemic-related. However, the company is currently in the news for reasons largely unconnected with its business activities, at least directly.

Let’s start with the headline: GameStop stock is through the roof.

What’s happened to GameStop stock?

The “natural” market price of a single stock in GameStop is around $18. That’s what GameStop hovered around for most of last year, though it’s fallen as low as $6 and closed as high as $63 before.

Right now, as I write this, GameStop is selling for $51 a share again; but it’s coming off an all-time premarket value of over $500 per share.

Here’s GameStop stock prices for the last year:

GameStop stock prices for the last year

Source

What’s happening?

GameStop’s short sellers

GameStop is itself being gamed, but adversarially, by two different groups — different in every way: how they see the stock market, how they approach investing, and how they regard GameStop.

The story really begins with hedge funds spotting an opportunity to make money from a failing business.

When businesses are in this kind of condition, there’s a good chance the value of their stocks will fall as the market watches their business vitals and sees them as less valuable. If you have a lot of money to invest, are risk-tolerant, and are pretty sure the value of a stock will fall, you can make money from falling prices by short selling.

Short selling essentially means selling a promise to buy a certain number of stocks at a future date — whatever the price of those stocks. Short sellers borrow the shares against their projected profits, immediately sell them and buy them back to return them on the appointed date.

The short squeeze

The trouble with short selling is that it’s a bet on other people’s betting patterns, one that is also a blank check. You agree to buy those stocks back, whatever the price. Which means if those stocks rise in price, you have to cover the difference. It’s a risky strategy.

There’s more bad news to come. Short sellers have to buy back their shares; when they do, they pump money into a market that’s already heating up, increasing the demand of something with a (theoretically) inelastic supply. Consequence? Stock prices go up and the short seller suffers more. This is called a “short squeeze”.

In the specific case of GameStop, here’s what happened. The company issued an earnings report on December 8th 2020, showing a 30% drop in sales on the same quarter of the previous year — and a $63 million loss.

On the basis of this commercial suffering, as of January 22, 2021, 140% of GameStop’s shares had been sold short. (This is possible because multiple short sales were taking place between investors, leading to a situation in which multiple investors claimed ownership of the same shares.)

Big hedge funds operating with millions of dollars were betting significant sums that GameStop share prices would fall.

Instead, Reddit got involved.

GameStop’s other investors

Reddit is organized into “subreddits”, communities with their own purposes and rules. The r/WallStreetBets subreddit stepped into the GameStop fray on the basis of some publicly-available investment intelligence.

GameStop had replaced three board members, and the newcomers were essentially a leadership team transplant from ecommerce giant Chewy, including Chewy founder and former CEO Ryan Cohen, Chewy former Chief Marketing Officer Alan Attal, and former Chief Financial Officer at Chewy Jim Grube. (Cohen is also a major GameStop shareholder through his private firm RC Ventures.)

Add the new ecommerce heavyweights to the news in that December 8 earnings report that GameStop’s ecommerce sales had risen 257% YoY, and there seemed good reason to bet long on GameStop, at least for some.

Chief among these was r/WallStreetBets leading light Keith Gill, better known to Reddit as [email protected]#$ngValue. Gill described himself as “bullish — perhaps foolishly so” on GameStock as far back as July 2020, and even predicted the short squeeze. He based his opinion on his own analyses of the underlying value of the company and its business, and encouraged his viewers to approach GameStop as a “roach, not a cigar butt” — an unkillable revenant rather than a burned-out husk.

The twin explosions: r/WallStreetBets and RobinHood

What Gill didn’t expect, however, was the sudden explosion in share price as other Redditors realized they could buy individual stocks in GameStop relatively cheaply, potentially make some pocket money, and support a beloved institution in the process. r/WallStreetBets turns out to be stuffed to the gills with gamers whose quasi-ironic affection for GameStop made them willing to pitch in. Reddit and the wider gaming community supplied more users, and r/WallStreetBets membership skyrocketed.

WallStreetBets membership

Source

For perspective, that graph tops out at just over 5 million users at January 28; ten days later, membership stood at 8.7 million.

When their aggregate investment turned out to be large enough to drive up the share price significantly, many were openly pleased at the side effect: the hedge funds that had bet on the demise of GameStop were left holding vast debts, losing $1.6 billion in a single day. Reddit itself was pleased at the buzz, if nothing else, as its superbowl ad alludes:

GamesStop superbowl ad

Source

But others were not so pleased. The casual approach to communication in the subreddit may have belied a serious attitude to analysis and investment, but some hedge fund operators were still outraged enough to take to the airwaves to call for regulation.

One of the biggest beneficiaries of the boom in GameStop prices, and in the number of retail investors ready to try their hands at the market, should have been retail investment app RobinHood; and so it proved, for a time.

RobinHood Growth

Source

RobinHood’s activity exploded the same time as r/WallStreetBets grew, and the investment app hit the top of the App Store at the same time as Reddit.

Introducing RobinHood

RobinHood was the most popular choice for r/WallStreetBets’ Wall Street neophytes, and its lack of sophisticated onboard discovery and analysis wasn’t important to most of them; they were getting their guidance from each other and from old hands like Keith Gill.

But RobinHood wasn’t set up for that kind of volume. Built by a team of ex-Facebook engineers and founded by Vlad Tenev and Baiju Bhatt in 2014, RobinHood was designed to make buying stock simple and easy. It aimed at a gap in the market: retail investors deterred by commissions that would eat their profits and complex on-ramping that ate their time. RobinHood eliminated both.

Now the company is a victim of its own success, as well as — arguably — some of its failures. Retail investors at home in lockdown pushed the app’s user numbers north of 20 million by December 2020. Then two things happened at around the same time.

One was that GameStop’s shares skyrocketed, largely due to small individual purchases by individual investors through RobinHood. The other is that RobinHood CEO and co-founder Vlad Tenev got a call at his home telling him his company needed to find billions of dollars if it wanted to open for business that day. Regulations meant RobinHood’s cash reserves had fallen too low, and trades were happening too fast for it to keep up. (The issue here is RobinHood’s antiquated backend; a blockchain-based trading platform could have had ~1-second clearing and settlement times, and many do; but they struggle to access the regular market, for now at least.)

At least, that’s how RobinHood tells the story. Other participants in the enfolding drama call shenanigans, including members of Congress’ House Financial Services Committee like Alexandria Ocasio-Cortez — as well as Ted Cruz. Ms. Ocasio-Cortez called RobinHood’s decision “unacceptable” and said she would support a hearing if necessary. That hearing is now scheduled for February 18th, and Vlad Tenev is expected to appear, along with a Reddit executive and representatives of financial regulators like the SEC.

The story of the GameStop short squeeze is dogged by allegations of impropriety, bad ethics and illegality, and some of the odium has stuck to nearly every participant — apart from GameStop itself. RobinHood has been hit with a class action lawsuit over its trading restrictions, Reddit users have been described as irresponsible by Wall Street — and r/WallStreetBets’ descriptions of Wall Street are available on Reddit.

But it shows some important things to our space too. RobinHood struggled with its regulatory responsibilities because it has a “human flesh backend”; after users make trades instantly on RobinHood’s touchscreen interface, actual market makers and settlement houses step in and do things the old-fashioned way. They’re all regulated by the SEC, and they’re all operating on the traditional T+2 (trade day, plus two settlement days) system. That’s fine when everyone else is, and it works OK when volume is low enough to disguise the disconnect. But when RobinHood’s volume exploded there was no system fast enough to hoover up all the slack. They maxed out their credit card. Only fully-digital solutions can be fast, flexible and secure enough to absorb a market whose users expect instant results.

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