Investing in the

Wild, Wild West

If there are no consequences to social media making up their own rules, colluding, and manipulating stock prices for smaller companies, then the integrity of the market could come into question.

Jeff Powell | Managing Partner, CIO Tweet

Most investors had never heard of Reddit, let alone gone to their website. That was before the website made headline news when a user group on Reddit encouraged their readers to buy several companies, sending their prices through the roof. Encouraging investors to buy a stock is nothing new.

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This user group on Reddit did something very different. They colluded with thousands of investors by encouraging their investors to buy “thinly traded” stocks with very high “short interest” in order to hurt hedge funds by creating a “short squeeze,” forcing some hedge funds to close out their “short” interest in some of the names on their list. 

Ok, that was a mouthful of information and a lot of new vocabulary for most of you. Before we go into any of the details about Reddit, let’s start off with a discussion about: what is “shorting” a stock, and what is a hedge fund? From there, we’ll fill in a few more of the missing pieces by explaining some of the vocabulary just used. Then we’ll discuss the impact Reddit had in the market.

Selling Short

The first concept that must be understood is “short selling” a company’s stock. Traditional investors buy a stock with the hope that it will go up on value, and then you will sell it. You are considered to be “long” in this position, and the position is “closed” when you sell the stock. What if you were very confident that a stock was going to go down in value? An investor can borrow shares, sell the stock, hope that it goes down in value, and then buy it at a lower price. This is known as “short selling” a stock.

Long Selling - Shoot Selling Stock - Polaris Wealth

Hedge Fund

Using the word “hedge fund” is about as specific as saying mutual fund. There are hedge funds that invest (long and short) in just about anything you can think up. The first hedge fund was created in 1949 by Alfred Jones. His theory was, you could make more money and lower your risk by “hedging” your investments. His concept was to be 120% invested in “long” stocks you believed would go up and “short” 60% in stocks you thought would go down. In doing so, you had lowered the market risk of your investments to 60% (120% long – 60% short = 60 market) but gave yourself the opportunity to make money on the 180% that was invested. This ideology is now known as a Long/Short Hedge Fund. As long as your “long” positions go up and your “short” positions go down, there is a lot of money to be made for the investor.

Short selling a stock is not for the faint of heart. First, when you short sell a stock, you are borrowing shares (typically from the broker/ dealer who is holding your assets). When you borrow shares, you are paying interest to borrow on margin. A typical margin rate is 3% over Fed Fund rates. Our zero-interest environment makes things a little better, but expect to pay around 3% annually to short sell a stock. You will also be required to pay whatever dividend the stock is paying, while short the stock. Paying this kind of interest on an investment puts a significant drag on performance. The Dow Jones Industrial Average has an average return of 9% from 1901 to the present. A short sell investor starts 3% in the hole, meaning they have to get a 33% higher performance in our current interest rate environment, just to be on par with a long-only investor. The last thing to consider is that your losses can be infinite. Let’s use our earlier example. What’s the most you can lose if you buy a $50 stock? $50 per share, right? A stock price can’t go below $0. What if you short sold the $100 stock? What’s the most you can make? $100 per share (by selling it at $100 and later buying it back at $0 per share). What’s the most you can lose? It’s infinite. The stock can go to $200 or $300 per share. What stops it from going to $1,000? Nothing. When a stock price goes up and there is a lot of short interest, it’s called a “short squeeze,” because the short sell investors’ only way of getting out of their “short” is by buying the stock, creating more upward pressure on the stock.

GameStop (GME)

The biggest name impacted by Reddit was GameStop, an investment that Polaris Wealth held long in our portfolios until mid- 2013. GameStop is a retail store that sells games, resells used games, and sells accessories for PlayStation, Xbox, and other gaming platforms. In 2013, Sony and Microsoft (the makers of PlayStation and Xbox) decided that they would make a major shift to selling their games online. At the time of the announcement, the majority of their games were sold via CD Rom in stores like GameStop. According to Statistica, 83% of all games were sold digitally by 2018. This cut GameStop out as a middleman in selling the games and significantly reduced their ability to resell older games. It has only gotten worse in recent years, with GameStop’s total sales dropping by 30%. Think back to when Netflix went completely to streaming video and the impact that had on Blockbuster Video. Polaris Wealth sold our long positions in the company and moved on to the next investment. Hedge funds, on the other hand, started selling the stock “short.”

There are some that will say that the hedge funds had a hand in GameStop’s stock price dropping from over $50 per share in 2013 all the way down to $4 per share in 2020 (see the chart below). It certainly didn’t help matters. Anyone doing any research on the company would have seen that 102 million shares outstanding, 68 million shares were sold short at the end of 2020, a very high “short interest.” An investor could have also looked at GameStop’s financials and seen a company with a broken business model.

Gamestop Share Price Chart

The feeding frenzy began in a Reddit user forum called r/wallstreetbets. GameStop’s stock was already on the rise as a result of bringing some high-profile new board members to the company. GME had fought back from $4 a share to over $43 on January 21, 2021. That’s when r/wallstreetbets readers colluded with other readers to drive the stock price up. I don’t use the word “collude” loosely. If I called a few friends in the business and said, “Let’s all buy GameStop,” I would be put in jail. Yet somehow, it’s currently ok for someone leading an online discussion forum to get their subscribers to purposefully manipulate a stock’s price in order to hurt hedge funds who were shorting the company’s stock.

Gamestop Share Price

On January 22nd, the stock closed at $65 a share, up over 50%. The real buying happened the following week, with the peak frenzy being on January 28th. GME had closed at $347 the day prior. It opened at $265, down 23%. It rallied as high as $483 before finishing down at $193. Now that the dust is settling, GME is trading slightly higher than where it was before this whole hype.

If you hear about from Reddit viewers is how much money they made on GME. My guess is, very few people made any money trading GameStop. Ask the person that bought in the 470 to 480 range, thinking that the stock was just going to continue to go up. The stock is now trading at $52 per share. That’s almost a 90% loss. While r/wallstreetbets may have hurt some hedge fund managers, they really hurt the underlying investor. Someone like you or me. And then there is the average r/wallstreetbets investor left holding the bag, owning GME stock significantly above the current price wondering what to do.

We received many phone calls and emails asking if Reddit was having an impact on their portfolios. The quick answer was “no.” It had no direct impact on any of your investments. There is a bigger underlying issue.

If there are no consequences to social media making up their own rules, colluding, and manipulating stock prices for smaller companies, then the integrity of the market could come into question. Right now, the Reddits and Robinhoods of the world don’t have enough clout to significantly move the price of bigger companies. For example, GameStop traded less than $100 million in share value a day for almost all of the 4th quarter of 2020. That’s considered to be a thinly traded company. Apple, on the other hand, trades about $12 billion in share value every day. You’d have to have a lot of money to manipulate Apple’s stock price. While there is a thin line between making an investment recommendation and colluding with your investor base, new rules and closer monitoring has to occur to protect the integrity of our markets.