GameStop in the name of the law!

GameStop explained and expanded!

The Gamestop bubble is great fun to follow right now. The events of the last week have drawn in a great cast of the world’s hottest media properties: the the shiny new Biden White House, the Democrat star Alexandria Ocasio-Cortez, the world’s richest man Elon Musk, hedge funds like Point72, Citron Capital, Melvin Capital, web forums like Reddit and Facebook. Soon the police and the SEC will also be joining the fun!

While this saga has nothing to do in reality with Video Gaming, my interest stems from the fact that the Nikeforos portfolio has been a holder of a constant position in GameStop since March 2018 ($15.85), it was comfortably one of of the portfolio’s worst performers. The bricks and mortar, mall-based model of selling games appealed to me and my old skool tendencies, especially as they sustainably bought and sold second hand games, and paid a small but regular dividend. But GameStop was fighting a losing battle against the reality of cloud gaming and mobile gaming. Selling luminous mouse-mats and Overwatch sweatshirts to teenage boys is not a billion dollar business. The stock was in a very long and steady decline down to $4 in July 2020. A sad reminder of a poor investment decision too small to sell, too doomed to buy more! What happened next?

October 2020, a small (1b USD) activist hedge fund Senvest bought a large stake (5.5%) of the company hoping to push the company’s management into a different direction (ie avoid bankruptcy). So far so good. I am a big fan of activist investors, I think that is the moral responsibility of a owner of a company to engage with it and take part in its management decisions. Activists may well be wrong some times, but they are engaging with their duty as owner of the company, and not just treating the share as a commodity.

Probably as a direct result of this investment a number of hedge funds took the view that Senvest were not going to succeed in turning around GameStop and that the stock would continue to dive. So far so good; one hedge fund bets the stock will go up, other hedge funds bets it will go down its another normal day in the world of financial markets.

Now comes the fun. Betting that a stock will fall can be done in many ways. But the most common way, short selling, is a crazy activity that you would have thought would have disappeared many years ago. What happens here is that the shorting hedge funds have gone to holders of the GameStop shares and asked to borrow them. Paying a securities lending fee (say 1% per year), and posting collateral (US Bonds etc) to the value of the shares they have borrowed, they have then sold those borrowed shares for the current market price, hoping that they can pick up the same shares later for a cheaper price and then give them back to the original lender. Why I say this is a crazy activity is because its like in order to bet that a horse will lose a race, you borrow it from the owner, sell it to someone else and then try and buy it back when it has lost the race. Why not just place a bet at a bookmakers?

Short selling is vilified by a lot of people, usually people who stand to lose money (ie the owners of the shorted companies (Elon Musk for example, someone we do not need to feel sorry for) and people who only have part of the picture. The truth is that when I buy a stock, I am hoping the stock will go up, when I short it I am doing exactly the same but hoping that the stock will go down. There is no morality in either position. If you want to invest in a company you should be happy that someone is pushing the price down as you will get it cheaper, if Elon Musk doesn’t like people shorting Tesla because it depresses the value of his company he can just buy some more Tesla at the reduced price. A healthy market has people with both positive and negative opinions about a price. Without it you just have a bubble, on a bubble riding on a bubble.

People and journalists who don’t have the full picture also miss that the cheap forms of investment, such as index funds and ETFs that are pushed by media and advisors as cost effective investments for ordinary investors, are in fact heavily subsidised by stock-lending fees. Without those fees they earn by lending out their shares, your index funds and ETFs would cost maybe double what you pay today in management fees. One fund I know can earn 15% per year on some of its stocks that it lends. That money goes (mainly) to the fund’s investors – you and me, so don’t knock it!

Anyway this is where the shit hits the fan. The hedge funds did not manage or care to hide their bets that the stock would fall, also their bets were for a relatively large part of the available stock (the float). As a result it became apparent to some Reddit investors that a relatively small amount of money would move the stock higher, as a result, demand for the stock would rise, making it necessary for the hedge funds to start looking for stock to mitigate their losses. This causes a feedback loop where the search to find stocks to close the positions causes the price to rise, creating even more demand, creating an even greater need for the hedge funds to find stocks to close their positions. The plan worked, the price soared, a lot of investors will have made a lot of money…. a lot will have lost.

The first thing to note is that driving a stock price higher is not a new activity, or especially hard. It is as old as the hills, in 2000 a teenager in a bedroom in New Jersey (this is a great article from the NYT) and more recently Navinder Singh Sarao are a couple of fun examples of how individual stocks or whole markets can be fooled by people who want to do it without at lot of money relative to the size of the market that is being moved. It is also illegal as those cases show, even if it is normally difficult to prove. However if you go on a public forum and say, “Hey lets all buy this stock to drive the price up and this will cause a chain effect when the shorters have to buy up even more stock driving the price up higher making us lots of money” then basically you are going to need a good lawyer.

Also requiring good lawyers will be the platforms where this trading took place. There are plenty to choose from, but Robin Hood is the platform people are singling out where a younger newer hipper breed of investors are finding out how to manipulate markets and pump and dump. For Free! It must be good if its free!

I have nothing against Robin Hood. I love fin-tech start ups and companies like them have properly challenged many abusive business models and as a result have provided value for their customers (as well as for their owners of course). However a financial service that markets itself as free has to set off some warning bells. Just the fact that they have the front to call themselves “Robin Hood” – suggesting that they are taking from the rich to give to the poor, is of course horse shit. That’s because if even if they were doing it out of the goodness of their heart, it is not possible to provide the service for free – someone has to pay somewhere along the line. They may be cheaper than many other options you have for trading, definitely possible with an agile tech infrastructure and deep pocketed investors, but free it aint. For example when you come across a money exchange that advertises commission free exchange rates, you know will be screwed on the spread instead. There are no free lunches. If I was looking into Robin Hood’s business model I would start by looking at how good the prices that they are offering their clients. Are they consistently getting best execution, or are Robin Hood´s brokers shaving off a few points here and there so that the prices are not actually as good as you could expect. I am not saying that this is happening, but if you want to find a revenue stream that is not immediately obvious then that is a place to look. Also you would want to look at the spread on the exchange rate that Robin Hood applies when its investors buy and sell foreign stocks in Euros or HKD for example.

Robin Hood is also a fin-tech start-up with very deep pocketed investors, Sequoia Capital amongst others. Basically as close to royalty in investor terms as you can get. Yesterday they called up Sequoia who wrote them a cheque for 200mUSD on the spot to assist their funding just like that, loose change. So its amusing to see people going now “oh no I thought they were the good guys and now they turned out to be just another bunch of abusive rich guys”. Er duh? Sequoia Capital are not in the free lunch business.

Back to the main issue with Robin Hood et al, why will they be needing lawyers? That’s because SEC and Stock Exchange regulations require them to monitor the possibility that their platform is being used for market manipulation. They also need to stop it if it is happening. Its a criminal offence for the investors to manipulate markets and so it is a duty of the platforms to stop this happening. That’s why eventually Robin Hood HAD to stop people buying the stock (note that people were always allowed to sell out of their positions).

And that last point puts the final nail the coffin of the “Stealing from the rich”/ Class Warrior/ one rule for the rich and one for the poor narrative. Alexandria Ocasio Cortez, John Stewart et al have got things the wrong way round here). Let’s remember that Market Manipulation, especially when you advertise doing it on Facebook and Reddit is stupid, and criminal even if profitable for Hipsters and 34 year-old retirees day-trading from their garden sheds. Trading platforms have a duty to stop it, and if they ignore it are likely to find their licences revoked, being fined out of business or find that the big broker dealers they need to keep the shop running sneaking out of the exits.

Who are the winners and losers?

The heroic reddit investors? The guiding light of the Reddit pack, Roaring Kitty, invested a measly USD 50,000 (the gross annual income of two junior nurses). And then live streamed, commented, talked up the investment incessantly for two years. His strategy paid off and his investment was worth over 70mUSD last week. His case and public statements will be being discussed by law enforcement. Others will have invested less and later, making some money, offloading their stocks onto other late-comers until the price will crash. Losing a lot of other small time heroes a lot of money over the next few months.

The real small guys? Not so much, the small guys in this story for me are the ordinary workers around the world whose pension funds will have invested in hedge funds like the ones that were shorting the stocks.

The greedy bankers? The shorting hedge fund managers are hardly losers, but maybe they will have smaller bonuses this year, (with plenty of time to make it up this year). Deferred bonuses from 2020, 2019 and 2018 will mean they don’t go home empty handed anyway at the end of the year in case you were worried.

The lucky? The biggest winner today is in fact the unsuspecting hedge fund Senvest, who picked up a piece of crap stock in 2020 they hoped to turn around for a 50% profit in a few years, and ending up with a billion dollar winning lottery ticket. And nobody is angrily tweeting about them either! Win win!