AN EPIC SHORT SQUEEZE
Millions of Reddit-users under the subreddit known as r/wallstreetbets coordinated one of the most epic short squeezes of all time. What’s a short squeeze? A short squeeze occurs when the price of a stock rises rapidly and investors who are short the stock are forced to buy the stock to cover their shorts and minimize their losses.WHAT IS A SHORT? What does it mean to be short? When an investor expects the price of a stock to fall, they short the stock. In other words, they borrow the stock from another investor, also known as the lender, for a fee, and sell it at current levels. When the price of the stock falls, the investor buys the stock and returns it to the lender. For example, let us assume that you determined that GameStop Corp. (GME) was overvalued and decided to short GME when the stock price was at $483.00. You borrowed one share of GME and immediately sold it at $483.00. Over the next six days, negative headlines caused the stock price of GME to decline by 89% and you decided to lock in your profits, so you buy one share of GME at $51.09 and return it to the lender. To keep this example simple, you don’t pay the lender a fee, so your total profit is $431.91 ($483.00 - $51.09).THE DIFFICULTY OF SHORTING A STOCKSell high, buy low? Exactly, but it’s not as easy as it sounds. Just ask Citron Research and Melvin Capital, who were targets of a short squeeze and had to admit defeat after suffering significant losses as the stock price of GME launched and was on its way to the moon. It’s believed that hedge funds began shorting GME when the stock price was below $10.00. Now, imagine if millions of retail investors from r/wallstreetbets decided to inflate the stock price of GME by indiscriminately buying and holding shares of GME until the stock price reached $483.00. Remember, hedge funds believed that GME was overvalued at $10.00, so these same hedge funds must have believed that GME was ridiculously overvalued at $483.00. However, fundamentals didn’t matter at this point, because retail investors owned a significant number of the float (the number of shares available to the public for trading) and realized that over 100% of the shares were shorted, which is impossible unless the hedge funds were naked. What does it mean to be naked? A short investor is naked if they don’t borrow the stock before selling the stock; this is also illegal. Long story short, brokers like Robinhood prohibited retail investors from buying shares of GME and other heavily shorted companies, such as AMC Entertainment Holdings Inc. (AMC), BlackBerry Ltd. (BB), and Nokia Corp. (NOK); this resulted in panic selling. The stock price of GME was on its way back to earth, hedge funds covered their shorts, and retail investors ignored this crucial information. Although many investors profited from this chaos, many retail investors were left holding the bag.HOLDING THE BAGWhat does it mean to be holding the bag? Holding the bag refers to investors who hold onto poorly performing investments. Theoretically, the retail investors could have outsmarted the hedge funds if they continued buying and holding, but this required the cooperation of every r/wallstreetbets follower, which proved to be difficult.WINNERS AND LOSERS Although many hedge funds profited and many retail investors became instant millionaires, other hedge funds lost billions of dollars and other retail investors lost their life savings. Citron Research announced that they will stop publishing short reports and Melvin Capital received a $2.8 billion bailout from Citadel and Point72. Coincidentally, or not, Citadel, who had to bailout Melvin Capital, is also a market maker for Robinhood, one of the brokers who prohibited retail investors from buying GME and other heavily shorted companies. Robinhood does not charge its users transaction fees and its business model relies on revenues from market makers like Citadel. This relationship will face scrutiny and the regulators have launched an investigation. Stay tuned.MATCO'S APPROACHSo what? At Matco, we invest in fundamentals, which prevents us from investing with our emotions or hype. GME’s business model is in secular decline; game sales are moving from an in-store model to an online model, as newer game consoles can connect to the internet, allowing users to download games. At a high of $483.00 per share, GME was valued at over $33 billion dollars and in its most recent quarter, GME reported revenue of $1 billion, which has been decreasing for the past five years, and a loss of $0.59 per share. Do your homework before investing or you’ll be left holding the bag.Baron Lee, CFAPortfolio Manager
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