Shorts and GameStop

There is a growing crescendo of stories in the financial press these days regarding short sellers, and the role that short sellers play in turbocharging the run-up in share prices of some companies from time to time. In the past this has included shares of Tesla (Nasdaq: TSLA), one of the most heavily shorted stocks at one time before ascending around 700% in 2020 alone. However, the stock being most discussed at the moment is GameStop (NYSE GME), a company whose stock has increased nearly 800% just since the beginning of this year. I will discuss this in the second half of the article because it is very representative of the backdrop in which short sellers find themselves today.

Several hundred percentage points gains in stocks might not be something you ordinarily associate with short sellers, which traditionally benefit from the decline in share prices rather than play a role in sharp increases in prices. In fact, it is generally believed by most efficient market practicians that short sellers play an important role, which is to identify what they perceive to be over-valued companies and – by shorting the shares – force the price back down to “fair value” which in turn facilitates more balanced trading. These investors generally go to great lengths to expose business fragilities, accounting or other irregularities. Shorting a stock involves selling borrowed shares on margin, with the intent to “cover the short”, or to buy the shares, at a lower price in the future. Ultimately, the roundtrip objective is for the investor to profit from a decline in the price of the stock in focus. Perhaps one of the more famous investors focusing on selective shorts is Michael Burry (Scion Asset Management), who shot to fame by correctly calling the housing bubble and resulting mortgage crisis that started the Great Recession in 2008. Both a book about this topic (2010, “The Big Short” by Michael Lewis) and a film (2015, “The Big Short”) is largely about Dr Burry’s contrarian bets, which paid off handsomely during the Great Recession. (I will come back to Michael Burry in a different context later in this article.) Other well-known short investors include David Einhorn (Greenlight Capital), Jim Chanos (Kynikos Associates) and John Paulson.

Over the last several years, the world for investors that specialise in profiting from selling shares short has changed rather significantly, making it more risky for these investors to pursue this sort of strategy. I believe this has happened for two reasons. Firstly, equities have generally been increasing since the end of the Great Recession, so long in fact that – at this point – underperformance is less defined today by a declining stock price and more by a stock with gains that have fallen short of a sectorial index or the market more broadly. As with many things, the pandemic has in fact exacerbated this trend because huge amounts of fiscal and monetary stimulus from governments and central banks around the world, led by the Federal Reserve, have made betting against the market a fool’s game, no matter how high prices might be based on conventional valuation methods. This backdrop in general does not favour short sellers. Secondly, the advent and broad use of social media to communicate or tout ideas regarding stocks means that news travels very fast, and inuendo is much more rampant. Against this backdrop, there has been a well-documented increase in retail day traders flush with liquidity and perhaps with time on their hands (i.e. not working due to the pandemic), or missing the “rush” of on-line and sports gambling, that are investing in stocks today. These investors, perhaps small in terms of bite size but significant in terms of number, make decisions to buy and sell stocks based on their collective view of the direction of the next few ticks, not on underlying company valuations or any sort of traditional fundamental analysis. In fact, investors focused on fundamental investing (like me) get left in the dust, because by the time I have finished even rudimentary work, a stock has often gapped up (mostly) or down based on absolutely no company news at all, but rather on trading flows, momentum of investors acting as a herd, and news or rumours circulating on social media sites like Reddit and Twitter.

The best chance to make money playing a stock on the short side involves corporate fraud, similar to cases involving Luckin’ Coffee (SEC press release here) and Wirecard (#FT article here), or further back, Enron and WorldCom. Even in cases like these, short investors need to have staying power, because the company often denies the fraud for quarters or even years, supported in some cases by incompetent accountants not properly doing their jobs. Running a short position requires an investor to sell shares he does not own on margin (i.e. that are borrowed), so there is a running cost. This can be a race against time because denial and the perpetuation of a positive investment thesis can support a stock being shorted or – as you will read later – even push it higher. Another way to successfully play the short side is to identify a deteriorating business or, more broadly, an asset class that appears to have been artificially inflated by FOMO. Identifying company-specific performance issues is not difficult, although it does not guarantee success because the price of stocks has in many cases become divorced from fundamentals. As far as asset or sub-asset classes, this can also be risky because you might very well find yourself on the other side of the Federal Reserve or another central bank, as they pump loads of liquidity into the system that is increasingly finding its way to risk assets like stocks. Remember for example how US airlines were in essence “rescued” by the US government early in the pandemic, a case of morale hazard that essentially destroyed the short story which undoubtedly would have worked for this sector. This might raise the investment idea of shorting an index into the “pandemic stimulus turning point” – meaning anticipating the time when the Fed eventually decides to step aside and taper QE, for example – but this would be extremely risky and very much akin to a fool’s game because the accommodative tilt could go on for some time and the Fed has unlimited dollars it can print.

My conclusion in fact is that about the only time a short investor would seem to have a fighting chance would be in cases where he believes that there is fraud at a company, and the pressure from selling a stock short in size and “talking up” the (potential) fraud will expose the issue quickly, pushing down the price of the shares. In fact, if you don’t believe in a stock or a sector or the market, the safest way to express this view – rather than going short – is to simply step aside and find other investments that you are comfortable owning. You can be right as far as the reasons for shorting a stock, but this does not guarantee success because the dynamics driving stock prices today are well beyond traditional fundamental measures. As more and more professional investors like hedge funds are learning, smaller (retail) investors are increasingly able to organise on social media and buy stocks that might large short interests “in herds” to rachet up the pain on short investors if the results are not fast, ultimately leading to a short squeeze. Simply put, playing the short side of anything today given the context is not where I suggest focusing except in a very few isolated cases.

Let me move to the most interesting story at the moment in which short sellers have featured, albeit not (at least so far) in the way intended. You have probably been following the saga of GameStop the last few weeks. As you might know, GameStop is predominantly a traditional “bricks & mortar” retailer of video games with over 4,800 stores located in shopping malls throughout the US and in several foreign countries. The company has a long history – it was founded in 1984 and did an IPO in 2002. As far as price action, GME stock has had a rather uneventful life over most of its history, peaking twice before 2021 at above $60/share (Nov/Dec 2007) and then above $50/share (Sept-Nov 2013). Aside from these two periods, the stock spent most of its time in the $20-$30/share range until 2017. The stock then started to decline more precipitously, falling below $20/share in late 2017 as traditional retailers were losing market share to on-line retailers and e-shopping sites, as the graph below from Statista illustrates.

The stock continued to fall to $10/share in April 2019, then fell further to trade in the $5/share context, staying there until around August 2020. In many respects, the company and its stock have not been dissimilar to that which led to the slow death of Blockbuster at the hands of Netflix in the early 2000s.

This trend towards higher on-line purchases over the last decade, accelerated by the pandemic, chipped away at GME’s operating performance. GME’s revenues declined from $9 billion in FY2015 to $6.5 bln in FY 2019, and the company lost money in both the last two fiscal years. The interim reports more recently have also not been good, with sales for the first three quarters of 2020 (ended October 31, 2020) declining to $3 billion, compared to $4.3 billion for the same period in 2019. The company was money-losing at both the operating profit and net income lines in both interim periods, but through a focus on expenses, the losses were at least diminishing. From a balance sheet perspective, the company had more debt ($460.5 million) and capitalised lease obligations ($669.6 million) than (unrestricted) cash ($445.9 million) at the end of October 2020, so the company was arguably very much dancing on the edge of financial distress. Acknowledging the weak financial profile, the company is rated Caa1/B-, so GME’s access to the debt capital markets is far from assured.

The graph below (#YahooFinance) depicts the company’s stock performance over its life. Before you rub your eyes in amazement at yesterday’s closing price, note that the stock is up significantly in pre-market this morning, above what is indicated below.

What have institutional / professional investors been saying? Perhaps the most vocal short investor until recently was Andrew Left from Citron Research. On a fundamental basis, it is hard to argue with his view – GME is a deteriorating “traditional” retail business in an increasingly digital world, and the company would continue to lose money as top-line revenues fell. This, coupled with diminishing liquidity and questionable access to bank and bond financing, could not justify a valuation above $20/share in his opinion, or a valuation of around $1.4 billion equity cap / $2.5 bln enterprise value. You can find more on his views in this YouTube post, dated January 21, 2021. Lest you think Citron is the only short in the shares, it’s not. In fact, GME’s stock is reportedly the most shorted stock out there at the moment. The current short interest of around 71.2 million shares exceeds the company’s total shares outstanding of 69.75 million shares, and well exceeds its outstanding float of 46.9 million shares. Another short investor in GME has been Melvin Capital, which in fact recently had to be bailed out by Point72 and Citadel due to shorts gone wrong.

Against this dour backdrop however, there have been some well-known investors willing to take the other side on GME. Several got involved mid-year 2020, but the most prominent has perhaps been Michael Burry who I mentioned earlier in this article as the investor that called the pre-Great Recession mortgage crisis correctly and was short going into that particular downturn. According to Fintel, his firm Scion Asset Management owned 2.8 million shares of GME at May 6th, 2020, and I believe he has been involved in the stock for some time, well before it became fashionable to play in this name. More recently, the involvement of Ryan Cohen, founder of Chewy.com founder (sold to PetSmart in 2017 for $3.35 bln) and an activist investor, added further counter-weight to the short investors in the stock. In fact, Mr Cohen, whose firm owns circa 13% of GME, and two former Chewy.com colleagues, joined the board of GME two weeks ago. On Monday, Chamath Palihapitiya (Social Capital) asked his Twitter followers for an idea to invest, and GME came in apparently as the favourite. Mr Palihapitiya bought what were at the time way out of the money calls ($115 strike) near Tuesday’s open ($80-$85), and his announcement on Twitter of this trade was another catalyst that pushed the shares to close at $147.98 on the day. Post-close, Elon Musk tweeted on GME overnight with a one-word tweet “Gamestonk!!” and added a link to a Reddit group of retail investors (wallstreetbets) that are long GME. This added further upside to the stock in the aftermarket, with shares now standing at $282/share as I am writing this. #Bloomberg wrote a very good article on GME Monday that is worth reading, because it also highlights the role of Reddit day traders: “How WallSreetBets Pushed GameStop Shares to the Moon. It is mind-blowing to think about how incredible this increase in share price really is, so much so in fact even the professional investors involved like Michael Burry are getting concerned (even though they have profited handsomely off the increase in price).

What are the reasons that GME shares have accelerated so quickly in this fashion off of their lows, especially noting the amazing increase since the beginning of the year? It obviously can’t solely be buying support from an army of retail investors alongside prominent activist investors like Messrs Cohen and Palihapitiya (and a tweet from Elon Musk). In fact, I believe that the significant short interest in the shares has perversely played a role in the shares meteoric increase, certainly over the last few days.

First, let’s first look at the fundamental case in support of GME being wrongly priced at below say $20/share. In fact, at this level I can see the activist (long) case for the stock. Just look at some of the ridiculous valuations of many WFH and techie names today. Many of these companies have never made a profit yet are considered disrupters and are benefiting from having a “tech” slant, trading at lofty multiples of sales (since EBITDA is negative). Yes, GME is mainly an old school “bricks & mortar” retail story, but there is a vision in the activist community that the company could transform itself by adapting more rapidly to the digital world, using as a base the goodwill and brand awareness around its name and long history in gaming. This is what has drawn in investors like Michael Burry and Ryan Cohen. It is a transition not without risk of course, but this is the role of activist investors. Secondly, the significant short interest has probably worked against short sellers because GME has managed to tread water and then increase in price, initially demonstrating resistance as longs and shorts fought it out. As I mentioned earlier, shorts are always in a race against time, and at some point the pain becomes too great and they are forced to throw in the towel to limit their losses by covering short positions. This buying pressure – a short squeeze – then provides even more upward momentum to the share price. Lastly, the writers of out-of-the money calls, presumably market makers for the most part, want to remain delta neutral. Therefore, they tend to buy the underlying shares when writing call options so that they are hedged, since their profit model is based on bid-ask spreads not directional moves. However, as the buying of call options accelerates and market makers have to write more and more call options to satisfy this demand, they then have to buy more and more stock to remain hedged. The reality is that as a stock moves upwards, covering short positions and acquiring stock to hedge against call options both create a feedback loop that just pushes the shares higher and higher.

In conclusion, short selling is risky, especially given the environment we are in at the moment. Short sellers perversely can even lead to exactly the behaviour they are not expecting, which is a stock’s price gapping up dramatically due to short covering. This is undoubtedly a contributing factor to what we are observing at the moment in the very interesting case of GameStop.