This website uses cookies to collect usage information in order to offer a better browsing experience. By browsing this site or by clicking on the "ACCEPT COOKIES" button you accept our Cookie Policy.

What GameStop’s Crazy Ride Can Teach Us About Investing

Validea

Contributor:
Validea
Visit: Validea

By:

President at Validea.com & Co-founder of Validea Capital Management

There’s a saying from Winston Churchill, “Never let a good crisis go to waste”, and while the news around the Reddit message board, r/wallstreetbets, and GameStop may not be a crisis per se, it certainly is something that has turned markets upside down, caused confusion among most main street investors, ravaged some multi-billion hedge funds, rewarded some nimble traders and hurt many others who got in too late (read, WSJ: GameStop Investors Who Bet Big—and Lost Big). The GameStop story and situation is extraordinary, and I think it can provide us with some broader lessons that are important to remember when investing in the market.

Disconnected from The Fundamentals

A year ago, GameStop traded around $4/share. At its peak in January of this year, the stock reached $347 on a closing basis. The 8500%+ gain, driven by coordinated buying among wallstreetbets and other retail investors combined with a massive short squeeze (at one point 140% of the company’s shares were being sold short), drove the stock to parabolic levels. The example of GameStop is obviously an extreme example, but the one thing to remember is that in the short run stocks can diverge from fundamentals, and sometimes do so to such an extent that it’s impossible to rationalize the move. In the short term, human behavior can trounce anything to do with fundamental value, but over time a company’s value will be driven by the future cash flows and the value it derives from its overall business.

In December 2020, Research Affiliates put out a piece, Tesla, the Largest-Cap Stock Ever to Enter S&P 500: A Buy Signal or a Bubble?”, in which they showed just how much Tesla would have to grow in order to reasonably defend its current valuation.

They wrote:

What assumptions would justify Tesla’s current valuation? Suppose Tesla sales grow by 50% a year over the next 10 years. That means its sales would need to increase 58 times over anticipated 2020 sales.10 The company’s current margin is not high enough to justify the 100 times multiplier over the rest of the industry. Suppose that in 2030 Tesla has a 10% net margin, higher than any existing auto company and 47% higher than its most recent 6.8% net margin. Nope, still not good enough. A 10% net margin would make Tesla “only” 85 times larger than it is today, not 121 times larger. Such high growth persisting over a full decade is implausible. Amazon’s growth rate over the last 3, 5, and 10 years has been in the high 20s, nowhere near 50% a year. Tesla’s own three-year revenue growth rate is 33% (the revenue growth was far slower than the 61% unit car sales growth), so 50%—for a full decade—is a major acceleration over its stupendous recent growth. Our analysis examines terminal value only. In order to justify Tesla’s current valuation, the assumptions about its sales and margin growth need to be even more aggressive.

So clearly prices and fundamentals can be highly disconnected, but mean reversion in the markets is a very powerful force and over time stocks will want to gravitate back to their fair fundamental value.

Few Stocks Drive Returns

On Validea, two of our models selected GameStop, based on the perceived value in the stock, in 2020. One of our models added the stock in April and the other in May. As a result of this, these two portfolios delivered incredible performance, driven almost entirely by the GameStop stock return. These two model portfolios at one point became our top performing portfolios solely due to gains from this position, but have since settled back down as the impact has been reduced. Right or wrong, fair or not, fundamental or behavioral, there’s an important point in this, which is often times most of a portfolio’s returns can come from a handful of stocks. This is especially true of focused portfolios. If you look at the distribution of returns in the market over time, what you’ll find is that most of the returns come from a handful of stocks way over on the right in the distribution. GameStop might be an extreme case and isn’t the typical growth stock like Amazon, Microsoft or Apple, but it’s key to remember a few stocks drive most of the returns in the market and finding those stocks, since they are in the minority, can be like finding a needle in a haystack. But if you are lucky enough to get one, they can dramatically impact your results.

Source: https://www.stlouistrust.com/why-most-stocks-underperform-index/

Changing Market Dynamics

One thing we can say for certain is that markets are always changing, always evolving, and we need to respect and understand that. In the late 90s it was technology names and Internet companies that were all the rage, from 2001-2006 it was value and international stocks, from 2009 – 2020 it was largely a large cap, growth driven market dominated by passive flows and starting in mid-2020 we saw a resurgence in individual investor participation and individual stock trading.

For example, according to this CNBC piece, trading volumes exploded in 2020 and continue to increase. Since 2019, trading volume in equities is up 100% — few anticipated this. Often times, these trends can last longer than many think, so it’s important to understand both the positives and negatives and consider these changing conditions and how it may impact returns over time. For instance, if you believe individual investor interest in stocks will remain elevated, one might start to look more seriously at smaller companies, which is where many of these retail traders are focused (small cap and micro caps are outperforming).

Equities: Average daily volume

  • 2019:             7 billion
  • 2020:            10.9 billion
  • 2021 so far:  14.7 billion

Source:  Piper Sandler

Source: https://www.cnbc.com/2021/01/22/trading-volume-is-up-so-far-from-2020s-breakneck-pace-as-retail-investors-get-even-more-active.html

To add further evidence, a newly published research paper set out to understand the impact retail investors were having on stocks. The research looked specifically at the trades made at Robinhood to determine how much influence these individual investors have. To summarize their findings:

Despite their negligible market share of 0.2%, we find that Robinhood traders account for over 7% of the cross-sectional variation in stock returns during the second quarter of 2020. We furthermore show that without the surge in retail trading activity the aggregate market capitalization of the smallest quintile of US stocks would have been over 30% lower. Lastly, Robinhood traders are able to affect the price of some large individual companies that are being held primarily by passive institutional investors. The Equity Market Implications of the Retail Investment Boom, Feb. 2, 2021

Avoid Borrowing To Invest

The Wall Street Journal article paints a picture of those who lost in the GameStop story. For example, a security guard borrowed $20,000 and invested it in GameStop and has since seen his investment go down by 80%. I think there are two important lessons here. The first is that most investors should not borrow money to invest in the stock market. Think about this investor – not only is his $20,000 investment down 80%, he now has to pay interest on the loan he took out. So, it’s a double whammy. Stocks are very risky in the short run, and given the variability of returns, borrowing to invest is something that most investors should avoid in my opinion.

The Value In Information

There are going to be hearings and investigations with respect to whether what transpired in GameStop was legal or if this will be determined to be market manipulation. This isn’t something I can weigh in on, but one part of the GameStop story that is interesting is the information and the asymmetric opportunity it offered those who were willling to dig into the data to find something that possibly seemed off. That story centers around a Reddit user who identified that roughly 140% of the shares of the company’s stock were sold short and if enough Reddit users banded together to push the stock higher, shorts would have to start covering their bets, thus unleashing a massive short squeeze. This is actually what ended up happening. But the lesson is not in actual event, but rather in the fact that the Reddit user uncovered something in the markets using publicly available information. Only time will tell whether or not what transpired was legal or not, but finding unique pieces of information on stocks can be a way to source ideas where others aren’t looking.

Nothing Is Really Free

One of the changes in the investing landscape, which has partially contributed to the interest in individual stocks among retail investors, is “commission-free” trading. It was offered first through the popular trading app Robinhood and now through mostly major online brokers (Schwab, Fidelity, Interactive Brokers) and many others. But the GameStop saga, which resulted in GameStop being halted on a few of these trading platforms, also helped bring to light that commission free doesn’t necessarily mean there isn’t a cost. Charles Schwab, Robinhood, E*Trade and others receive payments from trading firms like Citadel, Susquehanna and Virtu through which they send trades, This is known as “payment for order flow.” As this WSJ article points out, trading firms “make money by selling shares for slightly more than they are willing to buy them, and pocketing the price difference. They are willing to pay for order flow from online brokerages because they are less likely to lose money trading against individual investors than on an exchange, where traders tend to be larger and more sophisticated.” So on one hand, there is an idea that individual investors are losing out to these high frequency trading firms, while on the other hand some argue investors overall would be worse off if payment for order flow was restricted. But the bottom line is these firms are willing to pay for order flow so there has to be margin in the business, and that margin comes through the spreads these trading firms are capturing from individual investor trades and that are ultimately netted out of the price’s investors receive when buying and selling. Bottom line: trading is not really free.

Source: https://www.wsj.com/articles/GameStop-mania-drives-scrutiny-of-payments-to-online-brokers-11612434601

I have a feeling we’ll be talking about GameStop, Reddit and r/wallstreetbets and many of these other topics (i.e., retail trading, payment for order flow) for some time. But over time having success in the market is much more about thinking long term, setting up a portfolio appropriate for your goals, understanding the changes in the market landscape, respecting history and remembering why stocks offer the premium they do. If you can get those things mostly right, you probably won’t need to find yourself on a message board looking for the next GameStop. 

Originally Posted on February 17, 2021 – What GameStop’s Crazy Ride Can Teach Us About Investing

Disclosure: Interactive Brokers

Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from Validea and is being posted with permission from Validea. The views expressed in this material are solely those of the author and/or Validea and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

Disclosure: Hedge Funds

Hedge Funds are highly speculative, and investors may lose their entire investment.

Disclosure: Margin Trading

Trading on margin is only for sophisticated investors with high risk tolerance. You may lose more than your initial investment.

For additional information regarding margin loan rates, see ibkr.com/interest

trading top