GameStop: A Lesson In Short Squeezing

I guess I stumbled into some good timing recently in writing about the role of short squeezes in the valuations of Insuretech stocks as short squeezes have become the story of 2021 so far.

Last week, I wrote about the prominent short seller Andrew Left, of Citron, who targeted LMND after its recent run up. Well, after his ham handed hit on LMND, he returned with an even more controversial target – GameStop (GME). Spoiler alert: it failed miserably!

GME has been on fire – going from $20 two weeks ago to as high as $150 intraday yesterday! – as it has become the poster stock for the online stock tout community (particularly on Reddit) after the founder of Chewy bought a lot of the stock.

Now, while many in the insurance community like to point out the flaws in Lemonade’s business model (and there are plenty), Lemonade at least has a chance to do something really big.

The market may be overestimating the odds, but they’re not 0%. There is uncertainty and some can look at the cup as half full while others see it half empty. That’s what makes a market.

The odds of GameStop becoming a great company are zero. It is dying. I’ll explain why below, but for now, let’s accept the premise that it’s this decade’s Blockbuster.

Forcing A Fold (aka Manipulating Markets)

So why is GME riding a rocket ship? Because we are in a market where fundamentals don’t matter, not even a little bit, at least for high profile stocks.

While there is a cover story about how the Chewy guy is going to miraculously fix GameStop, I don’t think many of the touts really believe that.

I think what they saw is large short interest (reportedly > 100% of the shares) and they came up with a story that let them attack that. Remember, short squeezes are rocket fuel for controversial stocks.

It is analogous to playing poker without looking at your cards. You are trying to win by bluffing and reading your opponent’s tells. If you can cause your opponent (the short seller) to believe your bluff, they will cave and you will collect the pot.

That is what the Reddit crowd is really doing. They are demonstrating unwavering, irrational confidence to scare the other side from playing out the full hand.

Additionally, there is a feature here that is better than poker. In investing, no matter how strong willed your opponent is, once they start losing too much money one of two things happens: risk controls kick in and force them to reduce the position or their clients get scared and start redeeming assets which forces position sales.

In other words, institutional money can be forced into folding regardless of how good their cards are. It doesn’t matter if you are holding a royal flush. You still have to fold.

Magnified by Free Riders

But wait, it gets worse. When hedge funds get into a forced selling (or, in this case covering) mode, they are price insensitive. They only care about getting out of the position as rapidly as possible.

You may think I’m exaggerating, but I am not. The same thing happens when an investor leaves a firm. When I left a job, I could see the impact on stocks in the next few days when my positions were liquidated.

The mandate is always to get it done immediately, not try to get the best execution because that might take a couple of weeks. There are investors who as soon as they hear a competitor was laid off or switched firms would try to figure out their holdings and front run the looming sales.

When hedge funds were rumored to be folding during the Financial Crisis, everyone would look up their holdings and try to sell in front of them. It’s a “No Mercy” world.

So it’s not just that shorts in GME were forced to cover that was the problem. The problem is everyone knew they were forced to cover.

So to extend the poker analogy, it’s not just the bluffer who wins the pot…everyone in the room watching the match could also bet against the guy with the Royal Flush.

And to really beat the analogy to death, those watchers could also force the folder to match their bets too. It is a race against time to reduce the short before everyone gangs up on you. It’s a feeding frenzy.

And it already produced a casualty. Melvin Capital, which was known to be short GME, needed to raise nearly $3B of new capital from competitors to shore up its capital and possibly stave off a run on the bank scenario.

Could LMND Be Next?

This is why Citron gave up on GME after only two days. In this case, it wasn’t just losing too much money, but the online “bluffers” went so far as making personal threats in order to convince him they wouldn’t fold. This is obviously dangerous stuff and goes beyond the “all’s fair in trading stocks” noted above. It’s pretty scary stuff.

When I initially wrote about how it can be good for a stock to have an active short interest that could propel future gains, I was referring to “normal” times where psychology and momentum squeeze the shorts to new highs.

I wasn’t talking about situations like this where it is an all out war and the rules are thrown out. This is clearly an example of an investing tail event and I suspect the SEC or other authorities will investigate the behavior and potentially even bring charges if they can prove manipulation or intimidation.

So what does this foreshadow for LMND? Maybe nothing, but maybe everything. If the touters decide the next big thing after GME has played out is to go after another Citron short, then they are going to gang up on LMND.

This isn’t investing to them. It’s high stakes poker. If they think they can take LMND to $300 or $500, they will do it. My recommendation is to avoid the stock in either direction.

Even for professionals, this is a hard game to play (it is mostly big name hedge funds losing the GME trade). Don’t buy it. Don’t short it. Just watch from the sidelines and focus more on the operational progress.

GameStop’s Next Move

What about GameStop’s role in this? Well, like I said, they are a dying company. The parallels to Blockbuster are eerie. The only difference is we’re talking about video games not movie rentals.

Instead of losing to Netflix, GameStop is losing to digital downloads of games. Also, like Blockbuster, they had a significant business buying and reselling used product which is quickly going extinct (you can’t sell off your old digital games obviously).

I’m sure they’ll try all sorts of things to monetize the business before the stores go away, but so did Blockbuster. What, you don’t remember that? Exactly, but they did try.

There is only one thing left to do if you’re the management of GameStop. It’s the same thing Lemonade just did. When your stock price is expensive, you issue stock before it loses value.

Now, unlike LMND, GME doesn’t need capital to grow, but they do have debt they can pay down. They could even park the cash for now, wait for the stock price to come back down, and buy back the stock significantly cheaper.

That might be the most value creating thing they can do as a management team! If they issue 10M shares at $70, set the $700M aside and wait til the stock round trips to $14 and buy 50M shares, they will have reduced the total share count by almost 2/3! That is Hare style value creation!

If the management team just watches the stock trade up without taking advantage of it, they have failed shareholders.

Mark Cuban, The First Hare

Remember, the smartest man during the internet bubble was Mark Cuban. He sold his company at the peak and cashed out of the Yahoo shares he received to turn the bubble valuations into actual cash.

That is what you do during bubbles! You take advantage of the froth to create permanent capital. Everything else is a mirage.