Gamestop: how a group of nostalgic nerds overturned a short-selling strategy
In this article, Raphaël ROERO DE CORTANZE (ESSEC Business School, Master in Management, 2018-2022) talks about the Gamestop case which has shaken up Wall Street last january.
Gamestop: an unprofitable company with slender turnaround prospects
Gamestop is a US company specializing in the distribution of video games and electronic equipment (similar to Micromania in France). After golden years in the 1990’ and 00’, Gamestop has sunk since 2010 into a spiral of debt and successive sales of its stores around the world. The company’s response has been to cut costs and shut down underperforming stores, rather than trying to adapt to new trends of consumer behavior. Indeed, physical stores have lost momentum over the years, this decrease being powered by the rise of e-commerce and recently COVID-19 and lockdown restrictions. Hence, at the end if 2020, Gamestop’s future appear to be bleaker than ever.
Last January, Gamestop became the target of a short-selling strategy (see below) by several hedge funds. In a short-selling strategy, hedge funds bet on the decrease of a stock to pocket profits. But, retail investors came into action to “save” Gamestop from the claws of these hedge funds.
Indeed, in the United States, the stock market has opened up in recent months to small investors. Since the beginning of the Covid-19 crisis, many stocks have fallen, allowing an entry into the world of the stock market with little investment. Thus, students, employees or even retirees have been tempted. After having learned that some hedge funds were betting on a decrease of Gamestop’s stock, a retail investor began buying Gamestop stock on the Robinhood application, then calling on Reddit for other retail investors nostalgic of Gamestop to come to the rescue and buy more Gamestop’s stock to increase the stock price. Their strategy paid off: the stock price surged up to 1400% and the hedge funds had to incur losses.
What is short-selling strategy?
A short-selling strategy revolves around selling something you do not own. If you do not own something you want to sell, you can borrow it, sell it and then give it back at the end of the borrowing time. A short-selling strategy can be simplified into 3 steps:
- Investor A (that can be a hedge fund) borrows a number N of shares of the targeted companies from Investor B (usually an ETF or a mutual fund through a broker)
- Investor A sells the borrowed shares to Investor C at a price p
- When it’s time to give the shares back to Investor B (the lender), Investor A buys back N shares of the targeted company at the price p’ and gives them back to Investor B with fees f. Investor A pockets the following profit: (N * p) – (N * p’) – f = N * (p – p’) – f
In other words, a short-selling strategy bids on the fact the stock price of the targeted company will drop between the moment Investor A sells the shares it has borrowed, and the moment it buys them back to give them back to Investor B with fees.
Hedge funds pocket money only and only if the selling operation yields more than the absolute value of buying the shares back and paying the fee. This is why hedge funds target companies of which the stock price is expected to fall, due to poor financial management or bleak turnaround prospects. In this case, Gamestop was the perfect candidate for a short-selling strategy.
The lessons of the Gamestop case
Due to the mayhem around Gamestop’s stock price, Robinhood had to block its retail customers from purchasing GameStop shares because of a “too volatile” price (while hedge funds were still able to trade elsewhere). GameStop achieved its first quarterly sales increase in two years during Q1 2021, thanks to the notoriety brought by the case. Nonetheless, the hype around GameStop has quickly come to an end, as it is still an unprofitable company with slender turnaround prospects. The fall is GameStop stock price following the end-of-January records and the recent events demonstrate it. At the beginning of April, GameStop announced it may sell up to $1bn of additional shares as it looks to take advantage of the Reddit-driven trading frenzy. This announcement was quickly sanctioned by the market, and the stock price fell.
This demonstrates that a hype created by nostalgic retail investors is not sufficient to entail a turnaround of the financial situation of GameStop. It still has some major management problems, such as wages below average. A Stanford University Management Professor, Jerry Davis, argue on this case that “Rescuing an extremely low-wage employer from short-sellers by pumping up its stock is not exactly storming the Bastille.”
A few retail investors pocketed a lot of money by selling their GameStop shares at the right moment. But the majority were caught up by the harsh reality of the market and the decline in the stock price. Will GameStop be able to take advantage of the frenzy around its stock price to bring measures and decision which could make its future better without being sanctioned by the market? Time will tell.
The Financial Times (February 25, 2021) GameStop shares extend surge in early trading
The Financial Times (April 5, 2021) GameStop shares fall after it announces plan to sell up to $1bn in stock
The Financial Times (February 7, 2021) The biggest lesson of GameStop