The last two weeks saw an amazing confluence of forces that created a financial story that shook the nation. We saw the power of social media in the form of Reddit move the stock market. A populist stock brokerage firm called Robinhood gained praise and then rage. We learned about hedge funds taking ridiculous risks. And, at the end of the drama, we witnessed an angry mob wanting to punish the rich and spread wealth to the poor. It was a perfect storm that caught the attention of even nonfinancial people.
At the center of the storm was an unlikely little underperforming stock called GameStop. And now that the dust is settling, it’s worth a few moments of reflection to examine why this stock riveted the nation and generated such emotions. And why, in spite of powerful hedge funds, small investors like you and me can still outperform them.
First, what happened to GameStop stock? If you’ve ever seen the movie Trading Places, you’ve seen how a fortune can be made by short-selling (selling something you don’t own). In this case Eddie Murphy and Dan Aykroyd sell orange juice contracts at a very high price that they don’t own, and then buy them back (cover the short sell) when the prices tumble. They make a fortune by pocketing the spread.
But this isn’t Hollywood. What happened to GameStop was real. And it wasn’t the first time a short squeeze ended when the rules changed.
The Amazing Piggly Wiggly Story
Have you ever heard of Piggly Wiggly? It was created in 1919 by a guy named Clarence Saunders who invented the first modern grocery store. Before Clarence, people had to go into a store and hand a clerk the shopping list and wait for items to be brought out. The concept of selecting your own groceries was so successful Piggly Wiggly stores grew to 1,200 locations within three years.
Clarence took the company public and it was a big success. However, he licensed some stores to the wrong people and a few of them went out of business. The Wall Street crowd saw an opportunity. They began shorting the stock and it went from $50 to $40. Clarence got mad and that’s when things went GameStop nuts.
In order to burn the short sellers, Clarence borrowed $10,000,000 to buy Piggly Wiggly stock. To make a long story short (pardon the pun) the stock soared to $250 in a few days as he cornered the market and the short sellers had to pay up to cover their positions.
And that’s where the story gets similar to what made the GameStop/Redditt folks so mad. They changed the rules on Clarence to protect the short sellers. The stock exchanges of that time suspended the trading in Piggly Wiggly and extended the time for the short sellers to close out their positions. The short sellers found other stock and were able to deliver it to Clarence rather than pay him in cash, which ruined his plan to bankrupt his enemies. He ended up broke because he could not pay back his loan. His brilliant plan didn’t count on the rules of the game being changed.
The GameStop Story
In the case of GameStop, hedge funds sold the stock short, expecting the stock to continue to drop. They planned on buying back GameStop as it went lower to cover their short-selling, and make a nice profit. What could go wrong?
First, contributors on Reddit message boards realized that GameStop had been sold short by about 140% of the total shares outstanding. They knew if they could get enough of their readers to buy the stock and push its price up, the hedge funds would have to buy stock to cover their losses. They succeeded. This additional buying pushed the stock price up even further making Reddit buyers of GameStop wealthy.
Over the past month GameStop traded from a low of around $17 to a high of $380. If you timed it right by buying at the low and selling at the high you made 21 times your investment. Not bad.
But for the hedge funds who sold the stock short, many of them lost big as they had to buy GameStock at hugely inflated values. Some estimates show $19 billion in losses for the hedge funds.
The Rest of the Story
If the story ended there, it would already be a classic. But it got more intense when a brokerage company called Robinhood, who caters to young investors like those who read Reddit, complicated things. Robinhood, as the name implies, touted itself as a company that helps the poor grow wealthy. However, they announced in the midst of the short-selling squeeze of the hedge funds that they would no longer allow their customers to buy GameStop shares.
The action by Robinhood was explained in this press release. However, the news appeared to many to be a way to stop the short-squeeze and bail out the hedge funds. A populist fire was lit and all kinds of accusations were made about the wealthy hedge funds getting bailed out at the expense of the retail investors.
How to Think About Hedge Funds
I understand the populist rage. But I don’t fear or hate the hedge funds and neither should you for a variety of reasons.
First, to invest in a hedge fund you typically have to agree to pay them 2% of the balance of your investable funds, and 20% of any gains they generate.Why would we do that? They may be smarter than us, but usually they don’t make up in performance the additional cost they charge to manage money. And because of the high fees, they have to take more risk to cover their fees. The Wall Street Journal reported one hedge fund, Melvin Capital, lost 53% in January alone. Another study showed the S & P 500 index beat Hedge funds by 2.25% annually over a period from 1994 to 2018. Draw your own conclusions if they are worth the high fees.
Second, let’s talk a little theology. Perhaps the greatest sin connected with money is covetousness of others wealth. Rather than envy them, we should appreciate them. Hedge funds perform a valuable service that makes our markets more efficient than they would be without them. Jim Chanos is a good example of a short seller who got it right. He saw that Enron was a house of cards and bet against them. He made hundreds of millions from his insight. We should be thankful for insight like that which kept Enron stock lower than it might have gone without short sellers.
Third, like it or not, we are probably joined at the hip with hedge funds. Pension funds—which invest on behalf of teachers and police officers among others—may be unexpected causalities. Many pensions are allowed to invest more than 20% of their assets with hedge funds. While there was some metaphorical celebrating in the streets at the way GameStop hurt many hedge funds, the pain will be felt by many who are not millionaires.
Finally, give thanks for the amazing opportunities we all have to enjoy the fruits of capitalism at low costs. Many broadly diversified index funds charge zero commissions. As long as we accept that most of us are not going to be successful stock pickers, we can rest in our humility in knowing that we own the entire market at low cost. We don’t need hedge funds to succeed if our economy prospers.
It’s time to hit the send button, but I’d be curious how you processed the GameStop news of the past two weeks. Feel free to join the conversation with a post!
Joe Kesler
Joe, thanks for the Piggly Wiggly history. The Gamestop news this week reinforces for me the need to be diversified and avoid the temptation to pick “the” winning stock that will make you rich quickly. My wife and I built wealth by saving, dollar cost averaging into 401k and IRAs and living on a reasonable budget. It only took 25 years to achieve financial independence, although I kept working seven more years for a variety of reasons, including creating an extra cushion for peace of mind. During those 25 years we learned a lot through trial and error. In the end, index mutual funds and ETFs made up the bulk of our investing successes. Not everyone can see waiting 20 – 30 years for success (patience is a virtue) but we have found great joy in the journey and hope the same for everyone regardless of the financial outcome.
Brian, your experience is similar to mine. The “fear of missing out” emotion is strong for those who read the message boards on Reddit type social media. I learned that the hard way, but it gave me the experience and wisdom to follow the same path you and your wife took. “He who gathers little by little grows wealthy” is a wise proverb we can pass onto those who want to learn. Thanks for the comment.
Joe, thanks for the thorough, yet brief, description of hedge funds and short sales. When my sons-in-law brought up the Gamestop buy idea, the only thing I could say was, “Don’t do it. By the time you hear about something in the media, it’s already too late.” Your information helps immensely with the back story.
You gave some great advice Kirk! I hope he took it. I know a lot of people got in just at the wrong time and are regretting it.