The epic short squeeze in GameStop (GME) is the biggest financial markets story since the Great Financial Crisis.
We all know the story.
Redditors noticed that the short interest in GameStop (GME) has been over 100% for a long time. As the stock ticked higher, the idea of a massive short squeeze went viral.
The stock went further than most thought possible, reaching a high of $483 from a 2021 low of about $17.
Tons have been written on the subject, touching on all manner of broader societal phenomena.
Netflix even announced they’re making a film about the event. Doubtless, your email inbox is full of insightful thoughts on what these means for markets and beyond, so we’ll opt just to explain the story behind GameStop stock before the short squeeze occurred.
We’ll attempt to answer questions like why GameStop was such a favorite for short-sellers and who were the early GameStop bulls before the squeeze began?
We’ll also try to explain some of the nuances in market structure leading to a short interest north of 100%.
Why Was GameStop A Popular Short Candidate?
Something can never be obvious in the markets. If there’s a thesis in a reasonably liquid stock that is remotely apparent to any number of investors, it gets reflected in the price quickly.
However, GameStop is a situation where many seemed certain of the result.
Ecommerce crushed brick and mortar. Both console and PC games are now mostly digital, allowing you to buy games directly from your device. Consumers could easily sell what they previously may have traded-in to GameStop on eBay or similar online services and get more money.
The company’s poor capital allocation record didn’t inspire shareholders either. Nor did its share price performance. Here’s a chart from GameStop’s 2019 annual report:
In an activist letter to GameStop management, Michael Burry said:
“The unfortunate reality is that Amazon, not GameStop, bought Twitch in 2014. Instead, in 2014, GameStop started buying wireless store assets. And in 2017, Amazon, not GameStop, bought GameSparks – while less than a year ago GameStop reversed course and sold its wireless store assets. Shareholders are right to worry.”
GameStop is what long/short hedge fund manager Scott Fearon calls a “melting ice cube.”
Fearon is the author of Dead Companies Walking: How a Hedge Fund Manager Finds Opportunity in Unexpected Places, in which he explains how he found success shorting companies in doomed industries, usually being usurped by an innovative competitor.
GameStop’s current business situation–share price aside, is reminiscent of Scott’s Blockbuster experience.
When meeting with the company, a charming investor relations rep told him that they’re doubling down on retail instead of focusing their efforts on competing with Netflix digitally.
She explained that Blockbuster’s new strategy was to focus on selling, rather than renting, children’s movies and video games. They also were going to sell the novelty-size candies you see in movie theaters.
Fearon accounted his disappointment with the company as so:
I walked out into the chilly North Texas winter morning with one word playing over and over in my head: candy. I just couldn’t get past it. Blockbuster’s leaders were seriously pitching candy sales as the thing that would keep the company from the ash heap. It was almost sad. For a quarter-century, Blockbuster had been a massively successful business. Even with all its recent troubles, it still had almost $6 billion in revenues the year before my visit. And yet things had gotten so bad so quickly that its executives had been reduced to hoping that selling oversized boxes of Jujyfruits could save it.
You can imagine Burry had similar frustrations with GameStop.
Here, you had a solvent business with enough cash to dig their way out of eventual obsolescence. Instead, it was acquiring wireless stores and Geeknet, the operator of ThinkGeek mall stores.
Much like Blockbuster thought they could prevent their decline by selling candy and sprucing up the retail experience, GameStop was trying to make up for growth in their core video games business with collectables and broadening their footprint in the declining brick and mortar retail industry.
Things got exponentially worse for GameStop when the pandemic’s breadth became apparent in March 2020. The company temporarily closed all of its stores and had to rely on eCommerce and in-store pickup.
Their revenue plummeted, but they still had the obligations that any mall retailer does. This put them in an even more precarious position than before.
Here are some reasons short-sellers had to be bearish:
- Industry-wide decline. Amazon is destroying malls, and games are going digital.
- Same-store sales, a key retail metric, is steadily declining.
- The company’s strategy didn’t seem to make sense to the short-sellers on a gut level. It seems obvious to most that a mall gaming store won’t be a thing in twenty years, and the company’s strategy to pivot wasn’t inspiring to them.
- GameStop was doubling down on malls. They got into a bidding war with Hot Topic and bought Geeknet, the parent company of hobbyist store ThinkGeek for $140 million in 2015.
- To many, COIVD-19 lockdowns seemed strong enough a catalyst to put GameStop out of business.
What Was the Bull Case for GameStop?
Pre-short squeeze, GameStop’s future didn’t look too attractive. Not only was their core business in secular decline, but their acquisitions also focused on brick and mortar retail. They acquired more mall assets in 2015 when they bought Geeknet for $140 million.
However grim the short thesis may have seemed, it was priced into the stock and then some. In mid-2019, the company was trading at a market capitalization of roughly $310 million, compared to their $480 million cash balance.
They also had very little in the way of debt, making solvency highly unlikely under even the worst circumstances.
According to a 2019 SeekingAlpha article from Vince Martin, GameStop was one of a few companies trading for less than its cash balance that could realistically return said cash to shareholders.
Value investors like Michael Burry of The Big Short saw a turnaround opportunity. In 2019, Burry’s fund Scion Asset Management took a 3.3% position in GameStop, which, at the time, represented an investment of around $10 million.
In a letter to the company’s board of directors, Burry criticized what he deemed poor capital allocation and urged GameStop to buy back more shares with its cash balance.
The co-founder of pet retailer Chewy.com Ryan Cohen followed Burry’s lead and took a 13% stake in the company in 2020, landing himself three board seats in the process.
You couldn’t have been blamed for calling GameStop a deep value stock at this point, although many wrote it off as a value trap.
He told a reporter on January 26th that he was “neither long nor short” the stock anymore. One of his more widely reported statements is as follows:
“If I put $GME on your radar, and you did well, I’m genuinely happy for you. However, what is going on now – there should be legal and regulatory repercussions. This is unnatural, insane, and dangerous. @SEC_Enforcement”
Here was the bull case for GameStop before the short squeeze occurred:
- GameStop was trading for less than its cash balance, one of few such stocks at the time that could realistically return the cash to shareholders.
- Despite its dismal industry outlook, GameStop’s financial liquidity was pretty good, and bankruptcy was far from imminent.
- The company could have easily been a strategic acquisition target.
- The persistently high short interest ensured that any positive catalyst would have real buying pressure from short covering.
How Does Short Interest Exceed 100%?
One of the strangest things about this short squeeze is that several data aggregators reported GameStop’s short interest to be above 100%–meaning that more than the total float is short the stock. That seems impossible.
On January 25th, 2021, Benzinga’s PreMarket Prep had Tim Quast, the CEO of Market Structure Edge, on the show to explain the nitty-gritty of how this works.
One of the more shocking things he told Benzinga was that short interest is a “1975 measure that has no bearing, nor merit in a market that is electronic.” His firm instead pays attention to short volume.
He said that designated market makers are exempt from the requirement to locate shares to short. “They can manufacture them,” he said.
This isn’t nefarious on the part of exchanges or market makers but is part of maintaining orderly markets.
It’s essential to understand why Quast ignores short interest. It’s purely a once-a-month snapshot in time.
That snapshot could be distorted by all manner of non-directional trading and misinform you of how many directional traders are actually short a stock. Remember that market makers trade on a second-to-second basis.
Suppose some giant buy order came in right before exchanges take the short interest snapshot. In that case, the short interest will be unnaturally high because market makers have just supplied a bunch of liquidity to that order.
Here’s the same concept explained by Nope It’s Lily on Medium, who put it nicely:
Market makers, unlike hedge funds, are interested in keeping the market functioning and supplying tasty liquidity… Because of this, the government (the SEC) gives them special rules to allow naked shorting, with the understanding that they can almost always locate the shares before the settlement date. This almost always works because market makers are large institutions (Citadel, Virtu for some common examples) that handle these transactions at scale, and can handle drawdown.
Why Hasn’t GameStop Raised Capital?
One of the more surprising events (or lack thereof) is that GameStop hasn’t issued stock to raise capital yet.
This is probably because the acting chair of the SEC subtly hinted that these companies caught in short squeezes should think twice before raising money:
And then let me just mention one third area that we’re looking at very closely, and that is these issuers. Now, for the most part, there’s no new information in the market from these issuers. But we are going to make sure as we – you know, as we look to what they’re doing, whether or not they are trying to raise money in the middle of this. And if so, can they adequately disclose the risks associated with that?
AMC Entertainment, another firm caught in the short squeeze, quickly seized upon the opportunity, however.
They raised $506 million in equity, $411 million in debt and launched an at-the-market offering allowing them to sell $304 million of shares.
They got a cherry on top too, when $600 million worth of convertible bonds were converted into stock.
GameStop is one for the record books.
While at the time of writing, the stock closed at $53.50 while reaching a high of $483 just a week earlier, it’s impossible to tell what comes next in these dynamic situations.