The big-time potential of small cap stocks [PODCAST]
Pinpointing winners requires a sound investment process.
Pinpointing winners requires a sound investment process.
By Mark Simenstad, Chief Investment Strategist | 02/02/2021
This past week has seen yet another unprecedented phenomenon in the capital markets – the saga of GameStop and other companies whose stock prices have gyrated wildly.
Although some things are new in this development, some are not. Furthermore, many evolutionary market trends that have been going on for many years have contributed to this amazingly volatile story. Finally, it is important to distinguish that the players in this “game” are traders, not long-term investors.
GameStop is a small, money-losing company. Its business is selling computer and video games in small stores, predominantly in malls. It has struggled in a dynamically changing technology and retail environment where an increasing number of “gamers” are now downloading games from the Internet rather than buying them at a store. The company is also saddled with debt.
Due to its very poor operating performance and deteriorating financial performance, the stock has languished for years. Many sophisticated hedge funds that recognized this challenging fundamental situation collectively sold a significant amount of the outstanding stock “short.” In a short sale, a trader essentially must first borrow a company’s stock from existing shareholders before selling it. In doing so, the trader is obligated to abide by margin rules that the brokerage industry has established. These rules require that, if contrary to the trader’s bet, the stock starts going up, the trader is required to either buy back and return the borrowed stock or post cash collateral to maintain their short position.
Although hedge funds had established what seemed to be a rational short position in GameStop, as well as other companies experiencing challenges, some individual traders found a few kernels of potentially positive news and began buying shares in these deeply distressed stocks.
They also noted, through required public disclosure, that there was a growing level of “short interest” in these stocks. This information, along with the knowledge that traders who had sold stocks short would be required to buy back the stocks if prices started trending sharply higher, helped generate further interest in these stocks.
Individual traders then used the exponential communication power of social network platforms to broadcast their intentions and solicit new followers, thus garnering what was effectively a “flash virtual mob.” An astounding number of individual traders then began aggressively buying stock in these distressed companies.
Although this sounds like it was coordinated, it most likely began as a loose confederation of intentional retail traders attracted to a speculative play that led to a multitude of other trend followers, many of whom had little knowledge of the situation except that the stock was vaulting higher. From a fundamental perspective the buying seemed entirely irrational. However, from a technical perspective it was rational – it was a classic “short squeeze”.
This is the first significant circumstance where the intersection of social media and the securities markets led to such dramatic losses for some institutional traders, while generating incredible profits for some small individual traders (although many individuals probably also suffered losses). The press has reported this as a compelling story of David vs. Goliath, with small traders “slaying” the fearsome institutional hedge fund traders.
Indeed, this is somewhat accurate. A few notable hedge funds were blindsided by this development and suffered damaging losses. These hedge funds had established rational short positions (betting a stock would fall) in the stocks of companies whose prospects looked very dim. They were unprepared for what would be considered the “irrational” behavior of the “flash virtual mob” whereby individual traders were buying just to “play the game” or to be part of a movement to inflict financial damage to “sophisticated financial insiders” – aka hedge funds and other institutional traders.
Financial history is littered with speculative stories that are fueled by excessive positions, leverage (using debt or derivatives) and conflicting perspectives of an asset’s value. The GameStop and similar current situations are a little different from past “short squeezes.”
Evolutionary developments in the investment industry and capital markets that have been years in the making also added to the environment for this to happen. Technological advances have aided discount brokerage platforms such as Robinhood and others in providing the tools to easily execute securities transactions. Explicit trading commission costs are now effectively “free."
In previous generations, commissions were a real frictional cost that would inhibit excessive trading activity. In addition, shares of stock can now be purchased in fractional amounts. Information, and sadly disinformation, are now readily available and can be acted upon instantaneously.
Index funds have become enormous “non-thinking” players in the market. Index funds do not sell securities when prices go to what seem to be irrational levels. In fact, they may even be forced to buy at higher and higher levels. Huge holdings by index funds can vastly diminish the actual free “float” of a stock. This can contribute to more volatile price action in specific smaller stocks.
Fortunately, this situation does not seem to be a threat to the financial system. The mechanisms of the brokerage and banking systems appear solid. However, this development will probably lead to some changes in the regulatory environment, particularly in some of the arcane “plumbing” aspects of the capital markets.
A good example is the antiquated number of days it takes for a securities trade to “settle.” It also is clearly something that has implications for very active traders, both individual and institutional. Social networks can be unregulated “megaphones” to encourage traders to coalesce around an idea.
It is important to note this story is about traders, and much less about long-term investors. For long-term investors, although stories like this may be entertaining, disconcerting or both, it should not have ramifications for long-term wealth building. In the long term, investments in companies that provide a necessary service or product, are managed well, and generate growing long-term profits and/or dividends will dominate the transitory trading stories that will come in and out of the news.
All information and representations herein are as of 02/02/2021, unless otherwise noted.
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management, LLC associates. Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.
As of the date of this article, GameStop is held in certain Index Portfolios that are managed by Thrivent Financial for Lutherans. GameStop stock is included in the index(es) on which these portfolios are based.