January was favorable for HCP Quant, and the cycle supporting value stocks continued. The first few months of the year tend to also favor smaller companies, this phenomenon is known as the January Effect. Be it the January Effect, the emergence of the new cycle supporting value stocks, or a combination of both, it has delivered a long-awaited gust of wind to the sails of HCP Quant. While writing this, February has also had a strong start, with the fund nearing +20% returns for the start of the year.
But let’s return to January for a bit. HCP Quant returned +3.59% during the month. The MSCI ACWI SMID Value Total Return benchmark index, measuring the global development of small and mid-cap companies including gross dividends, returned +1.33%. Whereas the U.S. S&P 500 Total Return index fell -0.25% in euros, and the European S&P 350 Europe Total Return index fell by -0.77%.
The Reddit group Wall Street Bets (WSB) and its recent endeavors have gained a great deal of attention. Countless media outlets have already covered the topic, so I won’t initialize the matter thoroughly.
There have been a great variety of factors including conflicting interests, goals, ideologies, feelings, memes, humor, timing, and even cult mentality, which all contributed to the conditions that led to the events of the past weeks. WSB is by no means just a homogeneous group. I will simplify matters to present one aspect of the situation with Wall Street, the “nemesis” of WSB.
As we continue to live in the midst of a pandemic, normal life is limited and people are holed up in their homes. These circumstances create the perfect environment for an online community like WSB to thrive. When we combine the financial troubles caused by the pandemic, with young age, frustration with the current financial system (which is evident from the popularity of Bitcoin among young people, the widespread distrust of fiat currencies, and the attitude that Wall Street works against the common person), the stimulus checks in the USA, record cheap leverage, increased free-time, the relatively new convenience of buying shares (Robinhood application), inexperienced investors, and sprinkle on top some underground meme humor, the soup is ready to be served.
A company selling video games primarily in shopping centers, GameStop (GME) became one of the many targets of the WSB community. The original investment thesis was actually sound, but later the whole initiative took an unforeseen turn. GameStop has been struggling for some time now due to video game sales largely moving to online platforms, and more recently due to the pandemic closing shopping centers, causing GameStop to lose their customers. Many Wall Street hedge funds started smelling blood in the water and began short selling the stock aggressively, expecting GameStop’s problems to continue and the stock to keep falling.
One member of the WSB community, Keith Gill, bought call options for GameStop in 2019. Famous investor Michael Burry (“Big Short”, Scion Capital) bought GameStop shares the same year. Both of them thought that the stock was clearly undervalued. At this point, the investment was well justified, and Keith Gill continued to actively share his views and bank statements on the developments of the investment to the WSB community.
Earlier this year on the 22nd of January, the shorted shares of GameStop had grown to 140%. It was at this point that the WSB community saw an opportunity. The stock was undervalued, and the aggressive shorting by hedge funds could create an opportunity for a short squeeze with a great pay-off. For this to be possible, a large enough group of WSB users would have to work together, and so they did. The group now had over a million members, it was certainly large enough.
While initially, the basis for the investment was good, but as the stock rose wildly in a matter of days, it quickly became an absurd game of hot potato where people were just trying to pass the stock onto the next “player” (Greater Fool theory). The company’s share price became very disconnected from reality and fundamentals. In just a few days, the GameStop stock rose from 20 dollars to an unbelievable high-point of 480 dollars.
The large influence of WSB gained wider recognition as the media began reporting the story, which then inspired even more people to join the group, causing it to multiply manyfold in a short period of time. This rise in members was also necessary for maintaining the share price and making it rise even higher. At the same time, a common enemy had been established, making the act of dumping money into a wildly overpriced stock seemed ideologically justified to many (This is for you, Dad).
The common enemy in question was the hedge funds that had been short selling the stock. Many WSB users were prepared to buy GME stock and hold on to it (“HODL”, “Hold the line”, etc.) regardless of potential losses. For them, it was more important to see the hedge funds lose and hopefully even drive them to bankruptcy. The WSB community had power, and they were drunk of the realization that they could actually affect markets. The sentiment among the members seemed to be along the lines of “Let the Wall Street bankers cry, we have the power now! We will revenge the injustice!”.
They wanted to send Wall Street a message. It was no longer about GameStop being undervalued. GameStop had become a pawn in the game WSB was using to get back at Wall Street. The power of a large group is captivating. The feeling of being part of something greater is empowering, and if on the side it can also makes you some money, even better!
Ultimately, WSB wasn’t able to see it through quite this far. Did Wall Street really receive the message that WSB wanted them to get? I don’t think so. In the end, it was just a case of failed risk management. Risk management has failed investors countless times throughout history. When the risk management of LTCM’s PhDs failed in 1998, they needed 14 banks to save the day. During the financial crisis, banks were falling like dominoes as the subprime risks were realized. This time it’s a few hedge funds. But what did they and Wall Street learn from this? They learned that their models didn’t include sufficient risk of a short squeeze. The fact that the squeeze was orchestrated by a group of angry young people doesn’t change anything. Certainly, many hedge funds will have learned from this, and they will update their risk assessments to better consider these kinds of factors in the future.
While WSB was able to hurt a few hedge funds through the fall of their risk management, they also hurt themselves in the process. The Robinhood application is a very popular platform for making investments among WSB users. During the most hectic trading hours, even Robinhood’s own risk management gave in. WSB investors were lining up to invest borrowed money into highly risky derivatives through Robinhood. This led to Robinhood’s collateral requirements skyrocketing, and them having to rely on outside capital and restricting trading to avoid going bankrupt. In their attempt to hurt Wall Street, the WSB users nearly caused their own favored platform to fall as well.
Similar increases in collateral requirements also occurred on other brokerages that had significant trading activity for the select stocks that WSB was targeting. The restrictions to trading created many conspiracy theories about Wall Street working together to strike back at WSB. Naturally, this further drove the comradery within the group.
GameStop share price and trading volume. Source: Wikipedia
All good things must come to an end. WSB saw an opportunity for a short squeeze and grabbed it, the stock grew manyfold and the “Dethrone Wall Street” mentality had many people join just to hurt hedge funds. Everything seemed to be going well. Hedge funds had to realize some losses and many WSB investors made massive gains. It’s likely due to the inexperience that most didn’t consider who would be bearing the cost of all this. As the ones paying the price are in fact many of the WSB users involved. Not the hedge funds.
Short squeezes always follow the same pattern. The explosive growth is followed by the fall. When a company’s valuation gets too far from the value of the underlying business, it eventually goes back to a more justified level. GameStop has now fallen around -90% from the top. WSB investor’s risk management also failed. As a method for humor, many have changed their gloating to showcasing “loss porn”. In the end, the message they wanted to send turned out to be very costly. A boomer doesn’t pay for the kind of valuation multiples on GameStop that would make the share price hundreds of dollars.
WSB seems to be a victim of its own success. In a short time, the group was able to gain millions of users. They were able to manipulate the share prices of multiple companies (AMC Entertainment, Nokia etc.). The curiosity towards WSB grew into a phenomenon. The administrators of the group received offers to make a movie out of the events that had occurred, which caused internal conflicts. The GameStop saga ended with a large group of bitter investors condemning the market and Wall Street. When the funds have been burned, will there be enough left to move the next stock? There has to be a continuous influx of new investors to replace the fallen ones in order for something like this to continue.
In the end, I don’t think Wall Street will learn much from this. Besides adapting through adjustments to their risk models and creating systems to predict movements in the market based on the online communications of groups like WSB. However, I do hope that many individual investors learned from this saga.
Best Regards,
Pasi Havia
HCP Quant Portfolio Manager
“Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble… to give way to hope, fear and greed.”
Benjamin Graham