In case you missed our commentary on GameStop in last week’s video, here is a transcript. Co-Portfolio Manager on the International Shares Fund, Gareth Brown, and Chloe Stokes, Analyst on the International Shares Fund, discuss the recent short squeeze in this stock and outline a new Fund position benefitting from the madness.
Hi everyone and welcome. I’m Gareth Brown Co-Portfolio Manager on the Forager International Shares Fund. Today I’m joined by the very much in form Chloe Stokes. There’s a hundred things we could be talking about today Chloe, but this week there’s a black hole that’s sucking all financial news and attention towards it.
I’m talking of course about the GameStop short squeeze. We don’t normally like to comment on news of the day type sideshows, even if they are a bit of a freak show. But we actually have some interesting points to add into this debate and it also directly affects our portfolio, but let’s start from the top. What is short-selling?
Short selling is the process of selling a stock that you don’t own. When you’re short a stock, you make money if the stock price falls, and you lose if the stock price rises. So in order to sell a stock you don’t own, you need to borrow it from someone who does own it and you pay that owner for the privilege.
With ordinary long investing like we practice at Forager, in any stock position your downside is capped at 100% and your upside is unbounded. But for short sellers their upside is 100% and their downside is uncapped.
That’s a really good point. A short squeeze is when, for one reason or another, a large number of short sellers decide to close out their position en masse, adding to buying pressure on the market.
This can happen for normal risk management purposes. As you pointed out, when you have a problem short selling, your problem gets bigger and bigger. That’s the opposite of long investing where your problems get smaller and smaller. So normal risk management can have you out there buying stock.
It can also be related to issues related to the borrow. So as you said, you have to borrow the stock that you’re short and you have to borrow it for the entire duration that you are short a stock. Sometimes for a variety of reasons the price of borrowing stock skyrockets really quickly.
Other times stock becomes completely unavailable and so you have to step out in the market and buy stock and cover your short position in a very short period of time. That is the essence of what a short squeeze is. A whole bunch of short sellers out there closing out their positions and adding buying pressure to a stock and they can absolutely skyrocket, which brings us to GameStop.
So GameStop is an entirely unexciting video game seller whose physical store model is being threatened as more and more of the gaming industry moves online. Six months ago, the stock was languishing at $5. One side were short sellers saying the stock was worth zero. The other, a few deep value investors thinking they could wring $8 or $10 from the business. No one else really cared.
At the end of 2020, a couple of positive things had happened at GameStop and the stock was trading at $19. A little strange, but not outside normal experience. The short sellers were licking some wounds, but they must’ve been salivating at what now looked like easy money. Surely the stock was overvalued at that price on any conventional measure.
This is where short selling and short squeezes can become really interesting. They can become their own financial phenomena, completely untethered from any economic reality of the business. That’s when WallStreetBets entered, this is a posting board on Reddit. A bunch of day traders decided to engineer a collectivist short squeeze, and they picked GameStop as their target.
Now let’s not get into the legalities of what they’ve done. That’s going to be sorted out in the courts at some point. But in short, an army of day traders decided to enter the stock at once and buy it and force the stock higher. At that point some of the short sellers would have got out for risk management reasons, the borrower costs explode higher, others are adding to the fuel to the fire.
Then we find out that Melvin Capital, which is a big hedge fund, had a huge short position that exploded higher and they lost more than half their capital in a couple of days trading. You get brokers involved doing margin calls, you have bigger swinging investors and hedge funds coming in, smelling blood in the water, just piling on the buy side, some more short covering and the whole thing just snowballs upwards. It’s a classic, although potentially unprecedented short squeeze here.
So the stock has gone from $5 mid last year and as at Wednesday, it was trading at $347 per share. So it’s up 60 fold in 6 months. Now this isn’t just a short selling story. There’s one of options positions as well, which is both a beneficiary and a cause of what’s going on here. But Nicole gets angry when I make these videos too long.
So let’s just understand that that’s a parallel side story that somehow involved. But to recap, GameStop’s entire market capitalization mid last year was about $350 million. Now I reckon over the last couple of days, short sellers have lost something like $20 billion in positions on this stock and they’ve lost even more options trades.
That mostly went up in smoke in the last couple of days, it’s astounding. Chloe, what are the conditions that make a stock right for a short squeeze?
The chief variable is the percentage of the equity base that is short sold. There are many factors at play, including liquidity and free flow, but a stock starts becoming vulnerable when about 10% of its capitalization is sold short.
In this squeeze GameStop shares were more than 100% shorted, which sounds impossible, but take my word it’s not.
It’s ridiculous isn’t it? It takes getting your head around that there’s 69 million shares in GameStop, but at one stage there was more than 70 million shares sold short.
So how did we become part of this story? I’m not going to say that we caught the magnitude of this particular short squeeze, but a few weeks back, we saw the potential for something very interesting and large to happen. Now we’re too experienced to be smart enough to pile into GameStop and make our money that way but it seemed fairly apparent that something could happen and the direct players like Melvin Capital might have to abruptly de-gross, by which I mean buyback all their short positions, sell all their long positions and close out most of their book in a really short period of time.
That might have knock on effects for other funds or other investments. So how did we get involved?
Well, it just so happened that one of the stocks highest on our to-do list was also one of the market’s most shorted stocks with more than 60% of the outstanding shares sold short, the company is Bed Bath & Beyond.
It’s a homewares, baby and wellness retailer that was operating 1,500 stores in the US and Canada this time last year. The short thesis is easy to sell. The company is a traditional bricks and mortar retailer that had an extremely highly paid management team and they were massively behind the curve in terms of e-commerce. On top of that, Bed Bath & Beyond has historically had limited owned brand products.
So they largely sold items that consumers could purchase from somewhere else. Add the expected cash burn from COVID impacted sales and many bears expected the company to go bankrupt.
That sounds like a terrible investment. So can you tell us why we got involved?
I thought the same thing at first glance, but almost two years ago a group of activist investors showed up and pushed for change within the company.
Since then we’ve had a complete board and management team overhaul and many of the new hires have had experience with business transformation and operating omni-channel businesses. We’ve seen huge improvements in the online offering plus sales of real estate and monetization of non-core businesses. In the most recent quarter, 31% of the company sales were online and it should be even higher than that in the next quarter.
So a huge part of that bear thesis, the risk that they can’t manage the transition to online, it’s falling by the day. With the worst of COVID behind them, a net cash balance sheet and limited near term debt maturities, Bed Bath & Beyond has the flexibility to invest in the business and return capital to shareholders and the company has released detailed plans to do so.
With these changes, our base case valuation showed almost 100% upside. So we thought the business looked very attractive based on fundamental analysis.
Okay, so analysis was showing 100% upside longer-term, we were firming that up. The short term story meant that we had to work really quickly. There was massive short interests in a market where everyone was suddenly taking notice of that. You could just see straight up that Bed Bath & Beyond was 60% shorted.
Further investigation, Melvin Capital’s one of the big short position holders here. We know that they’re probably going to have to de-gross because of what’s happening on their GameStop position. So we need to hurry up cause they might need to close out their position in a hurry, which means they have to buy stock, stock skyrockets, we miss our opportunity. What’s next?
So as you mentioned, once the short squeeze started, we had to accelerate our work as we didn’t want to miss the opportunity.
It pushed us to get in earlier, but it’s not the main reason we own the stock. We bought a position about 10 days ago because we thought everything looked poised to the upside.
The stock has doubled. So it’s hit our base case estimate in 10 days. So this was a fairly risky position to begin with and that risk has risen with the share price we’ve been selling down in response.
Wow. Great trade Chloe. Look, thanks for the run through there. That’s worked out really well for us. It’s really hard to grumble about doubling your money in a couple of days but part of me wants to. This is a strange market, we feel more comfortable when an investment thesis takes a year or two to play out when there’s ups and downs in the meantime and this is a very unusual market and it probably won’t last particularly long.
A lot of the stocks that we’ve bought recently have worked out blisteringly quickly, others that we’ve been looking at and hoping to buy, have skyrocketed before we’ve had the chance to buy them.
There are still attractive investments out there. We’re finding them regularly, but the landmines between those good investments are getting bigger and they’re getting more numerous. But a win’s a win and we should celebrate.
Thanks for tuning in everybody. If you haven’t had a chance to read our December quarterly report yet you can find a copy on our website. Thanks for joining.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.