Speculating versus investing
There have been some fascinating news headlines in the last couple of weeks reminding me how investment markets work and of one of my all-time favourite movies. In the short term they get driven by supply and demand which in turn is largely driven by sentiment and summed up by being ‘bullish’ if you think prices will rise in the future, or ‘bearish’ if you think prices will fall in the future. For those of you, like the Baxters who always watch Trading Places at Christmas (every Christmas!), some of this language and update will be familiar!
Sentiment can shift quickly and sometimes for no apparent reason, or in some cases for reasons completely unanticipated, think 9/11, or Covid, which are known as Black Swan events. We call these up and down sentiment driven swings volatility, and when you look at a chart they can often look like a random walk, very hard to predict where they will go next.
Longer term the prices of most investment assets and particularly the ones we buy are driven by what we call fundamentals, a bit of maths that helps us feel what the valuation should be, for example with properties, or bond securities a multiple of the rental income generated or the bond interest payments.
When investments lose sight of the fundamentals underpinning their value, prices are driven entirely by supply and demand turning a purchase of such an investment into pure speculation. Put simply it becomes a bet. Examples would be Bitcoin, Gold and in the last few weeks the shares in the now infamous Gamestop Inc. It’s a great story.
There are a few players; Gamestop Inc. a little known gaming merchandising retailer based in Texas, Reddit an online forum (one of the founders I am reliably informed by the more worldly Mrs Baxter is married to Serena Williams the tennis star), some very weird contributors on Reddit (some with unrepeatable names and even less repeatable comments) under a ‘thread’ called ‘WallStreetBets’ (the clue is in the title), a couple of hedge funds one being Melvin Capital, Robin Hood a US share trading platform for retail investors (think AJ Bell, but no doubt much bigger) and of course, and no early 21st Century financial story will be complete without the involvement of Elon Musk, now officially the richest man on the planet with 42million twitter followers.
Until January this year Gamestop shares had been trading at a company valuation of around $850million and it was not forecast to make a profit until 2023. There had been some hiccups along the way, and most investors were bearish about its future. So much so that it had become one of the most heavily ‘shorted’ stocks on Wall Street and by Melvin Capital in particular. Shorting involves selling shares you don’t already own with the hope of buying the shares later at a lower price to make a profit. The process involves ‘borrowing’ the shares in the first instance and as you do this you need margin collateral, money with the broker who is placing the short bet for you in case the bet goes wrong.
A post on WallStreetBets, by someone who appears to be significantly above average intelligence for its participants, worked out that if enough retail punters (I use the phrase knowingly) bought the shares in this small company they could put a short squeeze on those shorting the shares. Think of the penultimate scenes in Trading Places, on the trading floor but with the protagonists switched around. The ‘heroes’, the retail investors in this story are going to go ‘long’ when in Trading Places our heroes start the session by going short. If you are already starting to get confused, don’t worry I have had to explain it every year for the last 20 years, to the same four people!
As the retail investors pile in, spurred on by the spreading social media comments, the price of Gamestop shares go up. Nothing has happened to the company’s fortunes, it is just supply and demand. The hedgies begin to sweat! They have done their maths (no doubt some of them were history graduates who should not be let near a calculator when it comes to statistics, no offence meant to history graduates!) but they did not see this coming, they weren’t on Reddit, it is their ‘Black Swan’ day. Then Elon alerts his Twitter base a fraction (of a very large number) of whom pile in and the rest is history!
The hedge funds lost billions and were forced to close, think Duke and Duke, selling their properties and seat on the exchange to meet their margin call at the end of the session. They were forced to buy shares at $300 which they had already sold for $20 and swallow the loss. It was several billion dollars.
Some of our ‘heroes’ made a lot of money selling stock they bought at $20 for $300 or more, a good few day’s work!
The random walk of the last few days has given hope to the hapless investors who were the last of Elon’s and WallStreetBets disciples to buy, however the pathway down to the fundamental valuation is emerging. Someone bought a slice of this company on the 28th of January on the basis it was worth $28bn. Less than a fortnight earlier and without any significant news on the business it had been valued at less than a $1bn. They have lost 83% of their investment in 8 days and will doubtless lose more if they don’t cut their losses.
So, what if anything did we learn? “Not that much”, was the conclusion of the Tideway Investment Committee that sat last week. Martin Shenfield of TS Lombard made a few comments, notably:
We did not feel there was a great risk of contagion given the amounts involved and market movements appear to be agreeing. It reminds us why fundamental analysis is important to avoid big irrecoverable losses, but also not to underestimate supply and demand. Something at the forefront of our minds as we invest against a backdrop of zero interest rates.
To finish the Trading Places analogy, you will be pleased to know that unlike ‘the couple of bookies’ commodities traders Duke and Duke, who were indifferent to whether commodities prices went up or down, our interests are aligned to yours and we make more money and are always delighted when portfolios go up.
We did not spend long on Gamestop in an otherwise very productive investment committee meeting, more of which in our next updates.
Have a good weekend,
The Tideway Team
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