The risk of the “meme” stocks

THE RISK OF THE “MEME” STOCKS

In our opinion not since the Dot-Com bubble of the late 1990’s have we seen so many instances in the stock market where the share price of the listed company bears little or no relationship to the underlying earnings of the company. This type of environment creates many possible pitfalls for the reckless investor but the risks are easy to spot, and easily avoided by the rationale investor. In this month’s Financial View, we look at the risk of these “Meme” stocks and give our views on a new type of investor that has entered into the market.

What is a “Meme”

When you hear the phrase “something has gone viral” it refers to the spread of content across social media platforms where the pace has accelerated through the compounding effect of people continually forwarding these items on. The most common of these items shared are called “Memes” which are often pictures with humorous text overlaid. Everyone of us and even the dinosaurs at Magwitch have encountered “Memes” before, whether on our phones or on our computers. It is a concept firmly routed in the age of social media where the spread of information is instant.

We had remarked in a previous newsletter that investors have never had it so good, especially with the access to information. But is there a risk that this is actually a bad thing? It turns out for many it probably is……

The Meme Stock

Like the funny pictures a meme stock is a share that has gone viral online, drawing the attention of retail investors. The share price of the company sees an increase in volume not because of the company’s performance, but rather because of hype on social media and online forums like Reddit. For this reason, these stocks often become overvalued, seeing drastic price increases in just a short amount of time.

The best-known example of a meme stock is GameStop. GameStop is a US retailer selling video games from physical stores across the globe. The problem with their business model is that many video games developers now distribute direct to the customer online and with the ability to download these products – nobody goes to the shops to buy video games anymore. In reality, GameStop is a company that has a declining revenue base and has lost relevance based on enhancements to distribution in their industry (the closest South African equivalent is Musica and they are no more).

In GameStop’s last financial year, they generated net revenue of $5bn which seems a big number, this is however significantly lower than the $9.5bn that they generated a decade ago. This huge decline in revenue means that GameStop makes a loss each year. Certainly, a company that the rationale investor would be avoiding – shrinking sales in an industry that has changed, compounded by the fact that more people are shopping online so shopping mall locations themselves are under pressure.

Yet the GameStop share price has never been so high. In fact, the current share price is 14X higher than what it was fifteen years ago. 

 In the above chart of the GameStop share price relative to its level fifteen years ago one can see that it peaked in 2007 and again in 2013, followed by a long decline for the next six years. This reduction in the share price intuitively makes sense as the business model became more and more outdated.

This outdated business model meant that GameStop became one of the most shorted companies in the world. It was a “no brainer” that the share price would fall so many hedge funds were taking out short sale derivative positions on GameStop with the expectation that the share price was going to continue to decline.

With the share price rapidly spiking they obviously got that call wrong, yet these hedge funds were themselves involved in the price spike.

A short is a term for a derivative contract where you will make money if the price declines. The stock is borrowed from a market participant and sold at the current price. You then plan to buy the stock at a lower price and return it to the market participant. The profit on the short sale is the difference between the price that you first sell the share at now (that you never owned, and only borrowed) and the price that you buy the share at a later date (to return to the person who lent you the stock originally).

Shorts are derivative contracts that theoretically have unlimited downside risk – you can lose more than your initial invested capital. To protect the market and themselves hedge funds put in mechanisms to close positions rather than losing more than their initial investment. To close a short sale you need to buy the stock and return it back to the original lender of the stock.

Users on the sub-Reddit group WallStreetBets hosts a discussion board where they discuss which shares to invest in (the name of the group may give it away that investing is not the main purpose of the exercise) and they selected GameStop as one to invest in. All this interest in the market caused the share price to increase which in turn triggered the protection mechanisms that the hedge funds had on their short sales which created even more demand for the share sending the price even higher. This was a “classic bear” squeeze situation and the hedge funds lost a lot of money and the retail investor declared it a victory for the common man over Wall Street.

It would have been fine and well if it ended there but the fact that the GameStop share price was flying caused more investors to flood in as they felt that they were missing out. Everyone wanted a piece of a company that ultimately still has a decaying business model and may still be destined to end up on the scrap heap in time.

The New Retail Investor

During the covid pandemic there has been the entry of a new type of individual investor into the stock market. The hard lockdowns caused the cessation of live sporting events and whilst sport is big money, gambling on sports is even bigger money. All these sports gamblers had idle time on their hands and a large number of them moved into investing in the stock market, utilising the same social media platforms that they had previously used for gambling. We also see more trading platforms that operate in similar ways to other social media platforms.

The problem is the mindset of the gambler is one looking for immediate returns – either the call is right or wrong with the resulting consequence. If you are investing in something that you don’t have any knowledge of yourself you will turn to the person who you believe to be an expert. As a result, the new retail investor listens to the new retail investment expert – who just happens to be someone who has a presence on a social media platform broadcasting opinion on shares, just as they previously broadcast their advice on the outcome of sports events. One can almost see where this is heading – we have the ideal situation for people to make money from ill-informed advice. Buy the share of the unloved company, promote that company and then sell your shares to the very people following your advice.

According to thebalance.com there are very four distinct phases in a meme stock:

• Early Adopter Phase: A handful of investors believe a particular stock is undervalued and begin to buy in large quantities. The stock’s price slowly begins to increase.
• Middle Phase: People who are paying attention begin to notice the increase in volume. More individuals then start buying, and the stock’s price skyrockets.
• Late/FOMO Phase: Word about the stock spreads across social media and online forums. Thus, fear of missing out—commonly referred to as FOMO—takes hold, and more retail investors join in.
• Profit Taking Phase: After a few days, buying peaks and the early adopters begin cashing out. Just like the buying phase, the selling phase becomes a chain reaction as people fear losing money. This is where the price goes down.

Because of this cycle, it’s the early adopters who really profit from these trending stocks. Once the meme stock cycle enters into the FOMO phase, it’s likely too late to make a profit. The people most incentivised to market the share are the early adopters as they are the ones who gain the most.

The GameStop story does come with a South African angle. Shortly after the first spike in January 2021 a local radio station interviewed a bunch of teenagers living in Gqeberha about investing in the stock markets. They were recent investors in GameStop and the one boy said that he was going to hold until the share price hit $350 – a price that it hasn’t yet reached, and very high for a business that once again is still in decline. As mentioned in the introduction we are living in time where the share price of some companies does not bear any relationship to the performance of the company.

Conclusion

When investing in the stock market you are effectively investing in the products, skills and knowledge of the company and their staff. It is very unlikely that a company can double its revenue overnight (excluding through receipt of a government tender) so it is unrealistic to expect a doubling of a share price overnight. Wealth generation in the stock market is about doing the right thing over and over again, for a long period of time. Whenever the share price of a company moves up (or down) very quickly take a step back and consider whether the earnings profile of the company has changed. Don’t be the boy in Gqeberha who has overpaid and because of the hype is waiting for the price to move even higher. Remember that there is no such thing as a money-making machine, if you are making it to easily be careful, and that in the long-term prices tend to track back to their mean and fair value.