By now you probably have heard about what has been happening with the trading in GameStop and other highly shorted companies.

I missed it, what happened? 

Several “professional investors” believed GameStop was a bad investment. As such, they felt the price of its stock would fall as other investors realized it was a bad investment and sold their shares. To make money on this situation they placed large bets on GameStop stock to decline by shorting the stock. At one point, close to 1.2 times the outstanding shares of the company had been sold short.

Explain short selling 

To short a stock, an investor must borrow the stock from someone who owns it (more on that in a minute). They then sell the stock with the goal to buy it back at a lower price, booking a gain and returning the borrowed shares to the owner. The problem with shorting a stock is that it leaves the short investor open to unlimited losses and capital gains since the stock has already been sold. Usually, short sellers place stop-loss orders above the short price to limit their losses in case the stock moves against them.

That seems reasonable. What went wrong? 

Some “retail investors” realized that the combination of a highly shorted stock and the mechanics of short selling could be taken advantage of under certain conditions. They banded together on a Reddit community called r/WallStreetBets to exploit this market inefficiency. Effectively, they started buying large amounts of GameStop shares through various trading platforms, with the stipulation that their shares could not be lent to short sellers.

The buying activity pushed the price of the stock up. That, combined with less shares available to borrow to short, forced some short sellers to cover their positions by buying shares. This buying activity pushed the price of GameStop up, which forced other short sellers to cover their short positions which pushed the price of GameStop stock up even further.

For the short sellers, this became a vicious circle and for the “retail investors” it became a virtuous circle. Since mid-January the short interest has decreased from 120% to 39% and the stock price has risen from a low of around $20 to a high of $483 as of February 1, 2021.

Wow, that has to be illegal. Is it?

There’s been a lot of hand wringing in the media that there was some sort of illegal collusion going on. However, what happened was perfectly legal regardless of whether it was professional or retail investors inflicting the pain. More than anything, we think the “professional investors” were mad that they were beat so badly at their own game.

For example, an analyst from Citron Capital, which was one of the biggest losers in this situation, routinely posts videos on YouTube providing the rationale for why they think a company is a bad investment. Why? They’re trying to convince investors to sell their shares of a company so it benefits the hedge fund. It’s also why you’ll see “professional investors” going on CNBC and the like either touting companies in which they have large long positions or slamming companies in which they have large short positions. It’s all very self-serving and legal.

If you want to take it one step further, rich guys have done this type of thing with no repercussions. In 2012, activist investor Bill Ackman took a large short position in Herbalife as he publicly laid out reasons for why he thought the stock was worthless. Carl Icahn, harboring ill will from a legal battle dating back to 2003, amassed a huge position with the sole purpose of screwing over his rival. But, now that a bunch of “unsophisticated” investors did the same thing, everyone’s losing their minds? Spare me the pearl clutching!

This is going to change how people invest. How do you plan to react? 

First, as noted above we view this as an inefficiency in the market that a group of investors were able to capitalize on. Short sellers, through sheer arrogance or ignorance, left themselves open to being outmaneuvered. Someone realized it and profited from it, punishing them in the process. (If the shoe was on the other foot, do you think they would’ve acted differently?)

It was a painful lesson for some of them to learn, but we think short sellers will be more wary of piling into crowded trades in the future. They will also, more than likely, pay attention to what’s being said about their short positions on social media. This will all lead to more efficient markets and therefore arbitrage opportunities like this will be few and far between going forward.

Second, plain and simple, what’s happened with these stocks is not investing, it’s speculation. At RTD, we don’t speculate, we invest for the long term. We’ve been through many events like this where there is a widespread belief that “this time is different”. It rarely is different, especially if you aren’t reacting (or overreacting) to the day-to-day moves in the market in general, and individual stocks in particular.

We don’t suffer from FOMO (fear of missing out) and we won’t be referring to stocks as stonks. We believe that the best way to invest is to hold a diversified portfolio of well-managed companies that create long-term value. Because of that, our investment philosophy and process will never trend on social media, and we’re OK with that. We’ll happily stick to what we do best and leave the speculating to others.