Merriam-Webster's Definition of Investing:
- 1: to commit (money) in order to earn a financial return
- 2: to make use of for future benefits or advantages
Merriam-Webster's Definition of Speculate:
- to assume a business risk in hope of gain -- especially to make a relatively risky investment in something (such as stocks or real estate) in the hope of making a large short-term profit from market fluctuations
Let's take a look at a business opportunity and see if it would be an attractive investment:
Net Profit: $402M
Net Profit: $304M
Net Profit: $230M
Net Profit: -$795M
Net Profit: -$464M
Net Profit: -$270
If you looked at the company's finances above would you consider this a worthwhile investment? This company's revenues over 5-6 years has declined by almost 50%. At the same time the profits have been steadily decreasing as well. Would you be excited to take your hard earned money and dump it in this company?
What if you were told that the company above was in an industry that is thriving, but the technology this company was built on was stuck in the 90's? Would that excite you?
What if you were told that the industry that they are in has changed their delivery method and this company's delivery method is now almost obsolete? If fact, you need a special tool to access their product but that tool isn't readily available any more unless someone goes out of their way to buy it? The reason this tool isn't readily available any more is because very few people were using it. With technology advancements it's faster and easier to just get the product directly now.
What if I told you that in a post-COVID society (think province-wide and country-wide shutdowns) relies a very large percentage of it's sales on retail stores located in shopping malls? And, the company can't really do anything about it because their business model requires retail locations.
What if I told you that the company is firmly entrenched in the technology sector, but their solution to improving sales is to introduce board games, playing cards and novelty T-shirts into their stores?
Am I selling you on wanting to invest? What? I'm not?
The company that I just explained above is GAMESTOP. With mainstream media covering this story, we seen more clients start inquiring about these so-called Reddit trades. We wanted to mention this because as investment advisors, one of our jobs is to help our clients make wise investment decisions. I'm not sure about you, but reading those financials numbers above and knowing what the company does is not very exciting to me. In fact, I would stay away from it with a 1,000-foot pole! So why is Gamestop going crazy? What is going on? I want in on that action -- or do I?
NOTE: When writing this article Gamestop was still up near its highs. Since then the share price as dropped a tremendous amount. However, we still decided to publish this article because the principles are still valid regardless of the stock.
Merrian-Webster's Definition of Boiler Room:
- a room equipped with telephones used for making high-pressure usually fraudulent sales pitches
In the 1960's to 1980's boiler rooms set up across the U.S. and the main purpose of those boiler rooms was to sell municipal bonds. They installed a bunch of desks, phone lines and hired a slew of salespeople to sell what they were saying was the best investment. This would drive up the activity which started to gather attention from other traders. It wouldn't be long until other "traders" jumped on board driving the price up. After a large run-up in price, the originators of the scam would move to other stocks or financial instruments. There is one thing in common though... The person at the top made their money and they walked away leaving everyone else to get burned.
So what does this have to do with Gamestop? Well, there was a unique opportunity in Gamestop in 2020. The company had been losing money for 5+ years. The big hedge funds saw the financials and the writing on the wall, so they decided to short the stock (along with a lot of other investors).
Short selling is when you borrow stock/shares from someone and then sell them on the open market. The short-seller is obligated to buy those shares back and return them to the owner regardless of what happens with the share price. If the value of the shares go down, then short-seller makes money, if the value of the shares goes up, they lose money.
Now the squeeze...
In 2020, the short sellers represented 138% of the total available shares available to on the market. It might not seem possible, since you have to borrow actual shares to sell them, but they do it through complex financial instruments called derivatives (derivatives go beyond the scope of this article). Needless to say, the amount of shorted shares was extremely high. So, someone got on top of this and started using Reddit as their soap box. They got others to buy more shares of the company. This causes the price to go up and now small investors that are short-selling with a low tolerance for pain sell their shares. This causes the shares to go up more so more small investors cut their losses and buy back their shares causing it to go up more. They aren't using offices with dozens of phones and salespeople, instead they are using social media that doesn't cost them a cent.
Back in the Reddit channel they are talking about how they are making money, they post screenshots (either real or fake) and this convinces more people to get in on the action because they have seen that they can make an easy profit. Fast forward a bit and more and more people pile on. The stock price now reaches a point where the larger players have started to capitulate and the stock starts popping higher and higher and the birth of GME-Mania begins.
These investors have been sold on the fact that they are going to take down the establishment. They've been told that they are large enough to take on Wall Street. They aren't.
History and the lessons it has taught us
If there is one thing we know, greed destroys the markets. When investors no longer invest for fundamental reasons and instead start speculating, it is never pretty! The early adopters move on with their profits, and while the little guys may have made some money, more often than not they get left holding the bag. Similar stories have been happening for centuries (see: Tulip Mania).
No one knows when the craziness will stop, some will make a fortune but most will lose everything (or a very large amount). So the question becomes, are you willing to bet your future on something like this? If so, that's your choice, but don't hide behind the illusion of being a great trader or investor. Call it what it is, gambling!
What should you do?
It was almost a year ago that the craziness of COVID rocked the markets for the first time. It was probably one of the scariest times that investors experienced because of the sheer speed at which the market dropped, and how far. At that time, we connected with our clients and tried to help put them at ease. We communicated when the markets went wild that you should stay the course and keep investing with your goals-oriented long-term plan. So what is different today? Nothing.
Today we have markets at all time highs again (less than 1 year later). We have craziness going on in the market just at the other end of the spectrum. The most reliable thing we can do as investors is look past the short-term, stay focused and continue our long-term plans. In my opinion, greed will only kill your portfolio!