There’s No Need to Catch the GameStop Falling Knife

There’s a lot of noise around GameStop (NYSE:GME) stock at the moment. In fact, there might be more noise around GME than any other single stock in recent memory.

A Gamestop video game store in the Herald Square shopping district in New York
Source: rblfmr / Shutterstock.com

The GameStop “short squeeze” literally became a national story. The narrative of a plucky band of individual investors taking on – and taking down – hedge funds captured the public’s attention.

Now, the story isn’t quite that simple. Yes, at least one hedge fund took a huge hit from its GameStop short and had to raise $2.75 billion in new capital as a result. But it is almost certain that a so-called “gamma squeeze” also was a major factor in the stunning rise in GME stock.

Regardless, for investors, it’s the fundamentals that need to underpin a long-term bull case. And after one of the biggest roller-coaster rides in the history of the stock market, the fundamentals for GME stock still aren’t quite strong enough.

What the Heck Happened?

Give credit where credit is due. The r/WallStreetBets crowd on Reddit made an impressive trade.

For all of 2020, at least 80% of GameStop’s shares outstanding were sold short. The figure on occasion cleared 100%. (As an aside, the 100%-plus figure does not mean that illegal naked short selling was taking place. So-called “synthetic long positions” skew the figure.)

The second half of last year wasn’t kind to shorts: GME rose 342%. But what the Redditors figured out was that coordinated buying could pressure shorts into covering – the essence of a short squeeze.

That’s not all that happened, however. GameStop bulls bought call options, and that created a gamma squeeze. Market makers who sold those call options (which represent the right to buy the underlying stock at a predetermined price before a predetermined expiration date) were in essence short GME stock.

To hedge those positions, they had to buy shares of the stock. And as GME kept rising, and more traders kept buying calls, they had to buy more and more shares.

It’s impossible to determine how much of the buying activity came from short sellers versus market makers. But both factors were at play in a truly incredible rally. GME entered 2021 just below $19 (and actually declined 8.4% in the first trading session of the year). It peaked intraday on Jan. 28 at $483.

Anchoring

As I write this, GME stock now trades just above $50. It’s declined 89% from that intraday high.

The size of that decline might tempt some investors – or some traders – to see an opportunity. It would seem like such a steep plunge would mean that GME stock has fallen far enough, or even too far.

But, for a couple of reasons, that’s simply not the case. The $483 price had nothing to do with the fundamental value of GameStop as a company. Indeed, at that price, GameStop had a market capitalization topping $30 billion.

More broadly, looking past prices as an indicator of future performance is a common investor mistake known as anchoring bias. Where GME stock traded at on Jan. 28 or on Oct. 15 or at some point in 2015 doesn’t make the stock “cheap” or “expensive” now.

The market is constantly updating prices based on new information. Meanwhile, as we’ve seen, trading mechanics can move a price significantly off fair value. As famous investor Ben Graham put it, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”

The Case Against GME Stock

Over the past few weeks, the voting machine went haywire. But, to stretch the metaphor, GME stock still doesn’t weigh enough.

At $50, GameStop still has a market capitalization of more than $3 billion. This is a company that does have some digital assets, but remains significantly reliant on its brick-and-mortar store base for sales.

Those stores are under threat. Game developers and console makers are moving to a digital download model. That not only hurts GameStop’s new game sales, but it’s undercut the company’s hugely profitable used game business.

Obviously, the novel coronavirus pandemic hasn’t helped. But GameStop was struggling long before the pandemic arrived. Adjusted operating income declined more than 80% year-over-year in the fiscal year ending Feb. 1, 2020.

Bulls will retort that the company took a hit from the console cycle, as buyers waited for newer models.  That’s probably true. But that’s far from the only point of pressure.

Bear in mind that in five years, GameStop’s adjusted earnings per share went from $3.90 in fiscal 2015 to 22 cents last year.

Can GameStop turn it around? Possibly. Cash flow should bounce back to at least some degree as normalcy returns. The bulls who dove into GME stock last year made a solid case, even before the 2021 squeezes played out.

But investors who think GME stock is cheap because it’s down 89% should remember another fact. The stock still has rallied 167% so far this year, and the news isn’t any different than it was six weeks ago. For all the hype about GameStop stock, it’s the GameStop business that matters. And that business remains headed in the wrong direction.

On the date of publication, neither Matt McCall nor the InvestorPlace Research Staff member primarily responsible for this article held (either directly or indirectly) any positions in the securities mentioned in the article.

Matthew McCall left Wall Street to actually help investors – by getting them into the world’s biggest, most revolutionary trends BEFORE anyone else. Click here to see what Matt has up his sleeve now.


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