Article by Ankur Shah, Ashva Capital

Recently two heavily shorted stocks GameStop (NYSE:GME) and AMC Entertainment (NYSE:AMC) have shot up in value again. GameStop is a failing video game chain. It’s failing for multiple reasons but primarily due to an outdated business model. Gamers no longer need to go to a brick-and-mortar store to purchase games. They can simply download them from the comfort of their own home. AMC is a movie theatre chain in the US that is facing significant headwinds from the pandemic and changing consumer trends. Interestingly, both are suffering due to the failure of the mall ecosystem. Both stocks have been involved in epic short squeezes.

What Is a Short Squeeze?

Short selling is essentially placing a bet that the shares of a company will fall in value. To initiate a short sale, an investor must first borrow the shares and then sell them on the open market. The investor borrows the shares from an investor that is “long” or owns the stock. Eventually, the short seller must return the stock to the original owner by buying back the shares. If the short seller buys back the shares for a lower price than they originally sold them for they will make a profit.

Does it sound complicated? I actually think that put options are a much more efficient way to bet on the price of a stock declines. However, I’ll save that discussion for a different article. Generally, the vast majority of short-sellers are institutional investors such as hedge funds. Thus, they’re very concerned about the short-term performance of their positions.

A short squeeze occurs when some catalyst causes the share price of a heavily shorted stock to rise. In the case of both GME and AMC, retail traders living in their Mom’s basement (I’m not kidding), got together on chat forums such as Reddit and collectively decided to push up the share prices of both companies. Once the share price rises, the short sellers must buy back their shares as quickly as possible to stem further losses. The initial buying begets more buying as everyone rushes to close out their short positions by buying back the stock.

I used to work at a long/short hedge fund and there is nothing more painful to an analyst than watching a short position rocket off to the moon. Not only does your bonus get impacted but you look stupid because you were wrong twice. First, you got the short position wrong. Second, you could have been on the other side of the trade and been long. There are no winners in a short squeeze except for the YOLO traders making once-in-a-lifetime money.

What Is a Meme Stock?

A meme (pronounced as ‘meem’) stock is generally considered any stock that rises in value due to being hyped up in social media and online forums rather than its fundamentals. The ultimate goal of meme stock traders is to engineer a short squeeze. GME is the poster child for meme stock investing. In January 2021, GME was trading at roughly $17.25 a level at which it traded for the vast majority of 2020. However, spurred by increasing coverage online in the Reddit forum WallStreetBets the shares increased to $147.98 by January 26, 2021. Eventually “meme lord” Elon Musk got in on the action and tweeted about GME. The shares went on to reach a high of $483 before correcting heavily. The shares made a roundtrip and were trading in the $40 range in February 2021. Subsequently, GME is once again back in the news as the shares recently topped $200. The extreme volatility of meme stocks make them a poor investment choice for long-term investors.

A large number of hedge funds were short the stock and thus had to cover their positions as the shares kept rising. Theoretically, your downside is unlimited as a short seller because there is no limit on how high the share price can go. Thus, an initial wave of buying begets more buying. The only problem is that once the short-sellers have covered their positions, the artificial buying demand dries up and the shares fall again. Anyone who went long the stock must sell before the share price inevitably crashes back to earth.

Why Meme Investing Is not Sustainable

Meme investing isn’t sustainable because eventually, we get reversion to the mean. A stock without any underlying earnings or cash flow will eventually revert back to its fundamentally derived price. As Benjamin Graham so aptly stated, “in the short run, a market is a voting machine but in the long run, it is a weighing machine.” Meme stocks are like lottery tickets. Traders are enamored with the idea of making fast money. Who has the patience to slowly compound their wealth through saving and indexing? Traders want to make a killing on the very next trade.

The problem with meme stocks is that there is no reliable gauge to determine when to exit your position. In fact, unless you’re early and buy during the pumping phase, you’re almost certainly too late to the party. As social media becomes more pervasive, I’m sure we’ll continue to hear about the occasional meme stock that shot to the moon. Or even stocks such as GME that made a roundtrip to the moon. However, for the serious investor meme stocks will never be more than an interesting conversation starter at a cocktail party.

There is no shortcut to riches in investing. As a fundamental investor, there are basically three valid investment strategies. The first is to simply index your money and allow it to compound slowly over time. This is the easiest form of investing to follow as it doesn’t require any research or analysis. The biggest factor in your success will be your ability to handle volatility and to not sell during the infrequent bear markets that will occur on average every five years. The other valid strategy is to conduct a thorough fundamental analysis and attempt to identify high-quality businesses that are trading at reasonable valuations. By following this strategy you have the opportunity to outperform the market over time. However, the opportunity to outperform also increases your likelihood of underperforming in the event your investments don’t pan out. For a small segment of investors analyzing and investing in individual stocks will prove to be materially rewarding.

The other downside is that investing in individual equities is a full-time job. At a minimum, you must analyze quarterly results, earnings calls, and equity research reports at least four times a year. If you then multiply this research by 10-15 positions, it becomes clear that you will not be able to maintain a life outside of your main career and investing if you choose to invest on your own. Fortunately, there is a third option which is to outsource your stock selection to a fund manager. There are clearly downsides to outsourcing but if you can find the right manager, you’ll have the possibility of generating market-beating returns in your portfolio and still have a life outside of investing. The key is to find a manager who follows an investment strategy that makes sense to you and ensure that the manager has a material stake in the fund that he’s managing. You can’t guarantee future returns, but you’ll minimize the chance of investing with the wrong manager.

Meme stocks are nothing but lottery tickets and should be treated accordingly. Only invest what you’re willing to gamble and ultimately lose.