Imagine hearing a news story from about 100 years ago involving a business owner who is well-liked in his community, a bit stubborn but a very determined person who comes from a smaller city such as Memphis. We then find out that this well-liked owner ends up traveling to New York City with $10 million that he borrowed to fight big Wall Street financiers who were trying to profit from a decline in his company’s stock. They were trying to take advantage of some recent financial challenges faced by the business. They attempted to short the company’s stock while also spreading rumors about the firm to help speed the decline of the stock price. Sounds like a good old-fashioned story of an underdog taking on a much bigger Goliath in Wall Street.
The story is true and the business owner was Clarence Saunders who owned a retail chain of grocery stores called Piggly Wiggly. These stores were the first self-serve grocery stores in America allowing customers to walk through the store and pick out their own groceries instead of depending on a store clerk.
When Wall Street traders began to short-sell Piggly Wiggly stock in order to drive down the stock price, Saunders fought back using his borrowed $10 million. He started a buying campaign to drive up the price of the shares. For a period of time, Saunders strategy worked and he was able to buy many of the stocks that the short sellers had borrowed. Then Saunders called for the delivery of all of the shares from the borrowers. The short sellers were obligated to return their borrowed stocks – therefore they needed to actually buy shares of the stock at elevated prices. The goal of shorting a stock is to borrow shares from someone who owns them and sell them at a high price. When the stock declines in price, the shorts buy the shares back at a lower price, make a profit, and then return the stock to the person they borrowed it from. Short sellers profit when the stock price falls while they can face unlimited risks if the stock prices rises. The additional purchases of stock shares drove the price even higher putting some of these financiers in a position to lose millions of dollars. Saunders was set to make tens of millions of dollars from his battle against Wall Street.
However, before reaching this point the New York Stock Exchange stepped in and suspended trading on all Piggly Wiggly stock and granted extensions to the time for delivering the borrowed stock. This slowed the rise in price and gave time for the short-sellers to go after every available share of Piggy Wiggly and return it to Saunders. As trading was stopped, this tipped the scales in favor of the short sellers leaving Saunders with shares that were no longer worth as much money – making it difficult to pay back his creditors for the $10 million that he borrowed originally. Eventually this ended with bankruptcy for Saunders and he was finally forced to step out of the Piggly Wiggly Company.
Does any of this sound familiar to the headlines we have been hearing today?
Today’s saga involved stocks from companies such as GameStop (GME) and AMC along with several
hedge funds, brokerage firms such as Robinhood, and individual investors in groups on social media platforms (Reddit).
GameStop (GME) lost $471 million in 2020 and had sales drop by 22% last year. Yet the stock took off from $4/share in August of 2020 to over $20/share by early January of 2021. Then during the last several days of January, the stock price surged to an intraday peak of $483 and performance was quoted as a 2,000% increase in value. The increase in price has resulted in some hedge funds being pounded into oblivion because they shorted these stocks.
Hedge funds are usually perceived negatively (“Goliath”) by many since they tend to be reserved for high net worth investors who have the money to invest into what could be volatile situations (e.g. short selling). Their goal is to reap huge profits for their high net worth investors who can afford to take some of the additional risks involved.
The “David” in this story is a group of many small investors who banded together in online forums (e.g. Reddit) to purchase the stock driving the price up much higher. They targeted GameStop, AMC,…etc. whose shares were shorted by various hedge funds. This “Reddit mob” bought lots of GameStop’s shares resulting in the rise in stock price which put a massive “squeeze” on hedge funds – it sounds more like this came out of gangster movie. Some like Melvin Capital were caught off guard. While hedge funds routinely short stocks to eventually profit on the stock’s decline, this scenario involved an almost opposite situation with the stock price soaring in value.
The individuals who owned GameStop stock quickly made a lot of money – which was the money that the hedge funds lost.
However, in the end, a group of large investing firms (brokerages, hedge funds…etc.) stepped in to limit the purchase of additional shares of GME stocks. This was perceived by investors as Wall Street having another “too big to fail” scenario where the big guy gets bailed out while the small investor who usually doesn’t get rescued is left to suffer during their own times of volatility. The news media and politicians began to question this activity and today there are calls for investigations and new regulations.
While determining the legality of these events is beyond the scope of this article, there are several general conclusions that can be made.
The GameStop squeeze may seem crazy but it is normal in the sense that this is a part of the history of the markets e.g. Piggly Wiggly. A more recent example was in 2008 when Porsche bought enough shares in Volkswagen to squeeze short sellers in the stock and briefly made Volkswagen the highest market cap company in the world. What was different this time was the “Reddit mob” stepping in to take advantage of the hedge funds short position. It presents an image of the smaller investor being able to take on Wall Street. The uproar came when trading was halted by the brokerage firms (e.g. Robinhood) to help minimize the losses to these affected hedge funds. This added to the negative perception of Wall Street compared to the likability of the small investor. No, it doesn’t appear that the markets were rigged but it did allow these Hedge funds to live to fight another day. More importantly, it puts the markets on notice of a new arrow in the quiver of smaller investors.
And while politicians and regulators will try to make their claim to solving any potential problems from these events, for investors, this really confirms a principle that has been stated on this blog previously – “very few people built their wealth on stock speculation or trading. Building true wealth is a process that occurs through adherence to proven investment principles and practices, patience and discipline.” If you want excitement in your life, go to an amusement park. Don’t blur the differences between speculation and investing and expect to make a consistent path to success. To have confidence in your retirement plan, there really is no room for speculation.