With Meme Stocks, a Fool and His Money are Soon Parted

A year after the highly publicized meme stock craze of 2021 (GameStop, AMC, etc.), I am still asked my thoughts on their pros and cons and whether they deserve a place in a growth stock portfolio. Meme stocks have become such a thing that they are now tracked by an index created by Bloomberg called the meme basket. To give you a clue about my thoughts on meme stocks, the meme basket, comprised of 37 stocks, is off 63% from its 2021 highs.

But there’s more to the discussion than their performance. At one point, GameStop and AMC, two of the meme poster children for 2021, were up 350%, which is astonishing. But when you consider that those gains were driven primarily by the “greater fool theory,” I’m not sure that’s something anyone would brag about.

To Understand Meme Stocks is to Understand the Greater Fool Theory

The greater fool theory goes back a long way. It has been attributed to such infamous events as the financial crisis and housing meltdown in 2008. When you invest according to the greater fool theory, you essentially ignore any of the fundamentals that have to do with the investment, which is foolish. The only reason one would invest in the stock is because they believe there’s an even greater fool out there who will buy it from them.

The only real attraction with a meme stock is it suddenly gains visibility because of a sharp increase in trading volume, which gives it price momentum. That’s what happened last year when an online trading forum on Reddit suddenly latched on to GameStop, a company with poor fundamentals targeted by institutional short sellers. Mostly out of spite for the short sellers, the burgeoning group of amateur traders started buying up the stock, forcing the short-sellers out of their positions, which drove the stock price even higher. The meme was hyped all over social media, attracting more fools to bid up the stock price and bail the initial fools out.

Eventually, the memes run out of steam when the market runs out of fools, the bubble starts to collapse, driving stock valuations back down to earth. So, the question becomes, if you need a fabricated market for a stock to have value, does it actually have any value? If all you are relying on is for another person—a greater fool—to buy it from you to give it any value, it doesn’t have any real value because that person may not show up. Investing as part of the greater fool theory is the purest form of speculation.

Intrinsic Value vs. Speculative Value

Conversely, investments with intrinsic value, such as fundamentally sound stocks and real property, don’t need a market to be of value to the investor. If you own something that has intrinsic value regardless of opinions or sentiment, that’s tradeable, and that you are perfectly happy owning without a market being present, it has value.

Some investments can have elements of both intrinsic value and speculative value. It’s up to investors to do the hard work and come up with a reasonable determination to discern the difference between the intrinsic value of its operation and the price investors are putting on it. If it can be determined that there’s a significant gap between the company’s intrinsic value and its stock market valuation, it may be driven by a chain of fools crossing the line into speculation.

For example, GameStop might actually have an element of both. They own assets, technology, and licenses and have a solid global brand that constitutes some level of intrinsic value. But, just before the speculative run-up in its stock price, its valuation was $380 million. Within a few days, at the height of its stock run-up, its market valuation reached north of $24 billion. After falling back to earth in recent weeks, its market valuation is less than $10 billion but still substantially more than $380 million. So, it’s up to investors to determine how much of that difference is intrinsic value and how much is speculative value. Thoughtful investors would stay away from the stock until its speculative value dries up entirely.

Legendary investor Benjamin Graham once said that “in the short run, the market is a voting machine, but in the long run, it is a weighing machine.” At the heart of his message is that stock market price movement is shaped by popular sentiment in the short run. But core fundamentals, such as a company’s earnings growth, cash flow, return on invested capital, and debt, determine how its stock performs over the long term. While it’s possible to make money with the greater fool theory approach, it’s no way to build true wealth.

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