To tell this story properly, we need to go back to May 2019. Forget about GameStop’s unprecedented short squeeze driven rally in 2021. What was GameStop? A forgotten, supposedly dying company that was poised to be the next Blockbuster, with a stock that had lost more than 80% of its value in the last five years. With it trading around $8 per share, I started buying. Over the next three months it fell further, and I bought more, eventually acquiring a meaningful amount of shares at an average cost of $7.38 each.
Why on earth would anyone buy this dying company? At the time that question was tough to answer. They had cut their dividend, were taking massive non-cash write offs, and were going through the first of several major leadership transitions. However, I saw value. Despite its declining sales, the company had a fantastic cash position and minimal debt, meaning there was almost no chance of the imminent bankruptcy that so many shorts were betting on. The company still had very strong cash flow from its stores. The absurdly high short interest (over 65% of the shares outstanding and rising) meant there was widespread, perhaps irrational, pessimism and the possibility of a short squeeze. The company’s recent year looked far worse than it was thanks to the non-cash acquisition write-offs. Its eCommerce sales were growing fast. And, very importantly, the company was actively and aggressively buying back its own shares. After looking at all these factors* and running some quick valuation numbers, I determined that the company was massively undervalued, meaning it was the perfect time to buy.
Of course, the story wasn’t immediately good. For over a year the stock languished, losing half its value quickly and getting as low as $2.57 per share when the pandemic began. For over a year, I had a massive unrealized loss in my portfolio from this dying company, and I’ll admit I questioned my position many times. Every time that I did, I just remembered the reasons I had bought, told myself the market could stay irrational for a very long time, and held on through the pain.
Suddenly the situation started to change. There had been brief signs of life previously, like when Michael Burry (who since has called the current rally “insane”) announced an investment in the company, but the stock didn’t really start taking off until September 2020. The reason? An investment from Chewy founder Ryan Cohen. Ryan saw the opportunity to turn GameStop into a specialty eCommerce store, became an activist investor and eventually got three board seats. Meanwhile, my biggest stock market loser had suddenly turned into a winner, going over $10 per share, then approaching $20.
I started selling in January with the stock around $18, ironically only a few days before the short squeeze mania began. As it started to explode, I eventually sold out at an average of $24.09, for an incredible return of 226%. My reason for selling was simple: I no longer saw the company as severely undervalued. It’s most recent quarter was also disappointing, showing negative sales growth despite the expected lift from a new gaming console cycle. They also announced a plan to issue more shares — the opposite of what they were doing when I first bought. While this might be a sign that they are investing in the Cohen eCommerce plan, it also likely means that they think the stock is at least fairly priced, or even overvalued.
As I sold off, the situation started to get crazy. Promoted by Reddit users looking for a quick buck, the stock has exploded into a short squeeze frenzy. I had long hoped something like this would happen as it was an ideal candidate for it, but I never expected the kind of ridiculous speculative wave that has happened in the last couple weeks. It’s far beyond a short squeeze, and it has actually become toxic. The stock as of this writing has been as high as $380 per share and shows no sign of slowing down. On the one hand, I should be really disappointed. I missed an incredible rally and profit opportunity by only a few days after holding a losing investment for over a year. I don’t want to give exact numbers, but if I had sold my shares at the peak, I would have made a seven figure profit. And there is certainly the chance it could go even higher with the current mania around the stock.
However, I know that I absolutely made the right decision to sell. Irrationality goes both ways. Sellers were irrational in how far they had pushed down the stock, and I took advantage of the situation to buy a discounted asset. Now, buyers are being irrational and pushing a stock far away from any semblance of fundamental value in the hopes of making a quick buck. Here is my favorite quote from a recent Wall Street Journal article on the situation (published when the stock was around $90 per share):
If that isn’t a sign of irrational speculation, I don’t know what is.
So what are the lessons here? For one thing, you make your money when you buy, not when you sell. This is one of the most classic pieces of investing wisdom, and this story couldn’t prove it more clearly. I may have missed out on a potential seven figure payday, but I still made an absurd 226% return. My profit may not have been seven figures, but it was six. This was only possible because I recognized an undervalued asset and bought it when pessimism was widespread about the company. Speaking of which, the other huge lesson here is to remember Warren Buffet’s key line: “Be fearful when others are greedy and greedy when others are fearful.” There is no question that others were fearful of GameStop in 2019, and that they are being greedy right now. If you want to beat the stock market and get a higher than normal return, it’s best to spend your time looking for undervalued companies, not riding speculative waves, no matter how tempting they might be.
* I’m including my original unedited write up of why I invested in this company. I wrote this shortly after completing my purchases in September 2019, and the stock was then near its low point. I think it’s interesting as a case study in logically thinking through buying a stock and holding it when it is down:
I researched this one pretty extensively before I bought it in May of 2019. To date it has performed terribly, but I’m very optimistic about a turnaround. Soon after I bought it the company announced they were eliminating their dividend in favor of investing in themselves. Their share price halved as a result. They did a Dutch Auction for a sizable amount of shares (I believe roughly 10% of all outstanding shares) and I also bought more during this time.
I originally bought the stock for the following reasons:
- It has been absolutely battered by a combination of bad press and short sellers. Even when I first started buying it had fallen almost 50% in the past year and over 80% in the last few. Currently 65% of shares are sold short. In other words, this was a contrarian bet with my reasoning based primarily on the other below factors of its fundamentals.
- Cash: The company had/has a very strong balance sheet with very minimal debt and high amounts of cash. In fact, when I first bought I calculated it had somewhere around $7 in share of net cash after paying off all debts. GAAP changes made an impact on this in the most recent quarter with how leases are counted as assets/liabilities on balance sheets, however, they still have a solid net cash position.
- Cash Flow: The company had very strong operating cash flow in all the years that I looked at. In fact, its share price was/is trading at a very low multiple of this cash flow.
- Prior Year Loss due to Goodwill: In 2018, GameStop had a very significant loss due to writing down their goodwill account to adjust for acquisitions that haven’t panned out. This made their fiscal year look absolutely terrible. However, if you take out this goodwill write off, which I don’t view as a true expense, they still had a very strong year with positive earnings and cash flow. I think it’s possible that this enormous write off led to some of the fear and negative views around this company that resulted in its share price collapsing so much. With the goodwill account now almost entirely written down, this issue will not repeat itself.
- Share buybacks: The company had authorization to buy back $300 million of its own stock. It did about 1/6th of this in its dutch auction. Considering its current market cap of $375 million, they could buy back almost all of their shares (which would also cause a massive short squeeze given how many shares are short).
- Other assets (ecommerce business ThinkGeek, Game Informer magazine): The company has several businesses besides its physical retail stores that have a value. The biggest ones are ThinkGeek, a solid collectibles ecommerce business that is growing, and the GameInformer magazine, which is one of the most widely circulated physical magazines left.
With all of that said, there are aspects to this stock that make me extremely nervous. They are:
- Decline of physical game sales. There is no denying that most people are downloading video games instead of buying the discs, and that trend may not every stop until physical games are eliminated entirely (see below).
- Decline of physical retail in general. I know a thing or two about this given my own ecommerce businesses, which is why it’s a bit odd I was excited to invest in a physical retailer.
- Gamble on next generation consoles. If the next generation XBox and Playstation don’t have physical disc drives, it’s pretty much gameover for this company. However, if they do have those drives, their release will spark a cyclical uptrend for the whole video game industry that GameStop will no doubt capitalize on.
- Management turnover: A brand new CEO was in place when I bought the stock, and there have been several recent changes in both CEO and other top management positions. This is never encouraging to me.
In short, I would say that this company did not have the exceptional fundamental underlying economics that I would like to see in any company I invest in. I was definitely attracted to it because of the price. This is by far the most contrarian bet I’ve ever made, and I hope that within a year or two it will prove whether either my analysis of the fundamentals were correct, or that I fell into a value trap.