In U.S. business news, the story of the week is day traders on the Robinhood stock trading app organizing stock trades via Reddit, a social media platform, to buy shares in the public company GameStop, all to make money while taking down Wall Street billionaires and their hedge funds.

The above sentence is probably the longest sentence I’ve ever written in my professional career.

If you can’t follow all the players and the drama, you’re not alone.

In addition, there have been accusations of collusion, federal government investigations launched, even more billionaires getting involved financially, and many getting involved in social media commentary.

The drama, craziness, and speculation have become so rampant that my teenager’s friends are asking for her bank account information in order to have more capital with which to day trade.

I thought I’d offer my perspective from the last 35 years of observing the equity markets, including four stock market crashes.

The whole thing is one hell of a spectacle.

First, let’s start with the basics.

GameStop is a business that sells video games via physical retail stores, typically located in shopping malls in the United States.

Due to COVID-19, very few people currently go to shopping malls, so their sales have gone down significantly.

In addition, similar to how movies are delivered via internet streaming, many video games are bought, sold, and delivered entirely over the internet. The days in which you had to go to a store to buy physical media to play a game are over.

In short, the GameStop business model as it is today is obsolete. (This is similar to how music retail stores selling compact discs (CDs) disappeared in the early 2000s and Blockbuster video rental stores collapsed after internet bandwidth was sufficient to deliver movies via streaming platforms like Netflix.)

From a financial-results standpoint, GameStop sales and earnings have declined dramatically over the years — and especially during the pandemic.

When you invest in a stock, there are two ways you can do so. The traditional way is to buy a share, hold on to the share for some period of time, and then sell it. This is known as “going long” in Wall Street jargon.

Presumably, the phrase came about because this kind of investor thought the stock price would go up, and thus they would hold on to the stock for a “long” period of time in order to reap the rewards associated with this expectation.

(I don’t know if this is the true origin of the phrase, but I use this analogy as a way to remember the definition.)

The key sequence with going long is that you buy the stock first… then sell it… in that order.

More sophisticated investors can engage in something called “buying short.” As you might imagine, buying short or “shorting” stock is the exact opposite of going long on a stock.

A long investor believes the stock price will go up. They buy the stock, hold it, then sell it… in that order. The idea is to “buy low” and “sell high.”

An investor who is shorting a stock does the exact opposite. They believe the stock price will go down. So, they execute a trade in the exact opposite order from a long investor. They sell the stock first, hold on to that position, then buy the stock later. The idea is to sell high first, wait until the stock price drops, and then buy low.

You might wonder, “How can you sell a share of a stock that you don’t own?”

The answer is by using “credit” or a loan.

When a Wall Street hedge fund shorts a stock, they’re allowed to do so because they have credit. They either have a large credit line with the brokerage executing their trade or perhaps have other assets with the brokerage that can be pledged as collateral.

In a normal loan, you borrow money to buy an object. For example, you take out a loan to buy a car or a house. You’re obligated to pay the lender back the money you borrowed.

Short sellers don’t borrow the money… they borrow the object. In this case, they “borrow” a share of stock, they sell the stock first, and to pay back the loan, they return the share (that they recently bought — ideally, at a lower price than they sold it).

To get this kind of loan or line of credit, you need a credit line or sufficient collateral. As a result, short sellers typically are more sophisticated individual investors or institutional investors like hedge funds.

What the Wall Street analysts noticed was that GameStop’s business model is obsolete. Their reasoning was that nobody buys games in stores anymore (just like nobody buys music on CDs in retail stores or buys movies on Blu-ray Discs from retail stores). I agree with this assessment.

Further, their rationale was that since earnings will inevitably decline, so will the stock price.

This is under the theory that stock prices are supposed to reflect earnings. While this is typically true in the long-run, in the short-run, there can be a lot of volatility and deviation from the long-term relationship between earnings and stock prices.

These Wall Street professionals decided to short the stock. In fact, a lot of hedge funds shorted the stock. At one point, more shares of GameStop had been sold short than exist in the public stock market.

Wait, how can this be possible?

It is allowed and legal.

How is this sustainable?

Well… in this case, it was not.

What a few million individual investors did was they got together on Reddit to execute something called a “short squeeze.”

Basically, the idea is to take the short sellers and squeeze them for all the money they have.

They noticed that Wall Street hedge funds had shorted more shares of the GameStop stock than exist. If for some reason, the stock price was to skyrocket suddenly, all of the lenders to these short sellers would get nervous and demand more collateral to protect their loan.

If the stock price kept going higher, the hedge funds would eventually not have enough collateral to maintain the loan, and they would be forced to pay back their loan by returning the borrowed shares they’ve already sold.

The problem with paying back a loan of borrowed shares is that the short sellers don’t actually own the shares. They have to buy the shares on the open market.

What happens when a lot of people are forced to buy a stock and very few people are selling it? The price goes up and, in some cases, skyrockets.

This is what happened with GameStop.

Millions of individual investors decided to coordinate their purchasing efforts to buy many shares of GameStop — enough to force the short sellers to pay back their borrowed shares by themselves, buying shares on the open market, and driving the stock price even higher. As the stock price went higher, other short sellers would be at risk of defaulting on their loans, and they themselves would be forced to repay their loan of borrowed shares by buying shares.

In a span of fewer than two weeks, the shares of GameStop skyrocketed 1,600% due to this “short squeeze.”

Billionaire hedge funds were at risk of complete collapse because of the shares they borrowed to “short” GameStop. They had to raise emergency capital into the billions in order to have enough collateral to not have their entire funds collapse.

Now we enter Act II of the saga.

Most of these trades from individual investors on Reddit were executed on the stock market brokerage app Robinhood. Robinhood allows one to buy and sell stock shares on the U.S. market without transaction fees.

While stock market trades are executed in seconds, it takes a few days for trades to “settle.” The settlement process involves changing the ownership records of particular shares involved in a transaction. If I sell a share to you, it takes a day or two for the money from the purchase to make it into my bank account. It takes a day or two for the digital paperwork to catch up and the shares to be re-titled in your account.

During this “settlement period,” the stock brokerage firm guarantees the transaction to the other party. If I execute a trade on Robinhood, and if I did so fraudulently, Robinhood would be responsible to the party on the other side of my trade for the fraud.

When the GameStop short squeeze occurred, there was such an incredible amount of trading volume that Robinhood itself ran out of enough cash on hand to guarantee the transactions of its customers (some of whom were executing multiple trades within a single day).

Robinhood subsequently decided to limit the number of GameStop shares that could be bought. The limit used to be an unlimited number of shares and had been reduced to just a handful.

This caused enormous outrage amongst the individual investors on Reddit. A few days earlier, the Robinhood mobile app was the #1 most downloaded app on Google Play and the App Store. Once the trading limits were imposed, over 100,000 one-star reviews were given to the app.

Robinhood itself was at risk for going under, as they no longer had enough cash to guarantee the trades of their customers. Robinhood raised several billion dollars so they themselves would not collapse.

This was perceived by many as financial institutions conspiring to screw over individual investors.

They were simply trying to stay in business and operate their business within the limits of the collateral they had on hand to “guarantee” trades during the settlement period.

Holders of GameStop shares say the value of their shares skyrocketed 1,600%. Once many short sellers got “squeezed” out of their short positions and Robinhood imposed a cap on the number of shares that could be traded for GameStop, the stock price for GameStop dropped by 80%.

This entire saga took place over two weeks.

Now the individual investors on Reddit have decided to target the stocks of other companies that have been sold “short” by hedge funds. One of them is AMC — one of the largest owners of movie theaters in the United States.

As you may know, due to the pandemic, going to a movie theater is currently not an option in some parts of the United States. In other parts, seating capacity is limited to 25% to 50% of the number of seats in the theater. Not surprisingly, movie theater revenues are down considerably.

I am curious to watch how all of this plays out in the stock market.

I thought I’d also offer my perspective on this form of “investing.”

There are two ways to invest in stocks.

The first is to view buying shares in a company as a way to become a partial owner of a company. Using this approach, you’d buy the shares because you want to benefit from the profits of the company.

I wish I had bought shares of Amazon, Google, and Apple in the early 2000s when I was spending a lot of money on each as a customer. If I thought the companies would earn more in profits in 2021 than in, say, 2002, I would have bought shares hoping to benefit from the growth in future profits.

Warren Buffett is probably the most classic example of this kind of investment approach. He likes to buy shares of companies or buy entire companies that have good products, happy customers, and high profit margins with solid competitive advantages.

(Disclosure: I am a shareholder of Warren Buffett’s company Berkshire Hathaway.)

He sees buying stock as a way to “buy” the earnings of the company itself.

The other approach is to buy based on the trading momentum and psychology of stock market participants. The entire GameStop/Robinhood/Reddit saga is an extreme example of this kind of profit approach.

Keep in mind that, during the two weeks when the stock price went up close to 1,600% and then fell 80%, the actual earnings of the GameStop business didn’t really change — and certainly did not increase by 1,600% and subsequently fall by 80% in the span of a few days.

I call the Warren Buffett style of profiting from stocks “investing.” I call the latter psychological style of profiting “speculating”… or “gambling.”

The last time I saw this level of speculating in stocks was in 2000 during the “internet bubble.” The speculation was rampant. Companies with no earnings and, in many cases, barely any revenues were “worth” hundreds of millions of dollars.

Companies in manufacturing that renamed their companies to add “.com” after their name saw their stock prices triple overnight — even though the underlying business didn’t change at all.

It was crazy.

In 2002, my alma mater, Stanford University, interviewed me on my thoughts regarding the dot-com era of 1999 and 2000.

Here’s the quote:

“It was a bewildering time,” recalls Victor Cheng. “You had a really strong temptation to do really stupid things because none of the smart things were working.”

Stanford Magazine, April 2002

I see a repeat of this pattern today. I’m seeing “day trader” listed as a profession on resumes and social media profiles. I see stocks and stock picks being discussed in everyday conversations and locations where it wasn’t before.

Back in 2000, NYC taxi drivers were constantly giving me stock-picking advice. (Hint: They wanted me to buy the stocks that they owned, thus driving up the price of the stock for them.)

On the one hand, it’s great to get more people interested in personal finance. I think this part of the trend is a good thing.

However, the way in which people are getting more involved in personal finance is concerning. Rather than learning the “investing” approach to profiting from stocks, I see people being swept up in the momentum of the stock market speculation (a.k.a. gambling).

Personally, I think investing is good, while speculating/gambling has a terrible risk-to-reward ratio. It’s not that you can’t make money speculating (you certainly can, and people do), it’s that the level of risk that’s incurred relative to the return is poor.

This is why I don’t gamble. (The math sucks.)

This is why I’ve invested in my own business and in the businesses of my clients (because through business skills, I can influence the odds and payout of success… and make the math much more attractive).

When it comes to investing, I’m what you might call “old school.” I like a business with good products, really happy customers, and high (well-earned) margins that have competitive advantages. The basics have been true for millennia.

Since currency was invented as a form of trade, it has always been an asset to have good products, happy customers, and to operate profitably.

For all eternity, it will always be an asset to have good products, really happy customers, good margins, and competitive advantages.

The rest is noise.

You can profit from adding value (to customers, to partners) or you can profit from the “noise.” I find the former to have a better risk/return ratio, and I personally sleep better at night too.

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