Invest wisely

The main topic of discussion across international financial markets over recent days has undoubtedly been the incredible surge in the share prices of what were until lately companies that had generally fallen out of favour among investors. When deciding on the subject of today’s article, it was therefore inevitable not to mention these extraordinary events unfolding on Wall Street.

The company at the centre of the controversy is GameStop Corporation which is a traditional brick and mortar retailer of video games, game consoles and consumer electronics. The company’s share price surged from USD18.84 on 31 December 2020 reaching above USD480 last Thursday 28 January, representing an increase of over 2,400%. GameStop had touched a low of USD2.57 shortly after the onset of the pandemic in early 2020. The incredible upturn in the share price over recent weeks was mainly brought about by coordinated efforts of retail investors through a social media platform aiming to punish short sellers.

Short selling is a trading strategy generally deployed by hedge funds. It involves borrowing shares from a brokerage house and then selling them in the market with the aim of buying them back later at a lower price (to return them to the original owner) thereby generating a profit. When hedge funds short a company’s shares, it is normally a warning to investors about high valuation multiples of a company or beliefs that a company has a troubled business model. In some cases, it could also unearth suspicious accounting practices such as that of the infamous case last year involving the German payments company Wirecard.

According to data available online, the number of GameStop shares that short sellers had sold was equivalent to 260% of the company’s total number of shares in issue.

In order to appreciate the extreme volatility experienced in the share price of GameStop, it is worth highlighting that last Thursday, it traded between a low of USD120 and a high of USD482. It closed the day down over 40% at USD193.60 before shooting back up 60% in “after-market” trading.

Most commentators attribute this unprecedented upturn in the share price of GameStop to a “short squeeze”. This occurs when a share or any other asset jumps sharply higher, forcing traders who had bet that its price would fall, to buy it in order to limit potentially greater losses in the future. When this happens, hedge funds try to cover their short positions by buying back the shares which adds additional upward pressure to the share price thereby creating a vicious circle for short sellers.

In fact, investment manager Melvin Capital suffered a 53% loss in its entire portfolio in January as a result of the surge in the share price of GameStop and its considerable short position in the company. This led Melvin Capital to close its short position and reposition its portfolio as a result of recent market developments.

This recent trading frenzy mainly by retail investors across heavily shorted stocks was not limited to GameStop but also spilled over to AMC Entertainment Holdings (which is the largest movie theatre chain in the world) as well as other companies such as Blackberry (which today is largely an enterprise software and technology services company), Nokia (a Finnish telecoms, IT and consumer electronics company) and Bed Bath & Beyond (a US chain of domestic merchandise retail stores).

As a result of the incredible developments that took place in recent weeks amid the hysteria triggered by ‘day traders’, I thought it would be opportune to highlight a number of important considerations to explain the rationale for investing across equity markets as well as the difference between investing and speculating.

An investor invests money into a business – either directly through buying shares or indirectly through a fund – on the expectation that the company will use this capital to grow and generate a profit. Annual profits can either be partly distributed back to shareholders as a dividend on a periodic basis or reinvested in the business to fund future growth opportunities.

A traditional investor generally takes a long-term perspective by retaining an investment in a company for a number of years in anticipation of healthy returns generated over time. Since the investment horizon of an investor would typically be for several years, the immediate price movement is not an important factor since such an investor would not expect to dispose of his shares immediately.

An investor should ask a number of questions before proceeding with any decision: is this company a good long-term home for my money? Is the business strong enough for me to hold it for several years even if the share price falls in the short-term? Are profits expected to grow in the future? Does the share price reflect that growth potential?

On the other hand, a speculator does not perform the same level of research into the future financial projections of the company since his main aim is for the price to be higher in the near-term in order to generate an immediate return over a short period of time.

Speculators don’t only trade in shares but also in commodities, currencies and cryptos. The focus of a speculator is on the price level at the time of the purchase and how the price will move immediately thereafter.

At times, one may come across certain financial commentators arguing that an investment into a specific company may be profitable over time should their product or service manage to penetrate certain markets or gain a certain level of market share. This would therefore necessitate investors to also ‘speculate’ in a more rational manner on the outcome of a company’s growth trajectory or success with a new product or service. However, the moves seen in a number of share prices over recent weeks cannot be described as normal speculation at all. In fact, there is widespread belief by several international commentators and financial journalists that the movements in the share prices witnessed over recent weeks have nothing to do with companies’ fundamentals. GameStop’s business as a retailer in a number of shopping malls across the US was understandably significantly impacted by the pandemic. The reason for the extraordinary gain in the share price of GameStop in recent weeks is therefore a result of a high level of speculation and little to do with its operations and financial fundamentals.

A recent article published in the international media providing statistics on average returns for the past 100 years shows that the Dow Jones Industrial Average and the S&P 500 have returned about 10% annually over the past century. This implies that an amount of USD3,000 invested at the end of 1920 would be roughly worth USD41 million nowadays. A return of 10% per annum is a good ‘rule of thumb’ for investors contemplating an investment across equity markets. Although this level of return may pale into insignificance compared to the stratospheric changes in some share prices in recent weeks, the short-term movements highlighted across the web and trading applications on a daily basis is not representative of normal market conditions.

In one of the many articles that I read in recent days documenting these extraordinary developments, the author stated that one of the clear signs that a bubble is close to bursting is when the retail investor enters the market by using leverage.

Some financial journals have therefore questioned whether the retail frenzy in these once-forgotten companies could represent a turning point for stock markets. Other commentators argued that the big losers in these instances are those investors who feared they are missing out and bought at the highest price in the hope of making a very quick gain.

Clearly, the lesson to be learnt is “Invest wisely”. Few people make a fortune overnight.

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