The framing of the David v. Goliath story dominating business headlines this week is missing the most valuable strategic lessons GameStop’s stock surge – from $4 six months ago to about $350 per share recently (a gain of over 8000%) – offers.
First a quick recap for those who missed it. GameStop is a video game retailer with about 5,000 physical stores in malls spread throughout the US, Australia, and Europe. Like most mall-based retailers, its revenue has been in a slow but steady decline over the last six years, dropping from just over $9b annually in 2014 to $7b before the pandemic hit at the start of 2020. When the pandemic hit and shoppers en masse avoided malls, revenues fell rapidly, today averaging $5b (12-month rolling average).
Here is what was “supposed” to happen. As the pandemic wore on, revenues would continue to fall, while their rent and operating expenses would remain relatively flat (they were closing stores but at a slower rate than their revenue was dropping). The stock price would plummet.
Or so professional investors like hedge fund manager super-star Gabriel Plotkin expected. Plotkin, founder of Melvin Capital Management, and others betted heavily that GameStop’s stock price (ticker: GME) would drop and sold shares short. A short sell is essentially a bet that a stock will drop in price. You borrow stock at today’s price, sell it, then buy stock in the future at a lower price and return it to the trader who lent it to you. As long as the stock goes down in price, you make money.
What the experts didn’t expect
But a new market force is at work today, driven by three trends:
- More day traders: With the pandemic forcing people out of offices and into homes, with less things to spend on and some extra stimulus money burning a hole in their pockets, there are many more individual investors trading from their breakfast tables in slippers.
- Lower barriers to entry to trade options: Ten years ago, it was complicated and expensive to buy and sell stock options. But today, thanks to new trading platforms like Robinhood, almost anyone can start trading. This is important because with options, you can create positions that, with relatively little investment, have the potential to generate high returns.
- Connectivity: These individual investors armed with stock options are now more connected than ever. On sites like Reddit, investors can flock and share ideas and tips. One Reddit community, WallStreetBets, has over 4 million individual investors.
These three factors created an unprecedented counterbalance to professional institutional investors who had, until recently, only had to contend with other institutions like them.
The power of the people
The power of the WallStreetBets community was first triggered on January 11 of this year when GameStop announced it was adding three new members to its board and that other board members, including their board chair, would be stepping down. Those three new board members were Ryan Cohen, co-founder of pet online retailer Chewy (which was sold to PetSmart for $3.35b in 2017), and Chewy’s former COO and CFO.
By that time, investors on WallStreetBets had already started rallying around GameStop. They had learned of Melvin Capital’s big-dollar bet that GameStop’s price would drop and they wanted to take on the establishment, posting things like “F*** hedge funds. This is a cross point into the future,” and urging fellow WallSteetBets members to keep buying the stock.
The announcement led to an 11% jump in GME’s stock price. This stirred up WallStreetBets members and, tasting victory, excited them to go for even more with posts like “looking at the 5-year GME chart is just insane” and “Hold the line! No room for doubters!”
Over the next week, GME’s stock doubled in value to $40 from about $20. When professional traders parked their Teslas and Masaratis, stepped into their glass-walled offices, and sat in front of their multi-screen Bloomberg terminals, they started to sweat. They had borrowed millions of shares at $20, would have to return those shares in about a week, and if the stock price held, they would have to buy them on the open market at $40.
Meanwhile, scatted throughout the world, in city cafes, living rooms, and park benches, millions of individual day traders were cheering on their success. Melvin lost so much money, they needed to arrange a special investment by other hedge funds to stay in operation. And the stock kept climbing. Goliath kept slipping. And to save face and his finances, Goliath started telling a story that, I believe, holds several strategic flaws.
The wrong narrative
The narrative that professional investors are spinning about this dynamic in business journals and on television is that this is a battle between logic and passion, between professional investors who invest based on the fundamentals of business and inexperienced ones driven by passion and herd mentality.
When the stock price, they argue, diverges too far from what the company is actually worth, based on its revenue and profit, we create market volatility and the risk of a bubble bursting. Professional investors are to be trusted because they take a fundamental, logical, fact-based view that leads to more efficient and predictable financial markets.
Now the stock price of GME – and other companies like Bed Bath & Beyond and BlackBerry that have been similarly propped up recently by such investor-crowd movements – may be higher than what the business supports and is likely eventually to come down. But the argument professional investors are making has three structural strategic flaws. Understanding these reveals levers we can pull, as business builders or investors, to create value in the modern reality.
These three flaws are the ideas that:
- Professional investors invest on fundamentals.
- A company’s value is determined by its fundamentals.
- WallStreetBets-like communities are anomalies.
Professional investors invest on fundamentals
The first argument you hear underlying established investors’ arguments as to why individual investor communities should be reigned in is that they are dangerous because they invest not on the fundamentals of the underlying company but simply on the hope that the stock price will increase. For two years I walked up the marble steps of Columbia Business School, to the top of a hill on which the campus sits, to learn from the motherland of Warren Buffett-style value investing. Buffett studied at Columbia, and two of his most influential teachers there – Benjamin Graham and David Dodd – are known as the founders of “value investing,” the investment approach Buffett popularized.
I was indoctrinated in value investing thesis: that a company has an intrinsic value that is fairly steady and that the market value of that company at any given day may be higher or lower than it. As long as you buy when the market price is below the intrinsic value and are willing to be patient enough for the market price to catch up with that intrinsic value, you will make a safe, long-term return. To this day, I prefer to look at the fundamentals of a business – cash flows, competitive advantages – and believe this is what led me to go deep into business strategy with my career.
But after moving to Greenwich, CT, ten years ago, I came to realize that few actual practicing investors invest this way. Their short-term focus leads them to invest not on fundamentals but on market forces. They look for pieces of news that are public but not yet widely known that will drive the stock up or down once investors learn of it. They talk about “momentum” – the stock’s trajectory up or down – irrespective of the company’s financial performance.
The investment game that most professional investors have been playing is not built on a deeper analysis of a company’s financials but rather on an ability to more quickly move in the direction of market movements. Like individual WallStreetBets investors do, they follow each other closely. When a hedge fund manager talks about his or her holdings on CNBC, others take notice and may buy the stock, pushing it up. Hunched over computer terminals in office buildings in Wall Street you will find thousands of mathematicians feeding trading data into models to try to reverse engineer the holdings of other successful investors.
The truth is, many, perhaps most, professional investors invest based on market forces, not fundamentals. Individual investors are doing the same. They are following each other and broadcasting their opinions. Their channels are different, but the investment approach is the same.
A company’s value is determined by its fundamentals
The second flawed idea is that a company’s value flows from its fundamentals. You create revenue and profit and that determines your valuation. Academics would say that value is the dependent variable and fundamental performance is the independent variable.
But actually, the cause and effect works the other way as well. Amazon, for example, is able to outperform its competition in part because its stock price is so high. Google as well. Rob Wolcott, innovation professor and partner at Clareo, says “Google is playing with Monopoly money.”
By enjoying access to cheap money, companies can invest in things that companies without such access cannot. For example, when Amazon buys a company, its valuation often goes up higher than the cost of that acquisition. In essence, then, Amazon can purchase companies for free.
This creates a self-fulfilling dynamic. Investor put a high value on your company. This gives you access to inexpensive capital, which you invest in opportunities; that creates a higher value. Another way of saying it is that Amazon has attracted investors that believe that Amazon CAN create a future value much greater than the current financials imply.
Or another way of looking at it is that Jeff Bezos is able to convince people to bet on him; they bet on him, he delivers, so they bet on him again. Elon Musk similarly is able to get people to bet on him – or get people to want to avoid betting against him – which results in a valuation for Tesla far above what the current fundamentals would support.
Could you look at GameStop as a bet on that Ryan Cohen and his team can transform it into a truly digital ecommerce company as they did when they created Chewy?
I am not a valuation expert and will not opine on what GameStop’s value should be. But looking at their balance sheet shows that the ratio of their company value to the actual tangible assets they hold is almost exactly that of Amazon’s. In other words, the premium that investors are placing on GameStop’s management to create something great with the tangible assets they have is about the same as Amazon’s investors place on their management team.
Below, I’ll suggest what that transformation strategy may be.
WallStreetBets-like communities are anomalies
Finally, the narrative professional investors seem to be spinning is that WallStreetBets-like communities are anomalies that should be put out. But that view overlooks the fact that the formation of such coordinated efforts is part of a broader strategic trend we have seen in development now for over two decades. We call it “coordinating the uncoordinated.”
Consider that 20 million people are pledging money on Kickstarter to fund inventors each month. Platform business models like Airbnb, Instacart, and Uber are restructuring entire industry chains.
WallStreetBets-like coordination takes this strategic theme to the next logical level. Instead of having a centralized platform that enables the coordination, participants coordinate themselves. Blockchain does this by motivating miners to mine data and self-organize. Flash mobs have been self-organizing for years.
Traditional financial players have based their advantages on the idea that power comes from control: of trading information, human intelligence, investor loyalty. What we need to do is appreciate that power increasingly comes from coordination, not control. A self-organized community can replicate, on its own, many of the advantages traditional financial players have depended on.
Again, though I began my career as an investment banker and feel pretty comfortable around financial models, I have been out of the game too many years and have spent too little time looking into GameStop to opine as to whether its stock price is worth the $4 it traded for six months ago, the $150 it is trading for as I write this, or the $350 it reached the day before.
But, if GameStop were to seize this opportunity in which it can access inexpensive capital from a community of investors who are betting on it, is this not unlike an inventor putting Kickstarter money to work to pursue a possibility that not everyone can see?
Let’s say GameStop sold 20 million shares over the next year or two, representing about 30% of the total shares outstanding in the market, and raised $3 billion at the current price of $150. Let’s say they then sold off their operations in Australia and Europe generating, say, another $500 million. What might they do with that?
- Pay down a significant portion of their $1.2b debt to reduce their interest expense.
- Shift to digital by strategically closing some stores – though Amazon’s and Apple’s success with a combination of brick-and-mortar and online shows the winning strategy is to be in both – and investing in ecommerce, initially selling video game downloads.
- Implement the same strategy Cohen used at Chewy – what I call “the two-front battle.” Borrowing from Zappos’ strategy, he conceived of Chewy as a customer service company that happened to sell pet supplies. GameStop could offer its customer base – gamers – an unparalleled customer experience.
- Leverage the power of community by converting the more than 50 million rewards cardholders into a community of gamers. Imagine chat boards, new levels of membership, peer reviews, etc. They could incorporate many of their individual investors into their community following a model similar to REI, which is technically a co-op owned by member customers.
- Expand beyond games. My son spends hours researching and selecting motherboards, peripherals, graphics cards, computer mice, etc. The PC gaming hardware business is already a $40b business and is growing rapidly (nearly 10% per year) due to COVID. GameStop could be capturing a lot of that business.
A strategy that takes advantage of GameStop’s sudden access to less expensive capital and invests it intelligently into a transformative digital strategy could justify a stock price far higher than the $4 it was trading at before individual investors let their power be felt. You too can take advantage of the underlying strategic principles GameStop’s story underscores:
- Paint a future vision for your company for investors to Don’t think you are only worth past performance.
- Use the willingness of your investors to trust you with access to less expensive capital to make smart investments that will ultimately realize tangibly the value you envisioned.
- Leverage the power of community. Put yourself in front of the “coordinate the uncoordinated” strategic paradigm.
Image by Scott Carr