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The GameStop short: what IS short-selling and how does it work?

GameStop is just one of many high-profile companies that have been in the headlines recently because investors have been “shorting” their shares.

In the financial crisis, for example, big-name banks were heavily shorted until regulators stepped in to control the activity. The last couple of weeks has seen a frenzy of short selling take place in a number of places, including the silver market, the US entertainment sector and the US aviation industry.

Ebeth Van Heerden, Schroders Head of Intermediary South Africa, says: “The number one lesson for investors is that the share price of a company doesn’t always reflect the worth of that company. In the short-term, a business can be surrounded by news which drives shares up, or down, but in fact has very little bearing on the true valuation of the business.”

According to Van Heerden, if you’re not into video games, you probably hadn’t heard of GameStop before all this fuss began. “In a nutshell: it’s a Texas-based provider of video games and other entertainment products that wasn’t doing so well before it landed up in the spotlight.

“With people no longer out and about on the American high street and consumers preferring to buy their games online, the company was struggling to survive.”

Van Heerden explains that some (big) investors bet that the company’s share price would plummet as a result. Other (smaller) investors were angry at how these big guys would benefit from the company’s demise. So they rallied a bunch of (similarly small) investors together to force the share price upwards.

She adds that enough of these (similarly smaller) heeded the call to action. “Some of them have made a lot of money as a result. The big guys who bet against the company’s survival have lost a lot of money, some could even be in financial ruin. 

Avo analogy

In order to simplify what the frenzy has been all about, Van Heerden brings in the millennials’ favourite fruit – avocados.

If you’re a long-standing avo addict (consumer?) and hot shot investor (if you do say so yourself), you’ll understand how avo prices fluctuate on a seasonal basis (cheaper in winter when they’re abundant and more expensive in summer when they’re out of season).

This season is going to be different though, says Van Heerden. “You’ve got a feeling that because the pandemic has put pressure on people’s purses, there’ll be less demand for avos than usual and prices will fall.

“You head off to your local grocer where avos are sold for R20 a piece. You ask him or her whether you can borrow 1,000 avos for a fee of R2 each and promise to return 1,000 avos to him before the end of summer.

“You’ve now spent R2000 to borrow these 1,000 avos which you subsequently sell for R20 each. You pocket your R20,000 revenue which becomes a profit of R18,000 when you include the R2000 borrowing fee you paid to the grocer.

As predicted, Van Heerden adds that some people have lost their jobs, others have taken pay cuts and so there’s generally less demand for what is really a rather expensive fruit. “This causes the price to fall and you start to see £ signs as you rub your hands with unashamed glee. 

“You figure that if prices drop down to, say, R5 an avo you’ll make a tidy sum. You’ll have to spend R5000 to get the avos back to the grocer which’ll take your overall profit to R13,000 and that’ll do nicely,” says Van Heerden 

But, she adds, the avo farmers see this happening and are really annoyed that you with your nice flat, fancy car and cushy job are so obviously going to benefit from what’s going on.

They rally together and encourage widespread buying of avos in order to limit supply and thereby push up prices. “A whole lot other individuals who don’t like you jump on the bandwagon and soon the price of avos rockets by 1,700% – quite literally the figure GameStop’s shares have shot up by since December (at the time of writing),” she points out.  

These avos have gone from an affordable R20 an avo to R340 a piece.

Now you’re in trouble, says Van Heerden. “Your deal with the grocer was that you’d return at 1,000 avos to him or her by the end of summer. But you don’t have the avos anymore because you sold them at the start of summer, remember? All you’ve got lining your pockets is the measly R18,000 profit you earned then.

“This little deal has set you back by R18,000 – R340,000 = R322,000. Which is a scary figure. It might even bankrupt you,” she adds.

According to Van Heerden hedge funds and short selling generally have a bad reputation amongst every day investors because of stories like this (remember Volkswagen in 2008?). “But both have an important role to play in markets in general – and what is true for short selling is true for all investment strategies: investors will be best served by taking the time to understand how different investment approaches work and what function they can fulfil in their overall financial plan. 

“Remember, you don’t have to do this on your own. Surround yourself with trusted professionals who can assess the true value of your investments and a financial advisor to guide you in finding the best approach for your individual circumstances,” concludes Van Heerden.

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