Should you invest in the GameStop trading frenzy?

Until recently, few investors had heard of GameStop. The Texas-based video game retailer was just another bricks-and-mortar retail chain with a dire future, squeezed between the coronavirus and e-commerce.

Last September, it announced the closure of up to 450 stores and short sellers piled in sensing blood.

Then a strange thing happened. Instead of collapsing, GameStop's shares went ballistic. Between September 11 and January 26, they shot up from $6 to around $148, a rise of 2,366 per cent. Last Wednesday, they more than doubled, soaring another 135 per cent to $347, lifting its market value another $10 billion to $24bn. By the close of trade on Friday in New York, it was trading at $325. This kind of return makes Bitcoin look like a low-risk, low-return bet.

Welcome to the crazy mixed-up world of penny stocks, which only seems to have gotten crazier lately, as speculative mania sweeps stock-tipping chat forums and social media. Many now fear the trend is out of hand and signals troubled times ahead for the wider stock market.

There is nothing new about penny stocks, also known as small caps, micro-caps or nano-caps, which are obscure, speculative and usually unlisted companies whose shares trade at $5 or less.

The appeal is obvious. If you load up on a stock trading at, say, $1, and the share price clicks up to $2, you will have doubled your money. If it hits $5, you’re rich! If it flies to, say, $347, then it's game on.

The danger is that it just as easily falls to 50 cents, in which case you will have lost half your stake, or more as penny stocks typically have a wide bid-offer spread. That’s if you can find a buyer for your holding at all.

Penny stocks have always attracted their fair share of dreamers and gamblers, but lately it’s all gone into overdrive, thanks to day traders on Reddit’s stock trading discussion forum WallStreetBets, and social media platforms such as TikTok and Stocktwits.

This is more than investing. Right now, it feels like ideological warfare.

Reddit's day-trader army isn't buying GameStop because the company's management has resolved its underlying problems. Something much more interesting is happening. The rag-tag gang of app-based investors is using low-cost platforms such as Robinhood to wage ideological warfare on Wall Street's hedge fund behemoths, who they blame for manipulating the market, destroying jobs and wiping out small investors. They also hope to make a lot of quick money along the way. Some are hailing it a populist revolt.

So far, the little guy is beating the big guy, or “whales”, as they call them. Hedge funds are thought to have lost an incredible $5bn this year by shorting GameStop. Short sellers including Melvin Capital are now waving the white flag.

The Reddit army's hero and figurehead is the world’s richest man, Tesla founder Elon Musk, or Papa Musk as they call him. He has good reason to hate short sellers, as they have been targeting his company for years. So far, he has won hands down. Last year, hedge funds lost $38bn shorting Tesla stock.

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Many tech start-ups started as penny stocks before achieving enormous gains in their value, then collapsing spectacularly

Last week, GameStop’s stock surged 50 per cent on the back of a one-word tweet from Mr Musk, which simply said "Gamestonk!!". This was a play on the popular “Stonks” meme, which is internet slang for stocks with a strong social media following.

A few words from Papa Musk can have them flying into all sorts of stocks.

Reddit traders have driven up two more old-school technology stocks, Finnish firm Nokia, whose shares recently hit a seven-year high, and Canada-based Blackberry, now trading at a nine-year high. Its stock has risen 185 per cent from $6.58 to $18.92 since the start of January, forcing management to issue a statement saying it was unaware of any corporate developments that could justify the surge.

All of which is fun in a crazy way, but think carefully before enlisting in the Reddit army, many of whom buy volatile call options that can magnify your gains (and losses).

Arun Leslie John, chief market analyst at Century Financial, says the trend is partly driven by the massive fiscal and monetary stimulus unleashed to fight off the pandemic, much of which is now flooding into markets.

FILE PHOTO: The Blackberry logo is shown on a office  tower in Irvine, California, U.S., October 20, 2020.  REUTERS/Mike Blake/File Photo

Another factor is the emergence of the so-called Robinhood generation, a band of “merry millennial” investors who bet smaller chunks of between $1,000 and $5,000 on the commission-free US platform.

Chaddy Kirbaj, vice director at Swissquote Bank in Dubai, says penny stocks tend to be popular with “non-professional traders, individuals and middle-class families”, who are attracted by the promise of fast and easy returns, affordable buying and quick selling.

Some kid themselves that stocks this cheap can only go up. “The reality is different, which is why big investors and hedge fund managers rarely indulge in them.”

Mr Kirbaj says investors face a myriad of risks, including “aggressive price fluctuations, fraud, liquidity issues, bankruptcies, share price manipulation and lack of information, as unlisted companies are not required to file reports with regulators”.

He says the issue is now getting out of hand and is beginning to feel like the late 1990s tech boom and subsequent crash. “Many tech start-ups started as penny stocks before achieving enormous gains in their value, then collapsing spectacularly.”

If you pick the right early stage stock, you can make a fortune, with Amazon being the classic example. “It traded at less than $2 when floated in 1997, but now boasts a stock price of $3,292, with more than $280bn in revenues and a million employees across the globe.

Mr Kirbaj warns against getting caught up in the speculative euphoria, and advises sticking to old-fashioned fundamentals before buying any stock. “What does the company do? Why is it trading at its current price? How is the management team? What is its vision? What sector does it operate in and can it grow?"

Mr Leslie John says he has his eye on a few penny stocks. He favours US digital media content and software network Limelight Networks, which trades at $4.65, and supports the streaming of Disney Plus and Peacock platform of Comcast International.

On-demand US food delivery business Waitr Holdings connects local restaurants to diners in under-served markets. It trades at $3.64 at the time of writing.

Investors who don’t want to spend their lives glued to a screen obsessing over penny stock movements could spread the risk by investing in exchange-traded funds.

Mr Leslie John tips iShares Microcap ETF, First Trust Dow Jones Select MicroCap Index Fund and Adviser Shares Dorsey Wright Microcap ETF.

So what about GameStop? Matt Weller, global head of market research at GAIN Capital, says there are some fundamental reasons for its “breathtaking surge”, as it brings in new management and belatedly wakes up to e-commerce.

Its most recent report shows e-commerce sales are up more than 300 per cent, to represent around a third of total revenues. “GameStop recently announced a partnership with Microsoft, allowing it to collect recurring revenue from digital sales on Microsoft’s Xbox console, and has been buying back shares hand over fist.”

However, Mr Weller says the biggest factor driving this year’s explosion is the “truly gargantuan short squeeze” as traders who bet the company would go bust are forced to close their short positions and buy the stock back. “This pushed prices up further, turning more short sellers into buyers, pushing the price even higher.”

Reddit traders believe they are revolutionising the investment world and putting power where it belongs.

It remains to be seen whether swamping innocent stocks in viral hype is the way to do it. A lot of unsuspecting investors who kidded themselves they were making a one-way bet will lose big money as a result.

Many analysts see the Reddit frenzy as typical late-stage investment cycle hype, the final mad party at the end of the longest US stock market bull run in history, that began all the way back in 2009.

It may also reflect the impact of Bitcoin on investor mentalities, as the crypto currency’s mind-boggling growth has helped drive today's get-rich-quick mentality.

Many fear the mania is getting out of hand, a joke that has gone too far. Top fund manager Michael Burry has called GameStop’s surge “unnatural, insane, and dangerous”. Political commentators said similar things about Donald Trump's presidential bid in 2016, and look how that ended. Populism is shaking the established stock market order, just as it shook up politics.

Today’s speculative penny stock euphoria may not be rational but you could make big money from it. At least, for a while.