GameStop Frenzy Reinforces Need for Quality in US Stocks

Written by: James T. Tierney, Jr.

The GameStop drama that has rattled US stocks reflects the growing power of individual investors to shape market events. But there are lessons for traditional, long-term investors, too. When markets ignore fundamentals, redoubling a focus on quality is the best way to produce consistent returns while reducing volatility.

Since late January, investors have been captivated by an unfolding showdown in the US stock market that’s been widely reported in the mainstream media. GameStop, a physical retailer of video games and hardware, was a struggling business. With the video game industry transitioning away from physical disks, GameStop’s stock has traded at about $5 per share over the past 18 months. Hedge funds smelled opportunity, and many sold GameStop shares short—totaling 140% of shares outstanding at one point—expecting that the business was about to disappear.

Calls to action circulating on internet trading discussion boards summoned large numbers of individual investors. Aggressive buying pushed GameStop’s stock price from under $20 per share at year-end to a peak of almost $470 per share in late January. The stock continued to gyrate daily, valuing the company at many times more than its real worth. Similar stories have played out around other stocks, including AMC Entertainment and Bed, Bath & Beyond.

Three Lessons from the GameStop Story

What’s the moral of this story? Much has been written about the heroic campaign by individual investors to slay giant hedge funds. It’s easy to understand why this narrative is compelling, but we think focusing on the democratization of markets misses the broader lessons from this story. Here are three thoughts on what we think the GameStop story really means for markets and investors.

First, it’s dangerous for investors to follow crowds in stock markets. US stimulus checks provided spare cash for investors to easily deploy using trading apps such as Robinhood. But those who bought GameStop close to its peaks are already nursing losses as the shares have come down. Overpaying for a stock at prices that don’t reflect business fundamentals isn’t courageous. Many GameStop investors will learn a painful lesson on the risks of market fads.

Second, the campaign targeting hedge funds should sound a warning bell for large companies and institutions. The coordinated short squeeze reflects the power of individual investors to impact markets in new ways. Network effects and digital platforms can enable investors and start-ups to disrupt powerful, established leaders. Similarly, coordinated consumer revolts can threaten a market-leading company’s competitive advantages. Investors should be aware of these trends, especially since the biggest companies in the US are far larger than they have historically been.

Third, the US Federal Reserve has played an unwitting role creating an environment where the GameStop challenge can happen. In the Fed’s efforts to stabilize the economy, money has become virtually free. Ultralow interest rates encourage people to borrow and to take bigger risks to seek better returns. As a result, record sums have been pumped into private equity funds and SPACs (special purpose acquisition corporations) are widespread. More money is chasing each opportunity, and many companies are coming to market prematurely without being fully vetted.

Cheap money is also fueling record retail trading activity. We’ve seen this before, when easy money helped drive the dotcom frenzy in the late 1990s and inflate the mortgage bubble, leading to the global financial crisis during 2008–2009. We all know that the party rarely ends well, but investor exuberance can persist for a long time. With the Fed fully supportive of low rates for the foreseeable future and more fiscal stimulus on the way, we expect more to come in 2021. The Fed will have to gingerly deflate bubbles that have emerged—a tough task that often causes unexpected collateral damage.

Quality Is the Best Recipe for Returns

We don’t know how the GameStop frenzy will end. But long-term investors shouldn’t be shaken. GameStop is an extreme event. But increased retail trading more generally can be expected to create anomalies in share price movements, which allow high-conviction active investors to capture opportunities in stocks of quality companies that become disconnected from their fundamentals.

Focusing on high-quality companies is a good defense against irrational market moves. And companies that enjoy strong organic growth drivers aren’t beholden to the hypercompetitive M&A market for growth. Building an equity portfolio based on businesses with sustainable earnings growth potential is a recipe for consistent outperformance and reduced volatility, even in a world where smaller investors can mount powerful campaigns to shock market leaders.