The Rise of Low Quality Investing, Part 2: Gamestop

In June of 2020, I wrote one of this website’s most popular articles to date, titled The Rise of Low Quality Investing: Catching The Falling Knives. 1 If you’re interested in the topic of what I’m dubbing “Low Quality Investing,” I do recommend reading that article. I’m about to get into how the recent trend of buying Gamestop’s stock is actually part of this bigger trend, but first, I’ll quote that article here to catch up readers who aren’t familiar with the current trend:

Investors are buying incredibly low-quality stocks at a feverish pace. By low-quality, I mean stocks with failing fiscal health, sometimes called “Zombie Corporations.”

The first time I wrote about this topic of Low Quality Investing, I remarked on the phenomenon’s tendency to bet on stocks with collapsing share prices returning to a “normal” share price. This time, we have a new spin on this trend, and that’s the “David versus Goliath” narrative to justify what is otherwise just another bet on low-quality stocks.

So who gets to say what stock is low or high quality? Isn’t that the job of a free market- to price assets accurately in light of both quantitative (that is, “the numbers,” such as earnings, balance sheet, etc) and qualitative (the “descriptors” of what a company is and does) factors?

It depends on how you define “quality.” Typically, “quality” means fiscal health. A quality stock represents a company with healthy balance sheets, low liabilities, strong and growing cash flow, a respect for shareholders and the duty to steward the company in their interest, etc. There are large volumes of research on quality and investing, and some of the more popular “quantitative” based investing strategies of recent years have been “Quality Factor” funds and ETF’s.

People who are making the argument that quality might be too subjective for any of us to “judge” are making bad faith arguments, trying to obfuscate the entirely clear meaning of a technical term. Quality actually is a well documented, well researched, and well defined investing factor. It is a relatively objective technical term in the financial world. 2

Markets tend to favor various factors in cycles. Quality sounds great, and it’s a factor Chaim Investment Advisors is very fond of for many reasons. It isn’t the only thing that motivates investors, however. Investors can privilege any number of factors based on what they see as a market leader at any given time. “Value” (i.e. “cheap”) stocks often go through cycles of being the favorite of investors looking to buy stocks at a bargain. “Growth” (i.e. “expensive”) stocks likewise attract a lot of attention from investors who are looking to invest in innovative, less established companies in search of new opportunity.

Low Quality Investing, however, is something else entirely. The stocks being pursued are usually quite expensive when you think about how many dollars of earnings you’re buying for every dollar invested (that’s the “Price/Earnings” or P/E ratio you see discussed in the financial press). People aren’t buying at classic “value” prices, and they aren’t buying “growth” either in many cases. After all, many Low Quality stocks that become highly speculated upon have been around for a very long time and are now on their last legs as a company. That’s why their stocks are heavily speculated against by Wall Street professional investors.

Let’s take an example from the last article on Low Quality Investing: Hertz. Hertz’s “Price/Earning” ratio, if you look it up right now, is “-.” That means the formula for calculating this ratio is broken. There are no earnings to put into the calculation. “Earnings” is one way of talking about profit, so if there are no earnings in a company, we’re already talking about a company that is not exactly quality. As a result, Hertz stock today is worth $2.00 a share at time of writing. It was between $15 and $20 last year. A frenzy in new buying activity from “investors” last Spring failed to buoy the stock of the failing company. In this case at least, the Low Quality investors have not been well rewarded for the immense risk they took on by buying a bankrupt company’s stock.

We’ve entered a new phase in the Low Quality Investing phenomenon with the Gamestop saga. This story has been so widely talked about, I struggle to come up with a link to it out of the hundreds that exist from the past day or so. Here’s one from Bloomberg that is relatively sober. 3

In short (no pun intended), Gamestop is a company that is not doing too well. For three years, revenue has fallen by an average of 6% per year. The Assets on the books have fallen in value while the debt has soared, creating an increasingly ugly balance sheet. Net income, operating income, and cash flow have all fallen steeply for years in a row. The “quantitative” side of things looks grim. The ratios that describe ability to pay off debt are extremely troubling. Qualitatively, the story is no better, as video game enthusiasts increasingly rely on digital marketplaces to buy their games and the malls and shopping centers that Gamestop locations inhabit are turning into ghost towns. Gamestop is the quintessential Low Quality investment, with little hope of recovering in the near future.

Nonetheless, the stock is sky rocketing in price as forums discussing market trading have taken on a defiant tone against those who would profit from the stock’s demise. Hedge Funds looking to make money on Gamestop going down have been relentlessly attacked in the markets by these forums (which I will not link because it would absolutely not be in the reader’s best interest to take part in these shenanigans). Forums and Social Media based commentators are doing what is called a “short squeeze” on Gamestop skeptics, looking to raise the price to such a level that those who bet against it will be forced to stop betting against it due to deep losses. Stop running and short squeezing are incredibly risky short-term trading techniques that usually fail in the long term.

The “success” of these reddit traders and Hedge Fund antagonists have been widely heralded by internet celebrities and even many in the financial press. Zerohedge.com (a rowdy, Right-Leaning financial press outlet with a sometimes antagonistic attitude toward Wall St.) has 7 articles at this moment on its front page about the antics of Gamestop boosters.

Analysts and commentators are struggling with this stock in a way I personally have not seen before. The narrative being pitched by the Wall St. antagonists boosting Gamestop shares is that this is a “David vs Goliath” showdown. That it is some kind of retribution against the upper class by the masses. Populist, anti-elitist tropes are being heavily employed in discussing the stock’s meteoric rise. 4 5 6

In my view, Low Quality Investing for a cause- whether noble or not- is simply not distinct from Low Quality Investing for any other reason. It’s still the “dash for trash” trade with a slightly more interesting motive. The narrative may exist, and it may currently be dragging the stock higher in the short run. It’s still Low Quality Investing, and those who are the new shareholders of this stock at stratospheric valuations are shareholders of a deeply unwell business model that has not proven itself capable of digging itself out of its predicament solely by virtue of its stock being up.

I also think that the fact that an ages old trope could be leveraged to boost a company with such dim prospects creates the likelihood that other or similar narratives could be used on other low-quality stocks. In short, there is sadly no end in sight at this time to the Low Quality Investing trend. Given the rise of the Wall St. zombie corporations (7), it’s possible we will see even further growth in the Low Quality Investing trend at this point.