Purple Haze
Purple haze, all in my brain
Lately things they don't seem the same
Actin' funny, but I don't know why
Excuse me while I kiss the skyPurple haze, all around
Don't know if I'm comin' up or down
Am I happy or in misery?
What ever it is, that girl put a spell on me
- Jimi Hendrix, Purple Haze
Replace “girl” with “subreddit,” and Hendrix’s immortal words are a pretty accurate description for how market participants felt this week. From Wall Street’s route by a brigade of highly motivated retail investors pushing up prices of heavily shorted stocks to continued concerns over valuations; it was a hazy week indeed. Below, we discuss our thoughts on the week and how we’re thinking about investing going forward. Do note this post was written Thursday, 28th Jan afternoon Asia time, so do take any information below in that context.
The Revenge of Retail:
Unless you’ve been living under an investing rock this week, you would have heard of a company called GameStop (although if you managed to avoid the news altogether, kudos). Basically the story is this – GameStop (a video game retailer) had a short-interest of over 100%, an army of retail investors caught wind of this and through loose coordination via the Reddit group wallstreetbets, bought enough options and stocks to trigger the mother of all short squeezes sending the stock skyrocketing 18.5x YTD. Now, this movement has made millionaires out of some retail investors while simultaneously forcing the Hedge Funds who were short, to take heavy losses, and in one case to such an extent that it had to be bailed out. This event has caused many fascinating discussions about wealth inequality, residual anger towards Wall Street over the 2008 crisis, the legality of such actions, and the power/risk in decentralized action. Now there is a lot here we are really not qualified to talk about (if you’re interested you can watch this and this, opposing sides of the argument), but we did have a number of thoughts as it pertains to investing, which we’ve shared below.
Shorting is damn hard: We’ve never shorted or recommended shorting anything in our lives (except for buying puts on index as a small hedge on portfolios). This isn’t because of the common argument that “a stock can go down a maximum of 100%, but can go up to infinity,” but because the actual mechanics of being successful are hard to get just right. Management has several tools to prop up stocks, timing is very difficult, and as we’ve seen this week the short-squeeze is a real threat. This week showed us that long-only continues to be a solid strategy for us, and while fund managers who short will still employ a shorting strategy, they will be far more cautious going forward. (side note we also don’t short as we’re natural optimists, so it kind of goes against our nature).
A good idea is a good idea: It doesn’t matter where the idea comes from. Those lambasting retail traders for not having a solid thesis for investing in GameStop are just showing signs of intellectual snobbery. The Reddit analysts found a market inefficiency, exploited it, and reaped the awards. Assuming this was all legal (not passing judgement either way) they won this round, and resoundingly so. It teaches us to never dismiss good ideas because of the source – ego, or shall we say, an air of superiority, should never get in the way of a profitable transaction.
Short-squeezing won’t always work: While it seems like every stock that has even a bit short interest is being squeezed at the moment, a GameStop-type success will probably be quite rare. So if you’re thinking of following the short-squeeze strategy, we would advise you to be careful. It takes a company small enough, with short-interest high enough for it to work, and while you’ll see successes pop up every now and then, we think that an 18x move in a few weeks will be hard to replicate (famous last words!).
Know what game you’re playing: At times, when you see people make life-changing gains in a few weeks while your portfolio has eked out just a few percentage points (even if you are outperforming the benchmark), you do briefly wonder what you’re doing with your life. However, this is where you must remember what game you’re playing. Are you playing a trading game, an investing game, a long-term game, or a short-term game? For us, our goal is to be stewards of our clients’ capital, and to help them make good long-term decisions. We’ve been very upfront with the fact that we’re quite useless at short-term trading, so our clients are quite clear on what game we’re playing (or more importantly what game we’re not). We think Li Lu of Himalaya Capital put it best when he said “In my opinion, the most important thing isn’t to think about in which pursuit you can earn more money. Because if you do, you’ll always be jumping around since there will always be people who earn more money than you. If you measure your life based on how much money you can earn, you will always be miserable. You must therefore follow your passions.”
Don’t lose sleep (point added on Friday 29th 2021 Asia time): We woke up to see that several brokers had stopped their customers from trading GameStop stock. Without insinuating whether this was right or wrong, it was inevitable. Now pain has not only been felt by the shorts, but by the longs as well. We’ve always avoided noisy/emotional/volatile stocks simply because we don’t want to lose sleep at night. There’s little in this world worth sacrificing your mental and physical health for, and making money is certainly not a reason for it (in our humble opinion). So we follow a simple rule – if a certain investment/action is going to make us lose sleep – avoid it.
Bubbles be bubbling:
If we ignore the GameStop tamasha[1] for a second, the broader market is also giving us a bit of unease. Now, we are aware of the arguments for rising equity markets due to low interest rates, not many viable alternative asset-classes, etc etc. However, we’ve noticed more and more participants state that it’s “too easy to make money” in this environment and honestly, we’ve felt it ourselves. As much as we think we do rigorous research and plan for consistent growth in our recommendations, some of the stock moves have been a bit too fast/furious. We also think people are discounting the bubbles in certain areas (SPAC bubble, EV bubble, short-squeeze bubble) and saying the overall market is still ok. But if the market is the sum of its parts, can we truly say that this is a logical train of thought? Aswath Damodaran of NYU did his own analysis of where he thought the markets were and came up with six scenarios of possibilities. In 5/6 of them, the market seems to be overvalued, and in some cases, significantly so. Obviously for some of these situations to occur, earnings have to be quite poor, and so far in the earnings season, so good. That said, according to this analysis it seems like the odds of the market going up are low compared to the alternative.
Now, if you believe the odds of a market correction are high, then the question is always timing, and the answer to that question can be anybody’s guess. Also sitting out of the markets completely is an over-reaction. You can build cash (which we have been recommending clients slowly do) but building too much cash can also be harmful if the market continues to rise. You could short parts of the market, but we just went through why that might be very dangerous in this environment, and costly too considering how high the VIX index is. Thus, the only way we’ve figured out is to protect the downside is through the quality of the portfolio and the valuations attached to the portfolio. Both features are important, you don’t want to own low-quality businesses even if they are cheap, and you don’t want to own high quality business if they’re trading at insane valuations. On the second part, Goldman Sachs released a list of mid/large cap stocks that they thought were the most expensive (and in bubble territory). Its a list of fantastic companies, but with even more fantastic valuations. We were pleased to see we only have recommended one stock on the list (Afterpay, which we had recommended at much cheaper levels), and that too, it is on the lower end of the list. We are in no way recommending or telling you what to do with your portfolio, but we still like to think that eventually quality and price will matter.
In the end, if you’re invested over the long-term, avoiding mark-to-market losses and volatility in financial markets is a fool’s errand. It will happen, and even the best investors in the world experience drawdowns over the short-term. However, we can prepare for those drawdowns by fortifying our portfolios and making sure we hold a good mix of quality and price.
We hope the above gave you some food for thought. Again NONE of the above is meant to be investment advice, but just our thoughts on how we perceive financial markets and portfolio construction. We wish you all the best for this year and as usual – happy investing!
[1] A Hindi word implying a celebration/show/drama/excitement/craziness all wrapped into one which I think is a very apt description of events that transpired this week.