Current Market Conditions And Square, Inc.

Hey, The Investor’s Podcast Network Community!

You’ve likely heard of the fight between Reddit, Wall Street Bets, and the “real” Wall Street, over companies like GameStop, AMC, and Nokia. Before we get into what actually happened, I want to talk about two key terms that are crucial to understanding what went on — short selling and margin.

As value investors, we typically purchase a stock that we believe is undervalued and will provide market-beating returns over the long-term. In this case, we are going “long” a stock — we are placing a bet that the stock price will appreciate. In the case of short selling, it is the exact opposite.

To define short selling simply, you’re placing a bet that the stock price will decline, and if it does, you profit.

When you short a stock, you’re borrowing the shares of stock from someone else who already owns it, then you immediately sell those shares. What happens with money or items that are borrowed from another person? It eventually has to be given back. At a future date, we must return the shares we borrowed to the original owner. To do that, we have to repurchase the shares on the open market at the current price then return them. If the stock price has decreased, you profit because you’re able to buy the shares for less than you originally received when you sold them – the difference is your profit.

When you’re trading with margin, you’re using borrowed money from a broker to purchase securities. This means, rather than strictly using the $1,000 you have in your account to invest, you can borrow another $600 from your broker and invest a total of $1,600. Theoretically, this can make sense when there is a spread on the interest rate of the margin debt and the rate of return you expect to receive on the investment. However, if your investment declines in value, you are required to cover the difference.

SEC Regulations and Wall Street professionals often argue that they put rules in place to “protect individual investors”, investors aren’t “sophisticated” and might not “know better”. Well, this GameStop situation may have proven this theory wrong.

Do you remember what happened with The Big Short? To simplify a rather complex situation, Michael Burry discovered a piece of data that he expected to unravel the financial markets, providing him a trade opportunity. If his thesis was correct, he’d profit handsomely. While on a smaller scale, a similar situation happened with GameStop (interestingly, Burry has also been involved in the GameStop saga).

Keith Gill, a financial adviser from Massachusetts, found a piece of data, similar to Burry, that he knew didn’t make sense. Like Burry’s case, there was no way the situation Gill saw in the data was sustainable.

What did Gill see? He saw that GameStop had more shares shorted than existed — and not just a few percentage points, 40% more. If we think back to the definition of shorting, we’re borrowing shares other investors own. How can you borrow shares that don’t exist? Well, you can’t, or at least, you shouldn’t be able to. Gill saw this and knew it wasn’t sustainable, so he invested long in the company, knowing that if his thesis proved true, the stock price had nowhere to go but up, providing him with a hefty profit.

And, the rest is history.

Gill’s thesis went viral on Reddit as more readers understood it, investors piled into the stock under the same notion, Wall Street hedge funds got short-squeezed, and we saw the stock price of GameStop skyrocket from the mid-10’s to nearly $350.

You, me, and millions of others could debate back and forth about whether or not what happened next is right or wrong, but all of that debate would go to waste because it won’t change what happened.

If we step out of the bubble that is news headlines, think a bit more critically about why it happened, and how we can be better investors because of it going forward, that’s where the real value lies.

The financial news wants you to believe brokerages chose to stop trading GameStop stock, and others, because they had an alternative agenda. Maybe they did, maybe they didn’t – I personally tend to believe some did, while others didn’t, but we will have to wait and see what the investigations uncover. These types of punchy and polarizing headlines garner a lot of attention, and that’s exactly what the financial media wants.

Let’s go back to margin, the concept I mentioned earlier as one that is important to understand.

When you borrow money, the lender is on the hook for that money until you pay it back. Of course, you, as the borrower, are obligated to repay it, but we all know that doesn’t always happen. If you don’t pay it back, the lender loses. It’s the same with margin. Brokers had massive margin risk from the GameStop situation. The severity of that margin risk isn’t fully clear yet — some speculate it could’ve made Robinhood insolvent, which is why they raised additional capital, but no one outside the company knows for certain.

Should Robinhood have managed its margin risk better? Sure, you can argue that, as I probably would. They received arguably the most hate for the situation but, they weren’t the only ones who halted trading in GameStop stock. Nearly every brokerage did because the clearinghouses who actually clears the trades did – leaving the brokerages with nothing to do.

Again, whether this is right or wrong is up to you to decide, but I challenge you to take it a step further than that — think deeper than others are, think more critically. You can’t change what has happened, so what can you learn from this situation that can help you become a better investor and more wealthy in the future?

For me personally, I’m continuing to avoid the above situations and looking for great businesses to buy that are trading at a discount to their intrinsic value.

In our most recent Intrinsic Value Assessment, I provide an analysis for a company that might just fit that description — Square, Inc. (ticker: SQ).

Back in our October 6th, 2020 newsletter, Stig wrote, “Today (and in the future), competitiveness is measured by the amount of data you have available.” This quote couldn’t be more true for a company like Square, with one of its five competitive advantages being the data it has access to. In the Intrinsic Value Assessment, I wrote, “It is said that data is the new gold, and well, Square has a lot of it. With its two-sided network, Square has data from the businesses, as well as the consumers, which is a dynamic that arguably no other company has. This is extremely valuable and provides a competitive advantage because it gives Square massive optionality.”

If you’re looking at the stock chart for Square and thinking to yourself, “I missed the opportunity,” please allow me to leave you with this quote from the article, “Square is a stock that is highly volatile and can provide great buying opportunities if given enough time to do so. I have email alerts set up in our TIP Finance tool to let me know when the momentum has changed in Square’s stock. After a decline in price, the TIP Momentum tool will notify me when Square’s momentum has turned a corner and is heading in a positive direction again – at which point I will highly consider stopping my DCA and start adding heavily to my position in Square again.”

To learn more about Square, you can read the full Intrinsic Value Assessment Of Square, Inc (Sq) here, and if you want to get the tools I personally use to find the value of companies, in a fraction of the time, you can find our TIP Finance tool here.

All the best,

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