What is a stock? *Rocket-ship Emoji*
The year 2021 has been a lot of things. One of those things is the year of the meme stock.
The idea of the meme stock was born of two technologies: social media and mobile applications. Increasing access to stock markets among average Joes and Janes (termed as “retail investors”) through platforms like Robinhood — which makes it easy to trade through its mobile application and its no commission business model — met with the massive information spreading and coordination power of social media, primarily Reddit, to birth a revolution in the participation of retail investors in the stock market. From this came the emergence of the meme stock.
The exact definition of a meme stock is still a work in progress, but the CFA Institute captures the general idea in their definition:
“In our analysis, we define them based on their prominence on Reddit’s WallStreetBets discussion board. Once a stock crossed a particular attention threshold on the forum, we categorized it as a meme and recorded the date when it reached that benchmark. AMC Theatres, GameStop, Tesla, Bed Bath & Beyond, and Tilray, among others, all attracted the requisite attention on WallStreetBets, as well as among retail traders and the media, to qualify as memes and were added to our list.”
With the increasing participation of retail investors in the stock market, it strikes me that there is a need for an accessible article to introduce the core ideas of stocks and also to explore some of the nuances around how these meme stocks captured the media’s attention in 2020, especially as it pertains to GameStop ($GME) and hedge funds.
The Concept of a Stock
A stock is a certificate of ownership of a company. They used to be literal paper certificates but have since become fully digitized starting around 1985. It may be instructive to understand the problem stocks are trying to solve.
Throughout human history there have been various types of business entities in various kinds of economic systems. The ones that have survived into the modern day can be generally categorized into three types based on ownership: sole proprietorships, partnerships, and corporations. From LegalZoom we get the following definitions:
- A sole proprietorship is one of the easiest forms of business to start partially because it requires no filing of documents. If a single person starts a business and takes no further steps, it is a sole proprietorship. All income or losses are taxed to the owner as personal income. This flow-through taxation is a significant benefit for many owners. However, a sole proprietorship also provides no liability protection for the owner. The owner is personally responsible for all liabilities, placing his or her personal assets at risk.
- A partnership is a business owned by two or more people that requires no filing of documents. Each partner participates equally in the operation unless a formal partnership agreement says otherwise. The partners may also agree in writing to an unequal share of the profits or losses from the partnership if this is the case.
Similar to a sole proprietorship, partners report their share of any losses or profits on their personal income taxes. Partnerships also provide no liability protection for owners. Each partner is personally responsible for all liabilities, placing the partners’ personal assets at risk. - Unlike a sole proprietorship or partnership, forming a corporation requires filing articles of incorporation with the state where the corporation will conduct business. A corporation is a legal entity that is separate from its owners, called shareholders. The shareholders do not necessarily operate the business. Instead, shareholders elect a board of directors who then elects the corporation’s officers to operate the business. Depending on the corporation, shareholders may also serve as officers.
As a separate legal entity, corporations pay taxes on profits. After taxes, profits are distributed as dividends to shareholders who then pay personal income tax on the dividends. Because they are separate legal entities, corporations provide liability protection. The personal assets of shareholders are not subject to the liabilities of the corporation.
The first two are operated directly by the owners of the business, and as noted, the owners are fully exposed to the risks of operating the business. There is also an additional dimension of sole proprietorships and partnerships that needs to be considered; since by definition they are owned and operated by the same parties, they are constrained in how they can raise capital to finance operations or growth. In particular, they would be largely limited to either use of their personal savings or seeking a line of credit (i.e. debt) to finance any additional monetary needs beyond their operating profit.
This can be inefficient for at least two reasons:
- It exposes the owners to a large amount of risk, either through loss of their own savings or through interest payments/collateral on the debt. If the owners are not sufficiently funded themselves, they are unlikely to be able to diversify away this idiosyncratic risk.
- It restricts the size of growth opportunities, and correspondingly the level of risk, the business can pursue. Personal savings are typically not at the scale needed to fund business expenditures and banks will not provide a line of credit for a very risky project where the bank faces the full downside of the risk (default on the debt) but not the full upside as they only receive the interest payments on the debt if the project works out.
These two problems restrict business growth and introduce a need for a new type of financing. This is where the corporation and stocks enter the picture. Since corporations are separate entities, their ownership can be bought and sold and this is done through the unit of a share of ownership, with one stock of the company being called a share. In addition to liability protection, the corporation structure enables the new type of financing that solves the two problems above: current owners can elect to sell a portion of the corporation to a new party who can finance growth/new projects. This is called equity financing.
Usually this new investor should be someone with sufficiently deep pockets that they can diversify away the idiosyncratic risk of the corporation’s projects, and withstand exposure to the full downside risk — losing all the money invested — in order to enjoy in the full upside of the investment if it works out.
As a case study, consider the Dutch East India Company. Again, from Investopedia:
- The Dutch East India Company was one of the earliest businesses to compete for the exports from the spice and slave trade.
- It was a joint-stock company and would offer shares to investors who would bankroll the voyages.
- The Dutch East India Co. is widely thought to be the first company to allow the public to invest in its business, in what was the world’s earliest initial public offering (IPO).
- Commonly known as “VOC,” for its Dutch name Vereenigde Oost-Indische Compagnie, the spice company thrived mainly due to its monopolistic hold over the East Indies.
- Investors ran the risk of unprofitable voyages due to unpredictable spice supplies.
The business of the Dutch East India Company was to venture to foreign lands and acquire items for trade like East Indian spices, or Indonesian coffee. However, this was during the 17th century, a time when there was much uncertainty in the world about the likelihood of a successful voyage to distant lands and therefore it was incredibly risky. Moreover, it is unlikely that the operators of these voyages had the finances to actually buy the ships and pay for a crew (which I imagine would happen at least in part before the journey). Consequently, they sold ownership shares in the venture order to raise money for the risky journey. While the risk was high, so too was the potential payoff which would have adequately compensated investors should it be successful.
This is much like Venture Capital firms today. [Early stage] VC firms invest in high risk/growth companies in exchange for ownership of those firms, and a stake in the profitability of those firms. Of course, if the venture fails then the VC firm loses the money it invested. However, if it succeeds then the investors can cash in on their investment, referred to as “making an exit”.
So far we have talked about shares, but we haven’t made any mention of the stock market where stocks are typically bought and sold. We now introduce it through the “initial public offering”, often referred to in short as the IPO.
Side Note: Sophisticated Investors
As noted above, the types of investors that are ideal for equity financing are typically those with deep pockets, but should also be financially knowledgeable, at least enough to fully understand the risks and capable of performing due diligence on investment opportunities. Typically these are not retail investors. Instead, these types of opportunities are restricted to a class of investors called “sophisticated investors”. From Investopedia: “A sophisticated investor is a high-net-worth investor who is considered to have a depth of experience and market knowledge that makes them eligible for certain benefits and opportunities.”
With the increasing participation in financial markets of retail investors and the rapid increase in access to these markets, there is a real risk of retail investors getting involved with financial instruments at exposures that are at levels which should be restricted to sophisticated, or other more capable, investors. Robinhood offers stock options as a financial instrument on its platform. Without going into the details, stock options can be thought of as highly levered stock instruments where small changes in the stock price can lead to much larger swings (up OR down) in the value of the options bought or sold.
In June of 2020, Alex Kearns took his own life at only 20 years old after mistakenly believing he’d lost nearly $750,000 in a risky bet on Robinhood. The story is available on CBS News. Should retail investors at 20 years old be able to access highly levered financial instruments with incredibly large risk exposure through the simply tap of a few buttons on a mobile app? We have the sophisticated investor classification for a reason, but regulation is much slower to move than technology.
Anyways, back to stocks.
The Initial Public Offering (IPO)
As noted above, equity investors often need a way to “make an exit”, i.e. to generate a liquid return on their investment. Having a $10M ownership stake in an asset is most useful when that stake can be converted to a liquid asset like cash. Firms like Facebook and Google started off with some type of investment to scale their operations while they were still in “startup mode” and these investors need a way to cash out that investment, typically within a specific time horizon like 8–10 years from the investment date.
One way to do this is for the company to be acquired, i.e. another, typically larger, company buys the “startup” either with cash or stock. If with cash, then it is clear how the investors exit, but if it is with stock then we are back to square one: how does one make an exit with stock ownership? This is where the other typical exit comes about: sell shares of the company to the public, to any investor that would be interested, through an Initial Public Offering. After the IPO the stock is now freely traded in the open market and these early investors can make their exits, while newly interested investors can choose to purchase the stock.
With the listing of shares onto a publicly traded stock exchange, anyone can buy the shares available. However, it is useful to distinguish slightly between “new shares” and circulating shares. Companies can choose to issue new stock for fund raising purposes post-IPO but this also dilutes the ownership of existing shareholders and so there is a decent amount of friction in doing this — in fact stock *buybacks* are very common — so I expect most shares being traded are shares in circulation rather than new shares. This adds some nuance to the term “investor” since in the case of circulating shares the person purchasing it is not adding additional money to the company, just purchasing the stock as a financial object for their own investment strategy, as opposed to for some type of growth opportunity through the business directly. Regardless, with the trading of shares on the open market comes the need to price those shares.
What goes into Stock Prices?
This is an important question that I think could be better understood by most people outside of economics and finance. Stocks are an ownership claim to the entity’s profits. The investors who bought shares in the Dutch East India Company were buying a proportional right to the profits from the trading expedition. In the simplest case we can think of profits as the left over money after a company’s expenses are subtracted from the money it generates from its operations, i.e. its revenues minus its costs. This profit is owned by the company and eventually redistributed to the owners. There are different ways that this can be accomplished.
In the case of a one-off business venture, like a single sailing of one of the Dutch East India Company’s voyages, the company can be dissolved after its intended operation and the money directly given to owners. In today’s world where companies typically operate in perpetuity, the two most common ways money is redistributed to investors comes in the form of dividends, where the company sends a portion of profits to owners, and stock buybacks, where the company directly repurchases shares from owners, compensating them with the value of the stock (or higher). The price of a stock is related to these mechanisms for returning profits to owners.
We will first take a brief detour to talk about how the time value of money works.
The classic introduction to this topic is the question: would you rather have a dollar today or a dollar one year from now? The correct answer is a dollar today.
If I have one dollar today, then I can typically invest that dollar at some annual interest rate, r, and have 1+r dollars in year, a whole r dollars more than the other option of receiving one dollar next year. The calculation is shown below.
As we can see, with at annual interest rate of 10% $1 today is worth $1.10 in a year while $1 in a year is worth only $0.91 dollars today. The value of money today based on its future worth is called the Net Present Value of money, usually shorted to NPV. How does this relate to stock prices? Let’s focus on returning profits to shareholders through dividends.
Dividends are typically paid on some type of dividend schedule, and while not all stocks pay dividends, for illustration purposes let us assume there is a stock which pays a $5 annual dividend in perpetuity starting from this year, and assume an interest rate of r = 10%. Then we can calculate the Net Present Value of that recurring dividend payment as follows.
*For those interested in how we went from the 3rd line to the 4th line you can search the term “geometric series”.
When we make the calculation, we see that this annual dividend payout of $5 per year starting from this year at an interest rate of r = 10% has a net present value of $55. Assuming no other money generated from owning this stock, the stock price should be $55. This is what we think of as the “fundamental value” of the stock; the net present value of all future cash flows derived from ownership of the stock.
As stated, not all stocks pay dividends, and even for those that do, they do not necessarily pay dividends all the time. However, cash flows may come in other ways such as a stock buyback, or from a future set of expected dividends. The main idea is that the fundamental value is proportional to the claim on the company’s profits afforded by owning the stock.
Side Note: Risk Free Rate
In the calculations above I used an interest rate of 10%. Where did I get this number from? In assuming that the dividends paid by this company are paid in perpetuity and that this will be guaranteed, I have asserted that this is a “risk free” source of cash. In other words, I assume there is no chance of this company failing to pay the dividend and so I choose to use the “risk free rate of return” as the interest rate. This is the rate of interest which can be secured on an asset that has no chance of default. No real world asset actually has this property; everything has a chance to fail, but the US Treasury bond is typically regarded as having such a low chance of failing to pay (due to something like collapse of the US government) that it is considered to be risk free. In the 1980’s the average interest on a 10 year government bond was around 10%, and this continues to be used for illustrative purposes, but today that rate of interest is more typically around 2%.
When evaluating a riskier asset, we often use a higher interest rate (also called “discount rate”) to account for the higher likelihood that the cash flows from the asset might not be paid.
Stock Prices, the Efficient Market Hypothesis, and the Wisdom of Crowds
We illustrated the concept of the “fundamental value of a stock” above; it is the net present value of all future cash flows from owning that stock. In our toy example we gave specific values for those cash flows, in the form of dividends, a specific payment schedule, annually into perpetuity, and used a specific interest rate, a proxy for the average risk free rate from the 1980’s. However, in the real world these values are much more complicated to infer.
There is much variation in the information people have, their personal beliefs about how well a company will do in its operations, their expectation of risk for a company, and even when companies will redistribute money to owners as some companies don’t even pay dividends at all. All this variation combines to different conclusions on what the fundamental value of a stock is. The trading price of the stock is the aggregate result of these different valuations.
Eugene Fama won the Nobel Price in Economics in 2013 in part for generating the “Efficient Market Hypothesis” which states that “share prices reflect all information”, and markets can be thought of as large bodies of individual people trying to determine the correct price for trading a good. Markets are something of a realization of the “Wisdom of Crowds” for price discovery. The combination of the efficiency of markets and the wisdom of crowds leads to a realized stock price that can be thought to be accurate in reflecting the fundamental value of the stock based on available information. If the price is too high, i.e. the stock if overvalued, then the stock will be sold off and the share price will fall, while if the price is too low, i.e. the stock is undervalued, then it will be bought and the share price will rise until it gets to the correct value. While this is what we typically expect will happen there are some anomalies in market behavior that lead to deviations in this result.
Stock Prices and Bubbles
Stocks can deviate from their fundamental values, typically upward in price, when there is a critical mass of people who believe the price will rise. When they act on this belief they can cause the price to rise and this in turn can cause others to buy the stock because they see the price rising, which further pushes it up in a self-fulfilling prophecy. Some of those buying the stock may only be doing so because they expect they can sell it at a higher price rather than due to some underlying belief in the fundamental value. This behavior can lead to bubbles.
Investopedia outlines the Five Stages of a Bubble:
1. Displacement
A displacement occurs when investors get enamored by a new paradigm, such as an innovative new technology or interest rates that are historically low.
2. Boom
Prices rise slowly at first, following a displacement, but then gain momentum as more and more participants enter the market, setting the stage for the boom phase.
3. Euphoria
During this phase, caution is thrown to the wind, as asset prices skyrocket.
4. Profit-Taking
In this phase, the smart money — heeding the warning signs that the bubble is about at its bursting point — starts selling positions and taking profits.
5. Panic
It only takes a relatively minor event to prick a bubble, but once it is pricked, the bubble cannot inflate again.
Meme stocks seem to be a type of localized bubble.
Bubble behavior has typically been started through some type of shock, “a new paradigm” as Investopedia puts it, but the displacements sparking the meme stocks seem to be the coordination of retail investors though Reddit and social media to artificially inflate the price of a stock. This coordination started with GameStop so it may be instructive to explore what happened with GameStop’s stock (stock ticker: GME) to drive that coordination.
Side Note: Long and Short on a Stock
We described above how we get to the share price of a stock using the future discounted cash flow to the owner, but we have not yet mentioned that this price can change. Stock prices go up and down all the time, so how does this relate to a stock’s fundamental value?
When there is new information about a company indicating an increase or decrease in profitability, this information will affect people’s expectation of the future cash flows from the company to stock owners and change the net present value of the expected cash flows. These expected changes move the price up or down depending on if the information suggests increased profitability or decreased. This is one way even stocks which are not being issued by the company can be attractive to investors: if investors believe there will be a change in the stock price in the future, they can trade on that belief today by either buying the stock “long” or selling the stock “short”.
Buying the stock and taking a “long position” in the stock means that the investor believes the stock price will go up in the future and they want to own the stock today so that when the stock price rises they will benefit from the appreciation.
Selling the stock and taking a “short position” is more complicated. If an investor believes that the stock is currently overvalued, i.e. the investor believes that the net present value of the future cash flows from the stock are lower than what the current stock price suggests, then one way to capitalize on that belief is to sell the stock today and repurchase it when the stock price drops to what the investor believes is the true value, pocketing the difference. How does an investor sell something s/he does not own today? The investor can borrow the stock from a broker and sell it today, then repurchase it to return to the broker at a later date (when the price drops to what the investor believes is the correct value). Of course, this is a belief and may turn out to be incorrect, so if the investor is wrong about their belief they can open themselves up to a large amount of loss should the stock price instead rise.
GME, Hedgefunds, and Reddit
In discussing stock prices that deviate from their fundamental value we focused on bubbles, where prices are artificially high, but while it is somewhat unprecedented, there is no law that says prices cannot be artificially low. It may be the case that GME represents such a case.
There are two things we need to establish:
- Selling stocks puts a downward price pressure on stock price
- Gamestop was excessively shorted
To understand the first one we can look at what happens when a stock index like the S&P500 experiences a change in composition, switching out one stock for another. TD Ameritrade describes what happens to the stock prices of the entering and leaving stocks:
“So when a stock is added to a widely followed index, millions, and sometimes billions, of purchase dollars flow into that stock, typically driving its price higher. Conversely, when a stock is dropped from an index, it is often sold by institutional players, usually causing it to drop in price. However, these price fluctuations are usually short-lived, and some studies indicate that just being a part of an index in and of itself has no permanent effect on a stock’s value.”
When there is more selling activity for an asset than there is buying activity, the price of that asset will fall, and when there is more buying activity for an asset than there is selling activity, the price of the asset will rise. This what happens in the case of a change in the index. The entering stock experiences a net larger amount of buying activity as all the funds that track the index clamor to purchase it for their index tracker while at the same time the exiting stock experiences a net larger amount of selling activity as those funds sell it off.
Typically, this type of net selling activity in the absence of specific news that would change the expectation of the fundamental value of the stock is temporary, as TD Ameritrade notes. However, as we mentioned earlier, bubbles can form if investors believe they can sell the stock at a higher price in the future, even if they believe the stock is overvalued at that price, and this can become a self-fulfilling prophecy.
In a similar way, it seems that Hedge Funds entered into a downward bubble in selling GME.
GameStop’s shares were more than 100% shorted according to Reuters. At the peak, 141.8% of GameStop’s shares were shorted. This means that shares which were borrowed and sold on the market were then borrowed again and sold again. This type of excess selling activity is exactly what the graph above captures. Hedge Funds were in a downward bubble; they kept shorting GameStop stock because they expected that the price would go down and therefore they could short it even more. What’s more interesting however, is whether these Hedge Funds knew exactly what they were doing, and more specifically, were they manipulating the market?
GME has been on a steady decline since Oct 30th 2015 where it had a share price of $47.06. This is not far from it’s pre-meme stock peak of around $57. It reached an absolute lowest share price of $2.80 on April 3rd 2020. What’s interesting is that in the wake of its meme stock status, analysts have concluded that GME is worth $10 per share. This is from both Loop Capital’s Anthony Chukumba and Bank of America’s Curtis Nagle. If analysts thought GME was worth $10 a share in the middle of a pandemic with lockdowns enforced across the country, and the move toward digital downloads replacing physical video game media, was GME really worth as low as $2.80 per share when conditions were much better? Shouldn’t the sophisticated investors in the market be buying GME at the low price in droves to capitalize on the appreciation of the stock to its fundamental value of $10? Instead, they were shorting it?
Markets are efficient, in the long run; this is why bubbles eventually crash. In the long run, markets are good at identifying the real price of something. Part of this process involves having enough momentum in the market to move the price to its true value and this can take a lot of capital. Size matters a lot, as well as influence, and Hedge Funds have both while retail investors typically have had neither. This has changed with Robinhood and WallStreetBets.
Retail investors, possibly guided by some financial insiders, were able to coordinate on what appears to have been a downward bubble and start setting the price on a course correction, but it has turned into an overcorrection. The new paradigm of the meme has spawned an upward bubble and after falling back down to around $40 per share in February 2021, the meme bubble has pushed the stock back as high as $300 per share in June 2021, with the current price at $190 as of close of day on September 22nd 2021. It is very unlikely that the true value of a struggling video game retailer which has been shuttering stores over the last decade leads to a share price of $190. The meme is a bubble, and like all bubbles will eventually come crashing down.
What is a Stock?
Ultimately, a stock is a unit of ownership in a company that affords a claim to the company’s profits. It is a financial instrument subject to the company’s business and market risks. It is also one of the few financial instruments readily available to the general public for investment opportunities. As part of the ownership, it may also afford the holder a voting right in the company’s business decisions or other corporate governance representation but not all stocks afford voting rights.
Stocks are tied to business operations, and therefore to understand the value of a stock we need to understand the value of the company, i.e. the underlying asset. The exact value of a stock cannot be determined and whether the stock price will increase or decrease is contingent on information about that company and information is very quickly priced into the price of the stock (since markets are efficient). It is very difficult (if not impossible) to “beat the market” as a result.
For most people, the best strategy for thinking about stocks as an investment vehicle is to invest with a long position in assets or technologies they believe is likely to appreciate. This may be something specific like technology companies, or green energy companies, or something more general like the “American market” which is what the S&P500 index is intended to proxy as an investment.
One of the most important things to keep in mind is that stocks do have a fundamental value and the market will eventually push the stock price to that fundamental value, so it’s important not to get caught up with trends without fully understanding the outlook for the underlying asset. No one “knows” what stocks to invest in, and if they say they do they are either lying or likely to be open to a charge of insider trading. This includes people with a PhD in economics or finance, so don’t ask your econ prof for stock tips.
If you’d like to learn more I highly recommend checking out Planet Money Summer School Season 2 which is all about investing.
