How Should We Navigate A Reddit-driven Market?

2021 started off with some interesting event in the stock market. In recent weeks, the small and amatuer retail investors band together under a community called WallStreetBets on Reddit to go long on a stock called GameStop (Ticker: GME).

The GameStop Story

GameStop is an American company that owns stores that sell video games, consoles, peripherals, assorted knickknacks and merchandise. It used to seem like a sustainable business model but fast forward to today, consumers now prefer to download their games easily over the internet than going to the physical stores to buy their games. Going forward, GameStop’s business model only looks to face bigger challenges in the years to come.

This backdrop makes the recent frenzy in GameStop even more strange with the turn of events caused by Reddit rallying investors to scoop up the shares. Within a couple of days, the market capitalisation of the stock went up by 1,100% from $2 billion to $24 billion. Prior to this, many big hedge fund managers that are bearish went short on the stock. As the prices went up high, some of them were forced to close out their shorts by buying back shares that they do not own, and caused what we know as a short squeeze, sending the prices even higher.

The Herd Mentality

All of a sudden, it appears that the winners are the ones that focus on chat rooms or discussion groups and act fast, and not those professional traders who spend time looking at balance sheets, stock charts or the viability of business models.

The herd mentality in the Reddit groups led everyone in there believe that this bubble is heading towards the moon, or some even say Mars. Because Elon Musk appears to be in this game as well. Life in a bubble always seems great, until someone takes out a pin and sends everyone to reality. Warren Buffett once said, “A pin lies in wait for every bubble and when the two eventually meet, a new wave of investors will learn some very old lessons“. Speculation is most dangerous when it looks the easiest.

This is not the first time that the stock market can be driven by irrationality, but when the price gets out of touch with the fundamentals, it only ends in tears for most of the people. Especially so for those who are late to this game of musical chair. Many of whom will end up as bag holders. A bag holder is a slang to describe a person who holds a position in a security that drops in value until it is virtually worthless. Such is the game that most of them will be signing up for. Being a bag holder is an awful feeling. Watching the stocks that you once thought could change your life coming lower every 10%, 20%, 30% or even more can be extremely psychologically distressing.

How do we not become a Bag Holder?

While there is no clear cut answer to this, there are at least 2 simple questions you can ask yourself before buying a stock at the very least.

1. How healthy is the cashflow of the company?

Cashflow statements tell us a lot about the fundamentals of a company. In fact, a cashflow statement sometimes tell more than an income statement. For income statement, there are certain inputs such as revenue and costs figures that can actually be ‘manipulated’ to make the income statement look better.

If a company is unable to pay its debt obligations, it signals a potential problem. Just think about this very simply. If the operations of a company cannot even generate sufficient cashflow to pay for its expenses and debts, how is the company even going to continue operating?

2. Is the company currently or in the foreseeable future, likely to face any cyclical or structural challenges?

A company with cyclical problems may still be able to do well at the right seasons so long it has pricing power, but structural issues can mean a more long lasting problem. It may mean that the products of the business is out of favour and demand will only be declining. Such is the case for Nokia which many of us are familiar with.

The point about investing or trading to me is to make money, in a joyful manner with calculated risks taken. If the odds are not in my favour, I would not get into the game. Reddit or other social media platform may have the chance to do this over and over again. Pump and dump groups have not been anything new but we must learn not to be the victim of one and lose our hard-earned money.

Back to the Fundamentals

Let’s all be very mindful to do our own due diligence when buying a stock and not because some groups said so in some forums. Study the fundamentals of a company by understanding the business model and looking at the financial statements.

Stay true to the basic investing principles and do not be distracted by sirens of the stock market luring you into the hyped up stocks with no fundamental support. Operate only within your circle of competence and focus solely on the estimate of the intrinsic value of the stock. Resist the cries and noises of social media such as Reddit and sail past them towards the destination that you have always known to be a good place. Don’t fear missing out opportunities that a lot of people seem to be taking advantage of. An investor’s greatest strength comes not just from knowing what to do but also in what not to do. The truly successful investors will be the little kids that resist the marshmallow test and seek for long term gains rather than immediate gratifications.

This is how we will make money in an irrational market joyfully.