Of Mice and Memes

Happy Wednesday, and welcome back to Dry Powder.

The meme stock bonanza was a fever dream for a certain class of retail investor—and a wake up call for the titans on Wall Street. Few among us are better qualified to explain how the GME short squeeze went down than Bob Sloan, a fintech analytics wiz and founder of S3 Partners. In today’s issue, my conversation with Bob about the financial mechanics and grievous miscalculations behind the frenzy, and how the industry changed thereafter.

Of Mice and Memes

A new three-part Netflix docuseries, Eat the Rich: The GameStop Saga, captures the essence of how the collective action of retail investors, relying largely on Reddit posts and their own desire to “stick it to the man,” nuked Melvin Capital. Bob Sloan, a star of the film, explains what the industry has learned ever since.

WILLIAM D. COHAN

I have long been fascinated by a strange phenomenon in the finance world: How a hedge fund manager’s fundamental analysis about a company can be spot on, but their technical analysis misses the mark and they whiff bigtime, even existentially. Take, for instance, Bill Ackman’s flamboyant 2012 bet that the stock of Herbalife, the publicly traded nutritional supplement company, would go to zero because, Ackman argued, the company was little more than an elaborate fraud that preyed on the unsuspecting and the vulnerable. He believed that Herbalife should be shut down or go bankrupt, or both. He set up an elaborate short bet that the company would fail and broadcast his views wherever and whenever he could—the Sohn Conference, CNBC, The New York Times, Bloomberg, etcetera. There was also a documentary film made about Ackman’s dramatic war on Herbalife, Betting on Zero, in which I had a cameo.

In the end, however, Ackman’s fundamental thesis about Herbalife may have been right, but he got his big bet tactically wrong and made himself vulnerable to what is known on Wall Street as a “short squeeze,” engineered by his rival hedge fund managers, Carl Icahn and Dan Loeb. Ackman’s Pershing Square ended up losing $1 billion. (Herbalife did not go to zero; it’s still valued at around $2 billion these days.)

The same thing happened to another hedge fund manager, Gabe Plotkin, in 2021, only the outcome for Gabe, and his hedge fund Melvin Capital (named for his late grandfather), was even worse. Plotkin bet, famously, that the stock of GameStop, the video gaming retailer, would collapse during the pandemic and that the company would have to file for bankruptcy, given its growing losses and the fact that video games could be rented, bought and sold over the Internet, no longer requiring a visit to a physical store. The trend away from in-store rentals and purchases was, of course, exacerbated by Covid. Or so Plotkin bet.

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His fundamental analysis was spot-on. Few would have argued then (or now, to be honest) that GameStop’s business prospects were anything more than bleak, at best. But his technical analysis—which seemed to ignore the possibility that Melvin Capital’s gigantic short position against GameStop would make the firm vulnerable to a “short squeeze”—was disastrous. Melvin Capital and its investors lost a whopping $7 billion. Had he not been rescued at the eleventh hour by Ken Griffin’s Citadel hedge fund (which invested $2 billion into Melvin) and by Stevie Cohen’s Point72 Asset Management (which invested another $750 million), Melvin would likely have been toast. In the end, though, he will be toast: Citadel and Point72 later redeemed their cash infusions and in May 2022, Plotkin told his investors he was liquidating the Melvin portfolio and closing up shop.

A new three-part Netflix docuseries, Eat the Rich: The GameStop Saga, captures the essence of how the collective action of retail investors, relying largely on Reddit posts and their own desire to “stick it to the man,” engineered the short squeeze that doomed Melvin. The question is: How can such smart, professional investors get their fundamental analysis so right and yet still lose their shirts? Why, or how, could they possibly have overlooked the technical analysis that nearly doomed them, especially when they are supposedly the most sophisticated investors on the planet with access to the best traders, the best analysis, and the best thinking?

“We Pitched Melvin 10 Times”

For an answer, I turned to Bob Sloan, a somewhat neutral third party and the founder and largest shareholder of S3 Partners, a private data analytics and workflow technology company. Sloan is an expert on short squeezes. S3’s Black App is one of the best-selling on the Bloomberg App Portal. According to Institutional Investor, its “extensive real-time and predictive analytics on short interest have enhanced transparency in the securities-lending market.” He appears as the voice of reason in the Netflix series.

S3’s business, Sloan tells me, is to acquire as much data as possible about the financial markets and then to build products that distribute the data. In addition to Bloomberg and Refinitiv, S3 also sells its data to Snowflake, FactSet and Amazon. “Wherever people want to get their financial information,” he says.

The GameStop reckoning, for many, revealed a new risk in the financial markets. For generations, the expert investor class had an asymmetrical amount of information and opportunity to explore outcomes in the markets. But the confluence of democratized trading platforms, pandemic-era boredom and brazenness, and an absurd amount of information on the open web, accurate or not, suddenly made the pros seem outnumbered. The meme stock phenomenon has been described in innumerable ways, but it laid out one fact clearly: henceforth, in order to perfect their technical analysis, the Pros had to know what the Joes were doing.

Sloan thinks that what happened in the GameStop situation is that small investors started searching the Internet for topics like “short interest” in the stock and came back with an unfiltered grab bag of information. “The search itself becomes the truth,” Sloan told me. They then took to Reddit to share what they thought they learned about GameStop’s short action. What the Internet said about GameStop’s short interest became the collective wisdom, he continued, regardless of whether or not it was accurate. “It bounces you off the source material,” he said of the information on the Internet. “And it gives you community opinion as fact. So what happens is that the information becomes used in financial models, and that information is generally flawed. But, like a broken clock, it’s right twice a day.”

Sloan thinks that inaccurate “short interest” calculations played a significant role in the GameStop saga, not only for Melvin but also for many other retail investors who held onto the stock as it peaked and then failed to sell it as the stock price all but collapsed. (On a split adjusted basis, GameStop hit $81.25 a share at the end of January 2021; it now trades at $26 a share, down roughly 70 percent. The market value of GameStop is still around an insane $8 billion. Before the Redditors got involved, the stock traded around $1 a share.) “Our firm realized there are two things wrong with the way float and short interest are calculated,” Sloan continued. “And they’re central to the story.”

According to Sloan, the numerator in the short-interest calculation—how many shares of a stock are short the market—was flawed because it took too long to reach the market; it was reported to the Securities and Exchange Commission 26 days after it had happened. The denominator in the calculation—how many of a company’s shares are outstanding—also was flawed because it failed to account for the shares borrowed and then sold, which increased the float, or the overall number of shares outstanding. He said that his Black App will, for most publicly traded stocks, accurately calculate short interest and float and will provide the price of the stock in the stock lending market, both if you’re a lender and a borrower, so you can see the spread. It will also give you the analytics to avoid short squeezes and to find concentration risk.

According to Sloan, he tried to interest Plotkin in using the Black App, which Sloan claims provides a more accurate picture of the short-interest in a stock and therefore could have alerted Plotkin to the growing likelihood of a devastating short squeeze. “We pitched Melvin 10 times and he turned us down 10 times,” Sloan said. “For $11,000 you could have avoided a $7 billion loss.” His pitch to Melvin was, “We have a way of updating float and calculating short interest. We think you should take a look at it. It’s accurate. And, by the way, subsequent to this we predicted the squeeze in Avis, Weber, Bed Bath & Beyond. I could give you a list a mile long because these things do happen. And it’s accurate. We’re not saying it’s foolproof. We’re just saying a very large percentage of the time it’s telling you where there’s a huge volatility event built up in the price action of the stock.” But Melvin’s traders told Sloan salesmen that they had it covered, and didn’t rent the S3 tool.

The New Reality

If the GME fiasco taught Sloan anything, it’s that it’s no longer enough anymore to get the fundamental analysis right; a professional investor also has to get the technical analysis right, too. Had Plotkin been more cognizant of the technical implications of his short position in GameStop, he would have been more aware of the volatility inherent in the price movement. “He would have been able to say, ‘Wow, there’s pressure building, am I comfortable with that or not? Maybe I should pare this back now while I still can,’” Sloan said.

The irony of the GameStop situation was that the guy who did the right fundamental analysis got burned while those who followed the Roaring Kittys of the world (a.k.a. the financial Redditor Keith Gill) did little or no analysis other than just participating in the mass movement on Reddit, and made a fortune (assuming they got out before the stock cratered; some did, some didn’t as the Netflix film makes clear). But Sloan says “market structure”—the technical stuff —is every bit as important today as the fundamental analysis. “It’s the way markets are trading,” he told me. “And your job as an investor is to be aware of liquidity at all times. In all shapes and forms. Rule No. 1: You’re there to preserve capital. Rule No. 2: Your thesis has to be right. And Rule No. 3: Hopefully you make money.” I interject that rule number four is that you can be very right and very wrong at the same time, and lose a lot of money. “Yes, you can be right and very wrong and lose a lot of money,” he agreed.

Sloan believes it’s no longer prudent, or professionally responsible, for hedge fund managers to have a large short position in their portfolio, which he defines as something like a position that is around 10 percent of the portfolio. “It means you have to change the way you look at companies and how you structure your bets,” he said. “That’s a fundamental change. And that’s happening.” He thinks professional investors need to move beyond how they’ve traditionally been trained to think. The way people get trained in financial services can take on an almost religious fervor. “It’s a belief system,” Sloan explained. “You believe that the world is constructed one way, you know, I’m a value person. I’m a momentum person. I’m a factor person. It’s a belief system. And those belief systems are built up over a long period of time. And they’re very, very, very hard to challenge once someone has a career and done well and done well for the people around them. It’s very hard to say, actually, you need a belief system plus you need to borrow from some other systems that might work for you and an adjacency. The irony is that we are using Steve Jobs’ invention that connects the dots for everything. But when it comes to investing, it’s very hard for investors to connect dots from other adjacent belief systems, so that they can adjust to the current reality.” He thinks only 30 percent of the marketplace—professional traders or investors—have come to grips with the new reality. “It’s not saturated by any stretch of the imagination,” he said.

In the end, Gabe Plotkin was wrong about GameStop for the right reasons while the Redditors were right about GameStop for the wrong reasons. What does Sloan conclude about the episode, I wondered, about Gabe Plotkin’s experience in GameStop. “That you don’t have to go to Harvard to make money,” he replied. “That’s how markets work. They’re not fair. And it’s your job to adjust, especially if you are a professional. That’s the way I look at it. If you have all these tools and you have the wherewithal to afford them, and you don’t do it, then you deserve what you get.” (For what it’s worth, Plotkin went to Northwestern.)

Sloan, who is a veteran of Credit Suisse First Boston, is onto something about how the markets are changing in real time—the impact of a world awash in data and the ability for people to express themselves in a powerfully collective (and unprecedented) way. If either Gabe Plotkin or Bill Ackman had fully understood how their very public bets, as logical and correct as they were, could backfire spectacularly for technical reasons, Melvin Capital might still be in business and Ackman would never have had to endure the embarrassment he suffered over Herbalife, even though he’s managed to rebound rather impressively from that and the $4 billion loss he suffered around the same time from his long bet on Valeant Pharmaceuticals. Or as Sloan might say, you have to be able to adjust.

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