HD Shares Will Be Repaired

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Home Depot reported better than expected EPS, sales, and comp store sales, but had a small margin shortfall.  The stock has reacted poorly to the results, but we remain bullish on the outlook.  HD shares are unchanged since last summer even as quarterly earnings have consistently grown at 20%.  This has led to a material compression in the stock’s P-E multiple on an absolute and relative basis.  The current P-E is below the market multiple for the first time since 2007.  We believe HD shares are a bargain at current prices given the company’s multiyear growth and financial profile.  Near -term trends are tricky as the company must lap the pandemic-driven 2020 boom in sales.  Northlake is willing to wait, if necessary.

We usually do not like to quote others but Credit Suisse analyst, Seth Sigman, captured the HD stock well by noting:

“Home Depot’s stock is caught in the usual cyclical dilemma; it outperformed early in this cycle, and now must compete with the prospects of a recovery in other parts of the economy, while battling difficult comparisons and the debate about what normalization in consumer spending actually means. Further, numbers are not moving up after today’s results, and margins in Q4 were messy.”

This explains the stocks sideways movement the last six months as well the reaction to a good 4Q20 earnings report.  It will take another quarter or two to resolve the issue of difficult comparisons.  Northlake believes current sales momentum will hold and allow HD to report positive sales growth in 2021.  Housing should remain strong post-pandemic as household formation improves among millennials and some levels of outmigration from cities is maintained.

HD management has always done a good job managing operations and finances.  The company has invested heavily in its supply chain over the past several years to enable leadership in ecommerce and serving professional contractors.  COVID costs have added another layer of spending.  We believe that the investments in secular initiatives should begin to pay off as the Pro business comes back and ecommerce and buy online/pick up in store continues to gain share of overall sales.  HD should begin to see leverage on these expenses, especially as a portion of the COVID expenses roll off.  This operating leverage should offset pressure on gross margins.  As 2021, moves along, HD should reveal that overall margins can be stable and then tick higher as sales growth returns to normal in the mid-single digits in 2022 and beyond.

Management did not specifically endorse this outlook but we believe they hinted at it.  Most likely, the unusual impact of the pandemic that boomed sales and increased expenses leaves the company wanting to maintain wiggle room in their outlook.  The reality is that no one knows for sure how the post-pandemic will play out.  We think management offered a very strong signal of confidence by raising the dividend 10% and restarting the stock buyback program.

We expect HD to prove the bears wrong and emerge through 2021 with positive sales growth and stable to improving margins.  The stock trades at less than 20 times 2022 earnings estimates, which is around a market multiple if S&P 500 earnings rebound as strongly as currently expected.  Should HD follow the path we expect, the stock should regain a premium to the market.  At 22X 2022 earnings HD shares would trade at $308, up 18% from current price levels, an excellent return for blue chip quality like HD.

HD is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov

Nexstar Achieves and Validates Long-Term Strategy

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Nexstar Media Group (NXST) reported better than expected 4Q20 results despite elevated expectations.  More importantly, guidance for free cash flow in the 2021/2022 cycle came in way above estimates.  The 21/22 outlook validates the strategy that NXST has followed since we first became familiar with the company back in 2013.  NXST management has steadily built the company through acquisitions of local TV stations across the country to now be the largest owner of local media assets in the country.  An example of the company’s reach is that its TV stations reach 370 out of the 435 Congressional districts.  This scale has long been the holy grail for NXST as it improves the company’s negotiating power with TV networks, cable, satellite, and streaming companies.  Accompanied by strong operational and financial management and a business model that requires little in the way of capital spending, NXST’s scale allows for prodigious free cash flow production.  The stock is up 10% on the news to a new all-time high but we think there is still plenty in the tank. 

Management borrowed a lot of money to grow from just a handful of stations to its current national reach.  The acquisitions culminated with the purchases of Tribune Media in 2019.  At the close of the Tribune deal, debt exceeded 5 times EBITDA, a worrying level for investors.  Northlake always appreciated the free cash flow characteristics and trusted NXST’s excellent management team to pay down the debt.  The pandemic added huge pressure and the shares fell below $50 in March and April 2020 as advertising dried up and cord cutting accelerated.  We remained confident knowing that a huge year in political adverting laid ahead that would at a minimum provide cash to reduce debt.

Management navigated the pandemic perfectly by focusing on finding new advertisers, cost cutting, debt refinancing, and debt reduction.  Many of the cost cuts are permanent and paying down $1 billion in debt reduces interest expense.  To show confidence in its outlook, a few months ago, management raised the dividend 10% and initiated a large share buyback.

Local TV broadcasting is a tough industry.  NXST faces challenges as viewership fragments and digital advertising steadily gains share.  Fortunately, local TV broadcasting is also a high free cash flow business as little capital needs to be reinvested in the stations.  NXST already reaches the maximum percent of the population allowed by the FCC.  This means that large acquisitions of additional TV stations are off the table.  Small acquisitions to leverage the reach of the TV stations and the station websites are possible.  In addition, a pending Supreme Curt ruling could allow the company to own duopolies in the larger metropolitan areas it serves.  However, we expect most free cash flow to be used to support share value via dividends, share buybacks, and further debt reduction.

We find it easy to support a price target near $180, up another 25%, without stretching our valuation multiple.  NXST shares have often been a bumpy ride in the last eight years and we expect periodic stretches where concerns about the twin pillars of revenue – advertising and net retransmission fees – create volatility in the stock price.  Northlake is willing to ride out these phases knowing the company has a great management team, competitive scale, and a superior financial profile.

NXST is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov. 

Streaming and Dreaming at Disney

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Disney (DIS) reported its first quarter under its new reporting structure which is designed to isolate the company’s three main businesses and especially highlights the Direct-To-Consumer (DTC) streaming businesses that are the future of the company’s media businesses.  Results in the company’s 1Q21 were better than guidance and analyst expectations but are not a short-term catalyst given (1) confusion related to the new accounting treatment, and (2) the huge run in the shares over the past several months.

Northlake continues to like DIS long-term based on success in streaming and a return of the company’s theme park and movie businesses to pre-pandemic levels.  DIS has elements of both COVID winners (streaming) and COVID losers (theme park and movies) that give investors a bullish story over the next twelve months.  That said, we could see the stock stall for a stretch before the next leg up later in 2021. 

Our revised price target is $225, up 20% from current levels.  It is important to note that we are using an unusual approach to valuation for DIS.  First, we’re looking out to 2023 to value the core businesses now placed in the company’s Content Sales and Licensing, Linear Networks, and Parks, Experiences and Products business segments.  These areas have been the most hard hit due to the pandemic and even with full vaccinations achieved in CY21, we do not expect the business to fully return to pre-pandemic levels until 2023.  We value these lines at 12X 2023 estimated EBITDA with Parks and the film studio worth a premium and the traditional TV media assets worth a discount.  Second, we value the DTC streaming businesses led by Disney+ at 80% of Netflix’s current market capitalization.  This is admittedly an arbitrary valuation measure but we believe that DIS has already proven its subscriber base will match Netflix within several years.  We use 80% of Netflix’s valuation since DIS is not yet close to profitability, unlike Netflix, and DIS average revenue per streaming subscriber (ARPU) is only about 1/3rd of Netflix.

Given movie theaters and theme parks are either closed or operating at limited capacity, there is not much to learn from 1Q21 results or management commentary on the conference call.  The DTC businesses remain the key driver of investor sentiment and stock valuation.  Overall, 1Q21 DTC results were better than expected led by another upside surprise in subscriber growth at Disney+.  Notably, ARPU fell to $4.03 from $5.56 a year ago as subscriber growth is presently being dominated by India.  However, excluding India, ARPU is holding firm.  ARPU is poised to inflect over the coming year as DIS has announced a price increase and many of the wholesale distribution agreements, such as with Verizon, are expiring.  This brings up the questions of churn.  Management is encouraged by early trends and is optimistic churn will be low.  In Northlake’s opinion, Disney + and the bundle including ESPN+ and Hulu (and Star soon to roll out abroad) offer excellent value which will limit churn.  Management was smart to initially price Disney+ and the bundle very aggressively to drive a quick ramp to scale in subscribers.  DIS has already joined Netflix as a winner in the Streaming Wars while success for everyone else remains uncertain.  As noted at the start of this blog post, operating losses in DTC were much smaller than expected.  Management refused to pull forward its timing of 2024 for DTC profitability and still maintains its outlook that losses will peak in 2021. We think profitability should be reached prior to 2024, and after making assumptions off the 1Q21 DTC segments we think that it is possible FY20 will be the peak for segment operating losses.  If we are correct, this would be the next major positive catalyst for DIS shares and lead to achievement of our $225 target.

DIS is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.  DIS is a net long position in the Entermedia Funds. 

Patience Will Continue to be Rewarding at Activision Blizzard

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Activision Blizzard (ATVI) reported 4Q20 results roughly in line with Wall Street estimates that were above the company’s own guidance.  More importantly, management provided initial 2021 guidance that was above analyst estimates and appears to be based on conservative assumptions.  ATVI shares have been fantastic performers for Northlake over the years and had a particularly good year in 2020.  Along with other video game publishers, ATVI has been a huge beneficiary of the COVID pandemic thanks to work from home creating more time for video game play and reallocation of entertainment spending.  Investors have had concern about tough comparisons in 2021, so the guidance for a good growth year was a relief and well received with the shares jumping nearly 10% to a new all-time high. 

Northlake has raised its outlook for ATVI but even with that we have a hard time justifying a stock price much above current levels based on the 2021 outlook.  We can see a path for further upside based on potential 2022 results.  Given our long-term success with ATVI, the company’s excellent track record, and what we view as a very positive strategic shift the company made in early 2019 that has set the stage for growth over the next few years, we are going to stick with ATVI.  We may have a period of consolidation in the stock over the coming months but in the case of ATVI we think patience will be rewarded with another leg up.

We had several key takeaways from the company’s quarterly call.  First, the 2021 guidance does not include any revenues from the next versions of Diablo Immortal and Overwatch.  Previously, consensus included some revenue from these games.  With guidance ahead of expectations, this implies that management expects a big year from the newly enlarged Call of Duty (CoD) franchise and solid results from a remaster of an old version of World of Warcraft (WoW).  Second, the enlarged CoD is a big winner and a template for future game development.  Back in 2019, ATVI decided to no longer produce games in the previously popular Destiny series and instead focus on other key titles including CoD, WoW, Diablo Immortal, and Overwatch.  At the time, ATVI and other publishers were under a lot of pressure due to the popularity of Fortnite.  ATVI made the decision to narrow its focus and broaden the reach of its franchises with free-to-play and mobile games.  The company began with its most important franchise, CoD.  Success was immediate; CoD is bigger than ever with multiple revenue streams including a greater percentage of high-margin digital revenue.  The CoD playbook is now a template for ATVI’s other major franchises. 

We expect similar success in Diablo, WoW, and Overwatch to roll out in 2022 and beyond and sustain the company’s growth rate.  This is the main reason we are willing accept the possibility of a trading range in ATVI shares up and down from the new all-time highs. With 2021 looking like a growth year despite challenging comparisons, we look ahead to 2022 when ATVI should be back on its beat-and-raise game.  We can justify another 20% upside in ATVI on the assumption the company exceeds initial 2022 estimates.  Given the company’s excellent track record, we are willing to wait if patience is required.

ATVI is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.

Sony Raises Guidance and Northlake Raises Target

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Sony (SNE) provided a great boost to our investment thesis with the company’s 3Q20 earnings results.  Earnings easily beat Wall Street estimates with strength in almost all segments.  Gaming and Image Sensors led the way.  Gaming got a boost from the rollout of the PS5 console, popular new games, and continuing subscription growth.  Image Sensors saw big gains from sales to Apple for the iPhone12 family and a return of shipments to Huawei.  Beyond the strength in Games and Image Sensors, better sales of Electronics Products (TVs, cameras), Music, and Pictures (film and TV production) also contributed.  Even more important than the earnings results, Sony raised operating income guidance for its fiscal year ending on 3/31/21 by 34%. 

Our initial investment thesis for Sony revolved primarily around the idea that the stock trades at a modest EBITDA multiple of less than 10X after backing out the value of 100% owned Sony Financial and a large portfolio of investments.  This is the case even though peer pure play competitors in video games, music, semiconductors, and film and TV trade for 15-20X EBITDA. 

Sony is a complicated Japanese conglomerate.  Complex conglomerates generally trade at a discount to the sum of the parts.  In the case of Sony, we think the discount is way too high, especially considering the company has no debt, substantial cash reserves, and is operated conservatively consistent with Japanese culture.  Furthermore, over the past ten years, Sony has dramatically narrowed its focus to the current set of mostly above average growth businesses and improved capital allocation in favor of shareholders.

The current CEO was elevated last year from the CFO position where he played a huge role in the company’s transformation.  Along with the 3Q20 release, management hinted at future growth plans that focus on better coordination across the business segments, particularly when it comes to synergy in content between video games, film and TV production, and music.  Sony is nearing the end of its latest three-year plan and is due to provide new targets in the spring.  We expect heavy reinvestment of the company’s substantial and growing cash flows in these businesses.  We also expect expanded capacity for semiconductors given Sony’s leadership position in camera technology utilized in high end smart phones and automated vehicles.

Sony’s 3Q20 results provide support for a higher multiple for the shares against material increases to earnings estimates following the 3Q20 report.  This explains the 10% pop in the shares the day after the report.  Due to the strong quarter and management comments, we are raising our multiple target from 13X to 14X on newly increased EBITDA estimates.  We also add the value of Sony’s large investment portfolio including stakes in Tokyo-listed M3, and U.S.-listed Spotify, Bilibili, and Tencent Music.  Finally, we also include for Sony’s wholly owned subsidiary Sony Financial that is excluded from EBITDA estimates.  Putting it all together, our target for Sony increases to $145 from $125 at the time of our purchase just two weeks ago. 

Sony is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov. 

Perfect ABCs at Alphabet

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Alphabet (GOOG/GOOGL) reported excellent 4Q20 results across the board in all segments and on all financial metrics.  Revenue, EPS, Operating income and profit margins each easily and materially beat Wall Street estimates.  These factors alone are worth a nice boost in GOOG/GOOGL shares.  However, the company also took another meaningful step to improve financial disclosure by breaking out revenues and operating profits for its fast-growing cloud business unit.  Google has long been criticized for its lack of disclosure, so while this additional information was promised this quarter, the underlying detail it revealed also helps the shares. This is exactly the type of earnings report Northlake hopes to see.  Better than expected results that lead to rising estimates and support expanded valuation metrics.  Simply put, Alphabet’s results are a catalyst in the short-term and support a more bullish multiyear thesis.

Google’s core advertising businesses including search and YouTube reported the best growth in almost two years.  Search bounced back to 17% growth from just 6% growth last quarter as advertisers appear to have returned despite the ongoing pandemic.  YouTube was particularly strong with revenue growth of 46%.  YouTube is reliant on brand advertisers that cut back sharply during COVID even as direct response advertising from e-commerce companies increased.  One concern for Google was that it was losing share to Amazon for product searches.  The fourth quarter results strongly suggest this is not the case.  Besides the return of brand and retail advertisers, Google also saw strength in technology and entertainment verticals.  This is very encouraging given that Google has large exposure to service industries in travel and hospitality, around 10% of advertising revenue, and these areas are poised to recover later this year and through 2022.

The widely anticipated results from Google Cloud revealed mixed news.  Revenue growth was fantastic at 48%, up a little from the growth last quarter and better than Amazon AWS.  However, the operating margin came it at -32% versus expectations as high as breakeven.  Clearly, Google is investing heavily for what it sees as a big opportunity in cloud services.  The company is way behind the top two players, Amazon AWS and Microsoft Azure, and the cost of catching up might be higher than Wall Street expects.  In 2015/16 AWS was about as large as Google Cloud is presently.  Back then AWS had a positive 25% operating profit margin.  Alternatively, Google Cloud spent 60% as much in operating expenses in 4Q20 and produced just 1/3rd the revenue of AWS.  Fortunately, investors do not mind, and maybe even prefer, heavy investments ahead of big new addressable markets.  Google Cloud should see profit margins hockey stick higher at some point but management cautioned that heavy spending would continue in 2021.

One positive of the larger losses at Google Cloud is that is that it implies that the margins at core Google search and YouTube are higher than expected both presently and historically.  Google profit margins have been a point of contention over the years.  The company spends aggressively to pursue growth.  Learning that core margins have been better than it appeared helps build confidence in the financial model and management’s discipline on expenses.

Overall, the quarter is a big win for Alphabet investors.  The results and added disclosure provide a near-term catalyst for the shares, which rose about 7% in immediate response.  For long-term investors like Northlake, the news is even better as the added disclosure and great results support elevated long-term growth expectations.

We have updated our valuation analysis for GOOG/GOOGL.  We have increased estimates of EBITDA, our primary valuation metric, based on the better revenue growth and margins in the 4Q20.  Management comments suggest growth is sustainable, especially given a coming boost from advertisers in leisure, travel, and hospitality.  We also slightly raised the multiple given the improved disclosure and transparency and the rapid growth at YouTube and Cloud.  Competitors in these businesses receive very high valuations.  Finally, we continue to add hidden value for Alphabet’s leadership in automated vehicles via Waymo along with other investments the company has in its Other Bets. 

At 15X 2021 EBITDA plus 60% of 2021 projected free cash flow and $80 billion in hidden value, we believe the shares have upside to $2,300, 12% higher than current prices.  Even higher targets can be calculated on a sum of the parts of the basis.  This approach is gaining more adherents now that adequate disclosure about the company’s business units have finally arrived.  Northlake clients will continue to hold GOOG/GOOGL and we will use any weakness to add to positions for newer clients.

GOOG/GOOGL is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov. 

Facebook Outperforms Again While Keeping 2021 Expectations in Check

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Facebook (FB) reported a strong beat on 4Q20 sales and earnings, topping expectations for the third consecutive quarter. Guidance for 2021 was unchanged from the initial outlook provided last quarter. FB continues to caution investors about a potential headwind in 2021 from changes to Apple’s data privacy policy and warned that 2H21 faces difficult comparisons after the strong performance in 2H20. Despite again beating expectations, the stock traded lower following the report as investors digested the warnings about 2021.

FB typically issues conservative guidance on expenses early in the year and has done well to keep expenses below the high end of guidance in recent years. Northlake expects this to occur again in 2021 and sees the potential for operating margins to improve long-term as FB gets more control over the security and privacy issues that have been driving expense growth for the last couple years. Similarly, concerns around the revenue headwinds from Apple’s privacy change and difficult 2H21 comparisons should ease throughout the year. However, investors may remain cautious on FB until there is evidence that guidance and warnings are once again conservative. More details on the impact from the Apple privacy changes should emerge earliest in the year among these three concerns. Investors may have to wait until the 3Q21 report to have a better sense of where 2021 expenses and difficult growth comparisons will end up. Earnings estimates for FB increased after the report, signaling analysts’ faith in the company’s ability to continue outperforming expectations despite the upcoming headwinds.

Investors are paying a large premium for growth in today’s market environment.  However, FB appears very reasonably valued compared to its consistent and sustainable high rate of growth. A relatively conservative valuation of 25x 2021 EPS of $11.18 would imply a near-term target of $280, or 7% above the current price.  A P-E of 25x 2022 EPS of $13.50 would get the stock to $337 with upside of 28% from current levels. Should FB continue to beat expectations, EPS estimates for 2022 and beyond should keep climbing higher, and the 25x target multiple could have room to increase. Northlake is willing to look past 2021 headwinds and focus on 2022 EPS and our target of $337+/

FB is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.

Sticking With Small Cap and Our Take on GameStop

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There are no changes to our thematic recommendations and positions for February.  Northlake remains all-in on small cap and neutral on growth vs. value.  Clients will continue to hold positions in the Russell 1000 (IWM), the Russell 1000 Growth (IWO), and the Russell 1000 Value (IWN) for at least another month.

Small cap did very well to start the year. Each of IWM, IWO, and IWN gained about 5% in January against a small loss for the benchmark S&P 500.  Northlake has liked small and mid cap for some time, but it took until the fall for the multiyear trend favoring large cap to reverse.  The anticipation of a post-vaccine surge in economic growth has caused a rotation from COVID winners to COVID losers.  This has really helped relative performance of small and mid cap and value as investor’s narrow obsession on large cap growth winners like Facebook, Apple, Amazon, Netflix and Google has given way to a much broader market advance.  We believe this trend will remain in place in an overall bullish market environment during 2021.  Northlake client portfolios are positioned with a nice balance between large cap growth in the individual stock portfolio and small cap and value exposure in our thematic index strategy.

GameStop, Short Squeezes, Option Gamma and A Market Correction

With no change in our thematic strategies, we thought a few words about the crazy action in the market last week would be interesting to clients.  Specifically, we are talking about GameStop and the wild trading that bled over to the broad market.  Our conclusion is that the GameStop and the Reddit forum WallStreetBets frenzy triggered a market correction.  However, we do not believe that the correction was based on fundamentals   We still see positive market and economic fundamentals ahead in 2021.  The correction in the broad market had to do with institutional portfolio positioning and fears about the health of plumbing that underlies daily trading activity. 

Northlake’s 2021 market outlook stated that a first quarter correction was possible before the market resumed its bullish trend through the first half of the year.  We are not sure whether last week’s decline was the correction we were looking for but at its deepest point, the S&P 500 was down about -5% from its all-time high.  This is a textbook level for a correction.  It fits perfectly in the playbook that the correction came from a factor no one had been anticipating.  Markets tend to be protected against anticipated crises and unprepared when something new and unusual occurs.

The GameStop story is complicated, and sadly Northlake clients did not own GME shares.  GameStop is a deeply troubled retailer.  It is steadily closing stores as video games are rapidly transitioning to purchase via download.  Sales are half the level of ten years ago.  Operating profits have gone from a $700 million profit to a -$300 million loss. 

GME shares fell from a high of around $60 in late 2013 to below $5 before the pandemic hit.  Along the way, short sellers who were betting against the company made a fortune.  Short selling is a legitimate hedging and investment strategy where investors borrow stock from a broker (paying interest on the value of borrowed shares) and sell it with the hope they can buy it back at a lower price.  For example, in early 2018, an investor might have determined that GameStop was in real trouble, borrowed the shares, and sold them at $20 with the hope at buying them back at $10.  Short selling is controversial because it cuts against the grain of bullishness and optimism that is associated with stocks.  Short sellers will often publicize their positions hoping to trigger a downdraft in the stock.  However, this is really no different than the daily parade of portfolio managers who appear on CNBC and promote their long positions.

What happened at GameStop was that even after the shares had declined steadily to below $5, short sellers kept piling on, likely assuming the trend toward game downloads would lead to bankruptcy.  In Northlake’s opinion, this was a good investment thesis.  However, the shorts got carried away and borrowed more shares than were available to trade (actually possible).  This left GME shares vulnerable to the time-honored Wall Street tactic known as a “short squeeze.”  A short squeeze occurs when traders gang up on a heavily shorted stock, attempting to drive the share price up and force short sellers to cover (buy back the borrowed shares they sold).  When this situation occurs in a heavily shorted stock like GME, the buying of the attacking traders and covering short sellers can lead to a rapid and large gain in the shares.

This brings us to GameStop in the summer of 2020.  WallStreetBets is a popular message board on social media website Reddit.  Reddit’s is popular with millennials and younger generations.  During the pandemic, the investing by younger people has soared.  This has been due to (1) having time on their hands while working from home, (2) stimulus checks, (3) the elimination of commissions on stock trades, (4) easy access to information via the internet, and (5) simple-to-use trading apps like Robin Hood.  Social media sites like Reddit allow retail investors to exchange investment ideas.  Social media can do the same thing for a stock idea as it does for politics and quickly amplify information and attract like-minded individuals.

In August, a very well-written and well-informed bullish analysis of GameStop was posted on WallStreetBets.  The author noted that GameStop had attracted an important new investor, the founder of Chewy, who perhaps had ideas of how to rescue the company.  Also noted was that in the past, when a new gaming console cycle occurred, GME shares were able to buck their long-term downtrend and produce a positive trading return.  Finally, it was noted that a massive short squeeze could occur as outlined above.  GME shares moved from $5 to $20 on this thesis between August and the end of 2020. For what it is worth, Northlake believes GME is worth no more than $20 and likely under $10.

In January, GME shares exploded with the stock reaching $490 last week.  This was caused by WallStreetBets investors all buying shares and call options in GME at the same time.  The call options added massive fuel to the fire.  An investor buys a call option to bet on a rise in a stock price over a particular period of time. For example, in December an investor might have bought a call option allowing the purchase of GME shares at $40 by January 15th when the stock was trading for just $20.  A broker sells the call option.  The broker is now on the hook to deliver shares of GME should it move above $40 by January 15th.  To protect their trading book, the broker will buy enough GME to hedge the sale of the call option.  If GME shares begin to rise toward the $40 strike price, the broker needs to buy more and more shares. Many of the articles about GME discuss option gamma.  Gamma is one measure of the changing relationship between a stock’s price and the strike price options. Gamma rises as the a stock rises toward the option strike price.  Gamma is what forced option brokers to buy GME as the stock rose.

WallStreetBets is made up mostly of small investors who love buying call options because you can make a small investment that controls a much larger value in shares.  1 call option for GME at $40 gives the holder the right to buy 100 shares at GME at $40.  The call option might cost less than $400 but control an investment worth $4,000.

In January, all these factors combined to create a perfect storm.  WallStreetBets used commission-free trading apps like Robin Hood to buy millions of call options on GME with social media amplifying the number of retail traders. The move higher in GME trapped shorts and forced them to cover their positions by buying back their shares, often involuntarily, as the lender of shares demanded repayment or more collateral.  Brokers who had sold call options were forced to buy ever more shares as the stock moved up (and more options were sold at higher strike prices) so that they had hedges to meet the winning option trades.  As GME shares exploded higher, this sequence became a circular prophecy.  Ultimately, thousands or tens of thousands of individual investors had stormed Wall Street in a populist uprising not unlike the populist political upheaval that has taken place around the globe in the past ten years.

The final step in the GME craze came as individual investors applied the strategy to a series of heavily shorted stocks including BlackBerry, Nokia, Bed Bath and Beyond, and AMC Theaters.  It is notable that that these are troubled companies with dying consumer brand names making it easy for individual investors to understand the concept of squeezing the shorts.  Almost all stocks with large short positions soared.  Several large hedge funds with big short positions took huge losses and required bail outs.  Large brokers and exchanges faced pressure to raise capital as the massive volumes in shorted stocks left them potentially without enough capital to settle the trades.  There was palpable fear that the plumbing underlying the purchase and sale of shares was springing leaks.  Fund managers, not just hedge funds, decided to protect against a worst case scenario, buying new hedges and selling holdings to raise cash reserves.  Stocks that had nothing to do with GameStop or shorting or options gamma began to fall.  The volume became overwhelming on the sell side and the overall market closed the week down -3% after reaching a low of -5%.

Beyond the fluctuations in client portfolio values, the GameStop correction had little impact on Northlake.  We concluded that the decline was due to unusual technical trading factors that had nothing to do with the basic market fundamentals of low interest rates, a strong post-vaccine economic outlook, more stimulus coming from Washington, and most importantly, a Federal Reserve that stands ready to protect the market through easy monetary policy or extraordinary steps to protect market functioning.

Whether the correction is over is an open question.  Monday’s trading suggests perhaps it is.  Northlake remains moderately bullish as outlined in our January 2021 Stock Market outlook.  Last week, we took a step to reduce cash balances with the purchase of Sony Corporation.  We see any correction as an opportunity to further reduce cash balances and are actively monitoring several new stock ideas.

Sony, Apple, Facebook, and Google are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.