In a few words before the House Committee on Financial Services in mid-May, Gary Gensler, chair of the Securities and Exchange Commission, captured the amazement and anxiety gripping U.S. stock markets.

“A stock that went from $20 to $480 and back down to $40, all in a matter of weeks, opened at $162 this week,” said Gensler. “GameStop, though, was just one of the many so-called ‘meme stocks’ that exhibited significant price volatility, trading volume, and attention in the markets.”

Seemingly out of nowhere, in January 2021 (four months earlier), the shares of formerly high-flying video game retailer GameStop had undergone a short squeeze. The culprits? Retail investors were chatting up the stock on social media platform Reddit. Specifically on its r/wallstreetbets online forum. The meme stock phenomenon was born.

The brand that started it all

Meme stocks generally experience a rapid increase in share price due to their brand heritage, fervid promotion on social media, technical trading signals, or all three. Underlying fundamentals like revenue and earnings play little or no role. Instead, the emotional attachment to a brand compels retail investors to “save” a business that otherwise was headed for the dump heap.  At least that’s the hope behind the hype, which has attracted millions of retail investors to buy stakes in other formerly successful public companies like AMC, Hertz, and Virgin Galactic.

Despite companies’ initial hesitation about the phenomenon, some have come to view it as an opportunity. The gulping roller coaster ride of many meme stocks merits attention from CFOs — whose companies may be in meme stock territory, whose investment portfolios may diversify into these stocks, and whose competitors can become meme stocks and amass a war chest to recapture the market share they once lost.

An Opportunity

Economists, institutional investors, management consultants, and shareholder organizations paint a picture of a fast-changing investment environment in which ordinary income earners are changing the public markets — for good, better, and worse. The challenge in bullish stock markets is knowing which. “There’s an old saying that rising stock prices make geniuses out of a lot of people,” says Eric Freedman, chief investment officer at U.S. Bank.

GameStop and other meme stock companies initially ignored the huge jumps in share prices. They didn’t want to dampen the animal spirits or draw the ire of the SEC.

Now, though, some CFOs of distressed companies effectively shunned by institutional investors, investment banks, private equity, and other sophisticated asset buyers see it as a capital-raising opportunity.

“As the stock price rises for a company with challenged fundamentals, it allows the CFO to raise equity or debt capital at spread levels that are more attractive than what they were previously,” says Freedman.

Assuming the CFO and board of directors have a business rebound strategy in mind, the capital infusion can be tapped to aim the business in a new and more profitable direction. Even better, the capital can attract other capital from more traditional sources.

“As the stock price rises for a company with challenged fundamentals, it allows the CFO to raise equity or debt capital at spread levels that are more attractive than what they were previously.”

— Eric Freedman, chief investment officer, U.S. Bank

“Retail investors squeezed out by the big boys eventually garner the big boys’ attention,” says economist Robert Hartwig, a professor of finance at the University of South Carolina. “Institutional investors see opportunities to gain on a speculative investment reinvigorating an older brand that had fallen off their radar screens, other than to short the stock.”

While these brands usually have financial problems, they may have been excessively shorted by the big hedge funds and investment banks relative to their actual value. By understanding where the short positions were taken and then taking the opposite tack, meme stock investors force the big investors to lose money and simultaneously refocus their attention on the brand.

As a meme stock’s price soars following the surge of retail investments, the company’s board may be encouraged to rethink the value of current strategy and management, resulting in hiring a new CEO and CFO, explains Hartwig. This was the case at GameStop and Hertz. “Hertz is a perfect example of a meme stock that rose from the dead with a new management team and reorganization plan,” says Hartwig.

“Countless other stocks like [movie theater chain] AMC were beaten down by the pandemic and were overly shorted,” says Hartwig. “Nobody went to the movies because they couldn’t. Meme stock investors understood better than the big investment houses that a recovery from the pandemic was inevitable.”

He adds, “I went to an AMC movie theater with my wife this past weekend, and it was pretty busy.” So was AMC’s stock, which finished the second quarter up a blockbuster 455%.

“Degenerates”

Much of what drives meme share prices is information — opinions broadcast on social media forums like r/wallstreetbets, a subreddit that fires up imaginations and possibilities about speculative investments. Forum users have their own jargon and refer to themselves as “degenerates.” Given the profanity-laced comments on r/wallstreetbets, particularly against short-sellers and hedge funds, the term makes sense.

Individually, “degenerates” may seem harmless. But when they become a crowd that reaches a consensus on a stock, they wield tremendous power and influence. Hertz is the poster child illustrating this clout.

Poster child

On May 22, 2020, as the pandemic killed off the travel sector, Hertz filed for Chapter 11 bankruptcy protection and laid off some 16,000 employees. Against all logic, retail investors began buying Hertz stock, ultimately bidding the shares up by more than 800%.

As retail investors lifted its stock to stratospheric heights, an investor group led by Knighthead Capital and Certares took the company out of bankruptcy on June 30.

Significantly, the bankruptcy did not wipe out shareholders. The bankruptcy plan gave them $1.53 per share in cash, a 3% stake in the restructured business, and warrants to purchase as much as an additional 18% stake.  The company plans to relist its shares on a major exchange by the end of the year. (It now trades on the pink sheets.) Mission pretty much accomplished.

Such Lazarus moments seemingly take great courage on the part of investors. But, with the economy strong and interest rates expected to remain low through 2022, this segment of the investing public seems unafraid of taking on more risk. What goes up will go down at some point. And that raises the question: will seasoned investors like asset management firms continue to jump on the bandwagon of retail investor-fueled speculative stocks once the equity markets cool and interest rates rise?

In other words, if the economic uplift degrades, the window for CFOs looking to take advantage of the meme stock phenomenon could close quickly.

“If a company’s stock and stock options are underwater or nearly worthless and it is willing to make some substantive changes, now may be the time to do it,” Hartwig says.

U.S. Bank’s Freedman agrees. “If the CFO can validate the retail investors’ enthusiasm through improved operations, increasing sales and cost efficiencies, what started as a cultish response to a flagging brand can result in favorable outcomes,” he says. “That’s a pretty powerful narrative for a CFO to bring to the board — the capital markets had faith in us, and we delivered.”

But Wes Bricker, vice chair, U.S. Trust Solutions co-leader at PwC, notes a potential downside to a rising stock price for CFOs planning a share buyback.“If there’s a short squeeze on the stock that changes dramatically because retail investors have piled in to buy it, the CFO is stuck buying back the stock at highly-inflated prices,” he says.

That scenario affects the number of shares the CFO can buy, as their price is higher. Says Bricker, “If the CFO is forecasting earnings per share based on the effect of the share buyback, [he or she] now needs to revisit and potentially revise the [earnings per share] estimate.”

A Bubble?

The considerable risk in meme stocks is their substandard (and worse) fundamentals. Of course, the share prices of many companies with poor cash flow and earnings fare better than common sense might dictate. Indeed, the trading signals and analyses of a stock’s price trajectory are equally instructive of a potential upward trend. Nevertheless, Roger Aliaga Diaz, head of portfolio construction and chief economist, Americas, at Vanguard, differentiates meme stocks as an anomaly for two factors — “social media frenzy at a time of U.S. economic growth,” he says.

What looks too good to be true could be just that.

“When a stock price fed entirely by information shared in an online forum keeps increasing and increasing, there’s a significant probability that it will become a zero-sum game,” Diaz says. “When prices detach from reality, one investor’s gain is effectively the equivalent of another investor’s loss. It’s hard to say who the winners and losers will be.”

“When prices detach from reality, one investor’s gain is effectively the equivalent of another investor’s loss. It’s hard to say who the winners and losers will be.”

— Roger Aliaga-Díaz, head of portfolio construction and chief economist, Americas, Vanguard

Retail investors who fail to rake in their winnings, thinking a particular meme stock has more juice in it, can end up being losers. This was the situation for investors in several meme stocks like GameStop and AMC, whose share prices skyrocketed before plummeting in late June, only to rise from the ashes again in mid-July.

“Meme stock price movements are similar to housing bubbles, where people think it’s a `no brainer’ to buy a house and flip it for a profit, until the housing market turns, the bubble bursts, and they’re underwater,” Diaz says. “By contrast with a more diversified approach to long-term value creation, meme stocks are not an enduring way to save for retirement and children’s college expenses.”

For the issuer, the result is incredible volatility, as short-term shareholders join the stampede and then sell their shares when the hoopla dies down. The wild price swings can also cause long-term shareholders to sell, thinking the stock is now outside the bounds of their risk appetite.

What’s important for CFOs to realize is that retail investors are a powerful force, and they must have access to good information about a company. It’s unlikely that every millennial retail investor chatting up a meme stock like GameStop with other “degenerates” has any idea about its executive compensation methods, debt levels, or shrinking margins. Given this possibility, meme stock CFOs must ensure that information outside of mandated regulatory disclosures that are disseminated to ordinary investors is “complete, accurate, and reliable,” says PwC’s Bricker. “Often, the 140-character posts on social media lack enough context about the risks and prospects of a meme stock.”

Investors that feel hoodwinked by stocks may lose trust in the entire equity investing ecosystem.

“The integrity of the U.S. stock markets, which have earned the confidence of countless millions of investors domestically and abroad, depends on basic protections like full, fair, and honest disclosures,” Bricker says. “If investors lose confidence, companies won’t have access to the lower cost of capital they’ve enjoyed for years. Our markets are truly a national treasure, one we must safeguard and protect.”

Russ Banham is a Pulitzer-nominated financial journalist and best-selling author.

Photos: Justin Sullivan/Getty Images (GameStop), Cindy Ord/Getty Images (Hertz); Main image by Gerd Altmann from Pixabay

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