Why GameStop's $2.1 billion stock sale taxes its shareholders and hurts the economy

By Larry Harris

Foolish traders are indirectly funding GameStop's balance sheet

GameStop's (GME) volatility has surged with Roaring Kitty's reentry onto the scene. His significant role in trading meme stocks is putting GameStop in the spotlight once again.

Less known is GameStop's announcement earlier this month that it raised $2.1 billion by selling newly issued stock directly to the market. These sales are costly to both GameStop traders and the U.S. economy in ways that most people do not recognize. Here's how these events are connected.

Three years ago, GameStop shares spiked when Reddit's WallStreetBets commentators speculated that the large short-selling interest - then about 100% of all shares outstanding - would buy in to cut their losses if prices spiked.

They were right. When the short sellers bought, GameStop's stock price accelerated. A stock that had been worth only $1.25 rose to an intraday peak of just $120 (after adjusting for a subsequent 4-for-1 split).

Those buyers smart enough to close their positions profited handsomely. The short sellers lost, as did many buyers who foolishly thought that the climb would never end. By my estimation, those foolish buyers lost more than the short sellers.

GameStop has become the ultimate video game.

This time, the short sellers are hardly involved with GameStop. They learned their lesson and won't be big losers this time. Instead, it's individuals who are buying GameStop shares, dreaming of the riches they hope to make.

Ironically, GameStop, a company devoted to promoting and profiting from the video game industry, has become the ultimate video game. But unlike video games, this game is rigged against the traders in ways that most do not understand.

When GameStop's stock spiked three years ago, and twice again over the past few weeks, the company sold newly issued shares directly into the market. These sales have raised a total of more than $4 billion in cash, adding about $11 per share to GameStop's book value. GameStop now has more fundamental value than it had before trading its shares became a game.

But GameStop's market value is still well above its fundamental value by almost everyone's estimation. And, of course, the best-informed traders are GameStop's senior managers and board of directors, who presumably understand their business better than anyone else. They undoubtedly directed GameStop to sell new stock because they believed the shares were overvalued.

GameStop's shareholders are better off because GameStop sold shares at prices above their fundamental value. But every GameStop shareholder still owns stock worth more than its fundamental value. Eventually, the price will fall as short sellers regain their nerve and fearful shareholders try to lock in their profits or stop their losses.

The money that GameStop raised did not come out of thin air.

The money that GameStop raised did not come out of thin air. It came out of the markets when GameStop sold shares to eager buyers. Those buyers, or whoever they ultimately sell to, will lose when GameStop ultimately falls to its fundamental value.

Every trade has a buyer and a seller. If prices fall, the buyer will lose, and the seller will have avoided that loss. If prices rise, the buyer will profit, and the seller will have lost the opportunity to profit.

Trading is a zero-sum game because the gains to one side are equal to the losses of the other. But when one of the sellers is the company itself, the rest of the buyers and sellers will lose in aggregate if the company profits. Thus, the money that GameStop raised is a tax on all the other traders.

Eventually, traders will figure this out. Losers will quit trading, and the winners will have nobody to profit from. GameStop's stock will eventually return to earth.

The biggest loser

In the meantime, consider the losses our economy suffers from these episodes. The money that GameStop raised issuing new shares is money that it now controls. It will waste this capital if it uses it to sustain its business, which continues to regularly lose money.

GameStop is in a declining industry. People are not buying video game software and hardware from brick-and-mortar shops like they used to, and no reasonable analyst expects this trend to reverse. Instead, GameStop's former customers now buy these products on the internet from well-established Internet vendors. Making further investments to sustain these brick-and-mortar shops is unwise.

The money that GameStop raised would likely be more useful to society if it supported research into better drugs, materials, or energy sources, to name just a few potential uses. Perhaps GameStop's management will make these investments wisely, as its board recently authorized it to do. But no reason suggests that the managers of a video game retailer would make wiser investments than the millions of investment professionals trained in the various sciences required to make good value judgments.

Foolish traders are indirectly funding GameStop's balance sheet through an extraordinary capital allocation system. We can only hope that GameStop's managers use their newfound wealth wisely.

Larry Harris is a professor of finance and business economics at the University of Southern California Marshall School of Business. He was chief economist of the Securities and Exchange Commission between 2002 and 2004.

More: Is GameStop the next Berkshire Hathaway? Here are 3 ways the company could spend its $4 billion cash pile.

Plus: Why Roaring Kitty is a GameStop 'true believer'

-Larry Harris

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06-25-24 1554ET

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