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In case you haven’t heard, something big happened in the stock market last week that brought about widespread disruptions in US trading, affecting multiple brokers. 

Oh, and some of the largest companies in the world reported earnings: Apple’s and Tesla’s earnings.

Something big: the GameStop saga briefly explained

Much has been written about what led to the battle between retail traders (specifically folks at WallStreetBet) and the hedge funds who have placed short positions in stocks such as GME, AMC, and others. 

For a good brief history, this twitter thread explains it succinctly (it actually started about a year ago). But here’s a high level summary:

  • Hedge funds started putting short positions on certain struggling companies. A short position is a bet that the share price will decline in the future. By taking a short position, investors borrow stocks to sell now, with the expectation that the stock price will decline. If the stock price declines, these investors then can buy it at a lower price, return the shares that were borrowed and pocket the difference. But if the price goes up instead, they have to buy the stocks at a higher price to cover the initial loan. And because share prices can rise without an upper limit – the losses can be unbounded
  • In contrast, retail traders were placing bets that the stock will increase in the future (either through buying the stocks outright, or buying options on margins, amplifying the trade volume). After gaining mainstream recognition, more and more retail traders joined the foray, pushing these stocks even higher.
  • As the stock price edged higher, the hedge funds got squeezed. They have to buy back stocks at a higher price to cover their initial short position
  • This became a game of chicken, but undoubtedly the retail traders were winning, placing the hedge funds in a precarious liquidity position. 

Events took a turn last week when mainstream media caught on, amplifying the retail frenzy even further.

On Thursday, January 28th 2020, the additional volume and volatility caused stress in the market. Nasdaq stopped trading on GME 19 times in one day – as the share price repeatedly hit the volatility circuit breaker. The impact was not limited to GME or these shorted stocks either. Widespread outages and trading disruptions were reported on many retail investing apps.

On the same day, some of the largest retail brokers in the world stopped taking new buy orders on these high flying stocks. Generally, there are several reasons why they did this (at least what has been disclosed publicly):

Mitigating risk for the broker

The price ran up and the high volume is largely because the majority of these retail traders use both leverage and options, amplifying the trade volume on the stocks with funds they may or may not have.

So, if the customers of these traders are unable to pay for their losses when the share price takes a turn, the brokers have to put their own funds to cover the losses to the clearinghouses. 

Liquidity Concerns

This risk raises liquidity concerns for the brokers. Even though trades appear instantaneously on your apps, in reality, there’s a lag – it takes two business days for the trades to settle.

From WSJ:

“Because of a lag between when investors book new positions in a stock and when their cash is actually exchanged for securities, brokerages like Robinhood have to maintain deposit accounts at the clearing firms that help finalize trades. Clearing firms, such as the Depository Trust & Clearing Corp., require brokerages to post more of their own money in riskier times to insure against losses.”

If after two days one side of the trade cannot come up with the cash required, the broker has to foot that bill. Can the broker remain solvent if these large losses are incurred? This risk was amplified in recent days when trades were concentrated around a handful of stocks and they became extremely volatile. Because of this, clearing firms (such as Depository Trust & Clearing Corp, DTCC) asked brokers to increase their collateral requirements.

According to Bloomberg, on January 28th, DTCC raised the industry wide collateral from US $26 billion to US $33.5 billion, a 29% increase in one day!

For some brokers, this is not a concern, but the amount of cash that has to be set aside as collateral varies for different brokers. For Robinhood, the increased collateral requirement required it to raise US $1 billion, and while it was raising this cash, it had to slow down the trading volume.

These two reasons mentioned above might be the real reason why Robinhood ceased trades on these stocks on January 28th. Nonetheless, there has been much speculation that Robinhood was pressured to seize trading by the same hedge funds that are experiencing the short squeeze, but these speculations got the basic facts wrong. At this time, these speculations are still unproven (For what it’s worth, the hedge funds have denied that they’ve exerted influence on Robinhood). 

As of Friday, January 29th, Robinhood has allowed some trading on these stocks.

The impact on the market

This phenomena caused distortions in the broader market:

Hedge funds that are facing the squeeze are selling long term positions to cover money-losing short positions, causing a higher level of sell-off.

Figure 1: Hedge funds are selling their long positions (red line) to cover losses from short sales. Image taken from here

In an attempt to catch lightning in the bottle twice, some investors are betting that this phenomenon will expand to other heavily-shorted stocks. But remember, finding a heavily shorted stock is easy. The really hard part is creating mass coordination as what has happened with GameStop (and a handful of other stocks).

For a really good overview on how this heightened volatility is causing issues with the plumbing of the market, read this article

How this will end

We do not know when the phenomenon will end, but we saw a glimpse of how it will end on January 28th after Robinhood stopped buy-orders for these stocks. They all tanked. 

What we know is that the current valuation is completely divorced from reality. So when the music stops, everyone will try to exit their positions at the same time. And there will not be enough liquidity when that happens. Price will drop precipitously. Limit orders will not function properly. Even market orders will get delayed, as we have seen several times this past week. 

Someone will be left holding the bag.

Ok – let’s get back to our regular programming. 

Apple’s Sep – Dec 2020 Earnings

Apple’s quarterly revenue crossed the US $100 billion mark for the first time (for the last three months of 2020, it generated US $111 billion quarterly revenue for the first time ever). 

Three key takeaways

The first: net sales of all of Apple’s product categories increased by double digit percentages (iPhone: 17%, Mac: 21%, iPad: 41%, Wearables, Home and Accessories: 30%, Services: 24%). iPhone revenue topped US $65 billions, a 17 % increase over the same period last year (Figure 1).

Figure 2: Apple’s net sales by category

The second: sales went up in all regions. The largest increases were in Greater China (57% increase) and in Japan (33% increase); while sales in the largest revenue region, the Americas, increased by 12% (Figure 2).

Figure 3: Apple’s net sales by region

The faster than expected increase in sales in the Greater China region stems from two factors. The first is the decline of Huawei. Huawe’s shipments dropped by 41% in 2020, due to sanctions by the US that disrupted its supply chain (cutting of its supply to Android’s operating system and the latest chip for its devices). The second is 5G. 5G is becoming a must have feature for smartphones in China, as deployment of the new spectrum in China outpaces that of the US (China has about 690,000 5G base stations, compared to about 50,000 in the US).

The third: Not only did the net sales go up, gross margins went up as well. 

  • Gross margin for services (think Apple Music, Fitness, News+, App store and others) is at 68.4% (4% higher than the same period last year). The services business is an important segment for the company as it is much more profitable and may fuel the future growth of Apple. Services allow Apple to extract more revenue from its install base, which has increased by 10% over the past year (the company has achieved 1 billion iPhones install base).
  • Gross margin for hardware is at 35%, almost 1% higher than the previous year. This is notable because this is a reversal in trend seen from the past 2 years (Figure 3). This suggests that the hardware sales mix skews on the higher priced, higher margin products, possibly the sales of iPhone Pro and Pro Max. 
Figure 4: Gross margin of hardware products and services

Tesla Sep – Dec 2020 Earnings

What a crazy time we live in, when Tesla’s earnings do not dominate mass media. 

Three key takeaways

The first: The company beat revenue estimates (US $10.74 billion in revenue vs. US $10.4 billion expected), but missed on earnings (US $0.80 eps vs. US $1.03 expected). 

The second: Car deliveries and free cash flow were largely as expected (long term trends in Figure 5). As car deliveries continue to increase, Tesla’s cash position strengthens, which enables it to continue expansion of manufacturing capacity globally. And with the global manufacturing expansion, Tesla expects the long term average annual growth rate for vehicle delivery to be 50% year-over-year (this is notable because 50% growth rate is more than double the 22% growth rate from 2019 to 2020)

Figure 5: Tesla’s quarterly car deliveries and free cash flow. Data is taken from the company

The third: In the earnings call, Elon commented that the company is refocusing its efforts on the energy generation and storage business. This segment includes the deployment of solar panels and roofs and batteries (powerwall and the megapack). 

Although still a very small portion of the company’s business, the segment is poised to grow. Typically, renewable energy production, such as wind and solar, are more volatile, since they rely on the availability of wind and sun. As such, an energy storage solution such a battery pack installation can act as a buffer to provide more reliably supply.

Despite the pandemic, Tesla’s energy storage deployment grew 83% between 2019 to 2020 (Figure 6). 

Figure 6: Tesla’s energy storage quarterly deployment in GWh  

As of 2020,  the energy generation and storage business is only 7% of revenue and is still not reliably profitable (see Figure 7). Gross margin for the segment fluctuates between 6% to -5% in 2020, while margins for automotive revenue varies from 24% – 28%. For Tesla to meaningfully grow cash flow from this segment, it has to focus on lower installation costs and better integration between storage (Powerwall) and generation (Retrofit Solar and Roof).

Figure 7: Tesla’s energy storage quarterly deployment in GWh  

In summary, this is a pretty drama-free earnings release for Tesla. But as is the case for the past several years for the company – the issue is how to justify the valuation. Its market cap is about US $750 billion, about seven times that of Ford and GM combined.

This article is meant to be informative and not to be taken as an investment advice, and may contain certain “forward-looking statements,” which may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms.  Examples of forward-looking statements include, without limitation, estimates with respect to financial condition, market developments, and the success or lack of success of particular investments (and may include such words as “crash” or “collapse”). All are subject to various factors, including, without limitation, general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors that could cause actual results to differ materially from projected results.

Our team members at Vested may own investments in some of the aforementioned companies. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for an investor’s portfolio. Note that past performance is not indicative of future returns. Investing in the stock market carries risk; the value of your investment can go up, or down, returning less than your original investment. Tax laws are subject to change and may vary depending on your circumstances.

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