The purpose of this case study is to perform a post-mortem analysis of my 2017 to 2019 investment in GameStop stock. GameStop’s ticker is (GME). A post-mortem case study is a method of analysis whereby an investor analyzes their investment process and results for a particular investment. The goal of such a study is to determine what lessons can be learned from the investment. I am studying my past decision making in order to improve my personal investment process.
I am sharing the results of my postmortem analysis publicly, in the hope that it will aid other investors. The critical aspect to understand is not the specific discussion of this particular stock. Instead, you should focus on understanding my learning process and the importance of learning from your investing mistakes and successes.
Initial Buy Thesis for GameStop stock in 2017 and 2018
I initially purchased GameStop stock in November of 2017. At that time, the dividend yield had exceeded 8% and was approaching 10% as the stock price steadily dropped. After doing due diligence, I believed the dividend was sustainable and decided to invest. I outlined my full buy thesis in Episode 5 of the DIY Investing Podcast. (You can listen on Apple Podcasts)
GameStop Stock Investment Results
I bought a majority of my GameStop stock in 2018. However, I made purchases in Q4 2017, Q1 2018, Q2 2018, Q4 2018, and Q1 2019. My holding period for each lot of stock ranged from 18.5 months for the earliest purchase to 4 months for the most recent purchase.
I sold all shares this week for an average sale price of $5.54. With an average purchase price of $14.24, this represents an approximate loss of 50-55% inclusive of dividends over my holding period.
Disclaimer: For privacy reasons, I am not going to provide more specific details. I believe the small range given maintains the integrity of the investing results while remaining mostly private. The alternative was not to share the results or my analysis publicly at all.
Analysis of my Results
The first thing you’ll notice when looking at the results of this investment is the large negative performance. I lost money on this investment, which was in part mitigated by large dividend payments I received over the last 18 months. Had I not received dividends, losses would have exceeded 60%.
However, my goal with a post-mortem analysis is to separate results from the process. The mental model of “resulting” is difficult to overcome but Annie Duke makes a good argument in her book that we must strive to do so if we want to learn and improve as investors.
Therefore, I will attempt to separate my process from the bad investment result. It is possible to have had a bad result with either a good process or a bad process. Unfortunately, as you’ll see, my process had errors in it that I can eliminate in future investments.
Analysis of my Process
The best way to analyze the performance of my investing process is to focus on my buy thesis and my sell thesis. Was my buy thesis correct? This question should be answered regardless of the financial result of the investment. It is possible to make a profit with a false buy thesis and to lose money with a correct buy thesis. I want to make sure that my reasons for investment are accurate. The accurate reasoning is the only part of the process you can control prior to investing.
Was my Buy Thesis Correct?
The short answer is: No.
However, let’s dig into the main points of my buy thesis and break them down one-by-one.
- First: “GameStop offers a greater than 10% dividend yield, with a payout ratio of less than 50%. As long as the dividend can be paid, we’ll make a good return.”
- Result: Wrong (The dividend was eliminated in June 2019 after a new CEO took over)
- Second: The business is cyclical and there is a chance we are at the bottom of a cycle. The release of new game systems could jumpstart the stock price.
- Result: Wrong (The cycle had not yet bottomed and the dividend was eliminated before the new game systems could be released in 2020)
I think it is worth trying to outline where exactly I went wrong. It’s not useful to simply know that I made a mistake. Instead, it is important for me to understand the underlying drivers of my mistake.
The Root Cause of my Investment Mistake
My entire investment thesis was built upon GameStop’s high dividend yield. When the dividend was eliminated, my thesis was proven wrong and I exited the stock. However, dividends don’t exist in a vacuum. Dividends are paid out of free cash flow.
At the time I bought GameStop, the company’s free cash flow was more than double the then current dividend payment. Even today, I believe GameStop’s free cash flow exceeds approximately $155 million in dividend payments the company would expect to pay out over the next 12 months if they hadn’t cut the dividend.
I believe my failure and the root cause of my mistake comes down to the following 3 reasons:
- Failure to fully understand the operating leverage risk inherent to GameStop’s retail business model
- As a retailer, GameStop benefits from operating leverage due to high fixed costs when times are good and revenues are growing. However, when revenue begins to drop, high fixed costs can destroy free cash flow at a faster than anticipated rate.
- I underestimated how close GameStop was to the operating leverage “cliff” if you will.
- Consequently, GameStop’s margin of safety was much lower than I originally anticipated. I did not take into account how a 5% revenue decline could lead to a 20-50% decline in free cash flow.
- I trusted management to act in shareholder’s best interest even though they didn’t have skin in the game. I even wrote an open letter to the board of directors outlining key actions they could take to be shareholder friendly.
- GameStop management does not own a large percentage of the company’s stock. (Either overall or simply as a percentage of their personal net worth)
- GameStop management never engaged in insider buying, which should have been a sign they would be unwilling to buy back shares in the open market.
- Cutting the dividend is less palatable to management if they receive more money in dividends from their personal stock holdings in the company than from their salary. Unfortunately, management avoided building or holding a large position in GameStop stock.
- Overestimated management’s willingness to reduce fixed costs in the face of rising operating leverage.
- The primary problem that GameStop has as a business is its high fixed cost structure.
- Individual stores are highly profitable. In fact, on multiple earnings calls management would report that 99% of stores were profitable at the store level.
- Therefore, free cash flow declines were driven almost entirely by Selling, General, and Administration expenses (SG&A) at the corporate level.
- The only way to solve this problem is to reduce SG&A expenses. I overestimated the management’s willingness to take this necessary action. I believe this was in large part because management lacked skin in the game.
Was my Sell Thesis Correct?
I believe my sell thesis was correct. A key rule in value investing is to sell a stock when your buy thesis is proven wrong.
This week, my buy thesis was proven wrong. It would have been speculative to continue owning shares in GameStop when I no longer had a clear understanding of what the future held. I had been proven wrong in the past, and was no longer confident in GameStop’s management looking out for the best interest of shareholders.
Therefore, I fault only by Buy Thesis and the thinking that went into it. I believe my sell thesis was the right decision. I will continue to believe this even if the stock price rises in the future. It is not worth the capital risk, or emotional distraction of owning a company you no longer believe in.
I did not sell GameStop simply because they eliminate the dividend.
A key criticism of dividend growth investors is that they tend to sell companies when dividends are cut. It’s a nice and simple rule that many dividend growth investors use.
I anticipate that some might criticize my decision to sell GameStop on the same grounds. However, I did not sell GameStop simply due to a personal rule to sell companies that cut dividends. On the contrary, I believe dividend cuts often offer the opportunity to buy good companies at a cheap price.
Free cash flow from declining businesses ought to be distributed to shareholders
The problem with GameStop is that they are NOT a high-quality company. The dividend elimination by GameStop is not apparently due to free cash flow dropping below the expected dividend cost. Instead, management cut the dividend simply to retain cash for future capital allocation decisions.
Unfortunately, this action highlights management’s lack of skin in the game. GameStop is a company beset on all sides with the competition. Many investors, including myself, recognize that. However, free cash flow still has value, as long as it is regularly distributed to shareholders or invested profitably.
It is my belief that GameStop will continue to struggle to profitably invest free cash flow, just as they have struggled over the last decade. Of course, management ought to do what they can to avoid a future where GameStop doesn’t exist. However, they should only act when they can make changes that increase the future cash paid out to shareholders.
This week’s dividend elimination confirmed to me that management was not approaching GameStop the same way I would. That made them unpredictable.
Conclusion
My 2017-2019 investment in GameStop stock was a failure because my purchase process involved mistakes built around an inaccurate buy thesis.
Unfortunately, my failed process led to a negative financial result. My successful sell process merely limited even greater financial losses and emotional stress. In the end, I lost approximately 50-55% of my principal investment in GameStop stock. Many other results were possible, so I should remember that I very well might have ended up with a more or less favorable financial outcome.
Lessons Learned
My investment in GameStop involved multiple process failures that I want to avoid in the future.
Therefore, I am going to use this opportunity to implement investment rules that will guide my future investments. Proper investment rules will eliminate or significantly reduce the probability of a future failed investment process due to similar reasons. You can read a full list of my current investment rules here.
Investment Rule #1: Never buy a retail company with declining revenue.
Investing in GameStop stock has taught me many lessons, but none more so than the risks of leverage. GameStop had leverage from debt, operating leases, and large SG&A fixed costs. I adequately accounted for their debt, thought I took into account their operating leases and failed to fully account for the large SG&A fixed costs.
Retail is hard. Retail companies are leveraged in more ways than might first be seen on the surface. Most importantly, it is difficult to accurately understand your margin of safety when investing in a retail company.
It only takes a small decline in revenues to quickly erode the owner’s earnings and free cash flow. Therefore, I believe it is best for my personal investments to simply avoid investing in any retail companies with declining revenues or turnaround situations.
Investment Rule #2: Never buy a physical retail company with debt on its balance sheet (If they lease their locations)
This investment rule follows naturally from the first one. All physical retail companies will have large fixed costs that create operating leverage. This leverage will exist whether they choose to own their locations or lease them.
However, debt will create an additional level of leverage which increases the risk to shareholders of losing their principal.
The only area where I can see this as acceptable is if the debt is used to replace operating leases with mortgages. When used in this manner, it is possible that the use of debt actually lowers the risk to the business by eliminating external landlords from the equation.
Investment Rule #3: Do not hold onto a stock once you know your investment thesis is wrong.
Investing is inherently a game of taking action under uncertain conditions. We must always come up with a buy thesis of how we expect the future to play out. If the reason that you bought a stock no longer exists, then you also shouldn’t continue to own the stock.
This investment rule is simply an application of the mental model “Zero Based Thinking.”
While this rule wouldn’t have saved me from my losses in GameStop stock, I certainly used it to time my exit. Unfortunately, I would have limited my losses significantly if I acted as soon as I began to think that my thesis was probably wrong. That is a lesson for me to remember. If possible, act quickly before the market fully catches on.
Investment Rule #4: Prioritize Investing in Companies where Management has Skin in the Game.
While management does not need to have skin in the game to make a stock a good investment, it certainly helps. Skin in the game goes well beyond simple incentives. Stock options do not create skin in the game.
I want to look for management with a large percentage of their net worth invested in company stock. A positive sign is when management earns more from annual dividends than their company salary.
The importance of this rule is highlighted when you want management to take shareholder friendly actions. This likelihood is increased when management is heavily invested alongside shareholders. Owning companies where the founder is still the current CEO is even better because they are likely to own a considerable portion of the stock.
GameStop is a company that lacked management with skin in the game. Consequently, they took actions that I don’t believe a comparable management team with skin in the game would have taken.
Nassim Taleb discusses this mental model in-depth in his book.
Red Flag #1: A combination of large stock price declines without insider buying or stock buybacks
I was first attracted to investing in GameStop stock after the price had fallen over 60% from its all-time high. The dividend yield was high and my review of the company led me to think it was undervalued.
However, management never validated this thesis by buying shares of the stock either with their own money or the company’s money. This should have been a red flag.
I don’t think I should totally eliminate the consideration of purchasing companies without insider buying or stock buybacks. However, if my initial interest is due to large stock price declines, I should want to see my valuation of the company validated by management action when possible.
Red Flag #2: Non-Investors you talk to think the company will be a bad investment
I’m sure that some value investors will read this red flag and scoff.
Isn’t the point of value investing to own stock in companies disliked by the market? Sure, absolutely.
Yet, that’s not what I’m talking about. Here, my focus is on the wisdom of non-investors. GameStop has taught me to listen carefully to the wisdom of those who don’t spend a lot of time thinking about investing.
When I would discuss GameStop stock as an investment with my friends and family, there was almost universal disdain for the future prospects of the business. In large part, I agreed with them. Yet, I still invested in GameStop because their cash flows were so high and I trusted management to properly allocate them. (Through dividend payments to me)
I do think it is important for every investor to always do their own research and due diligence. That’s why you see so many disclaimers on my website telling you to do your own research before making investments. I don’t provide investment advice.
You cannot outsource conviction in your investments. Yet, you should also carefully listen to the wisdom of crowds. There is almost always a grain of truth that can help you improve your investment process.
Disclaimer: This post is for informational purposes only and should not be considered investment advice. I do not know anything about your personal financial situation. Therefore, it is impossible for me to provide you with financial advice. This post is not a recommendation to buy or sell any investment. Please read my full terms of service for full disclosure and disclaimer information.
