There’s a trend I see currently which has been concerning me.
For lack of a better term, I will call this the trend of the meme stock.
What on earth is a meme stock?
I’ll quote a snippet from this post which covers it quite well:
Some of the common characteristics meme stocks share are they’re usually overpriced and experience spikes of rapid growth in short spaces of time. Popular amongst millennials, they are prone to high volatility with valuations based around potential rather than financials…. Usually, the sentiment around the stock is positioned around the future problem it solves, with talk of valuations very low down the list and usually only proposed by bears. FOMO is a big motivator to buy, while panic-selling at the slightest headwind is common, adding to the stock’s volatility.
Essentially, these meme stocks are propagated by communities on Reddit, Stocktwits, Twitter, and Facebook, and cause inexperienced investors to jump on popular stocks just because they’re being hyped up.
Such messages usually include a lot of 🚀 emojis, and maybe the term “to the moon”.
Tesla (TSLA) is the quintessential “meme stock”. Currently trading at $852.23, it’s already up 20.8% this year (in comparison to the S&P’s gain of just 3.5%).
Yet, the average analyst price target is $585.87.
With a market cap of $807B, it’s valued at literally 4 times that of Toyota (TM, $210B market cap), but with less than 10% of the sales. In 2019, Toyota saw revenue of $280.6B, whereas Tesla saw revenue of just $24.6B (source).
Yet it has gained a cult following, I think largely because of the personality of Elon Musk — but this influence has been spread through social media like wildfire.
The GameStop Short Squeeze
All of this came to a head recently in GameStop (GME).
Let me illustrate. Check out the chart of GameStop between 2018-2020:
And now check out the chart from the start of 2021 to present:
You’ll see that from 2018-2020, it ranged basically between $3-$22 with $22.35 being it’s two-year high. But this year, it’s ranged from $17, all the way up to $483.
No, there was no groundbreaking news with the stock. In fact, their revenue has decreased reliably for the last several years.
Instead, the culprit was a group of traders (I use that term loosely) from the r/wallstreetbets subreddit. This community is known for, well, less than prudent investing, shall we say.
But essentially, they noticed that GameStop had a huge short interest. In fact, over 100%, meaning more shares were sold short than actually existed.
Now for the uninitiated, when a stock is shorted, the short seller (the person doing the shorting) borrows shares of the stock from their broker, then sells those shares on the open market. Their goal is for the stock to fall in price, so they can then buy back those shares, give them back to the broker, and keep the difference.
So imagine a short seller shorts 1,000 shares of XYZ stock, which is currently trading at $100. They would borrow those 1,000 shares from their broker and sell them for $100 on the market, keeping the proceeds ($100,000).
Now a while later, the stock has fallen to $90, and so the short seller buys back those shares at a cheaper price, gives them back to the broker, and now they have profited $10 per share, or $10,000 total.
But the problem is that a short seller has unlimited risk. That stock, instead of falling to $90, could rise to $110, or even $150. They would still be obligated to eventually buy those shares back, and would have to eat the difference as a loss.
Shorting is popularly done by hedge funds, though it can be done by anyone. However, r/wallstreetbets got it in their head that if they buy up the stock, they could punish the hedge funds — kind of a fight against the 1% if you will.
Because what happens is this: if enough people buy up a heavily-shorted stock, the price starts to rise. To prevent massive losses, short sellers will eventually be forced to buy back their shares (called “covering”), which will drive up the price even more, forcing other short sellers to cover, and the cycle continues. This is what’s called a short squeeze, and can result in a huge gain in the stock in a very short period of time.
Well with a stock with over 100% short interest, it doesn’t take much to move that needle and trigger the whole chain of dominos to fall.
So these WSB traders bought up the stock, hedge funds had to cover, and the stock rocketed to northwards of $400 basically overnight.
Now I don’t really have a problem with this part of things. If some people want to buy up a heavily-shorted stock, that’s their prerogative.
The problem I have is that people actually started thinking this was a good trade, or in any way would last. The idea being propagated was that if everyone bought and refused to sell, short sellers would have no one to buy from, and so the price would be forced to go up. I saw people saying they wanted the price to go up to $1,000.
But, people being people, of course they did sell, and the price could only go so high. You can see from the chart that the majority of the price spike only lasted a couple of days, then quickly came back down again.
But people were sucked into this without really knowing all the possible consequences, and I’m certain tons of money was lost by amateur investors. I still see people on Facebook saying to buy and hold GME, but it’s clear the fun is over.
The other issue I have is that it caused some instability in the market. As hedge funds were forced to cover their shorts, they had to raise cash by selling other positions they held, which caused other stocks to fall significantly. This then had a chain reaction, scaring off long-term investors who believed all the speculation was a sign of a bubble and so sold out of stocks to cut their risk.
Investing Is Not Gambling
The biggest problem I have, though, is that none of this is investing. I dare not even call it trading. It’s nothing more than gambling, and it’s indicative of a larger problem.
These online communities are full of people asking what the next big “play” is, what’s taking off next week, and of course adding lots of 🚀 emojis.
When I see these posts, it’s clear they’re not asking what companies will be succeeding in the long-term, they are asking what slot machines will pay out the most. Will it be Tesla, or NIO (NIO), or Plug Power (PLUG), or Palantir (PLTR), or something else?
Here’s a post I just saw in a Facebook group I’m in:
Just for context, Dogecoin is a crypto currency created in 2013, as a joke. It literally has a dog as its logo. It has no intrinsic value, but with this recent frenzy, people have been buying it up as though it did.
Dogecoin is worth anything at all because people are willing to speculate on it. It has no intrinsic value: it’s not a company that has quarterly earnings, produces a product, or anything else. It’s just literally something people say has value. But how long will they decide that?
Same goes for Tesla: it has value because of what it produces. Right now most of what it produces is a dream: what Tesla will innovate in the future. But if that innovation never comes, then there’s nothing holding up the stock price and it’ll collapse.
And of course the same goes for GameStop. The market valued it at roughly $18 per share. There’s no way it’s worth $450, or even $50, even if a lot of people want it to be. Eventually, its intrinsic value will be reflected in the price, and it’ll be worth $18 again (or less if their revenue keeps falling).
Stocks are based on real companies: real companies that have real value, based on what they can return to their shareholders. You might not see this real value on a day-to-day basis as the price fluctuates, but over a period of months and even years, that value becomes evident.
A company’s job is to grow value for its shareholders. If it doesn’t do that, it’s failed as a company. GameStop isn’t suddenly a better company today because a whole bunch of people decided to pump their stock price. The stock price as it is currently reflects a lot of people’s hopes, but certainly not reality.
And this is why the stock market is not gambling. It’s not a casino. It’s a collection of real companies, being traded by shareholders, with the hope that those real companies will increase their real value over time.
It’s a long game, but one that generates incredible wealth over time.
And hey, I have no issue if you want to profit on the short-term price fluctuations of stocks. We call that trading, not investing, because the real value of companies becomes more or less meaningless at that point.
But realize that this is actually a lot less reliable over time, and it’s a lot closer to gambling, though still not entirely. It’s not entirely gambling because there is an element of skill in it.
The thing I take issue with is throwing money at the meme stock du jour and hoping to profit. There’s no skill, no intrinsic value, no thought of the underlying company. It’s just gambling, pure and simple.
Asking for stock picks on Facebook is like throwing darts at the wall. The popular stocks aren’t necessarily going to be those that are actually good companies.
Of course there’s a difference if you ask for opinions to back up your own research, but of course that’s not what most people are doing.
People Don’t Have Reasonable Expectations
And this leads directly into another issue: people don’t have reasonable expectations of how much money they can make in the stock market.
You hear stories all the time of someone turning $500 into $50,000 in a month. You see people claiming 100% gains in a few weeks.
Then you put your own money to work and wonder why you’re not a millionaire overnight. You wonder why your account has only increased 2% this week, and not 20%. Or you are shocked as you actually lose money, as if that were actually possible.
Again this goes back to the gambling mindset. People go to casinos with dreams of winning the jackpot. Or they play the lottery with the secret hope of getting millions of dollars.
There’s no skill, no reason to believe any of this will happen: just a reliance on simple luck.
Sure, stories of huge wins overnight are a dime a dozen, because these meme stocks just happen to be more volatile, and such people just happened to enter and exit at the right time.
But you don’t see all the stories of people who lost tens of thousands on a bad trade, because those don’t feel so good and don’t keep the dream of instant wealth alive.
Real investing takes time, as in years. Real investors are happy to have a 10 or 20% gain in a year, because it significantly outpaces anything else you could be doing with that money.
But real investing is also boring. It doesn’t have the instant gratification of putting money into a meme stock, waking up the next day and seeing it double.
Let me just illustrate with a few examples.
The S&P 500 reached its pre-pandemic peak on February 19, 2020. Yet even if you had invested at that peak, you would have still gained 10.9% by year’s end.
Now let’s head off two of the favorite meme stocks, along the same timeframe.
First we have Plug Power (PLUG), which creates hydrogen fuel cells.
If you had bought $1,000 of PLUG on February 19, by the end of 2020 you’d have $5,928.32, a 493% increase.
Before you think this was because of some intrinsic value of PLUG, note that they have never consistently made a profit, despite increasing revenues. Notably, in all of 2020, they reported a net loss in each quarter.
They trade at 66.99 X sales, compared to their industry average of 1.56. In other words, they are extraordinarily overpriced.
But let’s look at another meme stock, Virgin Galactic Holdings (SPCE), which aims to offer space flights to the public. Here’s their chart along the same timeframe:
If you had invested $1,000 into SPCE on February 19, it would be worth $635.34 by the end of 2020, a loss of 36.5%.
This is a company that literally saw no revenue (as in $0) for the last two quarters, so their price-to-sales multiple is rather meaningless.
And yet I didn’t show you the whole picture: as of February 5, 2021, SPCE was trading at $54.34, an increase of 125.6% YTD. And yet, for what?
I have two points here:
Firstly, that investing in overvalued companies, just because they are popular on Reddit or Facebook, is quite literally a lottery ticket. What it’s not, is investing.
Of course, you might legitimately believe in either one of these companies. In particular, there might be reason to believe in the long-term viability of SPCE. But long-term is not the mentality of such traders. They want the quick overnight success.
Secondly, that while you might luck out and make a 500% gain in less than a year, this isn’t the norm, at all, nor should you expect to make that much regularly.
Does it happen? Sure, of course it does. But 40% losses also happen as seen with SPCE above.
The best you can do is to invest in good companies with reasonable valuations, or at least which are reporting consistent growth and positive earnings.
Take Amazon (AMZN), for example, which in Q4 2020 saw YoY EPS growth of 118%, and revenue growth of 43.6%.
Here’s their chart in the same timeframe:
If you had invested $1,000 into Amazon on February 19 (let’s imagine fractional shares here since their stock is more than $1,000), by the end of 2020 it would be worth $1,500.74.
That might not seem as exciting as the increase from PLUG, but this is a company that actually produces reliable growth and increased value to its shareholders. It’s not a gamble, and with a price-to-sales of 4.34, you know you’re actually paying for results — i.e., real sales.
And for sure, there are actually good companies who do have massive returns. I’m not at all saying there aren’t. I’m just saying make sure the company you invest in is actually a good company.
And also, don’t expect these massive returns to be the norm, because they aren’t.
The Greatest Wealth Generator in History
The thing is, the stock market is the greatest generator of wealth in history.
From the time period of 1990-2020, the S&P has grown 963%, an annualized growth rate of 8.2%.
If you had invested $100,000 into the total S&P 500 in 1990, after 30 years it would be worth $1,062,838.14.
There are very few other investments which could ever return nearly as much.
And of course, that’s assuming you don’t beat the market. Which, if you learn how to pick good companies, is definitely possible.
Increasing that annual rate of return to just 15% by picking good stocks, increases your gains to $6,621,177.20.
Do you see now why people aiming for 100% in a few weeks or months isn’t feasible long-term?
Even claiming 100% annually, if you kept that up over 30 years, well, you’d have $107 trillion. That’s proof enough that no one has ever done it.
Respect this tool of wealth-creation for what it is, without trying to stretch it to its breaking-point. The more you try to get unrealistic gains, the more likely you are to lose over time.
Find good companies, invest in them regularly, and your wealth will be sure to grow.
But we’re looking at a timeframe of years, not weeks or months.
At some points, you may lose money. You’ll see in the chart above what a huge dip the S&P made in 2001, and then again in 2009.
But over time, if you keep to consistently-growing, reasonably-valued companies, your investments will grow.
To prove my point, let’s take a look at 5 growth stocks who have outperformed the market over the last 5 years, from 2016-2020.
Let’s set our benchmark, the S&P 500 (2016-2020):
- Total return
- Annualized return
- Total return
- Annualized return
You’ll notice with Amazon they’ve grown pretty steadily over the last 5 years. Some years were better than others, but each year saw a net gain, in total outperforming the S&P by 185.6%.
Apple (AAPL, split adjusted)
- Total return
- Annualized return
Apple has been much more variable in its growth, even losing in 2018 (despite being up 37% at one point). Yet despite that, its annual growth rate has been just slightly more than Amazon’s, and it has outperformed the S&P by 195.2%.
- Total return
- Annualized return
This is the lowest of the growth stocks, with just 21.2% per year — but it still outperformed the S&P by 63.4%.
Facebook had gains each year, all except 2018, where it lost 23%.
- Total return
- Annualized return
NVIDIA has always been an explosive growth stock, growing 231% in 2016. It, too, lost in 2018, falling 32%, far more than the market’s decline of 6.6% that same year.
Despite that sharp decline, it has outperformed the S&P consistently by a whopping 470.0%. It’s probably one of the best cases you can hope for with a growth rate of over 70%. Whether it can keep up that rate or not is anyone’s guess, but this sort of growth is rare.
Enphase Energy (ENPH)
- Total return
- Annualized return
This is an interesting case, because Enphase was more or less a dud for 3 years. In fact it went all the way down to just $0.65 in May of 2017. It’s honestly not something I would have suggested buying until 2018 at least.
In fact they didn’t even make a profit until Q4 2017.
Enphase started out with a 71% loss in 2016, only to turn around and see a gain of 136% in 2017, and 98% in 2018 (even though the broad market declined). Then the real fun began, with a 464% gain in 2019, and another 565% gain in 2020.
In total Enphase outperformed the S&P 816.9%.
Yes, I said you can’t expect a 100% gain per year, though Enphase demonstrates that sometimes, it really is possible. But, I guarantee it won’t be able to keep up that growth rate over the next 10 years, so my point still stands.
My point in showcasing these 5 companies is that even though their growth has looked very different, all have outperformed the market.
Could you have held on in 2018 while Facebook lost 23%, or NVIDIA lost 31%?
Would you have sold and claimed your profits in 2018 as Enphase gained 98%, only to miss a further 3,690% gain through 2019-2020?
These are not easy questions, but it demonstrates why an investor taking the long view often outperforms the short-term swing trader.
Every year, a stock will fluctuate up and down. But if their earnings are headed in the right direction, you will see growth in the long run.
If you had put $100,000 into the total S&P in 2016, after 5 years it would be worth $183,766.17.
If you split that same $100,000 equally between the above 5 stocks, after 5 years it would be worth $1,566,119.48, for an annualized return of 73.4%.
This isn’t a recommendation to hold these same 5 stocks now. As they say, past performance is not a guarantee of future results. But, it shows what is possible.
Indeed, I’ve been beta testing a portfolio I plan on releasing soon. In the last month, this portfolio has already gained 8.3%, outperforming the S&P by 139%. I have a few people beta testing it already, but am looking for more testers. If you’d be interested in testing out this portfolio for free for a few months, enter your email below and I’ll get in touch.
In this post, I tried to show why getting caught up in these meme stocks is so dangerous. You might win big, but you might just as easily lose.
The best way to guarantee long-term growth of your portfolio is by diversifying into a range of various stocks, from companies who are reliable and have proven their ability to consistently grow over time and return value to their shareholders.
How risky you are depends on your age and specific situation, though personally I like to be diversified into a mix of growth and value stocks, plus some conservative options for additional premium. This has proven the most successful strategy to me and has generally outperformed the market in the long-term.
There’s nothing wrong with speculating with a very small percent of your portfolio (maybe 1-2%), but realize that you can just as easily see massive gains by investing in reliable companies if you hold for long enough.
I like to say, we invest in companies, not stocks. That means, we don’t necessarily care what the stock is doing on a day-to-day basis, but pay more attention to the company’s performance quarter-by-quarter, year-by-year. Do we like what the management is doing? Are they allocating capital in a responsible way, whether towards growth projects, or towards dividends for the shareholders? Does the company have a wide moat that is resistant to competition?
If these things are all positive, then chances are the company will succeed over time, and the market will recognize this by their stock going up in price.
If you don’t feel like doing all that work, you can always follow the research of someone you trust, or else just put money into the total S&P via an ETF like VOO which tracks the index.
The choice is yours. But as an investor, you have access to the most powerful wealth-generating tool in history. Use it wisely.