US stocks GameStop (NYSE: GME) and AMC Entertainment Holdings (NYSE: AMC) have had an incredible run recently. Since 20 January, shares in the video game retailer and the cinema operator have surged 790% and 570%, respectively.
Here, I’m going to explain why these shares have skyrocketed. I’ll also discuss whether I’d buy these stocks for my portfolio.
WallStreetBets are buying GameStop and AMC stock
It’s fair to say the stories behind GameStop and AMC are quite unusual.
You see, both of these stocks have been heavily shorted by hedge funds recently. This means these funds were betting that their share prices would fall. To go short, a hedge fund borrows stock from a regular ‘long’ investor and then sells it. The aim is to buy it back at a lower price later on, return it to the owner, and make a profit in the process.
Now, what’s happened here is that a group of traders on a Reddit forum (r/WallStreetBets) have decided to take on the hedge funds by aggressively buying heavily shorted stocks such as GameStop and AMC.
This has pushed these stocks up significantly. As a result, the short sellers have been forced to rush out and close their short positions. In the process, there has been a scramble for shares, which has pushed the stocks up even higher. In the financial industry, this is known as a ‘short squeeze’.
Short squeezes are nothing new. They often happen when a heavily-shorted company suddenly releases good results or sees its future prospects improve substantially. This attracts more buyers, pushing the stock up, and forcing the short sellers to close their positions.
But the question I’m asking is whether the recent news from GME and AMC is good enough to justify these massive share price rises?
Let’s start with GameStop. It posted a trading update recently for the nine-week period ended 2 January in which there were some encouraging signs. E-commerce sales, for example, were up 309%. However overall, the results weren’t brilliant. Net sales were down 3.1% year-on-year, which I think is poor when I consider that the video game industry is booming right now.
It’s worth noting that GME’s revenue is forecast to fall 19% for the financial year ending 1 February 2021. Additionally, it posted large losses in the last two years.
Meanwhile, AMC has its own challenges. It recently announced that it raised a total of $917m in new debt and equity. Without this, it was looking at bankruptcy. Even with this new capital, it says its financial runway only extends to late 2021. It also reported a large loss last year. Of course, its outlook could improve if social distancing restrictions are eased soon.
Ultimately, it looks like both companies are set to face challenges in the near term, in my view. What concerns me is what could happen after the last short seller closes their position. We could then have a scenario where a stock with quite poor fundamentals is trading at an elevated valuation. In that situation, there’s a chance the stock could fall heavily.
GameStop and AMC are not for me
My investment strategy is based on buying high-quality stocks with substantial growth potential and holding them for the long term. GameStop and AMC don’t appear to be a good fit for my portfolio, so I won’t be investing in them.
Edward Sheldon has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.