Thursday, April 4, 2013

GameStop: Still In Business?

GameStop (GME) has been one of the more controversial stock ideas I've written up. Today, however, the stock is up almost 70% since it was first written up on this site. As such, GameStop becomes the latest company to join this site's Value In Action page.

Right from my first article on this company some three years ago (all of them are browse-able here), I began to receive a number of bearish comments on the stock. Short interest on this stock has reached upwards of 50%, with the very smart Jim Chanos among them. As a result, I think this investment illustrates some very important lessons that every value investor should remember.

First, predicting the future is hard, even when it seems obvious. Shorts saw the demise of Blockbuster, and saw the same fate awaiting bricks and mortar retailer GameStop. But predicting the timing of such events is wrought with failure. This is why low P/E investing works: today's cash flows turn out to be worth more than the future predictions.

Second, do your own research. Jumping in on the trades of other notable investors (in this case Chanos), no matter how smart they are, isn't smart investing. Even Warren Buffett has made a ton of mistakes, and will readily admit that he's right barely more often than he's wrong. If you have done your research and believe you are right, don't be afraid to go against a large number of shorts, either. It's not just longs that are subject to herding.

Third, quality management can make all the difference. If GameStop had had the same managers as Best Buy or RadioShack for the past few years, my opinion is the company would be facing a lot more trouble. Instead, GameStop's management excelled in two ways compared to its bricks and mortar peers: operations and capital allocation.

While competitors Wal-Mart and Best Buy tried to commoditize this industry by competing on price, GameStop sought other ways to add value for customers, and created itself a moat in the process. GameStop's used game business could not be replicated thanks to the network effects created by successfully executing on its first-mover advantage. (This is very similar to why eBay can dominate its market: buyers have to go there since that's where the supply is, and sellers have to go there since that's where the demand is, creating a positive feedback loop that provides pricing power and protection against competition). Management has since sought to expand on this moat by taking advantage of data gleaned from its rewards program, and by expanding the type of used product (e.g. phones, tablets) that can be sold.

Other management teams are good operationally, but then blow cash on iffy projects in an attempt to build an empire. Not so with this disciplined management team. The vast majority of free cash flow generated has been used to pay off debt and buy back shares at very cheap prices. Some technology platforms were purchased in order to hedge the company against online competition, but none of these acquisitions "bet the company" on such uncertainties. As a result, shareholders have been the chief beneficiaries of the company's performance, an occurrence which is probably not as frequent as one would expect.

While I still think the world of this management team, I sold my shares because I no longer see a margin of safety in the price. Mr. Market's sentiment appears to have turned positive on this company, which is my signal to look elsewhere!

Disclosure: No position

1 comment:

Anonymous said...

Great call. Congratulations.