Thought of the Week - What makes a good meme stock?

First, at the risk of stating the obvious. Retail investors may drive the meme stock craze, but they are not the ones who make money with meme stocks. I have discussed the miserable performance of retail investors in recent years here. Instead, as I have suspected right from the get-go, the investors that end up with the money when all is said and done are hedge funds. They went long meme stocks when the prices were low and then shorted them when the craze was in full swing, creating outsized trading returns for themselves.

Back to my original point, though. What makes for a good meme stock? For one, the stock should be well-known to retail investors. Gamestop, AMC, and Bed Bath & Beyond are all well-known consumer brands in the United States that need no explanation. No retail investor must go through the cumbersome process of ‘research’ to understand what the companies do. They sell video games, movie tickets, and towels, respectively. That’s it. I doubt that a company like Verisk will ever end up as a meme stock since it is likely unknown to anyone who doesn’t work in the insurance business.

Beyond brand recognition, there is another ingredient. The company must have fallen on hard times and the share price must have been declining for at least the past three months. Peixuan Yuan from Rutgers University discovered that retail investors are attracted to lottery stocks with share prices that have declined over the three months before they buy them. Lottery stocks (i.e. stocks with lottery-like payoffs of an expected negative return but the possibility of a massive gain if things unexpectedly go right) that have seen their share prices drop over the previous three months have a 61.5% chance of ‘popping’ the following month and showing strong gains compared to a 40% chance for lottery stocks that have seen their prices rise over the previous three months. In the case of Bed Bath & Beyond, the share price of that meme stock dropped from $22.84 on 1 April to the above-mentioned $4.60 on 26 July. That’s -80% in three months, which of course means that between 1 April and 17 August, an investment in Bed Bath & Beyond rose by a whopping 1%.

It is the classic gambler’s fallacy at work. If red has come up three times in a row at the roulette table, then surely, black must come up soon. If the share price has gone down a lot recently, then surely it must recover soon.

And that’s where the third ingredient for a good meme stock comes in. In order for a stock to ‘pop’, it helps if many professional investors agree that the company is in deep doo-doo. Ideally, there are a lot of shorts out on the stock so that when the retail money rushes in there is the potential for a short squeeze that boosts share prices even more, creating eye-catching returns that attract other retail investors. Therefore, it is probably a good idea to look at retail stocks that have many shorts against them. They often have well-recognised brands associated with them and may be in a lot of trouble at the moment, given the enormous cost pressures and the reduction in consumption due to high inflation.

So, for those of you crazy enough to hunt for the next meme stock, good luck. I for one recommend everyone to stay away from these stocks. Better to play the lottery than to invest in these kinds of lottery stocks.

Thought of the Day features investment-related and economics-related musings that don’t necessarily have anything to do with current markets. They are designed to take a step back and think about the world a little bit differently. Feel free to share these thoughts with your colleagues whenever you find them interesting. If you have colleagues who would like to receive this publication please ask them to send an email to [email protected]. This publication is free for everyone.
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