Rumpelstiltskin and Meme Stock Investing

Let’s say a company is ex growth, perhaps even deteriorating a bit year‐on‐year, but still doing about $5 billion of revenues annually. The business model is under severe duress, it is heavily indebted (say $4.5 billion of net debt), and the cost structure is rendering it unprofitable. They do 8% operating margins in the good times, and they’re now down to half that, and after the interest expenses from their big debt‐load, they are losing money.

But there is a contingent of investors out there who see some value down the road, and another faction that see optionality of a pivot. These marginal investors in the aggregate decide that the equity should trade at $500 million or so (which works out to an Enterprise Value of $5 billion).

But then imagine the stock inexplicably (at least to the value investors) starts rallying. For some reason it starts trending on r/wsb and a meme battalion starts launching TikToks stating how owning shares is sticking it to the man.

So the stock rips without any fundamental justification. Vinnie Value says “good, yours” and sells his shares at what he thinks is a silly price, and moves on. But meanwhile, Mo Horshack and many others join the “battle”, and the meme battalion becomes a meme brigade. Things get sillier.

Meanwhile, company CEO (Boom Boom Washington) is no fool, and starts issuing as much stock as he thinks he can. But as he does it, instead of the shares selling off, more troops join the battle! And before we know it, the meme battalion has become a meme Army.

The logic goes a little something like this. As the share price increases, the management can sell shares at higher and higher prices to embark upon new projects, transitioning it into a digital age. Meanwhile, the shares that were pressured severely by the mountain of debt dominating the Enterprise Value are now released.

This eliminates much of the cyclicality of the business, and effectively removes the short, intermediate, and probably even the long‐term risk of zero (a risk that Mr. Market believed was incredibly likely just a year ago). Finally, the strength of the stock price and the burgeoning cash coffers (and money‐spinning share sales) simultaneously lure the best and the brightest to join the ranks; not of the Army Brigade, per se, but of the actual company itself!

So the story goes that the exploding share price isn’t just a bunch of random craziness, the exploding share price is actually making the company more investible. It is making its sustainability more likely. It is increasing the value of the pivot option. The share price itself is changing the fundamentals of the company. The tail is wagging the dog.

As they say on Twitter, “What sort of sorcery is this?” Is this financial alchemy powering a perpetual motion engine that will result in higher and higher share prices?

Not exactly.

Let’s take it to the extremes to visualize it. Forget about all the reflexivity stuff for a second (the ability to hire great people, the optionality of new projects). Heck, as a starting point, even forget about the debt and/or risk of zero.

Just imagine a company with no net debt, and a business (fairly) worth $100 million, and 100 million shares out, trading for $1 a share. Then imagine that without any change in fundamentals, the share price ten‐bags to $10, giving the firm an enterprise value of $1 billion.

Then imagine the company (wisely I might add) decides it wants to sell more stock to raise some cash at these wild levels. Now pretend (not hard these days) that the stock market doesn’t react negatively to a big placing. Then assume that the management has authorization to issue, and then commences with, selling another 100 million shares at $10/share, raising $1 billion of cold hard cash.

So, what do we have? We still have a company with a fundamental business worth $100 million, and we have $1 billion of excess cash in the bank, so an equity value of $1.1 billion.

We have 200 million shares now, too, so that works out to fair value of $5.50 per share!

Wow! Is this a Rumpelstiltskin stock?

Nope, it isn’t. There is no free lunch. Sure, the stock is worth $5.50 per share, but the buyers who participated in the placing at $10 basically handed over nearly half their money to the existing shareholders. It’s just a straight transfer, that’s all that happened.

There is no Rumpelstiltskin. You can’t turn straw, or lead, into gold.(1)

Okay, but what if we introduce the heavy debt load now? If this $100 million business was deeply cyclical, and its ability to finance itself was risky, and it had long ago taken $90 million in debt to keep it going, then it only had just $10 million of equity value. In that case, those initial 100 million shares weren’t worth $1, they were worth just $0.10.

And if the stock price surges to the point where the value of the enterprise (the business) is the same $1 billion mentioned above, that means the equity is worth $910 million (the $1 billion less the $90 million they owe). That’s $9.10 per share.

If they go out and do the same 100 million share sale at $9.10, that raises $910 million. After doing so, they have a business which is fundamentally worth the same $100 million, with $910 million of new cash, of which they pay off the $90 million of debt (leaving them with $820 million of excess cash). This leaves them with $920 million of equity value, divided by 200 million shares, and a share price of $4.60 per share.

Sure, the return for the initial shareholders is even better than in the first example (thank you leverage) but it is still the same transfer from new shareholders to old.

That’s all it is.

And before anyone says “well, what if they just keep on doing that?” the answer is you can’t. You can’t do this forever. It smells a bit like a Ponzi Scheme already, in fact. Eventually, you run out of marks.

Sure, the suddenly invincible management team could take that new money, hire a bunch of smart people, pivot hard, or embark upon an entirely new business. And yes, that could one day make the $10 or $9.10 per share capital raise a profitable trade for Mo Horshack, with high fives from Epstein and even Mr. Kotter.

But it would have been a lot more profitable for Horshack if it were just a new company – one where his new money didn’t have to pay a nearly 50% entry fee to join the party.

Welcome back, insanity.