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On Dec. 7, shares of GameStop (NYSE:GME) tumbled 5% after CEO Ryan Cohen proposed using his company’s $900 million in cash to buy stocks.
It’s “one of the most inane moves we have ever seen,” criticized Wedbush analyst Michael Pachter. “GameStop’s management believes it will achieve better returns by buying equities aside from its own.”
But behind this “inane” decision is a cold calculation. Cohen knows he owns a struggling business in a fast-shrinking industry. 90% of all video games are now sold digitally, and selling gaming collectibles won’t make up the difference. As a Master Yoda bobblehead might say, a dying enterprise, GameStop is.
That leaves the CEO with several choices.
- Push Ahead (Best Buy Strategy). GameStop could emulate its rival and expand into related businesses.
- Share Buybacks & Dividends (Redbox Strategy). The firm could also take the path of Redbox and other sunset businesses — milking cash from the business before selling leftovers to private equity.
- The Warren Buffett Route. Or there’s a third route…
GME Stock: The Next Berkshire Hathaway?
Many will know that in 1965, Warren Buffett took ownership of Berkshire Hathaway (NYSE:BRK-A, NYSE:BRK-B), a struggling New England textile maker. Much of the industry had moved into the American South, where labor costs were lower, and cotton more readily available. The left-behind mills in the north saw their values plummet.
But it turns out that “cheap” didn’t mean “bargain.” As Mr. Buffett later admitted:
My first mistake, of course, was in buying control of Berkshire. Though I knew its business — textile manufacturing – to be unpromising, I was enticed to buy because the price looked cheap. Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965 I was becoming aware that the strategy was not ideal.
The problem is that value investing still needs a stock to go up. If a falling company goes straight to zero, no level of cheapness will ever produce profits for a buyer.
However, failing companies have other options for surviving. Some undergo reverse mergers, using their coveted Nasdaq and New York Stock Exchange listings to take other firms public. Investors in these “backdoor registrations” can see their penny stocks suddenly become worth $10… $100… or more. Others use cash flows to invest in income-generating securities. Insurance companies call this their “float” and frequently use it to boost profits. Even struggling firms like GameStop can have millions saved up that can earn interest. The videogame retailer itself generates roughly $50 million annually from reinvesting its cash hoard.
Then, there are gurus like Warren Buffett who realized he could use his company’s “bad” assets (cash and textile equipment) to buy “good” ones that earned higher returns. By 1970, the textile firm had invested in the National Indemnity Company, National Fire & Marine Insurance Company and the Illinois National Bank & Trust Co. of Rockford, among others. These enterprises would bring in over $7 million of net income, dwarfing the $788,000 made from Berkshire’s ailing textile operations.
And Mr. Buffett didn’t stop there. A decade later, his holding company owned large stakes in GEICO and The Washington Post. In 1985, Berkshire’s textile operations ceased to exist. And today, $10,000 invested in Berkshire Hathaway’s original listing would be worth $500 million.
Could Ryan Cohen Become the Next Buffett?
Ryan Cohen’s new GameStop plans look much like Buffett’s old one: Use the cash from a failing firm to buy shares in something else. Anything else.
It’s a strategy that could work surprisingly well. GameStop currently earns a negative 4.3% return on invested capital (ROIC), which means every additional dollar invested into the firm can expect to lose money. (i.e., the company should avoid building new stores since they are unlikely to break even).
Meanwhile, the average S&P 500 firm earns roughly 21% on its invested capital. And of those leading 500 companies, 492 earn more than GameStop’s -4.3% ROIC.
Mr. Cohen also has a history of spotting bargains. In 2020, his acquisition outfit RC Ventures bought over 6 million GameStop shares in the split-adjusted $1 range. (It’s still worth $16 per share today). And in January 2022, he bought 9.4 million shares of home goods retailer Bed, Bath & Beyond before flipping it eight months later for a 56% profit. His prior investments suggest he’s an aggressive buyer who doesn’t mind purchasing assets for well below book value.
When you combine high-returning companies with low valuations, the result… well… can’t be much worse than what GameStop currently faces.
…Or The Next Sears?
However, corporate America also has a long history of CEOs who destroy capital by investing for the sake of it. Many 1980s conglomerates ended as bloated enterprises, filled with underperforming segments. Some like General Electric (NYSE:GE) would even face near-bankruptcy after their subsidiaries began blowing up.
Then there’s Eddie Lampert, once considered the “Buffett of Canada” and one of the “brightest minds on Wall Street.” In 2003, the Goldman Sachs alum began acquiring debt of struggling discount retailer Kmart and became its chairman the following year. (Sound familiar?) The Wall Street whiz would then use his company’s newly minted shares to buy shares in another company (also sound familiar?) and become a billionaire after share prices surged (to the moon, perhaps?).
But the eventual outcome was disastrous. Lampert’s Sears Holdings would become a cautionary tale about what happens when you fail to reinvest enough cash into a business. Cutting back on store renovations eventually left Sears and Kmart stores looking old and tired. Reducing inventories to raise cash left store shelves empty. And no amount of physical asset sales could eventually stem the cash outflows as customers abandoned the stores. Lampert’s enterprise went bankrupt in 2018, taking his reputation along with it.
Other Wall Street “gurus” have also failed precisely because what Warren Buffett does is so hard to do. The average U.S.-traded closed-end fund has lost 12% since 2022 and trades at a 13% discount to book value. And many, like Carl Icahn’s Icahn Enterprises (NASDAQ:IEP) has almost collapsed on allegations of capital misappropriation. Outperforming the market is hard, especially when paying celebrity-level bonuses to CEOs. Only time will tell which path GameStop will take.
Should You Buy GameStop Stock?
Today, the most common path to Berkshire-style success is through bolt-on acquisitions. This involves a firm buying up a related company and then “bolting” the acquired product onto an existing business. Advanced Micro Devices (NASDAQ:AMD) can attribute its leading position in data centers to its 2022 acquisition of Xilinx, a maker of logic chips. Drugmakers like Novo Nordisk (NYSE:NVO) and Johnson & Johnson (NYSE:JNJ) are masters at buying up smaller healthcare firms to fill their pipelines. And in a perfect world, GameStop, too, would consider buying shares in related businesses.
These acquisitions tend to be both 1) lower risk and 2) higher return. CEOs already know the business they’re buying since it’s in the same industry. And adding an existing product to a new pipeline is generally a recipe for creating value. A biotech startup does not need to build a massive sales department if it sells itself to Johnson & Johnson’s drug marketing machine.
But GameStop has no clear path forward with bolt-on acquisitions. Its efforts in Web 3.0 gaming and NFT marketplaces have fallen flat; digital collectibles seem to have few overlapping functions with in-person game retailing. And the company’s retail locations are too small to convert them into yoga studios or electric vehicle showrooms.
That means Ryan Cohen will likely reuse the Oracle of Omaha’s strategy of buying shares in completely unrelated firms. It’s a risky tactic that will likely fail, if history is a guide. Most people should not buy GameStop for that reason alone.
But there’s always a tiny chance… no matter how small… that the 38-year-old Montreal native could be the next “Buffett of Canada.” He certainly has an eye for bargains. And if he can find companies that also return enormous amounts to his investment, Mr. Cohen could well become the savior that GameStop’s fans have been waiting for all along.
On the date of publication, Thomas Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
Tom Yeung is a market analyst and portfolio manager of the Omnia Portfolio, the highest-tier subscription at InvestorPlace. He is the former editor of Tom Yeung’s Profit & Protection, a free e-letter about investing to profit in good times and protecting gains during the bad.
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