No matter how long you've been investing, there's always something new to see. Last year, investors witnessed the fastest bear market decline of at least 30% in the S&P 500's history, as well as West Texas Intermediate crude oil futures plunging deeply (but briefly) into negative territory. This year, it's been all about the Reddit frenzy.
Without getting too far into the weeds, retail investors -- many of whom are young or novice investors -- on Reddit's WallStreetBets (WSB) community chatroom have effectively banded together to purchase shares and out-of-the-money call options on stocks with high levels of short interest. The goal of these WSB traders is to effect a short squeeze, which only fuels the upside in a momentum stock. Since most big short-sellers are institutional investors or hedge funds, the Reddit frenzy is being viewed as a battle between retail investors and the "big money."
While a number of Reddit stocks have skyrocketed, the vast majority are extremely dangerous investments. Here are seven sound reasons to avoid the Reddit stocks like the plague.
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1. They've detached from their underlying fundamentals
Arguably the biggest problem with the Reddit-stock rally is that there's no way to justify the underlying fundamentals for these companies.
Take video game and accessories retailer GameStop (GME +3.88%) as the perfect example. Though its e-commerce sales during the 2020 holiday season catapulted 309%, total sales still declined by 3% as a result of the company shuttering 11% of its stores. After waiting far too long to focus on digital gaming, GameStop's game plan is pretty much to close physical locations in an effort to cut costs and backpedal its way into profitability.
Then there's headphone, headset, and Bluetooth speaker-manufacturer Koss (KOSS 2.38%). After consistently trading at 0.5 to 1.1 times sales over the last decade, Koss is now valued at an estimated 11 to 12 times sales. Mind you, this is a company operating in a highly commoditized and generally low-margin industry that's lost money in three of the past four years. There's no way to justify its valuation.
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2. They're often serial diluters
When questionable stocks take off, you can usually count on the management teams behind these companies to use this gift as an opportunity to raise capital. In layman's terms, this means shareholders are forced to deal with dilution.
Canadian marijuana stock Sundial Growers (SNDL +0.70%) has raised more than $600 million in cash in a very short time frame. However, the numerous registered direct offerings, at-the-market offerings, and debt-to-equity swaps it undertook increased its outstanding share count by approximately 1.15 billion shares in five months. Sundial's board also recently OK'd another mixed-shelf offering that would allow it to sell up to $1 billion in securities over time.
Even if Sundial were to somehow become profitable and effectively put its cash to work, it'll be almost impossible for the company to generate a meaningful per-share profit with 1.66 billion shares outstanding. Without a reverse split, Sundial could regularly flirt with delisting.
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3. They usually lose money
A common theme among the Reddit stocks is that most aren't anywhere close to profitability. For instance, intimate apparel and swimwear retailer Naked Brand Group (NAKD +0.00%) has been popular both for its high level of short interest and its penny stock share price.
However, one thing you're not going to find with this company is profits. Sales have been on the decline since 2018, and the company hasn't produced a full-year profit in at least a half-decade. While it's possible Naked Brands' shift to an e-commerce-focused model could help lower its overhead enough to make it profitable, it's far from a guarantee. The retail space is highly competitive, and even successful retailers sport only modest operating margins, at best.
It's worth pointing out that GameStop and Sundial are losing quite a bit of money, too -- as are most of the other Reddit stocks I'll be mentioning below.
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4. Some lack innovation
Another issue with some of the Reddit stocks is that they lack true innovation. This can be seen in cryptocurrency miners Riot Blockchain (RIOT +16.56%) and Marathon Digital Holdings (MARA +7.16%), which have both been popular stocks within the WSB community.
These cryptocurrency mining companies use high-powered computers to solve complex mathematical equations to validate groups of transactions (known as a block) on Bitcoin's (BTC +0.25%) network. For doing so, they're given a block reward of 6.25 Bitcoin. That's worth close to $350,000. As the price of Bitcoin has risen, so have the share prices of Riot and Marathon Digital.
The problem with these stocks is they're completely tethered to the performance of Bitcoin. Over the last decade, the world's largest digital token plunged by 80% on three separate occasions. If that were to happen again, it's not even clear if the crypto mining operating model would survive. Devoid of innovation, Riot and Marathon are essentially crossing their proverbial fingers and hoping Bitcoin goes up.
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5. Quite a few are penny stocks
Retail investors in the WSB community have also been piling into penny stocks, some of which are heavily sold short. Though penny stocks aren't inherently bad news, the vast majority of companies with share prices below $5 are "cheap" for a good reason.
Veterinary healthcare company Zomedica (ZOM 5.83%) has been an especially popular penny stock with the Reddit crowd. Zomedica first received a boost in January after Tiger King star Carole Baskin mentioned the stock -- a mention Baskin was compensated for -- in a video posted to YouTube. Zomedica's shares gained further traction after the company announced plans to launch its Truforma point-of-care diagnostics system at the end of March.
But up to this point, Zomedica has been a developmental-stage company with no revenue. Even after Truforma officially hits the market, Wall Street is only counting on a little north of $20 million in sales by 2023. That's peanuts compared to Zomedica's $2.4 billion valuation.
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6. Some may not survive
There's also the very real possibility that some of the Reddit stocks being pumped by retail investors may not even survive.
Movie-theater chain AMC Entertainment (AMC +3.15%), arguably the most-popular WSB stock next to GameStop, came perilously close to filing for bankruptcy earlier this year. All that saved AMC was the issuance of nearly 165 million shares of AMC stock and more than $400 million in debt capital.
But even with this capital, it's not certain that AMC will be around in a few years. Coronavirus variants threaten to upend a return to societal norms, and select streaming services are encroaching on theaters' once-sacred space. AT&T subsidiary WarnerMedia is releasing all of its movies on HBO Max this year the same day they'll hit theaters. With movie exclusivity now being called into question, AMC's best days look to be long gone.
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7. Margin use is a concern
A seventh and final reason to avoid the Reddit stocks like the plague is the high amount of leverage being used by retail investors.
According to a Harris Poll of retail investors conducted back in September 2020, 23% had purchased options, 10% were using margin to buy equities, and another 10% were both buying equities on margin and purchasing options. In other words, 43% of all retail investors were speculating with market timing and/or using leverage in an attempt to pump up their gains.
The problem is that market timing doesn't work with any degree of accuracy over the long run, and stock prices can (and do) move in both directions. If equities get moving in the wrong direction with retail investors highly levered, it's possible we could see a number of Reddit stocks get absolutely throttled due to margin calls.
There's simply no reason for fundamentally focused, long-term investors to chase any of the Reddit stocks.
