I still clearly remember watching CNBC’s coverage of GameStop (GME) on January 25, 2021, and thinking “I’ve got to get in on this.” As I watched the stock fall into the $60s that day, a voice in my head was screaming, “Buy, buy, buy.” But I didn’t have the cojones to do it.
Over the next two days, I watched GameStop shares more than quintuple, and while lambasting myself in my head, I noticed something fascinating on my trading screen. Implied volatility on the options chain had exploded to such incredible heights that GameStop put options with insanely low strike prices were offering both absolute and annualized yields that I thought only a fool wouldn’t take. In my mind, Wall Street was offering free money, and if Wall Street was offering free money, it wouldn’t last long.
On January 27, 2021, I sold as many $0.50-strike GameStop puts that I could get my hands on. And surprisingly, there were a lot of them. The puts I sold provided 14% and 16% returns, respectively, over 79 days (roughly 65% and 74% annualized returns). My worst-case scenario on the trade was being forced to buy GameStop at 50 cents per share in mid-April. At the time, the stock was trading in the $300s. I also placed similar high-return trades on the $1 and $2 strike put options.
As GameStop’s stock plunged all the way down to $38.50 on February 19, one might intuitively think the puts would rise in value. But the opposite happened. With implied volatility also plunging, GameStop’s far out-of-the-money put prices collapsed. All the strikes I sold eventually went to zero, completing one of the easiest free-money-like trades I’ve seen in my investing and trading career.
I would like to officially thank GameStop short sellers for providing me that opportunity. While short covering did not account for all of the rise, in my mind, it certainly was the trigger that not only started GameStop’s vicious rally but also started a modern-day “meme-stock” movement, a movement that spread to other stocks and took on a life of its own. Eventually, the meteoric rises in those various meme stocks dissipated, but the threat of the meme-stock movement still remains, latently lurking in the background of the equity markets. If I were a professional short seller in some of the low-float, high-short interest, hard-to-borrow stocks, I don’t know how I’d sleep at night knowing what happened in 2021 to so many similar stocks. But some short sellers never learn.
Knightscope’s Short-Sellers Are Playing with Fire
On January 27, 2022, a company called Knightscope (KSCP) debuted in the public markets. This company designs and builds fully autonomous security robots, with a range of technological capabilities. The robots are currently found across a wide variety of verticals including, but not limited to, casinos, schools, parking facilities, corporate campuses, critical infrastructure providers, parks & rec, and more. Details on the company’s technology, crime-fighting wins, and more can be found here.
This past Friday, as Knightscope’s stock languished in the mid-$8s, continuing its multi-day drip lower on ever-decreasing volume, I decided to take a look at FINRA’s daily short-sale data. What I saw blew me away.
I didn’t expect to see a whole lot of short selling in Knightscope’s stock so soon after its market debut and felt this way for several reasons.
First, Knightscope has largely funded itself over the past several years on the backs of retail investors via Reg A+ offerings. The company amassed a following of tens of thousands of shareholders prior to listing on the Nasdaq. Many of these shareholders were restricted from purchasing amounts they otherwise would have purchased due to federal regulations governing Reg A+ offerings. They are now free to buy as much as they like. Concerning the shareholders who wanted to flip the IPO, they’ve already had a chance to do so (no lockup on Common A shares). These tens of thousands of retail shareholders Knightscope amassed prior to going public creates the foundation for a perfect meme-stock-like rally if short sellers become overzealous.
Second, I highly doubt the many thousands of shareholders who are in this stock for the long-term are going to make their stock available for shorting. I assume the long-term investors are (1) holding their shares in a cash account, (2) not taking part in a fully-paid securities lending program, and/or (3) have unenrolled themselves from such a program if they have accounts with brokers who auto-enroll investors. I can’t imagine any long-term investors intentionally allowing their shares to be borrowed by short sellers, thereby exerting negative price pressure on Knightscope’s stock.
Why would this affect current short sellers? The reason is it has turned Knightscope’s stock into a hard-to-borrow stock. On Friday morning, my broker quoted me a 150% annualized interest rate, accruing daily, and payable monthly if I wanted to short Knightscope. I figured someone would have to be insane to pay that type of interest just to short KSCP. The quantity of shares shorted relative to the hard-to-borrow status and the outsized borrow-rate has me wondering out loud if any unlawful naked short selling is taking place in KSCP. Only time will tell.
Third, a short seller who hasn’t done sufficient due diligence might think Knightscope should be worth less than its roughly $495 million valuation because of the company’s backwards-looking, June 30, 2021, financials found in recent SEC filings. For example, the bears like to point out that since 2013, the company has cumulative losses exceeding 92 million, to which I respond, “Only 92 million in nearly nine years!?”
It is out of this world for Knightscope to have accomplished so much with so little capital over that long of a time period, a time period during which its competitors were dropping like flies. How many billions of dollars have been blown by some of the best-known companies in the world attempting to make fully autonomous robots that can actually be commercialized and generate recurring revenue? I’m surprised Knightscope could accomplish what it has since inception without burning through $500 million. The co-founders should be teaching courses to most of Silicon Valley on efficient use of capital.
As a brief aside, in the months ahead, investors will likely continue to see the same types of negatively-biased articles written about Knightscope, regurgitating the same items that have been public knowledge for years. The recent Barron’s piece, hyper-linked above in the word “bears”, points out two incidents with the robots that took place five and six years ago when the technology was still being perfected. The first thing I thought of when reading the negative slant by Barron’s was, “If the only examples they can pull of something going wrong with the robots are from five and six years ago, Knightscope must have built something really special.” As an investor, I assume companies creating new technologies will have struggles. Look at all the difficulties Tesla (TSLA) has faced during the past decade. And yet, with time and capital, Tesla persevered and succeeded. There are countless other examples like Tesla. If Knightscope is given the time and capital, I am optimistic it will also eventually succeed in its mission to make the United States a much safer place, despite all the haters.
Turning attention back to the fundamentals, a simple examination of recent public statements, tweets, and press releases by the company paints a very different picture than the backwards-looking fundamentals in the SEC filings. I will have more to say on this and on the company’s massive growth potential in a future commentary on Knightscope.
Fourth, the estimated current float is not very large. Let’s examine the following cap table from Knightscope’s January 26, 2022, Form 253G2:
Keep in mind that only Class A common stock is currently registered. Therefore, at least for now, only Class A common stock is eligible for trading. If every single investor who owned Preferred stock converted all shares to Common A, the float would be 29,842,902 shares. I arrived at that number by taking the “Total Common Share Equivalents” of 37,795,283, subtracting the 10,189,000 of Common B shares granted to insiders (and locked up), and adding the 2,236,619 shares sold in the IPO.
I doubt all eligible Common B shares would convert to Common A for quite some time given the super-10:1-voting rights of Common B shareholders (Series A, B, and m-2 Preferred converts to Common B, and then, if the investor chooses, he/she can convert again to Common A). Theoretically, everyone could convert to Common A shares. But I think the super-voting rights will be attractive to some. I also assume the odds of those 10,189,000 Common B shares issued to corporate insiders (including 7 million to the CEO) converting to Common A is virtually zero since as long as they remain Common B shares (and out of the float), the co-founders control the voting rights of the company.
Therefore, in my worst-case scenario, the float would be 29,842,902 shares. At the time of this writing, however, it is likely far lower. The same SEC filing referenced above listed the total shares of Common A, as of January 18, 2022, at 15,256,965. These shares are from Preferred stockholders converting to Common A. If we add the 2,236,619 shares sold in the IPO, we arrive at a float of 17,493,584.
To summarize, we know the float is somewhere between 17.494 million and 29.843 million. For the sake of argument, let’s assume some investors waited until after January 18, 2022, to convert their preferred stock (full disclosure, I waited until after January 18th to convert mine). As an educated guess, I assume the float to be somewhere in the neighborhood of 20 million shares, simply because I think some preferred shareholders will not want to give up their liquidation preferences or super-voting rights.
With a float that low, and much of it likely not available for sale (the potential float does not equal the actual float), there is a huge risk that a short squeeze would send this stock mind-bogglingly higher. For a taste of what that could look like, take a look at the intraday chart of KSCP from Friday, January 28, 2022. Even though I don’t attribute that day’s rally to short covering, the rally demonstrates the difficulty investors will have accumulating shares, given how few non-short-seller sellers there appear to be.
Fifth, at the time of this writing, there is no option chain. At least with GameStop and some of the other meme stocks, there were call options available for shorts to hedge/protect their positions. At the time of this writing, no such hedging ability exists with Knightscope.
Sixth, the company just received a huge influx of capital relative to the total capital raised over its lifetime. Given how much Knightscope has accomplished with so-little lifetime capital, combined with the recent influx of cash, shorting this stock anywhere around today’s price wouldn’t be at the top of my sell list.
Those are some of the reasons I didn’t expect to see a whole lot of short selling so early in Knightscope’s life as a Nasdaq-listed public company. But FINRA’s daily data shows short sellers are playing with fire.
An Examination of Knightscope’s Short-Selling Data
At the link above under the word “data” as well as here, FINRA “makes short sale trade data publicly available for off-exchange (i.e. OTC) trades in exchange-listed securities reported to a FINRA Trade Reporting Facility (TRF) or the Alternative Display Facility (ADF), as well as for trades in securities traded over-the-counter and reported to FINRA’s Over the Counter Reporting Facility (ORF).” I like to think of “off-exchange” trades for exchange-listed securities as coming from dark pools. Others may have different terminology for such trades.
In the table below, I aggregated FINRA’s KSCP short-selling data for each day Knightscope has traded publicly.
When looking at the trading volume as well as price movements from January 27, it looks like something mechanically went wrong with trading in the opening minutes. Shortly after opening, the stock appears to have been halted three times, and most of the first day’s massive decline happened relatively quickly on anemic volume. The dark-pool data above seems to corroborate the idea that something wasn’t right from a market-structure standpoint when Knightscope opened for trading on the 27th. I spent that entire day watching trades cross on KSCP. It was like watching paint dry. It didn’t feel like any of the countless other market debuts I’ve watched over the years. The dark-pool volume and overall trading volume exploded on day two and has remained well above day one’s volume ever since. When I take all that into account, in my mind, I effectively view Friday, January 28, 2022, as the true market-debut for Knightscope.
In the table above, look at the massive number of shares sold short and not considered exempt (i.e., not related to “qualified” market-making activity) starting on the 28th. Also, look at the declining total volume each day since Monday, the 31st. The days-to-cover is likely rising rapidly as the total daily volume traded continues to shrink. We will know the exact percentage of the float held short when FINRA releases its first bi-monthly data that includes KSCP.
Moreover, it is quite possible the number of shorted shares outstanding now exceeds the most recent daily volume by a factor of nearly nine. Put differently, if none of the shorts have covered their positions, the days-to-cover would be approaching nine based on Friday’s volume. When combining all this with the way the stock behaves on intraday rallies (i.e., the stock explodes higher on the first sign of moderate-to-large volume), it tells me the shorts have boxed themselves into a corner and will have a hard time covering if the meme-stock traders decide they want to own Knightscope or if the company announces any good news.
The one thing short sellers do have going for them in the short term is the likely moderate-to-large overhead supply from traders trying to catch a falling knife as the stock declined from its high of $27.50. By overhead supply, I am referring to traders who are holding on until they can get out even on the trade. I suspect there is a lot of overhead supply in the $12.50 to $18 region. But between $9.01, where the stock closed on Friday, and the $12.50 to $18 region, I doubt the shorts will find enough sellers to let them buy back millions of shares. This is especially so given how quickly the stock seems to rise on intraday rallies, implying there aren’t that many non-short-seller sellers out there. All this sets the stage for a large, short-covering rally at some point in the future, and the lower the stock goes, the more vicious I suspect the rally will be.
Beyond everything already mentioned in this commentary, it is also worth noting that shorting a company whose motto is “Long Knightscope. Short the Criminals” seems as though short sellers are adopting the position, “Short Knightscope. Long the Criminals.” I realize Wall Street, so-to-speak, isn’t exactly known for being morally just, but to be “Long the Criminals” at a time when crime is skyrocketing all over the United States seems a bit much, even for Wall Street.