Three growing trends that will make you big profits on the internet

How many times have you been online today? If you're anything like me, you probably checked your email first thing this morning on your smartphone, did some work on the train on your laptop, and had a quick skim for interesting headlines on your tablet. It seems like we spend half our lives glued to a screen of one type or another.

Using the internet to go shopping, or consume media content, such as films, music, or even magazines, is nothing new. But what's different now is that ever more of the activities we used to perform in the real' world now take place online. We're not just working, or passively absorbing content we're socialising, playing games, and even dating over the internet.

No doubt part of the reason for this embrace of the virtual world is that we now have a generation of adults who have grown up with the internet. But it's not just bright young things who want to spend their lives online. Pensioners have also had 20 years to get to grips with the virtual world. Indeed, the Pew Research Centre in America found that the most rapid growth in American internet use since 2005 has come from the 70 to 75-year-old age group.

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Each group uses the internet in different ways, and for different things. Younger people are more likely to access the internet through a smartphone, while older users will probably sit at a desktop computer. But the one uniting factor is that they're all going online more often.

Finding love in a virtual world

So what are they doing online? Some of the biggest growth has been in online dating. The first internet dating service was Match.com, an American site set up in 1995. However, for a long time the idea of seeking love online carried a similar stigma to using classified advertisements it was seen as the preserve of socially awkward loners.

But the sheer convenience of the internet, and the widespread usage of social networking sites, means this has changed, says Fiona Orford Williams at Edison Investment Research. "Attitudes towards meeting partners online, whether through specific online introduction services, broader social networking, interest groups or one of the many other online communities have shifted dramatically over the last decade."

Analysing Google search data, Williams reckons online dating began its "gradual shift to the mainstream" in 2006. Nowadays, the internet is the third most common way for couples to meet, according to a study from Stanford University (nightlife' and introductions from friends' came in top).

A host of internet dating sites have sprung up to take advantage of this trend. The global online dating market is now estimated to be worth $4bn, with America alone worth $1.4bn. In Britain, online dating is so important that the Officefor National Statistics includes dating agency fees in its official inflation index. The trend has also spread to emerging markets. For example, iResearch says the Chinese market is worth $300m.

Moreover, because online dating benefits from a virtuous circle' effect "as it becomes more common, more new people are persuaded to try it" the market is growing quickly. The Chinese market is growing at 31.3% a year, says iResearch, and even the more mature American market is growing at 7.5% per year.

This spells opportunity for firms that seek to match people up online. But servicing a growing market is one thing making it pay is another. The traditional paid-for model whereby subscribers pay a fee to be matched with potential singles is losing ground to free sites, which match people without charge, relying on advertising to make money.

Others have settled on a freemium' model: a basic service that is free, but which charges users for extras such as seeing more profiles once they commit to the site. As for creating the sites themselves, dating websites have become so common that some operators now sell white label' sites. This means an aspiring dating firm can buy a ready-made site and just stick on their own branding.

But while technological barriers have fallen, the extra competition means spending on marketing has had to rise. Sites typically report a user churn (the number of people using then leaving the site) of around 25%. This means that, even at the best of times, dating sites have to spend a lot on advertising to attract new customers.

This flooded market means generic dating sites are becoming commoditised, says Williams. So many firms are now focusing on developing separately branded niche websites. For example, sites such as Jewish Mingle, or Muslim and Single, focus on particular religious groups. Others focus on job type, or offer extra-marital affairs.

The final big challenge for online dating is cyber-security. On some sites it's estimated that one in ten profiles is fake. Con artists have been known to use sites to find victims. This all adds to operators' costs. As a result, in mature markets at least, the industry is already consolidating. In the US, 50% of sales now come from just four firms. We look at a firm well placed to ride out the challenges below.

Gaming grows up

How big is the video games industry? The answer is: almost certainly bigger than you think it is. According to PricewaterhouseCoopers (PwC), the global video game market is worth $60bn. That's twice the size of the recorded music industry, and around 25% bigger than the global magazine market. Not bad, given that 20-odd years ago it was just "a cottage industry selling to a few niche customers", says The Economist.

The rate of growth shows no sign of slowing, says Alexandra Maclean at PwC. "Total global spending on video games will expand to $83bn in 2016, growing at a 7.2% compound annual rate." That makes computer games the fastest-growing major entertainment sector, and means that, by 2016, global computer game sales will have outstripped spending on newspapers.

It's the internet that's driving this boom and, more specifically, smartphones. Online and wireless games are set to overtake traditional console and PC games next year. By 2016 the online segment will have grown by 36%, reckons PwC.

"The ever-increasing computing power of mobile phones has put the means of playing games into the pockets of people who would never think of spending hundreds of dollars on a dedicated console or a PC," says The Economist.

This has opened up a whole market of casual gamers, who play while waiting for buses or on lunch breaks. The internet access on smartphones effectively turns them into tiny shop fronts, giving online games retailers unlimited selling opportunities.

Social media sites have also increased the popularity of such games. Zynga, a US-listed games maker, claims that almost 300 million people a month play its games on Facebook. Many of these users don't fit the stereotypical image of a gamer (a slightly nerdy male adolescent).

Rather, by using social media as a platform, games manufacturers have reached a new market. The Entertainment Software Association (ESA), an American trade group, reckons that 47% of gamers are female, while the average age is 30.

But while these social games may be free to play, firms have made big profits. One source of revenue is advertising. The other, more ingenious, way to make money is via the freemium' model also used in dating. The game is free, but within the game, players have the option to buy tools or extras with real money.

For example, in Zynga's FarmVille, players can use real money to buy a tractor that will help them advance more quickly in the game. For gamers keen to build up their online empire rapidly, this quick route to success is often irresistible. American gaming analysts SuperData Research value the market for online game accessories at $15bn. Thanks largely to the growth of mobile gaming, this will hit $20bn by 2016.

The success of the free-to-play' sector hasn't gone unnoticed. Facebook recently hiked the fees it charges Zynga, while online retailer and tablet-maker Amazon plans to enter the market too. Traditional offline games console producers and games makers are also fighting back. Their business models are changing to rely less on physical games and instead charge customers to download digital copies.

Profit margins on digital-only' games are larger as there are no manufacturing or shipping costs, and no physical retailers taking their share. Moreover, being connected to the internet means games makers can earn a steady stream of income by selling ongoing updates direct to existing users.

Betting on mobile gambling

The online gambling business has had a bumpy ride. America's nascent internet gambling industry came shuddering to a halt in 2006, when the European bosses of leading gambling firms were arrested and frogmarched off planes to US jails. The arrests dealt a shock to the industry and other online gambling firms promptly fled the country.

Even so, researchers H2 Gambling Capital reckon the global online gambling market is now worth around $36.5bn, up from $26bn in 2010. It still accounts for less than 10% of the total licensed gambling market, leaving much room for growth.

The spread of the smartphone is a factor in the industry's growth. As Mark Summerfield from consultancy KPMG notes, "with consumers increasingly comfortable using their mobile phones for products and services such as mobile banking... mobile gambling is likely not too far behind". Punters can "place bets at an event or at a bar or pub while watching a game. Live streaming of sporting events via faster connections has the potential to further enhance this market."

American federal law still forbids online gambling, although it's allowed in certain states. Due to this confusing legal patchwork, it remains a fringe activity in America. It's also illegal across much of Asia, including in China and India. As a result Europe is the biggest market, worth around €12bn per year. But legal issues are a problem there too.

In recent years, there have been 20 cases of betting firms complaining to the EU that restrictive national laws of member states are hindering businesses. Operations in Germany and Spain have also been hit by unexpected tax rises as cash-strapped governments look for ways to get money.

But despite the challenges, analysts expect online gambling's share of the overall market to keep growing. One reason is that consumers prefer it. The other is that governments, aware they're missing out on a source of tax revenue, are shifting their views.

An H2 Gambling Capital report notes: "As regulated interactive gaming becomes a reality in the US, Central/South America, Australia and possibly... parts of Asia, it could account for between a fifth and quarter of the industry's revenues as it does today in the likes of the UK, Sweden and Hong Kong." We look at one company that could profit below.

The four stocks to buy now

British firm Cupid (LSE: CUP) is one of the world's top five online dating companies. It has 54 million members across 58 countries, and chalked up sales of £53m last year. It operates general dating sites, such as Cupid.com, but has also been developing lucrative niche sites, such as Dating for Parents. So far its strategy of mixing popular general sites with niche offerings is paying off: sales rose 51% in the first half of this year.

What's the secret of its success? Well, dating firms are effectively technology stocks. So one big driver has been Cupid's Ukraine-based technology team. As DrMike Tubbs, author of the Research Investments newsletter, notes, "in this competitive business, firms need to make their websites attractive too... Factors like response time, range of probable matches and quality of prospect pool are all important... Cupid spends a lot of money developing its sites to be effective."

The biggest growth driver should be the US market. In the last two years, Cupid has managed to capture 2% of the American online dating market from a standing start. If that continues, earnings should rocket. On a price-to-earnings (p/e) ratio of 13.4 it's not cheap, but it's well placed to benefit as the increasingly competitive online dating market consolidates.

When it come to video games, there are two ways to play the story. One is through Electronic Arts (Nasdaq: EA). EA is a traditional physical games maker that is making the shift to digital products. The industry heavyweight's share price has fallen by 75% since its pre-crisis peak, as investors have worried about lagging sales for some of its big titles. That's left it looking cheap, on a forward p/e of 12 compared to a five-year average p/e of almost 100.

More importantly, there are signs of a turnaround. The firm is committed to moving games online. EA's head, Frank Gibeau, recently outlined its plan to "go completely digital". This will be achieved either by selling downloadable versions of games, or allowing physical game buyers to play online. Already 2.4 million gamers play its latest Fifa football game online.

EA is also willing to experiment: it is turning its poorly performing paid-for Star Wars title into a free-to-play online game. If successful, EA has more potential than most because of its vast collection of big-name titles: names like Medal of Honor, John Madden, and NBA Live may not mean much to you, but they carry serious kudos with gamers. Shares trade at around $12 but asset manager Needham & Co sees the price hitting $20 in 12 months.

A more risky play is Zattikka (LSE: ZATT), a Silicon Valley start-up that recently listed in London. The £22m firm develops freemium' games for PC web browsers, social networks, mobile devices and internet-ready TVs. It has two branches, one in China developing for the Asian market, and one in San Francisco doing the same for America. It's a huge punt but looks more promising than struggling incumbents such as Zynga. Investment bank Cannaccord Genuity rates it a "speculative buy" with a target of 122p.

There are several online gambling plays, but our favourite is William Hill (LSE: WMH). The firm only gets about 35% of earnings before interest, tax, depreciation and amortisation (EBITDA) online, but what we like is that its growing online business isn't fully in the price. On a forward p/e of 12, the price is in line with its long-term average, even although internet revenues are growing strongly.

What's more, William Hill looks set to increase its online capacity substantially. The first move is to buy British online gaming firm Sportingbet. A preliminary offer has been accepted: if it goes through this would expand William Hill's internet business in Britain, Europe and Australia. The second move is to buy out Playtech's 29% stake in the pair's online joint venture.

William Hill has an option to do so in the first quarter of 2013; the parties are said to be trying to agree a price. If these deals go through, JP Morgan analyst Matthew Webb estimates that the new' William Hill would get almost 50% of EBITDA online. That would leave it looking cheap compared to other online operators Paddy Power trades on a forward p/e of 21. It is, pardon the pun, a gamble but one with better odds than you'd get from most bookies.