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Three video game companies with wide economic moats

Matthew Partridge talks to fund managers Victoria Stevens and Matt Tonge, who pick three video-game makers that can keep competitors at bay.

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Video gaming is a $140bn industry, and is growing fast

Competition is the bane of corporate life. Not only can it result in competitors stealing sales and market share, but it can also ensure that each remaining penny of revenue, contributes less profit.

One way to make sure that competition doesn't end up hitting your portfolio is to invest in companies with an advantage (or "economic moat") that keeps competitors at bay. There are many type of moats, but those that come from a company's operations, rather than external factors such as regulatory barriers, are the most sustainable.

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Victoria Stevens and Matt Tonge are co-managers on the Liontrust UK Smaller Companies Fund and Liontrust UK Micro Cap Fund, and use the "economic advantage" strategy to pick stocks. This focuses on firms, which are rich in intellectual property, have a strong distribution network, or derive a large share of their income through long-term customers. (Both Stevens and Tonge are keen to emphasise that the theory was originally developed by Liontrust's founders, Anthony Cross and Julian Fosh, whom we spoke to late last year)

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Each of the three factors listed above provides a degree of security, and makes it hard for competitors to steal their business.

Having identified various targets, Stevens and Tonge check to see whether the company is generating a decent return on capital before finally making sure that it isn't too expensive.

This process has led them to three companies in the video game sector that they consider particularly promising. Though they stress that they are "bottom up" investors they focus on finding good companies they like the video gaming sector because it is a fast growing industry, worth $104bn according to PWC. The move to digital distribution has reduced the sector's reliance on big-budget games, which can be extremely risky to produce, so firms can make a good living by being part of a much longer tail of "cult" games that sell to a niche audience.

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Keywords Studios (AIM: KWS) is a company with a market cap of £1.2bn that provides services to top games publishers. It enables publishers to outsource labour intensive services such as artwork, which can a major headache, especially in today's games where customers expect everything to look like it was individually designed. Another revenue stream is localisation services, such as translation and making sure things are culturally appropriate for individual markets. It has a lot of clients around the world and a very good distribution network with offices around the globe, allowing it to capture a large share of the market.

Sumo Group (LSE: SUMO) is a much smaller company, with a market cap of just £238m, which was floated on the stock exchange at the end of last year. It allows companies to outsource the entire creative process, and has benefited greatly from an increase in the number of titles with in-game purchases (such as additional scenarios, "skins" or missions).

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This downloadable context (or DLC as it it is known in the gaming community) means that successful games now yield a recurring income revenue stream that can last for three to five years.

Sumo's reputation is so strong that many publishers have put it in charge of parts of established franchises, because they know that Sumo's team will be able to bring fresh eyes to the creative process.

At the moment, Sumo takes most of its fees in upfront payments. However, it has been experimenting with a model that allows it to receive some of its payments in the form of royalties. This enables it to have the best of both worlds, sharing the success of the various franchises, while still having a large degree of security from the regular income stream.

Stevens and Tonge aren't big fans of investing directly in game publishers, because their income streams can be extremely volatile. However, they are willing to make an exception for Team 17 (LSE:TM17).

This firm, which went public six months ago with a market cap of £351m, is best known for its ownership of the long-running Worms series at one time it was considered to be a single-product firm. But the Worms franchise now only accounts for just a small portion of its entire revenue.

Instead, Team 17 now gets a lot of its income from working with smaller studios, and even individual game-makers, helping these minnows translate their vision into a finished product. Although the budgets involved in the indie sector are much smaller, there have been many unexpected hits, such as Minecraft.

In the longer run, Team 17 is also working hard to develop "middleware" platforms that allow people to design a game without needing to know a lot of complicated coding routines.

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