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Why investors should keep an eye on video games

The video games sector will take a great leap forward when consumers start streaming them like films and music. Stephen Connolly looks at how to invest.

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Epic's 'Fortnite' has been an overnight success

The great and the good of the global video-games sector were out in force in early June for their annual get-together in Los Angeles. The Electronic Entertainment Expo or "E3" draws a big crowd, showcasing the top games and product innovations. For investors trying to assess who will be the winners in an industry going through profound change, this year was especially important.

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E3 highlights the imagination and advances in the industry. Whether mobile-phone gaming, breakthroughs in virtual reality or tie-ins with films and popular culture, the future for gamers is exciting.

Short-term turbulence

Call of Duty

Battlefield

Resistance from customers to "in-game" add-ons to squeeze out more revenue has had a negative impact. The overnight success of free titles such as Epic Games's Fortnite has prompted a rethink of how big publishers serve their customers. And censorship in China has slowed sales for some publishers.

It's inevitable that a sector moving from the fringes to the centre of the entertainment industry will experience bouts of adjustment. Rapid audience growth, new product formats and advances in technology all change what, how and on which devices gamers want to play. This puts pressure on business strategies, denting profits and share prices.

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Repositioning like this can make for choppier conditions at the individual stock level, but hasn't held back the sector's overall advance. The ETFMG Video Game Tech ETF a proxy for the global industry has gained 12.4% year-to-date. Positive, but not as good as the MSCI World Index, which is up 19.5%. Take a more reasonable three-year view, however, and it's up 58%, well ahead of the index's 42%.

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The shorter-term underperformance doesn't seem to have damaged longer-term optimism. Recently, Goldman Sachs began recommending Activision Blizzard as one of its highest-conviction ideas. Elsewhere, brokers' price targets for various stocks have been rising. Analysts highlight exploiting existing titles over new devices such as mobile; better timing of new releases to maximise sales; and opportunities for game relaunches to coincide with new games consoles as reasons for optimism.

Underpinning the more upbeat tone are strong industry trends. Independent consultant Newzoo sees the video-games market growing by 44% from $139bn to nearly $200bn by 2022, a 9% annual growth rate. There are already 2.5 billion gamers worldwide.

The next big thing in video games

The comparison isn't far-fetched Netflix, of course, has embedded itself into TV culture and become an entertainment "go-to" for millions who previously channel-hopped or went to the local video shop. With its monthly "view-all-you-want" subscription model, and broad content licensed from bigger media producers as well as its own productions, it has grown its customer base to around 150 million.

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The video-games industry can offer players an online library of most titles, all playable instantaneously for a subscription fee. For the industry, a switch from one-off fees for more reliable long-term subscription revenues would be likely to send share prices to premium levels. For gamers, who these days typically shell out $60 a pop, there would be no more buying cartridges in a shop or waiting hours for a title to download. Google reckons it takes just five seconds to start playing any title on demand on its new streaming platform, Stadia.

It's a further step towards video games displacing other media, including TV. Netflix's chief executive Reed Hastings has said that it competes with (and loses to) Fortnite more than leading US TV channel HBO. More time is now spent playing video games than using Facebook. A new era for video games is beginning.

So how to profit? We first tipped Activision Blizzard (Nasdaq: ATVI) at $63 last year and still see it as a buy at $46, as does Goldman Sachs. It's been cost-cutting and re-prioritising its top products. We also still favour smaller publisher Take-Two Interactive (Nasdaq: TTWO) and remain buyers at $113, having first recommended it at $109.

Zynga (Nasdaq: ZNGA), up 48% since we tipped it, is now a hold. But we think there's more to come over the longer term from this turnaround play. A lower entry point could emerge on a market setback.

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