Video games’ appeal will last beyond lockdown – here's how to profit

Being cooped up at home has made us far more inclined to play computer games. But this isn’t just a blip. The sector has embarked on a long-term upswing, says Stephen Connolly.

This article was first published in MoneyWeek magazine issue no 999 on 14 May 2020. To make sure you don't miss out in future, and get to read all our articles as soon as they're published, sign up to MoneyWeek here and get your first six issues free.

After the big hit to stockmarkets from Covid-19, investors are hunting for bargains. The obvious place to look is among companies that have had the biggest share price falls. But is this necessarily the best place? In the immediate wreckage of a market collapse, when selling can be at its most indiscriminate, there will be good companies that become cheap. 

But there will also be companies that remain overvalued despite their lower prices; others so badly buffeted by events that experts can’t even work out a fair price; and several that simply aren’t worth buying at any price. Getting it right requires not just skill, judgement and luck, but also confidence in one’s convictions – which is hard to maintain when surrounded by sellers. There will be winners and losers.

A different approach to finding bargains

Another area to search for bargains, away from that minefield, is among stocks going up. This sounds counterintuitive but makes sense. Investors buying stocks that are rising when markets overall are collapsing, and who keep on buying to send them even higher, must surely have very strong confidence in the future. 

And it takes a lot more than a couple of eccentric buyers on the edges of the market to push stock prices up convincingly in the face of fear and volatility, so investors should be taking note. One small sector of the market that stands out in this context is videogaming. While the US S&P 500 and the UK FTSE All Share have lost a respective 9% and 22% this year, video game stocks have gained 11%. 

That people forced into lockdown are taking up videogaming to pass the time can’t be much of a surprise. Market researchers at NPD Group estimate that spending on games and related devices jumped by 35% year-on-year to $1.6bn in the US in March. The top lockdown games have attracted millions of existing and new players. They include the latest number one sensation Animal Crossing: New Horizons from Nintendo, while established titles such as Fortnite, produced by Epic Games, Activision Blizzard’s Call of Duty and Sony’s baseball game MLB The Show 20 have also performed strongly.

The hardware cycle

But it’s not just the games, it’s what you play them on. And while this can still include desktop computers, dedicated games consoles endure. The earliest versions were produced in the 1970s, when Atari was the key brand; it was eventually eclipsed by the likes of Sony and Sega. 

The consoles lead a so-called “hardware cycle” in the industry, whereby manufacturers such as Nintendo, Sony and Microsoft upgrade or release new console models and thus lift the technical specifications the system can cope with, allowing publishers to take their games to higher levels of wizardry. But the great democratisation of gaming comes through smartphones. The reality is that almost everyone, whether they know it or not, has a console on them and is a potential game player and buyer.

The games and the hardware are both in demand. Even early in the lockdown phase, online gaming platform Steam surpassed 20 million concurrent users for the first time, while retailers have been selling out of consoles fast across the board. Nintendo’s Switch console, for example, which supports Animal Crossing, has been breaking sales records, shifting 21 million units in the first quarter. The game itself sold 13.4 million copies in the few weeks from its March launch – handily timed for lockdowns – until the end of the first quarter alone.

Not just a lockdown blip

These are big numbers but we know the lockdown will be eased and people will be going back to school and work eventually. Investors must satisfy themselves that the strong performance of the sector is more than just a short-term response to being kept indoors. And the good news is that the longer-term outlook for the industry is auspicious. 

There is plenty to suggest that lockdown has simply accelerated the integration of videogaming into our lives. It’s a fundamental shift, much more than a blip from bored people playing games and then forgetting all about them once the office re-opens (a phenomenon that will play out in various ways across other areas of post-lockdown technology such as remote working and teleconferencing). Growth should, therefore, remain brisk and, arguably, the sector should be rated more highly by investors.

A strong structural growth story

Video games, as we’ve noted in MoneyWeek before, are becoming a core means of delivering entertainment, encroaching on traditional television and online streaming, the hospitality industry and social media. There will be convergence between gaming as a social activity with friends online and pure escapism – the former is a progression from the latter that is embedding games into daily life. The group online games will also tend to reduce cinema and pub revenues.

Next month would ordinarily see the coming together of everyone who’s anyone in the industry at the annual Electronic Entertainment Expo, or “E3”, in Los Angeles. There will be no show this year owing to Covid-19 but there are still plenty of top games, new products and innovation to get excited about. The ascendancy of mobile-phone gaming, breakthroughs in virtual reality (making games more sophisticated technologically) and tie-ins with films and popular culture have especially intrigued analysts. Covid-19 or not, there is a buzz in the industry and a slightly more confident tone.

Last year was more subdued. The industry does have bouts of introspection and growing pains. Big games from the past go out of fashion and not every launch is a success. How the industry sells and relates to its customers can also cause tension as gamers react negatively to corporate excesses. But there’s bound to be some awkwardness as it moves from the fringe to the centre of the entertainment industry, forcing other media aside. The latest forecasts are upbeat, with research group NewZoo recently saying it expects the global games market to generate $159.3bn of sales this year, up 9.3% on last year. 

As the current interest in games inevitably recedes slightly from record levels as lockdowns ease, the growth baton will be picked up by sales of new generations of consoles later in the year. And while all parts of the industry are growing, it is smartphones that are growing the most. Mobile gaming sales will climb by 13.3% this year to comprise nearly 50% of the total. 

Looking further ahead, predicted annual sales growth of 8.3% will see the market reach the $200bn mark in 2023. To put that in perspective, television streaming group Netflix hit $20bn sales last year while international gross box office movie industry receipts were $31bn. 

No wonder, then, that banks and brokers are keen on the sector. Recent earnings announcements have been well received and analysts have been raising share-price targets significantly. Growth drivers vary from company to company but common factors include increasing margins from cheaper online distribution of games (as opposed to, say, cartridges that you have to insert into consoles); greater exploitation of intellectual property; and developing existing games for alternative devices such as smartphones and new consoles.

A “Netflix of gaming” is on its way

Investors are also pinning hopes on video game streaming online, which sees the industry follow a path similar to cloud-based music and films offered by iTunes and Netflix, among others. video games are sophisticated and need a great deal of processing power, so it’s a tougher task technologically than with films or music. And it’s not yet clear how streaming will pan out for consumers; games publishers as well as outsiders such as Google and Apple (exploiting their respective control of the Android and iOS phone operating systems) will try to grab market share. But a potential “Netflix of gaming” is exciting investors.

So how do investors play the games sector? We’ve recommended Activision Blizzard (Nasdaq: ATVI) in the past at $48 and $63, and we’re still buyers at the current $75. It is one of the biggest pure games publishers with a strong catalogue of big $1bn titles including Call of Duty, Overwatch, World of Warcraft and Candy Crush

We’re also still positive on Take-Two Interactive (Nasdaq: TTWO) at $132 having previously been buyers at $109 and $113. It is only about a quarter of the size of Activision Blizzard but is a well-established business with good profit growth. Its big game franchises are Grand Theft Auto and Red Dead Redemption, which are strongly embedded in gamer culture and highly cash-generative. It also has success in sport-related games. 

Having put forward Zynga (Nasdaq: ZNGA), another games developer with an emphasis on games that people can play together, at $4, we’re still positive for the longer term at $8– but bear in mind that it is a smaller company and has had a strong rise already. It has an especially strong presence in mobile gaming where there is plenty of growth to tap and it has good cash reserves to help it do so. Morgan Stanley was recently promoting the stock as an “overweight” as it favourably reviewed the sector overall.

Stephen Connolly writes on finance and business, and has worked in investment banking and asset management for over 25 years (sc@plainmoney.co.uk)

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