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Red Dead Redemption 2

Release date: October 26, 2018
Platforms: PlayStation 4, Xbox One

How to Make Money on Stocks of Video Game Companies

How to analyze companies, how to choose stocks, how not to lose money, how to create a winning trading plan and other useful practical tips


Many tech stocks continue their upward march, defying all critics. In fact, while the broad market, as defined by the S&P 500 index, has barely moved anywhere since the beginning of this year, many stocks related to the video game industry scored impressive gains.

For example, shares of Glu Mobile (GLUU), the maker of mobile games, are up 75% year-to-date while shares of Advanced Micro Devices (AMD) have gained 45% since the beginning of this year. The resilience of video game-related stocks comes on the back of a strong global growth, which significantly expands the customer base for both software and hardware developers. In this light, following and investing in video game-related stocks could be both an exciting and profitable endeavor.

Here’s what you need to make money on video game-related stocks (and stocks in general):

  1. Determine the companies with the biggest potential;
  2. Find an appropriate price and moment to buy their shares;
  3. Formulate your trading plan, taking both the opportunity and risk into account;
  4. Execute against your plan.

In this article, we’ll go through these points one by one. At the end, we’ll look at some stocks of video games – related companies in more detail.

How to find companies with the biggest potential

The art of finding companies with the biggest potential for future earnings is called fundamental analysis. Fundamental analysis allows you to assess the financial state of the company, its perspectives and whether the company is cheap or expensive on both the absolute and relative basis.

It is very important to understand that the share price of any given company can be significantly different from ‘’fundamentally justified’’ price in the short-term, both to the upside and to the downside. However, the market always comes closer to the ‘’fundamentally justified’’ price if given enough time. As per the famous quote from Benjamin Graham, in the short run, the market is a voting machine but in the long run, it is a weighing machine.

This phenomenon has two important implications. First, fundamental analysis skills are a must have if you plan to hold shares of a company for any significant period of time (meaning you are not a short-term speculator). Second, you should avoid trading on margin (borrowing money from your broker to increase the size of your position) when investing. Putting to work exactly the amount of money you have without borrowing anything will allow you to wait out the bad times if necessary.

The key information about a company can be found in its quarterly and annual reports. We’ll look at how to get them and what useful information can be obtained from them using the example of Take-Two Interactive (TTWO), the publisher of Mafia, BioShock, Civilization and many other games.

To get its reports, you should go to Take-Two Interactive website and proceed to the Investor Relations section.

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To get quarterly and annual reports, go to Financial Information -> SEC Filings -> Groupings Filter -> Quarterly Earnings/ Annual Filings.

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Annual reports go under the form 10-K, while quarterly reports are called 10-Q. It is a good idea to always start with the annual report. It provides general information about a company and its business, as well as financials for the last few years. The quarterly report provides an up-to-date shorter-term information for the most recent quarter. Do not forget that quarterly financials are subject to seasonality which is especially pronounced for video game makers – the quarter in which a hit game is released will be substantially different from the previous quarter. Thus, we’ll focus on the annual filings.

In the annual report, the first interesting part is the business description. There, the company tells its existing and potential investors about its business, strategy, the state of the market etc. Here’s how it looks like in Take-Two Interactive report:

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Note that this is only the beginning of the business description. The company later sheds light on its strategy, various businesses, intellectual property, manufacturing, sales, marketing, competition etc. Never ignore the important part of the annual report called Risk Factors, where you can read about the things that can negatively impact the company and, therefore, your investment.

After you have read about the company’s business and the associated risk factors, it’s high-time to look at its financials. Financials consist of three main parts: Income Statement, Balance Sheet and Statement of Cash Flows. If you are not experienced in the stock market, you should concentrate on Income Statement and Balance Sheet as Statement of Cash Flows contains information for more advanced users of financial information.

Let’s start with the Income Statement:

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Two key things to consider are net revenue (the ‘’top line’’) and net income (the ‘’bottom line’’). Ideally, you want to see them rising together year after year. Sometimes, the market is willing to pay more for a company that still has losses but whose revenue is showing good dynamics. A shrinking revenue is typically more problematic as it often shows that the company is losing market share and that its product sales are stalled. In the case above, we see a significant income growth in the last few years, but the revenue growth has recently stalled. Let’s look at the weekly chart of Take-Two Interactive to see how financials corresponded with the share price:

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As you can see, the biggest growth in share price came at the moment when the company showed both strong earnings and revenue growth. Once revenue growth stumbled, shares paused as well. Once Take-Two Interactive is able to continue its revenue growth (assuming that income growth continues at previous pace), its shares will be in greater demand and will easily get through recent levels around $120 per share. As Take-Two Interactive is in the game business, you can make your own forecast on whether upcoming titles will be hits or not. If you expect that upcoming games will be hugely popular, you can also expect revenue and income growth and, therefore, an increase in the company’s share price.

Another important thing is the balance sheet. Sometimes, the company borrows aggressively to show revenue growth which can lead to problems in the future. For investors, the key parts of the balance sheet are cash and long-term debt.

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Take-Two Interactive is a company with a solid cash cushion which has virtually no debt. For retail investors, it’s a good idea to avoid heavily indebted companies due to significant risks associated with them.

After you have studied the company’s business and examined its financials, it’s high time to look at how the company is looking in comparison with other companies from the industry and what analysts are thinking about its earnings potential.

There are many ways to value the company’s stock. Here, we’ll look at the simplest financial metrics – price-to-earnings (P/E) and forward P/E. P/E shows the ratio between the company’s price and its yearly earnings, while the forward P/E does the same for future earnings. The information about P/E, forward P/E, other financial metrics and analysts’ forecasts may be found on many financial websites, for example, Yahoo Finance:

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The stock market is about the future, so forward P/E plays a more important role than P/E in the valuation of the company. If forward P/E is less than P/E, analysts are expecting an earnings increase – just what investors should be looking for:

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To get a feeling of whether paying ~24 forward P/E for a company may be a good deal, investors should look at comparable companies. In the case of Take-Two Interactive, these are companies like Electronic Arts (EA) and Activision Blizzard (ATVI). Currently, Electronic Arts is trading at about 25 forward P/E, while Activision Blizzard is valued at about 26 forward P/E. Numbers show that the market assigns roughly the same forward P/E level to these video game giants. This means that when investors will be purchasing Take-Two Interactive shares, they will be paying an ‘’industry norm’’ based on forward P/E.

I’d like to note that looking at analysts’ estimates and basic financial metrics should only be the starting point of investors’ due diligence process. Industry trends and the fate of the company’s existing and upcoming products play a crucial role in determining the fate of its stock because, as was said above, the stock market is about the future.

The goal of the fundamental research is to find attractive companies with good prospects for growth. However, there is another important component of each investment – the price which an investor pays for the stock. Many investors believe that it is not a good idea to try and time the market, but I’d like to say that a good price greatly improves the chances of a good investment. To find a suitable moment to hit the ‘’Buy’’ button, many market participants use technical analysis.

When to buy good companies

Some people frown at technical analysis calling it fortune telling. It is certainly true that chart alone will never tell where the stock will be in three years. However, technical analysis is very useful in finding shorter-term patterns and, therefore, finding a suitable moment for entry.

There are two main tactics of getting a decent price. The first one is to buy the stock at certain minimums, below which the stock does not fall for a long time. These minimums are called the support level. Buying near the support level gives the investor the best price available in the short-term for this stock.

The second option is to buy on a breakout. A breakout occurs when the stock cannot rise above certain maximums for some time (these maximums are called the resistance level) but then breaks through this resistance and continues the upside trend. Buying at a breakout gives the investor a bigger certainty that his fundamental analysis is right, and the stock is moving in the right direction.

Here’s how it works in practice. Let’s look at the chart of another video game company, Activision Blizzard:

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Imagine an investor decided to buy shares of Activision Blizzard in 2018. What opportunities did he have? The first one occurred at the beginning of 2018, when shares of Activision Blizzard broke through the resistance and continued their upside. The second opportunity occurred in April, when shares pulled back but found support around $65.

Why would anyone want to buy on the breakout when buying at the support level typically ensures a better price? The answer is that no one has a crystal ball, and support levels in certain situations may be just a temporary stop before another downside leg. Therefore, buying on the breakout of the resistance level implies paying a bigger price for bigger certainty of a positive momentum in a stock.

It is important to keep in mind that price is a big component of the investment risk. All else equal, a better price ensures lower risk, so inexperienced investors are typically better off buying at pullbacks rather than on breakouts.

Trading plan

A good plan cannot guarantee that each investment will be profitable, but it will seriously improve chances to win. Here are the key parts of each plan:

  1. Know why you buy the stock. It may sound funny, but in reality, a number of investors cannot formulate why they bought this or that security, citing ‘’analysts’ recommendations’’, ‘’heard on TV’’ etc. This is a recipe for disaster.
  2. Know how much you can afford to lose. Before you start thinking about profits, you need to think about minimization of losses. Tech stocks are often speculative, implying big moves both on the upside and the downside. To avoid crushing your deposit with a single bad investment, you should determine a percentage of your investment that you can afford to lose. If you are losing more in your position, you should close it. This tactic could lead to some disappointment when the stock goes down below your mental stop loss before recovering, but it will save you from catastrophes – and this is crucial for long-term success in the market.
  3. Have a target price. A stock cannot rise forever. At some point, it’s time to sell and take your money off the table. Realistic assumptions greatly improve trading results. Making 50% in your position? Maybe it’s a good time to take at least some chips off the table.

Execution

You can find a great company in whose shares to invest, have a good trading plan but still lose money if you fail in execution. Humans are not robots and often fall prey to their emotions. In practice, it means that if your plan says, ‘’sell at $16’’, you do not sell when the stock reaches this price because ‘’it will rebound!’’. That’s a great way to become a so-called bag holder, a person who failed to sell the stock in time because of greed and is now ‘’holding the bag’’ watching the stock fall even more. Here are a few tips on how to avoid it:

  1. Do not rely on hope. Hope is a poor advisor in the stock market. If the stock has reached your sell level, you should sell. If it implies taking a loss, you should take it. The stock market is a probability game. If you do the right things for a sufficient period of time, profits will come. If it is truly difficult for you to sell the stock that is going against you, you can set an automatic stop-loss order in your trading software.
  2. Do not spend much time analyzing what you should have done. Everyone knows when they should have bought and when they should have sold when the stock has already made a move and it is put on the chart. This is a useless exercise.
  3. Do not rely on conspiracy theories, ever. The stock market is a game with incomplete information. You will never know all the facts. The good news is that you can achieve good results by picking healthy companies and buying their stocks at reasonable prices.
  4. Do not buy at an uncomfortable price. When you buy a car or a house, you have a set of demands. If they do not meet your requirements, you go search for something else. Stocks are no different. If the price seems too high, wait for a better price. If a better price never comes, search for another investment – the market is always full of opportunities.

Despite the apparent simplicity, execution is a difficult and very important part of every good trade, but if discipline is applied, success will come.

Practical tips

  1. I have already said it above, but this one is worth repeating – do not use margin if you are just starting your journey on the stock market. Margin is a double-edged sword that should be used only by experienced investors and speculators.
  2. If you are just starting out, your goal is to familiarize yourself with the stock market and not to lose money in the process. Don’t hurry, profits will come if you are diligent and disciplined, but the first goal is to avoid significant losses at the very beginning.
  3. Stick to what you know. You are much more likely to have an edge in the segment that you have knowledge about in real life.
  4. Read annual and quarterly reports. They may seem a bit boring at the beginning but reading first-hand information from the company is paramount if you plan to invest in it.
  5. Watch charts to familiarize yourself with how stocks behave. After some time, you’ll start to see patterns that will help you pick decent prices in your own investments.
  6. Don’t waste time on social media and TV. The time spent on reading twits about the stock market will be much better invested in reading another annual report.

Video Game Stocks

Let’s now examine some video game stocks. Since we have earlier discussed Take-Two Interactive and Activision Blizzard, we’ll first look at its peer Electronic Arts (EA):

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Shares of Electronic Arts (FIFA, Battlefield, Need for Speed etc.) have recently breached the $130 level and continue their multi-year upside trend. Franchises are working well; the company has low debt and the increasing popularity of e-sport also plays in favor of the company.

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Chipmaker NVIDIA is also going strong this year. Keep in mind that NVIDIA is not only about games. Earlier, cryptocurrencies gave a boost for NVIDIA products. Also, it looks like self-driving cars have a future and NVIDIA is securing a significant position for its production in this market. The current forward P/E is about 30, but future is coming at a price.

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Zynga (ZNGA) has finally found a way to make a sustainable income from mobile games. The company’s shares have successfully breached the $4 resistance line this year but are currently pulling back. The forward P/E is 21, which seems reasonable, so mobile game wizards may want to take a closer look at this company.

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Sony (SNE) seems to have found a solid uptrend and looks ready to breach the resistance. As a big established corporation, it’s forward P/E of 13 is reasonably cheap and the company’s diversified nature may help it profit from the positive developments in all things digital.

Important note: always do your own due diligence and never rely solely on anything you have read on the Internet and elsewhere. Stock market trading involves significant risks so think carefully before putting your hard earned money in any stock.


Ostrog