Into the metaverse: how to invest in the video game boom

A common symptom of the first lockdown was chronic Animal Crossing: New Horizons consumption – a video game developed by Nintendo (JP:7974) that stimulates a peaceful island life of harvesting fruits, building furniture and running around with friends through virtual towns. The game became such a popular substitute for real life that its virtual ‘Bank of Nook’ slashed its interest rate by 45 basis points, in step with the European Central Bank and the Fed, in an attempt to encourage more adventurous saving. Nintendo sold 22.4m copies of the game in the first four months after its release. 

Last year was an exceptional one for the video game industry, propelled by two important catalysts. First, an environment in which everyone was forced to stay inside and not socialise. Second, industry titans Sony (JP:6768) and Microsoft (US:MSFT) released new consoles: two models of the PlayStation 5, and the Xbox Series X and Series S. New generations only typically reach the market once every seven years. 

These twin boosts meant that video game consumption rocketed. Industry revenue totalled $175bn (£124bn) in 2020, marking a 20 per cent increase from the year prior. That has also accelerated the rise of micro-economies and adjacent industries.

Take streaming, for example: now millions of users will tune into a specific platform to watch their favourite internet personalities play video games live. Or the lucrative world of esports, where gamers compete in international tournaments and prize pools can be north of $40m. “Just like how software has eaten the world, video games is eating the entertainment world,” says James Lockyer, a technology analyst at Peel Hunt.

But investing in video games is not straightforward. For investors who want to ride this tech-media trend, there are three overlapping areas to be aware of: the hardware, the software and the platforms.

The hardware: chips and consoles

Getting under the hood of the machines that power video games can produce exciting returns. We need look no further than 2020 stock market darling Nvidia (US:NVDA), which specialises in graphics processing units (GPUs) – the computer chips that were originally designed to create three-dimensional visual effects on a flat digital surface – for evidence of that. Nvidia's technology has revolutionised virtual landscapes, and is used in a number of consoles, including Nintendo’s Switch handheld device. 

The wide application of GPUs means that its manufacturers do not usually rely on the gaming industry for most of their revenues. But keeping an eye on the top dogs in the market can inform which chipmakers are leading innovation, and are more competitive in the long run. “Video games are often at the most cutting-edge of technology,” said Demis Hassabis, chief executive of Google’s artificial intelligence (‘AI’) arm DeepMind, in an interview with Azeem Azhar on the Exponential View podcast. “Hardware and software techniques actually often are applied first in games.” 

Compare the performance of Nvidia and GPU rival Advanced Micro Devices (US:AMD) to Intel (US:INTC) over the past year. The latter is traditionally a computer processing unit (CPU) designer and manufacturer. But a decline in its CPU competitivity, combined with a lack of experience in the GPU market, has caused the stock to suffer. The company only released its own flagship graphics card, ‘DG1’, last October, which it hopes will rival Nvidia. Its second version, ‘DG2’, is set to be released later this year. 

A key quality marker for a GPU chipmaker is expenditure on research and development relative to overall revenue. Nvidia enjoys particularly high margins, because it contracts out its manufacturing to other companies such as Taiwan Semiconductor Manufacturing Company (TPE:2330), and because of its highly cash-generative data centre products. That means that it has plenty of resources to fuel its innovation: just under a quarter of its revenues went into its research and development projects last year. And its work has been fruitful: return on capital employed (which measures how effectively a company turns its assets into profit), has averaged 29.8 per cent over the past five years. 

As for the console makers, Sony, Microsoft and Nintendo are the undisputed leaders in the field, but it is difficult to compare these businesses’ fundamentals, housed as they are among various other, more lucrative lines of business. The easiest way to discern the market leader is simply by unit sales. In the first quarter of the year, both versions of Sony’s PlayStation 5 combined outsold both versions of Microsoft’s Xbox series by more than two to one. Meanwhile, Sony’s PS4 market share is continuing into the new generation, although it is hard to gauge the real level of demand given the current impact of supply constraints in the market. In any case, most pundits view Sony as the incumbent. 

But last year the head of PlayStation, Jim Ryan, told the Financial Times he was unsure if the company would create another console. Meanwhile, Microsoft sees the industry as transforming from “a device-centric era to a player-centric era”. And given Microsoft’s long expertise in consumer-facing software, it could have the edge over Sony in a future where a powerful machine is no longer the norm for gamers.

The software: developers and platforms

This leads us onto developers and platforms. All of the ‘big three’ (Sony, Microsoft and Nintendo) have in-house studios, which develop their own video games. But there are a number of companies that develop their own intellectual property (IP), or contract out development services for other big brands. 

Happily for UK investors, the London market presides over a number of high-quality video game developers, such as Team17 (TM17), Frontier Developments (FDEV) and Sumo (SUMO). Bigger, international developers include Ubisoft (Fr:UBI), Take-Two Interactive (US:TTWO) and Fifa-maker Electronic Arts (US:EA). A key differentiator is often access to proprietary intellectual property. Decades-old beloved games like Team17’s Worms often serve as a powerful moat, creating a loyal fanbase that fuels a steady stream of revenue. 

Investors should bear in mind, however, that developers face notoriously tough deadlines, and if a title is panned by industry critics, it can be hard to recover the costs of the creation. 

This might make games that are platform-agnostic more appealing, given that they are typically less complex to create. Some of the most popular games last year were Epic Games’ Fortnite and Roblox (US:ROBLOX) – both online platform-based games that do not require a console or a disc. 

The latter, which is popular among children, has fast evolved into a social platform, too. Circles of friends commune virtually in what chief executive David Baszucki describes as the ‘metaverse’. This underpins the wider trend of gaming beginning to encroach on the territory of traditional social media. Big tech giants including Amazon (US:AMZN), Facebook (US:FB) and YouTube parent Alphabet (US:GOOGL) have all launched their own video game streaming platforms, although Amazon’s Twitch is the undisputed leader. 

There are few big fish that specialise solely in games. Of the three giants, the exception is Nintendo. But Microsoft, one of the biggest companies in the world, clearly views the market as a long-term growth driver: last year, it acquired developer Bethesda for an enormous $7.5bn, its largest takeover since LinkedIn in 2016. The tech giant, which has made its name from its office software, was also reportedly in talks to buy Discord, a social media and streaming platform especially popular among gamers.

Prior to the pandemic’s onset, several market research studies were pegging forecast global software sales growth in the low-double digits over the coming decade, across console, mobile and computer devices. That remains well above projections for both inflation and digital media sales, yet likely underplays the proliferation of new gaming audiences over the past 16 months.

At the same time, two themes look set to dominate content: the 5G-enabled improvement in mobile gaming, and the entrenchment of ever-more immersive and culturally significant video game productions. Few commentators doubt there will be room – and huge commercial opportunities – for both blockbuster video game creators and subscription-based content creators.

Video game companies might not replicate the step-change that was 2020 every year, but the opportunity for accelerating growth has never been clearer. LA