Why Every Investor Should Own a Video Game Stock

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The video game industry has been picking up steam in recent years. Market researcher Newzoo recently increased its 2020 revenue estimate for the industry to $143 billion, which represents a growth pace of 8.2% per year. Millennials are spending more time playing video games, as game companies are not only producing compelling games, but they are also finding new ways to attract new players through spectator gaming, such as esports and game streaming sites like Amazon.com's Twitch, where millions of viewers can watch others play games online.

Let's review the big trends driving the video game industry's growth.

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New technologies are pushing the industry forward

The most fundamental factor that drives sales of video games over time is the ongoing advancement of graphics-processing technology. Chip makers such as NVIDIA and Advanced Micro Devices release new graphics cards each year that make games look more lifelike, and that allow game creators to make more immersive games. Above all else, this serves as great marketing to attract both hardcore gamers and those who only have a casual interest to play games.

The growth of mobile platforms is also having a big impact on industry growth. The $50 billion mobile gaming market is the fastest growing category of game sales, according to Newzoo. As the graphics capabilities of tablets and smartphones approach the processing power of traditional game systems of PCs and consoles, the mobile market should only continue to grow.

Emerging technologies including virtual reality and augmented reality create interesting growth opportunities as well. You might remember Nintendo's (NASDAQOTH: NTDOY) mobile game Pokemon GO making headlines in 2016 for its use of augmented reality. By creating entirely new ways to experience games, the industry can't help but push itself forward.

A shift toward high margins

Another reason to consider a video game stock is that gaming is becoming more of a service, and that is translating to higher margins. Over the last 10 years, game companies have shifted toward digital distribution strategies in order to lift margins and generate year-round revenue, as opposed to relying on annual game releases, which can produce inconsistent revenue performance. It costs these companies much less to distribute digital content than physical game discs, and this strategy has made them much more profitable while lowering their risk to investors.

The three largest U.S.-based game companies -- Activision Blizzard (NASDAQ: ATVI), Electronic Arts (NASDAQ: EA), and Take-Two Interactive (NASDAQ: TTWO) -- generate around half of their annual revenue from sales of digital content that players purchase while playing the game. With more revenue coming from digital content, Activision and EA are generating high margins that you typically only see among software technology companies that have low capital requirements like Microsoft. Activision's operating margin has been hovering in the mid-30% range in recent years, and EA has seen its margins steadily rise as well. Take-Two is smaller than its larger peers and has struggled in the past to generate consistent annual free cash flow, but that has changed with the growth of in-game spending.

Gone are the days of selling a new game for $60 and then waiting another year for the next release to make money. Game companies have shifted focus to growing in-game spending, and that's why they are pursuing adjacent growth opportunities including esports, consumer products, and cinematic experiences. What do these new ventures all have in common? They can drive higher awareness and enthusiasm for specific games, which can lead to more time spent playing games and, therefore, higher spending by players.

Where to start with gaming companies

The trend toward digital distribution and spectator gaming is causing the video game industry to experience dramatic change -- and for the larger companies, that's been a good thing.

Over the last few decades, smaller companies like THQ and Atari couldn't keep up and went bankrupt. But companies like Activision, EA, and Take-Two have continued to thrive by churning out blockbuster titles that provide the profit necessary to reinvest in new games and to acquire smaller companies and broaden their revenue stream. In 2016, Activision did just that by purchasing King Digital Entertainment -- the maker of the hit mobile game Candy Crush -- for $5.9 billion.

Larger game makers are also starting to invest heavily in building esports ecosystems around their biggest games. The most ambitious effort so far has come from Activision with its Overwatch League, which has already attracted sponsorships from major, global brands like Toyota Motor, Intel, and T-Mobile.

Nintendo has gone through ups and downs, but is on a upswing with strong sales of its Switch game system. Take Two is seeing success with its massively popular Grand Theft Auto V and it also has an esport league based on its best-selling NBA 2K franchise in the works.

There's never been a better time to consider investing in video game stocks. By owning one of the larger video game companies, investors have the broadest exposure to all the trends impacting the growth of the industry, and that's likely a smart place to focus. With these stocks trading at high P/E multiples, it could be wise start small.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. John Ballard owns shares of Activision Blizzard and Nvidia. The Motley Fool owns shares of and recommends Activision Blizzard, Alphabet (A shares), Alphabet (C shares), Amazon, Nvidia, Take-Two Interactive, and Twitter. The Motley Fool recommends Electronic Arts, Intel, and T-Mobile US. The Motley Fool has a disclosure policy.