Over the next few weeks, we'll be buying gifts for friends and family. And while our shopping lists differ, they likely have one thing in common: video games.
The holiday season is one of the busiest times of the year for game lovers, and this year will be no different. According to NPD Group, a market research firm, gaming-related sales will increase by double digits this holiday season over the year prior. In September, game sales rose by 39% year over year, reaching $1.2 billion during the month.
While plenty of us will be buying games for the kids in our lives--and likely for a few adults--some may be thinking about purchasing a few gaming-related stocks for their own portfolios. After all, since January several video game companies, such as Nintendo (NTDOY), 
Activision Blizzard (ATVI) and China's Tencent (TCEHY), have seen their stock prices soar. Those stocks are all up more than 80% year to date as of this writing, vastly exceeding the S&P 500's 17% return. Although the video game industry has exploded over the past few years, it's still expected to grow at a healthy clip going forward. PwC estimates that global industry revenues will surpass $120 billion by 2021, up from $60 billion in 2013.
Continued growth is one reason why Josh Spencer, portfolio manager at T. Rowe Price, remains excited about the sector. Despite the strong gains made by several companies, he still thinks most operations can grow revenues by mid-single digits and increase margins.
"This isn't a 30% growth kind of business," he says. "It's already a big industry, but it has a lot of staying power and durability."
Unleashing recurring revenues
One of the reasons Spencer remains bullish is that the gaming industry has found a way to keep money coming in, even when no new games are coming out. In the 1990s (when everyone wanted to own a Super Mario game), companies made money off new consoles and cartridge sales. Granted, Nintendo and others brought in a lot of cash with this approach. But for these businesses to succeed, people had to spend $200 on a machine and then another $60 on a game.
Today, most games come with in-game downloads, whereby people can buy additional levels, tools and other items to enhance their video game experience. And these add-on sales have allowed companies to generate additional revenues off a single game.
"It used to be that there was no opportunity to keep people engaged in a particular game beyond a certain point," says Spencer. "Many of these franchises have more staying power."
Increasing revenues off already existing games is also a boon to margins, adds George Cipolloni, a portfolio manager at Chartwell Investment Partners.
"If you're buying extra ammo or weapons, that's really additive to the bottom line," he says. "It's pure margin for these companies, and we have seen margins and free cash exploding as a result."
Better mix of mediums
The video game industry has something else going for it: It's not just a console world anymore. Today, people play games everywhere: on mobile devices, on their computers, through virtual reality headsets and more. It took a while for some companies to create mobile-only games, but it's starting to pay off.
Over the last year, for instance, 200 million people downloaded Nintendo's first mobile game, Super Mario Run, while 2 million people downloaded their next game, Super Mario Odyssey, in the first three days of its release. Nintendo's US$157 million in smartphone-related revenues in the third quarter only make up a fraction of the company's overall revenue, but management has said it thinks those figures can grow as it releases more mobile games.
Console sales still make up a big portion of revenues -- Nintendo's Switch, which it released last March, is expected to sell 14 million units by its fiscal end in March 2018, up from the 10 million sales it initially predicted. But the industry's overall revenue mix is shifting.
"Mix is everything," says Neil Macker, an equity analyst with Morningstar. "Some games even start mobile and then find their way to console."
Looking farther into the future, there is potential for gaming companies to post even higher growth. Games like League of Legends, a PC-based game owned by Tencent, and Call of Duty, created by Activision Blizzard, have been turned into competitive sports, where teams play each other; the competitions are often televised, like a football game might be. Such electronic sports could become a US$1.5-billion market by 2020, according to Newzoo. That may give companies new ways to generate revenues. Companies are also turning games into film franchises and selling merchandise, which is bringing in even more money.
Keep the stocks on the wish list for now
Clearly, the industry has a lot going for it, but Macker says to wait before buying in because valuations are too rich right now. According to Morningstar, Nintendo (which Morningstar doesn't have on its analyst coverage list) is trading at 175 times forward price/earnings. Most of the video game stocks that Morningstar does have analysts covering -- Activison Blizzard, Electronic Arts (EA) and Take-Two (TTWO) -- are all trading well above their fair value estimates as of this writing. Tencent is trading in 4-star range, suggesting it is undervalued.
"We don't recommend people getting into most of these names right now," says Macker.
Unfortunately, the industry is fairly small, so the names like Activision Blizzard, Tencent, Take-Two, Electronic Arts and Nintendo are essentially the only options for interested investors. Microsoft (MSFT), which makes Xbox, and Sony (SNE), which makes PlayStation, also have big console businesses, but the companies have too many other things going on to consider them gaming operations, says Macker. There are several smaller operations -- some of which are grabbing market share from the bigger players -- but until they become public (if they ever do), investors only have a handful of now-expensive names to choose from.
Macker also wonders how well the industry will do in the shorter term. He too thinks businesses can post single-digit revenue growth, but the downside of creating a game that can last for years is that there's less of an incentive to buy new games. Plus, with so many hours in a day, people may be content with just playing the one game they know or like best.
"With games that have long tails, like Minecraft, you can play for a long time," he says.
Fundamentally, though, these are still strong franchises that will continue to expand margins, he says. He has no problem with people owning these businesses, he just thinks investors should wait until there's a decline before buying in.
"If the market dips, then some of these names become attractive," he says. Macker thinks Electronic Arts and Activision Blizzard have the strongest overall franchises; both earn narrow economic moat ratings from Morningstar.
Investors may not have to wait for the broader market to fall to pick up one of these names If a game misses a projection, the maker's stock may take a hit. In 2016, Activision Blizzard released yet another Call of Duty title (it has 26 in total), but the title didn't perform as well as the company had hoped. The stock dropped, and that's when Spencer swooped in.
"It didn't capture people's imaginations as much as other Call of Duty games had," he says. "The stock took a hit and it became a great time to buy."
While investors may want to wait a while before adding gaming stocks to their stockings, it's a good idea to at least keep some of these names on the wish list.
"For anyone under 30, video gaming is still a key part of their entertainment time," says Spencer. "There's still a strong appetite for games."
