Wednesday, 23 May 2012
Investment Thoughts: Social Media and Gaming Companies & Irrational Exuberance
Over the years I’ve been asked on a number of occasions whether I’m going to invest in this gaming company or that gaming company, especially when I have a fair idea about the industry, and even go as far as using a couple of different gaming companies (mainly Blizzard’s or EA’s) annual reports when teaching finance etc (though, admittedly, the seminar itself is on the concept of value and the uncertainty of future gains when looking at past performance…). In particular two occasions come to mind; one distant past regarding EA and one very recent regarding Facebook.
The first regards EA and SWTOR, way back in 2008-09 (the mists of far-ago-land as it is now). I was having a very detailed discussion with a colleague one afternoon (as you do in a Business School!) over the state of the MMO gaming industry, the profits and money to be made, and in particular what would be the “next big thing”. My colleague, an academic who sees himself as an astute investor and businessman (he once admitted he was sorely tempted to try out of TV’s “The Apprentice” to “test his mettle”), was quite astounded that I finished our discussion on the future viability by admitting that despite the fact that I could see huge potential in EA’s share price if SWTOR turned out to be another WoW, I wouldn’t be buying. As it turns out, in our two or so hour discussion (we did plan out a seminar in that time as well, in my defence, around what we were discussing…) I’d managed to “convince him” that EA’s shares where ripe for an upturn and that he should buy straight away and get a “huge pay-off” in 2012-15 when SWTOR had 10 million or higher customers each paying $10 a month.
Now, I’m quite happy to be a risk taker with my money, I’ll take a decent calculated risk, and, to be fair, EA looked like a decent enough bet at the time with the limited amount of information I’d told him. The difference of course in our viewpoints is what I hadn’t informed him, regarding the slew of mediocre WoW-clone MMO’s over the 2004-2009 period, and how during that period WoW had steamrollered them all. How I could clearly see a rather interesting “irrational exuberance” starting to develop in the way both MMO-games where being marketed to investors, and how the idea that an MMO could be a huge cash machine was becoming prevalent in the market, and a lack of basic business fundamentals was being missed out.
At its heart, computer games companies are very much like the movies industry they often aspire to be compared with; they are hit based companies. Or, put more succinctly; they are hit and MISS based companies. However, and this is unfortunate, where the computer games companies usually fall down against movie companies is that they mostly simply lack the scale to take the portfolio approach needed to mitigate the risks of such a hit-based business model. In other words, movie companies can invest in twenty or more different projects, and for every high risk £80m sci-fi flop you have (which you hoped would succeed) fortunately have three or four mediocre low cost romantic comedies (Hey, it keeps Jennifer Aniston in employment I suppose) you "know" will make a reasonable return to balance it out.
Most games companies don’t have this, a single huge failure can seriously hurt them, and perhaps two will sink them. These are the basic business fundamentals of most computer games companies. Ask the former employees of APB producer Realtime Worlds if you don’t agree.
Now admittedly EA and Blizzard Activision, because of their current scale, are actually the closest the computer games industry has come to their movie counterparts in portfolio diversification ability so far. They have many different projects, across different platforms even, and their scale and ability to absorb losses means that if they play their calculated risks well then they should, on their portfolio of investments, hopefully get a good return (By the way, my view still is that SWTOR will break even, and perhaps even turn a profit). However, the sheer “irrational exuberance” surrounding investment in these companies still made me wary in 2008-09.
That and I’d spend a long plane journey in 2008 from Newcastle to Hong Kong and back again reading sequentially; Irrational Exuberance, Extraordinary Popular Delusions and the Madness of Crowds and Why Smart Executives Fail. Three books which I think everyone should read before ever considering investment.
So yes, in retrospect, while I can claim probably logical reasons for not being as interested in buying EA, like most decisions we make as people, it’s fair to say my decision was also coloured (perhaps even unfairly) by my then rather grim outlook (after reading those three books) on the true share price value that EA may be if you removed all that positive market sentiment and got down to cold hard accounting free cash flows.
So, back to my more recent 2012 investment decision. No, I did not buy Facebook stock. And also no, I don’t think, with the information currently available, it’s going to be a great investment overall. However on Facebook, as well as the grimness instilled by Shiller, Finkelstein and a dour Scot called Charles Mackay in my investment outlooks, I’d also add the voice of Warren Buffet’s pre-Dot.com bust advice; “Never invest in a business you cannot understand”. Interestingly Buffet was mocked before the dot.com bubble burst for his rigid attitude towards free cash flow, strong balance sheets and, well, what most rational people would call solid business sense! He was accused of being a dinosaur, of not seeing the “new economy”, not being sufficiently visionary.
Well, fortunately, I do understand Facebook’s (advertising space selling) revenue business model. Unfortunately, unless they diversify radically or significantly change the nature of the business model, I’m not quite sure how they can grow it with the money they’ve just raised. Yes, you can invest in the development of a new spangle-y platform, but will that increase revenues? The entire point of taking the company public is usually to raise money for an investment of some kind, and to create a market for people to be able to cash out.
At the moment from Facebook I’ve read about a large amount of people cashing out with their shares. I’ve read about a large amount of money being raised. But very little is being said about what the next investment is going to be in. Yes, there’s a lot of speculation. With the huge cash pile Facebook have just acquired they could diversify easily into mobile phones etc. However, simply put, I’m rather concerned at the investment decisions that Facebook has made. Instagram bought for $1bn; seriously??? As someone who lists Why Smart Executives Fail and Think Again as required reading, I’ll entirely accept that I can be a rather cynical in this regard, but the decisions seem more Saatchi & Saatchi 1980’s in quality, filled with hubris and naivety (a rather dangerous mixture investors have found over the years).
The prospectus itself is an interesting read. It has sections entitled “How We Create Value for Users”, “How We Create Value for Developers…” and “How We Create Value for Advertisers and Marketers”.
A pity for investors that they seem to have missed a quite important bit out; “how we create value for shareholders”.