I’ve been starting to think that there may now be relatively more return from me digging a little deeper into the long term fundamentals in choosing investments. While I still think the overall strategy is the most important thing to get right, at this point it feels like there are diminishing returns to continuing to tweak my approach from a top-down perspective. We are at a point in the cycle where I’m starting to feel more wary about following momentum and want to focus more on holding the investments where my long term conviction, given current valuations, is highest.

While in the medium term I’m still feeling bearish, in the short term the market has been holding up pretty well and looks like it may even be shaping up for another run. It wouldn’t surprise me too much if high growth stocks have further to go before the cycle turns but I’m now wary about getting sucked in again. I’m pretty happy at the moment with my more cautiously positioned portfolio, which has been chugging away steadily. At this point I think it makes sense for me to wait for events to play out and give my current vintage of investments a bit more time to mature. This gives me some space to get to know my portfolio and watchlist constituents a bit better. So in the coming weeks I’m planning to write up a few ‘deep dives’ into the detail of some of these businesses.

I have just one purchase to update on for April – Activision Blizzard.

Activision Blizzard

Activision Blizzard is a large US video games developer with a market cap of about £50bn. It has three main business units: Activision, creator of the Call of Duty franchise; Blizzard, which has developed various fantasy games including World of Warcraft; and King, which specialises mobile games, including the unlikely phenomenon that is Candy Crush.

I’ve become more interested in video games developers recently. The sector as a whole clearly has a lot of growth ahead of it and the businesses have always had many attractive characteristics. There has also been a shift in business model by many developers away from making money simply from the release of newly-launched games to creating longer term franchises that continue to be improved on an ongoing basis and are monetised through in-game payments. This seems like a much better business model which echoes the shift to SaaS in enterprise software. It has a number of advantages which I touch on below.

Quality

• Business economics: Activision has a capital-light business model and throws of lots of cash. However, profitability is not as high as I might hope. Margins are above 30% but returns on capital have consistently been in the low to mid-teens. I expect profitability to improve over time with the shift in business model towards freemium franchises that rely more heavily on in-game payments. Once a franchise has successfully built up a network of players, the economics of creating and selling additional content (eg character avatars, additional levels etc.) becomes very attractive. There is also the benefit that revenues become less lumpy over time. Call of Duty has largely made this transition and the other main franchises are on their way.
• Track record: the long term track record is great. Despite a bit of lumpiness from year to year, if you zoom out there is fairly consistent growth in revenues and profits over the longer term. The share price is up almost 100x over twenty years, some pretty decent compound growth.
• Competitive advantage: any developer of original differentiated video game content that is not straightforward to produce naturally benefit from some competitive advantage. Even more so if the games involve immersive artificial worlds that continue to be developed over time and allow players to interact with one another. Continued development over time can make players more engaged and invested in the game and less likely to switch to something else. Interaction with other players can lead to powerful network effects. Activision already operates several well-established franchises that benefit from these advantages and look likely to be able to sustain themselves for a long time. Developing this sort of franchise is not easy and involves both luck and skill. It seems likely that Activision’s past success has helped it develop know-how to be better able to roll out further franchises. A rapidly evolving sector like video games does present some risk from changing technology or a new hyper-successful phenomenon emerging, like Fortnite.
• Growth prospects: one of the main attractions of this investment is that the long term prospects for the video games sector as a whole seem excellent. The fact that Activision is already such a large business does limit the potential upside to some extent, but there still seem to be no shortage of opportunities for further growth eg by further optimising its business model or rolling out further franchises.

Price

The current momentum in the underlying business is excellent, though in part due to a boost from the pandemic so there is a question about how much growth will slow down when it wears off. I’m optimistic about this and in any event happy to look past an short term slowing of growth. Price momentum is good, though the share price has been consolidating for the last couple of months. The valuation seems very reasonable given the long term prospects.