As I mentioned in my last post, I’m planning to do a few deep dives into some of the constituents of my portfolio and watchlist. I think a good place to start is with what has been my largest current investment for some time – Best of the Best.

I embarked on what I was originally intending to be a series of deep dives a few years ago but after one review I didn’t continue. I was a bit discouraged by the fact that my call to bail on Games Workshop turned out to be quite misguided in hindsight. More importantly I’ve tended to be sceptical about the value of carrying out detailed research to gain a high level of conviction in a specific investment. I find that in practice the most important qualities of the best businesses tend to be apparent. Beyond that it is hard to discern the signal from the noise and all too easy to become enamoured with your own research or inadvertently selective in focusing on the aspects that support your own pre-judged conclusions. Confirmation bias is a serious issue for even the most careful researchers.

For me this means that detailed research is not my main focus. One one hand I’m wary of treating it as a psychological safety blanket to validate my existing investment choices. On the other I’m conscious that too critical an eye can find material concerns with any investment. To be clear, I don’t think detailed research is worthless, just that there is a very real and often neglected challenge in putting it all into the right context. There can be value in getting into the detail, as long as you can focus on the important questions without getting distracted by unnecessary details.

So it’s with a bit of trepidation that I’m going to get stuck into BOTB.

BOTB has already been my most successful investment so far by in absolute terms, up almost ten times since I bought near the end of 2019. It’s one of my largest holdings and the shares are very illiquid – so the stakes are high.

BOTB sells tickets to enter into regular ‘spot the ball’ prize competitions. This is a game where a picture of a football match with the football removed is presented to players, who have to predict to the nearest few pixels where a panel of judges decide the football should have been. The prizes for winning BOTB’s competition are generally luxury cars.

It’s a simple and easy to understand business model. There are two sides to the business: the operation of the competitions and marketing to find new players. The business has gone through a drastic shift in strategy over the last decade. Originally, BOTB relied on UK airport concessions to find customers, but when this ran into trouble it started to focus more on online advertising. This turned out to be a blessing in disguise as online advertising proved to be a vastly more effective distribution channel. Now its business is fully online and the airport concessions are all gone.

I’m not going to spend too long on the fundamentals as it is obvious that this is a business that is extremely profitable. Operating margins have risen to around 30% over the last few years as economies of scale have been realised. The online marketing strategy has allowed a lot of growth to be generated with fairly negligible capital requirements. BOTB also has a favourable working capital dynamic in that it receives cash from ticket sales long before it actually gives away the prizes. The result is that BOTB has returns on capital consistently in excess of 100% and throws off huge amounts of cash. These attractive figures are what originally brought BOTB onto my radar.

Given BOTB’s profitability and current growth trajectory, the current valuation (a forwards earnings multiple of under 20) seems miserly, even after the share price has ‘ten-bagged’ in little over a year and a half. This still looks like a good investment – potentially one where the market has been slow to react to the positive developments in the fundamentals and is still playing catch-up – a classic ‘momentum play’. It’s tempting to leave things there and not get too bogged down in speculating about the risks BOTB faces. It seems unlikely that they would be material enough to derail the investment case, but in the interest of getting to know my largest investment a little better, I’m going to see how far I can get exploring what I think are the three main questions:

• What are the limits of its growth potential?
• What is the risk that BOTB is copied by rivals?
• What is the risk of regulatory intervention?

How far can this rocket ship go?

The events of last year make it more difficult to get a good handle on BOTB’s growth trajectory, though it appeared to be experiencing accelerating growth even before last year. The pandemic response has then provided BOTB an opportunity to generate some rather extreme growth rates. It seems inevitable that growth will slow down considerably from here, but where it settles is very difficult to extrapolate from the past. It’s not out of the question for growth to decelerate sharply and suddenly if and when the limits of the addressable market start to bite. At some point it will become harder (and more expensive) to attract new players and BOTB may find its marketing activities focused on simply replacing the natural churn of existing players as they lose interest.

The bird’s eye view

At the moment the story still seems compelling. ‘Spot the ball’ competitions lie in a regulatory niche, shaped by the scope of the gambling laws. They share much of the appeal of lotteries – they tap into the desire for people to dream about winning ‘life-changing’ prizes for small stakes, despite the odds of success not being very favourable. However, they face limited competition from other lotteries. While in the UK lotteries cannot be run for profit, spot the ball competitions escape this as they are deemed to be ‘skill-based’. This seems like a useful regulatory moat for BOTB to have around its business, provided the law doesn’t change (more on this below).

The fact it sits in this regulatory lacuna doesn’t appear to prevent BOTB’s prize competition from having wide appeal. As well as its lottery-like attraction, it taps into two popular themes – cars and football. This type of competition has been very popular in the past – the Littlewoods Football Pools spot the ball competition was played by millions each week back in the Seventies. Given the success BOTB has had so far in revitalising this old idea, it seems unlikely to me that it would go out of fashion any time soon.

BOTB currently has an annual turnover of around £50m. To give a sense of scale this compares to the approximately £8bn spent on the National Lottery each year. A bit of desktop research suggests that other lotteries regulated by the Gambling Commission probably add up to a somewhere not far off £1bn in revenues. Obviously, it’s unrealistic to expect BOTB to become as popular as the National Lottery, but these statistics give some comfort that BOTB is still relatively small and most likely has plenty of addressable market left to go for. One additional point that BOTB has on its side is that it can expand internationally. It already has many international players and can ship prizes to other countries without too much difficulty.

The growth engine

Another angle for looking at BOTB’s growth potential is from the bottom up ie the mechanics of how it generates revenues. BOTB’s ‘growth engine’ is fueled by digital advertising. Digital advertising enables the systematic use of data, both to identify and target specific audiences and to measure what audiences do after they see an ad. This allows the new customer revenue generated by the advertising to be measured against its cost and used to continually optimise the advertising strategy over time.

BOTB’s annual reports suggest that in practice it predicts the ‘lifetime’ revenue a new sale is likely to generate for as long as the customer continues to play the game. It then compares this to the cost-per-acquisition (CPA) – the cost of advertising per sale that the advertising generates. The ratio of lifetime revenue to CPA essentially captures the profitability of the advertising or its ‘efficiency’. This ratio can then be used both to inform the optimal mix of advertising used and the overall advertising budget. There is a balance to be struck in increasing the advertising budget to drive further growth and ensuring that the efficiency of the advertising remains high.

There are several ‘levers’ at BOTB’s disposal that can be adjusted to minimise CPA. Broadly speaking, these involve choosing more effective advertising messages, channels and audiences to target. Optimising how these levers are set relies heavily on interpreting the data and learning from experimentation. This process creates the potential for the advertising efficiency to be improved over time (all else equal). The benefits of this can be very significant. For instance, it is possible to measure how effectively an ad campaign is performing almost in real-time. This means that the budget allocated to a certain channel can be scaled up very quickly if it is performing especially well (and vice versa) making it possible for a business like BOTB to exploit opportunities, such as those presented by the pandemic response, much more effectively.

The benefits of advertising optimisation seem likely to be greatest early on and then to diminish over time as BOTB perfects its strategy. In addition there are natural constraints on advertising efficiency – as BOTB’s ad budget grows the more it is forced to allocate spend to channels and audiences where the advertising is less effective, causing CPA to rise. The other dynamic to bear in mind is what is happening in the online advertising market as a whole. On one hand improvements in the technology and advertising opportunities available may help BOTB continue to improve its efficiency and reach new audiences. On the other hand, increased adoption of online advertising may continue to bid up prices. Prices on Facebook have been rising steadily as demand continues to rise while its supply of ad inventory has plateaued. Other fundamental changes to the digital advertising industry, such as Apple’s introduction of ATT, also have the potential to have serious knock-on consequences for businesses that rely heavily on digital advertising.

While digital advertising provides a powerful mechanism for exploiting BOTB’s growth potential, ultimately what determines this potential is the attractiveness of the prize competition itself. BOTB’s prize competitions certainly aren’t an essential service that its customers rely on – it seems likely that many BOTB customers will see an ad, have a go and then move on. However, quite a few are likely to play multiple times and some might keep on playing week after week for years. Improving the prize competition in a way that leads to better customer engagement and retention can increase lifetime revenue and consequently the return from winning new customers. It can also increase the size of the addressable market itself. The main tools at BOTB’s disposal to encourage greater retention seem to be improving attractiveness of its prizes and the user experience of its website. As for the advertising side of the business, there seems to still be plenty of scope for BOTB to continue to experiment with its offer, see how changes affect retention and then optimise over time.

From this you can see that there are several moving parts to BOTB’s growth engine that make its potential very hard to extrapolate (even ignoring the temporary pandemic boost). It seems naïve to assume that BOTB can continue to grow at the same rate simply by incrementally scaling up its ad budget. It looks more likely that there are ‘s-curve’ dynamics at play, driven by improving advertising efficiency early on and subsequent slowing as the business grows larger and the benefits of optimisation suffer diminishing returns. It’s hard to say anything more concrete about how this will play out in practice without more empirical evidence, but the fact that BOTB seems to be in the relatively early stages of implementing its advertising strategy make me fairly optimistic that there is still plenty of growth potential to be exploited. That said, there are also some risks that lie outside of BOTB’s control.

What about the competition?

As I mentioned above BOTB is protected from competition by other forms of lottery by fairly stringent gambling regulation, so the main competitive threat it faces is from other similar skill-based prize competitions. At first blush it seems that the barriers to entry are not really all that high. All that is really needed to set up a ‘spot-the-ball’ prize competition is a website, some judges and prizes and a marketing budget. Indeed with a quick bit of Googling you can find several competitors with ‘spot-the-ball’ competitions or similar, such as Spot Prize, Spottheball, Balls-out, and Bounty Competitions.

However, these all seem like rather inferior versions of BOTB based on the quality of their websites and the prizes they offer. Some of them have been set up in the past year, presumably to try to take advantage of the same pandemic tailwinds that BOTB benefited from. BOTB appears to be a long way ahead of them in terms of scale and this should bring some advantages. Obviously some scale is needed for the economics of prize competition to work well and to be able to offer decent prizes. There are also likely to be some benefits to scale in optimising the marketing strategy as I’ve discussed above. There is also a scale advantage from the need to develop a trusted brand and reputation. Credibility seems likely to be a major issue as many prospective customers will want some reassurance that they are not being targeted by a scam. I am fairly confident that BOTB has sufficient scale advantages over its upstart rivals that the threat it faces from them over the long term is not so great. However, this is not a foregone conclusion and it would be foolish to ignore the risk entirely.

The other possible concern is that BOTB is copied by a larger established gambling player that could leverage its existing advantages, such as its brand and customer databases. There don’t seem to be any hard barriers that would prevent this from happening so I don’t think you can rule this risk out. However, it doesn’t seem all that likely to me that these larger players would see this opportunity as a very neat fit with the rest of their business or of sufficient scale to be worth throwing much time and resource into. There seems to plenty else going on in the gambling sector with various major changes in regulation creating risks and opportunities all over the world. I’m also not very convinced that the outcome of this sort of entry would be all that terrible. It should only happen if spot the ball competitions appear likely to take off in a bigger way and this is something that would obviously benefit BOTB too. While the entry of a large rival could stunt BOTB’s growth ambitions somewhat by making it more difficult to acquire new customers, I’m doubtful that profitability would suffer too much. There isn’t direct competition on price and the proportion of revenues that competitions pay out in prizes is not transparent.

The sword of Damocles

The final issue is to understand how much of a threat BOTB faces from regulatory intervention. Currently the law on lotteries as captured by the Gambling Act 2005 is very strict, essentially restricting lotteries from being operated for commercial profit. However, that spot the ball competitions are exempt from the current legal definition of ‘lotteries’ under the Gambling Act seems pretty clear. Based on Gambling Commission guidance what BOTB offers is not a lottery because it is ‘skill-based’. The test for whether a competition is skill-based is whether the competition includes an element of skill would prevent a substantial proportion of people from either participating or receiving a prize. Based on the guidance this seems to be a pretty low bar for meeting the exemption. It eliminates the possibility of avoiding the lottery definition by adding a too easy a question (‘what is the capital of France?’) but apparently not a lot of skill is required for the competition to be skill-based. For spot the ball competitions, any residual legal uncertainty is further reduced by the fact that there is some specific guidance about what conditions need to be met for a competition to avoid being classed as a lottery. Based on this, it looks like it would be an uphill battle to challenge that BOTB’s competition is exempt from being classed as a lottery.

There could be a fly in the ointment from a recent legal case won by Sportech (operator of the original Football Pools spot the ball competition) against the HMRC. In this case, Sportech successfully argued that spot-the-ball competitions that use a panel of judges (similar to BOTB) are ‘games of chance’ as defined under the Gaming Act 1968, the implication of this being is that VAT does not apply to such ‘games of chance’. This has resulted in Sportech (and BOTB) being owed a VAT refund. More importantly, this raises the question of whether there is a tension between BOTB’s competition not being classed as a lottery for the purpose of the Gambling Act, while also being a ‘game of chance’ and so not being required to pay VAT for the purposes of the Gaming Act.

At first blush, it seems that there could be a tension here but on closer look at the legislation I’m not sure there is. The distinction between a ‘game of chance’ and ‘game of skill’ under the Gaming Act seems very different to the distinction between a ‘lottery’ and a skill-based prize competition under the Gambling Act. It’s clear from the Gaming Act that the relevant bar for a competition to be ‘a game of chance’ is not that the game involves no skill whatsoever – a combined game of skill and chance is explicitly treated as a game of chance. In contrast under the Gambling Act, it is clear that to avoid being classed as a lottery, a competition only needs to involve a material element of skill such that it does not ‘rely wholly on chance’, not that there is no chance involved whatsoever. The Sportech judgment clearly finds that the spot the ball competitions, such as BOTB’s, involve significant elements of both skill and chance. This suggests that they can be both ‘games of chance’ and avoid the definition of ‘lotteries’. The contrast between these two sets of regulations might seem awkward but this hardly seems unusual or logically inconsistent to me. There is not an apparent reason why these different definitions have to match up. I’m fairly convinced that the Sportech judgment is a red herring.

The more salient concern is that the definition of a lottery under the Gambling Act will change. The consequences of BOTB’s prize competition no longer benefiting from its ‘skill-based’ exemption and instead being classed would require a drastic change in direction for the entire business model. The Gambling Act is currently in the process of being overhauled with a new version due to be implemented in the next couple of years. Based on what the government has said so far about the scope of its review of the Gambling Act, it doesn’t look like the definition of lotteries is going to be something they will consider. There is no guarantee that this won’t come up but it seems highly unlikely to me that this would be seen as a priority at the moment. If it doesn’t feature in the current review, the good news is that there is then unlikely to be another one for a good many years.

While I don’t think changing regulation is an imminent threat, I’m still uncomfortable about BOTB’s situation. I don’t see a strong fundamental rationale for why BOTB’s competition should be treated so differently to other types of lottery. Similar issues around addiction and the need for player protection seem relevant. The general direction of travel for gambling regulation seems to be to crack down harder on protecting people from gambling harms.

BOTB’s situation leaves it particularly susceptible to negative publicity becoming a catalyst for a regulatory crack-down. It’s not hard to imagine the ingredients of a possible scandal that could lead to questions being asked about BOTB’s regulatory status: allegations of excessive profitability; a non-transparent payout ratio; some case studies of harm from addiction. No doubt that BOTB will do its best to behave inscrutably but even then it could be the victim of events outside of its control. It’s not inconceivable that this business model is cracked down on or even outlawed within the next 10-15 years. The risk seems remote right now but my concern is that it would only increase as BOTB becomes more successful.

Overall

As I might have expected, further digging into the detail has brought up some concerns and made me feel a bit more pessimistic about my investment here. There are some significant risks that should be reflected in the valuation of the shares. The main risks seem only likely to grow if BOTB becomes more successful. I don’t want to lose sight of the positives and still think the overall reward to risk is promising given the growth potential and lowly valuation. However, I do feel some unease, especially given how illiquid the shares are. In the short term, it seems possible that the share price may struggle as momentum from last year slows down. I don’t think this warrants being my largest holding despite the success I’ve already had with it. I’ve been steadily trimming my position over the past month or so but will pause for now given the price has come off a bit.