I can remember when I was a teenager playing Need for Speed on my PlayStation for countless hours (after I had finished my homework...) trying to get a new best lap time. Funnily enough — 20 years later — investing can feel the same at times! Investing is a race that never ends, constantly going round and round in circles looking at new investment ideas — hoping to find just a handful of good ideas that will keep you at the top of the leader board.
Over the years in financial markets it has become harder to achieve this objective, partly due to increased competition from hedge funds and computer algorithms making the market more efficient. Today active manager's need to be more creative in identifying situations where others in the market (particularly short term orientated funds) may be missing a trick. With thousands of potential investment candidates globally and lots of competitors looking at the same investments, it is very important for us to spend our time looking in spots that are more likely to be rich in misunderstood opportunities.
Our recent trip to the US, and meeting with Electronic Arts, the global gaming giant, provided a good example of one such area — industries where the traditional means of distribution have been disrupted. Ten years ago if you wanted to play Madden NFL you had to bike to your nearest video game store and buy the game off the shelf (packaged in a DVD case). However, in the last five years, with faster broadband speeds it is easier to simply download the game.
While this may not seem like a big deal, it has a huge impact on Electronic Arts' profitability. Selling a game at full price for download on the online PlayStation Store rather than via a physical retailer allows them to capture the profit margin a retailer like Noel Leeming would have made on the sale. Electronic Arts also saves the cost of printing the games onto a CD, boxing them up and shipping them to stores. Based on our numbers EA earns more than double the profit on each game they sell digitally.
In 2013, EA was barely profitable. Revenues from its game sales only just covered its large team of game developers, salesmen and administrators. Since then, while the company has only grown its sales at 6% per annum, this digital transition has helped magnify its earnings almost 10-fold. Not surprisingly its share price is up over 700% since the start of 2013!
While it is futile trying to outfox hedge funds attempting to forecast Wal-Mart's the next quarterly earnings number to 2 decimal places (they use satellites to count the cars in Wal-Mart carparks to help them), the Electronic Arts example highlights how subtle but important changes in the business models of specific companies can be missed by short term investors.
Though the Electronic Arts opportunity is now largely understood by the market, we are constantly looking for opportunities that may not be. One company that sits in this camp is Walt Disney, another company we met on our US trip. Fast broadband has allowed Netflix to build a highly successful business distributing TV content directly customers — circumventing TV networks, cable and satellite TV operators. Eventually content creators like Disney will more aggressively distribute their shows directly to viewers and capture the profits made by TV networks for simply providing a distribution service.
Another candidate would be L'Oreal, whose augmented reality app 'Makeup Genius' allows customers to try on new looks from their phone and then simply click 'buy' and have them delivered. While it's still early days, online sales for L'Oreal would allow them to capture at least part of the profit pool currently taken by department stores and make up specialists like Sephora.
As with video games, where the next level you unlock may not be as you expected, the situations that will provide us with opportunities will vary considerably from year to year. That said, we believe an investment process structured around identifying businesses with a misunderstood medium term story can provide ripe opportunities that others may miss.
Pictured: Harry Smith, our Senior Investment Analyst deep undercover at Electronic Arts.