Activision: strong company in a weak industry

Invest in companies or invest in industries?

Question:  Which is likely to be a better investment–a strong company in a weak industry or a weak company in a strong industry?

(My) Answer:  It depends.  Outside the US, where equity investors tend to focus more on national and international macroeconomic and political issues and less on individual security analysis (many wouldn’t know an annual report if they fell over it), the merits of the industry far outweigh those of the individual company.   Holding the best companies, without regard to the industries they’re in, is a recipe for disaster.

In the US, on the other hand, which has been a pillar of relative macro and political stability, “big picture” issues have tended to be irrelevant.  Instead, everyone is a stock picker.  Holding the best stocks, without regard for their industry, has been the ticket to success.

US equity trading is taking an unusual path, I think

I’m not so sure that this rule of thumb, extremely reliable in the past, has held in the US in the current bull market.  The two clear patterns I see in this year’s stock performance are:

1.  economically sensitive industries have done well; more defensive industries, like telecom, utilities, healthcare and staples, have consistently done badly.

2.  toward the end of the summer, the market narrowed its focus from looking at economically sensitive industries across the board to focussing more narrowly on the strongest members of the strong industries–that is, from value to growth.

In all of this, it seems to me that stocks in weaker industries have just been ignored, no matter what their merits.

ATVI as an example

…which brings me to ATVI (a stock I own).

ATVI closed last Friday at $10.75 a share.  It’s up about 30% from the lows in March, or about half the gain the S&P 500 has achieved.  It kept up with the S&P fairly well until mid-summer and has been fading since.  What’s wrong?

The simplest explanation, and, given that even the best equity investors are wrong almost half the time, is that my analysis of the company has been faulty.  At least in terms of stock performance, it certainly has been.  But at the risk of keeping on deluding myself, I think there’s something more than that.

The shrink-wrapped video game software industry is in trouble, in a number of respects:

1. Some competitors aren’t doing well.  The long-time industry leader, ERTS, has been faltering for a number of years and new management so far seems unable to straighten things out.  Similarly, TTWO, famous for its Grand Theft Auto series, recently announced it was having trouble with the sports game franchise it bought from the former Sega.

2.  Wall Street is worried about the competitive threat of casual gaming, simple games played for short periods of time on mobile phones or through social networking sites.  This is an issue because the cost of creating a console video game has risen far beyond the point where it can be profitable by only selling to hard-core gamers.

3.  Video games generally are proving less recession-resistant than had generally been thought.  Software sales in the US are down 3% year on year.  That isn’t much, but the consensus expectation had been for a rise.

Why should ATVI be any more attractive than ERTS or TTWO?

1.  ATVI’s first person shooting franchise, Call of Duty, launched its newest version, Modern Warfare 2, on November 20th.  Through the end of the month, according to the NPD data collection service, over 6.1 million copies of MW2 had been bought, making it the most successful launch ever or a video game.  True, two expensive games ($90+) for consumers to buy, DJ Hero and Tony Hawk: Ride have been turkeys so far, selling 245,000 and 114,000 respectively through the end of November.  But their negative effect on results will be swamped by MW2‘s positive impact.

2.  ATVI owns Worlds of Warcraft, by far the most widely-played subscription-based online fantasy game.  What makes WoW unusual is its appeal to audiences in the Americas, Europe and Asia–typically markets with widely different taste in games.Subscription revenue seems to be plateauing at slightly north of $1 billion yearly, implying, say, $800 million in annual operating income.

3.  Although long-delayed, ATVI says it will launch a new version of Starcraft in 2010, intending to try to duplicate the online success it has had with WoW. No one knows yet whether ATVI will be successful, but earlier games in the Starcraft franchise have also enjoyed immense worldwide popularity.

4.  The company has no debt and $2/ share in cash.  ATVI will likely add at least $.50/share to that total by the end of the holiday season.  It has been revising its earnings guidance up–doubtless due to the success of MW2 (which it had a strong hint about through pre-orders).  Assuming ATVI could earn $.70 a share in 2010, it is trading at 15x earnings.  If results are indeed being held down by recession at present, an improving economy might push ATVI’s earnings higher.

A wider implication

ATVI may or may not turn out to be a good stock.  Stock-specific risk is the reason you hold a portfolio instead of one stock–to make sure your success doesn’t rise or fall on one name.  But there’s a wider point I want to make.

It seems to me that the US market has been bought since March in a top-down, industry-orientation way that would be more characteristic if European equity managers or global bond managers were making the decisions.  Bottom-up, traditional American-style growth stock investing appears to me to have taken a back seat.  This implies that looking through laggard industries–healthcare, telecom, even (gulp) media–may be very worthwhile.

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