Why Sony and Nintendo Stocks Could Rack Up Higher Scores

In the years before World War II, British economist John Maynard Keynes boldly predicted that by the time his grandchildren were grown, the average person would spend just 15 hours a week at work, thanks to technological innovations.

Fast-forward 85 years or so, and there’s at least one trend that’s moving in the direction that Keynes predicted. American men between the ages of 21 to 30 worked an average of 203 hours less in 2015 than they did in 2000, according to a recent National Bureau of Economic Research working paper. But it wasn’t because machines became man’s best coworker. Rather, the authors postulated, much of the decrease was due to young men carving out more time for one technology in particular: video games.

Such is the appeal—and the economic­ power—of gaming, a medium whose shadow has expanded to eclipse music, movies, and television on the pop culture landscape. Revenue in the gaming market, including mobile, PC, and console games, is expected to grow 8% in 2018, to $134.5 billion worldwide, according to market research firm Newzoo. “It is the fastest-growing entertainment segment,” says Tom Wijman, a market consultant at the firm.

Investors have raced to cash in, and recently they’ve been richly rewarded. In 2017, while the Nasdaq composite index rose 28%, the ETFMG Video Game Tech ETF, which tracks about 60 stocks related to the industry, scored a 60% gain. (The fund’s cheeky ticker symbol: GAMR.) The question now is whether there is any more juice left in the rally. In an industry in which the hottest game franchises and playing platforms tend to go through boom-and-bust cycles, can video game stocks outdo today’s high scores?

James Ayer, portfolio manager of the Oppenheimer International Equity Fund, believes they can. Ayer identifies several tailwinds that could keep the industry growing. For one, the sector has reached a sweet spot in its conversion from an over-the-counter retail model, in which players buy new games on discs from retailers, to an e-commerce model, with customers increasingly downloading games. That transition is enabling gamemakers to cut back on middlemen and reduce their expenses: Their gross margins are about 80% for downloaded titles, compared with 60% on packaged games, T. Rowe Price estimates.

Nintendo Switch vs. <a href="https://fortune.com/company/sony-2/" target="_blank">Sony</a> PS4 best stocks to buy
Courtesy of the companies
Courtesy of the companies

That’s hardly the only source of new income for gamemakers. Consumers are spending more time playing games; they’re also becoming more willing to make in-game purchases—spending real money to buy, say, new weapons for their fictional characters—enabling some companies to replace a dependency on new hits with a steady, recurring revenue stream. And thanks to the ubiquity of smartphones, mobile gaming is expected to become the fastest-growing segment of the industry in coming years, says Newzoo’s Wijman.

No video game name was hotter over the past year than Nintendo (NTDOY), which enjoyed a dramatic turnaround thanks to the March 2017 release of its new handheld console, the Switch. In its first 10 months on the market, it became the fastest-selling game console in U.S. history, and the company expects to sell 14 million units by its first anniversary. Jefferies analyst Atul Goyal notes that Nintendo derives most of its earnings from software and games rather than consoles, so profits from the Switch are something of a bonus. And with the device still early in its product cycle, Goyal thinks Nintendo’s earnings have six to seven more years to grow before peaking.

What’s more, the company is on the verge of what Morgan Stanley analyst Masahiro Ono calls “a big chance to enter the China market.” Nintendo has largely stayed out of that country until now, but it recently inked a distribution deal with Chinese Internet giant Tencent that will help expand the reach of some of its game franchises, and it is gearing up to introduce the Switch in China by early 2019.

Nintendo’s stock looks relatively affordable despite its recent gains, with its American depositary receipt trading at a price-to-earnings ratio that’s less than half its five-year average. But the company also faces potential pitfalls. In the past, Nintendo has struggled with delays in rolling out new versions of major game franchises, especially The Legend of Zelda. Similar setbacks could crimp revenue, says Goyal. Nintendo’s ability to avoid such stumbles could determine how long investors’ winning streak lasts.

While Nintendo has captured big returns from a new product, its Japanese rival Sony (SNE) has squeezed unexpectedly strong results out of an old one. Though it’s a highly diversified consumer electronics company, Sony’s PlayStation 4 console—introduced five years ago—has become a major profit driver (see the box “Game Changers” to learn how), and the company now derives roughly 30% of its revenue from gaming. Bernstein senior analyst David Dai thinks Sony can grow gaming profits by more than 20% annually over the next three years. Downloads and in-game purchases are helping Sony too, even with games that Sony itself doesn’t publish; console makers typically take a cut of up to 30% from downloads of games they didn’t create, says Dai.

The big question for investors is whether gaming alone can sustain Sony’s momentum. Sony is focused on turning the PS4, which streams music and video, into a connected home device. But the company has yet to confirm a launch date for the PlayStation 5—with educated guesses ranging anywhere from late 2018 to 2021. One potential danger sign: Last Thanksgiving, Sony offered a $100 discount on the PS4 for a price tag of $199, but the Switch still beat its rival console among online retailers while selling at full price ($299), according to data from Adobe’s Digital Insights. And Sony’s other business segments, like smartphones, are healthy but slower growing. Bottom line: The outlook for the company’s stock is good, but shares aren’t likely to match 2017’s blistering 70% pace.

For all the headlines the device-makers have generated, many investors think in-game monetization is where the industry’s next big wave of growth will come from. Wedbush Securities managing director Michael Pachter has gravitated toward Electronic Arts (EA), maker of popular sports titles like Madden NFL and FIFA soccer. Those franchises helped EA earn $1.81 billion in the 12 months ended mid-2017 from recurring sources such as microtransactions, subscriptions, and game expansions, up 25% from a year earlier. Of course, the formula doesn’t always work; EA pulled in-game purchasing out of its Star Wars Battlefront II game last fall after facing a consumer backlash. But as gamemakers strive toe please investors, such retreats are likely to be the exception, not the rule.

A version of this article appears in the Feb. 1, 2018 issue of Fortune with the headline “Can Video Game Stocks Level Up?”

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