Pembridgecap

A Wealth Creation Journal

Live Portfolio Update – 2020 #10

Added 3% to Ryman Healthcare @ NZD 13.

Increased conviction in their Australia growth prospects where they literally don’t have any serious competition because a lot of the Australian retirement village operators are really property developers who are hesitant to take on age care operational risk due to the scandal-prone Australia age care sector.

Ryman is hence very uniquely positioned to grow in a huge market for a long period of time. And Ryman charges 20% deferred management fee while competitors charge north of 30%.

How often do you find the lowest cost operator is also the highest quality operator in a sector with VERY VERY long growth runways.

Live Portfolio Update – 2020 #9

Ryman Healthcare reported its annual results ending Mar 2020. Overall they have done a fantastic job taking care of the residents and NZ as a country also did a great job containing COVID. The likelihood of a liquidity crisis at Ryman has reduced significantly as the sales process has resumed and the care business generated strong cash flow even at the peak of COVID-19 crisis. Nonetheless, the near term financial performance is likely to be negatively impacted as the sales momentum takes time to resume. However, Ryman’s long term prospects are intact and, if anything, Ryman is likely to emerge as a stronger company.

Added another 4% to Ryman Healthcare @ NZD 13 per share

My conviction in Nintendo grows as I learn more about the company. Recently, there was a Bloomberg article that claimed Nintendo has reduced ambitions in mobile games due to its success with Switch. And a few days later, Nintendo announced a new Pokemon game called Pokemon Unite which is a joint development with Tencent. Despite the deluge of criticism by Pokemon hardcore fans, I am very excited about this game. I think Pokemon IP has incredible adaptability and this is just the beginning.

More importantly, this signals another attempt by Nintendo to transition from Game as a Product (GAAP) to Game as a Service (GAAS) over time. (For more details on GAAP vs GAAS see this post ) While it is hard to predict exactly how this transition will happen, I am confident that it will happen. My best guess is that Nintendo will use mobile games as a way to funnel gamers to their own game system and they will adapt more service capability to their game system over time. Pokemon Unite is one such example.

Added another 2.5% to Nintendo @ JPY 50700 per share

Thoughts on the video game business

I am a gamer myself and I am very excited about the future of video game as a great entertainment medium and a “subset of reality”. But I am even more excited about the lucrative prospects of video game businesses as an investor!  I have learnt so much from the great thinkers in this industry – Chris Crawford, Nicole Lazzaro, Satoshi Iwata, Gavin Baker, Shigeru Miyamoto, Matthew Ball and many more. And I have taken their work and organized it in a way that is useful to me as an investor.

Note: While I will use game and video game interchangeably here, I recognise that many great games, such as Magic: the Gathering and Warhammer, share many common features with the video game as described below. For this discussion, I mostly focus on video games

1. Unlike traditional media of TV, books and music, video game is an interactive entertainment media. This is a highly immersive environment where the gamer can interact with the game environment and change the course of events in the game world. Video games, because of this interactivity, are in essence problems for gamers to solve. For example, puzzles in Legend of Zelda, defeat enemies with finite resources in a real-time strategy game, opponents to be killed in a first-person shooting (FPS) game. It is believed that human instinctively derives happiness from solving problems and the harder the problem, the more intense the feeling of happiness when the problem is solved. Using this perspective, a video game is a very cheap and effective medium to create all kind of problems for humans to solve. It would be stupendously expensive to recreate a typical role-playing game that involves 100 characters to act out 100 hours of game-play content in real life! So game worlds simulate problems for gamers to solve and gamers derive happiness from solving the problems. 

2. In this context, the video game industry has tremendous future ahead of it! Beyond its current incarnation as an entertainment media, video games can be used to solve real-world problems such as education and politics. Imagine the value that could be created if job interviews involve the candidate playing a game which simulates the work environment with high fidelity or two countries before engaging in a trade war is required to play a game that simulates the economic consequences of their trade policies in a game! Humans can sometimes only learn from things that they have experienced and games are an efficient way for human to learn from experience albeit in a virtual environment. This is very far into the future but I believe this is the direction that we are heading towards.

3. The most important difference, from a business model perspective, between video games and traditional media is that video games’ interactive nature creates a feedback loop of inputs and rewards. Gamers give up time and effort to create inputs into a game and the game rewards the gamer with some kind of positive emotions. If the gamers feel that they receive more reward from the game than the effort they put in, the gamer is said to be in a positive feedback loop where his/her emotional attachment to the game grows with time. Some game companies exploit this feedback loop (through mechanisms such as loot boxes) in a way similar to gambling. Other game companies create truly beautiful games where the gamers are treated to a rewarding emotional journey similar to watching a well-made movie.

4. There are three main roles in the video game value chain – 1) Game developers (Nintendo / Blizzard) who made the game, 2) Game publishers help to market and distribute the game. Game publishers can either buy the game content from game developers outright and take on the marketing cost to sell the game or more commonly finance part of the game development cost and strike a profit share agreement with the game developers. It is common to see big game developers such as Activision develop and publish their own games, 3) Game distribution platforms. Apple / Google for mobile games. Steam / Epic for PC games. Sony / Xbox / Nintendo for console games. Most game companies are involved in multiple roles across the value chain. E.g. Tencent takes on all three roles – game developer, game publisher and a distribution platform 

5. Game developers and distribution platforms capture the majority of the profit pool in the value chain while the game publishers are increasingly squeezed in the middle. Game publishers’ service, relatively speaking, add less value and least differentiated and hence they take the smallest slice of the cake on thin margins. Tencent is a unique case where it began as a game distribution platform and game publisher and grew to become a very successful game developer. As a content creator, the game developers differentiate themselves through game content. Fans are extremely loyal to great games but the challenge for the game developer is to consistently produce great games.  Game distribution platforms such as Apple App Store through their control of users are extremely profitable. For a typical mobile game on iPhone, the Apple app store clips 40-50% of the total revenue and the game publisher takes 10-20% and the game developer accounts for the rest

6. Why do people pay for virtual items in games? Gamers pay because they receive an emotional reward in exchange for time and money spent on the game. Ultimately, the maximum amount of money people is willing to pay depends on the quantum of emotional reward they receive. There are a couple of ways for people to get an emotional reward – not a comprehensive list. 1) enjoy a good the storytelling (similar to emotional reward from movies) 2) sense of competence as one becomes good at the game 3) social interactions – critical for many online games. E.g. gamer pay for cosmetic appearances for their in-game avatar. When my 15-year-old cousin was asked why she pays for virtual clothes in-game, she said “you don’t walk around naked nor wear the same cloth every day so why shouldn’t I behave any different in-game”.

7. Traditionally (let’s say before the 2000s), in the Game as a Product (GAAP) revenue model, gamers pay a fixed sum in exchange for unlimited gameplay time to get an unknown amount of emotional reward. The traditional distribution model of games is in essence very similar to books. A gamer walks into a physical game store to check out the latest games available and make a purchase decision based on very limited information. Pretty much judging a game by its cover. It is impossible to charge each gamer a different price based on how much each gamer liked the game. For the most part, the gamer cannot try the game before deciding on the purchase. Furthermore, the gamer’s relationship with the game developer is indirect because the game developer does not know who plays the game nor how the game is played. Feedback collection mechanism is chunky and ineffective. The entire experience is sub-par for gamer and game developer.

8. Internet and smartphones herald a new revenue model – Game-as-a-Service (GAAS). GAAS employs a continuous revenue model with free-to-play being the most dominant GAAS model for mobile games. GAAS spreads the revenue across the entire lifecycle of a gamer while GAAP is 100% upfront payment. There are many different manifestations of GAAS such as a game subscription, in-game transactions, in-game economy tax. I am excluding the discussion of cloud gaming here because cloud gaming is more about computation and I want to focus on game monetisation method here. Conceptually, GAAS is a superior revenue model to Game-as-a-Product because 1) game developers can build direct relationships with its gamers and own that relationship; 2) price discrimination of gamers; 3) maximise gamers’ lifetime value. Said in another way, for great games that use the GAAS model as opposed to GAAP model, the gamer’s loyalty is higher, generate higher revenue and play longer while also getting more emotional rewards from the game.

9. We are still exploring what is considered fair and ethical in the GAAS model. Some game developers design GAAS games with feedback loops similar to those that cause gambling addiction or create an unfair advantage to paying gamers.  Other GAAS games, such as League of Legends, sell virtual costumes for purely cosmetic purposes and does not impact the competitive gameplay at all. I believe that GAAS is especially powerful for great games with a fair monetisation mechanism.  Because great games are by definition offering tons of emotional reward, and it is likely to be under-monetised in the GAAP model because great games’ sale price is not too different from the average game price. On a price per unit of emotional reward basis, the great games are arguable under-monetised as a GAAP game. Using a GAAS model, gamers who otherwise cannot afford the game could play the game for free and the most passionate fans can be monetised based on the different amounts of emotional reward they each individually receive.

10. A great example is a Chinese online MMORPG game created by Netease called Fantasy Westward Journey. This game has two monetisation methods – 1) gamers pay an hourly rate of USD 1 to play the game and, 2) Netease charges a 1% commission rate for transactions between gamers. Most passionate fans are willing to spend thousands of US dollar to buy powerful characters from players who committed incredible time and effort to train up the character. Netease charges a 1% commission rate for this kind of transactions. The commission dollars help to keep the hourly rate low which then keeps the players with a lot of time and less money in the game to train up their characters which they can sell to players with more money but less time. Such an in-game economy structure improves the game experience, increase gamer loyalty and maximise gamers’ lifetime value in a continuous game world using a GAAS revenue model

11. Gamers can become incredibly loyal to one game over a long period of time once they become invested in the game. I started playing DOTA when it was just a customized game within Warcraft in 2007. DOTA has inspired League of Legends and the entire MOBA genre. DOTA has a reasonably high barrier to entry because the gamers need to develop a base level of game knowledge and skill to start enjoying the game meaningfully. Given that I have already become a reasonably good DOTA player, I don’t want to commit to another game where I need to build up a base level of competence to play that game. Instead, I prefer to enjoy the joys of playing a game that I am already pretty good at. And DOTA, which is now hosted on Steam, continues to release new game content to enrich the game experience which means it is never boring for me. The point here is gamers become loyal to a game when they become highly invested in the game world and the challenge is for game developers to provide new content to continue to enrich the game experience. Again this is only possible in a continuous game world

12. Finally, let’s think about how to value a game developer. There are two components to the value of a game developers 1) the present value of all free cash flow generated by the existing game franchise and 2) the present value of all free cash flow generated by future game franchises. The total profit generated by the existing game franchise requires one to estimate A) longevity of the game, B) revenue per gamer and C) the ongoing operating cost of the game. A game company’s development capabilities determine the probability of producing successful games in the future. It is much harder to assess the value created by futures games but it can have very real value

13. To assess the existing game franchise, one must understand the drivers for gamer loyalty to a specific game (longevity) and the quantum of emotional reward (revenue per gamer) received by the gamers. One can investigate the strength of the game community to get some sense of the social bond between gamers. The social bond formed through the game can be one of the most powerful retention mechanism. Another neat trick to assess gamer loyalty to the game is to investigate the behaviour of returning players. For example, Warhammer 40K has many gamers who played as a teenager but stopped playing as they got older. However, given a chance, many old Warhammer 40k players readily come back into the game. The “relapse rate” for Warhammer is very high. The revenue per gamer should be proportional to the emotional reward per gamer. However, if the game is fun for a sub-group of gamers at the expense of another group of gamers then the game might not be sustainable. Hence the pay-to-win model is inherently quite risky. Sometimes it is clear that the game is under-monetised. For example, Nintendo’s Animal Crossing is a great example. Many gamers are paying hundreds of dollars to acquire certain items from other gamers which Nintendo is not capturing. Finally, for any game franchise to attain super long longevity, the game developers must continuously innovate and create new game experiences in the game world.

14. There are a few exceptional game franchises that have proven their capacity to sustain themselves for a very long time into the future. Pokemon, League of Legends, Magic the Gathering, Legend of Zelda and the sports franchises are such examples. Pokemon is able to build an incredible IP and continue to generate high-quality game content. While Pokemon has sustained its longevity under the GAAP model, its transition to a GAAS model through Pokemon Go is going to make Pokemon a much more valuable franchise!

15. To assess the game development capabilities of a company, one must understand the game company’s culture, its development process and historical success rate. It is hard to define the commercial success of a game on an absolute basis. Typically, the game industry, just like any other creative industry, is defined by huge but few successes. So it is better to define success through return on investment. For the sake of this discussion, I define a 10x return on investment as a successful game. A great game company tend to have a very strong and unique culture. Some game company care more about making really great games than others who are more concerned about short term commercial success. Some great game companies have well-defined game philosophy, for example, Nintendo is a big believer in hardware and software integration as a source of differentiated game experience. One needs to assess if the game development team’s organizational structure makes sense for the games that they are trying to build. From an investor perspective, the most important method is to study the game development track record. CD Projekt Red is developing a very impressive track record and its future game franchise value makes up the majority of its market value. Nintendo maintains a very impressive game development track record over a long period of time though it is not proven in the mobile game space. Blizzard has a great track record but they are struggling in the mobile era. Netease and Tencent both have impeccable game development track records!

16. Scale matters a lot for game developers. Luck plays an important role in the outcome of any one particular game. Assume a good game developer can expect a 5% success rate and each successful game yield 10x return, then the game developer’s expected return is 50%. However, the game developers need many tries before the expected value can be achieved. Hence the two gamers with the same expected return, the larger of the two is much more likely to realise the expected return. But as game companies grow larger, they tend to become more bureaucratic and hinders the creative process and reduce the expected return. So scale matters only to the degree that the expected return doesn’t decline with scale.

17. GAAP vs GAAS involves very different game development process. Chinese game companies are generally leading in this regard. GAAS requires a game development team that continuously create and improve game experience after the game is launched. However, GAAP game development process pretty much ends after the game is launched. This difference to game development approach is, I think, one of the main reason why traditional console game companies, such as Nintendo and Activision, are not able to be very successful in the mobile game era.  Mobile games almost exclusively adopt GAAS model while console games are still very reliant on GAAP revenue model.

As an investor, I prefer game companies with incredibly strong game franchises and a proven game development track record. There are very few game companies that fulfil both criteria. Netease, Tencent and Nintendo are some examples. Please let me know if you know of any! The goal is to buy such game companies at a discount to its existing game franchise value and future game value is margin of safety.

Live Portfolio Update – 2020 #8

The deal is finalised today and closed out all Bitauto / Yixin positions.  A cool 20% return in 6-months. I consider special situation opportunities such as this one to be perfectly reasonable investment opportunities given the generally high market valuation. Will probably participate if similarly good opportunities arise again.

However, one must recognise the real money is made with a great company that can compound over time. The special situation opportunities seem to me to have real reinvestment constrains because one cannot always find wonderful special situation investments with attractive absolute returns despite good risk-adjusted return. And not scalable after a certain capital size(not an issue for me now but hopefully it will be).

Frankly, it just feels less satisfying than owning great businesses that just keeps improving and making a real impact on the world.

Live Portfolio Update – 2020 #7

Added ~3% to Nintendo @ JPY 44500. After the latest result for FY 2020, I am gaining more conviction in the company. Though the management Q&A this time is very short and lacking in solid content. Very disappointing from that regard. More details for Nintendo will come later.

Concentrated Investing vs Change

My initial introduction to investing exposed me to different strands of thoughts and notions about investing. Only a few of these notions about investing are fundamental principles and exist as objective truths in my opinion. (yes, I see the contradiction here) One such principle includes the notion that the intrinsic value of a business is determined by the sum of all future cash flow that is generated by the business discounted at an appropriate rate. Another is the notion that shares represent partial ownership in businesses. Besides these fundamental principles, there are many tried and tested investment lessons and stylistic preferences that work for different individual investors. For example, many successful investors prefer to do highly concentrated investing. Warren Buffett famously said:

“I always tell students in business school they’d be better off when they got out of business school to have a punch card with 20 punches on it. And every time they made an investment decision, they used up one of their punches, because they aren’t going to get 20 great ideas in their lifetime. They’re going to get five or three or seven, and you can get rich off five or three or seven. But what you can’t get rich doing is trying to get one every day.”

I am intuitively attracted to the basic premises behind concentrated investing – 1) great ideas are hard to come by and when given the chance needs to bet big, and 2) high concentration forces discipline to focus on companies that are within one’s circle of competence. The mantra of concentrated investing contradicts the conventional investment wisdom which preaches diversification. In the name of diversification, most investment funds would routinely own hundreds of stocks. Investment managers who own 20+ stock would be considered concentrated by average industry standards. As a fully-signed up practitioner of concentrated investing, I generally own no more than 10 businesses and currently, my top three positions make up over 50% of my portfolio.

Lately, I am observing something strange. As I learn more about businesses in the technology and creative industries which typically exhibit extreme pay-off characteristics, I am struggling to apply the concentrated investing to investment opportunities with small chances of success but have huge pay-offs in the event of success. For example, video game companies are typically considered by the investment community as a hit-driven business and hence not investable because no one can figure out the long term earning power of a game company. However, there are compelling situations where the combinations of valuation, unique insights into the business and historical track records that can lead to profitable investment opportunities into a game company. Any cursory look at Nintendo’s historical earning profile, which is very highly cyclical, would seem to reinforce the view that video game is a hit-driven business and hence uninvestable. However, a confluence of technological trends and industry changes seem to herald a very bright future for Nintendo. Through the proliferation of cloud computing, higher Internet speed and adoption of the subscription business model, Nintendo could be building a direct and continuous relationship with its customers and transition the hit-driven revenue model into a stable and growing earnings stream. In this case, Nintendo could be worth multiples of its current market cap.

Nintendo is in a state of change – it could navigate the changes perfectly or it could fail to transform itself and relegated into the oblivion. I believe Nintendo has a non-trivial chance of wild success due to its unique culture, extraordinary game development track record and strong IP. Let’s call a non-trivial chance of success as 10%. And let’s assume that if successful, it could be worth 10x more.  But it still has a 90% chance of failure and would be worth 50% of its current valuation in the event of failure. The expected return for Nintendo would be 1.5x which seems like an attractive bet to make. However, it is not reasonable to have this as a large position size, say 20% of the portfolio, because there is still a 90% chance that I will lose 50%! The logical strategy is to spread the bet over a large number of these opportunities such that we can achieve the expected return. But spreading the portfolio over a large number of bets runs counter to the mantra of concentrated investing!

Now consider another investment opportunity that has the following characteristics – 70% of a 1.7x payoff and a 30% chance of 5% loss – which has the same expected return of 1.5x as the Nintendo example. Now, this looks like a classical asymmetric bet and could be a big bet in the portfolio despite having both investment opportunities having the same expected return. The second investment opportunity is likely to be a stable business with a solid asset value to act as valuation backstop. It could be an elevator OEM going through a cyclical low point and the earnings are depressed because new elevator sales loss is masking the true profitability of the maintenance income. If both investment opportunities are available to me, I would always pick the second one over the first one! It becomes really challenging if the opportunities with the best expected return exhibit extremely pay-off structure like the Nintendo example.

While I have not done a rigorous study, it does seem like concentrated investing works better in a stable industry environment where the company’s intrinsic value is relatively stable and the difference between the best operator and the average operator is relatively small. However, companies that are currently in a rapidly-changing industry with winner-take-most characteristics can produce extreme pay-off structures because the winner is able to grow its intrinsic value dramatically. Maybe these binary investment opportunities might not be so suited to the highly-concentrated investing style. But what if the best investment opportunities lie in these rapidly-changing industry with extreme pay-off structures?

This runs into another notion of investing where Warren Buffett famously said that change is the enemy of investors. Four years ago, I would agree whole-heartedly. I am less sure now. I think change could be the friend of an investor if, and only if, the investor has unique insights into the nature of the change that allows the investor to handicap risks confidently and figure out the pay-off structure clearly. One still has to do the work to gain real insight into an industry / a company that is undergoing change.

Arguably, it requires a lot more work to gain insight into a changing industry versus a stable industry. So all else equal, I would much rather make the same amount of money with the least amount of effort possible. Alas, the investment management field has gotten more competitive and what used to work before might no longer work so well anymore. So to stay ahead of the competition, one has to do things differently. Maybe this includes being open-minded about how to conduct concentrated investing and perceive industry changes in the context of investing.

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