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How Investors Can Profit From E3

Investors haven't had a lot of luck with the video game sector over the past few years. Stock prices of traditional publishers have been down as new ways to play emerged on the market and many of those same publishers instituted turnaround plans that took longer than expected to bear fruit.

Electronic Arts Headquarters, Redwood City, California
AP
Electronic Arts Headquarters, Redwood City, California

But as the industry gathers for E3, its annual trade show, there's a sense of excitement about the future—and if the recent boosts in share prices of Electronic Arts (which hit a 52-week high at the end of May) and Activision (which climbed on news of a new method to monetize the "Call of Duty" franchise) are any indication, the sector could be on the move again.

If you're looking to buy into the industry, there are a few basic things to look for. First, the days of scatter shot releases are over.

Smart companies are scaling back their releases, and focusing their research and development dollars on what they feel are sure bets. Any company that seems to be throwing a lot of ideas at a wall to see what sticks should raise a red flag.

Also, beware of falling for clever marketing. E3 has kindly been called a circus, but that really doesn't do the show justice. It's an orgy of sights, sounds and, more than anything else, hype. It's easy to get dazzled by multi-million dollar booths and the enthusiastic pitches of game developers and be fooled into thinking an average game is destined to be a breakout hit. And for investors, that's a dangerous tightrope to walk.

E3 Electronic Entertainment Expo - A CNBC Special Report
E3 Electronic Entertainment Expo - A CNBC Special Report

While most gaming websites and publications will offer their own "Best of E3" awards by the end of the show, smart investors will take those with a grain of salt. Real buzz is generally not created by editors, but by gamers—and they're quite vocal about what's exciting them in the forums of those sites.

Game-centric destinations like G4 and Shacknews have rich communities of players and can be a good place to spot up and coming trends. That, in turn, can signal which titles might see strong pre-orders.

"If people are excited about a game and there's curiosity, the initial data point people pay attention to is pre-orders," says Mike Hickey of Janco Partners. "[E3] is where excitement can be created."

The flip side of forum chatter is gamers are often victims of that aforementioned hype. And while previews help people get excited about games and drive pre-orders, it's ultimately reviews of the finished product that affect sales (and, thus, the company's stock). Last year, for instance, gamers were eager to get their hands on Bethesda Softwork's "Brink," but when the game shipped it only received an average metacritic score of 70, scuttling sales.

"I don't think that what happens at E3 is going to be a good indicator of what investors can expect one way or another," says John Taylor of Arcadia Research. "The winds are blowing in this industry and you go to E3 to figure out which way—and the weather man I'm watching suggests the winds are blowing to other platforms."

Gaming is certainly undergoing a seismic transition. Apple has been a major disruptive force in the portable gaming market, impacting both Nintendo and Sony. And digital distribution is growing at a steady pace, which some companies (like EA and Activision) are actively preparing for and others seem to be ignoring. Keep an eye on which companies are talking about digital and online plans and you might find a long-term bet.

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Digital delivery is especially important to the core gaming audience. After Sony's hacking woes, casual players are likely to be a bit gunshy about the digital push, so companies that can attract avid players stand to benefit.

"I'm much more interested in who's going to be able to capture the core audience as the business models shift and as platforms open up a little bit," says Taylor. "It's hard to put a company name on that. [Valve Software's] Steam is doing an ok job with that. EA is doing the best job in embracing the new models. And Activision has the world's most amazing business with 'World of Warcraft'."

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