Interesting Investment Pattern: KWS (Keywords Studios)

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Pattern Matching can be an important component of developing an investment thesis. As a result, studying successful investments can help us to develop a framework for finding winning stocks.

A great way to do this is by learning from successful hedge fund managers. I came across an interesting investment thesis for KWS (Keywords Studios), a European Company in the Video Game Industry, courtesy of Connor Haley of Alta Fox Capital [link].

His Simplified Thesis:

1. The video-game industry is large and growing high-single digits per year. And it will continue to grow as the technology keeps improving and since this is a relatively cheap form of entertainment.

2. While the industry is growing, money spent on outsourcing is growing even faster. Only ~40% of video game services spend is spent on outsourcers today.

3. KWS is the largest outsourcer of video game production in the world. They work with 23 of the top 25 gaming companies and can offer any service with multiple price points and geographies.

4. KWS’ strategy is working. From 2014-2018, the company has expanded revenue 572%, EBITDA 581%, and EPS 314%. As a result, the company’s stock price has increased over 850%! 

5. KWS is trading at ~30x forward earnings, a modest multiple given the long runway for 20%+ EPS growth.

My Key Takeaways and Thoughts:

1. I completely agree that the video game industry should continue to grow 

   • Not to mention, games are super addictive!

2. Betting on KWS avoids the challenge of picking which games will win, but rather reduces risk by choosing a “picks and shovels business, so to speak”. 

   • Consumers have fickle tastes. Games are always improving (better gameplay, graphics, performance, experiences) and distribution channels and business models are changing rapidly. 

3. Outsourcing is growing → this was the big surprise for me. 

   • Games typically require highly specialized developers, artists, PMs etc to create and distribute a high-profile game. So I would have thought such functions would be better suited to being in-house. 

   • Although this was a surprise to me, it’s pretty clear from the performance of the company that there is a massive demand for outsourcing. So the question becomes, why is there such a demand?

4. According to Alta Fox Capital, it turns out that Gaming Companies tend to scale up hiring as they ramp production on a new game. New hires are subject to a very demanding and high-pressure work environment on a tight game deadline. Once a game is released, a large percentage of those hired are terminated because they are no longer needed. This type of hiring cycle is very inefficient. 

   • An Aside: When I was in Undergrad, I do recall several classmates of mine complaining about their high-stress demanding working environment at EA (Electronic Arts). I suppose that is a common practice in the industry.

5. Conventional Wisdom says “Buy Low Sell High” - in this case, the stock price performance is a great indicator that a company’s strategy is working in the marketplace, and hence has the potential to keep working. 

   • I imagine the large majority of people would view the price appreciation and say “it’s too late, I missed it”, and thereby, help create the investment opportunity.

Pattern Matching

As I mentioned, Pattern Matching can be an important component of developing an investment thesis. The pattern here is as follows:

1. Find a growing industry.

   • Here, it’s Video Gaming.

2. Find a powerful trend in this growing industry. 

   • Here, it is outsourcing.

3. Find the leading company benefiting from this trend.

   • Here, KWS is riding the outsourcing trend. KWS has the most scale, they work with 23 of the top 25 gaming companies (by revenue). 

   • Growth in Revenue, EBITDA, and EPS, and Stock Price performance can help identify which companies may be winning.

4. Understand why this trend exists and will continue to exist. 

   • Here, the opportunity is created due to inefficient & complex hiring cycles.

5. Determine what price you are willing/comfortable to pay.

6. Lastly, ensure there is a sound (Talented & Ethical) Management Team leading the company 

   • No mention of Management Team in this thesis, but I presume that Alta Fox studied the management as well.

What’s Hard About This Pattern?

1. Convincing yourself that the “powerful trend in the growing industry” is sustainable for the duration of the investment horizon (at least the next few years).

2. Price anchoring can be difficult to dismiss. 

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