The Best Video Game Stock Ever

This article is part of our Rising Star Portfolios series. Sean is co-manager of the Dada Portfolio.

Perfect World (Nasdaq: PWRD  ) , Shanda Games (Nasdaq: GAME  ) , The9 (Nasdaq: NCTY  ) , Changyou.com (Nasdaq: CYOU  ) , NetEase.com (Nasdaq: NTES  ) -- probably not a list of household names for many of you, yet these are five of the most well-known online gaming companies in China. Still, it's probably good that you haven't heard of them because most of their stocks have been dogs.

Perfect World IPO'd in 2007 and has basically gone nowhere. But treading water is still better than Shanda Games' -34% return in the past year and a half, and it certainly beats anybody who invested in The9, which came public at the end of 2004 and has since dropped 72%. Changyou has admittedly done well, more than doubling since its debut two years ago. But there's really only one stock that stands out.

NetEase came to American shores in the middle of the dot-com bubble, in July 2000. In the intervening 10 years, its stock has returned 1,422%. And if you were prescient enough to catch it at an adjusted share price of just $0.177 a share on August 24, 2001, you would have a 22,647% explosion in your portfolio! I, myself, did not partake in this incredible run-up, but if any of you readers have, please feel free to gloat in the comments -- you deserve it.

The secret sauce revealed
So what caused that massive difference between NetEase and all the rest? Let's dig a little deeper. All of these companies operate massively multiplayer online role playing games. MMORPGs, as they are often abbreviated, are subscription-based games that tend to generate customer loyalty and recurring revenue streams. Unlike your old console game heroes of yore -- Super Mario, Sonic the Hedgehog, Pac-Man -- the character that you play with in an MMORPG doesn't exist outside of the game companies' servers. You can't go home, dust off your cartridge, and pop it in to your game system for a quick round anytime you feel like. Instead of the traditional video game setup of one upfront payment for a game, users have to pay to access these characters, whether through time-based fees, usage fees, or newer payment systems that charge for add-on upgrades. And since gamers invest so much time and energy into their digital avatars, the sunk cost is often so great that they just keep coming back for more.

It's an excellent business model, and all of these companies have seen tremendous revenue growth in the past. Perfect World had a three-year annualized revenue growth rate of 178% in 2009, Shanda Games grew sales 45% year over year that same year, Changyou had a blistering 387% two-year growth rate in 2008, and even The9 had a trailing-three-year compound annual growth rate of 233% as late as 2007. In fact, by this metric alone, NetEase seems like the worst performer, with "only" a 28% five-year growth rate in 2010.

But of course, that masks the fact that while the other guys were sprinting out of the gate, only NetEase has managed to find a way to "slowly" but steadily continue to grow revenue. Its winning strategy? Be the exclusive distributor in China for Activision-Blizzard's (Nasdaq: ATVI  ) World of Warcraft -- the absolute best-in-class, best-of-breed, holy-crap-when-was-the-last-time-I-got-up-to-pee? archetype of the MMORPG genre (which, if you've already forgotten, is also the best model for operating video games from a business perspective).

But past success is no indication of future awesomeness
But how many marriages are truly forever? While NetEase does have its own internally developed MMORPGs, it's no secret that the massive 47% year-over-year revenue jump in 2010 wouldn't have been possible without the licensing of Blizzard's intellectual property -- property that was given and property that may be taken away at any point. In fact, it was The9 that used to own the coveted World of Warcraft license, and the loss of it has contributed immensely to The9's subsequent stock performance. NetEase faces a similar risk. World of Warcraft has faced significant regulatory hurdles in China that have tempered the game's potential growth.

Still, NetEase is certainly an interesting company to keep watching. Let us know if you have had the fortune of participating in its incredible run-up and if you think there's still more to go. Leave us a comment on our discussion boards. You can also follow the Dada Portfolio on Twitter @TMFDada.

Learn more about Dada
The Dada Portfolio is a part of the Rising Star series of real-money portfolios. It is co-managed by Sean Sun and Ilan Moscovitz.

Sean owns shares of Activision-Blizzard. NetEase.com is a Motley Fool Rule Breakers selection. Activision Blizzard is a Motley Fool Stock Advisor pick. Motley Fool Options has recommended a synthetic long position on Activision Blizzard. The Fool owns shares of Activision Blizzard. Alpha Newsletter Account, LLC owns shares of Activision Blizzard. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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