Video gaming is big business. The industry is valued at around $100bn right now and with the rise of mobile gaming and the widening of the demographics that are playing, it only looks set to expand.
Unfortunately for us, most video game studios tend to list in America, but there are a few small-cap shares with direct exposure to this gargantuan and growing industry, one of which I believe could transform your portfolio.
From tabletop to desktop
Games Workshop(LSE: GAW) is famous for its Warhammer and Lord of the Rings tabletop war-games. These games have rich backgrounds and gamers are as invested in experiencing the game worlds as they are in playing the game itself.
"The history behind these fictional worlds has been built up since 1975. There are literally hundreds of novels and thousands of short stories written about the universe. One of those novels, A Thousand Sons by Graham McNeil, even hit the New York Times Best Sellers List. The rich tapestry created by this library of fiction isn't easily replicated and the resultant fictional worlds are the company's greatest assets. Gaming studios are often attracted by the detailed lore and established customer base, and pay Games Workshop handsomely to take advantage of both.
But the company's core business of selling models to hobbyists is spluttering, largely due to poorly received rule changes and aggressive price hikes. Sales have fallen from a peak of £134.6m in 2013 to £118m last year. This took an even greater toll on core operating profit, which fell 27% last year, but a mammoth jump in video game licensing profit from £1.5m to £5.9m kept operating profits level.
Unfortunately, with the core business struggling and licensing income depending on the success of outside influences, Games Workshop's prospects are unclear right now.
Trading at only 12.4 times last year's earnings, the shares may appear cheap, but if the lumpy licensing income was to return to 2015's level, operating profit could drop from £16.9m to around £12.5m, with the share price likely to follow.
Therefore, I recommend waiting on the sidelines unless the core business turns around.
The key to video gaming returns?
Little-known small-cap Keywords Studios(LSE: KWS) is, in my opinion, the very best way to get exposure to gaming on the UK markets.
The company is a 'picks and shovels' play on the industry, because Keywords provides services to games developers, rather than creating games itself. This includes voice acting and recording, testing and localisation services (translation of speech, marketing and packaging).
Keywords provides these services to a number of big-name developers, including Rockstar, creators of Grand Theft Auto, and PlayStation owner Sony. This means Keywords isn't dependent on the success of a single game, instead earning cash from many projects at once.
Even though it's only a £250m market cap company, Keywords is the biggest fish in its niche. Scale is important to big development companies, who don't want to deal with multiple entities. Keywords' competition consists of relative minnows worth only a few million, allowing it to grow through consolidating the industry.
Revenue has increased more than fourfold since 2011 and growth shows no sign of letting up, with a 77% increase in revenue in the first half of this year. I believe the company's impressive growth rate and strong positioning justifies a forward PE of 20, although I would size my position accordingly. This is, after all, an aggressively expanding small-cap.
But if Keywords' valuation is a little rich for your liking, our analysts have found a top small-cap trading at only eight times earnings.
The management team has a string of successful acquisitions under its belt and we believe it's well on the way towards significant margin improvements that could send the share price skyrocketing.
Click here to find out how this under-the-radar share could drive your returns.
Zach Coffell has no position in any shares mentioned. The Motley Fool UK has recommended Keywords Studios. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.