Motley Fool’s “The 4 Stocks We Believe Are Poised To Dominate The Virtual Reality Market”

by Travis Johnson, Stock Gumshoe | July 9, 2016 1:01 am

This article was originally published on May 23. It has not been updated or revised, other than to update my disclosure and ownership stakes.

We haven’t seen many big new teaser ad pushes from the Motley Fool[1] Stock Advisor[2] lately. They did pretty aggressively promote David Gardner[3]’s latest IPO[4] recommendation over the past month or so (that was Match, we covered it here[5]), but most of their ads have been reruns of pitches that we’ve seen and written about many times (new golden age of TV[6], etc.)…

… so when I saw this new Fool spiel come across my desk here at Gumshoe HQ, I figured we’d see a lot of questions about it.

And, of course, I wasn’t disappointed. The latest Stock Advisor ad hits right in the center of what has been the hot story in tech investing for the past six months or so, and the story most ardently pushed by the various investment newsletters:

[drum roll, please…]

Virtual Reality[7]

It’s still far too early to know whether virtual reality (immersive artificial worlds, like with the Oculus[8] Rift headset) or augmented reality (providing something on top of the visible world, like with Google Glass or Microsoft Hololens) will end up being a revolution that really creates wealth in rapid fashion, or whether it will be, like 3D printing, a story that gets ahead of the economics…

… but I suspect that most of the virtual reality stocks we hear about will end up being far stronger than most of the 3D printing stocks, if only because most “Virtual Reality” stocks we see teased and hinted at and talked up by pundits are really pretty diversified technology companies who won’t rely on a massive breakthrough of virtual reality technology in order to stay solvent.

But let’s get into the nitty gritty of the Fool ad, shall we, and see if we can identify those “four stocks” that their experts believe are “poised to dominate the virtual reality market?”

If you like them and their rationale, go ahead and sign up for a Motley Fool subscription if you feel like it… but you’ll usually find yourself in a more rational frame of mind for investing decisions if you get the first introduction to a company from someone who isn’t selling you the information with a “dominate the market” spiel. Let me ID the names first and get you started on a little research, so you can tame your lust before you pull out the credit card or call your broker.

Here’s what the Fool starts us out with, to go along with their video discussion:

“From the investing system that The Wall Street Journal reported as one of the best performing in the world…

• Discover the 4 stocks we believe will explode when virtual reality takes off
• Proof from an obscure Wall Street insider report that predicts a $182 billion windfall for VR investors.
• In-depth research laying out the case for a tidal wave of VR adoption by US consumers in the near future”

Eric Bleeker is the analyst who runs the video presentation in this ad, and he starts us out with his two base assumptions:

1. “VR is going to be big. It has the potential to change the world in the same way that smartphones, the Internet, and computers have over the past several decades… and…
2. “Because of that potential, investors who make the right moves today will make an absolute killing.”

So you may question those assumptions, but that’s where he comes from. The first bit of the story is all about avoiding the luddite trap of doubting new technology, with quotes from lots of sources about how the “flying machine” would never work, the automobile was a dangerous novelty, individuals would never need a computer and certainly wouldn’t have one in their homes, television will never be able to compete with radio… etc. etc.

That, of course, puts you in a different trap of assuming all new technologies will be adopted to huge acclaim and become major parts of the economy like airplanes, automobiles, television and computers. That’s obviously not true, and we don’t often think about all of the failures — industries that never materialized despite some exciting new technology, or companies within those successful industries who didn’t achieve or sustain success. The survivorship bias makes us forget about the failures and think only about the glories reaped by the survivors. Which is probably a good thing in that it keeps humanity moving forward and innovating, but it isn’t necessarily a good thing when building your assumptions about an investment.

Here’s a bit of that from Bleeker:

“I’m guessing that you missed your chance to be an early investor in Microsoft back in the 1980s.

“Or Amazon in the 1990s.

“Or even Google in the early 2000s.

“But none of that matters right now.

“I don’t care if you’re 25, 55, or 85… if you’re rich or poor… working or retired… man or woman… college grad or high school dropout.

“One of the great things about the stock market is that your past does not matter.

“Even if you’ve invested in 100 duds in a row, you start every new investment with a clean slate.

“It takes just one big winner to completely change your life. And as you’ll soon see, I think this could be the kind of once-in-a-decade opportunity you need to do exactly that.”

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“It takes just one big winner” is true, I suppose, for those who are lucky or unusually prescient, but it’s a dangerous way to think about building a portfolio because you start to make big bets on the stories you think will be “big winners” … those who do the sensible thing and diversify across many industries and sectors and economies will see their winners muffled, but they also probably won’t see their losers crush their dreams of retiring or sending their kids to college (let alone the dreams of buying a yacht, Maserati or private island that so many newsletters like to use to tantalize us).

Bleeker repeats some of the industry expectations about the virtual reality market that we’ve seen from other newsletters, like the Goldman Sachs prediction that Virtual Reality could be a $182 billion market “within the decade” …

“… taking a closer look at Goldman’s $182 billion market size prediction, it’s a combination of hardware and software sales: $110 billion for hardware and $72 billion for software.

“So right there we have a cornerstone for our VR investing playbook: include both hardware and software plays.

“Because in any game, you want to give yourself as many chances to win as you can.

“So my plan of attack includes 4 companies to invest in that’ll give you exposure to both sides … hardware and software… in a couple of ways.”

He also lists the industries he thinks are “ripe for disruption” by VR, to give some idea of the size of the potential market, and that includes Video Games, Live Events, Video Entertainment (immersive movies), Health Care (improved telepresence), Real Estate (house tours), Retail (testing or trying on products), education (mimicking the classroom experience), engineering (virtual prototyping), the military (simulations and training), and tourism.

He thinks we’ll start to see non-video-game headlines about virtual reality applications this year, and that we’ll be awash in that kind of news by next year, so that’s at least part of why he thinks we’re at a tipping point for virtual reality now.

The building blocks that will “power the boom,” according to the ad, are the technological capabilities that get us to real immersive environments — faster computers, clearer screens, and dramatically better graphics.

And then, finally, we get to the hints about “The 4 Stocks We Believe Are Poised To Dominate The Virtual Reality Market” … we’ll go through them in order:

“Stock #1

“Take a look at the companies announcing major VR plans this year. From Sony, to Facebook, to Samsung, they’re all relying on one specific kind of screen technology. It’s known as organic light-emitting diodes, or OLED. And since it is a critical component of all the major VR devices, there’s a tremendously lucrative path to cashing in on the emergence of VR.

“The key piece of information for investors is that there’s a single company that has managed to accumulate a huge treasure trove of patents that pay it a ‘toll’ as OLED use explodes….

“This company’s revenues have soared 526% in the past five years….

“… a huge amount of opportunity ahead for this company, because the adoption of VR will create a great deal of demand for OLED screens.”

This one is almost certainly Universal Display (OLED)[9], which is a stock that always makes me a little grouchy — I owned it more than a decade ago, and sold before the big run from $10 to $50 in 2010 and 2011. Though, to be fair, this has been a stock where it has been quite difficult to capture the gains — it has not been a smooth ride, over the past five years following that big run the stock has bounced from $20 to $50 to $30 to $40 to $20 to $50 based both on fundamentals and on rumors and excitement about possible growth. The sales are indeed up by about 500% over a little more than five years, but the stock is not up anywhere near that much — partly because the earnings growth has not yet become consistent.

The stock is bumping up nicely today, that’s mostly because Goldman Sachs upgraded the shares. The company issued guidance last quarter for revenue growth of about 15%, which would be a nice bump up after 2015 revenue was about the same as 2014 (and 2015 earnings were far lower than the previous year, though that was partly due to some inventory writedowns because of lower-than-expected sales).

OLED’s business is basically built on two things: Patent licensing fees that they earn from companies who use their OLED or Phosporescent OLED (PHOLED) technologies; and material sales to many of those same companies who buy the chemicals and materials that go into building OLED and PHOLED displays. I’d be a bit encouraged by the fact that their patent licensing revenue has been increasing, even though that’s set against material sales that are decreasing, because the licensing revenue comes with much lower costs because they don’t have to manufacture or supply anything (and, therefore, they earn a much better profit margin on that revenue).

The big thing to think about on the material sales end is probably volume — and in that regard, much like Corning (GLW)[10], they’ve been suffering from the fact that some of the most popular uses of the highest-end display materials is for the manufacture of the smallest devices, which require less glass and less OLED materials to manufacture. Phones and tablets use a lot less glass and other screen materials than do 60-inch televisions.

Televisions are still selling, certainly, but there are also several competing technologies for big screen TV displays, from LCD to LED to Plasma to OLED and PHOLED, and it might be that the extra cost of OLED is not compelling enough for TV consumers (part of the argument is that it’s more energy efficient, which matters less for a large TV that’s plugged in than it does for a smaller device using battery[11] power). So that will continue to create some significant lumpiness, I assume as will the fact that Universal Display is not the only company with patents for Organic Light Emitting Diodes — they are the only “pure play” stock in that regard, I imagine, but there are many other patent portfolios out there and that slice of the display market will probably see increasing patent litigation as (if) it grows.

OLED displays are preferred to LCDs for virtual reality, partly because the refresh rate is faster so the action can seem more seamless, which probably helps to cut down on motion sickness for virtual reality users. And it wouldn’t surprise me to see that all the high-end virtual reality headsets end up using OLED screens, or even to see that all of them use materials or patents from OLED. But it’s questionable, in my mind, whether that will have a dramatic impact on OLED’s financials. There are already some big-volume small-screen OLED products that presumably use screen technology from Universal Display, like Samsung’s Galaxy phones that have had OLED screens for several years… and Universal Display is expecting $75 million in patent licensing revenue from Samsung this year, which presumably includes both television and phone/tablet displays (that will probably be a little more than a third of OLED’s total revenue for the year). How many virtual reality headsets would it take to make a big impact on that? Even if we assume that the revenue is dominated by just the Galaxy phones, which may not be true (Samsung sells plenty of OLED TVs, too), then you’re looking at a market for Galaxy phones — which have similar size displays to a virtual reality headset — of about 50 million a year.

Virtual reality headsets with built in displays (like the Oculus Rift or Sony VR headset, but unlike the Samsung or similar competitors which require you to slide a phone in that acts as the display), are expected to be a far smaller market for a while — probably between 2-4 million this year. So even if they grow at 100-200% a year out to 2020, which is what most of the excited experts are predicting, that’s likely only getting to be similar to the Samsung Galaxy market five years from now. That’s meaningful, and it would mean, if we’re assuming that all else is equal (it never is) that OLED could see their revenues perhaps double over five years just from virtual reality (meaning, within five years it could be that the OLED virtual reality market is as big as the phone OLED screen market is today — assuming that the phone OLED market for Universal Display now is dominated by Samsung, which may not be true).

So yes, there’s growth potential. But OLED stock is also already trading at about 40X next year’s expected earnings… which is a little steep given their recent lack of earnings growth, but is clearly in anticipation of accelerated earnings growth over the next couple years. If that growth comes through and they really do grow earnings by 20% a year over the next five years, then the price is reasonable… if things don’t come out that rosy, the shares are awfully expensive. If I were considering this stock, I’d want to dig deeper into their reports and see where the money is really coming from (big screens, phones, etc.) and what the prospects are for those markets to really grow, and I’d want to keep half an eye peeled on the other display technologies that compete with OLED and PHOLED. If the patent base is solid enough to keep them earning from Samsung and other OLED manufacturers then it’s not a terrible idea, from what little I’ve gleaned in trying to catch up on this stock over the past half hour or so, but it may well be an overpriced one. How’s that for wishy-washy?

How about another stock?

“Stock #2

“Another building block powering the VR boom is the speed of modern computers.

“Virtual reality is all about delivering vivid, life-like experiences. Which take some serious computing power to create. In fact, those top of the line VR experiences require 7X the power of most normal video games today.

“One company specializes in the unique processor technology needed to power VR systems.

“No, it’s not Intel.

“In fact, Intel had to pay this company an astonishing $1.5 billion just to license the patents of its incredible technology! In total, company #2 counts more than 7,000 patents issued and pending, and spends more than $1.3 billion every year on R&D to extend its lead over the competition.

“Even with VR just getting started this year, company #2 stands to potentially make several hundred million on VR technology already this year. Looking forward just a few years to the end of the decade, that figure could swell nearly 8X to more than $2.2 billion in a single year!”

Well that, as you may have guessed, is our old friend NVIDIA (NVDA), which I think earns the prize as the “most hyped for virtual reality by financial newsletters” stock. NVIDIA makes graphics processors, the primary market is high-end gaming (which could include virtual reality over the next couple years) but their processors are also being used for self-driving cars, artificial intelligence, data centers[12], anywhere a large number of parallel calculations need to be made in a hurry. I don’t know that they’re going to “potentially make several hundred million on VR technology” this year, though they are positioning themselves and making the argument (the company even has a piece up on the “10 Ways NVIDIA makes VR a Reality”[13]), and their GeForce graphics processors are being used in the computers that are being packaged as especially “Oculus Ready” for new Oculus Rift buyers (the actual computing power in high-end virtual reality headsets doesn’t come from the headset itself, they’re connected to high-end gaming PCs — or, in the case of Sony’s anticipated headset, to gaming consoles).

As I’ve noted a few times before while NVDA has been hyped as a virtual reality stock, I did own some LEAP[14] call options[15] on NVDA — I’ve now sold those. I still like the stock and may re-enter at some point, but taking those profits was attractive because the shares are quite expensive and I’m being cautious about leveraged exposure and options at the moment. Being connected to several hot stories (artificial intelligence, self-driving cars, cloud computing[16], and virtual reality), and having a very strong year in earnings growth, has helped NVDA get to a pretty scary valuation of almost 30X this year’s earnings (their year ends on January 31, 2017) even though analysts are predicting flat earnings for the year beyond that… and even though some analysts are starting to notice that AMD, NVIDIA’s most worrisome competitor, seems finally to be recovering a little bit after years of declining revenues.

The stock has more than doubled over the last year, and made a huge leap just after earnings a couple weeks ago, so it’s hard to jump in at this valuation without holding your nose… but they have grown earnings very rapidly over the past year or two, they have a great cash hoard and are buying back stock and increasing their (small) dividend, and they do have a chance at taking some meaningful market share in some pretty exciting markets. The worry, for most investors, is that the high end gaming chip market or the core “built in” GPU markets that they serve will deteriorate faster than their newer technologies and markets grow to fill the gap, but the gaming market has been pretty resilient and it has been fun to watch the stock soar.

And yes, virtual reality could be a strong market for NVDA if it becomes a big market, but the company’s results won’t be markedly different in a world with 10 million virtual reality headsets sold than they would be if there are only three million headsets sold… NVDA is already a $25 billion company, so my guess is that it will take some serious growth in that market for a few years before VR really hits their bottom line.

Next!

“Stock #3

“Let’s look again at one of the Goldman Sachs quotes about how VR was poised to ‘become the next big computing platform, and as we saw with the PC and smartphone, we expect new markets to be created and existing markets to be disrupted.’

“Thinking back in time, the most ‘sure bet’ for PCs was Microsoft, the company that built the software platform for hundreds of millions of computers.

“For smartphones, I trust you’d say the ‘sure bet’ was Apple, a company that controlled software and made a king’s ransom collecting a fee from everything sold on its wildly profitable App Store.

“Company #3 is the company I’ve identified as the most likely ‘sure bet’ for the next computing platform. It’s already an incredible company, having seen sales skyrocket 808% in the past five years…

“This is one company we believe you can’t afford to miss out on.”

Well if NVDA is going to have a relatively muted exposure to Virtual Reality in the near term, for this one VR is going to be a bare speck at the bottom of the footnotes of the financials in the near term — this is, believe it or not, Facebook (FB), which did indeed grow its revenue by 808% from 2010 to 2015. Sales for FB over the last four quarters are just shy of $20 billion, and essentially all of that is from advertising. Forecasters think they might sell as much as several million Oculus Rift headsets this year (they bought Oculus a couple years ago for $2 billion), and it’s possible that they will end up controlling the dominant “operating system” for virtual reality (that’s certainly Zuckerberg’s hope, I doubt that he spent that much on Oculus just to sell gadgets), but even if they’re successful in that regard it won’t be a big chunk of Facebook’s operations for at least a couple years, and it will be so small this year that they probably won’t even have to break it out in their financials or provide any detail on sales if they don’t feel like it.

And, of course, Google and Apple and Microsoft won’t surrender the market to Oculus and Facebook… nor will Sony, which is probably in the best position among the gadgetmakers because they have a huge installed base of Playstation owners to sell their headset to next year, and their headset won’t require a souped-up gaming PC (with NVDA chips) like the Oculus does. I own Facebook (FB) shares, and it’s my largest personal holding, but I suspect that virtual reality and Oculus will be a long-term investment that isn’t likely to generate any earnings power over the next few years… thankfully, their increasing dominance of mobile advertising in duopoly with Google/Alphabet (GOOG, which I also own) means they can easily afford this long term investment in virtual reality.

But wait, there’s one more!

“Stock #4

“Virtual reality will eventually transform markets from live events, to health care, to real estate[17]. Yet, in the coming years, its largest impact will be felt on video games.

“Goldman Sachs believes the video game market hit $106 billion in sales last year and will continue to surge ahead. Within a decade, it projects an astonishing 216 million people will be playing games in VR!

“So for my fourth investment, I’m honing in on the video game producer that I believe will make some of the most popular VR games.

“That shift of VR making video games bigger than ever is an enormous opportunity for Company #4. It sits on a murderer’s row of franchises, the most successful of which can generate $500 million in sales in a single day.”

Aaaaaand, here’s another “regret” stock — this is Acvitision Blizzard (ATVI), which I suggested to the Irregulars way back in late 2008 and sold three years later because the stock was refusing to move despite substantial operating improvements (and because I was getting worried that as Guitar Hero’s popularity waned, they were becoming increasingly reliant on the huge Call of Duty franchise). ATVI was attractive because of the combination of hot “blockbuster” games like Call of Duty, which has opening weekends that best many Hollywood hits, and their strong and steady global subscription base for World of Warcraft and their other (smaller) online role playing games, and that’s still the setup — though their acquisition of King, which has now closed, also gives them a strong position in casual mobile “app” games (King’s big hit that led to their IPO was Candy Crush, and they’ve been trying to replicate that success ever since).

But Activision Blizzard, by all accounts, is sitting firmly in the backseat, along with major competitor EA, when it comes to virtual reality — they’re waiting to see how the market develops, and what works well in the first generation of high-end headsets, before they put $100-200 million or more into developing a Call of Duty or other high-end games for virtual reality. There are some third party game developers who are established in the console space and also betting on VR, like Ubisoft, but even they seem to be treading pretty slowly into the market — articles that I’ve seen speculate that there won’t be big, blockbuster-size virtual reality games from the major game studios for at least a couple years, the first hits are likely to be games developed in house by Sony or Oculus as they try to drive demand, or by the little game studios that are more willing to take risks.

Activision is a fine company, and the valuation (17X next year’s earnings estimate) is not terribly ridiculous for an industry leader, particularly if their Warcraft movie is a big hit and drives more subscribers into the game, but they are still very much blockbuster-driven and my guess is that virtual reality will be either a non-event or a negative for Activision Blizzard over the next year or two. It will probably have no material impact, since the VR market will be so small compared to the console and mobile game markets, but if it does have an impact I think it will be because virtual reality sucks all the oxygen out of the gaming market for this next Christmas season and folks are buying Sony VR headsets instead of the latest (non-virtual) Call of Duty game release. We’ll see.

So… no big surprises there. No stock that will triple in a year because virtual reality is in the headlines… and, I’d argue, no companies that will suffer meaningfully if virtual reality fails to take hold as quickly as expected. These are strong, profitable companies who have some exposure to virtual reality — and my suspicion is that there are no companies of meaningful size who have real leverage (as in, it could move their earnings by 20% or more) to virtual reality over the next two years… so if you want a real “bet” on virtual reality you probably have to go with the tiny upstarts who are trying to develop their own headsets or games.

Of course, essentially all of the tiny innovators or virtual reality “pure play” companies are private, as far as I’ve found, and most of them will have a terrible time trying to compete with Facebook or Sony or Google or the big chip companies, so you’re probably better off with these ancillary plays on VR, assuming you like the company just fine with or without the virtual reality potential, than you are gambling[18] on higher-risk little component makers. So that’s a little sobering, I guess… but when you invest real money, sober is probably better.

Think I’m being an old fuddy duddy? (My arthritis is acting up a little, so you might be right — it’s making me cranky.) Think you’ve got a better idea for investing in virtual reality? Have a special fondness or ire for one of these four stocks? Please share your thoughts using our friendly little comment box.

Updated Disclosure: As noted above, I own shares and/or call options on Apple, Facebook and Alphabet/Google. I have sold the NVDA calls noted above since the original publication of this article. I don’t own any other stocks mentioned above, and won’t trade in any covered stock for at least three days per Stock Gumshoe’s trading rules.

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