The best opportunities in the UK stock market are often in unconventional areas. They tend to be in companies missed by most analysts, or simply that look too risky. 
These fears might explain why the high growth gaming sector is overlooked by many. Despite some strong share performances, and the prospect of bids and mergers, this industry has not yet made the mainstream. Yet, some of the businesses now have substantial market capitalisations and are liquid enough for all but the very largest active funds.
Why are the risks being misunderstood?
The industry was one of the first to exploit the internet opportunity; offering effective online competition with traditional bricks and mortar betting. Betting shops are rarely an attractive experience, and many customers prefer the richer experience and privacy offered online.
And, mobile online services are boosting demand. The digital world also offers better data analysis and pooling of risk. It was a fertile environment for disruption. But inevitably, this took many of the businesses into regulatory grey areas. This risk, highlighted by a few high profile regulatory breaches, seems to have deterred many institutional investors.
These uncertainties on the legal and regulatory position of online gaming are partly due to the fact that much of the applicable legislation predates the internet. This means that its application to online services is inevitably open to debate and challenge.
Even in jurisdictions where online gaming is legalised and regulated, there are some grey areas. For example, in some European countries, online gaming is legal but as a government-approved monopoly. This is likely to come under attack on fair competition grounds. In other countries, authorities still turn a blind eye to online activities.
However, governments do see the potential of legalised and licenced online gaming services as a potential source of tax revenues. This is encouraging new licencing regimes, although regulating purely within borders will remain challenging.
But despite the shifting regulatory landscape, the sector has gradually found safer ground and continued to grow. The listed sector now offers an ecosystem in which there are specialists in each area such as sportsbook, casino, bingo and poker, combined with broadening geographical coverage.
There are also specialists in the supply chain, with some focusing on administration, others on client acquisition. Some businesses, such as GVC and Playtech, operate almost entirely B2B, supplying platforms for others.
Performance of stocks versus index over 5yrs
Source: FE Analytics
Some markets remain a grey area, but are nevertheless growing. These include Turkey, Germany and Brazil. But by spreading interests across a broader international exposure, companies can become less exposed to duty and regulation risk in each individual country.
Operating in grey areas can also involve markets that are less competitive and offer higher margins. The risk of punitive regulation remains, but may not spell disaster. More likely, the penalty is that regulation of online areas becomes formalised, and that licensing will add to cost.
The UK itself is a more mature market, with low regulatory risk.
The maturity of some areas is encouraging consolidation. Earlier this year, the merger of Paddy Power and Betfair created a FTSE 100 group and gave the combined business great scale advantages.
Paddy Power Betfair now has a clear lead in some key areas, such as the resources it can apply to marketing and technology. This is likely to encourage more industry mergers.
Performance of stock since merger
Source: FE Analytics
This may bring some execution risk, but there will be cost-cutting and diversification benefits. Many of the businesses now have excellent management, determined to focus on specific competitive advantages. New opportunities such as eSports will emerge.
Increasing regulation may by itself create new entry barriers, and help to form moats of protection around the larger listed businesses.
While costs might increase, there would be greater certainty in operation. Licencing encourages governments, in order to maximise revenue, to avoid setting taxes on stakes too highly. Governments would then share in the industry economics, and have little interest in hitting revenues.
Investor concerns range from fears of increasing regulation to greater competition combined with a weaker consumer background. But, these concerns have always plagued the industry and yet over the years it has confounded critics.
What was once a fragmented industry, operating in some areas of questionable legality, has now become sizeable and stable enough to merit institutional investment. The prodigious amounts of cash thrown up by many of the businesses have seen investors enjoy special dividends as well as growth. Further consolidation is also still likely in the industry, with increasingly the major groups strengthening their positions via branding or proprietary technology.
Online gaming has come of age and institutional investors should recognise the opportunity.
SVM UK Growth fund holds a number of investments in the gaming sector; including Paddy Power Betfair, Ladbrokes, GVC, Rank and Playtech.
Colin McLean is co-manager of the SVM UK Growth fund. All the views expressed above are his own and should not be taken as investment advice.
