What I Learned Selling My Nintendo Stock

I’ve been giving some thought to what I have learned from my experience with investing in and subsequently selling Nintendo stock over the last 5 years.

The story begins in 2012, when I noticed that this beloved company, one whose products I was intimately familiar with growing up, was trading at a price that valued the company little beyond the enormous pile of cash on its balance sheet. This cash stockpile was the result of an enormous run of success with the company’s smash global hit game console, the Wii, and its conservative corporate practices. The Wii-era resulted in the coining of a new term amongst the company’s followers and managers, “Nintendo-like profits”, which translated into layman’s terms simply means “insane profitability.”

Investors came to expect “Nintendo-like profits” from Nintendo as a right, when the reality of looking at the company’s business in the past would’ve shown that it was a cylical business with unpredictable fads and discouraging failures. The Nintendo Entertainment System (or Famicom, as it was known outside the US) put the company on the map as a home gaming company, the Game Boy handheld gaming system proved to be revolutionary and a success and the follow-up 16-bit era console, the Super NES, was also commercially successful.

But the follow-on systems in the Game Boy line, while commercial successes, were not global phenomena like the original. And the home console business took it on the chin two generations in a row. While fondly remembered by fans, neither the Nintendo 64 nor the Gamecube saw wide install bases in the era of the Sony Playstation and Microsoft Xbox, an era that also saw the downfall of SEGA and other one-off competitors. Like clockwork, this led to critics and investors questioning the Nintendo model, which had emphasized creativity and pushing the cutting edge of technology whereas Sony and Microsoft competed on the basis of raw hardware power emulating a home PC and captured the coming-of-age “hardcore gamer” market demographic. Nintendo seemed like kid stuff, for people who weren’t serious about gaming.

Of course, that is precisely where Nintendo scored its home run with the Wii, a console aimed at casual players. I rehash all this history only to demonstrate that the company never was and likely never will be a “blue chip”, steady eddy company with a predictable earnings stream built on a permanent plateau. The nature of creative offerings (like a movie studio) and the insistence on being fresh, original and looking for new ways to play (“blue ocean strategy”) is inherently cyclical and prone to incredible volatility in earnings and expense.

Luckily, Nintendo has a super strong culture that knows and understands their own business strengths and weaknesses and engages in corporate planning accordingly. They don’t carry debt and, as mentioned before, they held on to their massive cash stockpile earned in the boom years, knowing it would be valuable to them in getting through the inevitable lean years. Most companies would go on an acquisition spree after this kind of “windfall”, not knowing what to do with it. And their mercenary management team would be looking for another big score to increase their glory before driving the company off a cliff– and rolling out the door of the vehicle and on to their next disaster before it plummets to its fiery death.

But Nintendo is served by extremely-long tenured managers and creative designers, many of whom have been with the company before it was a dedicated gaming company and was a purveyor of cheap toys and other mishmash business lines.

Additionally, Nintendo has built a powerful library of IP over the years with their character and game world properties, which they have done little to monetize in ways outside of traditional gaming through other creative licensing. And it wasn’t even until recent generations of their game systems, such as the Wii, where they even had the technology or willingness to monetize their own game library for nostalgic customers.

So, let’s review some items discussed so far:

  • Nintendo is a cyclical company prone to booms and busts in its fortunes
  • Nintendo has a strong culture, driven by its long history and dedicated creative and marketing strategy
  • Nintendo has long-tenured leadership with experience and comfort with the cyclical nature of its business
  • Nintendo has a pristine balance sheet driven by its conservative corporate culture
  • Nintendo has an extremely valuable IP library it has barely worked to exploit

Because the company has a cyclical model, it was available at an unreasonable price when I came upon it, trading for little more than the value of the cash on the balance sheet. While it is true that the cash is “phantom” because the company will need it to fund its continued R&D and marketing during off years, that didn’t make it a value trap but rather valuable– outsize success is as predictable as disappointing failure for this company, and over time value is accruing to stockholders on average.

This is a strong franchise business, one that will be worth more and more over long periods of time because of its IP-based business model. And when you’re able to buy it so cheaply, the Margin of Safety is enormous, because the company has so much positive optionality because of its strong culture, strong IP library which remains unexploited and its conservative corporate practices. There are so many things that can go right for it which are surprising and hard to predict, while there are relatively simple and certain threats or things that can go wrong which are already accounted for and factored into the price– a poorly-received system, a change in the industry that makes dedicated home consoles a less valuable offering, etc.

What I did wrong is I got scared and I got greedy. From the lows at which I purchased stock in Nintendo, the company rocketed upward over the next 4 years, in spite of the massive depreciation of the Yen (which actually caused major forex headaches, because a lot of the company’s cash has been repatriated and held as Yen), in spite of the sudden death of its beloved and talented president, Satoru Iwata, and in spite of the abysmal fortunes of the Wii U. The company followed its strategy very faithfully and began exploiting its IP in new ways, as predicted– movie studio partnerships, licensing to theme parks, strategic partnership with a mobile gaming company (DeNA) to release official Nintendo smartphone games, the opening up of the company’s game library IP to more “virtual console” sales, greater emphasis on digital product distribution at higher margins, renewed success with the 3DS handheld gaming platform, the rollout of the wildly popular Pokemon GO and most recently, the release of the greatly anticipated Nintendo Switch, which has met both critical and commercial acclaim during its first two, non-holiday sales period months on the market.

I decided to “take profits” during the Pokemon GO craze, thinking this bubbly atmosphere was not sustainable and people would soon come to their senses. I was worried about the Nintendo Switch (still code-named “NX”) being a flop. I was worried about a global recession taking the wind out of consumers’ sails and reducing discretionary income for gaming. I was worried about the lack of news about Nintendo’s “Quality of Life” division. I was noticing a big gap between Nintendo’s new valuation and its actual reported earnings, creating a multiple I wasn’t comfortable with.

I am not trying to engage in hindsight based off of recent price movements. While the company’s stock is off its most recent highs during the Pokemon GO craze, it is still “lofty” compared to where I bought it (as of this posting, the stock trades for about Y29,000 per 100 block unit, and I bought around Y9,800 per 100 block unit). What I am trying to do is evaluate a decision to sell a company that is just now hitting a predictable stride when I bought it at a price closer to it seeming like it was going out of business.

What I have learned from this experience is that when you buy something valuable cheaply, you can afford to wait. You can afford to be patient. You can afford to watch it run up, and potentially run back down again. It doesn’t matter. You make your money in buying it below what it’s worth, not selling it when it’s “too far gone.” That low cost basis becomes an absurd comp for future dividend streams, embedding a high cap rate in the initial purchase, and then you get whatever further corporate value the company generates in the meantime as a bonus.

I really regret selling Nintendo, not because the stock didn’t crash like I thought it would (it was silly for me to think I could “time” it, but that’s a separate issue), but because I had owned it so cheaply, it has done everything I expected it to and I could’ve afforded to be patient.

Notes – Sanborn Maps, Dempster Mills, Nintendo’s Rise

Warren Buffett & Sanborn Map: An Early Balance Sheet Play

  • Buffett first got involved with Sanborn Map in 1958 because it represented a relative undervaluation compared to his then current holding in “Commonwealth”, even though he still thought “Commonwealth” was undervalued
  • Beginning in 1958, it represented 25% of the partnerships assets and BLP was the largest shareholder which “has substantial advantages many times in determining the length of time required to correct the undervaluation”
  • By 1959, represented 35% of partnership assets
  • Buffett recognized that the business operated in a “more or less monopolistic manner, with profits realized in every year accompanied by almost complete immunity to recession and lack of need for any sales effort”
  • Sanborn faced a changing business environment which beginning in the 1950s which “amounted to an almost complete elimination of what had been sizable, stable earning power” (after-tax profits: 1930s, $500,000; late 1950s, <$100,000)
  • Buffett estimated the reproduction value of Sanborn’s map assets at tens of millions of dollars
  • In addition, Sanborn Map carried a valuable portfolio of marketable securities which it began accumulating in the 1930s
  • Buffett: “Our bread and butter business is buying undervalued securities and selling when the undervaluation is corrected along with investment in special situations where the profit is dependent on corporate rather than market action”
  • The margin of safety was based on the fact that the investment portfolio was worth far more than the company was selling for in the market
  • Additionally, Buffett took a control position which gave him an added margin of safety
  • Buffett made roughly a 50% profit, according to Roger Lowenstein

Warren Buffett & Dempster Mills: Control Investing And Asset Conversion In A Net-Net

  • In 1962, BLP owned 70% of Dempster Mills’ shares (with another 10% controlled by associates), representing approximately 21% of partnership assets
  • Buffett: “Control situations, along with work-outs, provide a means of insulating a portion of our portfolio from [general market overvaluation during a strong bull market]”
  • Buffett: “When control is obtained, obviously what then becomes all-important is the value of assets”
  • Buffett chose to value the partnerships shares based on a discounted estimate of what the assets would gather in a prompt sale (discounted liquidation value)
  • Buffett originally hoped he could turn around the company with existing management; when this failed, he brought in Harry Bottle on the advice of Charlie Munger
  • Bottle, at Buffett’s behest, proceeded to liquidate the balance sheet, converting assets from the manufacturing business (a poor business) into marketable securities, which BLP saw as a good business
  • Buffett: “Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. The better sales will be the frosting on the cake”
  • Buffett’s first purchases of DMM began in 1956 when it was a net-net trading at $18 with $72 in book value and $50 in NCAV per share; the company had had profitable operations in the past but was a break even at the time of purchase
  • Buffett: “Experience shows you can buy 100 situations like this and have perhaps 70 or 80 work out to reasonable profits in one to three years… [due to] an improved industry situation, a takeover offer, a change in investor psychology, etc.”
  • Harry Bottle’s effect:
    • Reduced inventory by 75%, reducing carrying costs and risk of obsolescence
    • Correspondingly freed up capital for investments in marketable securities
    • Cut SG&A by 50%
    • Cut factory overhead expenses by 25%
    • Closed 5 unprofitable branches leaving the company with 3 profitable branches
    • Eliminated production lines tying up capital but producing no profits
    • Adjusted prices of repair parts to yield additional annual profits
  • Buffett: “It is to our advantage to have securities do nothing price wise for months, or perhaps years, while we are buying them. This points up the need to measure our results over an adequate period of time. We suggest three years as a minimum.”
  • Other notes:
    • In 1961, Buffett committed $1M to DMM (his biggest investment yet), buying the controlling interest and staking 20% of BLP’s assets in the process
    • Sold the company as a going concern in 1963 for a $2.3M profit, nearly tripling his investment
    • Bottle’s employment agreement was based on a percentage of profits

Harvard Business School: Nintendo’s Competitive Advantage In The Early Home Video Game World

  • Prior to Nintendo’s dominance, the home video game market was led by Atari and suffered a number of boom-bust cycles where as much money was lost on the way down as was made on the way up
  • The cost of video game consoles has been falling in real terms since the 1980s:
    • 1977, Atari VCS $200, game cartridges $25-30 retail, $5-10 cost to mfger
    • 1983, Commodore, Casio and Sharp game systems sold for around $200-350
    • 1983, Nintendo launches Famicom system at $100 retail price (believed to be at or below cost), and had extracted a rock-bottom chip price of $8/chip by placing an order for 3M units
  • Home video game systems were a growing market:
    • 1982, 17% of US households had a video game system
    • 1990, Nintendo Famicom/NES console was in 1 out of every 3 households in the US and Japan and home video games represented a $5B worldwide industry
  • Nintendo’s development costs were up to $500,000 per title (Y100M) and marketing expenses were several hundred million yen
  • Nintendo’s approach was to focus R&D on developing one or two hit titles per year rather than several minor successes
  • Manufacturing of cartridges was subcontracted at a unit cost of $6-8, which then retailed for $40
  • Part of Nintendo’s value was in hit franchises such as Super Mario Brothers (1985), the Legend of Zelda (1987) and Metroid (1987), the first two of which were developed by hit designer Shigeru Miyamoto
  • Demand for games soon outstripped supply, so Nintendo allowed six firms to be licensed software makers, paying royalties of 20% of the $30 wholesale price per game:
    • Namco
    • Hudson (later acquired by Nintendo and brought in-house)
    • Taito
    • Konami
    • Capcom
    • Bandai
  • By 1988, 50 licensees, who were also charged the 20% royalty rate and had to absorb Nintendo’s manufacturing costs
  • Cumulative sales of Famicoms from 1983-1990 = 17M, Nintendo had gained 95% market share of 8-bit home video game market
  • On average, Japanese consumers bought 12 games for every Famicom system purchased
  • Nintendo, via Nintendo of America subsidiary, rolled out NES (Famicom) in the US in 1985 at $100/system
  • NOA limited licensees to producing 5 NES titles per year; had to place orders for manufacture through NOA at a cost of $14/game cartridge which wholesaled for $30 and were then marked up an additional $15 at retail
  • By 1991, 100 licensees with only 10% of software development in-house at Nintendo
  • Nintendo began licensing Mario and other characters to TV shows, cereal packets, T-shirts, records and tapes, books, board games, toys and other media
  • NOA’s highly targeted ad budget was about 2% of sales and promotional partners were utilized extensively
  • WMT did not stock competing video game systems
  • In 1989, NOA proposed creating a proprietary online network for its game consoles, allowing users to play games, trade stocks, do e-banking and other activities that would later become common place throughout the late 90s but which Nintendo itself failed to capitalize on with its own later systems repeatedly!
  • 1989, Nintendo releases Game Boy handheld game console in Japan, retail price $100, games $20-25, designed to broaden the appeal of their systems (another strategy Nintendo would later utilize with the Wii)
  • By 1992, 32M Game Boys shipped worldwide and consumers bought on average 3 games per year
  • In 1991, Nintendo signed a consent decree with the FTC ending many of their dominant licensing, manufacturing and wholesaling/retailing practices, completely changing the economics of Nintendo’s business