Investors play the market for hot video games

If you see your nephew or daughter waving a plastic wand like a crazy person at the TV, rather than calling a shrink, you might want to dial your broker.

Novel types of controllers, like the motion sensitive wand used to move on-screen characters on the Nintendo Wii console, have shown investors that video games have burst light years beyond the dark basements of geeks.

Games like rock 'n' roll simulator Guitar Hero and exercise game Wii Fit are luring people who'd never thought of themselves as "gamers" to play video games — and investors are hoping to cash in. "Nintendo has struck a chord," says Michael Pachter, video game research analyst at Wedbush Morgan. "It is really expanding the market to people who thought they'd never buy a console in a million years."

But at the same time, the expanding audience is changing the way investors need to approach the infamously tricky industry. Some video game makers have been subpar investments in the current generation of consoles, which unofficially kicked off on Nov. 22, 2005, with the release of Microsoft's msft Xbox 360.

Anyone who bought shares of the largest video game publisher, Electronic Arts erts, the day the Xbox 360 came out has lost more than 22% in a period in which the Standard & Poor's 500 index has been flat.

And three of the four largest video game software companies, Electronic Arts, THQ thqi and Take-Two Interactive ttwo, lost money their most recent fiscal years. And there's concern consumers might not pony up $250 to buy a video game console and $50 or more for games with gas prices soaring and the economy slowing.

But despite the challenges, Pachter says the potential is huge for video game makers that position themselves well because the pool of prospective customers is massive. Microsoft has sold 10.3 million of its Xbox 360 consoles in the USA, followed by Nintendo's 10.2 million sales of Wii consoles and Sony's sne sales of 4.5 million PlayStation 3s, says industry tracker NPD Group.

That's why investors will be carefully watching developments at the industry's grand event in Los Angeles next week, E3, for ways to cash in on what appears to be an industry in transition. Analysts recommend looking for video game companies that:

•Capitalize on new ways to interact. Publishers that have taken most advantage of the popularity of new types of controllers have been the biggest winners so far on Wall Street. Nintendo is the classic example. Shares of Nintendo, which trade on the lightly regulated Pink Sheets market, have soared more than 400% since Nov. 22, 2005. And Nintendo shares are up 154% since the Wii was released on Nov. 19, 2006.

THQ is creating software to work with devices Wii owners may already have, says CEO Brian Farrell. The company will release de Blob for Wii, where players use the Wii controller to steer a creature and add color back to a colorless society. It's also releasing All-Star Cheer Squad, which lets players compete in cheerleading using a Wii balance board, a pressure-sensitive board players stand on like a skateboard.

•Leverage existing hit titles. Activision's atviGuitar Hero series, which lets gamers use a plastic guitar to play along with rock 'n' roll tracks, has made air guitar something that's rewarded instead of mocked.

Activision bought the rights to the Guitar Hero game in June 2006, and it continues to be a big seller. Guitar Hero III sold 2.5 million units this year, NPD says, making it the No. 3 game behind Grand Theft Auto IV (4.2 million units) and Super Smash Bros. Brawl (3.2 million). Meanwhile, the company has released a version of the game for the portable Nintendo DS console.

Having a stable of popular games allows publishers to focus their resources on known winners. "The most innovation comes from franchises that you own and control and have history with," says Activision CEO Robert Kotick.

•Have the scale to compete. As games cost more to produce, companies need financial heft so they can devote enough people to projects. THQ, for instance, has been developing and perfecting its upcoming Red Faction 3 shooting game for four years, Farrell says.

Given the Hollywood-size budgets needed to develop games, several video game software companies are combining to increase their resources. Activision is becoming Activision Blizzard, in a complex transaction with the video game arm of France's Vivendi approved by shareholders Tuesday that will give Activision access to Vivendi's lineup of popular online games such as World of Warcraft. Meanwhile, Electronic Arts has been pursuing Take-Two Interactive, publisher of this year's best-selling game, Grand Theft Auto IV, which is a big reason Take-Two shares are up 18% the past year.

The mergers are another sign of the industry growing up into serious business. And investors expect more from companies than just one hit title followed by a bunch of misses, Kotick says. "There's no magic anymore. These are big companies that (investors) own for earnings growth and consistency," he says.