Sustainable Equities Boutique

Emerging-market equities: semiconductor outlook in the year of the rat

Emerging Markets

Roger Merz

Head of mtx Portfolio Management, Senior Portfolio Manager

Unlike Chinese fortune tellers, we cannot predict the future accurately. However, we can draw conclusions from recent trans-Pacific developments (see also outlook video), and more specifically, the cycles in the Asian semiconductor industry (see also “topic of the quarter” video). The latter is a segment of the Asian economy we have been covering for a long time1.

2020 Outlook

The quick gold rat jumps over the lazy pig

Regarding the outlook for emerging-market equities, we are cautiously optimistic. After all, according to the Chinese zodiac, 2020 is the year of the rat. On January 25, the quick-witted rodent – it’s the “metal” (or golden) rat this time – will officially succeed the pig. The latter in 2019 behaved a bit like a bull in a china shop owing to the fight with another imposing economic animal. With China and the US now apparently unlocking horns, the odds are the going will become easier. We have dealt with the likelihood of an at least partial resolution of the trade dispute in detail in our previous outlook item.

Topic of the quarter: The semiconductor market

This time, we would like to take a closer look at the emerging-market high-tech segment that has become the envy of the west: semiconductor manufacturing. In the second half of 2019, Asian information technology and especially semiconductor companies performed significantly better than the overall index – a stark contrast to a downward trend in the previous months. This led many of our clients to ask questions about the structure and cyclicality of the semiconductor sector.

The limits of “Moore’s Law”

Intel’s co-founder Gordon Moore in 1965 estimated that computing power would double every two years, as measured by millions of transistors per square millimeter on an integrated circuit. His prediction proved correct, except that the technology is now so complex that it is getting increasing harder to make significant progress. Some of the big players such as UMC and GlobalFoundries have already stopped developing the most advanced chips. We believe that only the strongest companies will be able to maintain a leading position.

If you remember the spectacular growth rates of smartphones, for example, and the subsequent signs of market saturation, you become aware of the semiconductor industry’s cyclicality. Over the past ten years, semiconductor companies grew sales by double the rate of their countries’ GDP increase, and the contract-manufacturing subsegment managed to growth three times as fast. We are confident these growth rates can continue over the long run, as we are entering the era of 5G mobile phones and big data, and the so-called internet of things (IoT) that will connect tens of billions of smart devices.

The semiconductor industry has undergone an amazing development in emerging economies. They started out as the workbench of the world, benefiting from the outsourcing trend to lower-cost production locations. Today, they are centers of technological excellence in their own right. A good example is Taiwan Semiconductor, or TSMC, whose thriving contract manufacturing business has made it roughly ten times larger than the next-biggest competitor. This also holds true for other companies such as South Korean industry heavyweight Samsung Electronics, a leader in the memory chip segment, or Taiwan-based Novatek Microelectronics, a major designer of chips used in electronic displays.

Taiwan is home to the world’s most important foundries, i.e. microchip manufacturers for companies such as California-based Qualcomm that have outsourced production. Its market share is this area is 67%, and another 44% in the field of outsourced semiconductor assembly and test (OSAT). South Korea dominates the memory chip industry with a 63% market share, and the US leads in integrated circuit design (see table).

Table: US leads in chip design, Asian competitors excel in other segments

  IC design Memory chips Foundry OSAT Equipment
Value (USD billions in 2018) 270 130 64 29 60
US share 68% 32% 9% 15% 37%
South Korea share <1% 63% 9% 3% 9%
Taiwan share 15% 1% 67% 44% 8%
China share 14% 1% 7% 24% 7%

IC=Integrated circuit
Foundry=Microchip manufacturer for companies that have outsourced production
OSAT=Outsourced semiconductor assembly and test

Source: Morgan Stanley, Vontobel Asset Management, data from 2018

China lags behind, but likely to catch up

China lags behind in all segments of the semiconductor market, but is a major producer of hardware and electronic components. It has long sought to establish homegrown industrial champions, which culminated in the “Made in China 2025” initiative in 2015. While the country still relies heavily on semiconductor imports, the trade war with the US has moved China to renew efforts to close the technology gap. This process will take time. China’s largest foundry SMIC still generates almost no return on invested capital and lags Taiwan-based TSMC’s technology by at least five years. We see more potential in areas where Chinese players already have a strong foothold, like outsourced semiconductor assembly and testing, or special semiconductors for specific applications such as, yes, surveillance devices2.

Despite high expectations and elevated stock valuations, we believe the outlook for semiconductor companies remains solid. The market will be driven by soaring demand for fifth generation telecommunications equipment, data centers, and cloud migration, as well as the emerging new land of plenty, the internet of things. Despite these favorable prospects, the sector is likely to remain volatile in the future as demand cycles are amplified by supply mismatches in this highly capital-intensive industry.

Apply the rat’s shrewdness to increase wealth

For our part, we will continue to focus on companies with a high return on invested capital (ROIC) and a strong market position, which often makes them what we call leaders. Keeping in mind that the rat stands for qualities or attributes such as shrewdness and wealth in Chinese culture, we will try to take our stock picks accordingly in her year.

1 As of December 31, 2019, information technology stocks made up around 15% of the Vontobel Fund - mtx Sustainable Emerging Markets Leaders. In terms of country weight across all sectors, China came top with almost 38%, followed by South Korea with 12%, Brazil with nearly 11%, and Taiwan with close to 8%.
2 As of December 31, 2019, Chinese stocks Alibaba and Tencent were the second and third-biggest positions in the Vontobel Fund - mtx Sustainable Emerging Markets Leaders, with portfolio weights of 5.9% and 4.8%, respectively. The single-biggest stock was Taiwan Semiconductor (TSMC) with 6.3%.

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