Most investors associate Taiwan with technology. But even so, it’s easy to underestimate the importance of this sector. In fact, IT-related companies make up a full 50% of the MSCI Taiwan index.
That’s not to say that tech is the only reason to invest in Taiwan – there are plenty of other interesting stories here, as I’ve written in the past. But it’s clearly very important – and for most people, the easiest one to invest in. Any Taiwan fund you buy is likely to have a very heavy weighting in tech, while the handful of Taiwanese stocks listed abroad are mostly tech stocks.
So on my latest stop in Taipei, I decided to set up a couple of meetings to hear about recent trends in this sector. In particular, I had a chance to sit down with some analysts from the highly-rated tech team at Yuanta Securities and asked them for some of their top ideas for the long run …
The firms behind the brand on your laptop
Unless you follow tech closely, you probably won’t know the names of many Taiwanese firms. In computing, you might recognise Acer and Asus, which have developed into reasonably respected brands. More recently, you might have become familiar with HTC, which has used good design and tie-ups with Google to become the third largest smartphone firm after Apple and Blackberry maker Research in Motion.
But these three firms are unusual in that they’ve gone some way down the path to building major consumer brands. Many other Taiwanese firms remain very anonymous even to the users of their products.
For example, if you’re reading this on a laptop, there’s a very high chance that it comes from a Taiwanese-owned factory even if it doesn’t carry an Acer or Asus badge. Taiwanese original design manufacturers (ODMs) such as Quanta and Compal build, and, to varying extents, design the notebooks that carry the name of Hewlett Packard, Fuijitsu, Lenovo and others.
And of course, each assembled product contains components from many other firms, many of which are also Taiwanese. The processor in your laptop might be designed by the US firm AMD – but it may be fabricated by TSMC and packaged and tested by ASE. The screen panel might be made by AU Optronics, the backlight by Radiant … and so on through hundreds of parts, each sourced from a different supplier. Even the hinges may come from a Taiwanese firm.
They don’t dominate everything: the memory is more likely to come from a Korean firm such as Hynix, or even a Japanese one. But the notebook supply chain invariably involves many anonymous Taiwanese stocks.
The same is true to varying extents in many other electronic sectors: mobile phones, TVs, DVD players and many other products. Apple, for example, does absolutely none of its own manufacturing. All the assembly work is carried out by Taiwan’s Hon Hai/Foxconn group, with components sourced from hundreds of other firms.
Which firms are feeling the pressure?
Tech is always a competitive, high-pressure business. So what kinds of challenges are these tech firms facing at the moment?
One is cost. Many Taiwanese tech firms have gained their competitive advantage through using low-cost manufacturing in mainland China while retaining management and research functions in Taiwan. This allows them to make use of China’s low labour costs. A shared language and culture has given them advantages over companies from other countries in running factories on the mainland. But as you’ve probably heard, wages are rising sharply in China, pushing up costs. And manufacturers must adapt to this as best they can.
One way is to relocate factories to cheaper areas. Firms such as Quanta have been establishing new plants in areas such as Chongqing in the west of China, rather than on the coast, home to existing plants. But this apparently isn’t saving them much in wages, since costs are going up across China. But they are at least picking up tax breaks from local governments keen to lure them in.
Another option is to increase automation and productivity – when labour gets more expensive, you try to squeeze more from a smaller workforce. In some areas, there’s scope for this – but in others it’s tricky. For example, assembling iPhones is always labour intensive and Hon Hai’s workforce just keeps growing and growing.
Another problem is that because tech is built around innovation, it can be hard to establish and maintain market leadership. For a current example, take Mediatek, which designs system-on-a-chip solutions for mobile phones, among other products.
To sum it up simply, Mediatek found a profitable niche producing the core of a mobile phone – a simple package that anyone could buy, stick a shiny case around and have a working product without having to do any real tech design work. These were sold to low-tech manufacturers who used them to produce low-cost lookalike products for the iPhone or whatever model was hot at the time in China and other emerging markets.
Mediatek did very well for a while. But now the firm is being squeezed. Spreadtrum, a mainland Chinese firm with government support, has worked out how to do the same thing with the 2G systems Mediatek produces and is undercutting it. Meanwhile Qualcomm, the US firm behind the chips for more sophisticated phones – including HTC’s – is now selling 3G kits for the same prices as Mediatek’s higher-end 2G ones. So it’s no surprise that Mediatek’s share price has collapsed as investors wait to see how it will response.
A third issue is the ever-present threat of disruptive technologies. For many years, laptops were a growth sector, powering brands such as Acer and ODMs such as Quanta. But laptop sales are now slowing. Following the success of Apple’s iPad, the new growth market is tablets.
For branded firms such as Acer and HTC, as well as rivals such as Samsung and Motorola, the rush is on to get their own tablets onto the market. Their sales will suffer if they’re unable to produce a hit product.
For ODMs geared towards notebooks such as Quanta and Compal, this means they’ll need to look for new growth sectors such as tablets and handhelds, or perhaps move into new areas such as cloud computing servers. While they had a strong position in the highly consolidated notebook ODM market, they face a lot more competition establishing themselves in these new emerging areas.
And further down the chain, some component suppliers will be in serious trouble from the shift. Tablets don’t require hinges, for example. So a firm that supplies them has nothing to gain from the tablet boom.
Three firms in pole position
All in all then, tech investing is a highly complex area that requires a lot of work to keep on top of trends. In addition, it’s highly cyclical, so there are many companies that are effectively always in play. You only buy them when there’s a downcycle and you sell them when times are good – they’re not buy and hold investments.
I don’t have that sort of expertise, so I asked the local tech teams for some ideas about Taiwanese firms really stood out in terms of the strength of their position. Not simply which might do well in the near term, but which are well placed to thrive and add value over a few years, even if they’re not the cheapest stocks around.
Unsurprisingly, top of the list was TSMC (TT:2330, NYSE:TSM). This firm is a global leader in custom chip manufacturing. These are produced to order according to designs from ‘fabless’ firms such as AMD or Qualcomm, who don’t have their own fabrication facilities. It doesn’t produce memory chips (DRAM), which is a commodity business where suppliers are under a lot more pressure. But it does produce the more complex and sophisticated processing chips at the heart of modern electronic systems.
TSMC is well placed to benefit from the shift in laptops that use Intel processors to handhelds and tablets based on infrastructure from ARM. Intel mostly makes its own processors, whereas ARM does no manufacturing. This means increased orders for independent foundries such as TSMC.
Of course, chip-making is a capital-intensive business and requires frequent investment in the next generation of chips. And TSMC faces competition from rivals such as Globalfoundries and Samsung (which mostly produces commodity chips, but is expanding its contract chip manufacturing division).
However, TSMC is technologically at the head of the pack. And the fact that it’s not tied to an electronics manufacturer (unlike Samsung’s division) should help it win business from Samsung’s rivals. On a p/e of 11.7 and a yield of about 4.1%, TSMC looks good value for the long run.
Elsewhere, conditions are looking tough for TFT flat screen manufacturers. Notebook sales growth and the replacement of old TVs with flat screen ones have driven earnings in recent years. But these trends don’t look so encouraging for the future. Meanwhile, competition in this area is heating up.
Meanwhile touchscreens are a key part of tablets such as the iPad and are likely to continue spreading into other areas. Producing these is more complex than a TFT screen. And a firm’s success comes down to being able to make screens that meet the exacting standards of clients such as Apple, while being able to get the yield rate from each pane of glass up high enough to make money.
TPK (TT:3673) is the industry leader in this area, supplying 50% of screens for Apple’s products. It faces growing competition, including efforts by Foxconn-controlled TFT screen manufacturer Chimei Innolux to expand into making touchscreens for Apple. But a tricky learning curve on the crucial lamination process, a move towards using larger touchscreens (which are harder to make) and the firm’s exceptionally high yields should see it do well from a coming touchscreen boom. Although it’s on a high trailing p/e of 35, the Yuanta analysts think that it’s placed to do well for the next few years.
A third interesting idea was something I’d never thought about at all: chip distributors. These are the firms who distribute products from vendors such as Texas Instruments, Intel and Qualcomm to small and medium sized manufacturers who don’t deal with them directly.
Asia and in particular China is a fast-growing market for these integrated components (IC) and distributors should be able to add a lot of value here in the future. But at present, distribution is still fragmented with many small players, while major US distributors such as Arrow and Avnet come from a very different culture and are struggling to gain market share.
This could offer a great opportunity for Taiwanese distributors. The technical barriers to entry in this business are obviously not high. But success will be down to networks, cultural understanding and efficient working capital management to get the best out of relatively low gross margins (5-6%).
WPG is the largest distributor in Asia and looks in prime place for this in the long run. On a p/e of 11.7 and a yield of 3.2%, it seems reasonably priced. However, it has some work to do integrating a recent major acquisition. So smaller Taiwanese rival WT Micro (TT:3036) may outperform in the short run. It trades on a p/e of 8.3 and a yield of 4.25%.
The snag with Taiwanese shares is that, like Korea last week, this is not the easiest market to invest in. A few tech firms, including TSMC, have liquid US or UK secondary listings, making them easy to buy. But it is a small minority of larger companies; even HTC doesn’t have one at present.
So if you have a particular interest in tech and want to be able to buy most leading Taiwanese firms, you might need to look at brokers who will trade this market directly. In my view, this is most easily and cost effectively done through an Asian firm that offers most regional markets and caters to international investors, such as OCBC in Singapore or Boom in Hong Kong.