Looking beyond the obvious – the tech enablers

Ross Teverson

Ross Teverson, Head of Strategy, Emerging Markets.

The world’s technology giants continue to capture headlines, having grown to dominate large industries as the world becomes increasingly digitised.

The likes of Apple, Tesla, Facebook, Tencent and Alibaba have for some time been household names in large parts of the world. Investors are clearly excited about the growth potential of the long-term structural trends that these companies are thriving on, such as the rise of e-commerce, the proliferation of smartphones, the rapid development of electric vehicles and the popularity of social media.

With so much optimism around, however, it is not surprising that these companies have seen very strong share price growth in recent years even beyond the growth in their earnings. As a result of that, valuations have also risen a great deal and their weightings in indices have become extreme. In the MSCI Emerging Markets Index, for example, the Information Technology sector accounts for 27.8% of the entire index and the largest four stocks in the index are all IT companies, representing 17.1% of the whole index by themselves.1 As so many investors prefer to access market through passive products these days, money naturally herds into these already quite highly-priced stocks, especially as it is a market-cap weighted index. This is a crowded trade.

Company Country Sector Index Weight (%) P/E ratio
Tencent Holdings China IT 5.40 40.53
Samsung Electronics Korea IT 4.06 8.69
Alibaba Group China IT 3.84 48.16
Taiwan Semiconductor Taiwan IT 3.77 16.67
MSCI Emerging Markets Index 14.86

 

Jupiter’s global emerging markets funds only hold Samsung Electronics. Because we seek to invest in companies where change is underappreciated by the market, we invest in Samsung through the preferred shares, which are trading at a 24.7% 2 discount to the ordinary shares.

Source: Sector and % weight from MSCI, price/earnings ratios from Bloomberg as at 26/04/2018.

So, then, is an investment in these technology giants the best way to access the underlying structural opportunities that they represent? Not necessarily. After all, they and companies like them are just the most visible members of extended networks, with many companies supplying and supporting them and the markets they serve. For investors with the ability and willingness to look beyond the obvious mega-cap stocks, there are many other opportunities to be found in quality companies that are benefiting from all the same long-term changes, but with potential that is perhaps underappreciated by a market fixated on the big names.

Identifying change in technology stocks

As bottom-up investors in emerging markets, our research starts with an analysis of individual stocks, but we also look at their competitors, customers and suppliers to get a rounded view of each company’s place in its industry. What we want to identify are companies that can benefit from change, and where that potential has so far gone underappreciated by the market. Examples of the kind of change we look for include

  • A change to the company itself, for example higher margins, resulting from a change in product mix or cost reductions.
  • An industry-wide change, such as easing competitive pressures, resulting from a more consolidated sector.
  • A long-term structural change, such as rising market penetration for the company’s products.

It is only after conducting this research and putting together a short-list of high conviction ideas that some themes and trends start to emerge from this analysis. One of the common threads that links several of our stock ideas is technology enablers, meaning companies that supply components or services as part of those long-term technology trends.

Examples include SK Hynix, a South Korean company that is a major supplier of dynamic random-access memory (DRAM). Its chips are used in Apple’s laptops and Google-branded tablets, as well as servers used by Chinese internet giants Tencent and Alibaba. Server demand is an important driver of DRAM growth, in our view, as the number and capacity of servers is a fundamental requirement for so many of the things that people are excited about in the tech world, such as AI, autonomous cars, and social networking. While it feels like a dangerous game to predict who the winners and losers will be in these emergent technologies, what we believe is that they will all require significant quantities of DRAM.

Historically, the DRAM industry was characterised by a relatively high number of players and the constant threat of new entrants with access to cheap capital. This, combined with long equipment lead-times and very high fixed costs, led to a high degree of earnings volatility. In recent years, however, there has been a change in the industry, with weaker players either exiting the industry or being taken over. SK Hynix is now one of only three major players in DRAM, giving it market share and a strong position in its marketplace.

A smart way to access smartphones

More than 1.5 billion smartphones were sold to end users worldwide in 2017, with the market continuing to be dominated by Samsung and Apple, who combined have a 35% global market share.3 The technology within these phones is becoming ever more sophisticated and depends upon high quality components from trusted suppliers.

Vendor 2017 Units 2017 Share(%) 2016 Units 2016 Share(%)
Samsung 321,263 21 306,447 21
Apple 214,924 14 216,064 14
Huawei 150,534 10 132,825 9
OPPO 112,124 7 85,300 6
Vivo 99,685 7 72,409 5
Other 638,005 42 682,915 46
Total 1,536,536 100 1,495,959 100

Source: Gartner, as at 30/02/2018.

Mediatek is a global fabless semiconductor company which supplies the chips for mobile devices like the iPhone. The company is driven by strong momentum as it recovers from a tough 2017, when aggressive pricing from Qualcomm, a multinational semiconductor manufacturer weighed on its revenues. 2018 has so far seen an improvement, helped by restocking demand and the potential for stronger Chinese smartphone sales as new models are generally lower-priced than those introduced in 2017. Our view is that the change happening within Mediatek, as it develops new and more specialised products, should help it make ongoing market share gains. For example, its new Helio P23 chipset has comparable or better cost/performance relative to Qualcomm’s equivalent.

Mediatek share price versus MSCI EM Index (USD)

graph 1
 
Source: Bloomberg, 28/04/2017 to 19/04/2018, USD

It isn’t just the component suppliers for smartphones that can represent potential investment opportunities, but also crucial services. Chroma, for example, is a Taiwanese company that provides testing equipment for technology such as the advanced facial recognition sensors in the new iPhone X. Chroma isn’t just involved in the smartphone industry, though, it also designs testing equipment for the batteries which go into electric vehicles.

Electric vehicles on the charge

Electric vehicles (EVs) are both the future and the present. Plug-in hybrids and battery-powered electric cars have been on our roads for several years now, with consumer adoption growing steadily to the point that they represented 1.7% of global auto sales in 2017.4

Yet in many ways the EV industry is still in its early stages; global carmakers have announced plans for a combined $90 billion of research and development spending on EVs.5 The opportunity for companies able to serve this growing industry is clearly significant, providing that stock pickers can identify the winners.

Chroma was an early partner of Tesla, and is a key equipment supplier to Taiwan’s solar industry and the main equipment supplier to Delta Electronics. We see its corporate governance as good, while the company’s history of paying reasonable dividends is supported by high and stable gross margins of between 52% and 55%.

Chroma’s largest revenue contributor historically has been “Test Instruments and ATS”, which involves testing and assembly equipment for a range of industries including PCs, flat panels, solar, LED, batteries and electric vehicles. However, sales for this part of the business have struggled to grow in recent years due to slowing PC shipments and the time taken to digest overcapacity in solar and flat panels.

Chroma’s dependence on IT-related business is much lower than in the past, however, and we see rising cleantech exposure (EV, solar, LED) as a potentially material sales growth driver for the business in future. This change happening within Chroma as its shifts emphasis is exemplified by its relationship with Tesla, to which it provides a crucial service in testing batteries, an area which Tesla has made a key technological edge.

Batteries within electric cars are typically comprised of numerous cells which need to be connected in a way that ensures complete reliability and optimum performance throughout the life of the vehicle. Taiwan-listed specialist engineering company Bizlink are the experts in this technology, providing components known as battery wire harnesses for electric vehicles. The company’s expertise is reflected in high-end clients such as McLaren and Tesla.

Bizlink’s supply of wire harnesses and charging station cable sets to Tesla contributed 13% of the company’s sales in 2016. In 2017, Tesla produced around 100,000 6 vehicles and has impressive growth ambitions for future production, with the goal of 6,000 Model 3’s per week by the end of June 2018 7. We must remember, however, that Elon Musk is no stranger to making bold predictions that end up undershooting, and Tesla’s production line is not without its snags.8 As ever, then, there are risks – but considering that Tesla already has an order backlog of 500,000 for the Model 3 9, there is clearly scope for Bizlink’s earnings accruing from its relationship with Tesla to increase materially from historic levels, even if Musk’s ambitions for higher production levels are not fully met.

Bizlink share price versus MSCI EM index (USD)

graph 2

Source: Bloomberg, 28/04/2017 to 19/04/2018, USD

(USD) 2015 2016 2017
Revenue 265 285 513
Revenue yoy 12% 8% 80%
EBITDA 31 38 62
Net income 24 28 38
Net inc yoy 23% 18% 35%

 

Summary

An active approach to seeking underappreciated change

Stock opportunities like those described above are examples of the sorts of underappreciated change we look for in our emerging markets strategy. They also illustrate our willingness to invest down the market cap scale when appropriate to find the most compelling opportunities. This lack of reliance on the mega-caps is something that can separate passive funds from truly active funds. Our ability to be selective also means that our portfolios can be tilted away from the most highly-valued parts of the market to areas where valuations are more reasonable, but the ability to benefit from long-term structural trends is just as strong.

To find out more, visit jupiteram.com

1 Source: MSCI, as at 30/03/2018
2 Source: Gartner
3 Source: Bloomberg, as at 30/04/2018
4 https://www.businessinsider.com.au/the-rapid-growth-in-global-electric-vehicle-sales-in-4-charts-2018-1
5 https://www.reuters.com/article/us-autoshow-detroit-electric/global-carmakers-to-invest-at-least-90-billion-in-electric-vehicles-idUSKBN1F42NW
6 http://ir.tesla.com/releasedetail.cfm?releaseid=10532452
7 https://uk.reuters.com/article/us-tesla-stocks/tesla-aiming-to-build-6000-model-3-cars-per-week-by-end-june-report-idUKKBN1HO38Y
8 https://www.reuters.com/article/us-tesla-stocks/tesla-production-pause-adds-to-model-3-concerns-idUSKBN1HO1QJ
9 http://fortune.com/2018/02/25/tesla-model-3-preorders/

Important information
 
This document is intended for investment professionals and is not for the use or benefit of other persons, including retail investors. This document is for informational purposes only and is not investment advice. Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The views expressed are those of the author at the time of writing, are not necessarily those of Jupiter as a whole and may be subject to change. This is particularly true during periods of rapidly changing market circumstances. Every effort is made to ensure the accuracy of any information provided but no assurances or warranties are given.
 
Jupiter Asset Management Limited is authorised and regulated by the Financial Conduct Authority and its registered address is The Zig Zag Building, 70 Victoria Street, London, SW1E 6SQ, United Kingdom. No part of this commentary may be reproduced in any manner without the prior permission of Jupiter Asset Management Limited.

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All figures correct as at 19.11.2018.