We believe it's time for investors to position themselves for a recovery of the Asian technology sector.
Author : Lim Chung Chun
Untitled Document ASIAN TECH - TIME TO POSITION FOR A RECOVERY
(Fundsupermart.com) The Asian technology sector is an important sector as it accounts for a substantial share of the stock markets and GDP of many Asian economies, including Taiwan, South Korea, Singapore and Malaysia. Asia is a production centre for the world when it comes to technology products (semi-conductors, personal computers, and various electronic components).
WHEN IS THE BEST TIME TO BUY AN ASIAN TECH FUND?
Our short answer is: After the technology/electronics sector has seen a slump.
One should always remember that stocks move in anticipation of a recovery. When investors anticipate that there will be a recovery, share prices will move up as they are prepared to pay a higher valuation for these stocks. Conversely, when investors anticipate that the electronics sector will go into a cyclical downturn, valuations have to go down to very attractive levels before investors are willing to buy.
Looking back at the last few cycles in the electronics sector, one can note that the best time to buy into electronic stocks in Asia is after various indicators (the changes in global semi-conductor sales give a good idea of what is happening in the electronics sector) show a slump in the electronics sector. Look at the charts below.
Global semi-conductor sales and electronic stock prices picked up right after the slump in mid-1998 and 3rd quarter 1996. From the two examples, one should therefore buy at a time when many companies globally are announcing lay-offs, when numerous semi-conductor manufacturers are cutting capital expenditure and shutting down loss-making plants. Psychologically, it is difficult to do. But historically, it has been proven that this strategy gives good long-run returns.
The interesting point to note is that when investors anticipate a recovery, they are typically willing to pay premium valuations for the stocks. Hence the best investment opportunities surface only after a slump has been seen. There will be no euphoria of recovery without the pain of a slump.
Historically, the average PE ratios (price-earnings) of electronics stocks range from 8x to 15x near the bottom of the cycle to 20x to 30x near the top of the cycle (PE ratios do not apply very well to semi-conductor companies during a slump; different yardsticks are often used). This means that if you buy at or near the bottom of the cycle, and hold it till the top of the cycle, you could double your money. Earnings growth could add on to that.
When investors have already known for 12 to 18 months that the electronics sector is expanding rapidly, chances are valuations will no longer continue to move upwards. Share prices may continue to move up at this stage only for certain companies that have good earnings growth.
The time to increase exposure to the technology sector is certainly not at a time when numerous fund distributors are recommending technology funds furiously because that is the easiest fund to market (remember early 2000?).
Also, do not wait for the government to make the pronouncement that the electronics sector has recovered before buying. It will be too late by then.
ELECTRONICS SECTOR - WILL THERE BE A RECOVERY?
The global electronics sector has always been cyclical. The state of the semi-conductor industry gives a fairly good idea on how cycles generally move. It can be seen that generally, the downturns last 3 to 4 quarters. Based on past experience, one would expect the electronics sector to start recovering sometime in 4th quarter 2001, or latest 1st quarter 2002.
But the question that has to be asked first is: Will there definitely be a recovery? Or could recovery be much further away? For instance, 2 years down the road.
To answer that question, investors have to first realise that Asia's electronics sector output at any point in time depends on the production cycle of the electronics industry (of which the PC industry is a key part), rather than the sales to end-consumers. While the sales volume to end-consumers is obviously a key variable, this does not explain the ups and downs that one sees in Singapore's electronics industry. For instance, electronics output can swing from a growth of 20% to a decline of 10% in matter of 2 to 3 quarters.
Does global consumer demand (PCs, telecommunications products, consumer electronics, etc) swing in that manner? Certainly not. Generally, end-consumer demand continues to show year-on-year growth even when global economies slow significantly (albeit demand may possibly slow down from a growth of 12% to 15% to a growth of 5%). The variable that links the production level (direct determinant of the electronics sector output) to the sales to end-consumers is the inventory level. Inventory adjustments are generally what cause wild swings in the production cycle.
Let me illustrate what I mean. Let's assume that globally the end-consumer demand for PCs is 140 million units in 2000 and 150 million in 2001 - implying a growth of 7% in demand in 2001. However, the actual production of PCs in 2000 is 155 million units. Since there is an overproduction in 2000 (by 15 million units), the PC manufacturers will realise by end-2000 that they have 15 million units in excess inventories.
In 2001, the PC manufacturers will cut back on the production levels to about 135 million units (150 million in end-consumer demand less 15 million in inventories). This implies that there will be a 13% contraction in the electronics output for the PC industry in 2001 (from 155 million units to 135 million units), despite the fact that global consumer demand for PCs increases by 7%. This is what creates the "electronic slump" and the accompanying falling utilisation rates, job cuts, and etc.
In 2002, the global end-consumer demand for PCs may grow to 160 million units (a very modest 6 to 7% growth). Since the inventory adjustment will be over by then, PC manufacturers will have to start ramping up production again. Production will likely increase to 160 million units in 2002. That will mean an 18.5% jump in electronics output in 2002 compared to 2001. The electronics sector will therefore see a "recovery."
Hypthetical Example Showing Why Recovery Will Come
In Millions Of Units
Inventory Overhang At Year-end
The above example explains why the electronics slump typically lasts only 3 to 4 quarters, and the recovery, when it eventually comes, will be robust (generally over 10% growth). The recovery will happen even if the US economy remains weak (unless of course the world goes into a major depression such as that seen in early 1930s).
We believe this present cycle is similar to past cycles, and clear signs of recovery will be seen by 4th quarter 2001. In all likelihood, Asia electronics production will grow at a healthy rate again in 2002 (10% or higher).
WHAT ARE THE EXPERTS SAYING?
Let's hear from the technology experts out there.
Clearly, there are always opposing views. Take the semi-conductor sector. 3 weeks ago, Jonathan Joseph, the semi-conductor analyst from Salomon Smith Barney upgraded his recommendation for the sector to a "Buy." Soon after, the analysts from Merrill Lynch (Joseph Osha) and Lehman Brothers (Daniel Niles) came out to reiterate their still negative view of the sector. Who is right?
In our opinion, it is more important to understand the thought process behind each of their recommendations, rather than try to decide if the "Buy" or "Sell" recommendation is right.
Let's look at the negative arguments (bearish call). Osha of Merrill Lynch says that semiconductor stocks will probably bottom out only in June or July, or 3rd quarter 2001. Niles of Lehman Brothers thinks likewise.
What is interesting, however, is that all three analysts seem to agree that the fundamental bottom (i.e. actual semi-conductor sales, as opposed to stock prices) for the sector will likely be within the next 6 months (2nd or 3rd quarter).
Furthermore, all of them do agree that a recovery will eventually come. It is a matter of when the recovery will come, not a matter of if the recovery will come.
The optimists are saying that share prices of semi-conductor stocks are already at the bottom, and the upside will be substantial over the next 12 to 24 months (over 50% upside). The pessimists are saying that share prices will still be down in the next few months (possibly by 25% to 30%), before recovering subsequently.
Both the optimists and pessimists believe that the share prices will be higher in 12-24 months' time. The disagreement is only with regard to what will happen in the next few months.
Under such potential scenarios, what should investors do?
In our opinion, now's the time for investors to start buying into Asian technology funds. The potential returns in the next 2 years will be substantial. However, be aware that in the short time, there could still be volatility. Be prepared that downside risks of 20% to 30% cannot be ruled out completely. Investors who are not psychologically prepared to take such volatility should not buy.
WHICH FUNDS TO INVEST IN?
The investment opportunity that we have described above arises as a result of expected turnaround in Asia's electronics production. One fund that gives exposure to this sector is the UBS (SG) Investment Fund - Asian Technology.
This fund invests in technology companies in Asia ex-Japan. 44% of the holdings of this fund are in semi-conductor companies (as at 31 March 2001). The top 2 holdings are Taiwan Semiconductor Manufacturing Company (TSMC) and United Microelectronics Corp (UMC), which are the world's largest and second largest semi-conductor foundries (the superior competitors of Singapore's Chartered Semiconductor). Semi-conductor foundries will be some of the beneficiaries of a potential recovery in the semi-conductor sector. 61% of the holdings are in Taiwan, 16% in Korea and 13% in India. Please refer to the fact sheet and prospectus for further details.
Lim Chung Chun is the Executive Chairman and Research Director at Fundsupermart.com Pte Ltd. He is a licensed investment advisor. You can write to him at firstname.lastname@example.org.
This article is not to be construed as an offer or solicitation for the subscription , purchase or sale of any fund. No action should be taken without first viewing a fund's prospectus. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Please read our disclaimers.