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The history of semiconductors dates back to the 19th century, marked by Karl Ferdinand Braun’s discovery of rectification in 1874. Practical applications then emerged in the early 20th century, such as the cat’s whisker detector, a rudimentary semiconductor device used in early radio receivers. This device consisted of a thin wire, or ‘whisker’, that made contact with a semiconductor crystal, such as silicon, to detect and convert electrical signals into audio signals.

Since its inception, the industry has been characterised by cyclicality as well as its relentless pursuit of innovation, defined by Moore’s Law, which states that the number of transistors on computer chips double every two years with little change in price. Of course, the industry has come a long way since those first primitive semiconductors and their applications, and continuous advances have given way to semiconductors so sophisticated that they have become indispensable to the functioning of modern society. The industry’s rapid evolution is reflected in its staggering growth, with annual sales quadrupling in just two decades – soaring from $139 billion in 2001 to $573.5 billion in 2022¹. This rapid growth is well illustrated by the development of ASML’s market capitalisation below.

Cyclicality and Semiconductors

Most recently, the semiconductor industry has faced global supply chain disruptions, triggered by the Covid-19 pandemic. While some sectors, notably automotive, faced reduced orders, most, such as consumer electronics, saw unprecedented growth due to the shift to remote working. US sanctions on companies with ties to China, combined with factors such as the 5G rollout, the Russia-Ukraine war and severe weather events, added to sector volatility. Semiconductor manufacturers responded to heightened demand during the pandemic by increasing inventories, supported by government subsidies. However, the end of the consumer electronics replacement cycle resulted in an industry slowdown in the latter half of 2022 and excess chip inventories.

A year later, inventory levels stabilised, particularly in the global IT components sector, marking a turning point in the cycle. TSMC’s revenue, a key indicator of industry health given they manufacture around 90% of the world’s advanced chips, rose by 14.4% in Q4 2023 from the previous quarter². Some concerns persist regarding oversupply, especially for foundational chips, as Chinese chipmakers continue to increase production. Nonetheless, the industry is expected to maintain its upward trajectory, with sales revenue estimated to reach between US$588-613 billion in 2024, surpassing 2022’s record of US$574 billion, and 2027 forecasts come in around US$736.40 billion³.

Geopolitics and Semiconductors

The global shortage of semiconductors provided a wake-up call for many governments, particularly in the US and Europe as it served to highlight the vulnerability of over-reliance on the global supply chain. In response, governments began efforts to de-risk their supply chains through onshoring and nearshoring production. This trend has proved beneficial to some players in the supply chain as the total addressable market for existing suppliers increases in line with an increase in capacity and production. For example, Park Systems, which supplies wafer inspection equipment, is benefitting from the increasing demand of smaller nodes and the corresponding expansion of manufacturing lanes.

The US government’s 2022 CHIPS Act is a prime example of efforts to onshore. It allocated $52.7 billion⁴ in federal subsidies to support domestic chip R&D, manufacturing and workforce development. Just recently, President Biden announced up to $8.5 billion direct funding to US chipmaker Intel under the CHIPS Act to fund new chip plants in the US.

The US government-imposed restrictions on the export of advanced chips and chip manufacturing equipment to China in October 2022, and tightened the restrictions in November 2023. The move was intended to pre-empt the prospect of Chinese global dominance in the industry, as the Chinese government also sought self-sufficiency. However, the move has yielded mixed results. While it has hindered China’s progress in advanced chip manufacturing and AI development, leading to a focus on foundational chip manufacturing instead, it has likely accelerated China’s path to self-sufficiency by making this an even higher priority for Beijing and forcing Chinese companies to be more innovative in order to develop their own advanced chips. For example, in October 2023 Beijing announced a $40bn state-backed fund to boost the semiconductor sector, and at the same time, scientists at China’s Tsinghua University announced the development of the world’s first fully system-integrated memristor chip in October 2023, with significant applications in AI and autonomous driving⁵.

Semiconductors and Artificial Intelligence

In 2024, the consumer electronics sector is poised for solid growth with a forecasted 3.5% and 4% increase in PC and smartphone sales respectively according to Gartner. This upswing is fuelled in part by a new notebook renewal cycle, as well as a wave of smartphone replacements driven by on-device AI, which allows smartphones to process data within the device rather than on a remote cloud server; this reduces security issues and enables AI services without internet connection. This development, we believe, will benefit a number of our portfolio companies that cater to this industry. One example is Elite Material, a key supplier of high-density copper clad laminates, a crucial component used in advanced chip production. Another example is LEENO which is set to see higher revenue growth in 2024 given their significant R&D exposure to on device AI.

NVIDIA’s recent Q4 2023 report of a 265%⁶ increase in quarterly revenues from one year ago serves as a prime example of the substantial growth AI can drive, with CEO Jensen Huang asserting that AI has reached a ‘tipping point’. The seemingly limitless potential of the AI revolution will sustain growth in the semiconductor industry for years to come, benefiting well established companies like NVIDIA and Arm, as well as lesser-known businesses in our portfolio that cater to such industry giants.

eMemory Technology

Within the semiconductor industry, eMemory, a world-leading IP provider to over 2,400 foundries, IDMs and fabless companies, is a prime example of the type of company we like to invest in, with deep moats, sound balance sheets and a strong outlook based on sustainable growth and expansion. In a recent quarterly earnings call, chairman Charles Hsu summarised their strong growth potential: ‘‘Our total addressable market will increase as the world expands foundry capacity and move toward more advanced technology. Our technology coverage in each foundry will increase as more technology processes develop and more fabs are established.’’ To this end, the company has several advanced 3/4/5nm semiconductor projects underway and has successfully licensed its 3nm OTP and PUF technology to a US foundry customer with whom it will work to develop the most cutting-edge processes. In addition, the royalty income for each foundry is increasing, as is the demand for licensing, resulting in increased licensing income, all of which increases eMemory’s profitability.

The promising outlook for eMemory, which will very likely profit from both increasing semiconductor capacity and complexity, is reflected in the positive outlook for many of our other portfolio companies. For example, LEENO, (see Company Spotlight in our Q1 2024 Manager’s Commentary) should be benefiting from the increasing complexity of chips, which require more advanced pins and sockets for testing in the R&D phase.

Outlook

The expanding total addressable market of semiconductor end markets, facilitated by this expansion in semiconductor capacity and complexity, suggests we may come to see a potential reduction in the industry’s cyclicality. The industry may become increasingly shielded from the vulnerabilities associated with single market trends with dampened demand in one sector likely having a less pervasive effect on the overall semiconductor industry and its supply chain. Furthermore, many of the new end markets, such as automotive, industrial automation, 5G infrastructure, AI and cloud computing, have larger chip demands per unit compared to those associated with consumer electronics. The outlook for the semiconductor industry is positive, not just for 2024, but for the next decade. Despite historical peaks and troughs, the industry’s overarching trend is one of exponential growth, with forecasts pointing to a milestone of $1 trillion in market revenues by 2030.

At MCP, we avoid trying to time each cycle perfectly and instead focus on identifying highly innovative companies that are positioned to benefit from the industry’s long-term trends, such as eMemory. This strategy does not begin and end with the semiconductor industry, but extends to all the industries in which we invest. In this way, we aim to create long-term, sustainable value for our investors.

To find out more about portfolio manager Carlos Hardenberg’s and the MCP team’s insights into the semiconductor industry, listen to Decoding the Semiconductor Industry. This episode is part of our new podcast channel, Insiders and Outliers – MCP on Emerging Markets. Monthly episodes are available on Spotify, Apple Podcasts and Soundcloud.

¹ SIA

² TSMC

³ Statista

⁴ The White House

⁵ CSIS

⁶ NVIDIA

On 26 February 2024, South Korea’s Financial Services Commission (FSC) together with the Korean Exchange (KRX) announced the country’s Corporate Value Up Programme. Similar to, and most likely inspired by, Japan’s decade-long initiative, the aim is to raise valuations and boost shareholder returns. This is a move to address the so-called ‘Korea discount’ where listed companies tend to have lower valuations compared than their global peers. In fact, over two thirds of listed companies on the Kospi have a price-to-book (P/B) ratio of less than 1¹.

Source: Bloomberg

A significant contributor to the Korea discount is weak corporate governance standards, particularly within the notorious chaebols – wealthy and influential family-owned conglomerates like Samsung, Hyundai Motor and LG. Chaebols have traditionally prioritised maintaining control over maximising shareholder value and including minority shareholders in active participation. One notable example is the deliberate suppression of company value to minimise the blow to the next generation when it comes to paying the hefty 50-60% inheritance tax. However, it’s important to recognise that while chaebols play a crucial role, there are other factors contributing to the discount, including traditionally low dividend payouts and inefficient asset utilisation among Korean companies.

The Corporate Value Up Programme is a set of voluntary guidelines encouraging companies to devise mid- to long- term plans and targets to increase shareholder value, with board members playing a key role in the implementation. Companies are encouraged to disclose these plans annually on the KRX website. Korean financial regulators have emphasised that there are significant financial incentives for companies to participate in the programme, claiming that the incentives will exceed those offered by Japan in its equivalent initiative. In addition, best practice companies (those with a proven track record of profitability or those that are expected to boost valuation) will be included in the upcoming Korea Value-up Index, the other major pillar of Korea’s efforts.

The Korea Value-Up Index, to be introduced in June, mirrors Japan’s JPX Prime 150 Index by including companies that are making efforts to improve their valuation. The purpose of the index is to create a market environment that promotes investments in such companies, makes them more accessible to retail investors and enhances market transparency. Pension funds and institutional investors will use the index as a benchmark, and ETFs tracking the index are expected to be launched by December. Evaluations of key financial indicators, including P/B ratio, price-to-earnings ratio and return on equity will be part of the index’s criteria. These indicators, along with dividend payouts, will be regularly published on the KRX website.

Concerns have been raised about the lack of detail in Korea’s Value Up Initiative, particularly regarding the unspecified tax incentives the FSC places great emphasis on. Another source of disappointment is the voluntary nature of the programme; without enforcement companies may not take decisive action to improve valuations, rendering the initiative meaningless. As a result, the Kospi Index fell by 0.8% on the day of the announcement².

The FSC has responded to such criticism by stating that is it more realistic to provide powerful incentives than to enforce cooperation, and that final guidelines will be announced in June. The FSC has also stressed the importance taking a long-term view. Chairman Kin Joo-hyun stated that “enhancing the corporate value of a company is not something that can be achieved in a short period of time with only one or two measures.”

A look at Japan may help to better understand Korea and its initiative. Japan has faced similar challenges of low valuations and shareholder returns since its market crash in 1987. As a result, the country embarked on a corporate governance mission over a decade ago. Efforts ramped up last year when the Tokyo Stock Exchange (TSE) announced in March that listed companies with a P/B ratio of less than one must submit a plan to improve capital efficiency. In October, the TSE announced its ‘name and shame’ measure whereby from January 2024 it will publish a list of companies with poor shareholder returns that have disclosed these plans, thus indirectly calling out companies that haven’t. These efforts are finally bearing fruit as the Nikkei 225 hit a 34-year high on 22^nd Feb closing above 39,000 points³. Many investors are putting Japan back on the agenda in 2024 after a 34-year hiatus.

So, what lessons can Korea learn from Japan? While Korea’s initiative may result in little change in the short-term, due to its unspecified and voluntary nature, it should not be deemed insignificant. Given that Japan’s reforms took over a decade to take effect, Korea’s equivalent reforms should not be expected to happen overnight but should be considered an important starting point for long-term improvements.

¹ Bloomberg

² Bloomberg

³ Bloomberg

As China enters a new year it is fitting to draw a comparison with this year’s zodiac animal, the dragon. Undoubtedly, the Chinese economy could do with a bit of luck and strength, attributes associated with the dragon. However, the key question remains: will the market heat up or will investors just get burnt?

Rewind one year and investors were projecting a strong recovery in China given a long-awaited farewell to its zero-Covid policy. This optimism was short lived. The rally in China’s stock market quickly tailed off as structural problems became alarmingly apparent. Deep-seated problems in the property sector, with defaults by major developers led by property giant Evergrande, had a knock-on effect on domestic lenders. FDI flows, domestic manufacturing, exports and consumer spending all remained weak, exacerbating China’s deflationary cycle. Such issues left Chinese equities trading at record lows.

However, a closer look at key metrics could indicate a disconnect between market sentiment and the reality on the ground. Box office sales increased in 2023, domestic tourism is booming with planned travel expenditures for 2024 surpassing 2019 figures, and car sales are reaching unprecedented highs. These are all important signals for a potential rebound in consumer spending this year.

Furthermore, the Chinese government has initiated measures to strengthen domestic demand, support the stock market and shift away from an over-reliance on infrastructure and real estate investment. A recent measure by Beijing to mitigate selloffs in the market and promote stability comes in the form of increased purchases of onshore Chinese stock market ETFs by state and sovereign wealth funds.

While measures so far have fallen short of substantial fiscal interventions many investors hoped for, the cumulative impact of the government’s smaller-scale initiatives should not be ignored. Furthermore, China’s upcoming National People’s Congress (NPC) session on 4-5 March is a key annual meeting where economic and social development plans for the year will be unveiled. Analysts expect a GDP growth target of 5% and the announcement of further measures to boost growth, support demand and improve the business environment.

So, given China’s attractive valuations, improving consumer sentiment and increasing fiscal support, why do we continue to invest cautiously in China?

First of all, despite some positive signs, structural challenges remain. 70% of household wealth is tied up in property, and the crisis is by no means over. Property investment and new construction dropped 9.6% and 20.4% respectively in 2023¹. Furthermore, Evergrande’s liquidation order in January and the liquidation petition filed against Country Garden on 28^th February are exacerbating the lack of confidence in the property sector. This may lead to an extended period of cautious consumer spending.

Additionally, the CCP’s intervention in the economy, coupled with lower corporate governance standards among Chinese companies compared to their Asian EM counterparts, continue to steer us away from direct investment in China. The CCP’s near destruction of the EdTech sector in 2021 is a prime example of the regulatory risks inherent in the country.

Finally, when it comes to companies, we rarely find the level of governance, fundamental quality and innovation that would meet our investment criteria. Instead, we prefer to access the Chinese market indirectly through countries such as Taiwan and South Korea which also benefit from improving consumer sentiment in China. For example, our portfolio includes Elite Material, a Taiwanese company specialising in components for the semiconductor industry. It operates manufacturing facilities across China and generates a significant proportion of its revenues in the country while offering Taiwanese standards of governance and transparency.

No investor can afford to ignore the world’s second largest economy and China is still forecast to grow by 4.6% in 2024², much faster than any developed market economy and many of its emerging market peers. So, we continue to scour the Chinese market for exciting companies that meet our quality investment criteria.

¹ National Bureau of Statistics of China

² IMF World Economic Outlook Growth Projections, January 2024