Technology enablers – “picks and shovels” in the tech gold rush
Ross Teverson, Colin Croft, and Matthew Pigott explain why they favour companies enabling technological change over some of the more ‘obvious’ names.
Ross Teverson, Colin Croft, and Matthew Pigott, portfolio managers of Jupiter Emerging & Frontier Income PLC, argue that investors may be better off looking beyond the obvious names in their search for those companies that are best positioned to drive, and to benefit from, the major technological changes playing over the coming years.
A lot to be excited about (and a cautionary tale)
Digital disruption, ubiquitous high-speed telecommunications, migration to the cloud, electric vehicles, and the promise of autonomous driving – for all of us, as consumers of rapidly evolving products and services, there is much to be excited about. From a sustainability perspective, the potential that these new technologies present for greater productivity with lower environmental impact is also considerable. And for investors this pace of change creates a multitude of investment opportunities. However, it also brings with it risks, including the risk of failing to identify the “winners” from these developments. This risk is amplified by the very high prices that investors are currently paying for shares in those companies perceived to be the most obvious beneficiaries of technological change.
At the turn of the millennium, investors were understandably excited about 3G telecommunications. Mobile phones were becoming more affordable and 3G promised to deliver fast, reliable internet access straight into the palms of consumers. Financial analysts were forecasting widespread take-up of new handsets and services and this excitement helped to drive the valuations of “obvious” beneficiaries, such as Vodafone, Nokia, and RIM (makers of the BlackBerry), to extremes.
Today, 22 years later, investors who bought Vodafone at its peak in March 2000 have experienced a total return of -20% (dividends have helped partially cushion the blow of a -79% fall in the share price)1 . However, this dismal return makes Vodafone the best returning stock of the three by a considerable margin. It is not that analysts overestimated the rate at which consumers would embrace new technologies – if anything, analysts’ forecasts proved too conservative in that regard. So, what went wrong? For one, analysts underestimated the level of competition and disruption in a market where so many players were chasing the same opportunities. And investors had bought into a narrative at the expense of ignoring the valuation they were paying to get exposure to that story.
Of course, a handful of stocks from that period did go on to become exceptional long-term performers, but the experience of Vodafone, Nokia and RIM should serve as a cautionary tale, and prompt investors to consider whether there are parallels to be drawn with some of the high valuations being paid for certain stocks in today’s market. It also begs the question as to whether there may be another way to get exposure to technological change with a higher degree of confidence that we, as investors, will actually profit from it. Our preferred method is through investing in “technology enablers”: companies providing some of the key components and services that make new technologies possible.
The semiconductor leaders enabling technological change
Over the past two decades, many of the technology enablers proved to be excellent investments. This is particularly true of semiconductor manufacturers, such as Samsung Electronics, the world’s leading memory chip manufacturer, and Taiwan Semiconductor Manufacturing Corporation (TSMC), the world’s largest contract logic chip manufacturer.
While neither Samsung nor TSMC have been immune from cyclicality in equity markets, over the period from March 2000 to today, shareholders of these companies have been rewarded with a remarkable compound total return of 14.8% and 14.6% per annum respectively2. Moreover, current share prices look undemanding, in our view, as they value Samsung Electronics at a level 11 times that of its forecast earnings for 2022, and TSMC at 22 times its own 2022 forecasted earnings. These are valuations we’re happy to pay as investors in order to access the long-term growth potential each company represents in our eyes. It is also noteworthy that both companies have net cash on their balance sheets and the financial capacity to reinvest for growth, while, at the same time, paying dividends (one of the drivers behind the impressive total return figures above).
Both Samsung and TSMC enjoy very high technological barriers to entry. The experience of SMIC, a Chinese company that listed in 2003 with the promise of becoming “China’s TSMC” demonstrates that this is not an industry where competitiveness can be achieved simply by investing vast sums of cash into expensive semiconductor equipment. From 2004 to 2020, SMIC invested US$23.6bn in a bid to close the gap, but is forecast to have generated only US$5.4bn in revenue in 2021, making it less than one tenth of TSMC’s size3. TSMC’s scale and breadth of intellectual property enables it to continue pulling away from would-be contenders such as SMIC. Similarly, Samsung Electronics (along with SK Hynix and Micron, which together form an effective oligopoly in DRAM semiconductor memory chips) has a manufacturing capability that would be almost impossible to replicate from scratch.
From our perspective, what makes these companies even more compelling as a means of investing in technological change is that they supply to such a broad range of customers that they are positioned to capture the benefits of rising spend on emerging technologies, regardless of which companies ultimately win the battle for the end user. For example, TSMC is the principal manufacturing partner for Apple’s handset chips but also supplies to Mediatek, the world’s largest supplier of chips for Android-based handsets. Even Intel, at one time seen as the global technology leader in semiconductor production, has committed to increase its outsourcing to TSMC because of its own inability to match TSMC’s pace of technology migration.
TSMC’s Revenue Breakdown by Product Segment
Source: Company 3Q2021 results presentation
Samsung’s DRAM memory chips are used in everything from PCs to servers, to smartphones and electric vehicles. DRAM memory is effectively the high-speed, short-term memory of a device and it is essential for manipulating and moving data quickly. As society processes and consumes ever more data, whether it be for the purposes of streaming videos or enabling driver assistance aids in a vehicle, demand for DRAM will rise. This means that we do not need to predict exactly what end markets will look like, or which products or services will ultimately win consumers’ hearts, minds and wallets, to be confident that demand for DRAM will be higher in the future than it is today.
Aggregate Global DRAM Demand
Source: Gartner, company reports, Bernstein estimates and analysis
Powering the electric revolution
We believe that a similar argument applies to the incredible growth that we are seeing in electric vehicles (EVs) and the promise of autonomous driving capabilities. EVs will almost certainly displace internal combustion engine (or ICE) passenger car sales over the course of the next two decades. This will happen first in markets where there is a strong political commitment to the transition, such as in the UK where the sale of new ICE cars is set to be outlawed in 2030. However, we are close to a point where EVs offer a more compelling cost and performance proposition to consumers, even in those markets without any form of policy support.
In 2020, EVs comprised 4.6% of global automotive sales, and if we assume that the share will have to get close to 100% to achieve net zero targets, then this is a market where penetration could rise twentyfold over the next 30 years. It is no surprise then, that investors are willing to pay higher valuations to invest in companies seen as having the most obvious exposure to growth of that magnitude – such as Tesla, the shares of which, at the time of writing, value the company at around 99 times the level of its consensus expected earnings for 2022.4
However, the most obvious way to play a trend does not necessarily offer the best risk-reward balance for investors; the history of the early automotive industry is littered with promising companies that did not survive the cut-throat competition of a market whose growth prospects were so obvious as to attract countless new entrants.
Global Electric Passenger Car Sales
Source: International Energy Agency and Roland Berger
In the case of the EV industry, one could argue that the most threatening “new entrants” are the “old auto” companies such as General Motors (GM), Hyundai, and Volkswagen (VW). Having been late out of the gate, these companies are now investing heavily to counter the challenge from EV pioneers, and it is very difficult to forecast how the ensuing battles for market share will ultimately play out.
Consequently, we believe the best way to get exposure to the EV transition is through areas where technical barriers to entry are high, competition is correspondingly less fierce, and share price valuations are less demanding. This is true of the EV battery industry for example. It is incredibly difficult to make large EV batteries reliably and at scale. It is not the kind of business that you can start up without deep pockets and a solid starting point in battery chemistry and mass production. As a result, EV battery production is a far more concentrated industry than auto manufacturing – it is dominated by a handful of large players such as CATL, LG Chem, Samsung SDI and Panasonic.
We have chosen to invest in LG Chem, a Korean company that is the world no.2 EV battery maker with 26% market share. It has strong strategic relationships with large automakers such as GM and VW, but also with dedicated EV manufacturers, such as Tesla and Lucid. Despite having a leading position in an industry directly exposed to EV’s impressive growth profile, LG Chem’s shares value the company at a level 16 times that of its 2022 consensus forecasted earnings5. We hold the preference shares of LG Chem, which are roughly half the valuation of ordinary shares, despite having the same economic value (preference shares, unlike ordinary shares, do not carry voting rights). We are thus getting exposure to growth in electric vehicles through a business which not only enjoys strong barriers to entry, but which trades at a share price valuation which is a fraction of that ascribed to dedicated EV manufacturers.
LG Chem’s low valuation may be partly explained by the company’s conglomerate structure, with divisions that include petrochemicals and agrichemicals. However, we believe perceptions will change over time, as battery earnings grow and come to overshadow the petrochemical segment – and perhaps sentiment will change sooner rather than later, given that the company’s January 2022 initial public offering of its EV battery division, which brings full transparency to the value of this high-growth asset.
Until this change in perception occurs, shareholders of LG Chem are incentivised to wait, with the company aiming to pay out at least 30% of recurring profit as a dividend. For these reasons, we see LG Chem as an attractively valued ‘picks and shovels’ type of business that is far more appealing as an investment than the highly rated ‘gold prospecting’ businesses of listed EV manufacturers.
Chroma ATE: testing new markets
Continuing with our ‘picks and shovels’ analogy, we believe Taiwanese company Chroma ATE closely fits the bill. Chroma manufactures and sells electronic and automated testing solutions that spot faults and inconsistencies as well as provide feedback for a wide range of components and devices.
Originally focused on testing IT power solutions (effectively power supplies for laptops and consumer electronics), Chroma has a strong track record of developing test equipment for the latest technical innovations over the past thirty years. For example, the company pioneered LCD display testing in 2006, solar cell testing in 2008, and 3D sensing in 2017. The result of this first mover approach is that Chroma has consistently grown revenues ahead of the industry and now has exposure to a diversified base of high-growth sectors.
Two of the latest sectors where Chroma is growing its business are electric vehicles and 5G telecommunications. Electric vehicle component testing now represents close to 30% of revenues and Chroma have asserted themselves as one of the leading testing businesses globally. 5G is at an earlier stage but Chroma should be well positioned to see significant growth, driven by increasing network traffic and speed requirements.
Regardless of who the ‘winners’ are in the 5G era, or which electric car maker comes to dominate the market, businesses like Chroma will remain part of the critical infrastructure which enable these sweeping technological changes to take place. They are the unglamourous but indispensable side of the technology revolution which are available for us, as investors, at in our view sensible valuations. Chroma for instance trades at a share price valuation well below that of many high-profile end customers which could not get their products to market without a business like Chroma.
Conclusion
Our change-based investment approach aims to generate long-term capital appreciation by investing in companies where positive change is not currently reflected in share prices. There are clearly a number of major structural changes playing out globally, which are driven by technological innovation, and we look to get exposure to these changes without overpaying.
The experience of investors who bought into the “obvious” beneficiaries of technological change during the late 1990’s/early 2000 boom without paying sufficient attention to competitive challenges and valuations should serve as a cautionary tale.
21 years on we would argue that little has changed – while it remains very hard to predict which providers of products and services will be the ultimate winners as technology evolves, the strong long-term shareholder returns delivered by “technology enablers” suggests that investors may do better to look beyond the headline names to some of the key players in the supply chain. We believe that those companies enabling change – the makers of “picks and shovels” in the technology gold rush offer investors an attractive risk-reward proposition.
Please bear in mind that all investments involve risk and the value of, and any potential income from, your investment may fluctuate and are not guaranteed. The company examples mentioned above are for illustration only and not a recommendation to buy or sell or investment advice. We recommend you discuss any investment decisions with a financial adviser, particularly if you are unsure whether an investment is suitable. Jupiter is unable to provide investment advice. The views expressed are those of the authors at the time of writing and are not necessarily those of Jupiter as a whole and may change in the future. This is particularly true during periods of rapidly changing market circumstances. 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. Past performance is no guide to future performance.
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1Source:Bloomberg, to 21.01.2022
2 Source: Bloomberg, to 21.01.2022
3 Source: Bloomberg, to 21.01.2022
4 Source: Source: Bloomberg, to 21.01.2022
5 Source: Bloomberg, to 21.01.2022
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