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Taiwan Still Oversold?

(February 8, 2007)

Dear Subscribers and Readers,

When it comes to the stock market, the first rule of the game is to make sure you never lose money.  The second rule?  As Warren Buffett puts it, “don't forget rule number one.”  Once that is taken care of, the profits should take care of themselves, as long as one is taking calculated and manageable risks.  If one is investing in individual stocks, then one should read the 10-Ks and 10-Qs of your companies.  Know their competition, the industry, as well as the history and integrity of the management teams.  In the stock market, buying and selling a certain stock or industry (or certain asset class) based on relative valuations (whether this is measured based on historical valuations with the asset class or current valuations with other asset classes) can sometimes be a much better timing mechanism than investing based on absolute (such as strict P/E ratios) valuations.  For example, the low relative valuation between US stocks vs. US bonds and the majority of other asset classes in the world during the summer of last year was the main reason why we decided to go long US stocks.  In most cases, when the stock price of an entire industry or a blue-chip is hammered relative to their historical valuations or valuations of other industries – the thesis of an entire industry or a large cap usually has not really changed.  This was the case with IBM in the early 1990s, Phillip Morris in 2000, and Merck during late 2005.  In some cases, even if the thesis has changed, investors would usually overreact and create a great buying opportunity.  In many ways, US stocks are still undervalued today – and so subscribers should continue to hold on to their positions if they are already long (of course, this thesis may or may not apply if you are buying certain individual stocks). 

Of course, the concept of “relative valuations” only work in cases where one is investing in a blue-chip company, a relatively established industry, or a developed country.  That is why Japan still remains on many investors' (including mine) radar screens today, despite 17 years of underperformance.  This is another reason why many investors remain wary of many of the emerging markets – despite their advances in recent years.  Look no further than the short-sighted economic policies from the military government of Thailand last year.  Not to mention that continuing widespread energy subsidies courtesy of the Indonesian government or the widespread nationalization policies of Venezuela.  Lest people forget, South Korea was on the verge of bankruptcy as recently as ten years ago.  Ditto the Hong Kong Dollar, which was under attack by currency speculators all around the world in October 1997 (although I would not classify Hong Kong as an “emerging market”).  Need we say more?

Interestingly, Taiwan remain relatively unscathed during the Asian Crisis in 1997.  Given its high exposure to the US technology sector, the performance of the Taiwanese stock market and economy has historically had a higher correlation to the performance of the US technology sector more than any Asian country or anything else, for that matter.  The Taiwanese stock market also consists of many world-class companies such as Taiwan Semiconductor Manufacturing, Asustek Computer, and Quanta Computer – the world's largest notebook maker.  As well as serving the US and other developed markets. Taiwan's exports of electronic items to mainland have also been soaring over the last few years.  Moreover, valuations on the Taiwanese stock market are very decent, as exemplified by the forward P/E of 14.7 and a forward dividend yield of 5.1% (source: Morningstar).  Following is a chart (sorted by ascending forward P/E ratios) comparing the various valuation measurements of Taiwan and other countries in East Asia:

Various valuation measurements of Taiwan and other countries in East Asia

On both a current valuation and a growth basis, Taiwan is most probably a good buy today – despite the 16% to 19% return (in US Dollar terms) we saw during 2006, depending on which index or investment vehicle you looked at.  Moreover, unlike South Korea (where earnings are set to decline this year), the growth in earnings of many Taiwanese companies is also expected to remain in the double digit area of the foreseeable future.

Moreover, both the dividend yield and the earnings yield (which is really the inverse of the P/E ratio) in the Taiwan stock market remains variable relative to both the Taiwanese discount rate (which is currently at 2.75% and is not expected to increase any further given that inflation is only at 0.4%) and the 5-year corporate bond yield.  In other words, not only does domestic liquidity remain ample, but the relative valuation of the Taiwanese stock market also compares favorably with other financial investments in the local markets (those being bonds and putting money in a savings account).  Following is a monthly chart showing the dividend and the earnings yield of the Taiwanese stock market, as well as the Taiwanese discount rate and the 5-year corporate bond yield from January 1988 to January 2007:

Earnings and Dividend Yields vs. Bond Yields and the Taiwanese Discount Rate (January 1988 to January 2007) - The difference between corporate earnings and bond yield is still very favorable for further gains ahead.

As mentioned on the above chart, the difference between earnings yields and corporate bond yields (purple line) in Taiwan is still close to a historical high.  Sure, it is not as high as it was in early 2005 – but don't forget – earnings are still growing at a very healthy pace in Taiwan.  Moreover, the valuations of other Asian countries (especially China and Hong Kong) have been increasing at a faster pace than Taiwan has – meaning that on a relative basis (when compared to other Asian markets), valuations of Taiwanese companies have been getting cheaper – not more expensive.

In a recent Motley Fool article, Bill Mann discusses that if he can only buy one foreign market, it will be Taiwan.  Quoting Bill:

Because it lacks diplomatic relations with much of the world and has been embroiled with mainland China in conflict for nearly six decades, investors seem to believe that Taiwan is a has-been, a market that is going to be subsumed by its bigger Chinese neighbor. But people don't seem to realize that the world's high-tech industry is almost totally dependent on Taiwan, with its big foundries run by monstrously profitable companies such as TSMC (NYSE: TSM), the former Taiwan Semiconductor. Taiwanese companies also have invested more money into China than those from any other in the world.

Think they're going to get eaten up by China? Heck, no! China runs on Taiwanese capital, and Taiwanese companies are uniquely culturally adept in fording the difficulties of the Chinese market. Taiwan has gone from being a manufacturing center to one that uses its capital and intellectual property, so they're not spending capital to build high-cost plants in Taiwan. Yet the Taiwanese stock market trades at little more than 13 times earnings, and it pays dividends close to 4%. Yet no one's looking there. Strange.

As Bill Mann mentions, Taiwan has been ignored by institutional and retail investors alike.  Besides the potential conflict with China (the chances of this happening is very small, IMHO), another set back for the Taiwanese stock market has been its focus on the technology and electronic industry.  That being said, recent electronic exports from Taiwan to China jumped 17.9% in January, with overall expected export growth to be approximately 6.1% in 2007.  GDP growth is expected to be much more moderated at 4% - on lower consumption spending going forward.

Interestingly, current forecasts of earnings growth do not take into account the potential growth in capital spending as companies ramp up their upgrade cycle due to Microsoft Vista and Office 2007 over the next 12 to 18 months.  Over the next 12 months, actual spending on these new Microsoft products is expected to be relatively moderated – but just like the rolling out of Windows 3.1 (when consumers did not really start buying until 12 months after its release) – I expect Windows Vista and Office 2007 to be a tremendous addition to Microsoft's cash flow going forward.  With the commercialization of the “solid state hard drive” later this year – the demand for memory devices, laptops, and other electronic items will be huge come the Christmas of 2007 and most probably continuing for the rest of 2008 and 2009.  This will be a tremendous boon to the Taiwanese stock market going forward.  Frankly, I would not be surprised if the Taiwanese stock market becomes the best-performing market in Asia during both 2007 and 2008.

And finally, just how oversold is the Taiwanese stock market?  Just look no further than the following chart showing the trailing returns (in US Dollars) of the various Asian markets and indices as of December 31, 2006, courtesy of Morningstar:

Trailing returns (in US Dollars) of the various Asian markets and indices as of December 31, 2006

On a country basis (with the exception of China), the above is sorted based on ten-year annualized trailing returns on a descending basis. Note that where the history of the iShares performance is not available, we have used the performance of the corresponding MSCI index instead.  Note that out of all the developed Asian countries, the performance of the Taiwanese stock market on both a 3, 5, and 10-year basis has been dismal.  In fact, the 10-year performance of the Taiwanese stock market is only slightly lower than that of Malaysia's (as exemplified by its iShares) – which suffered a great setback during the Asian Crisis and which – to this day- remains an emerging market at best.  Given the fact that Taiwanese is a very well-developed country, and given its current high growth rates, I believe our readers should definitely take a second look at Taiwan.

As always, please email me with any suggestions and/or questions.

Signing off,

Henry To, CFA

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