During February the fund outperformed the MSCI Emerging Markets index by 1.2% even as equity markets pulled back from the strong start to the year.
A number of markets contributed positively this month, with our stocks in Taiwan, China, Mexico, Greece and the UAE all performing well. Brazil and South Korea were both drags on performance. We have continued adding to Taiwan which is now the largest overweight in the portfolio, while trimming exposures in China and Korea. Investors continue to fret about whether the global economy is currently stumbling into a recession – and if it isn’t, whether the Federal Reserve feels compelled to trip it up. Meanwhile, some sectors have already been experiencing a few quarters of a collapse in demand due to post-Covid inventory hangovers. In fact, these have been so dramatic that companies are indicating the trough. An inventory-led earnings recession is a temporary version of the real thing, but can feel just as bad. We have just seen this play out in the tech sector, with Taiwan being a major focal point.
The process is fairly straightforward: clients build up too much stock and then stop ordering entirely from their suppliers until they’ve reduced stock to normal levels. Their suppliers see a dramatic but temporary collapse in orders to levels well below actual end-demand – there doesn’t actually need to be a real recession for this to happen. It ends when inventories reach acceptable levels and suppliers can restart deliveries in line with actual demand. Covid has produced one of the most spectacular inventory blow-ups of all time. Because it created supply problems with everything and was followed by a spike in demand, retailers and assemblers started ordering stock and components like crazy. Once supply and demand normalized, all these orders were delivered to them just as their sales started to slow. Whether you are a sporting goods retailer or a PC assembler, you probably have way more sneakers or chips in stock than you need or want. Purchasing managers are cancelling orders and refusing to place new ones until this has been cleared out. Unsurprisingly US ISM survey of “Business Customers’ Inventories Too High” is at the highest level in a decade. Taiwanese technology companies that supply computer chips to PCs and consumer electronics experienced this to the extreme. A good example is Asustek – a company that sells PCs and components (graphic cards). Before Covid it was reporting between TWD2bn and 3bn of quarterly operating profits. When everyone rushed to stock up on work from home equipment during 2021, quarterly profits quadrupled to over TWD10bn. Retailers couldn’t get enough notebooks and other PC makers were desperate for graphics cards. Then, as supply chains normalized, orders stopped and profits evaporated during the second half of 2022.
In Q4 last year, the company made a loss of 4bn and will probably not manage to break even in Q1 as it continues to also write down its own inventories. Interestingly enough, Asustek and many other companies are now expecting a trough in demand at some point during the first half of 2023 as these excess inventories are finally digested. This would be followed by a normalization in client orders and pick up in profitability. There is little doubt whether this will happen – what will be key is when and whether the “new normal” levels of demand are higher than before Covid. We try to select companies in Taiwan that benefit from underlying structural growth or that have been steadily gaining market share. This underlying growth has been masked by the Covid boom and bust but should result in a larger ongoing business than in 2019.
Share prices in Taiwan have already been recovering somewhat since the end of last year, in anticipation of the inventory digestion trough. It is very hard to predict the exact timing and different businesses will feel it at different points in time.
Depending on end demand, things could take longer than hoped. However the opportunity is to look past this volatility and buy undervalued long term prospects. The good news is that for many stocks, long-term valuations remain attractive especially considering the low cost of capital.
