As semiconductors replace oil as the key commodity in the modern global economy, China is keen to establish a domestic production industry. This will see plenty of investment opportunities in emerging markets as a new ecosystem is required. But the road to achieving this will not be without conflict, Wasatch warns.
For more than a hundred years, oil has been the lubricant that has kept the industrial machine running smoothly.
Starting as a cheap, clean fuel for lighting homes in the form of kerosene, the demand for oil started to really take off with the invention of the motor car in the late 1800s, accelerated by the development of the affordable Model T Ford in 1908.
But it wasn’t until WWI that the strategic importance of oil was realised, and by the time WWII ended, every nation understood how critical access to this commodity was. After all, the control of oil had been a deciding factor in who won the war.
Today, oil isn’t just used to fuel cars and airplanes, but it permeates nearly every aspect of our lives as it is applied in the production of plastic items and generation of electricity and is even found in fertilisers for the production of food.
But the world is changing.
Increasingly, businesses are not relying on oil to make the wheels go round, but on semiconductors, which find their most common application as transistors in microchips.
As businesses have increasingly adopted technology as the key enabler of their activities, semiconductors have become the new oil, Ajay Krishnan, Portfolio Manager and Head of Emerging Markets at Wasatch Global Investors, says.
In the industrial age, it was the main factor of production that everyone wanted access to. Today, ... every business, whether they are a bank or a retailer, is becoming more knowledge intensive and, therefore, uses technology to solve its problems.
“If you think about the last 50 to 70 years, all the major conflicts in the world have centred around access to oil, or as former President George Bush [Senior] said: “Why did God put our oil in their land?” That was the crux of it,” Krishnan says in an interview with [i3] Insights.
“In the industrial age, it was the main factor of production that everyone wanted access to. Today, if you look across the world, not just in emerging markets, but globally, we have become more technology centric.
“Every business, whether they are a bank or a retailer, is becoming more knowledge intensive and, therefore, uses technology to solve its problems.
“The main way that technology is implemented is through silicon, by which I mean semiconductors. The world has been trying to gain access to that manufacturing capacity of semiconductors.”
Krishnan immediately touches upon a sensitive point: access to crucial resources has often involved conflict, as was the case with oil. If history is any guide to go by, then access to semiconductors could bring along its own share of sabre-rattling.
The current tensions between China and the United States and the increasing aggression of China towards Taiwan might be a sign of things to come.
“Say you are writing a novel and there is only one pencil available in the world and that pencil is being manufactured by the United States, well then you are going to need that pencil. And that is what is happening in semiconductors. China has that problem to address: how do we gain access to semiconductors?’” Krishnan says.
China considers Taiwan to be part of its own territory and the presence of the world’s leading semiconductor producer, Taiwan Semiconductor Manufacturing Company (TSMC), on the island might prove to be too big a prize to ignore.
The problem for China in producing its own semiconductors is one of continuous miniaturisation of transistors, which requires complex technology to pull off.
TSMC is the clear leader in this field. The number two, Intel, recently said it is behind in the production of its 7 nanometer chips and now expects the first chips to be produced in 2023. TSMC began production of 256 Mbit SRAM memory chips using a 7 nm process back in June 2016.
A potential grab for control of the leading producer of semiconductors should not be ruled out, Krishnan warns.
“Over the last 20 to 30 years, China has built the manufacturing expertise to create an economy that is self-sustaining. The only piece that they don’t have access to is leading-edge semiconductor manufacturing and the only country in the world that has it now is Taiwan, which, oh, happens to be in their neighbourhood, which, by the way, they think of as their territory and where they did have an incursion in 1958,” he says.
“Besides, the West has lost its moral high ground after it let Russia take over the Crimea and the mess in the Middle East. So one could argue that the stage has been set.”
China has built the manufacturing expertise to create an economy that is self-sustaining. The only piece that they don’t have access to is leading edge semiconductor manufacturing and the only country in the world that has it now is Taiwan, which, oh, happens to be in their neighbourhood
Asked what the likelihood is of China forcing access to TSMC, he points out he is an investment specialist, not a geopolitical expert. But he is willing to elaborate.
“This is above my pay grade, but let me have a stab at it. There are two options: either China could overrun the island, and it could do that in a heartbeat unless you want to engage China into a nuclear war, or they may try a little more of a covert manner by trying to control the manufacturing, trying to get people who side with them to influence the government and so on,” he says.
“I think it is likely that it is going to be a little bit more aggressive. If you look at even just the last few weeks, there have been Chinese incursions by the military into the Taiwanese airspace. So they are testing the waters.
“But TSMC is not sitting still; they just announced that they will spend US$12 billion on setting up a fabrication plant in the US.”
But regardless of whether China makes a grab for TSMC or not, the country is likely to develop a competitive semiconductor industry over time and this will create investment opportunities across a range of emerging market countries in companies that supply this industry.
“The Chinese want to start their own semiconductor manufacturing industry. What this shift will do is create an opportunity for emerging countries, which used to be dominating [the semiconductor industry] back in the day,” Krishnan says.
In the early days of chip making there were hundreds of fabrication plants, also called ‘fabs’, around the world. But as profit margins fell and the development of new generations of chips required increasingly higher levels of investment in research and development, the industry became centred on just four manufacturers: ASML, Intel, Samsung and TSMC.
“Over the last 25 years, you’ve seen that shifting of power in the market, where a lot of the chip companies recognised that they don’t have the wherewithal to keep investing in these fabs and so they started outsourcing,” Krishnan says.
Chinese semiconductor companies ... are not the leading edge. They are two, three generations behind what is happening in other parts of the world. But their valuations are leading edge. People are recognising that Chinese semiconductor companies are going to be the next frontier
“Today, you only have ASML in the Netherlands, but there used to be a time where there were a lot of leading-edge semiconductor equipment companies out of Europe. But because of the consolidation, they all moved away.”
To remain a dominant player in technology and potentially a leader in the future, China needs access to cutting-edge semiconductors. Currently, it can only buy these from the four players, and the Chinese government is painfully aware of the reliance on foreign producers, especially as trade tensions have flared up in recent years.
It has put much effort into building a domestic semiconductor industry, but this is not an easy task.
“The Chinese have tried for 15 years and spent billions of dollars. They haven’t been successful,” Krishnan says.
“Today, if you look at the Chinese semiconductor companies, they are not the leading edge. They are two, three generations behind what is happening in other parts of the world.
“But their valuations are leading edge. So you have companies like SG Micro, which is trading at 40 times sales. Clearly there is a lot of froth in the market. People are recognising that Chinese semiconductor companies are going to be the next frontier.
“There is a lot of interest and overexcitement, but there will also be opportunity along with it.”
The Chinese government has indicated tit wants to build a semiconductor industry that could be as big as in the US. If this happens, then it stands to reason a US-type of ecosystem will be created there too.
The reason why there hasn’t been a revival of semiconductor equipment companies yet is that so far they haven’t been able to compete with the likes of Applied Materials, Lam Research and KLA-Tencore.
But if a second ecosystem comes into existence, this might create opportunities for countries such as Bangladesh, India and Vietnam to develop competing equipment industries.
“If you think back to the Asian Tigers, back in the day, Taiwan, Korea, Malaysia and Singapore, they started as manufacturing powerhouses and then they passed the mantle over to China. But China was so big that it soaked up all the oxygen in the room and so you didn’t have the next wave of manufacturing-led economies,” Krishnan says.
“If China becomes a more inward-looking country, then that might provide an opportunity to Bangladesh, Vietnam and India as manufacturing-led economies.”
Besides, the coronavirus pandemic has laid bare the dangers of a concentrated supply chain and many companies across the world are looking to diversify their sources.
“Both Apple and Samsung have announced that they will shift some of the manufacturing to places like India,” Krishan says.
“Apple is probably the company that has nailed it most impressively, saying they want to get 40 per cent of their exports from India. That creates a tremendous opportunity.
“So there will be new chip companies emerging. When I started in the business 25 years ago, there were tons of small chip companies and then it started consolidating, because nobody really cared about the hardware; everybody was getting into software.
“Everyone wanted to create the next Facebook and what have you. But now there is a realisation that those companies are hitting the limits in terms of how good the silicon is and so now there are a lot of good people coming up in silicon companies again.
“So you see almost a revival in independent chip makers, but the early opportunity will be in the equipment space.”
Too Much Tech?
The trend towards increased use of semiconductors is undeniable, but most of the recent stock market activity already seems focused on technology companies. Is there not a danger of becoming too tech heavy?
“Not really, because it is hard to discern what is not tech anymore,” Krishnan answers.
“Is a bank a technology company? No. Do they use tech intensively? Yes. That is how they are creating a differentiated product. Is a retailer a tech company? No, not really, but they use technology aggressively as well.
“So it is hard to disentangle what is a tech company and what is not. Almost every industry is tech enabled or being destroyed by tech. Does that mean we own too much tech? No, because it is more progressive than it has been at any point in our lives.
“Maybe 25 years ago you had to be a tech company to use technology. If you wanted to deposit a cheque, you had to stand in line at a bank. Now, I can’t imagine going into a branch at a bank. That is what we have to keep in mind and it is only going to accelerate.”
The coronavirus pandemic has done much to accelerate the adoption of e-commerce and web-based technologies in the developed world as governments shut down their economies to avoid widespread infection. And although most emerging markets did not experience the prolonged lockdowns seen in other parts of the world, they also experienced a shift towards a broader take-up of e-commerce.
“If you look at Brazil or Mexico, you’ve seen a clear increase in the adoption of e-commerce. And there are various reasons why these things never took off [before],” Krishnan says.
“In Brazil, and in countries like India, it used to be the lack of trust. I placed my order and they charged my credit card, but I may or may never receive it. In Brazil, you’ve had the added challenge of people delivering it in cities like San Paolo, a city of 30 million people, and by the time you come home, the parcel is gone.
“It happens in the US as well, but it is much more common in countries like Brazil. But having tasted this convenience, I think it is hard to go back.”
Another example is telemedicine in China, a service where people can call or electronically chat to a doctor to obtain a diagnosis and order medicines. This system has proven a key weapon in tackling large backlogs of people trying to access the medical system.
“The typical wait when you walk into a Chinese hospital is around four hours because there aren’t enough doctors. But that problem is solved by telemedicine. For example, companies like Ping An have a pool of several thousand doctors who are on their payroll and they consult across the country,” Krishnan says.
“Not every ailment requires you to have a doctor examine you physically; some ailments can be diagnosed remotely. The government has figured out that this is one of the ways to solve the bottlenecks for healthcare. So telemedicine is here to stay.”
Information in this document regarding market or economic trends, or the factors influencing historical or future performance, reflects the opinions of management of Wasatch Global Investors as of the date of this document. These statements should not be relied upon for any other purpose. Past performance is no guarantee of future results, and there is no guarantee that the market forecasts discussed will be realized.
References to specific securities should not be construed as recommendations by Wasatch Global Investors to buy or sell shares in those companies. As of December 31, 2020, Wasatch Global Investors strategies had less than 1% of net assets invested in Samsung Electronics Co. Ltd, and Applied Materials, Inc. Wasatch Global Investors strategies were not invested in any other companies mentioned. Current and future holdings are subject to change.
This article is paid for by Wasatch Global Investors. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.