20 November 2020
A cluster of EM stocks have bucked a broader EM equity decline in recent years. GAM Investments’ Tim Love has coined the name ‘START’ for the five companies and suggests they could present investors with a strong growth and value proposition compared to the well-known and much-publicised US FAANG names.
Despite emerging markets (EMs) underperforming in 2018 and 2019 and continuing to underperform the S&P 500 in 2020, it would be wrong, in our view, for investors to walk away. Under the vast umbrella of EMs, one group of stocks has firmly bucked the decline and are poised to keep climbing. Even the souring US-China relationship that threatens to put a dampener on some Chinese stocks has not rattled this universe. We have termed this group of strong, innovative companies START (Samsung Electronics, Tencent Holdings, Alibaba Group, Reliance Industries and Taiwan Semiconductor). We believe START will become an acronym within EMs, just like FAANG (Facebook, Amazon, Apple, Netflix and Alphabet - formerly known as Google) in the US, and will adjudicate the performance of the entire asset class. We have identified these stocks based on their market dominance, leadership position, future growth potential and sustainability, execution capabilities as well as value proposition. We introduce START below. In an upcoming article, we will explore the structural elements of Asian markets, where these companies operate, as well as START versus FAANG financial metrics and ESG comparisons in greater detail.
We believe Samsung Electronics will have strong margins among memory players, supporting its market-leading position through technology advancement. Improving shareholder returns is another factor supporting our positive view. Samsung Electronics' lead in 5G handsets could start to generate meaningful profit by gaining market share from Huawei. The company is in a much better place than many would have expected a few months ago and has shown higher resilience / improved execution with a long-term strategy that is proving increasingly transformational to drive semiconductor growth and returns. The valuation discount to peers remains unjustified, in our view, considering structural growth characteristics in computing, 5G, data, rising total available market, as well as top-notch execution in the sector, a USD 100 billion cash position, and high free cash flow generation and return on capital employed.
Samsung's governance practices and related party transactions with its subsidiaries remain key concerns, although the appointment of an independent director shows it intends to improve governance and burnish its image amid uncertainty over vice chairman Lee Jae-yong's bribery charges. We look forward to higher board independence and transparency. We also foresee the company having an independent audit and compliance system, using external benchmarks with high standards with regard to anti-corruption issues, which is important, not only given its complex business structure, but also with associated risks throughout supply chains. Although the company has set up formal grievance handling procedures to facilitate the monitoring of employee engagement and satisfaction, these measures have not protected the company from alleged violations of workers' rights in some of the countries where it has moved operations from China. We are optimistic that the company will improve its compliance with human rights and labour laws.
Tencent dominates China’s online consumer market in terms of revenue, size and traffic volume. Most of its services rank among the top three by user base. Sales of in-game value-added services are likely to keep growing, led by its strong mobile ecosystem, in particular its operation of Weixin (China's largest communication and social network). Its revenue mix is diverse, with 16% originating from online advertising, 23% from social networks, 26% from fintech and business services and 34% from online games. The company's cash position of circa USD 40 billion and potential USD 20 billion of free cash flow this year provide robust support to its liquidity. Strong fundamentals and a solid growth outlook have allowed the company to increase its debt load without sacrificing balance sheet strength. Bloomberg consensus expects Tencent can deliver 2020 sales and pre-tax earnings growth of 28% and 27%, respectively. An expansion of Tencent’s gaming business in international markets, higher social ad monetisation, greater fintech offerings, and strategic upgrades to capitalise on consumer and industrial internet are some of the positive potential catalysts for future outperformance.
Tencent employs a variable interest entity (VIE) corporate structure, but has the highest governance score among its peers. Its Hong Kong listing arguably provides stronger shareholder protection, and the company does not employ a dual-class share structure with different voting rights. The gaming and social media company continues to face regulatory pressures to comply with censorship policies in China. The company has implemented anti-addiction measures, including a healthy gameplay system by which 32 mobile games were removed due to alleged incompliance. The company has also initiated a parental guardian platform to assist parents in preventing children from game addiction. In addition, we anticipate higher engagement with external auditors for reviewing security protocols.
Given its e-commerce leadership in China, we believe Alibaba provides a compelling value proposition for merchants through an ecosystem that integrates commerce / logistics, marketing tech, cloud computing, payment and entertainment. We believe it will continue to benefit from accelerated user and merchant adoption in online groceries, cloud services and remote working applications. It is also likely to benefit from unleashing more synergies across its +900 million digital economy users and broad spectrum of products and services as it captures nearly a third of payments within China’s retail consumption and penetrates further into less developed areas. Its 33%-owned Ant Group is seeking a dual listing in Hong Kong and Shanghai at a valuation of at least USD 225 billion. Its experienced leadership should continue to drive product innovation and we anticipate under-monetised assets to start contributing to revenue growth meaningfully in the coming years. With revenue expected to climb toward USD 100 billion in fiscal 2021 and with free cash flow rising rapidly (cash topped USD 54 billion at the end of June), Alibaba's balance sheet has never been stronger, in our view. Few tech issuers, including FAANG, maintain comparable levels of cash and short-term investments.
The company has robust employee incentive programmes and strong data protection measures. Its partnership structure is designed to retain and incentivise talent and progress its updated six values for long-term sustainability. We believe Alibaba’s rewards systems and on-going training investments make the firm generally well-positioned to remain an attractive employer for top talent in China, although the business faces criticism for excessive working hours and overtime. Its ownership and board structure are a cause of concern for minority shareholders, in our view. It is effectively a controlled company due to its partnership structure and related voting agreement. The company's VIE structure also tilts control towards the senior leadership, while its ownership risks are enhanced due to legal uncertainties. Strong data security safeguards seem inevitable since a breach at the company's logistics subsidiary, Cainiao, in June 2018 indicates that it remains vulnerable to heightened privacy risks.
The company is embarking on its journey to address the USD 700 billion organised retail and e-commerce market in India, more than USD 300 billion in chemicals, and USD 50 billion plus in renewable energy as demand shifts from oil to alternative fuels. Net debt in the next investment cycle will be a lot more measured versus the past cycle as it takes the partnership / joint venture route. The move to diversify from pure refining into other sustainable energy forms - integrating petrochemicals assets, moving telecom cash flows into other digital assets and 5G solutions, expansion into both offline and online retail - would help a re-rating similar to what we have seen in various global companies. The vision and gumption of the company is underappreciated, in our view, and under-priced.
Reliance is a family owned firm with a combined CEO-chairman position. Going forward the company is likely to have a more diversified board (at least four out of 14 directors are long serving currently) with large executive representation to provide effective governance oversight. Higher revenue from telecom and retail has lowered its environmental risk profile although we await explicit targets for its energy business for reducing its greenhouse gas and toxic emissions. Despite concerns, we acknowledge that the company has been more responsive and engaging with its minority shareholders in recent times.
Taiwan Semiconductor is the largest dedicated contract semiconductor manufacturer in the world, with roughly a 50% market share. Overall, it makes more than 10,760 products using more than 270 technologies for about 500 customers. The on-going semi content growth in mobile, rise of artificial intelligence (AI), and proliferation of the Internet of Things (IoT) should result in sustainable upside in aggregate computing power globally. Stronger sales contribution from mass-produced 5-nanometer chips and a plan to start trial production of 3-nanometer chips in 2021 implies a widening technology gap with peers that will ensure it retains a dominant market share in leading edge foundry businesses over the next three years. The firm’s research & development expenses and physical assets are the highest among contract chip makers, enabling it to maintain leadership in technology, market share and profitability. The company dominates the advance node processing foundry market and will likely maintain that position with its capacity expansion and lead in advanced chipset manufacturing technologies. The company's expenditure on advance node capacity expansion in 2020 is likely be above USD 10 billion, and probably more than double the second-largest spender. The company's extreme ultraviolet lithography (EUV) process capacity is more than triple its peers after it spent more than USD 3.3 billion on 18 new EUV machines in 2019.
The company continues to demonstrate strong water management systems with a water protection plan that includes recycling and reuse initiatives to address potential operational risks arising from water shortages. It offers competitive compensation packages and comprehensive career development programmes and therefore reported annual employee turnover rate is low compared to the industry average. We believe the company will proactively develop semiconductors with cleantech applications such as smart grid and renewable energy.
The information in this document is given for information purposes only and does not qualify as investment advice. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. The companies included are not necessarily held by any portfolio and do not represent any recommendations by the investment manager. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.