The comeback of tech

After stagnating for nearly a decade, we believe the Taiwan stock market is now an attractive investment destination. As such we recommended the MSCI Taiwan Index Fund (EWT) to Members in February (FAT4). The Fund is effectively a proxy for the Taiwanese economy and stock-market. EWT tracks the Taiwan Stock Exchange (TSEC). We expect the growing resurgence of the IT sector in particular to provide a significant fillip for the country's economy and equity

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"After stagnating for nearly a decade, we believe the Taiwan stock market is now an attractive investment destination."

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Taiwan is one of Asia's most developed and prosperous markets, and the 17th largest economy in the world. Unlike the emerging economies of mainland China and South East Asia, Taiwan boasts a highly skilled workforce which has assisted the country greatly with producing high value added goods.

Taiwan has grown into a technologically advanced and wealthy nation. This however was to the country's detriment at the start of the decade. The 'IT heavy' economy suffered badly in the fallout from the 'tech wreck'. The damage caused has meant that Taiwan's recovery has lagged others in Asia. However there are clear signs that a revival is underway.

The country's main export industries (electronics, information and communications goods, textiles, plastic and rubber products) are booming. Demand from large trading partners, China, Hong Kong, the US and Japan has been particularly robust. As a result Taiwan is firmly established as a creditor nation. The country holds the world's third largest stock of foreign reserves ($259 billion as of April).

Recent trade figures suggest that the country's 'balance sheet' is set to grow in strength. The value of exports hit a new high of $18.79 billion in April, an annual rise of 15 percent. The monthly trade surplus stood at a healthy $2.37 billion.

Solid economic growth of around 3.9 percent is now forecast in 2006. Inflation is well contained, despite soaring oil prices, with the annual rise of Taiwan's CPI expected to be below 2 percent. Unemployment remains at a five year low of under 4 percent.

With such a positive economic backdrop we expect investor sentiment towards the equity market will become increasingly positive. We continue to regard the underlying valuation of the Taiwan stock market as compelling, with a dividend yield of around 4 percent. This is significantly higher than Taiwan's 10 year bond yield of 1.8 percent.

The market trades on a prospective price earnings multiple of less than 14 times. This valuation compares favourably to Taiwan's Asian neighbours - China, South Korea, Japan and Thailand. Company earnings meanwhile are forecast to grow 27 percent this year, compared with a 10 percent gain for the region.

Investors have historically associated Taiwan with political frictions with the People's Republic of China. However there are signs that tensions are easing, despite China remaining openly opposed to Taiwan President Chen Shui-bian's calls for independence.

A trade summit between leaders of China's Communist Party and Taiwan's Nationalist Party took place in Beijing last month. China announced 15 measures to boost investment and trade as well as plans to allow Chinese citizens to visit Taiwan.

Although President Chen is unlikely to soften his hard-line approach to China, there is some respite on the horizon. Lien's successor Ma Ying-jeou has pledged to bring closer political and economic ties with China. Ma is expected to run for presidency in 2008.

The focus of investors' attention on the relationship between Taiwan and China evolves from the island's dependence on 'big brother'. China is the key market for exports and investment. Companies based in Taiwan have more than $100 billion invested on the mainland in factories that produce mobile phones, laptop computers and flat-panel displays. In April exports to China (and Hong Kong) jumped 19 percent to $7.5 billion from a year earlier.

With future political risk declining foreign investors are unsurprisingly returning to the Taiwanese market. Net investment in Taiwan has reached a record $20 billion in the past six months.

That said, it is also pleasing that Taiwan is seeking to reduce its dependence on the mainland. On February 11th, the Taiwan-India Co-operation Council was launched in Taipei. Chaired by Yu Shyi-kun, a former prime minister, it is intended to raise India's profile among Taiwan's businesses and help persuade them to diversify away from China. This week, as part of the initiative, a delegation arrived in Delhi. We believe such positioning is astute with India's rapid industrialisation likely to gain further momentum over the coming decades.

Drilling down, the Taiwan stock-market is top heavy in Information Technology (IT). Hardly surprising given that IT is the heart of Taiwan's financial prosperity. Other sectors include general manufacturing, financials, steel, utilities, services and transportation.

As at the 30th April 2006, EWT had the following sector weightings.

Sector	%
Technology Hardware and equipment	30.8
Semiconductors	27.4
Banks	11.6
Materials	11.5
Insurance	5.1
Telecommunications	3.5
Diversified Financials	2.8
Capital goods	2.3
Consumer Durables	1.4
Transport	1.3

The Taiwan Stock Exchange Index, has been a laggard amongst other Asian markets since 1998. After exceeding 12,000 in 1990, the index is now around 7,300. In our opinion Taiwan has underperformed because of a heavy weighting in IT. However with excesses of the bubble removed, there are excellent foundations for a sustained revival. Capacity levels in the IT sector have declined, utilisation rates are rising, and demand returning. The fortunes of the two heaviest weighted stocks in EWT reinforce this trend.

As at the 30th April 2006, the top ten holdings of EWT were as follows:

Stock	%
TAIWAN SEMICONDUCTOR	15.9
HON HAI PRECISION	7.8
UTD MICROELECTRONICS	4.4
CATHAY FINANCIAL	4.2
MEDIATEK	3.4
AU OPTRONICS	3.1
CHINA STEEL	2.9
CHUNGHWA TELECOM	2.7
MEGA FINANCIAL	2.6
FORMOSA PLASTICS	2.5

Taiwan Semiconductor is the world's largest supplier of custom-made chips. The company is now recovering strongly from a chip glut and soft demand last year. Management recently advised that 2nd quarter revenue will increase to NT$80 billion ($2.5 billion), a gain of around 4 percent on the previous three months.

The semiconductor industry has been extremely depressed over the last five years. Manufacturing capacity added during the late 1990s resulted in utilisation rates plummeting after the tech bubble burst in 2000. Demand for semiconductors slowed with many companies in the IT industry undergoing extensive rationalisation. Industry investment in new products has since been moderate, with cost cutting taking centre stage.

The semiconductor industry is now however poised to recover strongly, with new product and software launches being the likely catalyst for higher chip demand. Utilisation rates are today back above 90 percent for companies such as TSM, with capacity within the industry having rebalanced.

The launch of Windows Vista, and a recovery in the LCD TV market should boost semi-conductor demand. However the key growth driver will be the rollout of 3G handsets which are expected to account for 11 percent of the global semiconductor market by 2008, from 6 percent currently.

Hon Hai Precision, which trades as Foxconn, is the second largest holding in EWT. The company is one of the world's largest contract electronics manufacturers. The company (whose customers include Apple, Cisco, Dell, Nokia, and Sony) is also benefiting from a recovery in growth across the board. Hon Hai Precision recently posted a 52 percent increase in first quarter profits to NT$11.2 billion ($345 million) on the back of strong demand for computers and high-margin consumer gadgets.

On the charts a robust performance since March has seen the fund rally firmly from $12.12 to $14.94. This represents a gain of more than 20 percent and marks the highest prices achieved in five and a half years.

Following such rapid price appreciation we should not be surprised to see the Fund pause for consolidation in the near term. However, we believe that downside risks are limited with moves below initial support at $14.05 to find additional support in the $13.45 region.

As shown on the weekly chart, the latest gains have revived upward momentum and extended the three and a half year upward trend. In time, we believe that the Fund has the potential to extend above $14.94.

In the year to 31 March 2006 the Fund has delivered an average annualised return of 11.0 percent, and 18.8 percent over the last three years. We believe that the overall performance of the Fund and Taiwan stock market will improve going forward as an IT led recovery gains momentum. The Fund also benefits from semi-annual dividends.

We remain of the belief that the Taiwanese stock market is undergoing a broad based revival after an entrenched bear market. The underlying value of Taiwan equities compares favourably with other countries in our opinion. As such, the Fund, as a proxy for the Taiwanese stock market, offers excellent upside potential. Accordingly, EWT will remain firmly held within the Fat Prophets Portfolio. For Members without current exposure to EWT, we recommend buying around $14.14.