Sabre Rattling starts in earnest

The Asia Pacific Economic Cooperation (APEC) summit in Sydney has provided the latest setting for Taiwan and China to air their respective opinions regarding the official status of the island. Whilst distracting, we have expected the rhetoric to intensify before next year's presidential elections in Taiwan. Meanwhile, we are staying focused on the investment potential of the Taiwanese stock market.

As we have stated on previous occasions, stock markets have historically experienced boom and bust cycles and vice versa with uncanny regularity. Despite the consistency of this cycle, investors are all too often unduly influenced by previous experiences to re-enter recovering markets and sectors.

It is with this in mind that we have been increasing our focus on the technology sector. Following the deflation of the dotcom bubble several years ago, wary investors have shied away from the former high flying industries. In our opinion, however we believe opportunities in the sector are on the rise.

Following an extended period of lacklustre performance, the industry in our view is due for a recovery. The fundamentals of many constituent components now bear the hallmarks of value rather than the outrageous growth assumptions of the 1990s.

Telecoms have made the largest impact on the portfolio as a result of this position. We now hold no less than six individual recommendations including Britain's BT and Vodafone, Spain's Telefonica, France Telecom, Australia's Telstra and Japan's NTT along with the iShares S&P Global Telecommunications Index Fund (IXP). Clearly a sector we like.

However we have also added mobile phone manufacturer Nokia, computer pioneer Dell and software giant Microsoft (see today's report) in order to gain broader exposure to the technology sector. But perhaps our most diversified exposure to the market is via Taiwan where we have recommended two funds, The Taiwan Fund (TWN) and iShares MSCI Taiwan (EWT).

These holdings in Taiwan give us great exposure to some of the world's largest chipmakers and designers, sub-sectors about which we are particularly bullish. In fact, the Fund's fourth largest holding is Taiwan Semiconductor (TSM), a company we like so much, we have specifically recommended the NYSE listed ADRs to Members.

As the world's largest contract chip maker, we believe the company is in an ideal position to benefit from the increasingly powerful electronic gadgets coming to market, that will in turn underpin demand for chips in the future.

The table below is a full listing of TWN's top ten holdings as at the end of June (the latest available).

What should be apparent from this table is the heavy weighting investors receive in technology by owning the Fund. This is not surprising given Taiwan's position as a world leader in high-tech manufacturing which is demonstrated by TWN's largest holding in Hon Hai Precision.

Hon Hai's products are pervasive, although the company itself is probably one you have never heard of. As a contract manufacturer to some of the world's best known brands such as Dell, Apple and Sony, however, you will no doubt at some point use their products on a regular basis.

Clearly Taiwan's stock market is not purely a single sector play. However, the Information Technology and Telecommunication industries do make up over 60 percent of the Fund, as the table of the top five sector allocations below illustrates:

As an investment destination, Taiwan has other appealing characteristics. For instance, buoyant global growth is creating healthy demand for the electronics the country is so well known for producing. As such, Taiwan is a net exporter with a healthy trade surplus. Unemployment remains low and corporate earnings have in general been favourable.

Initiatives such as the one between the trade associations representing the semiconductor industry in Taiwan and India will help ensure access to one of the world's fastest growing markets. And despite the occasional political row, Taiwan already has established business relationships with China, the other Asian powerhouse.

These markets will be important to Taiwan in the coming years due to the slowdown we anticipate in America. Already intra-Asian trade is on the rise. And in a sign of the times, China along with several other emerging countries in Asia, are exporting more to Europe than America for the first time.

We believe this could be the first sign of the decoupling the world economy must make from America if growth is to continue in the years ahead.

Now about the current spate of sabre rattling. Taiwan will hold presidential elections in March of next year. In the run up to polling day, nationalist feelings are played upon to garner votes. This is usual and not unexpected.

However, President Chen Shui-bian has elevated the rhetoric with attempts to gain entry to the UN under the name of Taiwan. This action was met with a stony response from China and opposition from the island's most influential supporter the US. Diplomats will be working overtime to ensure this question does not make it on to the March ballet as a referendum.

In the end, we do not believe the talk of joining the UN or the WTO for that matter, as Taiwan will amount to anything more than election rhetoric. As such, we suggest investors should focus on the investment fundamentals rather than political opportunism.

From a technical perspective, The Taiwan Fund has performed strongly since our initial buy recommendation in February 2006. At current levels around $21, the share price is up approximately 27 percent on our initial entry of $16.46.

Despite a volatile period between July and August, prices have rebounded strongly over the past three weeks. However, given our existing overweight allocation to technology, which includes chipmakers TSM and Infineon (see today's report), and our holding in iShares MSCI Taiwan, which shares many of the same holdings, we believe it is prudent to reduce our fund exposure.

Therefore, although the longer-term upward trend remains intact, we believe that the latest rebound provides an opportune time to take profits on this investment. Accordingly, Fat Prophets recommend selling TWN around $21.47. iShares Taiwan (EWT) will remain firmly held for the broad market exposure the units provide.