Despite ongoing territorial tension around Taiwan and net foreign selling of Taiwan equities, the weight of Taiwan keeps going up in the MSCI EM index. For active EM investors using this benchmark, the TSMC decision is as important as that across all of Brazil and South Africa.
The valuation argument in favour of Taiwan and TSMC is heavily reliant on the positive momentum in earnings forecasts over the past couple of years being sustained, ie continual analyst upgrades, and no significant geopolitical disruption.
Geopolitical tensions persist around Taiwan
Territorial friction around Taiwan persists, with: 1) US-Japan joint naval drills, including two US aircraft carriers normally based in the US (17 Jan); 2) China's largest aircraft sortie in the south-west portion of Taiwan's air defence identification zone year to date (23 Jan); and 3) reports in the Financial Times of a new continuous deployment by the Chinese navy in waters to the south of Japan and east of Taiwan (23 Jan).
Geopolitically disruptive risks on the radar of global investors so far this year have been around Russia (Kazakhstan and Ukraine), Iran (nuclear negotiations, Houthi attacks on UAE), and North Korea. But ongoing events around Taiwan mean it too should remain in focus.
Foreign net selling but rising EM index weight
Foreign investors have been net sellers of Taiwan stocks in 2020 and 2021 (with net outflows of cUS$15bn in each year) and so far in 2022 (with a net outflow of about US$1.4bn).
At the same time, however, the weights in the MSCI EM equity index of Taiwan and, in particular, TSMC, the global leader in outsourced semiconductor manufacturing and the country's largest stock, have increased.
Indeed, the investment decision in TSMC alone is now as important for the portfolio manager benchmarked to MSCI EM as all the decisions taken in Brazil and South Africa combined.
The contradiction of foreign outflows despite increasing MSCI EM index weight in Taiwan is the mirror image of that in China, which has seen foreign inflows despite decreasing MSCI EM index weight. But, putting debate on China's fundamental drivers to one side, this is explained by the likely increase of China, over the long-term, in the MSCI ACWI (All Country World Index), which is used as a benchmark for a much larger pool of assets than MSCI EM.
Taiwan expensive on trailing multiples, not so on forward ones (continual forecast upgrades)
Taiwan equities (TWSE index), excluding TSMC's 30% weight in the local index, are up about 20% in the last twelve months and down 6% ytd (in total US$ return terms). Over the same respective time periods, TSMC is up 4% in both cases.
Valuation of Taiwan equities is now among the most expensive in the large EM peer group, when measured by trailing PB and PE multiples relative to their 5-year medians.
But this valuation premium is not evident when looking at forward multiples. Taiwan consensus forecast upgrades over the last year and a half mean that stocks have "grown into" their multiples.
For example, the consensus forecast for TSMC earnings per share has almost doubled since the start of 2020. TSMC forward PE is 21x, almost in line with its 5-year median.
The risk to a valuation argument in support of Taiwan which relies on earnings forecast upgrade momentum is that any slowing or halt to those forecast upgrades could cause a sharp de-rating of the multiple applied. Just ask investors in Netflix.
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