Chips with Everything

Table of Contents

The main news story in equity markets in the last two weeks was Nvidia a US technology business creating high end micro chips and IT equipment used in computer based artificial intelligence (AI) applications.


AI is the buzzword in technology as we have noted a few times of late. Nvidia confirmed it was not just a buzzword when it provided a 50% upgrade in its revenue guidance due to the demand for its AI enabling Chips. AI really is happening and is likely to create a new age for computing. The frenzy for AI has also pushed up shares in other big US techs, with Microsoft in particular gaining value and getting back to its all-time high valuation.


Coincidentally I recently listened to a Radio 4 interview with Andre Geim a physicist who won a Nobel prize for the discovery of Graphene, an allotrope of carbon consisting of a single layer of atoms arranged in a hexagonal lattice nanostructure. You don’t need to understand the physics to enjoy the story in which the breakthrough came from putting a bit of sticky tape on a graphite block and looking at that tape under an electron microscope after it has been torn off.


Graphene is incredibly strong and conducts electricity 10 times better than copper and will in time revolutionise Chip manufacture.


As a further coincidence my long standing, brilliant client and Hong Kong resident, Stephen O’ Sullivan, wrote me a paper on China discussing, amongst other things, the geopolitical tensions between China and the US, and the importance of Chip manufacture and Taiwan’s currently dominant role. We will publish this paper in the next few weeks for those who are interested.


President Biden’s CHIPS Act includes $39 billion in subsidies for chip manufacturing on US soil along with 25% investment tax credits for costs of manufacturing equipment, and $13 billion for semiconductor research and workforce training, with the primary aim of countering China.


It seems it really is Chips with everything at the moment. These coincidental occurrences got me discussing Chips with Nick to find out what our fund managers are doing to take advantage of the boom in AI and likely boom in Chip manufacturing, given it is already a massive industry. According to Wikipedia it was a $556bn industry in 2021 expected to rise to $730bn in 2027.


Looking at our two core global equity managers Heriot Global and Schroder Global Equity Income we can see two quite different approaches and one similarity.


Neither own, or have intention to own, Nvidia. I was relieved. I know that its shares have performed very well up around 120% in the last year, but it is now eye wateringly expensive and a massively risky investment. Nvidia is now valued at just shy of $1trn and has revenues of just $30bn a year.


Revenues actually fell in the reported quarter, down 13% year on year. It is valued at 200 times earnings and 33 times its revenues. That’s basically saying that even if it had zero costs to manufacture its products, i.e. a 100% profit margin and revenues grew by 20% p.a. it would still take 20 years to get your investment money back in earnings. It is a very profitable business by any standards but its net profit margin in this quarter was around 30%.


No business has zero costs and sustaining 20% p.a. growth for 20 years is a tough ask. The downside risk is horrendous. As we will see in a moment if anything goes wrong in Nvidia’s business it’s not unthinkable you could lose 90% of your money investing in Nvidia today based on its current value.


In the words of Dragon’s Den, “I’m out!”


Heriot Global owns Taiwan Semiconductor Manufacturing Company (TSMC), they make Chips for Nvidia and are the current dominant global manufacturer. They have more than double the annual revenues of Nvidia and are valued at around half the price at $518bn. They too are very profitable with a net profit margin of around 40% putting the valuation at around 16 times earnings and 8 times revenue. This is classic Heriot, they are buying a top brand, market leader, proven profitable business at a sensible price in a growing market. It is what we call quality investing.


They also own Dutch ASML and US based Applied Material, both big suppliers of TSMC so they are investing down through the Chip supply chain.


Schroder Global Equity Income are value investors and one of their top holdings is US based Intel. Intel made a big mistake focussing on PC Chips and missed out on the bonanza in mobile phone chips and is still worth half what it was in the dot com boom of the late 1990’s as PC sales have stagnated.


But it’s still a great business with a focused plan to invest heavily and get back into a market leading position in Chip manufacture in the US with Mr Biden’s support and cheque book behind it. It is not making a profit at present as it invests in its new production technology, but it is still selling around $40bn worth of Chips a year (more than Nvidia), is still paying a good dividend and has a much admired and technically very competent CEO. It could easily emerge again as a market leader in a strongly growing market. How much is it worth today? $133bn, that’s about 13% of Nvidia and less than 4 X revenues.


If Intel can get its profit margins inline with TSMC it should be worth roughly twice its value today. If it starts to share in the AI bonanza it could be worth a lot more than that.


I looked at both Heriot and the Schroder fund this morning against the world index from November 2021. I chose this date as I remember I had been out of internet reach for 3 days somewhere between Gibraltar and the Canaries off the coast of Morocco.


As we re entered the modern world again we found out we had a new President in the US and the Covid vaccine was both highly effective and good to go, the world would come back to normal at some point!


As can be seen below both managers have done a great job without holding Nvidia, Tesla or Facebook whose stocks have been on a tear this year and lifting the indices with their massive market weightings. This accounts for Heriot’s slight underperformance since March this year.


Schroders returns have been exceptional with a 12% plus out performance of the index, which has struggled since the end of 2021 with the impact of the steep rise in interest rates and risk free returns as discussed in the last update. I like their Intel pick and it gives me confidence they can continue to out-perform. As I do the Heriot team with their approach.




We think it is entirely right to be aligned with our clients and investment house views and for full disclosure Ursula and I have had around half our pension accounts in these two funds for some time. I have also bought a few Intel shares, although it goes without saying that buying an individual share is far higher risk than investing in these diversified funds. We could afford to lose the amount involved in the Intel investment, we can’t afford to lose our pensions!

Investments Update

Investments Update - Chips with everything

Source: FE Analytics

Fixed Income:

Versus Investment Association’s UK Gilts sector which has returned -3.26% year to date and the Strategic Bond sector which has returned 0.83% over the same time period, our fixed income selections have been relatively consistent with four of our six selections having returned over 2.5% just over five months into the year.

As we reiterated a few weeks ago, we are starting to see the effect of higher yields coming through into returns with levels of income now being large enough to offset weak market sentiment over short time periods which was not the case prior to Central Bank rate rises in late 2021.

Artemis’s fixed income team is responsible for managing both Tideway’s pure High Yield (Rating agency BB rating and below) and Investment Grade (BBB and above) exposures. The former, Artemis Short Dated Global High Yield, has been our top fixed income performer returning 4.67% year to date and the latter, Artemis Corporate Bond, has been amongst our worst performers returning -0.19% over the same period.

Investment Grade companies tend to be able to fix their debt for longer time periods than their high yield counterparts and therefore as a universe tends to have a longer duration making it more susceptible to interest rate risk. Inflation in the UK has been stickier than expected with the market is pricing in more rate hikes sending yields higher. This has caused the negative return in gilts year to date putting more pressure on those managers exposed to interest rate risk, including investment grade managers.

With gilt yields now approaching the highs achieved in the brief reign of Liz Truss and a UK economy which is heavily dependent on short term mortgages, we do not think there is scope for rates to go much higher. Although possible, further surprises to the upside are not our base case and are considering further allocation to investment grade corporate bonds as one of our highest conviction picks for the next 12 months.

    • Yields of c.6.5% achievable – gap narrowing versus high yield
    • As the description Investment Grade would suggest, we think defaults in the universe will remain relatively low and should perform relatively well in a risk off environment relative to other asset classes.
    • Tideway overall duration positioning has been relatively short – provides opportunity to extend duration in anticipation of rates coming down in the future.

We do not expect returns in fixed income to grow in a straight line from here, but they should be more consistent that their equity counterparts. With a larger than average allocation to Fixed Income versus the wider market we should be less volatile though will be prone to underperformance when Equities have a strong period.

Equities:

James has already highlighted our highest conviction Equity picks, Heriot Global and Schroder Global Equity Income, as being strong performers year to date so I will focus elsewhere. In general, the market year to date has been fuelled by the largest stocks with the vast growth potential of Artificial Intelligence driving returns of some of the S&P500’s largest constituents which has resulted in a very healthy year to date return for the S&P500 index, as the performance of Fidelity’s index tracker illustrates. This is somewhat misleading however as the below will hopefully illustrate:

The S&P is a market capitalisation weighted index – larger companies have a higher weighting in the index, which up until June 1st had returned 8.9% for the year.

The top ten stocks however have accounted for over 10% of the total return of the index– Apple, Microsoft, Tesla, Nvidia, Alphabet, Amazon, Meta, United Health, Berkshire Hathaway and Exxon – meaning the remaining 490 constituents actually delivered a negative return for their investors. Put another way the chart below shows a comparison of returns if each of these 500 stocks represented an equal portion of the index:

 
Chips with everything: equities

These returns suddenly do not look so impressive. Although we certainly have exposure to all these companies through both our passive S&P500 fund and our active Equity managers, we do not think the smart money continues to pile into these names whilst valuations remain so elevated – even if strong performance continues in the short term.

S&P500 10-year price to earnings ratio

Chips with Everything: S&p 500

Source: Macrotrends

Instead, we prefer to focus our attentions and investor money in areas of the market which provide more margin for error where valuations are lower and backed by cashflows which are returned to shareholders. One example of this is in the UK domestic market where we continue to believe there are some excellent opportunities for the patient investor.

Unicorn UK Income:

  • Yield on the fund is 5.3% with the absolute dividend value back to pre-pandemic peak, wider UK market still at a discount; dividend at a 47% premium to wider UK market.
  • Valuations compelling versus history – Calendar year price to earnings ratio of just 12.7 times. Only one company trading at a premium versus long term average forward P/E.
  • Strong balance sheets – 51% of companies having net cash meaning they could pay off all long-term debt from cash.
  • Long term performance of UK smaller companies – 14% annualised since 1955 – Smaller company premium.2022 was in the top decile of worst 12 month returns for small caps versus large caps.
  • Historically has performed very well after a drawdown – past performance however is not a guide to future returns.
  • 22% average over next 12 months (positive 69% time)
  • 64% average after 36 months (positive 97% of time)
  • +120% over 5 years (100% positive)
  • Catalyst? Not needed – portfolio yields 5.3% – M&A prospects for immediate re-rating – Brewin Dolphin, Clipper Logistics, Numis and Devro have all had bids at large premiums to listed share price over the last 12 to 18 months.
  • Earnings expectations are being delivered.
  • UK Equities trading at a 40% discount versus rest of the world.

Source: Unicorn Asset management 31/03/2023

  • The content of this document is for information purposes only and should not be construed as financial advice
  • Please be aware that the value of investments, and the income you may receive from them, cannot be guaranteed and may fall as well as rise
  • We always recommend that you seek professional regulated financial advice before investing