Semiconductors Archives

Trade Wars: Portfolio Hedges | 3-D Printing

“It’s easier to hold your principles 100 percent of the time than it is to hold them 98 percent of the time.” — Clayton M. Christensen

“Character, like a photograph, develops in darkness.” — Yousuf Karsh

In this week’s piece we discuss hedges to provide some portfolio protection under the different potential outcomes to the US-China trade dispute as the 1 March deadline to reach an agreement approaches. Also this week, we discuss 3-D printing — the one time darling and now much maligned corner of the technology sector — and consider potential long ideas within the segment.

Trade Wars: Portfolio Hedges

US trade representative, Robert E. Lighthizer, and US Treasury Secretary, Steven Mnuchin, are heading to Beijing this week, ahead of the 1 March deadline to reach an agreement and prevent a further hike in tariffs. As part of the on going negotiations, the Trump Administration is demanding China to (1) reduce its trade surplus with the US, (2) stop enabling the theft or forced transfer of intellectual property and trade secrets from US businesses operating in China, (3) ease restrictions on foreign investment and foreign ownership of Chinese companies, and (4) put an end to industrial subsidies and the preferential treatment given by the Chinese government to state-owned enterprises.

In broad terms, we think there are four possible outcomes to the on-going trade related negotiations between the US and China. These outcomes are:

A compromise much akin to kicking the can down the road whereby China agrees to reduce its trade surplus with the US and increases its purchases of US products and services. Nothing else of material consequence is agreed upon and both parties make assurances of negotiating over unresolved matters in the near future.
Both parties make some concessions and meaningful progress is made on trade, giving Corporate America greater access to the Chinese market and intellectual property theft by China.
One of the two parties capitulates. In the case of China capitulating means agreeing to an overwhelming majority of the Trump Administration’s demands. While the US capitulating means most demands unrelated to the China’s bilateral trade surplus are dropped.
There is no agreement and a hike in tariffs goes ahead as planned.

The type of hedge a portfolio may need depends on how said portfolio is positioned.

A portfolio positioned for an amicable resolution to the trade dispute needs hedges for the first and fourth scenarios briefly outlined above. While a portfolio positioned for a prolonged trade war requires hedges under the second and third scenarios.

Positioned for an Amicable Resolution

Given China’s ambitions on the technology front and the Trump Administrations to rein Chinese technological through use of national security measures and export controls, the semiconductor industry is likely to be a key battleground in the dispute.

Investors positioned for an amicable resolution to the trade dispute can hedge themselves, we think, by going long South Korean semiconductor companies — China will need to turn to them in the event export controls are imposed on US semiconductor companies. Investors can further hedge themselves by shorting Taiwanese semiconductor companies because, if China’s thirst for semiconductor supplies is as strong as we think it is, the risk of annexation of Taiwan by China to secure supply rises significantly in the event of a less-than-amicable end to the negotiations.

Positioned for a Prolonged Trade War

Investors positioned for a prolonged trade war can hedge themselves, we think, by going long US agriculture commodity producers — one of the simplest ways for China to shrink its bilateral trade surplus is to increase purchases of agricultural commodities from the US.

3-D Printing: Inflection Point?

At the beginning of 2018, Bugatti revealed it had developed the first series-production 3-D printed brake caliper for use in its vehicles. In December last year, the Volkswagen Group released a video of the finished product in action.

In October last year, Dutch robotics company MX3D completed the 3-D printing of a steel bridge and announced that it will be installing the bridge across a canal in Amsterdam during 2019. Two months later, the Marines from the 1st Marine Logistics Group at Camp Pendleton, California – with the help of the Marine Corps Systems Command Advanced Manufacturing Operations Cell and the Army Corps of Engineers — successfully 3-D printed a concrete bridge on site as opposed to in a factory setting.

NOWlab, the innovation arm of German additive manufacturing company BigRep, unveiled NERA — a fully 3D-printed motorcycle – in November 2018. All parts of the motorcycle — excluding the electrical components that power the bike — have been 3-D printed, including the tyres, rims, frame and seat.

In January, Relativity Space — a rocket-building company founded by former SpaceX and Blue Origin employees — revealed that it has been granted permission by the US Air Force to launch its, almost entirely 3-D printed, rockets from Launch Complex 16 at Cape Canaveral in Florida. And just last week, UK-based space startup Orbex publicly unveiled its Prime rocket — the world’s largest 3-D printed rocket engine — at the opening of its new headquarters and rocket design facility in Forres in the Scottish Highlands.

The Innovation S-Curve

Many investors have turned their backs on 3-D printing after exhibiting irrational exuberance towards the technology over years past. After a failed promise of endless growth, and a bursting of the stock price bubble that sent shares of publicly traded 3-D printing companies tumbling, we wonder if interest in 3-D printing stocks may be rekindled as the potential benefits of the technology begin to be realised?

Everett Rogers, previously professor of communication studies at the University of New Mexico, popularised the theory of diffusion of innovations in his book Diffusion of Innovations. The theory is amongst the oldest theories in social science.

The theory postulates that the adoption of an innovation within a social system is determined by four factors, namely:

The innovation itself;
Communication channels;
Time; and
The characteristics of the social system.

Over the years, the innovation S-curve has been popularised a means of measuring the adoption of existing technologies. The innovation S-curve is an application of Professor Rogers’ theory.

Source: ideagenius.com

3-D printing has gone through its early adoption phase. The recent delivery of a number of innovative solutions based on 3-D printing makes us wonder if 3-D printing technology is now at an inflection point within its innovation S-curve and ready to enter a phase of rapid growth? If indeed it is, many of the publicly listed 3-D printing stocks could, in a few years time, trade at many multiples of the prices they trade at today.

3-D Printing Stocks

Below we highlight two 3-D printing related stocks that caught our attention upon initial screening,

The ExOne Company $XONE

$XONE is a micro-cap stock with market capitalisation of US dollars 172 million. Short interest in the stock is high at more than 27 per cent of free float.

The company was spun-off from Extrude Hone Corporation, a global supplier of precision nontraditional machining processes, 2005.

$XONE is a global provider of 3-D printing machines, 3-D printed products and related services to industrial businesses operating across the aerospace, automotive, pumps, heavy equipment and energy industries. The company’s product and services offering revolves around industrial strength sand castings and moulds and directly printed metal parts.

Following a transition year in 2018, during which the company took measures to improve operating efficiencies and reel in costs, the company’s management expects net income and operating cash flows to be positive in 2019. Further, the company will be introducing larger format 3-D printing machines during the year to increase the size of its addressable market and to up sell existing clients.

Stratasys Limited $SSYS

$SSYS has a market capitalisation of US dollars 1.4 billion. Short interest in the stock stands at almost 12 per cent of free float.

The company manufactures 3-D printers used by designers, engineers, and manufacturers for office-based prototyping and direct digital manufacturing to visualise, verify, and communicate product designs. Engineers, for example, use Stratasys systems to model complex geometries in a wide range of thermoplastic materials such as polycarbonate.

$SSYS’s CEO, Ilan Levin, resigned in May 2018 and its Chairman has been serving as its interim CEO since. Levin’s exit came after the company posted losses of of almost US dollars 40 million in 2017 and US dollars 13 million during last year’s first quarter.

The company has been witnessing growth in 3-D printing system orders since the second quarter of last year and management expected this trend continue into 2019. They are also see their customers moving from experimenting with 3-D printing to deploying and expanding the capacity of these systems in true production environments.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

AIG, Robert E. Lighthizer, Made in China 2025, and the Semiconductors Bull Market

“The icon of modern conservatism, Ronald Reagan, imposed quotas on imported steel, protected Harley-Davidson from Japanese competition, restrained import of semiconductors and automobiles, and took myriad similar steps to keep American industry strong. How does allowing China to constantly rig trade in its favour advance the core conservative goal of making markets more efficient? Markets do not run better when manufacturing shifts to China largely because of the actions of its government.” – Robert E. Lighthizer

“Patience is essential. We should step back, take a deep breath and examine carefully the ties that bind us together.” Maurice “Hank” Greenberg, former CEO of American International Group, at the congressional hearing on US-China economic ties in May 1996

American International Group (AIG), the once venerable multinational insurance group, was founded in 1919 in Shanghai, where it prospered until the communists forced it to leave in 1950. AIG had to wait over four decades to re-enter the Chinese market. In 1992, AIG became the first foreign insurance company licensed to operate in China and established its first office on the Mainland in Shanghai.

We doubt it was sentiment that led China to grant AIG the license. After all, there is little room for sentiment in the high-stakes game of global trade.

In 1990, Maurice “Hank” Greenberg, then chief executive of AIG, had been appointed as the first chairman of the International Business Leaders’ Advisory Council for the Mayor of Shanghai. In 1994, Mr Greenberg was appointed as senior economic advisor to the Beijing Municipal Government. In 1996, at the time when China’s status as Most Favoured Nation (MFN)[1] was under threat due to a resolution put forth to the House of Representatives in the US, he was appointed as the Chairman of the US-China Business Council.

While all of above mentioned appointments may have raised an eyebrow or two, they do not amount to much in and of themselves. When we throw in the fact that Mr Greenberg had been part of the President’s Advisory Committee for Trade Policy and Negotiations since the 1970s – the official private-sector advisory committee to the Office of the US Trade Representative – we begin to realise the possible reason why the Chinese leadership took a liking to Mr Greenberg and afforded his company the luxury of becoming the first foreign insurer to operate in China.

In May 1996, Mr Greenberg, during a key congressional hearing on US-Sino economic ties, testified in favour of not only renewing China’s MFN status but also making it permanent.

There we have it: quid pro quo.

In June 1996, the House of Representatives endorsed China’s MFN status by a vote of 286 to 141. At the time of vote AIG had eleven lobbyists representing its interests in Washington. One of those lobbyists was Skadden, Arps, Slate, Meagher & Flom, where AIG’s affairs were handled by one Robert E. Lighthizer – the current United States Trade Representative.

Senior American and Chinese officials concluded two days of negotiations on trade and technology related grievances the Trump Administration has with China. As many may have suspected, the talks appear to have achieved little despite the US sending a team comprised of top-level officials including Treasury Secretary Steven Mnuchin, Trade Representative Robert Lighthizer, White House trade advisor Peter Navarro, Secretary of Commerce Wilbur Ross, and National Economic Advisor Larry Kudlow.

As part of the talks the US representatives have submitted an extensive list of trade and technology related demands. In our opinion, the demands represent a hodgepodge of objectives as opposed to one or two key strategic objectives the Trump Administration may have – symptomatic of the differing views held by the various members of the US team. We expect US Trade Representative Robert E. Lighthizer to slowly take control of proceedings and to set the agenda for US-China trade relations – after all he is the only senior member of the team with meaningful experience in negotiating bilateral international agreements.

Mr Lighthizer’s primary objectives with respect to US-Sino trade relations are (1) for China to open up its economy – by removing tariffs and ownership limits – for the benefit of Corporate America and (2) to put an end to Chinese practices that erode the competitive advantages enjoyed by US corporations – practices such as forcing technology transfer as a condition for market access.

Mr Lighthizer’s goals are ambitious. They will require time and patience from everyone – including President Trump, Chinese officials, US allies, and investors. For that, he will need to focus Mr Trump’s attention on China. He will not want the President continuing his thus far ad hoc approach to US trade policy. If NAFTA and other trade deals under negotiations with allies such as South Korea are dealt with swiftly, we would take that as a clear signal that Mr Lighthizer is in control of driving US trade policy.

Unveiled in 2015, “Made in China 2025” is China’s broad-based industrial strategy for it to become a leader in the field of advanced manufacturing. The strategy calls for directed government subsidies, heavy investments in research and innovation, and targets for local manufacturing content.

To date, China’s industrial base is dominated by manufacturing of basic consumer products such as clothing, shoes and consumer electronics. The overwhelming majority of technologically advanced exports out of China have been made by multinational companies. The Made in China 2025 strategy identifies ten key areas – such as robotics, electric and fuel-cell vehicles, aerospace, semiconductors, agricultural machinery and biomedicine – where China aims to become a global leader. And it is these very industries that Mr Lighthizer aims to attack for the benefit of Corporate America.

One area where China is clearly at the cutting edge of global research is artificial intelligence. According to research published by the University of Toronto, 23 per cent of the authors of papers presented at the 2017 Advancement of Artificial Intelligence Conference were Chinese, compared to just 10 per cent in 2012. And we suspect, especially given the Chinese leadership’s dystopian leanings, China is going to be unwilling to relent on its progress in artificial intelligence regardless of the amount of pressure the Trump Administration applies.

Artificial intelligence requires immense amounts of computing power. Computers are powered by semiconductors. China cannot risk its AI ambitions by being hostage to semiconductor companies that fall under the US sphere of influence. China, we believe, will pull out all the stops over the next decade to develop its local semiconductor industry manufacturing capabilities with an aim to end its reliance on US-based manufacturers by 2030.

Investment Perspective

Investors often talk about the one dominant factor that drives a stock. While we consider capital markets to be more nuanced than that, if semiconductor stocks have a dominant factor it surely has to be supply – it certainly is not trailing price-to-earnings multiples as semiconductor stocks, such as Micron, have been known to crash when trading at very low trailing multiples. Chinese supply in semiconductors is coming.

While we expect the bull market in tech stocks to re-establish itself sometime this year, if there was one area we would avoid it would be semiconductors.

[1] From Wikipedia: MFN is a status or level of treatment accorded by one state to another in international trade. The term means the country which is the recipient of this treatment must nominally receive equal trade advantages as the “most favoured nation” by the country granting such treatment. (Trade advantages include low tariffs or high import quotas.) In effect, a country that has been accorded MFN status may not be treated less advantageously than any other country with MFN status by the promising country. There is a debate in legal circles whether MFN clauses in bilateral investment treaties include only substantive rules or also procedural protections.