Ivy CIO Insights: Global tech and U.S.-China trade war

11.21.19

The escalating U.S.-China trade war over the past 18 months has created an uncertain macroeconomic backdrop with both challenges and potential opportunities. We sat down with Charles John, CFA, assistant portfolio manager on the Ivy Global Growth Fund and Ivy global technology analyst, to discuss the implications of the trade war on the global technology landscape as well as China’s aggressive pursuit of more localized technology.

Q: How do you analyze the trade war and trade more broadly?

John: The main thing we’ve noticed over the last 18 months is the escalating level of rhetoric between the U.S. and China. Markets fluctuate based on euphoria about a potential trade deal or fear because both sides are far apart – as it appears they are now. As fundamental investors, we stay aware of macro factors, but our focus is on stocks we can own over the longer term.

We think the technology sector is front and center in the trade war, notably semiconductors. One statistic puts this in perspective: China consumes 50% of global semiconductors produced, but only manufactures 20-25% of the semiconductor market. That’s an imbalance the leaders in China want to solve for the long term. They are aggressively trying to create their own technology ecosystem, not just in semiconductors, but in software, artificial intelligence and other key areas within technology. I think irrespective of the trade war outcome – whether it gets solved in the next few months or the next few quarters – China’s aggressive ambitions in technology are very clear and likely to be undeterred.

Q: Technology is a huge part of the economy globally, whether it’s software, services, internetrelated businesses or hardware. Ultimately, the semiconductor industry feeds all of these areas. What business models are appealing to you as a long-term investor? And what are the implication of China’s scale, business capabilities and strategic ambitions?

John: I think we have to take a step back and ask one question: Why are we seeing this phenomenal growth in semiconductors and technology? I think it is because of the confluence of several factors, which has not happened before:

  • Cloud computing allows people to access huge amounts of storage and computing for little capital outflows.
  • New algorithms like deep learning and machine learning have created vast amounts of innovation in the technology space.
  • The significant semiconductor demand for new devices, such as televisions, smartphones, artificial intelligence, speakers or health care.

These things together have created significant innovation that demands semiconductors and supplemental technology.

In terms of China’s capability, one fallacy is that China has small companies trying to imitate U.S. companies. That may have been true a decade ago but it no longer is accurate. For example, Huawei Technologies Co., Ltd. is a Chinese company that has roughly 180,000 employees, more than 80,000 patents, the top market position in 5G equipment and the largest share of the smartphone market worldwide. HiSilicon is another example. This little-known company is owned by Huawei and creates the majority of the chipset technology that drives Huawei.

Chart Showing The rise of connectivity

Source: “Fujitsu World Tour 2017: Co-creation with SAP S4HANA,” Fujitsu, March 2017

As we think about the imbalance within China, one thing China’s leaders want to do is use companies likes Huawei, HiSilicon, Baidu, Inc., Tencent Holdings Ltd. and Alibaba Group Holding, Ltd. to create more localized technology within the country.

Q: What does that mean to an investor in the U.S., even in your case where you’re focusing on investments in global growth portfolios?

John: There are two ways to analyze the trade war and China’s ambitions for the long run. The first is to consider who benefits from higher silicon intensity and the second is to invest in companies that have minimal exposure to the gyrations of the trade war.

When we think of potential beneficiaries of the trade war, we’re talking about higher semiconductor usage throughout the world, whether it is televisions, smartphones or digital devices. This higher silicon content in “things” can be thought of as rising silicon intensity, or increasing amounts of silicon.

According to Fujitsu, there has been growth in digital products from 100 million personal computers in the 1990s to billions of smartphones in the early 2000s to a forecast of 50 billion connected devices in the Internet of Things by 2025.

When you have higher silicon intensity and a new player like China enters the market, by definition China will have inefficient designs, sub-optimal architectures and larger chip sizes versus its U.S. peers that have been finetuning these silicon designs for decades.

In terms of good business models, we think an obvious beneficiary of this trend is the foundry companies that help manufacture these different chipsets. There are two key areas in which we think they benefit: They can gain from more players in the market that are trying to make silicon chipsets and they are paid based on the size of these chipsets. Given the inherent inefficient Chinese designs for now, foundries get paid more in price per chipset. Essentially, these companies serve as the “arms suppliers” in the silicon wars.

The other aspect I mentioned is finding companies with minimal exposure to trade war risk. For example, analog semiconductor companies have high margins, complex products, thousands of customers, thousands of unique products, and they’re hard to replicate and catch for a new player in the market, such as China.

Q: To recap, the “arms suppliers” are the fabrication businesses with dominant scale, minimal competition and benefit from secular growth and continuing semiconductor consumption. And China as a consumer and producer is going to drive continued demand. Separately, the analog space is a classic competitively advantaged industry structure with a moat that prevents new entrants. They appear to be value-add vendors that have a locked-in position, regardless of the trade war.

John: That’s right. An extension of the two premises that we’ve built around China’s goal of producing more homegrown technology is that you do not want to own at-risk companies. Several large-cap technology companies around the world have been insulated from new players coming into the market. China has the intelligence, capital and wherewithal to enter the space for a long time.

As long-term investors, we seek to avoid at-risk companies and thus try to avoid exposure to the downside risk. Overall, I believe companies in the foundry or analog spaces provide the least exposure to trade war risk, which may help lessen the downside.


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