The Long Reach Of Technology In Taiwan by Jim Harvey and Dilip Badlani, Royce Funds
Taiwan is one of the high-tech epicenters of the world, and while it headquarters some of the industry’s most dominant players, the country is also home to a large and diverse group of smaller companies that provide a vital supporting role to the growing demands of the global markets.
For the Royce team, 2014 was a fairly busy year for international travel. Tell us a bit about Taiwan, your final trip of last year.
Dilip Badlani: Jim and I went to Taiwan in November of last year, slightly more than a year after we took over responsibility for Royce International Micro-Cap Fund. It was our first visit as a team to Taiwan, and a really important trip in terms of how we try to locate undervalued international micro-cap companies.
In addition to being one of the highest weighted constituencies in the global index, Taiwan is home to many smaller companies that fit the Royce criteria of strong balance sheets, high returns on invested capital, targeted niche products, high insider ownership, and good dividend-paying policies. So the trip was a little overdue.
Jim Harvey: While on the road, we met close to 20 companies. One of the “Four Asian Tigers,” alongside Hong Kong, South Korea, and Singapore, Taiwan is the twenty-sixth largest economy in the world.
The country boasts a substantial trade surplus and a huge amount of foreign reserves, largely due to its export orientation, and is one of the high-tech epicenters of the world. There are some dominant tech companies in Taiwan—all supported by many well-run smaller companies, so it’s a really deep market for us.
Dilip: Our first impression visiting Taiwan was similar to what we observed in South Korea. Both countries experienced significant growth in the ’70s and ’80s when they transformed from being agricultural societies to industrial societies, and they have a nominal GDP per capita above $20,000, far higher than most countries in Asia.
Like South Korea, Taiwan is outward looking, export driven, and its work force has a strong work ethic. Because of its lack of natural resources, Taiwan is also a very entrepreneurial economy that needs to create high-tech products that meet a demand in the global economy.
What opportunities have you been finding in the technology space in Taiwan?
Jim: Before we go into that it might be useful to first define what we mean when we talk about companies in the tech space. There are pure-play tech companies, for example, which are typically more directly related to semiconductor demand. But there are also companies, which we find in abundance, that are more tied to industrial technology, or that play into growing areas such as industrial automation.
So although many of these companies are highly sophisticated in terms of their technology offerings, they are not directly tied to the semiconductor cycle.
Dilip: In other words, this latter group is often less volatile and driven more by GDP growth.
Jim: And they sell around the world.
Dilip: As micro-cap investors, we see a lot of companies that benefit from Taiwan’s pre-eminent position as a high tech manufacturing base. For example: The list of suppliers to Taiwan Semiconductor—one of the world’s largest semiconductor companies—is amazing.
To Jim’s earlier point, there are a lot of smaller companies that support Taiwan Semiconductor, as well as other larger global players. The CEOs of some of the largest tech companies in the world regularly visit Taiwan because they are so reliant on the country for their supply chain.
What is Taiwan’s relationship with China, and in what way does this relationship tie into the country’s emphasis on exports?
Dilip: Taiwan had been benefiting from U.S. trade assistance after World War II and was able to establish itself as an export powerhouse well before the Chinese economy opened up in the late 1970s.
When China opened up a lot of Taiwanese businesses recognized that China was a far bigger market, and eventually began moving their manufacturing plants to the mainland in order to lower costs while keeping headquarters and R&D in Taiwan.
Given its geographic proximity, shared cultural background, and similar language, Taiwan also benefits greatly by exporting to China. Today, the United States, China, and Japan are Taiwan’s three largest trading partners.
Jim: For better or for worse Taiwan and China are very much tied at the hip. Even though Taiwanese companies export to all over the world, China acts as a key conduit for that activity.
Let’s revisit opportunities in tech. What companies do you currently like that directly or indirectly play on this theme?
Jim: Flytech Technology was founded in 1984 and is a world leader in the design and manufacture of point of sale (POS) hardware equipment, which represents 85% of the company’s revenue. As the required features in POS equipment vary by region, Flytech sells customized products mostly to the hospitality and retail industries.
At the point of sale today, most of the world is using an iPad. The problem with using an iPad as a proxy for a POS system is it’s really not a sophisticated tool: it doesn’t adequately support inventory management needs or do the detailed analysis on a retailer’s business. So heavier duty tablets running on the Android Operating System are going after the market pretty heavily and starting to take share.
Flytech’s product is riding the big data wave and is able to incorporate data that simpler tablets are unable to capture at the point of sale. Its costs are also much lower, and the company is gaining very rapidly in the emerging markets.
Dilip: In many ways Apple created this market. However, people are starting to see the realities of the market and the need for products that are designed for industrial use. That’s the market that Flytech is targeting.
Jim: Flytech also makes what it calls panel PCs, a business it entered in 2007 and which makes up 15% of its business today. And they make a ruggedized panel for uses in factory automation, which is a market that’s growing 10% a year. Flytech has had margins north of 30% for some time, and it’s able to offset any price erosion in the market pretty much through productivity. So the company is executing pretty well.
Dilip: I think it’s worth pointing out that our trip also gave us a read on what else is going on in the world given the country’s export-driven economy and how dominant it is in so many different technological areas.
For example, we met a surveillance company that highlighted for us just how tough the competition is in the surveillance market. Even though the market has lots of potential for growth, there were a lot of points that management made that trimmed our excitement about some of the opportunities out there.
At this point it’s hard to figure out if any of the companies in the industry are going to make a lot of money in what seems to be an increasingly commoditized market. No one seems to have a dominant share, and consumers appear to be growing agnostic about the product.
Because of this meeting we decided that for now the industry is one we should avoid. Over the past several years we met a few companies in this space, and while we were originally attracted to their growth characteristics and what we believed were high returns on invested capital, it now appears to us that these characteristics are probably not sustainable.
Jim: On this trip we also learned about a type of business that we never knew existed. Shih Her Technologies performs precision cleaning of semiconductor capital equipment. The company considers itself the largest precision machinery cleaning and regeneration service provider in Taiwan, which makes it one of the largest in the world.
It’s a fairly labor intensive business. We toured the facilities, and what we saw was workers taking apart massive pieces of semiconductor capital equipment and cleaning them by hand, packaging them, keeping a database of every piece they touch, and then shipping it back to the customer. This prolongs the life of the equipment.
Dilip: What’s great about this company is that it maintains a detailed database of every piece of equipment it touches and the best practices for the safest and most efficient way to clean each piece. So the company’s customers trust it to handle this very expensive equipment, which establishes a high barrier to entry.
We also met with Hermes Microvision, which inspects semiconductor equipment, which is another example of how we learned about continuous changes in the semiconductor industry.
Jim: Hermes Microvision is the leading provider in what it calls electron beam inspection. In the market there are two types of inspection: optical, which is the traditional, more limited way of doing things, and electron beam inspection, which could push beyond optical’s limitations.
We didn’t buy Hermes Microvision for the International Micro-Cap Fund because its market cap is too high. But one of the benefits of going out on the road is being able to share what we learn with other Royce portfolio managers.
So while Hermes Microvision doesn’t quite meet International Micro-Cap’s criteria, another manager at Royce may find the business attractive for his or her portfolio or use the information when analyzing a U.S.-based company.
What about some companies in other industries?
Dilip: The good thing about many Taiwanese companies is they very much fit the Royce framework. They’re well run, they’re slow grinders, and they grow over time. That’s what we’re trying to get at. We’re not trying to play product cycles or one-off wins. We’re trying to find steady growers with good dividend yields.
Taiwan Paiho is a global leader in original design manufacturing of fasteners for shoes and supplies all the large players such as Nike and Adidas. It was invited by Adidas to be a member of the “A-Team” (only 11 companies are in this team globally) and was elected as a strategic partner by Nike in 2014.
This is an incredibly innovative company. They’ve pioneered a new way of making shoes with a product called a “one-piece upper.” This new product saves shoe makers time and money because it eliminates the need to stitch together various pieces of fabric to form the upper part of a sneaker. As the company develops new products, it vastly increases the content per shoe, which should lead to higher sales and greater margins. We also like that the company has good insider ownership and pays an attractive dividend.
Jim: The company has been around since 1985, and is being run by the younger generation of the founding family. So I think current management has breathed a little bit of new life into the company. The big shoe companies almost exclusively use Taiwan Paiho because of its reliability and quality, in addition to some of the patents it holds (the company had over 250 patents at the end of 2014).
Its competitors either lack in quality or have lead times that are too long. Taiwan Paiho is growing nicely and increasing the content per shoe will secure the company’s position as a dominant player in its niche. It’s being met pretty favorably in the market.
Dilip: The company is also using its technology to increase its addressable market. It has entered the automotive space through its molded hook business and, if its technology will be adopted it could have a disruptive impact on the manufacturing process for car seats. Using molded hooks instead of steel bars would enable a reduction in manufacturing time and is being considered by some global OEMs.
One of our longer-term holdings in Taiwan has been Makalot Industrial, an OEM company that manufactures for the leading retailers around the world. It’s a very well-run company, a great dividend payer, and a consistent grower with a good cost position.
This company is a little different than some of the other OEM companies that we have visited across Asia. It doesn’t only have production in China—it also counts manufacturing facilities throughout the ASEAN (Association of Southeast Asian Nations) region. Management’s view is that as China’s labor costs go up, Makalot is able to flex capacity depending on where costs are best. Additionally, by having a presence in all these different countries, Makalot is able to play off where the best duty rates are for exports into the U.S. or Europe.
This diversified manufacturing base has enabled the company to maintain consistent margins in the face of increasing labor costs and a volatile raw material environment. Management has rewarded shareholders with a strong dividend payout; it has consistently paid out north of 80% of earnings as a dividend.