EWT - EWT: Taiwanese Equities Offer Good Value But Political Risk Remains

2023-05-31 13:12:21 ET

Summary

• iShares MSCI Taiwan ETF offers investors exposure to Taiwanese equities, with a heavy focus on Taiwan Semiconductor Manufacturing Co Ltd.
• Despite political headwinds, EWT provides good value with a net IRR estimate of over 10% per annum for the next five years.
• However, investors should be cautious of the unpredictable risk of increased tensions between China and Taiwan, as seen with the Russo-Ukrainian War and its impact on the Russian equity market.

Introduction

iShares MSCI Taiwan ETF (EWT) is an exchange-traded fund that provides investors with exposure to Taiwanese equities. I last covered the fund in June 2022 and while I was bullish, the fund has fallen -10.57% since then versus the S&P 500's change to date of 14.44% positive. I did however caveat that political risk was likely to over-shadow EWT for years to come, which is likely to weigh on the fund in the form of an implicit political risk premium. Nevertheless, the fund has fallen; I think it makes sense to review the fund to see how EWT is priced relative to consensus estimates of earnings growth.

I should also mention early on that EWT is heavily exposed to Taiwan Semiconductor Manufacturing Co Ltd ( TSM ) ("TSMC") at 22.98% of the fund as of May 26, 2023. The exposure would no doubt be larger if it were not for the fact that EWT invests in accord with the MSCI Taiwan 25/50 Index, which limits any single constituent at 25% or less. TSMC is arguably the world's most advanced semiconductor contract manufacturing and design company. Most of the leading fabless semiconductor companies, including Nvidia Corporation ( NVDA ) are customers of TSMC. With the growth in the AI industry over the past 6-12 months especially with the surge in popularity of high-end GPUs from companies like NVDA (owing in large part due to the growth in Large Language Models, or LLMs) TSMC has plenty of tailwinds. Of course, the political headwinds do however remain.

EWT's expense ratio is 0.58%, with a 30-day median bid/ask spread of 0.02%. Net assets under management were $4.25 billion as of May 26, 2023, while net fund flows were negative about -$593 million over the past twelve months (see below). The negative fund flows are unsurprising in view of the poor performance of the fund, although fund flows have been net-positive on a shorter time frame.

Valuation Gauge

Morningstar's consensus figure for three- to five-year earnings growth rate expectations is currently 5.96%. Meanwhile, the most recent factsheet for EWT's benchmark index offers trailing and forward price/earnings ratios of 12.55x and 14.31x, respectively, with a price/book ratio of 1.78x. The indicative dividend yield was 4.90%. These figures unfortunately imply a forward year-one earnings growth rate on average of -12.30%. However, I can use Morningstar's figure to support a higher return on equity in year two, but I am not quite comfortable with assuming a flat 6% average growth rate in light of MSCI's likely more prudent year-one estimate of a decline. I will instead assume an average return on equity of circa 12-13% over the forecast.

As a result of this assumption, and keeping most other factors constant (including the forward price/earnings multiple), I arrive at a net IRR estimate for EWT of 10.47% over the next five years. I have also included the local 10-year yield of 1.16% and a local country equity risk premium from Professor Damodaran's estimates of 1.03%, to calculate an underlying equity risk premium (CRP-adjusted) of 8.28%. That is actually a very high equity risk premium, suggesting plenty of further political risk factored into the portfolio besides the 1.03% per Damodaran's previous estimates.

I am comfortable with holding the forward price/earnings multiple at 14.31x, as I think this already provides a healthy cushion. However, another approach to the above is to consider EWT's very high beta of 1.47x on a three-year basis relative to the S&P 500 U.S. equity index. Scaling the sum of the country risk premium and CRP-adjusted ERP (in total: 9.31%) by the fund's beta of 1.47x takes us to a beta-adjusted ERP of 6.33%. That is still high, higher than what I would expect of circa 4.2-5.5% as a general range for a risk-adjusted ERP. However, it is much "closer to Earth", and suggests less under-valuation than our CRP-adjusted alternative of 8.28%.

EWT is heavily exposed to TSMC. This is not a bad thing intrinsically, but it is worth remembering the simple fact that you can invest in TSMC directly. The rest of EWT's portfolio is essentially a macro bet on Taiwan, at least in terms of the remainder of its stock market, together with an implicit bet on less tense Cross-Strait relations . Also, while TSMC is an amazing company to own, and EWT offers good value overall, it is next to impossible to effectively hedge the political risk associated with both TSMC and EWT. I think long-term shareholders should do well, but this is an optimist speaking. Other investors may not want to take on the unpredictable risk of a heat-up in tensions between China and Taiwan.

In summary, on the basis that EWT offers objectively good value, I would maintain a bullish stance. Over the next five years, the net IRR stands to exceed 10% per annum. On the other hand, no matter how optimistic you are, I think the Russo-Ukrainian War that escalated in early 2022, and the subsequent write-off of the Russian equity market internationally, provides us with a very strong contemporary lesson: do not hold any high exposure to idiosyncratic political risk. EWT is no exception.

For further details see: