KF - Taiwan Fund: Buying On 2023 Pullbacks

Summary

• The Taiwan Fund's discount to NAV is approaching 20%.
• This looks like one of the most attractive emerging market closed-end funds.
• I will accumulate during any country-specific or emerging market declines this year.

Opportunity Overview

Taiwan, the 2nd largest country in the MSCI Emerging Markets Index, is an intriguing larger emerging market to follow. I am planning to accumulate the Taiwan Fund ( TWN ), which has underperformed other emerging markets during the past year. This closed-end fund will continue to trade at a compelling discount to NAV during any pullbacks this year, and I believe it is a better option than the iShares MSCI Taiwan ETF ( EWT ) because of this fact.

Below are some of the main factors to consider:

• Semiconductor Industry : Taiwan's economy and equity markets largely hinge on the performance of this industry, as Taiwan is a global leader in this area. Most ETFs/closed-end funds invest over 20% of their assets in Taiwan Semiconductor ( TSM ).
• Economy : Taiwan's economic growth may only be 1-2% this year. China's economy also impacts Taiwan, as 42% of its exports go to China.
• General Emerging Market Sentiment : Taiwan does not struggle with some of the common issues in emerging markets now, including rising inflation and sovereign debt. However, further emerging market turmoil could hit Taiwan particularly hard, as it is likely one of the largest countries in most emerging market funds, and accounts for 14% of the MSCI Emerging Markets Index.
• Political Risks : Global political risks with China and Russia are rising, and further escalation in any area, particularly with China, is a significant risk for the equity market.

Discount

This fund currently trades at an approximate 17% discount to NAV, which is very attractive relative to other closed-end international and emerging market funds. This fund outperformed the iShares MSCI Taiwan ETF by more than 20 percentage points during the past ten years. However, the fund has underperformed in the short term, mainly due to the expansion of the discount to NAV.

The underperformance was stronger toward the end of 2022 when semiconductor stocks experienced a pullback. The best time to accumulate will be when semiconductor or emerging market stocks sell off later this year.

Industry Focus

As of the end of 2022, the fund had around 69% of its assets invested in information technology companies. The fund only invests 7% of its assets in consumer stocks and less than 2% of its assets in financial and basic materials stocks.

This industry weighting led to significant underperformance at the end of 2022 . The fund has since added to consumer stocks and reduced its exposure to semiconductors. Despite the pullback in these stocks last year, this is still a promising investment. McKinsey projects that this industry will continue to grow by around 6-7% through 2030 to reach a total value of $1 trillion. Taiwan currently controls around 70% of the world's semiconductors.

Meanwhile, the iShares MSCI Taiwan ETF has more exposure to financials and consumer stocks, which are solid industries to consider. I will continue monitoring the Taiwan Fund's industry weighting, as recent comments from the portfolio managers have explained how they have been buying more consumer stocks and reducing exposure to semiconductor stocks. However, I am not necessarily bearish in this industry and would prefer to avoid this ETF because of the higher weighting in financials.

iShares MSCI Taiwan ETF

ADR Options are Limited : When possible, I try to focus on identifying a list of consumer ADRs if the ETF is too heavily concentrated in one industry. However, the vast majority of ADRs include tech companies. Therefore, it will be difficult to replicate this industry breakdown unless you trade directly on the Taipei stock exchange, which is difficult for US investors to do. Overall, I think the Taiwan Fund's portfolio accurately reflects Taiwan's economic prospects, and I am fine with the heavier tech weighting and lower financial weighting.

Economic Outlook

Exports currently account for 70% of Taiwan's GDP , and it is very exposed to a global slowdown in economic growth. The economy has multiple risks ahead of it this year, and the 2+% growth forecasts may be too optimistic:

• Semiconductors : There was weak demand for semiconductors at the end of 2022, which hurt Taiwan's economy as this accounts for around 40% of its total exports.
• Currency : Taiwan's currency depreciated against the USD by over 10% during 2022 . Furthermore, devaluations will not likely help Taiwan be cost-competitive with other Asian countries, which have lower wages and manufacturing costs.
• Export Structure : More than 70% of its exports go to Asia, and North America and Europe are more minor export destinations. Thus, Taiwan's growth largely hinges upon electronics demand in Asia and is not very diversified. However, this fact is positive for those bearish on Europe and North America's growth outlooks.
• Consumption : Taiwan has not struggled as much as other emerging markets in terms of inflation, but consumer confidence is still at a 10-year low.

I think a bet on higher-end exports, rather than other Asian countries with lower-end exports like textiles, is a smarter move in this economic environment. The mobile penetration rate in Asia Pacific is still only at 59% , so there is still room for long-term growth in this area in the next decade.

Risks and Final Thoughts

I think that Taiwan's economic outlook is superior to most of its peers in Asia, and I am worried about the slowdown in semiconductor demand in 2022. However, growth will likely come in below the 2+% projections. The greater opportunity here in my opinion is this closed-end fund itself. I would not likely consider investing in Taiwan when only limited to ETFs/ADRs. Similar closed-end funds, such as the Korea Fund ( KF ) or the Japan fund ( JEQ ), only trade at a 13-14% discount. I plan to initiate a position later in 2023 and am monitoring the following risks:

• Global Recession : I will focus heavily on Asia, as only around 21% of its exports go to the United States and Europe.
• Semiconductor Demand : Although demand will be strong this decade, there may be short-term slumps, as seen in 2022. Any slowdown in demand would likely result in a stronger discount to NAV, which would be an excellent buy opportunity ( i.e.. 20+% discount to NAV)
• China/Taiwan Tensions : This issue could come into the spotlight in 2023-2025, and would be extremely bearish for emerging market equities in general.

For further details see: