This article first appeared in Capital, The Edge Malaysia Weekly on July 22, 2024 - July 28, 2024

THE valuations of Bursa Malaysia-listed semiconductor and semiconductor-related companies have been notably higher than those in other sectors, and even global giants, since the outbreak of Covid-19 in 2020.

At the height of the chip shortage between March 2020 and December 2021, local tech stocks were trading at an average price-earnings ratio (PER) of 48.3 times, above the average of 35.9 times for their counterparts overseas.

Today, Malaysian semiconductor stocks are trading at an even higher trailing PER of 64.4 times, but below global multinational corporations’ (MNCs) historical average PER of 70.3 times.

This gap could be partly due to local technology stocks’ lack of exposure to the artificial intelligence (AI) sector. Whereas in the US, chip giants like Nvidia Corp and Advanced Micro Devices Inc are seeing their share price skyrocket due to the AI hype.

In terms of forward PER, however, Malaysian semiconductor stocks are trading at 34 times earnings, higher than the global average of 26.3 times.

Unisem (M) Bhd (KL:UNISEM) and Malaysian Pacific Industries Bhd (KL:MPI) are currently trading at more than 80 times historical earnings, while ViTrox Corp Bhd (KL:VITROX) is trading at 70 times and Oppstar Bhd (KL:OPPSTAR) and Frontken Corp Bhd (KL:FRONTKN) are above 50 times. Even the relatively cheaper counters like Pentamaster Corp Bhd (KL:PENTA) and Greatech Technology Bhd (KL:GREATEC) are trading above 40 times historical earnings.

For comparison, the stocks of MNCs like Taiwan Semiconductor Manufacturing Co Ltd, Intel Corp, Semiconductor Manufacturing International Corp, Texas Instruments Inc, Lam Research Corp and Qualcomm Inc are trading between 20 and 35 times earnings, while Nvidia and Broadcom Inc are trading at about 70 times.

So, what factors should investors pay attention to when choosing between local semiconductor firms and the more established players abroad with their comparatively lower valuations? Will the higher price-earnings multiples of homegrown companies alone drive them to invest in these foreign firms?

It would seem that there are a number of investors who still think local chip stocks are worth investing in. Most Bursa Malaysia-listed semiconductor stocks have posted gains of 10% to 40% year to date. The rally is seen as a rotation to laggards since the tech sector underperformed in the first four months of 2024.

Investors may well be reacting to reports of inventory restocking, the China Plus One (C+1) strategy of diversifying supply chains, the spillover from the US-China trade war and influx of investments from global players setting up plants in Malaysia.

Malaysia, being the sixth largest exporter with 13% of the global chip testing and packaging market, is anticipated to benefit from these geopolitical structural trends. In 2023, the country’s electrical and electronics (E&E) exports stood at RM575 billion, which was 40% of total exports and more than the next nine export segments combined.

According to the Malaysia Semiconductor Industry Association’s inaugural MSIA E&E/Semiconductor Quarterly Pulse Survey for 2Q2024, some 39% of the companies surveyed reported better business performance during the quarter compared with 1Q2024.

A notable 58% of respondents said they were planning to invest in new technologies, expand into new markets and develop new products. Some 72% of the companies had an optimistic outlook for the next 12 months, indicating sustained confidence in the sector’s long-term prospects.

Although a generally cyclical industry means there will continue to be periods of weakness in capital expenditure or demand slowdowns due to various factors — such as inventory destocking, replacement cycles, shifts in the global supply chain and geopolitical issues — longer-term investors may see these bouts of weakness as buying opportunities to capitalise on the long-term structural growth trend in the coming years.

Notably, Wall Street’s semiconductor index lost more than US$500 billion (RM2.33 trillion) in stock market value last Wednesday in its worst session since 2020. This drop followed a report that the US is considering stricter controls on the export of advanced semiconductor technologies to China.

What could serve as the next rerating catalyst for these stocks and what potential downside risks should investors be mindful of as we move into the second half of the year?

Nixon Wong Gok Hey, chief investment officer at boutique fund house Tradeview Capital Sdn Bhd, opines that the current high valuations of local tech stocks are “somewhat harder to justify” in terms of sustaining their positive momentum, especially given the limited exposure to AI tech at this juncture.

Nevertheless, he acknowledges that the high valuations — while subjective and open to various opinions and perspectives — can be “somewhat explained” by the solid earnings growth, backed by a degree of order flow certainty from end-clients, as indicated by foreseeable order books.

“This is in contrast to the giants’ business models which, despite being front-end and trend-setting, require high capital expenditure to expand capacity and maintain technological capabilities. This can lead to cyclical performance and make it relatively harder to predict outcomes in the global market competition … But again, the difference lies in the shareholders’ composition and stock liquidity,” Wong tells The Edge.

He says the relatively higher price-earnings multiples could be due to the limited free float, relatively smaller market capitalisation and low earnings base but there is a scarcity premium owing to the high earnings growth profile compared to other sectors with lower growth prospects.

“Indeed, high valuations imply high expectations built into a company’s share price, emphasising the importance of the company’s execution and ability to meet investor expectations,” he elaborates.

“In this era, data is the new oil, indicating a healthy growth trend as people use more data, driving the need for technology upgrades and capacity expansion, which benefits the entire supply chain. Expectations for the sector are reasonably high.”

Wong points out that it is essential to consider forward valuations to determine whether expecting similar earnings growth in the coming years is sensible and justifiable.

“We should account for the expected growth of selected companies rather than merely focusing on historical valuations, as the growth profile demonstrates the importance of a company within the supply chain. In Malaysia, another factor could be the limited free float of the sector, leading to a scarcity premium compared to other sectors with limited earnings growth, also with the strong support of GLC (government-linked companies) funds,” he says, referring to the existence of large local institutions with sizeable mandates.

Wong observes that higher expectations are placed on the tech and industrial production sectors for positive structural reasons. “If there were a choice, global leaders — mostly in front-end businesses — would still be trendsetters and prioritised by foreign fund managers over Malaysian stocks,” he reckons.

Having said that, he warns that a pullback is possible, especially after the recent rally, as the upcoming US presidential election may pose a risk to the sector due to increased volatility and profit-taking.

“However, prices may quickly find support as many investors view weaknesses as buying opportunities. Factors supporting this include recovery driven by inventory restocking, a rebound in China demand, anticipated US interest rate cuts by the end of 2024, growth in data centre investments and exposure to the booming AI theme,” he adds.

Phillip Capital head of research Tan Jian Yuan concurs that the local technology sector has been trading at elevated valuations due to the scarcity premium for growth stocks. This is expected to keep valuations high, he says.

“Despite the limited exposure to AI, the anticipated recovery in global demand, the street’s low earnings expectations and potential earnings upgrade in the coming quarters could spark a further rally in the sector,” he tells The Edge.

The World Semiconductor Trade Statistics forecasts a 16% rebound in global semiconductor sales in 2024, fuelled by robust demand for memory and logic chips.

“Malaysia’s E&E export recovery over the past few months supports a positive outlook on the Malaysian technology sector. After several quarters of inventory digestion and anticipated global demand recovery, particularly with the introduction of AI-enhanced products, we believe earnings have bottomed out and are poised for recovery, serving as a strong catalyst for a sector rerating,” says Tan.

“We believe investors may focus on companies with front-end exposure, which will likely experience quicker earnings recovery and have a larger total addressable market, before the back-end recovers. We prefer companies with exposure to strong secular growth trends such as AI, 5G, data centres and solar.”

For sector exposure, Phillip Capital likes Frontken and TT Vision Holdings Bhd (KL:TTVHB), with a target price of RM6.29 and RM1.50 respectively.

TA Securities tech analyst Tony Chan Mun Chun believes there are two main reasons for the high valuations of local tech stocks. First, the scarcity premium and, second, the expectations of earnings recovery going forward — in line with the global semiconductor sales recovery — which will bring down the high PERs.

“Earnings growth is something that investors should always prioritise. The share price has a strong correlation with earnings, and earnings will directly influence the valuation. Personally, I have no particular preference for local or global tech stocks, as long as the forward PER is reasonable,” he tells The Edge.

Chan expects the bullish sentiment to be supported by an anticipated healthy recovery in global demand, rising trade diversion opportunities as a result of the C+1 strategy, as well as fiscal support from the National Semiconductor Strategy.

TA Securities’ top picks are Inari Amertron Bhd (KL:INARI) and SKP Resources Bhd (KL:SKPRES), with a target price of RM4.43 and RM1.43 respectively.

The domestic equities team of Nomura Asset Management Malaysia points out that Malaysian semiconductor firms tend to trade at a premium to global leaders due to captive domestic liquidity, along with the scarcity premium. Furthermore, the technology sector offers structural earnings growth potential that has been lacking in other sectors in the local market.

“Being at the forefront of technology development, it is certainly compelling to invest in global tech leaders, where they have also proved to be multi-year compounders. However, there could be a preference to invest in local tech names due to familiarity and home currency considerations,” the asset manager tells The Edge.

Furthermore, there are global leaders among the local tech companies that investors can have a position in.

“Local tech companies could also tap domestic investor support for fundraising activities to fund expansion plans, helping them to emerge as more formidable players in the sector. A diversified selection providing a balance of global and domestic exposure would be a good approach to building investments for longer-term returns,” the firm suggests.

Nomura expects local tech stocks to remain buoyant in the second half of this year as AI-driven technology spending and applications broaden out and drive growth in servers, smartphones and personal computers that benefit the domestic tech ecosystem. Catalysts to watch out for include the positive earnings revision trend for local tech companies in 2H2024 as expectations have largely been reset over the past year, it adds.

The asset manager highlights that while valuations for local tech stocks are at a premium to those of global tech players, the forward PERs are at a discount to the peak levels in 2021, prior to the inventory correction that plagued the sector in 2022/23.

“Going forward, with the emergence of the AI secular trend, the valuations of local tech stocks could trade back up to previous peak levels. Intermittent consolidation would be healthy as well to serve as a check on any exuberance,” it says.

“Meanwhile some risks that should be monitored include the potential escalation of the US-China trade war, an unexpected prolonged inventory normalisation and a general economic slowdown.”

Tech stocks, both local and global, are expected to remain on investors’ radar screens so long as the demand for chips remains strong, driven by megatrends such as AI. Relative to stocks in the older economy, the price-earnings multiples may continue to stay elevated despite the geopolitical uncertainties.

As Malaysia and its local chip champions continue to show robust earnings prospects as they deepen their strategic position in the global supply chain, their stocks should not be overlooked purely because of their high valuations. 

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