Warren Buffett Buying Taiwan Semiconductor Sends A Message

First off, it’s easy to understand why Warren Buffett might be interested in Taiwan Semiconductor Manufacturing Company (NYSE:TSM) stock.

This is a company which dominates its market as a semiconductor foundry, and does it through what has been, for a while, a technological advantage. This advantage is brought by TSM’s ability to reach new semiconductor process nodes ahead of its main competitors, Samsung, Intel and GlobalFoundries.

For many of TSM’s customers, being on the most advanced node possible is a necessity. It provides their own products with an advantage either on cost, power efficiency or performance. All are extremely needed in many different end markets, such as servers or smartphones.

Hence, being at the forefront of semiconductor manufacturing produces a clear advantage for customers, and this in turns allows TSM to have pricing power and higher margins. It also allows TSM to invest more than competitors, thus perpetuating its advantage.

Finally, the US creating a ban on the sale of advanced semiconductor equipment to the Chinese foundries doesn’t hurt. This will likely set back emerging Chinese competition to TSM for years.

All of these factors are present at a time when TSM stock was punished hard, mostly because of a perceived unfavorable semiconductor cycle. The negative cycle is real, but again TSM is rather insulated since there’s excess demand for its higher-priced leading processes, which should be enough to make 2023 a flat year at worst. Hence, Warren Buffett pounced when this leader got available at little over 10x earnings. Not a surprise.

Yet, there’s another angle regarding which no one is talking about.

The Unspoken Angle

You see, around 96% of TSM’s current production capacity is in either Taiwan (89%) or China (7%). Although TSM is investing in some factories elsewhere (in the US), this reality won’t change materially even looking forward one decade. Not least of it, because TSM also continues investing in new Taiwan production capacity.

Now, for investors, there is one overwhelming fear about China. This is the fear that China could eventually try to take Taiwan by force.

It’s a long story, but in 1949/1950, the communist revolution in China was coming to an end. Nationalist forced fled to Taiwan, and the communists were giving chase to complete the revolution by taking the entire Chinese territory. At that point, the US, which had already been supplying the Nationalist army, blocked the ability of the Chinese to cross the Taiwan Strait.

Ever since that day, both sides recognize there’s “one China”, but there’s never been a solution to reunite it again. (Mainland) China keeps the intention to reunite, and while it prefers a peaceful reunification, it never excluded the use of force (since it sees Taiwan as a breakaway region). At the same time, China always emphasizes that unless Taiwan tries to go for full independence (which it hasn’t), there won’t be a conflict.

Anyway, in the present day, and especially after the Russia-Ukraine events, the fears have been elevated that China could be close (years away) to trying such reunification by force. These fears are present even though there were much “hotter” moments in the last 70 years where such could have happened than now. Also obviously, the Chinese military is now relatively more powerful. But at the same time, there are no signs that China is changing its stance or being more aggressive over this issue.

As a result of these fears, alongside mostly normal regulatory actions, Chinese stocks – especially those quoted in Hong Kong – have been heavily battered. Hong Kong now trades at the same levels reached 22 years ago. And the iShares China Large-Cap ETF (FXI), a good proxy for Hong Kong-listed Chinese shares, trades at an average Price/Earnings of just 8.6x. This is so even though there are many large, technologically-advanced, appealing, growing and highly-profitable Chinese companies. Furthermore, the same Chinese stocks, as traded in Shanghai, trade on average 42% more expensively.

So, what has all of this to do with Warren Buffett buying TSM stock?

Well, as we saw, 96% of TSM’s production capacity is in Taiwan or China. Any such event as a war between China and Taiwan would compromise this entire production capacity! Not least, because it would either be destroyed by China or Taiwan itself, and it would anyway not be operable without the people with the knowledge and motivation to operate it.

Hence, a bet on TSM is the same as a bet that the risk regarding China attacking Taiwan isn’t large. On top of TSM’s fundamentals, that’s what Warren Buffett is betting on! And this, most people never seem to talk about.

Moreover, it’s even more interesting. By buying TSM, the bet isn’t just that China won’t invade Taiwan, but also that China and Taiwan won’t reunite. Why so? Because in seeking to contain China’s ascendancy, the US has put bans on Chinese access to the latest semiconductor production equipment. Now, if China reunited with Taiwan, almost surely these bans would have to be extended to Taiwan itself. Hence, that would also punish TSM.

This is ironic, in the sense that the risk China will attack Taiwan + the risk that China will reunite peacefully with Taiwan is surely larger than the risk that China will attack Taiwan. Yet, most Chinese stocks are only exposed to the first risk (that China will attack Taiwan), and wouldn’t suffer from the second!

Anyway, this is all to say that Warren Buffett’s message is clear. If TSM is acceptable as an investment, then so are most other Chinese stocks (not exposed to bans), though of course their own attractiveness might differ here and there, because of their own fundamentals.

Conclusion

Warren Buffett’s TSM investment is a bet that the risk the market most fears regarding China, that China might attempt to take Taiwan by force, isn’t high. This same logic can also thus be applied to many other interesting, undervalued, Chinese stocks.

I am bullish on TSM, because I also don’t believe there’s any heightened risk of China taking Taiwan by force. Also, TSM fundamentals continue to be bullish themselves – there’s more demand for its leading-edge processes than TSM has capacity to satisfy. As a result, TSM has pricing power and mix advantages which should allow it to have a flat 2023 at worst, even as semiconductor companies in general face a cyclical downturn.