During October the strategy lagged the MSCI Emerging Markets index by 0.8%, even as markets continued rallying. This was primarily due stock selection in Taiwan, where TSMC continued setting the pace. Other markets were mixed with a good recovery in Argentina after the elections but weaker performance among other Latin American markets.
Over the month we have added to financials in South Africa where the macro outlook continues to improve and cost of capital is declining while valuations remain reasonable. We have also been increasing exposure in South Korea while trimming China and Brazil.
South Korea has been the standout market this year with the benchmark KOSPI index having risen by over 70%. One may reasonably ask whether this is beginning to look stretched. Despite the move, MSCI Korea trades on just over 10x consensus earnings for next year, in line with its ten-year average and still at a significant discount to the 13.7x of the MSCI Emerging Markets index. This is because Korean earnings expectations have risen by close to 40% since the start of the year and because the index had started off near a historically low multiple of 8x consensus earnings.
If we dig into the Korean earnings bonanza, it becomes obvious that it is overwhelmingly down to one factor – the exploding price of DRAM memory. Two of the three global DRAM makers are Korean – Samsung Electronics and SK Hynix. They account for over 1/3rd of MSCI Korea by market cap and even more of its prospective earnings.
Historically DRAM has been a highly cyclical business with swings from shortage to overcapacity driving wild price fluctuations. It has improved in recent years with consolidation to three players and more supply discipline. This notwithstanding, the current situation created by AI demand is unprecedented.
Nvidia requires specialized HBM memory for its GPU chips and memory makers have focussed all their resources on delivering this. Global HBM capacity is fully sold out on long-term contracts and suppliers are dealing with physical constraints to ramp this – there are simply not enough clean-room fabs or machines to supply the booming AI processor market. As a result, investment in traditional DRAM memory production has been constrained – in fact, facilities are being converted to HBM production, crimping DRAM supply. While PC, mobile phone and other electronics demand is fairly steady, mushrooming AI datacentres also require huge amounts of DRAM to embed alongside their cutting edge Nvidia GPUs. As a result, spot prices for DRAM have roughly quintupled in the space of two months. Longer term contract price moves are not likely to be as spectacular, but are driving up earnings for manufacturers.
At current prices DRAM production is incredibly profitable and supply will eventually respond but this cannot happen in the short term. The top DRAM makers are growing wafer processing capacity by 10% annually up to 2027 but HBM chews up 3-4x as many wafers as DRAM so this will not help much. Unless there is a complete collapse in AI datacentre investment, it is hard to see the memory market coming back into balance in the coming three years.
While we cannot assume that DRAM prices remain high indefinitely, the coming years should produce enormous profits. Plugging current spot prices into Samsung Electronics’ P&L would put the stock on a P/E multiple of 2x. With Korea’s newfound focus on corporate governance, at least a portion of these earnings should find its way back to shareholders. In this context, the market moves seem a lot more justifiable.
