Taiwan Semiconductor: A Repeat Performance in the Making?

Taiwan Semiconductor Manufacturing Company Limited or TSMC (NYSE:TSM) stock has been on a rollercoaster ride in recent months, underperforming its peers in the iShares Semiconductor ETF (SOXX) since late January. We have been cautiously optimistic about TSM since mid-December, as we assessed that the near-term optimism in its stock was likely reflected. However, the outperformance of the SOXX against TSM was more significant than we had previously anticipated. Interestingly, the SOXX last traded at a normalized P/E of 22.1x. However, TSM's NTM adjusted P/E of 16.1x suggests it's discernibly cheaper than its industry peers. Notably, the underperformance of TSM against the SOXX has occurred since its highs in February 2021, suggesting that market operators have taken the opportunity to "sell the rip" in previous TSM's momentum spikes.



As seen above, there have been several instances when market operators let TSM's outperformance spike against the SOXX over the past two years. However, these operators also leveraged the opportunity to sell the rip and rotated out of TSM as they dissipated the rip. Interestingly, TSM/SOXX has not recovered its long-term outperformance since its highs in February 2021. More worryingly, market operators continued to sell the rip in January 2023 after they picked up the pieces from panic sellers in the mean-reversion opportunity in late October 2022. We also highlighted in an article on 23 October 2022 that "these levels are too attractive not to start buying." TSM remains up nearly 50% since that article, but its momentum against its peers has stalled, as seen above.

So, herein lies the problem. TSM is cheaper than its peers by a fair distance. Morningstar considers it a wide moat company, given its technological and cost advantages against its industry peers. Intel Corporation (INTC) is not close to assuming process leadership. However, Bernstein highlighted in a recent commentary that "at this point, near-term fundamentals may have troughed. It is unlikely to get worse." So, does it suggest that Intel is on track to supplant TSM as the foundry leader? We think it's too early to tell. However, the point being made likely suggests that the pessimism in INTC has been priced in. In contrast, investors need to assess whether the optimism in TSM has been priced in, with investors still rotating out even though it's the foundry that AMD (AMD) and Nvidia (NVDA) rely on to fabricate their AI chips. Hence, the long-term secular drivers driving these opportunities should keep investors committed to the success of the leading-edge foundry.

However, we listen to the market, and TSM's price action suggests otherwise. So where could things go wrong from here? We discussed in our December article that cost overrun could be a significant challenge as TSMC diversifies its foundries out of Taiwan. TSMC is expected to leverage its technological leadership to keep its gross margins stable (i.e., make its customers pay more for its relocation). In addition, the company has not deviated from its long-term gross margin target of 53%, suggesting management remains confident in its pricing strategy. However, that's also a problem in itself. The market has likely reflected that TSM will maintain its leadership but has yet to price in adequately of a scenario where it fails to.



Also, the political risks between the US and China have intensified since our previous update, as China has moved forward with its own review. For instance, China recently instituted a "cybersecurity review" of Micron (MU), seen as a retaliation against the Biden Administration's steps to hamper China's semiconductor ambitions. Could it get worse? No one knows. However, it suggests that investors may need to consider a wider "political risks discount" against TSM. US Commerce Secretary Gina Raimondo also made it clear recently that the Biden Administration is unhappy with the status quo, where TSMC still makes most of its chips in Taiwan. She accentuated:

> Nobody thinks that we should be making everything that we need in America. [But,] the fact that we buy 90-plus percent of our leading-edge chips from Taiwan is also unsustainable and, quite frankly, almost dangerous.

Has the market priced this in? We believe market operators' behavior of rotating out of dip buying opportunities by selling the rips against the SOXX suggests that they aren't looking to keep their exposure to TSM for long. Despite its lower relative valuation, we parsed that TSM's underperformance against the SOXX could continue. Moreover, we believe the SOXX reached a short-term top in the last week of March (we alerted members of our service on March 31), which should add more pressure against TSM's recovery momentum.

With that in mind, we encourage investors to consider rotating out of their exposure in TSM progressively. Rating: Sell (Revised from Hold).

Important note: Investors are reminded to do their own due diligence and not rely on the information provided as financial advice. The rating is also not intended to time a specific entry/exit at the point of writing unless otherwise specified.