In the third quarter of 2022, Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) acquired a $4 billion stake in Taiwan Semiconductor Manufacturing Company (TSM, Financial), as per its 13F filing.
Investors should be aware that 13F reports do not provide a complete picture of a guru’s holdings. They include only a snapshot of long equity positions in U.S.-listed stocks and American depository receipts as of the quarter’s end. They do not include short positions, non-ADR international holdings or other types of securities. However, even this limited filing can provide valuable information.
This move by Warren Buffett (Trades, Portfolio)'s firm honestly surprised me; perhaps it was meant to be a strategic hedge or a play on dividends going into a possible global recession? However, I will not be following Buffett into this trade. Sure, it’s a very prominent company in the global technology market, but the price to value situation is just not good enough to produce a significant return on investment in my estimates.
About the company
Currently, Taiwan Semiconductor is the largest semiconductor foundry in the world, with global market share north of 60%. While its headquarters is in Taiwan, it also has manufacturing facilities around the world, including in mainland China, Europe and the United States - including a $40 billion investment going into building a facility in Arizona right now that is one of the largest foreign investments in U.S. history and the largest in state history.
What does a foundry do? It fabricates integrated circuits (ICs) based on designs provided by customers. Taiwan Semiconductor works with many of the world's largest technology companies, such as Apple (AAPL, Financial), Qualcomm (QCOM, Financial), Nvidia (NVDA, Financial) and Huawei.
It's true that Taiwan Semiconductor has a huge advantage over its competitors thanks to its scale advantage and intangible assets, realized from its leading position in process technology. Newer competitors are typically confined to low-end levels of manufacturing because of the prohibitive costs of building out plants and engineering know-how associated with being on the leading-edge in the technology industry. Smaller foundries often have to build facilities first and then wait for orders that Taiwan Semiconductor cannot fill.
Over the years, Taiwan Semiconductor has helped numerous companies and can be easily adapted to different customers' needs, such as with Apple in mobile chips, Nvidia in graphics processors and Xilinx in reprogrammable chips. This flexibility helps to justify investments in the advancement of its manufacturing processes, keeping it ahead of the competition.
However, the industry is known for its cyclical nature, and foundries can tend to over-invest in capacity during periods of high demand, which can lead to underutilization and profitability issues during downturns in the market.
Taiwan Semiconductor will remain a market leader
That said, the company has crushed it for over a decade and continued to do so in 2022. Revenue rose 5% quarter-over-quarter, driven by strong demand for its leading 5-nanometer technologies. These technologies now make up 28% of total sales, a significant increase from 21% in the previous quarter and 18% in the same quarter last year. This trend bodes well for future earnings, as advanced technologies often carry higher profit margins. In fact, technologies 7 nanometers and below now make up 54% of the company's total revenue, compared to 52% in the same period the previous year.
More importantly, 3-nanometer technology is coming to market down the line as well, which is why Taiwan Semiconductor will remain the leader in the industry.
Not Buffett's usual style
Taiwan Semiconductor's market leadership is a huge advantage, but that also means having to keep up this level of investment in innovation. That’s why I believe it is so peculiar that Buffett would make it one of Berkshire’s largest holdings. It requires a lot of spending to stay competitive, and Buffett has said in the past that he dislikes capital-intensive businesses. As business costs rise, which they will, those costs could grow faster than innovation.
Taiwan Semiconductor can be the leader in the market and still trade flat to down over the next five to 10 years. To see this possibility, we just have to look at Intel (INTC, Financial), which was previously the world’s leading chip maker based on revenue for decades, but trades at the same market capitalization it did in 1998 with a bunch of choppy price fluctuations in between. Economic moats dry up or become inconsequential easily in the technology industry, and I think we can't ignore that possibility with Taiwan Semiconductor.
Slowing growth outlook
While the company's underlying performance is expected to remain strong, the global economy faces challenges in the coming year, with some of the world’s leading experts predicting a recession. However, even if the recession never comes into fruition or turns out to be rather mild, the market for smartphones is completely saturated at this point. Smartphones and high performance computing make up 80% of Taiwan Semiconductor's revenue, and while artificial intelligence will drive the next decade and beyond of chip making, five out of every eight people on the planet have a smart phone.
While this means growth will be slower going forward, one positive is people will still want to buy the newest smartphone models. One part of me finds the fast technology cycle completely gross and unsustainable, while another side sees the value from an innovation perspective. First world cultures love new stuff and as long as they have the money to pay for that new stuff, they will. The issue comes in when the money isn’t enough to afford technology. Apple is already bumping up the prices on its phones and users can definitely hold onto their phone for an extra year or two without issues, just as they’ve been doing with computers and tablets. If this happens, spending by Taiwan Semiconductor's partners will slow down considerably.
Still not worth the price tag
With all this in mind, I believe Taiwan Semiconductor is overvalued. It trades at 14 times earnings and is expected to grow earnings to $8 a share or more by 2027. Higher interest rates will mean lower price multiples across the board for stocks, and I don't see inflation waning anytime soon. So, even with the same price-earnings ratio and assuming earnings coming in at estimates, the share price could hypothetically rise from $80 to $112. Some investors may be alright with that performance, especially if it's a long recession, but I don't think it makes a strong bull case.
