Refrigerators. Sofas. Toys.
Consumers across the globe continue to be frustrated by shortages of all types of goods, the result of kinks in the supply chain, clogged shipping ports, and a global semiconductor shortage. These shortages have contributed to a spike in inflation of more than 5% in the 12 months ended Sept. 30.
Yet Dhananjay Phadnis, a Fidelity portfolio manager who focuses on Asian equities, is seeing signs that shortages are beginning to ease. In this excerpt from his recent interview for Morningstar's The Long View podcast, he discussed what he's seeing on the ground, as well as his outlook for an industry at the center of the supply-chain woes and shortages--semiconductors.
Christine Benz: We wanted to switch over and talk a little bit about supply chains and inflation. We're continuing to hear about snarled supply chains, especially in Asia. What are you seeing and hearing from the companies that you follow yourself, or from your analysts who cover them, on your behalf?
Phadnis: Supply chains have been an extremely topical issue. We're still seeing significant dislocation in supply chains across the region and across the world. If you think about some of the biggest manufacturing hubs in Asia, we've gone through a few lockdowns, countries like Vietnam, and even in most of the manufacturing parts around Asia, we are seeing some dislocation there, and that's leading to very tightened supply chains. But also, what happens when you see a potential for supply chain disruption is an extremely strong inventory-rebuild cycle. So, if you're using a certain commodity or using a certain product in your supply chain, there is a tendency to build buffer stocks and safety stocks. Having said that, what we are noticing more recently is that some of these shortages are beginning to ease off. So, you can see already in some of the semiconductor industries, maybe even in the auto supply chain, toward the end of the year, we could potentially see easing in some of the tightness we've been seeing so far. Another sector is container shipping, which is again, showing signs of easing so far in terms of supply chain pressure. So, I would say supply chain pressure still exists, depending on how we get out of the lockdowns in some of the key manufacturing hubs. But I see signs that some of those supply chain issues are being resolved, and inventory in the system is reasonably high. And to that extent, the unwind also can be quite meaningful.
Jeff Ptak: A related issue is inflation. Do you think we've shifted into a different regime that will see higher inflation? Or do you see the recent uptick in prices, some of those being supply chain related, as something that will recede over time?
Phadnis: This is again hard to call. As a bottom-up stock-picker, I spend pretty much most of my time looking at stocks and understanding how some of these things going on can affect my companies in terms of earnings. And inflation is an important variable. It's just really hard to call. What we are seeing in terms of inflation--more recently, we've seen a big surge in commodity prices, which is beginning to feed through in the cost structure of some of these companies. And the analysis I tried to focus on is which of my companies have strong pricing power to be able to pass that on and which of these companies could go through cost and margin pressure.
So, supply chain disruption will have a somewhat of an inflationary impact. The key question in my mind is how much of that is permanent and how much of that is transitory. And again, which of my companies are able to pass on and absorb some of these pressures and which of them cannot absorb these pressures? It's a hard one to call. But we're really approaching this on a stock-by-stock basis and understanding where earnings could be impacted.
Benz: I wanted to talk a little bit about the semiconductor space. Can you talk about how your view of what is a fair price to pay for a company in that space has evolved and explain why, because it was pretty routine in the past to pay a lower multiple, mid-teens multiple, to own the shares of even the best firms in that space five or 10 years ago, but they were recently trading for around double that.
Phadnis: I think the semiconductor space particularly has gone through quite a bit of evolution in terms of market structure over the years. So, you look at the business like foundry, where given the changes that Intel has gone through, you're pretty much left with two leading players in Taiwan Semiconductor Manufacturing and Samsung. And even if you look at the memory space, you will see that from being six or seven players maybe a decade ago, we are now down to essentially three companies, which is Samsung, Hynix, and Micron. And when you get a more reasonable market structure, you actually reduce some of the cycles or some of the cyclicality in the business. So, historically, we would see a lot of capacity being added, a huge dive in prices. And then, you need a couple of players to go bankrupt before the cycle comes back again. But now, when you have a market structure--and there is a moat around this market structure given the huge amount of money and capital expenditure required for any company to go back into these businesses. And I would say that's been the biggest change where it's a much more rational market, investment cycles are much more rational, capital allocation is reasonable. And to that extent, you will probably see less volatility in cycles; there will be cycles, but these just will be less volatile as we go forward.
The other thing that's kind of changed is that we're still seeing strong demand for advanced nodes and memory. That outlook seems to be quite strong and that's somewhat reflected in the valuation multiple that you referenced, Christine. One of the things though I would call out is that to our initial discussion around supply chains, like I mentioned, supply chains are beginning to ease somewhat. There's a lot of inventory which has been built up at some parts of the supply chain. So, as this inventory unwinds and as supply chains normalize, there is potential for the semiconductor sector to go through a lower growth patch in the coming quarters, and investors should probably watch out for that. But I think if you are a long-term investor like me with a three- to five-year horizon, you will sort of see the benefits of the change in the industry dynamics as well as the long-term outlook for growth. And I think some of these stocks in the sector would still look quite compelling on a long-term view.