Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark Lamonica: So, Shani, we've talked before about how somebody said that I sounded like Kermit the Frog. Well, we got a new one today. I got an email, and somebody said that I sounded like Fozzie the Bear and not Kermit the Frog.

Jayamanne: I don't know who that is or what that is.

Lamonica: Okay. Well, he is a bear.

Jayamanne: Okay.

Lamonica: He is best friends with Kermit. So, he's also on the Muppets.

Jayamanne: Right. Okay.

Lamonica: Yeah. And so, I think the issue is that he has a self-esteemed problem. So, he is a comedian, so he tries to be a comedian.

Jayamanne: Is this a kids show? This sounds really sad.

Lamonica: Life is sad. You have to prepare children for them. But yes, it is a kids show.

Jayamanne: Okay.

Lamonica: So, Fozzie and Kermit are best friends, and Fozzie is a comedian, but he is terrible at it. He is not really funny, and he has low self-esteem.

Jayamanne: I mean, do you think it sounds like he was in vocally or just like your personality…?

Lamonica: I don't know. I don't know. But now, I am sad like Fozzie the Bear.

Jayamanne: So, what did you say to this?

Lamonica: Well, I wrote back that I don't know all the redeeming qualities of both characters. But Kermit, kind of—I don't know if he got the girl, but he has a woman pursuing him.

Jayamanne: Okay.

Lamonica: Miss piggy. Do you really not know anything about The Muppets?

Jayamanne: I know—I've heard of these characters. I've never seen it.

Lamonica: Okay. Well, Miss Piggy pursues Kermit, and Kermit always rejects her. But I was just saying that that must be nice at least, it must be validating that somebody want you unlike Fozzie the Bear.

Jayamanne: He has nobody pursuing him.

Lamonica: He has nobody pursuing him and he is just sort of pursuing Kermit.

Jayamanne: Okay. All right. I feel like we've gone into tangent. Should we get on with the episode?

Lamonica: Yeah. Well, today, we're doing another installment of one of our most popular series on Investing Compass, and that's not Shani and Mark talk about Muppets, but it is Shani and Mark talk…

Jayamanne: Are Muppets.

Lamonica: Are Muppets?

Jayamanne: Yeah.

Lamonica: Yeah, exactly. Exactly. Shani and Mark—so two Muppets talk about popular funds or ETF holdings and then, of course, what are analysts think of the top holdings in those funds or ETF's.

Jayamanne: And we normally look at ETFs that have star fund managers or funds that have been in the news. Today, we're looking at ETFs that are taking big bets. We're looking at ETFs that have a large percentage of the fund in their top holding or top few holdings.

Lamonica: And the first ETF we're looking at today is an active ETF, which means that there is a fund manager who is determined which stocks go into this fund, and of course, thinks they are promising prospects and have decided, of course, to take an outsized position in this particular company. And then, the second ETF we're looking at is a passive ETF. So, it follows an index, but it also has an outsized position in its top holding. So, regardless of whether this has been purposely chosen by somebody or it's just an index, investors of course have an outsized exposure to one position.

Jayamanne: And once I've explored these choices, we'll weigh up what our equity analysts think about the holding. And a little spoiler here is that both stocks that we're going to talk about today are looking like opportunities. So, let's get started.

Lamonica: Okay. So, the first high-conviction ETF we're looking at is the Fidelity Global Emerging Markets ETF, with the ticker symbol of FEMX. So, FEMX invests in a portfolio of 30 to 50 emerging market securities. The portfolio is designed to generate returns through market cycles and each holding is intended to have a demonstrated track record of strong corporate governance.

Jayamanne: And the fund has decent outperformance since inception in 2018, which is not what we'd call a long track record. It has generated a 5.28% excess return over its benchmark, the MSCI Emerging Markets Index. It's unconstrained by sector, region or country, except for what they determine are frontier markets, where a maximum of 20% of the fund is permitted.

Lamonica: Yeah. And frontier markets are type of developing country that is considered riskier than an emerging market country. So, they're either too small, they have some sort of high risk, or the markets are too illiquid to be classified as an emerging market.

Jayamanne: So, for a fund that invests in risky assets, it's just narrowing that spectrum a little on the risk by limiting investment in frontier markets. The fund aims to have between 30 to 50 stocks, but they do have restrictions on how big a bet they can take on stocks as an initial position, and that's a max of 8%.

Lamonica: And that's of course interesting because the current top holding sits at 7.7% of the ETF. And we'll come back to this in a second. So, when we start to look at how the fund is invested by geography relative to the benchmark, the fund has taken larger bets in India, Hong Kong and Taiwan, and then smaller bets in China and South Korea.

Jayamanne: That's right, Mark. And when we look at industry, FEMX is overweight in IT, financials, consumer discretionary, and industrials compared to the index.

Lamonica: And we've spoken a little bit about the active/passive barometer. But what our research suggests is that emerging markets are somewhere where active funds can add value. So, they have large addressable markets where inefficiencies are more common, meaning there's more of a chance that securities are mispriced, and that can translate into opportunities for investors.

Jayamanne: And before we take a look at the top holdings, let's take a look at the ETF as a whole to provide a bit of context. So, Morningstar currently rates FEMX as neutral. This is because there was an upheaval at the helm of the fund in 2021, including a replacement of the portfolio manager. The emerging market strategy for this fund looks promising, but there does need to be a bit more of a track record for the new portfolio manager to move Morningstar's rating from neutral.

Lamonica: So, that's a little bit of a background on the fund. But we're here to assess what our equity analysts think of their high conviction holding. So, let's start with that top holding we've been referencing, and that is Taiwan Semiconductor, with a ticker symbol TSM and so, listed on the New York Stock Exchange. So, Taiwan Semiconductor was born in Taiwan. And guess what, Shani? I was also born in Taiwan, but I am not listed on the New York Stock Exchange.

Jayamanne: Okay. But if you were listed on the exchange, what would your ticker symbol be?

Lamonica: Well, earlier when we were rehearsing this, Shani joked that my ticker symbol would be OLD. And I asked her if she was going to say that during the actual podcast, and she said, it's too mean. I don't want people to think that I'm too mean to you.

Jayamanne: Okay, but…

Lamonica: Yes. Well, anyway, this is why people are comparing me to Fozzie the Bear, because you've destroyed my self-esteem. Anyway. Taiwan Semiconductor or TSMC is the world's largest dedicated contract chip manufacturer. Unfortunately, there's no media releases or statements from Fidelity explaining why they are heavily invested in TSMC, but let's have a look at what they do and what our analysts think of it as an opportunity.

Jayamanne: Okay. After that very embarrassing recount let's start with what they do. They make integrated circuits for their customers based on their customers' intellectual property. And basically, what an integrated circuit is, is a set of electronic circuits on a small flat piece of semiconductor material, and it's stuffed into a tiny chip. And they're basically just those black chips that you find on basically any circuit board.

Lamonica: Yeah. So, Taiwan Semi makes these integrated circuits based on their customers' designs as Shani mention, but this hasn't always been the case. Many firms used to make the integrated circuits in-house, but now many profitable firms operate on what is called a fabless design, and fabless designs are simply just the customers that outsource the production, outsource it to companies like Taiwan Semi.

Jayamanne: And Taiwan Semi has done pretty well benefiting from the transition from the integrated business model to the fabless designer model, and they assume the cost and capital expenditures of running factories in a highly cyclical market for its customers.

Lamonica: And these markets are cyclical because you tend to add excess capacity during times where there's an increase in demand and this capacity is often underutilized during downturns, and that can of course hamper profitability.

Jayamanne: So, the fabless design model works well for this, and it has maintained the growth of foundries which has in turn encouraged increased competition. But a good point to note about Taiwan Semi is that they've been in the game for a while. They have bright minds. They have established processes. And they have the capital base to ensure that they always have the leading-edge technology. A lot of new entrants can't compete because of these prohibitive costs and a lack of engineering know-how.

Lamonica: All right. So, that's a little bit of background on the business, but we're of course going to look to the future and where we see opportunities for TSMC. We've been speaking about the evolution of this industry to outsourcing semiconductor production. And really, it's been survival of the fittest. There's been consolidation of semiconductor firms, and that will create demand for integrated systems made with the most advanced nodes, and that's what Taiwan Semi can provide.

Jayamanne: For example, NVIDIA is a major customer, and they're looking to acquire Arm to consolidate intellectual property and bolster high-end offerings in data centers and AI. Then, a second long-term growth factor is the organic growth of AI and high-performance computing. AI and high-performance computing play a central role in quickly processing human and machine inputs to solve complex problems like autonomous driving and language processing.

Lamonica: And we see demand for that increasing in the future. So, let's look to the economic moat. We believe that TSMC has a wide moat and that it stems from cost advantage and intangible assets.

Jayamanne: TSMC gets its cost advantage from being able to correctly and consistently prioritize the right areas. They're able to do this through experience, and it means they create really high-quality products that justify higher prices than its competitors. And because of this, we think that its position at the top of the pile means that they can attract and retain more customers, they have more stable utilization of the production capacities, and this means that they can lower production costs, and they can generate a higher return than competitors because of the resulting cost advantage.

Lamonica: And what that leads to is profit and sufficient enough profit to bolster up R&D programs that creates this virtuous cycle that keeps them at the top of the pack.

Jayamanne: And when we look at competitors, there were six companies with cutting-edge nodes in 2015. But because of technical hurdles, advancement has been more costly, and this means that a lot of these firms have divested from these endeavors. And that leaves two major players—Taiwan Semi and Samsung. There are definitely smaller players that compete, but ultimately, they're not able to replicate the breadth of offering, quality and cutting-edge technology of TSMC.

Lamonica: So, they've got very stable market share as well strong historical and projected returns on invested capital and superior margins, and all of that, Shani, are indications of a wide moat.

Jayamanne: All right. So, let's touch briefly on risk before we move to fair value and what our analysts think Taiwan Semi is worth. We mentioned before that the semiconductor industry is cyclical. TSMC can't always raise prices during shortages but have to deal with high fixed costs in all downturns.

Lamonica: But they dealt with this comparatively well. When we look at earnings, they've been less volatile than peers, and there have been no earnings per share declines larger than 20% in the past 10 years. This is the likely scenario going forward as well, because they've dominant shared high-end products, and they are their customers preference and a lot of times their sole foundry.

Jayamanne: And as great as this is, it's also a risk. TSMC has client concentration risk with the largest customer contributing 26% of revenue in 2021, and the top four clients about 50%. That large customer was Apple, and they have been their largest customer for the last five years. There are few other risks that are worth mentioning and just brushing over. So, there's political risk, currency risk and pushback from locals as expansion requires more land, more electricity, more water. But our analysts believe they are all manageable risks that are unlikely to impact TSMC.

Lamonica: All right. So, let's get to what we think TSMC is worth. Our base case fair value for TSMC is USD$166. And as of the 7th of October, it is trading at a discount of 56%, which makes it a 5-Star stock. With a wide moat we think this is an attractive opportunity, and we certainly understand why Fidelity has conviction in the future prospects of Taiwan Semi.

Jayamanne: Okay. So, let's speak about our second high-conviction opportunity. Mark, do you want to let us know what our next ETF is?

Lamonica: Yes, I do want to let us know. If I don't, the episode will just grind to a halt, right, Shani? And we don't want that. So, our next ETF is the VanEck Australian Property ETF with the ticker symbol MVA. VanEck says that MVA aims to give investors exposure to a diversified portfolio of ASX-listed securities, and the aim is to provide investment returns before fees and other costs that closely follow the index.

Jayamanne: And the index in this case is the MVIS, Australia A-REITs Index, and it's designed to capture the performance of the property sector of the Australian economy. The index tracks the performance of the largest and most liquid ASX-listed real estate investment trusts, or A-REITs.

Lamonica: Okay. So, is this rated by our analysts, Shani?

Jayamanne: It is. So, our analysts have given it a Bronze medalist rating. So, funds and ETFs are rated on a scale of negative, neutral, bronze, silver and gold. So, it isn't a stellar rating, but it's still positive.

Lamonica: And these ratings are based on how likely our analysts think that the fund or ETF can outperform their benchmark on a risk-adjusted basis over the medium term. So, in summary, our analysts like it and think it's a good choice for diversified exposure to Australian REITs.

Jayamanne: And this ETF is extremely concentrated. It has 18 holdings and the top 10 make up 81% of the fund. The top holding is Mirvac Group with the ticker symbol MGR.

Lamonica: And MGR is structured a little differently to most shares. It trades as a stapled security. And what that means is that it contains two or more different securities that are legally bound, so they can't be sold separately. In the case of Mirvac, it contains one share in the corporation, that is Mirvac, and then one unit in the Mirvac Property Trust.

Jayamanne: And about 80% of earnings come from a passive commercial property portfolio housed within Mirvac Property Trust. Earnings from the rent collecting business are usually pretty stable and predictable while most of the remainder comes from a residential development business that can be lucrative but is a bit more cyclical. Mirvac's REIT status results in low company tax because trusts pass income and tax liabilities through to the end investor. Mirvac pays slightly more tax than some passive real estate investment trusts because of the development business within the Mirvac Corporation.

Lamonica: Let's speak about the 80% of earnings coming from the passive commercial property portfolio. It's underpinned by long leases to solid tenants, bestowing some earnings predictability. But in other parts of the market, there's risks. Inbound immigration is a major driver of new household formation, and we all know what's happened to immigration during COVID.

Jayamanne: And although borders have reopened, it hasn't really recovered. We've seen lots of different ways that the government and businesses are trying to attract new talent from overseas. But ultimately, the major driver of population growth is job creation, which needs to speed up to reduce risk.

Lamonica: And to accommodate for this slow growth, Mirvac is gradually reweighting its business in several ways. It's allocating most of its capital towards passive rent collecting. It's allocating more to industrial and mixed-use commercial, trimming retail exposure and refocusing its retail portfolio on urban areas.

Jayamanne: All right. So, let's look at their economic moat. Simply, they don't have one either for their residential business or the commercial property portfolio.

Lamonica: And when we look at their competitors in residential development, there are so many, and they're all varied in their business models, competing at different levels of the production process from site acquisition to architecture to design, engineering and construction. Mirvac are particularly competent on executing the planning, construction and sale side, and that means that they're a cut above many of their rivals. It also helps that they've scale strong brand, a good track record and a reputation for higher-quality buildings and a large land bank.

Jayamanne: And these trends do tend to help maintain margin, and it has definitely helped that they have so far been able to avoid disasters like some of their major competitors, like buildings with flammable cladding. Unfortunately, though, it isn't enough to award a moat as ultimately there are too many competitors that specialize in each area of the housing development process, both domestically and globally, to be able to maintain a sustainable competitive advantage.

Lamonica: Yeah. It's good that the only qualification for a moat isn't building something…

Jayamanne: With flammable cladding.

Lamonica: Yeah, exactly. But anyway. I don't know much about construction. But that seems like a no brainer, right? Okay. So, we do think that Mirvac can endure the occasional deep downturn in the development industry, where some competitors may disappear, but we just don't think they have enough advantages to generate excess returns beyond a decade, and that's the minimum hurdle required for us to consider a business to have a moat.

Jayamanne: All right. Do you think there's anything else that's worth mentioning in this talk?

Lamonica: Yeah, Shani, the only thing we haven't really spoken about is REITs on Investing Compass, and we should probably put that on your schedule for an episode for the future. But we have talked about LICs or Listed Investment Companies. These are obviously structures where you're holding assets inside a trust and you're purchasing the trust.

Jayamanne: That's right, Mark. And so, we have this situation again, like with LICs, where we have an NTA, or net tangible assets, where we're looking at what the assets are within the trust and then looking to see whether the units are trading above or below that net tangible asset value.

Lamonica: Okay. So, let's try and make this a little more understandable with an example. So, let's say, you have two houses within a trust. These two houses are both valued at about $1 million each. That would mean that the NTA is $2 million. But that doesn't necessarily mean that the trust has to trade at $2 million. Trust could trade at $1.9 million or $2.1 million or any value above or below that.

Jayamanne: And so, when we look at Mirvac, their NTA would place the stock at $2.79. But this isn't what we think Mirvac is worth. So, let's speak a little bit about fair value.

Lamonica: Yeah, we believe that the fair value for Mirvac is $3.10. So, that's obviously different to $2.79. But our analysts believe that the fair value is worth more than the NTA because of the brand name of Mirvac and the intangible assets. The main challenges that we see for Mirvac in 2023 and 2024 is what you would think—it's interest rates and in turn declining dwelling prices. However, Mirvac has a large number of sales contracts already signed, so the residential division is well-positioned for the moment. And we spoke about that for it to continue this way immigration will be needed to sustain these numbers and contracts.

Jayamanne: So, as it stands, MGR is trading at a 36% discount to fair value at $1.99, and this is at the 7th of October. Although it's not an active decision to hold MGR in the VanEck Australian Property Trust, it is an attractive opportunity that is undervalued according to our analysts.

Lamonica: Okay, we made it. We talked about two Muppets and two ETF's.

Jayamanne: Two Muppets talked about ETFs.

Lamonica: And then, two Muppets talked about ETFs. So, yes, we did everything we set out to do. So, thank you guys very much for joining us. We really appreciate any podcast comments and ratings. And once again, thank you very much for supporting our sponsor.