(Bloomberg Opinion) -- From sanctions to export restrictions, the rest of the world views China’s chip champions like Huawei Technologies Co. and ZTE Corp. with suspicion and skepticism. But inside the country, all investors see is a $300 billion-a-year golden opportunity. One could almost say that the Chinese have a chip on the shoulder by rewarding semiconductor startups with such a vengeance.
Companies that have anything to do with the industry are among the year’s best performers. Of the 44 names classified as semiconductor stocks by the widely followed local index provider SWS Research, the average gain is a whopping 170%. They command $128 billion of market cap, backed by only $15.5 billion of annual sales.
Brokers have been busy selling clients on the notion of import substitution. Last year, China imported $312 billion worth of integrated circuits, surpassing $300 billion for the first time. They’re the largest import category, accounting for 15% of the total pie and topping crude oil for the fourth consecutive year.So, the thinking goes, if the U.S. and its allies restrict chip component sales, big clients such as Huawei, which makes smartphones and 5G network equipment, will have no choice but to turn to domestic suppliers. Pile in now and wait for Donald Trump and trade nationalism to do the rest.
At the same time, pricing power is gradually shifting back to chipmakers. Pinched by the U.S.-China trade war and the global economic slowdown that has ensued partly because of it, movers and shakers in the chip world have cut back their capital expenses. As a result, prices of memory chips have stabilized recently.
We may start to see a price rebound in DRAM memory chips used in computer servers in early 2020, according to HSBC Holdings Plc. On Wednesday in the U.S., Micron Technology Inc. gave a strong sales forecast for the December quarter and told investors the worst of a slump in the memory chip industry is over. This seems like a global consensus. Share prices of South Korea’s Samsung Electronics Co. and SK Hynix Inc., for instance, soared lately. The Philadelphia Stock Exchange Semiconductor Index reached a record high. Seen in this context, perhaps Chinese chips’ melt-up isn’t all that extraordinary.
There’s a big problem with this investment thesis, however. The $300 billion-a-year import substitution argument is essentially a bet on the total addressable market, a favorite phrase used in consulting firms’ case interviews. But when was the last time a Chinese company managed to capture a good portion of its market?The furthest China’s industrial sector has gotten toward an oligopoly is with its air-conditioner makers, and even these players — Midea Group Co. and Gree Electric Appliances Inc. of Zhuhai — don’t skip a beat in luring each other’s customers away. It’s rare in China when a few big companies dominate. Wherever there’s a golden nest, thousands enter and erode away any pricing power. So, what really is the quality of the stocks for investors if all they see are big sales numbers, but tiny profit margins?
With Beijing actively promoting its nascent startups with state funds, it’s just a matter of time before China Inc. ruins the healthy supply and demand dynamics, not unlike what it did to the solar industry. Three-year-old Yangtze Memory Technologies Co., managed by the business arm of the prestigious Tsinghua University, President Xi Jinping’s alma mater, is only half a generation behind the global NAND flash memory leaders. Meanwhile, every business entity, including local government financing vehicles, is edging into chip making because it’s close to Xi’s heart and therefore to state-owned bank vaults.
China is a huge market, with billions of dollars of opportunities opening up every year. But it’s also a place defined by its profitless prosperity, with companies battling like gladiators to their own demise. Investing based on the size of the overall arena completely misses that bloody reality.
(Adds Micron’s sales forecast in the sixth paragraph.)
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Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. She previously wrote on markets for Barron's, following a career as an investment banker, and is a CFA charterholder.
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